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Monthly Economic Letter

January 2020
Feature article

What could cause Canada’s next recession?

First, an important disclaimer: We’re not expecting Canada to enter a recession anytime soon. On the contrary, Canada’s economy should do slightly better in 2020 than it did in 2019.

We believe increases in residential investment, more investments in the oil and gas sector and the resolution of trade disputes will drive growth this year. That said, there are risks on the horizon. This article looks at three of the more important risks we are keeping our eye on.

Recessions don’t just happen

Quick reminder: Recessions are said to occur after at least two quarters of negative GDP growth. The graph below plots Canada’s real GDP growth since the early 1980s. As shown, there have been four recessions in Canada since 1981. Each one was triggered by a particular set of circumstances and events.

Specifically, high interest rates plunged the economy into recession in the early 80s. In the 90s, a recession in the U.S., restrictive monetary policy and increases in taxes, triggered a recession on this side of the border. Canada’s two most recent recessions were caused by the sub-prime mortgage crisis and the collapse in crude oil prices in 2015. The point is that recessions don’t just happen, they need a trigger.

The following sections describe potential triggers and risks we are keeping an eye on.

Household debt

Household debt levels are at historic highs in Canada. The figure below shows how Canada’s debt to income ratio has grown since 2012.

High debt payments mean households have less money to spend on other things and represents a risk should higher interest rates or unemployment force households to cut spending further.

Let’s take a closer look at this risk, turning our attention first to interest rates. With inflation under control (core inflation is hovering around 2%) and the economy doing moderately well, we don’t expect much, if any, movement in the Bank of Canada’s policy rate in 2020.

Further, the job market in most of the country is strong with 35,000 new jobs created in December and 320,000 added during all of 2019. We see no reason to expect a downturn in employment in the near future.

Provided that interest rates don’t increase materially, and the job market doesn’t turn for the worse, we feel the risk from household debt is currently under control.

The future of Canada’s oil and gas sector

Oil prices remain significantly below levels seen in 2014 and earlier. Recently, a leak in the Keystone pipeline and a CN Rail strike kept the price of Canadian crude low.

In the long run, headwinds from lacklustre global oil demand growth, higher U.S. shale oil production and the transition to a low carbon economy are also likely to hurt oil prices. A dowturn in prices because of a fall in global oil demand or a delay in completion or cancellation of a new pipeline would obviously have a significant negative impact—especially in Western Canada.

However, it’s important to note that the oil and gas sector’s contribution to Canada’s economy is significantly lower than in the past. For example, capital investments in oil and gas in Canada are about 44% of what they were in 2014—right before the last oil-related recession.

The fact the sector is now smaller, would lessen the impact of a downturn, especially in regions outside of Canada’s oil producing heartland, making it less likely an oil-related downturn would trigger a Canada-wide recession.

External shock

Canada is an open economy so the trigger of our next recession could come from abroad. A recession in the U.S. would quickly have an impact in Canada. So, let’s take a quick look at the state of the U.S. economy.

U.S. economic fundamentals remain strong. Job growth over the last 36 months has resulted in an unemployment rate at a historic low of 3.5%. Further, inflation is under control and consumer spending shows no sign of letting up. The risk from an all-out trade war was mitigated recently by the Phase 1 deal with China. Stock market valuations are high, but price-to-earnings ratios and house price indexes are at reasonable levels compared to historic highs.

The consensus view of economists is for the U.S. economy to generate another solid year with GDP growth of around 2%. (See the US tab of this letter for a more comprehensive assessment).

These factors make it unlikely that issues in the U.S. economy will trigger a recession in Canada.

Bottom line

We’ve looked at three potential triggers of Canada’s next recession: Household debt, a downturn in the oil and gas sector and an external shock from the U.S. The evidence suggests they are unlikely to trigger a recession soon.

Canadian economy at a glance

Canada’s economy likely slows, but job numbers reassure

Canada’s economy slowed during the last quarter of 2019 as consumption and the housing market lost momentum.

In October, GDP growth turned slightly negative and thousands of jobs were lost in November. However, employment bounced back by a reassuring 35,000 in December and our outlook for 2020 remains positive. We expect the economy to produce modest but solid growth during the year.

Temporary factors slowed the economy at the end of 2019

Canada’s real GDP fell by 0.1% in October, which signalled slower growth for the end of 2019. Employment, housing starts, manufacturing and retail sales were all weak.

However, some factors driving the slowdown were temporary, including strikes affecting General Motors and CN Rail.

Other factors were more unexpected. For example, building activity softened, which surprised most analysts. Housing should regain momentum as underlying demand remains strong amid solid demographic trends, low unemployment and rising household income.

Other sectors of the economy should also support growth in 2020. Exports will continue to be strong as the world economy improves. Business investment should also perform better, supported by more investment in the energy sector. Finally, the federal government will probably introduce new programs and reduce income taxes, which will stimulate the economy.

The job market made very solid gains in 2019

The rebound in the job market in December seems to indicate that November’s poor performance was due to temporary factors in what was a robust year of employment gains. Employment increased by 320,000 jobs, with 283,000 of those being full-time. The unemployment rate is now 5.7% in Canada, the lowest in the last 40 years.

Unemployment remains low in most provinces, with the notable exception of Alberta where the economy slowed down significantly in 2019 due to the troubled oil sector. Ontario (5.3%), Quebec (5.3%) and British Columbia (4.8%), the three largest provinces, have all benefitted from very low unemployment rates (see table 1).

These results are significant, not only because jobs provide opportunities for Canadians, but also because employment levels are one the best indicators of the health of the economy. These numbers show that Canada’s economy continues to perform well, and is actually, growing close to its potential.

Economic growth in Canada will be modest but solid in 2020

Despite the slowdown of the economy at the end of 2019, we believe the Canadian economy will continue to grow in 2020. The good performance of the job market will support consumption and the housing market.

Canadian exports should also continue to perform well because the U.S. economy is enjoying solid growth and the fortunes of the world economy are improving. We also expect stronger government spending to support growth in 2020.

What does it mean for entrepreneurs?

  1. The housing market will perform better in 2020, supporting the construction industry. Lumber manufacturers and building supplies wholesalers should benefit as well.
  2. As the global economy improves, demand for Canadian products and services will be solid in 2020.
  3. Labour shortages will remain an important challenge in many regions.
U.S. economy at a glance

The U.S.-China trade deal will reduce tensions and help the economy

Just before Christmas, the U.S. administration announced two important pieces of news on the trade front.

First, the Trump administration reached an agreement with congressional Democrats to ratify the free trade agreement between the U.S., Canada and Mexico. Although, the three countries had finalized the pact, Democrats in the House of Representatives wanted tougher language on labour standards in Mexico before agreeing to ratify it. That hitch was resolved just before Christmas and the new trade agreement is now ready to be ratified by the three countries.

Second, the administration announced an initial trade deal had been reached with China, avoiding another round of tariffs that had been scheduled to come into effect in December. This agreement doesn’t end the trade dispute between the two countries, but it will reduce tensions, lift some uncertainty and support economic growth.

A new deal with China

Over the last 19 months, the U.S. has imposed tariffs on Chinese imports in an effort to force the country to provide better market access to American businesses. The tariffs have created a high level of uncertainty with many American businesses feeling the effects on their bottom line. As a result, business confidence and investment declined in 2019.

While the U.S. economy performed well over the last two years, the trade dispute limited growth and forced the Federal Reserve to reduce interest rates. It also slowed the growth of the Chinese economy and had a negative impact on economies around the world.

President Donald Trump has characterized the agreement with China as Phase 1 in negotiations between the two countries. Besides halting the new round of tariffs, the deal will also reduce some previously imposed tariffs. In exchange, China has agreed to increase its purchases of American farm and energy products and provide better protections to American companies operating in China.

The deal does not solve the trade dispute but will reduce tensions and lift some uncertainty for American businesses. It not only reduces obstacles to doing business in China, but also opens the door to a larger deal that could eliminate all the tariffs imposed over the last two years.

The U.S. economy continue to create jobs

Meanwhile, the U.S. economy generated solid growth in 2019 and the job market reflected that performance.

The economy created 145,000 jobs in December and 250,000 in November to keep the unemployment rate at 3.5%, the lowest in the last 50 years.

More people are finding jobs and salaries are increasing more rapidly. Indeed, the number of discouraged workers dropped by 98,000 in 2019, which is a very significant sign of health.

These workers have been unemployed for a long period of time and have difficulties returning to the job market. The fact they are now finding jobs is a sign that the employment market is tight, which benefits millions of American by producing higher salaries. It also mean the U.S. economy is running at full capacity.

What does it mean for entrepreneurs?

  1. U.S. demand for Canadian exports will remain strong and continue to provide opportunities for Canadian exporters.
  2. The Canadian dollar should remain at a relatively low value against the greenback providing exporters with an added advantage.
  3. Interest rates in the U.S. will remain low over the next few months, meaning low borrowing costs.
Oil market update

Will oil prices continue to go up in 2020?

Global oil prices have been on the rise since the beginning of December with Brent spot prices going over US$65 per barrel and West Texas Intermediate (WTI) over US$60. However, it would be surprising to see oil prices well above these levels in the long run.

Conflict between Iran and the United States was behind the recent price rally. In retaliation for the killing of General Qassem Soleimani in an American drone attack, Iran launched missile strikes on two U.S. military bases in Iraq.

Following the attacks, oil prices surged. Fortunately, officials from both countries have since issued calming statements, reducing the likelihood of an all-out conflict. Although tensions remain high, markets have been somewhat reassured and prices have reverted to pre-attack levels.

Economic fundamental are likely to keep prices stable

Even before the U.S.-Iran confrontation, prices had been rising due to modest upward pressures from both supply and demand factors.

Positive economic indicators from the U.S. and China reduced worries of an upcoming global economic slowdown. As well, the completion of the U.S.-China Phase 1 trade agreement is improving sentiment about the economy, specifically the prospects for manufacturing and trade—two sectors linked to oil demand.

On the supply side, OPEC and its partners agreed to deepen existing production curtailments by 0.5 million barrels per day (mb/d) with Saudi Arabia voluntarily reducing production by an extra 400,000 barrels per day, bringing the total cut to 2.1 mb/d.

At that meeting on December 6, OPEC+ members did not extend cuts past March 2020, but many analysts expect the group to revise that decision in the coming months.

Although OPEC production is set to decrease, non-OPEC production will more than offset the contraction. This should result in a build-up of inventories in the first half of the year and downward pressure on prices before they rise again in the second part of 2020 when inventories diminish.

The U.S. Energy Information Administration forecasts Brent spot prices to average US$61 per barrel in 2020 and WTI around US$55 per barrel.

WCS discount not shrinking any time soon

The price of a barrel of Western Canadian Select (WCS) went up slightly in December—although the spread with WTI remains high at over US$20 per barrel.

The big discount is attributable to higher Canadian inventories resulting from temporary transportation restrictions. The restrictions resulted from a leak in the Keystone pipeline and a CN Rail strike. As a result, western Canadian oil stocks reached a record-high of 39 million barrels at the end of November.

The discount between WCS and WTI will probably narrow slowly, easing on the completion of the Canadian portion of Enbridge’s Line 3 and a potential increase in exports by rail.

Bottom line

The answer to the question “Will oil prices continue to rise in 2020?” is “probably not.” We do not see oil prices picking up before the second half of the year, once inventories diminish. Canadian producers will likely see some relief at the end of 2020 once the U.S. portion of Enbridge’s Line 3 becomes operational.

Other economic indicators

Bank of Canada and the Fed to remain on the side-line for 2020

The Bank of Canada will likely maintain the status quo on January 24, meaning the overnight interest rate in Canada will stay at 1.75%. The Federal Reserve in the U.S. will likely do the same, at its next meeting on January 28. There have been three rate cuts since the summer in the U.S. while Canada`s policy rate has been stable for more than a year now. Both central banks see improvements in the global economy and inflation that is under control, as reasons to be patient.

The loonie notched slightly higher

The Canadian dollar started to pick up value at the end of 2019. The rise in the loonie can be explained by three factors: Oil prices that improved recently, the U.S. and Canada interest rate gap shrank and a certain level of uncertainty has been lifted following the U.S.-China “phase one” deal. While these factors helped the loonie gain ground, we don’t see them driving further increases in the value of the loonie soon. The dollar should remain relatively stable in the coming months.

Small business confidence ebbed further in December

The confidence of Canada's small and medium-sized business (SME) owners dropped to its lowest level of 2019 in December. The Canadian Federation of Independent Business (CFIB) Business Barometer Index lost less than a full point and stood at 55.5, but this is following a big hit in November. The level of optimism among SMEs has deteriorated in every province except for Ontario and British Columbia. Oil-producing provinces were already the most pessimistic of all and the sentiment deteriorated furthermore. Index values for Alberta and Saskatchewan were below 40. The proportion of owners reporting their business to be in good shape drop to its lowest level since 2016. There is also a greater share of owners believing that the weaker domestic demand is limiting their capacity to increase their production or sales.

Credit conditions are stable

While credit conditions have eased in most parts of the globe, the effective interest rates for businesses and individuals remained stable at about 3.5% and 3.7% respectively. Effective interest rates mostly reflect changes in the central bank’s policy rate which has been stable in Canada for over a year now. Given that the Bank of Canada anticipates a slightly better outlook for the economy in 2020 than in 2019, we expect it to keep its key interest rate at 1.75%. The effective interest rate should also remain stable and credit conditions will likely stay accommodative in 2020.

Key indicators—Canada