Earlier this year, I expressed my concern about a potential secular downtrend in the Canadian dollar. Nearly three months later, the dollar still sits near parity, but ongoing developments are leading me to reinforce my conviction that foreign investors are about to revisit their optimism on the currency.
In a nutshell, my thinking goes like this: The Canadian economy will soon underperform its U.S. counterpart, commodities and Canadian housing prices are heading south, and Canada's competitive position is in very bad shape with the current Canadian dollar level. Let me briefly revisit these themes.
First, a quick recap of the loonie's ascent
It is fair to say that the loonie's strength over the past few years can be explained by a combination of strong fundamentals in Canada (e.g. well capitalized financial institutions, credible monetary policy and lowest federal indebtedness ratio among G7 countries), but also by rising commodities prices and resilient domestic demand fuelled by booming real estate prices. In terms of credit rating, Canada also remains a member of the prestigious AAA club, inducing many central banks over the past three years to add Canadian dollars to their currency reserves.
Of course, fundamentals will not erode overnight, but the bullish story of rising commodity and housing prices is much more cyclical by nature than structural. We see significant headwinds for both commodity and housing prices in upcoming quarters. These developments will hurt economic activity and public finances, and be a serious stress test on our so-called resilient banking sector. It is worth noting that the well-respected BCA Research (former employer of incoming Bank of Canada Governor Stephen Poloz) predicted just two weeks ago a 50-50 chance of recession in Canada.
Strong headwinds for the Canadian economy
The various signs of overheating in the housing market are now turning to signs of cooling, with building permits, housing starts and prices sharply down since the start of the year. The Teranet-National Bank House Price Index was recently down for the six consecutive month, a first outside a recession. It seems that the regulatory measures imposed on the market by Ottawa (elimination of very long-term mortgages, minimal down payments, etc.) are starting to have the desired impact. Housing inventories have surged and prices have no place to go but down. Of course, in the absence of exotic mortgages, we do not foresee a replay of the U.S. scenario, but a 15-20 per cent price decline in the condo market over the next three years seems very likely. In fact, The Economist sees Canada's housing market as among the most overvalued and vulnerable in the world.
What should most strongly tarnish foreign investors' perception of the loonie will be the ongoing weakness in commodities prices (we have an 18-month target of $80 (U.S.) on the West Texas intermediate oil benchmark). Beyond the recent deceleration of the Chinese economy (which is still growing at more than 7.5 per cent a year), the pressure should come from the supply side.
In its latest report, the International Energy Agency (IEA) forecast that supply growth in North America (shale oil and oil sands, mostly) will be larger than demand growth over the next five years, leading to a possible buildup of spare capacity around the globe. The IEA sees the U.S. as the world's largest oil producer by 2017. Add this to the view that the U.S. should be a net exporter of natural gas by 2020, and our neighbour is heading for energy independence within just seven years.
This is very bad news for Canada. Even if Alberta ramped up its oil sands production, the current Western Canadian Select oil price discount relative to WTI is not going anywhere without new pipelines. When (and if) these projects finally get approved and new pipelines become operational, global international prices should be already much weaker – unless OPEC members accept to curb their market share much further.
Turning to Canada's competitiveness, not much has changed over the past five years. Canada lags the U.S. in terms of productivity gains, and we are already seeing some companies move their plants south of the border. According to the World Economic Forum's Global Competitiveness Report, Canada ranked as the 14th most competitive country in the world in 2012, four spots behind its 2008 ranking. Canada's current account deficit sat at $17-billion in 2012, the equivalent of 3.8 per cent of GDP.
Predicting currency movements is not an exact science; readers should be careful about positioning their portfolio based on this analysis alone. However, it would be a good idea for snowbirds with financial obligations denominated in U.S. dollars to consider buying some financial assets also denominated in U.S. dollars, as a measure of protection in case our bearish scenario becomes a reality.
Clement Gignac is senior vice-president and chief economist at Industrial Alliance Inc., chair of the World Economic Forum Council on Competitiveness and member of the Forum's Sustainable Competitiveness Advisory Board.