Canadian economy: Broad-based growth (with worry over oil)
Canada’s economy was poised to enter 2015 with more cause for optimism than any time since the Great Recession. But oil’s slide has cast doubt over how the recovery will now unfold.
Economists have been anticipating that Canada would finally achieve its elusive broad-based economic recovery in 2015, after years of leaning on high energy prices and a debt-fuelled housing sector to keep it afloat. Strong U.S. growth should drive a revival in demand for Canadian exports, which is expected to spur long-dormant business investment in new capacity and create jobs across a wide range of sectors.
“It’s better, more broadly based growth,” said Craig Wright, chief economist at Royal Bank of Canada.
But the alarming plunge in prices for oil – one of Canada’s biggest exports – has thrown a spanner in the works. While economists disagree about how big an impact oil’s fall will have on the Canadian economy, the fear is that it could be a serious drag on national income and investment, and will pull the rug out from under a key source of strength.
Bank of Canada Governor Stephen Poloz estimated in early December that oil’s decline to that point, if sustained, would subtract about one-third of a percentage point from Canada’s economic growth in 2015. Since then, crude has dropped even further. Economists’ consensus forecast for 2015 real growth is 2.5 per cent, but that number could creep down toward a relatively timid 2 per cent should the oil slump prove prolonged.
By contrast, the neighbouring U.S. economy, the world’s biggest consumer of oil, is expected to benefit from cheaper fuel prices. Its growth is forecast at about 3 per cent in 2015 – and the oil dividend could lift it even higher.
“ will mark the biggest shortfall of Canadian GDP growth versus the U.S. since 2003,” said Douglas Porter, chief economist at Bank of Montreal.
Such a gap would almost certainly mean the Bank of Canada would hold off on interest rate increases for longer than the U.S. Federal Reserve. The Fed looks likely to raise rates by mid-year; the Bank of Canada could stick to the sidelines for one or two quarters longer, especially if the oil slump substantially hampers the hoped-for recovery in business capital investment, to which the energy sector is a major contributor.
That should provide respite for the country’s overstretched household debt loads, but it will also put more downward pressure on the Canadian dollar, which lost about 8 per cent against its U.S. counterpart in 2014. A lower loonie, though, would give a competitive edge to a broad range of Canada’s non-energy exports – which already stand to benefit from the strengthening U.S. demand.
“[Oil’s fall] is a negative directly [for Canada], but when you consider the indirect impacts, it might be a net positive,” Mr. Wright said.
Mr. Porter doesn’t disagree, but he thinks the positive impacts won’t materialize in time to undo the damage in 2015.
“At least in the first year, the negatives outweigh the positives,” he said.
The markets: Watching Yellen for signs of turbulence
If you aren’t yet obsessed with every utterance and inflection from Federal Reserve chair Janet Yellen, you soon will be.
The Fed has held its key rate close to zero per cent for six long years, driving the bull market in stocks since early 2009.
Over this period, the S&P 500 has soared more than 200 per cent from its lows and even the plodding S&P/TSX composite index has gained about 90 per cent.
But the era of ultra-low rates is drawing to a close as the U.S. economy improves, adding a potential source of turbulence to the year ahead – depending on what the Fed says and does.
Already, observers are speculating when the Fed will start to raise rates, how aggressively it will continue to increase them and what impact the higher rates will have on markets that at times appear addicted to central bank stimulus.
Optimists argue that rate hikes coincide with an improving economy, an improving economy is good for corporate earnings and earnings are good for stocks.
Moreover, history suggests that stocks tend to perform well during early rate hikes.
While most Wall Street strategists caution that volatility will pick up, they expect the bull market will persevere. The average year-end target for the S&P 500 is 2,200, implying a gain of nearly 10 per cent.
But today’s backdrop is complex, arguing for anything but a smooth ride ahead. U.S. inflation is still below the Fed’s target of 2 per cent and although unemployment is falling, it is not at levels pointing to an overheating economy.
“Add to this troubles abroad – the direct spillover from Russia or even Europe is fairly small, but the rising dollar means that good news on manufacturing may not last – and there is a real risk that any rate hike will turn out to have been a mistake,” Paul Krugman, the economics professor and New York Times columnist, said on his blog.
The concerns don’t stop there. Even bullish observers recognize that stocks are fully valued, which suggests that gains will have to rely on earnings growth.
Rate hikes will also likely affect the bond market, driving yields higher and offering investors a compelling alternative to the stock market.
In Canada, investors will have to navigate volatile crude oil prices and a housing market that the Bank of Canada believes is overvalued by as much as 30 per cent.
Although that adds up to a lot of concern, it doesn’t mean that investors should be fearful that the bull market in stocks will come to a violent end in 2015. Indeed, the bull market has thrived in previous years on similarly weighty concerns.
But when Ms. Yellen speaks, you should probably listen.
Energy: Hunkering down amid oil uncertainty
The watchword in the oil patch is prudence. A number of companies – from drillers and small independents to big oil sands players – have rolled out tighter budgets or slashed dividends, or both, while warning of deeper cuts as crude prices nosedive to multiyear lows.
Surging production from U.S. shale plays and weak demand in key markets pushed North American oil prices down 46 per cent in 2014, forcing some companies to cut dividends and others to pare back spending as executives rewrite growth plans to protect plunging cash flows. Investors have punished energy shares, driving the S&P/TSX capped energy index down more than 18 per cent in the past 12 months despite strong gains made in the first half of the year.
The rout in oil prices accelerated after the Organization of Petroleum Exporting Countries (OPEC) in November refused to cut production in a bid to defend market share.
Some OPEC members now say the cartel will stand by that move even if global oil prices touch $40 (U.S.) a barrel, or lower, raising the likelihood of a prolonged slump in Canada’s oil patch and more pain for investors as 2014 fades into the rear view mirror.
“The risks on the macro side of the oil markets now are evolving from the direction and absolute price level of oil to how long do we remain at lower oil prices,” said Chris Cox, an analyst at Raymond James Ltd. in Calgary. Prices will eventually snap back from today’s lows as high-cost production is shelved and cheaper oil fuels new demand, he added.
“It’s a question of how long do we need to stay at these low prices to balance the market out in the interim,” Mr. Cox said. “I think it will take a lot longer than most expect.”
Spending in the oil sands is poised to drop roughly 28 per cent from 2014 levels to $20-billion (Canadian) as several big-ticket expansions move from construction to operations, according to energy consultancy Wood Mackenzie Group. Drilling activity in early-stage but expensive shale plays such as Alberta’s Duvernay zone could fall 15 per cent, Bank of Nova Scotia said.
Oil patch giants are hunkering down as sinking crude prices threaten earnings growth and undermine even the most conservative corporate forecasts. Energy-rich provinces, from Alberta to Newfoundland and Labrador, are preparing for leaner times.
Husky Energy Inc., Cenovus Energy Inc., MEG Energy Corp. and Baytex Energy Corp. are rethinking long-term projects. Meanwhile, debt-heavy producers will face increasing pressure to sell assets or be taken out by better-capitalized rivals.
However, December’s $8.3-billion (U.S.) takeover of Talisman Energy Inc. by Spain’s Repsol SA may not kick off a flurry of transactions in the short term, analysts say, as gyrating oil prices weigh on valuations.
Housing: A stable market – at least outside Alberta
Canada’s real estate industry forecasts a stable market nationally in 2015, although weak oil prices are expected to put a chill on Alberta’s housing sector.
In the Toronto and Vancouver regions – the two largest markets that are also closely watched for trends – prices are predicted to continue their rise but to cool off from the pace of past annual hikes. The Canadian Real Estate Association forecasts that average prices nationally will rise 0.9 per cent to $409,300 for the existing residential market, which includes single-family detached houses, condos and townhouses. That compares with an estimated price increase of 6 per cent in 2014.
In Greater Toronto, the price averaged $567,198 for properties sold in the first 11 months of 2014, up 8.4 per cent from the same period in 2013. For the Toronto and Vancouver regions in 2015, Re/Max is predicting increases of 4 and 3 per cent, respectively.
In Greater Vancouver, the average price for detached homes, condos and townhouses will edge up in 2015, said Cameron Muir, chief economist at the B.C. Real Estate Association. Greater Vancouver residential prices are on pace to average $814,000 in 2014, up 6 per cent from 2013. But Mr. Muir has a more conservative view than Re/Max’s outlook. He reckons a modest increase in Greater Vancouver of $1,000, or about 0.1 per cent, will result in the average price reaching $815,000 in 2015 on slightly higher sales volume.
Longer term, Mr. Muir and other industry analysts see strength in the Vancouver area due to projections for continued population growth as people migrate from other provinces and overseas.
Re/Max thinks Calgary could fare well in 2015, and is calling for a 3-per-cent hike to the roughly $497,500 average residential price. But that forecast was made before oil fell below $60 (U.S.) a barrel in December. “I would be more cautious on Calgary now,” said Elton Ash, Re/Max regional executive vice-president in Western Canada.
Depending on how long oil prices might be in a slump, Calgary and Edmonton could see resale housing demand taper off, Mr. Ash said.
Nationally, Re/Max expects a 2.5-per-cent increase in average prices in 2015 for existing detached properties, condos and townhouses, compared with its estimate of a 6.2-per-cent jump in 2014. Still, the Bank of Canada warned in December that “there is some risk that the housing market is overvalued, and our estimates fall in the 10- to 30-per-cent range.”
Mr. Muir doesn’t see a housing bubble, especially in an environment where mortgage rates are anticipated to stay near historical lows in the foreseeable future. “People who are buying homes today will be able to withstand some modest upticks in interest rates,” he said.
Financials: Big banks brace for fading fortunes
Canada’s banks stand out as the country’s stalwarts since the financial crisis, churning out record earnings many times over. Yet this year there are legitimate fears the good fortunes will fade.
Bank chiefs themselves are fanning the flames. When the largest lenders reported earnings in December, a number of executives braced their investors for belt-tightening and weaker bottom lines as they retool their retail operations.
Most notably, Toronto-Dominion Bank chief executive officer Bharat Masrani stressed the need to “increase efficiency and streamline our cost base” – language that usually portends job cuts and restructurings – and Bank of Nova Scotia reiterated plans to slash 1,500 jobs both at home and abroad and to close branches in its international arm.
The big question for 2015 is whether these moves are warning signs that the industry is shifting, or simply pet projects of new CEOs who feel the need to trim fat that built up under their predecessors. Investors who remain bullish must hope the lenders that recently sounded the alarm are simply making short-term changes, rather than bracing themselves for a long-term structural shift in the industry.
Bank investors are clearly confused. As the lenders reported earnings in early December, bank shares collectively slumped 9 per cent. Just a few weeks after they bottomed out, however, the S&P/TSX bank index has already gained back roughly half of this drop.
And investors can’t be blamed for these swings. In this market, it is tough to know where to stand. Despite the comments from TD and Scotiabank, as well as warnings about higher expenses at Canadian Imperial Bank of Commerce, Royal Bank of Canada, the country’s largest lender, remains unabashedly optimistic.
The main reason: The U.S. economy is rebounding nicely. Despite all the uncertainty about major markets such as Europe, Brazil, Russia and China, American consumers are spending again, and RBC believes that is bound to be good news for Canadian banking. The U.S. remains Canada’s largest trading partner, and strong growth south of the border is expected to influence our own.
“There are a lot of things in the world that create uncertainty,” CEO Dave McKay said in a recent interview, citing Russia’s political and economic unrest and choppy oil markets as two examples. But U.S. consumers are showing signs of strength, and that “should be cause for optimism.”
Amid all of the conflicting messages, here are a few things that have proven to be true: Personal lending is undoubtedly slowing because Canadian households are up to their ears in debt; despite a hot economy, U.S. retail banking is an incredibly competitive industry with thin loan margins; and wealth management and capital markets earnings will always be subject to market swings.
As for the latest drop in oil prices, the banks haven’t shown any signs of worries. In fact, they’ve all expressed calm because the companies they lend to are expected to endure the recent volatility.
Telecom: In an election year, wireless giants on alert
In the the months leading up to the next federal election, Canada’s biggest wireless companies will keep a wary eye on Ottawa as the Conservative government continues to pursue pro-consumer policies that favour competition in the sector.
After waging a public battle with the federal government over policy in 2013, leaders at the country’s dominant carriers have since adopted a more conciliatory tone, often stating they are content to compete no matter what regulatory conditions are imposed.
A ruling from the Canadian Radio-television and Telecommunications Commission on domestic wholesale roaming – the rates companies pay to competitors when their wireless customers roam outside their home territory – is due in early 2015.
Ottawa already legislated interim caps on the rates in an effort to help smaller players without national networks compete but Barclays Capital Inc.’s Phillip Huang wonders whether some of the pressure to impose aggressively low rates has lessened.
“We believe the government can now confidently declare that it has succeeded in creating a fourth wireless player in each major market in Canada,” he said, referencing the government’s policy of promoting alternatives to Rogers Communications Inc., BCE Inc. and Telus Corp. (BCE owns 15 per cent of The Globe and Mail.)
He noted that recapitalized Wind Mobile, which serves about 800,000 customers in Ontario, British Columbia and Alberta, is increasing both its subscriber base and revenue per user, and Quebecor Inc.’s Videotron Ltd. mobile business is grabbing market share in Quebec.
Meanwhile, Eastlink Wireless offers an alternative in Nova Scotia and Prince Edward Island as do SaskTel and MTS Inc. in Saskatchewan and Manitoba.
The incumbents still dominate more than 90 per cent of the market, but the presence of these options could alleviate some pressure from Ottawa.
Yet, Scotia Capital Inc.’s Jeff Fan said in a year-end research note that he believes the government will continue to encourage an even stronger consolidated fourth carrier and could intervene if it is not satisfied when the CRTC’s decision comes down.
Mr. Fan says a “double cohort” will also be a risk for the incumbents’ margins and churn rates in 2015 as a wave of subscribers on two-year contracts (the maximum length under a new national code) will see their agreements expire around the same time as a group still locked into three-year deals. This will leave both groups free to shop around and eligible for new subsidized devices at the same time.
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