When Canada returned to the US dollar market after a 10 year absence in September 2009, demand for its five year $3bn global bond underscored its status as the safest of safe havens within the sovereign, supranational and agency (SSA) universe.
Despite being priced at 15bp through mid-swaps, the tightest level any borrower in the sector had achieved since the previous October, Canada’s marquee offering generated demand in excess of $15bn from 299 investors.
Canada’s coruscating global bond in 2009 was by no means a one-off, but was emblematic of investors’ apparently insatiable appetite for Canadian risk-free assets, which remain in short supply in the international capital market. As Michael Gregory, senior economist at BMO Capital Markets in Toronto, wrote in a research update in August, “during the heady days of late 2009 through early 2011, global foreign exchange (FX) reserve managers started looking at Canada as a destination for diversification.”
“In the wake of the global financial crisis,” Gregory’s piece goes on, “these investors were attracted by Canada’s pristine sovereign credit rating (only one of eight nations with an unencumbered, undisputed AAA rating) and strong banking system (the soundest on the planet according to the World Economic Forum).”
With some shorter-dated Canadian government assets even offering a pick-up to Treasuries, foreign investors piled into loonie-denominated assets. According to Gregory’s research, having plunged from well over 35% in the early 1990s, the share of Government of Canada bonds held by non-residents surged from under 15% in the second quarter of 2009 to over 30% by the second quarter of 2012 and to 31.3% in August 2013.
The credit metrics that encouraged these inflows, say economists, came about neither by accident nor by default. At National Bank in Montreal, chief economist Stefane Marion says that the outperformance of Canada during the global financial crisis had its roots in policies implemented well over a decade earlier. “Don’t forget that the 1990s was a very painful period for Canada which was marked by low growth, budget deficits that the government strove to eliminate and a debt to GDP ratio that needed to be reduced,” he says.
1990s’ sound measures pay off
The consequence, adds Marion, was that a number of measures were taken that — be it by luck or judgement — would fortify Canada against the downdraught of the recent crisis. “Important decisions were taken in the 1990s which involved the reduction of the government’s indebtedness and a significant improvement in the productivity and flexibility of the labour market,” says Marion. Specifically, a deficit of 6% of GDP in 1995/96 was quickly eradicated, while net debt to GDP, which was over 70% in 1995/96, had been reduced to just under 23% by 2007/08. It is now 35%, compared with a G20 average of 85%.
This, twinned with the inherent conservatism and low leverage of the banking system, meant that when the shockwaves of the global crisis started to spread across the globe, Canada’s government had much more room for manoeuvre than those in the US and most of Europe. “Because it did not need to bail out the banking system, the Canadian government was able to confine its help to areas such as infrastructure spending in order to support a revival of growth,” says Marion. “Historically, you’d assume that it would be impossible for Canada to escape when the US enters into a recession, but it did so because the government was able to step in.”
There were a number of other factors that helped to shield the Canadian economy from the global financial crisis, say economists. Foremost among these was the strength of emerging economies and the demand this created for commodities, which supported the performance of resource-based economies such as Canada and Australia.
The numbers tell the story plainly enough. After falling by 2.8% in 2009, real GDP bounced back to grow by 3.2% in 2010 and 2.6% in 2011. According to the IMF, “supported by the strong monetary and fiscal policy response and a quick rebound in the terms of trade, the Canadian economy grew well above potential in 2010-11.”
“Our peak to trough decline in GDP was very similar to what we saw in the US, at a little over 4%,” says Craig Wright, chief economist at Royal Bank of Canada in Toronto. “But in Canada’s case this took place over three quarters, whereas in the US it was over a period of six quarters, so the recovery in Canada was much quicker.”
Where there was a marked difference between Canada and the US, says Wright, was in employment. While Canada had a 2.5% drop in employment during the crisis, in the US the fall was closer to 6%. “Canada regained all the lost jobs within a year and half, whereas the US is still a couple of million jobs short of its pre-recession employment level,” he says.
Growth slowed in 2012, to 1.7%, which the IMF attributes to a combination of fiscal consolidation, high levels of household debt and “external headwinds” which depressed exports and business spending. Nevertheless, the speed with which Canada recovered from the crisis was an impressive testimony to the restructuring made in the 1990s.
Victim of its own success?
The paradox, today, is that Canada may be a victim of its own success in managing the global downturn as effectively as it did. “We were able to supercharge domestic demand, and with interest rates so low and the job market remaining strong, there was inevitably an increase in household debt,” says Marion. “But because we front-loaded domestic growth, I’d ague that there’s no way the domestic economy will be able to outperform the rest of the world as it has in recent years. So we are about to face a period of slower growth, meaning that we will be increasingly dependent on exports going forward.”
Avery Shenfield, chief economist at CIBC World Markets in Toronto, agrees. “Low interest rates worked the way they’re supposed to work, by encouraging Canadians to borrow and spend on consumer goods and housing,” he says. “Inevitably that has created a hangover in terms of a high level of houseful debt. This doesn’t threaten a wave of defaults, but it will constrain the ability of the economy to grow on the back of housing and leveraged consumption. We don’t think there is a risk of an imminent credit crisis, but we do see some signs of borrowing fatigue.”
That may be. Nevertheless, a number of Canada-based economists bridle with indignation at what they regard as gloomy and ill-informed chit-chat about the prospects for the Canadian economy.
More specifically, they rankle at the oft-repeated concerns about over-indebtedness among Canadian households and potentially unsustainably lofty house prices. Douglas Porter, chief economist at BMO Capital Markets in Toronto, distributed an especially punchy rebuff to the doomsayers in July. “Concocting dire scenarios for Canada’s economy and financial markets has become a veritable cottage industry among domestic and, more notably, global pundits,” he wrote.
That’s quite a charge, given that one dictionary definition of the verb ‘concoct’ is “to invent an excuse, explanation or story in order to deceive someone”.
But Porter is clearly frustrated by external prophets of doom. “We flatly reject the extreme negativity of many recent analyses — which have mooted everything from made-in-Canada recessions, to a Canadian bond bubble, to a housing collapse (the favourite call among the punditocracy), to a deep dive in the loonie,” he wrote in July.
Truth in the rumour?
The doubters are, however, not exclusively from overseas, nor are they all mischief-making traders looking to short Canadian assets. The local regulator, OSFI, has made no secret of its misgivings about stretched house prices. The Economist, meanwhile, reckons Canadian homes are more overvalued relative to rents than in any country in its sample other than Hong Kong. Relative to income, according to the same analysis, only French houses are pricier. On both measures, Australian houses — frequently identified by analysts as a bubble in the making — look reasonable relative to Canada’s.
On the surface, a growing number of international investors seem to have become increasingly disenchanted with the prospects for Canada. In June, foreign investors reduced their holdings of Canadian securities by $15.4bn, which is the largest monthly drop since October 2007. The decline was driven entirely by bond sales, with foreigners dumping $7.1bn of federal bonds and $3.4bn in provincial issues in June.
Economists caution against reading too much into the summer sell-off. “There was an unprecedented amount of maturities in June, so I wouldn’t put too much credence into one month’s figures,” says Gregory at BMO. “It’s clear that foreign purchases of Canadian bonds have fallen since their 2010 peak, but accumulation of reserves by central banks are also down from 2010.”
The reduction in foreign investors’ holdings of Canadian securities, Gregory adds, has nothing to do with economic fundamentals. Nor is it any reflection of concerns over Canada’s rock-solid triple-A rating. “The triple-A rating is not in jeopardy,” says Shenfield at CIBC. “We’re still making good progress with reducing deficits, and as long as the economy continues to grow at a reasonable pace we would expect that to continue.”
Although slowing in 2013, the outlook for economic growth remains respectable. The OECD has just revised its forecast for GDP growth in 2013 to 2% from the 1.4% it was anticipating earlier this year. The Bank of Canada’s most recent projections, meanwhile, are for growth of 1.8% in 2013 “supported by very accommodative financial conditions,” and 2.7% in both 2014 and 2015.
Economists in Toronto concede that household debt and house prices are both potential banana skins worth monitoring. “The main risk in the housing market is over-investment, which creates over-supply and downward pressure on housing,” says Gregory. It’s a valid point. Ask virtually any property developer on Spain’s Costa del Sol.
Demographics look good
But Canada-based economists also insist that there are some important factors that some commentators have a habit of overlooking in their analysis of the Canadian housing sector. “One dynamic that people tend to ignore is Canada’s demographics,” says Marion at NBF in Montreal. “The population within the 20-44 age bracket, which is the age group that fosters the strongest increase in household formation, is one of the fastest growing in the OECD. While some European countries expect a decline of 7% or 8% within this age group over the next five years, Canada is projecting a growth of 3% in absolute terms.”
In some provinces, Marion adds, the expected growth rate is even higher, with Alberta forecasting a rise of 7% in its 20-44 year olds in the next five years — an expansion bettered only by India. “Population growth driven by immigration will be a formidable anchor for the housing market, so I find it fascinating that people seldom take this into consideration,” he says.
Another broader dynamic that is sometimes missed by overseas commentators is relative affordability levels. In a note published in June entitled Debunking Doomsday Predictions for the Canadian Economy, TD pointed out that “Canadian households are far less financially vulnerable than their US counterparts were heading into the crisis.”
It added that “largely owing to a continued low interest rate environment, mortgage interest costs as a percent of personal disposable income have fallen despite the sharp rise in the debt-to-income ratio.”
Beyond the twin threats of household debt and high house prices, there are other broader challenges still facing the Canadian economy. One is continued doubts over the productiveness of the labour force, in spite of the reforms made in the 1990s. “Productivity is probably the main challenge Canada faces today,” says Gregory at BMO. “But Canadian companies are becoming more productive and stepping up their investment in machinery in order to become more competitive.”
NBF’s Marion adds that productivity in the Canadian labour force has come a long way. He says that according to parameters used by the World Economic Forum, Canada now ranks fourth in the world for labour force flexibility. “We ranked way below this in the 1990s, now we’re only behind Singapore, Hong Kong and Switzerland,” he says. “Our flexible labour market and our corporate tax rates, which are among the lowest in the OECD, mean that Canada is well positioned to capture more inward investment.”
The relative flexibility of the Canadian labour force was emphasised by former Bank of Canada Governor Mark Carney in May, when he delivered his last speech before taking up his new job at the Bank of England. Observing that by some estimates Canada’s labour force is almost four times as flexible as Europe, he pointed to the mobility of Canadian workers as compelling evidence. “An obvious example of this flexibility is the way Canadians have responded to the higher wages and employment opportunities in the energy sector,” he said. “Last year, there was a net inflow of more than 40,000 people into Alberta from the rest of Canada, a level of mobility that approaches its previous peak.”
Another challenge identified by economists — which many say that won’t go away in a hurry — is the strength of the Canadian dollar, which has rallied recently following strong building permits and employment numbers. It may be too soon to conclude that the loonie has bottomed against the US dollar. But performance of the currency in recent weeks would seem to vindicate those who argued that it was an over-simplification to assume that the Canadian dollar would go the way of its Australian counterpart because both currencies are influenced by global demand for commodities.
CIBC, for one, advised in a report published in July that “we view the bout of Canadian dollar softness this year as an opportunity to buy it ahead of a likely appreciation in 2014.” One reason, said this report, is that “the export focus of Canada is much more varied than that of Australia.”
Camilla Sutton, managing director and chief currency strategist at Scotiabank Global Banking and Markets (GBM) in Toronto, agrees that exporters will need to get used to a strong dollar. “At just below parity today, the Canadian dollar is extraordinarily strong by historical standards,” she says. “Even though we have some weakness built into our forecasts until year end and a stabilisation next year, in a historical context this is still 30% stronger than it was 10 years ago, leaving exporters facing a strong currency.”
The strength of the Canadian dollar is inevitably a concern, given the general consensus that exports will need to lead the economy going forward.
But a number of economists say they are comfortable that Canadian companies have made the necessary adjustments to deal with a strong currency.
Besides, they argue that the impact of a strong currency should not be overestimated, for two reasons. “The bulk of capital equipment is imported from the US, so a stronger Canadian dollar is supportive of business investment,” says Gregory at BMO.
“Additionally,” he says, “although the exchange rate obviously is not favourable for Canadian exporters, the main driver of US imports is demand, rather than price.” In other words, the benefits to Canada of a sustained economic recovery in the US are likely to outweigh the impact of a stronger currency.
Signals that this is already happening may already be emerging. “The good news for us is that the recovery in the US is taking place in the sectors that Canada exports to, such as auto equipment and the housing sector, which is positive for the Canadian forest products industry,” says Wright at RBC.