Contemplating Canada

“Debt and deficits are not inventions of ideology. They are facts of arithmetic.”

– Paul Martin, 21st Prime Minister of Canada

Conclusion:  The economic outlook for Canada is quite favorable, especially vis-à-vis the United States and other developed nations.  As such, we continue have a bullish stance on the Canadian Loonie and Canadian equity markets. 

Keith and I spent the last couple of days visiting subscribers in Western Canada, namely Vancouver and Calgary.  The trip also gave us a chance to revisit and contemplate our thoughts on the economy there.  From an anecdotal perspective, our trip verified one key point -- free market capitalism is alive and well north of the border.

 As we’ve discussed in past notes, there have been a number of inflection points in the Canadian economy that are unique to anything we’ve seen in recent history.

The first point to highlight is unemployment.  As the chart below shows, for the first time in 30 years Canada has a lower unemployment rate than the United States.  In fact, not only does Canada have a lower unemployment rate, but there is a meaningful divergence.  Based on the most recent economic data, Canada’s unemployment rate is 7.6% and has been ticking down consistently for the last 18 months or so.  Conversely, U.S. unemployment is currently at 9.8% and has barely ticked down since the start of the most recent recession.  We view this as a real and noteworthy inflection point in comparing these economies.

Contemplating Canada - d1

In the shorter term, the relative success of the Canadian economy versus the United States, combined with the fact that the Bank of Canada has raised rates 3 times in 2010 while the U.S. Federal Reserve has continue to ease, has led to a strengthening of the Loonie over the past 12-months.  In that time period, the Loonie is up almost 5% versus the U.S. dollar.  

Yesterday, the Bank of Canada highlighted this increase in the value of the Loonie as a risk to the Canadian economy and a reason to keep interest rate increases on hold.  As the value of the Loonie increases versus the U.S. dollar, it inherently increases the costs of Canadian exports to the U.S. and lowers demand for Canadian goods.   Currently, more than 70% of Canadian goods are exported to the U.S and ~57% of exports are in the commodity sectors (energy, forestry, and mining).

Interestingly, the Bank of Canada sounded a little Hedgeye-esque as they highlighted more broad risks to the Canadian financial system yesterday, with a particular focus on interconnected risk.  Specifically, the Bank of Canada notes in their statement:

“Four major interconnected sources of risk emanate from the external macrofinancial environment: (i) sovereign debt concerns in several countries; (ii) financial fragility associated with the weak global economic recovery; (iii) global imbalances; and (iv) the potential for excessive risk-taking behaviour arising from a prolonged period of exceptionally low interest rates in major advanced economies.”

Certainly we understand these risks and also understand that Canada’s close ties to the U.S. economy will continue to be an important factor when evaluating the economic outlook for Canada.  That said, similar to out point on unemployment above, Canada has also recently seen a divergence in growth versus the United States in the last few years.

In the chart below, we’ve highlighted relative GDP growth rates of Canada versus the United State going back to 1980.   In the prior two periods of negative growth (the early 1980s and early 1990s), the Canadian economy contracted more than the U.S. economy.  In this most recent recession, the Canadian economy contracted less and then accelerated to a higher rate of growth post the recession.  In fact, Canada had the lowest real GDP contraction of any member of the G7 from Q2 2008 to Q3 2009.

Contemplating Canada - d2

So, what is causing this divergence and our longer-term bullish stance on Canada?  We would point to three key factors: energy independence, a strong financial system, and the government’s balance sheet.

  1. Energy independence - Amongst the G7, and really most industrialized nations, Canada has probably the best energy position.   It is, obviously, a net exporter, but has also seen its spread of production versus consumption increase over time.  From 1980 to 2007, Canada’s total energy production (mostly natural gas and oil) grew 87%, while its total consumption only increased 44%.  With the inclusion of the vast Canadian oil sands, Canada has the second largest oil reserves after Saudi Arabia.  In an increasingly short energy world, this long energy position will continue to advantage the Canadian economy.
  2. Strong banking system – In contrast to the United States, where many U.S. financial institutions underwrote loans, particularly of the mortgage variety, during the boom year leading up to 2008, the Canadian banks kept lending standards high.  As a result, unlike the major and pervasive bank failures in the U.S. over the past couple of years, there were no comparable bank failures in Canada.  (In fact, Canada’s banking system has proven to be incredibly resilient over time.  The last major bank failure in Canada was in 1923.) Prospectively, we should see this benefit in the stability of Canadian home prices and the quality of loans held on Canadian bank balance sheets.  A good proxy for this is mortgages in arrears, which are running below 1% in Canada compared to +9% in the United States.
  3. Government balance sheet – In the 1990s, Canada was the poster child for poor fiscal management.    When Paul Martin took over as Finance Minister in 1993, the Canadian government was running a deficit of 6.6% of GDP and by the following year debt as percentage of GDP eclipsed 100%.  By implementing massive spending cuts and raising certain taxes, Paul Martin got Canada’s fiscal house in order.

Currently, Canada’s debt-to-GDP is estimated to be 77% by the IMF, which is substantially lower than the U.S. at 98% and well below real problem nations, such as Italy (121%) and Japan (227%).  While Canada is expected to run ~C$50 billion deficit in 2010 – 2011, this is just over 3% of GDP, which pales in comparison to the United States, whose deficit as percentage of GDP will be closer to 10.5% in 2011.  As it stands, Canada should not eclipse the 90% debt-to-GDP ratio, which correlates with slower growth.

While we aren’t quite ready to say this is the Canadian century (except in hockey of course), we are seeing a number of inflection points that point to and highlight some longer term and sustainable advantages north of the border.

Daryl G. Jones

Managing Director