Q4 Canadian GDP slump is just the start

Canadian GDP grew at a 0.4% annualized pace in the fourth quarter underperforming consensus of 1% and the Bank of Canada’s’ expectations of 1.3%. For the month of December, GDP growth declined -0.1%, the third decline in four months. There wasn’t much to like in the report. And in fact, the drivers of growth in the fourth quarter, inventories (+1.5%) and net exports (net exports grew however, exports fell while imports fell by more) are much like a backhanded compliment – this is not how one wants an economy to grow. Business investment fell -10.9% and household consumption slowed to +0.7%, the weakest growth rates since 2012, and residential investment fell -14.7% (the steepest drop since 2008). For the first time in almost three decades, the construction sector declined for the seventh consecutive month.

The headline read, “Weaker GDP Than Anyone Expected Shows Canadian Growth Stalling.” Perhaps it should have read, “…Weaker than anyone wanted to acknowledge.” The truth is, the signs were there as we have been pointing out for months now. Auto sales, retail sales, housing, oil prices, interest rate pressure, (see charts below) each have been contributing to our weaker outlook and greater risk of recession in Canada in 2019 than apparently many were expecting. We aren’t yet closing the book on the prospects for the Canadian economy to skate by a recession in 2019. But we do reiterate our odds of recession in 2019 at 50% and the trend doesn’t look promising.

“Denial ain’t just a river in Egypt”

This will no doubt keep the Bank of Canada on the sidelines next week in terms of an interest rate increase. In our view, we expect the BoC to be on hold through 2019. Further, the Bank of Canada will have to take a serious look at their projection for GDP growth of 1.7% for 2019. We are not of the belief that the weaker fourth quarter will rebound sharply in Q1 as Canada faces compound stresses of a weaker consumer, falling housing activity and a weak energy sector.

The read-through for investors is what this is likely to mean for the Canadian dollar. The loonie dropped to US$0.7520 on Friday from just above US$0.76 at close on Thursday. We believe the near-term trend for the Canadian dollar is lower as the correlation between the loonie and the 2-year interest rate spread between Canada and the US re-establishes itself. Over the last month it would appear the Canadian dollar has been driven by oil prices while the relationship to interest rates had broken down. With the reality of the BoC’s rate path – or lack thereof – coming to the forefront, investors may start to price in the likelihood of a wider 2-year spread as the BoC may be more likely to hold, or even cut rates, than the US Federal Reserve.

Based on the historical relationship between the loonie, rates and oil, our fair-value model for the Canadian dollar would suggest a level of US$0.73 should the historical relationships resume. Over the near-term, we would not be surprised to see the CADUSD retest the lows of December. At the beginning of the year we had set a range for the Canadian dollar at US$0.72 -0.76, which we revised modestly higher through January to US$0.735-0.77. That upper bound seems much further away this year unless we see a significant spike in oil prices to above US$75/bbl (which we believe is unlikely). Therefore, we are likely to see the near-term trend to the lower end of the range. And, subject to the US Federal Reserves’ decision on rates, if Powell and company do raise the Federal Funds rate once or twice more, the risk to the CAD may skew to the downside. Investors should take note, the Canadian dollar may have seen its peak for the year.

Chart 1 – The correlation between rates and the CADUSD has broken down. If it resumes, the CAD is headed lower.

This is a line chart showing the three-month correlation between the Canadian dollar and 1) oil and 2) the 2-year interest rate spread between Canada and the United States between January 2016 and March 2019. The Canadian dollar and interest rates are uncorrelated at March 2019, which means that the Canadian dollar could be headed lower. Source: Bloomberg, Manulife Investments as of March 1, 2019.

Chart 2 – The CAD appears overbought relative to our fair value model.

This is a line chart showing the modeled Canadian dollar to U.S. dollar exchange rate versus the actual Canadian dollar to U.S. dollar exchange rate from 2013 to 2019. The model shows the fair value model to be lower than the actual value, suggesting the Canadian dollar may be overbought. Source: Bloomberg, Manulife Investments as of March 1, 2019.

Chart 3 – Auto sales don’t paint a promising picture for the Canadian Consumer

This chart shows Canadian auto sales 12-month totals and year-over-year change in auto sales between 2005 and 2018. The line chart indicates that auto sales are on a downward trajectory between 2017 and 2018, indicating a potentially greater risk of recession in Canada in 2019. Source: Bloomberg, Statistics Canada, Manulife Investments as of December 2018.

Chart 4 – Is the indebtedness of the Canadian consumer finally taking hold?

This line chart shows household debt as a percentage of household income between 1990 and 2018 for Canada and the United States. The debt of Canadian consumers as a proportion of household income continues to rise while the debt to household income of U.S. consumers has fallen since around 2007. Source: Bloomberg, Manulife Investments as of December 2018.

Chart 5 – The rate picture will continue to weigh on consumption.

This line chart shows Canadian debt service ratio in total terms and interest only terms between Q1 1990 and Q2 2018. The debt service ratio continues to climb and the direction of interest rates will continue to affect Canadian consumption. Source: Statistics Canada, Manulife Investments as of September 2018.

Chart 6 – Energy will continue to pose headwinds for the economy.

This is a line chart showing the price for Western Canadian Select oil and Canadian GDP between 2011 and present day. Historical low oil prices are shown to coincide with weaker Canadian year-over-year GDP in 2019 and weak oil prices should continue to be challenging for the Canadian economy. Source: Statistics Canada, Bloomberg, Manulife Investments as of March 2019.

A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates. 

Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.

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Kevin Headland, CIM

Kevin Headland, CIM, 

Co-Chief Investment Strategist

Manulife Investment Management

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Macan Nia, CFA

Macan Nia, CFA, 

Co-Chief Investment Strategist

Manulife Investment Management

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