KWR International Advisor #12 December 2001

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For much of the past decade, the Canadian economy has grown at a robust pace. This was due in large part to the relative strength of the US economy, and the spillover effects of a continental-wide free trade agreement. In addition, the Canadian government demonstrated world-class fiscal prudence such that the federal and most of the provincial governments were able to realize balanced budgets by the latter half of the decade. However, if the current recession in Canada continues through much of 2002, then not only will economic growth stall, but certain of the provinces will also experience severe budgetary pressures due to declining revenues and increased health care and education expenditures. Since May of 2001, investment in Canada has slowed as unemployment has increased. This has been a worldwide pattern of course. The tragedy of September 11 and the resulting security costs incurred will further strain the Canadian fiscal balance.

Many economists are expecting Canadian economic growth to be in the 1% range in 2002. We share this view, but think this headline figure will mask a second-half turnaround that should take the growth rate to 2.7% from its flat levels today. If the US economy improves in the second half of 2002, then we expect Canadian growth to be in the 3-4% range in 2003. But if Canada does achieve this growth, it will have to overcome certain obstacles. For example, inventory-to-sales ratios are at uncomfortably high levels and more cost-cutting efforts are needed before profit margins can be expected to bottom out. As US companies are ahead of their Canadian counterparts, we look for the Canadian economy to lag the US during the early stages of recovery in 2002. This follows previous patterns as well.

In general Canadian business cycle contractions are less brutal than their US counterparts, averaging 2.5% compared to the US 3.7% since 1962. But the Canadian economy typically takes longer to recover-five months more on average. This difference is explained, in large part, by the exchange rate. Canadian monetary conditions are influenced as much by the currency as by short rates. It is estimated that a 3% depreciation of the Canadian dollar has roughly the same effect on the Canadian economy as a one-point rate cut. In November 2001, the Canadian dollar touched a record low of 62.3 US cents as exports fell and investors turned elsewhere. The lack of pent-up demand in the Canadian consumer sector is another roadblock in the way of a typical post-recession snapback.

There are reasons, however, to be optimistic about the Canadian economy going forward. The Bank of Canada has dramatically eased interest rates and, coincident to this, long-term credit spreads have tightened 35 basis points since November 1. In fact, we think the Bank might reduce interest rates another 50-75 basis points in the first quarter of 2002. Canadian stock market prices are up 25% from their bottom, and industrial commodity prices have improved by 5% from their worst levels in 2001. Inflation is negligible. These are all encouraging market signals that the Canadian economy is about to make the transition from contraction to expansion.

Investors should also note that Prime Minister Chretien and the Federal Liberal Party remain popular and would easily win an election if it were held in the near-term. A federal election is unlikely in 2002 however. Furthermore, investors might note that the sovereignty movement in Quebec, although never dead, is completely dormant at the moment. There is little political risk of sovereignty for the foreseeable future. Rather, the priority of the Quebec government — like all of its counterparts in the other nine provinces -- are elsewhere. All are facing substantial fiscal pressures due to slowing economic growth and increased demands for health care and education expenditures. Although, all of the provinces are committed to balanced budgets in 2002, we think there is a 30% chance that Quebec and Ontario will have operating deficits due to these budgetary pressures.

According to BMO Nesbitt Burns Inc. the combined provincial balance of (CDN) $11 billion in surplus in 2000 will turn into a deficit of almost $2 billion in 2001. From Newfoundland, which forecasts an $80 million deficit in 2001-2002, to British Columbia, which is braced for a $2 billion shortfall, the provincial outlook is beginning to look very difficult in the next year. In general, provinces that eliminated their deficits quickly and began paying down their debt, like Saskatchewan and Alberta, are in better fiscal shape. By contrast, Nova Scotia continues to run deficits and its debt is now a whopping 46% of its entire economy.

So we have a mixed bag. The global recession has hurt the Canadian federal and provincial economies, but the national government is poised to recover fairly quickly. Indeed, net public debt is expected to be CDN $547.4 billion in 2002, which is less than 50% of GDP for the first time in 17 years. By contrast, several of the provinces may be hard pressed to deliver balanced budgets. In short, we think that Canada will remain an attractive investment destination in 2002 as the nation emerges from recession. But we caution that fiscal pressures will remain for the foreseeable future.

Contributing Writers to this Edition: Scott B. MacDonald, Keith W. Rabin, Uwe Bott, Jonathan Lemco, Jim Johnson, Andrew Novo, Joe Moroney, Russell Smith, and Jon Hartzell