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Canada: Headed into Recession, but Economic Recovery Should Return in The Spring

By Jonathan Lemco

The September 11th terrorist action has had dismal economic implications for many of the United States’ allies. Not surprisingly, one of the most affected is Canada, which is the largest trading partner of the U.S. by far. Prior to the tragedy, the Canadian economy had been limping along with modest growth, with little new investment in its vitally important commodities sector. But the events of September 11th, and the resulting uncertainty, have been the "icing on the cake". In fact, investors should expect continued economic weakness in the Canadian credit for the remainder of 2001, but expect some economic pickup by the second quarter of 2002 as the U.S. economy begins to recover.

For now, Canadian exports will decline in volume. As well, increased security at the border with the U.S. will result in a slowdown of cross-border flows. The automobile industry is particularly vulnerable. However, Canada remains a "safe harbor" compared to the volatile emerging markets. For investors seeking safe, if unspectacular results, Canada and its provinces offer adequate and fairly predictable returns.

In the near term, what might we expect of the Canadian economy and polity? First, interest rates will continue to hover around historic lows and thereby provide support for economic improvement next year. Consumer confidence will remain low (it fell 4.5 points in Q3 to the lowest level seen since the 1997 Asian crisis), as consumers postpone the purchase of big-ticket items. Housing starts fell 7.6% month-to-month in September. Business confidence has also fallen dramatically and is likely to remain stagnant through the second quarter of 2002.

Inflation is of virtually no concern to the Bank of Canada at the moment, and it can devote its attention to easing interest rates as a spur to the moribund economy. In the next six months, investors should expect flat or marginal (perhaps 1.5%) economic growth. Unemployment is currently at 7.2% and could rise to about 8.0% early in 2002. But it should then decline to about 7.5% by December of next year.

In early October, Ontario government took the lead on the fiscal front by accelerating personal and corporate income tax cuts originally scheduled for the beginning of next year. When the full impact of the economic stimulus in the U.S. and Canada takes effect by year-end 2002, growth may accelerate to 2.5% or so.

The Canadian dollar, which is worth about U.S. $0.63, is competitive on a world scale and thereby supports the broader Canadian economy. For international investors and tourists alike, Canada is a tremendous bargain. Given the likelihood of world economic uncertainty for the foreseeable future, we think there is little chance of Canadian dollar appreciation. Once the uncertainty eases however, we think that Canada’s positive fundamentals, i.e. low inflation, a shrinking debt load, and a sizeable current account surplus, should push the struggling Canadian dollar higher.

The Federal and Provincial governments’ fiscal prudence in recent years has been rewarded without ongoing credit rating upgrades by the major credit rating agencies. We think that Canada’s fiscal performance will remain strong despite the current economic slowdown. In fact, the federal government should still enjoy a modest budget surplus through the end of 2002. It will be difficult to pay down much more of the federal debt, however, despite the government pledge to pay down $3 billion of debt next year.

Many economists forecast an economic recovery in the U.S. by the second quarter of 2002. Whenever the U.S. economy strengthens, Canadian exports should see an attendant improvement. In the meantime, the Canadian federal and provincial governments will continue their policies of fiscal prudence, balanced budgets, etc.

Of particular interest to fixed income investors is the province of Quebec. Quebec paper offers modest yield to investors, but that is acceptable at a time of economic uncertainty worldwide. In recent years, the province's political leaders have followed the model of their federal counterparts and registered balanced budgets or surpluses. The sovereignty issue, although never dead, is dormant. We think that Quebec bonds offer good relative value to conservative investors.

To conclude, we don’t mean to dismiss the negative impact of the worldwide recession and the events of September 11th on Canada. But we would balance this situation with the acknowledgment that the Canadian economy is fundamentally healthy and should be quick to recover in six months or so when the major world economies begin to grow again.