Winds of Change
Canadian economic growth continues to be disappointing due to the serious economic declines in Alberta and Saskatchewan. While seen as our country’s economic leader, Ontario’s economy has not been built on a stable foundation as much of this growth has been fueled by profligate government spending. To put Ontario’s debt levels into perspective, compared to California, which is the highest debt state in the U.S., the province of Ontario has twice the debt level, yet one third of the population. This places Ontario as the dubious leader in debt of any sub-sovereign borrower in the world! While the debt levels are currently serviceable, they would become a significant issue when interest rates begin to normalize.
There is better news from our southern neighbour, the United States as it is showing increasing signs of a recovery from the meltdown of 2008. The U.S. is our largest trading partner and has the largest economic impact on the Canadian economy.
U.S. household balance sheets are in improved shape compared to 2008. Debt servicing costs, which include mortgages and credit card debt, are at a record low using data going back to 1980. Mortgage debt costs have been reduced to approximately 4% by refinancing and terms that have been lengthened. U.S. businesses have continued to hoard cash since 2007. Cash flow required to service debt is well below average and 75% of debt has been lengthened in term and locked in at low rates.
The U.S. financial system whose collapse caused the Great Recession has been revamped by regulation to be much less exposed to risk. Capital ratios and liquidity have been improved and risk avoidance emphasized. U.S. job growth has shown a steady rise since 2009 and unemployment has fallen to levels that have encouraged workers who had left the job market to return. Wage growth is accelerating and unfilled positions continue to expand.
One major source of future growth is U.S. housing. New home sales in the U.S. peaked in 2006 at 1.3 million units and bottomed in 2011 at 300,000 units. While recent sales have reached 600,000 per year, we believe that these levels will improve to better match family formation and population growth. The current challenge is that the housing industry is suffering from a lack of skilled labour, but as wages increase this hurdle will eventually be overcome. The good news is that new home construction and re-sales have a multiplier effect on the economy. Both require the manufacturing of a wide range of products from roofing to stoves, which provide a broad boost to economic growth. All in all, economic growth in the U.S. may reach levels closer to 3% in the second half of 2016 and early 2017.
While there is uncertainty surrounding the upcoming U.S. election, what has been conveyed by the public is that they find the sub-par economic growth over the past 8 years unacceptable and that new policies are desperately needed. While Quantitative Easing and low interest rates did stabilize the financial system after the credit crisis,the current monetary policy of 0% interest rates is not effective.The root problem is that it transfers wealth from savers to the primary source of borrowers – governments. A low interest rate environment reduces investment and spending by the public and therefore reduces economic activity and growth.
Whatever the outcome of the election, there should be a marked economic improvement under either candidate as both favour increased spending in “good debt” projects such as infrastructure (roads, bridges, water and sewage, electrical grid, etc.) which are desperately needed in the U.S.. This may also be a positive for many Canadian businesses and families as Canada’s Keystone energy pipeline project may finally be approved after it has been stonewalled for almost 8 years by the current U.S. administration. Infrastructure like pipelines are the best way to transport oil and natural gas, as these are significantly safer for the environment and the public than rail.
For Canada, the recovery of the oil industry may be a key element in returning to more normal economic growth. Since the oil price drop, global energy capital expenditures and thus drilling and exploration for oil have also dropped significantly. While inventories are still high, they are declining. U.S. oil production has dropped from 9.2 million to 8.5 million barrels a day. Around the world, natural decline rates and a lack of new wells will reduce future production as world consumption continues to grow. Oil markets are moving towards a balance between demand and supply. However in the $50 to $60 range the U.S. shale producers will experience good profit margins and new supply will come onto the market. While we expect Canadian producers to be able to implement cost reductions forced by recent low prices, the significant carbon tax imposed by our Federal government will provide an additional economic drag for these companies and the provinces of Alberta and Saskatchewan. The Canadian dollar is likely to remain weak, if not weaker, against the U.S.dollar particularly with the expected U.S. Federal Reserve rate increase.This is a definite positive for the Canadian manufacturing sector and will help other industries as well.
While financial markets have performed very well since the Great Recession in 2008, looking ahead we can see challenges to the returns of many asset classes. With interest rates beginning to bottom around the world, any material rate increase would place stress on financial assets such as bonds and stocks as well as on many governments to service their debts. In equities, we continue to emphasize exposure to securities that display lower volatility than the overall market. We especially see risks in mid and long-term bonds, as when interest rates begin to rise, the value of these investments will fall. Thus, we are placing significant emphasis on taking advantage of opportunities in alternative asset classes through the investment with institutional-quality asset managers in areas such as direct
lending, hedge funds, private equity and real estate.