The Coming Economic Downturn In Canada

• Canadian GDP growth has outperformed this year, helping the Canadian dollar
• As GDP growth slows and the Bank of Canada turns neutral, catalysts turning negative
• Crude oil and real estate look set for a downturn, with negative implications for the currency

Given its natural resource-based economy, Canada is a boom and bust kind of place. This year, the country has enjoyed a significant boom. Thanks to a government stimulus program, rising corporate capital expenditures and consumer spending, Canada’s GDP growth has been nothing short of spectacular in 2017. According to Statistics Canada, the latest reading for year-over-year GDP growth is a healthy 3.5% (as of August 2017). While this is stronger than all major developed countries, growth is decelerating from its most recent peak in May 2017 (when GDP growth was an astounding 4.7%). A visual overview of historical GDP growth is shown below for reference:

Turning a corner: Canadian growth comes back down to earth

Source: Statistics Canada

Following the crude oil bust in the second quarter of 2014, Canadian growth rates cratered. While the country avoided a technical recession, the economic outlook was poor until early 2016. After crude oil returned to a bull market in the first quarter of 2016, the fortunes of the country turned. Given limited growth in 2015, the economy had no problem delivering 2%+ year-over-year growth rates in 2016. As a substantial stimulus program ramped up government spending in 2017, growth rates have continued to accelerate this year.

Storm clouds on the horizon: crude oil and real estate

While Canada has delivered exceptional growth in the last two years, the future outlook is much more challenging. Beyond the issue of base effects (mathematically, year-over-year GDP growth will be much tougher next year), key sectors including the oil & gas industry and Canadian real estate look ripe for a downturn.

Crude bull market intact today, but at risk in 2018

As WTI crude strengthens beyond $55, crude oil is clearly in a bull market today. Looking at figures from the International Energy Agency, global demand growth continues to run ahead of supply growth. Thus the ongoing bull market is supported by fundamentals. Thanks to the impact of hurricanes and infrastructure bottlenecks in 2017, US shale hasn’t entirely fulfilled its role as the global ‘swing producer’ this year. The dynamics of supply growth versus demand growth are shown below:

Who invited American shale? US supply ruins the crude oil party

Source: International Energy Agency, forward OPEC supply estimates via US EIA

Unfortunately, the status quo looks set to change as US supply returns with a vengeance. According to estimates from the IEA, supply growth will outstrip demand growth in the first quarter of 2018. Digging deeper into supply estimates, US shale is once again to blame. Our view is that this changing dynamic will lead to a new bear market in crude oil. Looking back at recent history, crude prices formed a long-term top in the second quarter of 2014 once supply growth overtook demand. Similarly, crude prices bottomed in the first quarter of 2016 once supply growth fell below demand in early 2016. Given Canada’s dependence on crude oil exports, a bear market for the commodity is likely to result in a weaker currency.

As China enters its latest real estate downturn, Canada not far behind

While Canadian real estate has enjoyed a great year, the future outlook is much tougher. Similar to its peers in Australia and New Zealand, Canadian real estate prices tend to lag real estate prices in China. This is both because Canada’s economy is deeply intertwined with China, and because the country is a big destination for overseas investment from China. While overseas investors make up a relatively small portion of buyers (around 5% according to government estimates), they serve an important role by acting as the marginal buyer for prime property. A comparison of new house prices in China versus Canada is shown below for reference:

Canadian real estate boom set to run out of steam

Source: Statistics Canada, China National Bureau of Statistics

As Chinese new house prices accelerated significantly in early 2015, Canadian real estate prices followed in 2016. As the Chinese market is now decelerating, negative growth appears to be on the horizon. In March 2015, Chinese house price growth bottomed at -6.1%. While the Canadian bull market continues for now (September new house prices registered at 3.8%), a downturn is likely over the next 6-12 months. As real estate makes up 13% of Canadian GDP, a significant decline in the fortunes of the industry are likely to spill over to the broader economy.

Implications for the Canadian dollar

At the beginning of the year, the Canadian dollar enjoyed a wide number of bullish catalysts including accelerating GDP growth, rising rate hike expectations, a relatively strong crude oil market and speculator sentiment that was at a bearish extreme. These catalysts, and the Bank of Canada’s actions in particular, helped the currency strengthen until late September.

Today, almost every factor that drives the Canadian dollar is working against it. Future GDP growth rates are set to keep decelerating. Looking at the Bank of Canada, its outlook for future rate hikes is now “cautious”. This is a big change from its hawkish tilt earlier this year. While speculator sentiment is no longer at bullish extremes, waning interest in the Canadian dollar is weighing on the currency. The ongoing NAFTA negotiations are another source of potential political risk. Finally, an impending downturn for both crude oil and Canadian real estate further worsen the picture. Thus, our longer term outlook on the Canadian dollar is bearish.