Restraint And Resilience
China's ascendancy (and that of Asia generally) is the economic story of the decade. Such phenomena are never smooth, however, and 2006 will likely present the region with a particular challenge: the loss of its best customer. The U.S. provided much of the final demand that fed exceptional growth in the rest of the world. But the U.S. economy now seems tapped out, with both the personal savings rate and national net savings in record negative territory. The combination of a profligate government and a bubbly housing market permitted the U.S. economy to keep chugging on defiantly in recent quarters. But as the Fed tightens monetary policy (it hiked rates by 325 basis points during the past 19 months), America will likely spend more within its means in 2006. That suggests less spending on domestic and foreign products alike, with the risk to the latter compounded by growing protectionist sentiment in Washington.
I think the surprise in 2006, however, will be that Asia impresses with its economic resilience, despite slower U.S. growth. Two developments look particularly supportive here. First, Japan looks to be finally shaking off its decade-long torpor, with markets providing the best evidence — the Nikkei is up nearly 40% over the past six months to a five-year high, and the front end of the yield curve is discounting a visible end to the Bank of Japan's zero-interest-rate policy. Despite its long stagnation, Japan remains the world's second-largest economy and the regional heavyweight; stronger demand there should provide important offset to weaker demand across the Pacific. Second, hitherto strong export-led growth in China and elsewhere across the region has sent incomes soaring, giving local consumers and businesses alike the wherewithal to increase their own demand for stuff. And these two developments interact to suggest that any slowing in Asian countries' trade with the U.S. can increasingly be compensated for by more trade with one another, accelerating a trend already long in place that has seen intra-regional trade in East Asia approach levels in NAFTA or the EU.
Rather than derailing Asia's economic ascendancy, then, the loss of the U.S. consumer in 2006 may even accelerate the process.
The phrase “global growth rotation” probably best describes this anticipated scenario for 2006 — less U.S., more Asia, with the replacement perhaps incomplete but nonetheless keeping global economic growth relatively firm. And, as usual, this international backdrop will probably matter more to Canada's economic and market prospects than anything that goes on domestically, yielding four predictions.
The first is that the Canadian dollar will stay strong. In foreign exchange markets' eyes, we're still drawers of water and hewers of wood (and, increasingly, tappers of oil wells). Commodity prices are the single biggest influence on the Canadian dollar, and are the dominant reason for the currency's surge over the past three years. Those commodity prices, in turn, are most influenced by the strength of global demand, particularly in the current environment, with supply still constrained by years of underinvestment. If the anticipated global growth rotation leaves Asia's economies strong, then expect the world's hunger for raw materials to remain robust and prices to rise further. The Canadian dollar will go along for the ride.
Secondly, the Canadian stock market will continue to thrive. Expected further buoyancy in commodity prices is the main driver here, too, given that the energy and materials sectors now account for more than 40% of the TSX's market capitalization. The strong loonie plays a role as well, in attracting foreign capital as global investors' returns on Canadian assets are compounded, and in keeping more of Canadians' money at home. One must be ever cautious because this virtuous market circle can turn vicious. But with the bulk of the positive drivers of recent years remaining in place, the outlook for stocks continues to look positive for 2006.
My third prediction is that interest rates will rise, but not by much. If I had told you at the beginning of 2003 that the Canadian dollar would by now be back up to levels last seen in the early 1990s, you'd probably have responded, one, “You're nuts,” two, that the Canadian economy would get crushed, and three, that the Bank of Canada would be furiously cutting rates. And you'd have been wrong on all three (well, certainly the last two). The big reason is that the U.S. economy remained strong, shielding Canada's still-large manufacturing sector from the stronger loonie's full bite. But as that shield slips in 2006, expect both real activity and any pressure on core inflation to slip too, and with them the bank's desire to tighten the monetary reins.
Finally, Canada's regional divergences will intensify. Prices for commodities have risen. Prices for manufactured goods have fallen. The West produces more of the former. Central Canada produces more of the latter. Hence Alberta and B.C. posted nominal GDP growth of 8.5% in 2004, compared to 5% in Ontario and Quebec. That divergence appeared to widen in 2005 (the data won't be out for a while yet). And it should intensify further in 2006, as the expected rotation in global growth leads geography to compound the price contrast, with the West more exposed to a resilient Asia and Central Canada more exposed to a weaker U.S. We've already seen how economic divergence can breed political tension, and it is on that front where the risks are most visible going into an otherwise generally favourable Canadian economic and market environment in 2006.
David Wolf is head of Canadian economics and chief strategist at Merrill Lynch Canada in Toronto.
Whither The Loonie?
The strength of Canada's dollar against foreign currencies (particularly the U.S. greenback) has spawned concern in recent years. Although it rose most sharply through 2003, the loonie took flight again late in 2004 and through most of 2005. A strong dollar helps Canadians buy imports from abroad, but it makes our exports more expensive — and thus less attractive — to foreign buyers. Given that our economy relies heavily on exports, it's no wonder some Canadians are jittery.
Fortunately, our economy has so far weathered the rising loonie. The net export surplus declined through the first quarter of 2005 but recovered in the subsequent two quarters. We believe the Canadian dollar will hold steady at current levels through the next year. Thus we believe that Canada has already largely adjusted to the strong currency — one reason why we at the economics department of BMO Financial Group are optimistic about our economy in the coming year.
Other factors support a positive outlook. One is that our main trading partner has enjoyed relatively robust growth. Despite devastating hurricanes, the U.S. economy appears poised to expand by about 3.5% in 2005. We expect this pace will continue in 2006, thus providing a growing market for Canadian exports.
Another factor is strong demand for natural resource products. Much of that demand comes from China, though other Asian countries are also contributing. This demand pushes commodity prices higher, which boosts both Canadian incomes and profits. China's growth should moderate slightly through 2006, but will remain strong — as will the global economy generally. This will be mirrored in commodity prices, which are expected to edge lower, yet remain near historically high levels.
High commodity prices and solid profits contribute to another reason for optimism: strong investment. Recent anecdotal evidence of rising capital expenditure has been particularly apparent in the energy sector. This reflects, in part, a growing expectation for continued elevated oil prices due to rising political tensions — and attendant concerns about supply — coming from the Middle East. Higher oil prices are particularly favourable for prospects of developing Alberta's vast oilsands deposits. Various firms have recently announced capital expenditures in this area that, taken together, approach an astounding $100 billion. Though this spending will be spread out over the next decade, some initial expenditure will occur in 2006.
We also expect increased business investment outside the energy sector in the face of rising capacity utilization. In other words, many firms are almost fully employing their existing equipment and facilities; there's little slack available to meet any additional demand. However, thanks to recent solid profit gains, many companies are well-poised to respond by adding to their capital infrastructure. They'll be further aided by the strong Canadian dollar, which essentially lowers the price of imported capital (particularly machinery and equipment) from the U.S.
The most disappointing element in Canada's economic performance so far this decade has been the almost total lack of growth in labour productivity. It's been particularly stagnant over the past couple of years — a fact made all the more glaring because our southern neighbours have made very robust gains. The expected rise in investment spending is an important prerequisite for boosting productivity growth from its recent lethargy. Though spending on imported capital goods does not directly contribute to growth in GDP — which only reflects spending on domestically produced goods — it can have an indirect and positive effect by boosting productivity.
Growth will be offset somewhat in 2006 by rising interest rates. While we expect the Bank of Canada to ratchet up rates in the near term, this is best viewed as removing unneeded stimulus rather than aggressively tightening credit. Growth in interest-rate-sensitive areas (like residential investment and consumption of durables) will likely slow but won't retrench sharply. Therefore, these areas are likely to continue to add to growth, though by a smaller amount relative to the initial years coming out of the 2000-01 slowdown.
All things considered, we expect Canada's GDP to rise 3.5% in 2006, up from a projected 3.0% rise in 2005. If this higher growth rate is achieved, plaudits are due to Canadian businesses for adapting to the surging loonie.
Paul Ferley is assistant chief economist at BMO Financial Group in Toronto.
Stay The Course
These days, more Canadians hold financial assets directly in personal portfolios than ever before. Investors face a deluge of media coverage on day-to-day developments in financial markets. They have plenty of information at their fingertips, but this has encouraged some to make investment decisions based on short-term market movements.
Chasing current market fads generally makes for a poor investment strategy. Most investors should focus on building well-diversified portfolios, holding a mixture of cash, bonds and equities based upon their personal risk tolerance. And unless an individual is near retirement, the time horizon should be a decade or longer.
These observations are particularly relevant today, as there are storm clouds on the horizon. The global, U.S. and Canadian economies are on track to deliver solid economic growth this year and are likely to experience healthy gains in the first half of 2006. But the combination of tighter monetary policy, continued high energy prices and a cooling in overheated North American housing markets (particularly in the U.S.) may dampen the economic expansion in the second half of 2006 or in early 2007.
Such an outcome would be consistent with history. Economies fluctuate regularly over time, with recessions followed by recoveries and then expansions. Economists call this the business cycle, and over the past several decades the macroeconomic fluctuations have tended to be about 10 years long. Remember the recessions in the early '70s, '80s and '90s and the economic slump in 2001? Economic cycles, however, are far from smooth. There are often mid-business-cycle slowdowns, where economic growth slips to well below its long-run trend pace for several quarters. That is what happened in 1995, and we expect it to begin again in six to 12 months. If so, economic growth would be lacklustre for several quarters before accelerating once again.
A mid-cycle slowdown would have a number of major financial market implications. First, while the Bank of Canada is currently in the midst of a policy-tightening cycle, the peak in interest rates is likely to come at historically low levels and should not be sustained for long. The central bank would probably cut rates in response to the future economic weakness. Second, bond yields may rise in the near term, but they too would retreat again when economic conditions soften. Third, corporate profit growth would slow, posing a hurdle to equity markets.
There is much more to this investment story, however, because the characteristics of the business cycle have changed. Most importantly, fluctuations in economic growth, inflation and interest rates have become significantly less pronounced over the past several decades. The reduction in volatility means that while peaks are not as high, troughs are also not as deep. So, while financial markets will be affected by short-term changes in economic conditions, lower volatility should mean more stable financial returns over the long haul. However, since financial returns are also a function of risk, and lower volatility means less risk, the implication is that financial markets will likely deliver more modest returns than in past decades. Using a variety of conservative long-run assumptions, TD Economics expects a well-diversified portfolio to deliver average annual returns of 6% to 8% over the next decade.
If a mid-business-cycle slowdown occurs, Canadians will be bombarded by negative news. They should resist the urge to respond. Indeed, the most prudent strategy for those with well-structured portfolios is to stay the course, ride out any near-term rough seas in markets, and continue investing for the long haul.
Craig Alexander is vice-president and deputy chief economist at TD Bank Financial Group in Toronto.
What About Household Debt?
Turn on the TV or open a newspaper, and you may be confronted with alarming stories decrying the precarious state of household finances. A minority of economists tell us that consumers are up to their eyeballs in debt and that they'll be in deep trouble when interest rates rise. Few deny the importance of consumer spending to the overall economic outlook; Canadian households directly control almost two-thirds of overall economic activity. Fortunately, the pessimists have been wrong for at least a decade. And they'll be proved wrong again in 2006.
Much of the gloomy viewpoint relies on misguided analysis. One flawed comparison sums up all household debt and expresses it as a share of after-tax personal incomes. This reveals a rising trend over the decades —suggesting households have acquired debt with abandon. This approach would earn an F in first-year economics. It unfairly stacks a person's total debt against a single year's income. Mortgages make up three-quarters of personal debt — debt that one finances over much of one's working lifetime.
It's better to look at debt payments as a share of total income. These are comfortably within historical ranges. You could also examine how much debt households have in relation to their assets. This debt-to-assets ratio has always trended between 13 and 19 percentage points since the 1960s. Lastly, debt growth properly adjusted for inflation is comfortably in line with long-term trends.
Another oft-cited concern is that households are saving little to nothing on average out of their after-tax incomes. While true, this excludes wealth gains such as rising values of homes and equities after netting out rising debt. When included, we see a very strong saving picture and continued growth in home equity and household net worth. At the same time, households are flush with liquidity: cash and near cash holdings equal almost half of total after-tax personal incomes. That's a strong buffer against future shocks.
When you consider Canadians' cash flow situation, there's little cause for panic. Since the start of this decade, our economy has cranked out about 1.75 million new jobs. Our unemployment rate is the lowest in more than three decades, and the share of the population that is currently employed is higher than at any prior point over this same period. Job growth has been the linchpin in driving the consumer sector forward. It's likely to play that role again during 2006, during which 300,000 new jobs are forecast. Tight labour markets create difficulties for businesses, but consumers benefit from strengthening income growth and may get an added boost from modest tax cuts. A low-inflation environment, with some prices particularly for imported goods actually falling, is also favourable to spending.
Granted, high energy prices may modestly slow consumer spending. They will not, however, pull the rug out from beneath consumers' feet. Consider this: over the period from the end of 1998 up to the present, oil prices soared from US$10 a barrel to six times higher. Over this same period, consumers increased their spending on all fuels for vehicles and homes by only an extra 1.25% of their after-tax incomes, to about 5% of income today. When it comes to cash flow, job growth and income gains have trumped higher energy prices.
What about rising interest rates? If this were Australia, the U.K., Germany, Spain, Finland or Ireland — where at least three-quarters of mortgages have variable rates — there might be greater cause for concern. But in Canada, only about one-quarter of all outstanding mortgage accounts are variable rate and exposed to a rising interest rate environment. (In the U.S., the figure stands at about one-third.) In other words, three-quarters of a generation of Canadian homebuyers have locked in at the most favourable borrowing costs seen in decades. The other quarter of mortgage holders with variable rates have enjoyed even lower rates and more of their payments are therefore going toward paying down principal. What's more, even though sub-prime high loan-to-value-ratio mortgages are growing, they remain a very small and legitimate part of the market.
Even the oft-cited risk posed by rising interest rates to personal lines of credit is typically overstated. Balances on lines of credit have expanded from 10% of consumer loans excluding mortgages a decade ago, to almost 40% today. But they've grown at the expense of higher cost and less flexible borrowing options like credit cards and instalment loans. These arguments are some of the reasons why economists at the IMF, OECD, Bank of Canada, U.S. Federal Reserve and most major financial institutions think that overall household conditions are healthy.
So what are consumers going to buy? They will likely purchase slightly fewer houses each year ahead in a controlled cool-down in housing markets that will leave prices to enjoy modest single-digit gains. They will also probably demand somewhat fewer automobiles after a tremendous run. But that still leaves ample room for healthy growth in services that comprise more than half of consumer spending, non-durable items like clothing that account for another quarter, and big-ticket items that account for the remaining 21% of spending, of which autos are just one part.
On balance, while perhaps not quite as good as recent years, conditions are still ripe for ongoing growth in consumer spending in 2006.
Derek Holt is assistant chief economist at RBC Financial Group in Toronto.
What Raise Will You Get?
Canadians will see higher wages in 2006. Upward pressure on compensation stems from a shortage of skilled workers, an aging working population opting for retirement, and a sense among union leaders that pay raises have not kept pace with corporate profitability. Workers in red-hot Alberta will see the fattest pay increases. “Go west if you want to get rich” is the motto for the coming year.
Labour markets will continue tightening as employment growth accelerates to 1.9% in 2006, and the unemployment rate will reach a remarkable low of 6.6% nationally. Whereas employers held the hammer during the late 1990s, it is fast becoming an employees' market.
Healthy employment gains in sectors such as oil and gas appear to be changing workers' attitudes. Job anxiety, a key reason for holding wage growth, is giving way to demands for bigger pay raises in the midst of a roaring economy. Employees are more confident that they will have no problem finding work, and are leaving jobs for higher pay elsewhere. Voluntary turnover increased to 8% in 2005, up from 6.6% in 2004. Employees with less than two years of service are even more footloose, and will readily hop for money.
It's no surprise that 67% of Canadian organizations say they face difficulty attracting and retaining employees with the specific skills they need, a steep jump from 49% in 2004. This challenge is particularly acute out west; the figure is 88% in British Columbia and 82% in Alberta.
The Conference Board of Canada's Compensation Planning Outlook 2006 survey of 347 medium-sized and large organizations indicates that firms are planning to provide average base-pay increases of 3.4% in 2006 for non-unionized employees. A more likely scenario, based on consultation with senior corporate leaders, is an average increase verging on 4% nationally. An analysis of past research supports this. Our experience shows that actual increases have been consistently higher than forecast during good economic times.
However, those in hot sectors (like oil and gas) or in high-demand occupations will do even better. Increases in Alberta are likely to reach 6%. With more than $40 billion invested in Fort McMurray tar sands projects, it's no exaggeration to say that there is a war for employees in this region. The labour supply-demand gap is so big for some specific skills that more frequent ad hoc adjustments to base pay — instead of the regular annual increase — are not uncommon. Companies are also turning to enhanced annual bonus plans, as well as signing, retention and employee referral bonuses to sweeten their rewards offerings.
Salary increases for public sector employees will average 3.6%. Most governments are eager to attract and retain employees, because a large cohort of their workers is nearing retirement. This increase will help close the gap between private and public sector pay that resulted from many years of salary freezes for public sector employees in the 1990s.
Non-unionized workers in Ontario will likely receive the lowest increases, estimated to be 3.1% on average. This is principally because the manufacturing sector has been hard hit by fierce competition, rising energy costs and the strong Canadian dollar. A 3.1% increase in this difficult environment suggests that companies are mainly focusing on keeping their employees. However, management will expect significant increases in productivity as a quid pro quo.
Management is likely to take a tough stand on managing the wage bill during collective bargaining in 2006. Unionized employees can expect average increases of 2.5%. Controlling the escalating cost of health-care benefits and retirement plans will be a critical issue at a range of well-established companies, many of which compete with companies having negligible retiree costs. Unions will in all likelihood take the opposite stand in bargaining; they will focus on improving pension benefits for their members (reflecting union demographics) and employment security.
Taken together, a booming economy and skills shortages imply that the pendulum of power is clearly shifting toward employees in 2006. This swing will only intensify by 2010 when our aging workforce begins retiring in substantial numbers. For companies with a high proportion of older workers and a good defined-benefit pension plan, that could arrive even sooner.
Prem Benimadhu is vice-president of organizational performance at the Conference Board of Canada in Ottawa.
Fuelling The Fire
It's no secret that 2005 has been the most prosperous year in the history of Canada's oil-and-gas industry. That prosperity reflects this country's position as a global energy powerhouse. We've come a long way from 19th-century explorers like Kootenai Brown and John Lineham, who realized that oil seepages on the surface pointed to energy riches in the rocks beneath our nation. The riches are still there, more valuable than ever, and so Canadians should expect prosperity from a robust oil and gas industry to continue resonating across our country into 2006 and beyond.
Let's look at some numbers. Canadian upstream oil-and-gas revenues — the dollars generated from the sale of unrefined petroleum products and natural gas — will top $105 billion in 2005. It's the first time the hundred-billion-dollar level has been breached. That level is 25% greater than last year, and five times what it was a mere decade ago. After-tax cash flows show similar, spectacular growth, and should exceed $55 billion. The prognosis for 2006 is for a similar performance, and notwithstanding a global economic meltdown, $100-billion-plus revenue numbers are likely sustainable by our oil-and-gas industry for several years to come. That has important implications for the Canadian economy. Higher tax and royalty revenues, a growing need for materials, equipment and services, and high-paying jobs for workers from across the country are among the benefits accruing to Canadians.
The primary impetus for the stellar top line in our petroleum industry comes from strengthening oil-and-gas prices, which have risen with conviction over the past five years. Though the causes are complex, the economics are simple: tightening supplies in the face of a steadily growing global dependence on oil is why prices are rising — and the symptoms are not going away overnight.
Collectively, our energy-hungry global community is now demanding 85 million barrels of oil every day — or roughly 1,000 barrels a second. That's four Olympic-size swimming pools full of oil being drained every minute. And global consumption is not slowing. It's not a question of if consumption will grow next year, or the year after. The question is, By how much? Under modest global economic growth scenarios, oil demand will grow by at least one million barrels per day, per year, for the rest of the decade and beyond. The U.S. still has the biggest appetite, but China and other rapidly industrializing Asian nations are growing thirstier as they use oil as their “booster rocket” for economic growth. That Olympic swimming pool full of oil will drain faster and faster every year.
Supplying the planet's new oil consumers, from drivers to industrial companies, is getting neither easier nor cheaper. The era of drilling holes in the ground and being rewarded with oil gushers is history. After 145 years of consuming oil, the world's inventory of prospects is becoming more limited, and more difficult to develop. Consequently, costs escalate and prices go up. But let's be clear: we're not running out of oil, as some like to suggest. There's plenty of oil in the world. The big issue is that each additional barrel of oil that the world is demanding is now much costlier to bring to market than even five years ago.
And that brings us back to Canada, and our famous oilsands. As the name implies, oilsands are an aggregation of tarry, “heavy” oil mixed with sand. It's an unconventional or secondary source of oil. Unlike conventional oil, which flows easily out of a well drilled into the ground, oilsands must be specially processed to yield the “lighter,” “sweeter” oil that refineries require. Exploiting and processing oilsands is an energy-intense process that requires billions of dollars of infrastructure.
Fort McMurray, Alta., was put on the international stage in 2004, when oil economists at the U.S. Department of Energy officially recognized that Canada's oilsands contained more than 200 billion barrels in oil reserves, the second-largest accumulation of oil in the world (after Saudi Arabia). In 2005 the oilsands made mainstream headlines as companies from as far away as China joined the gold rush to secure the area's valuable energy supplies.
The gold rush of investment in the oilsands, about $95 billion over the next 10 years, is expected to increase Canadian production over two and a half times from the Fort McMurray region to 2.7 million barrels per day by 2015. This bonanza represents the largest energy project in the world today. When oil was US$20 per barrel, it took vision by companies like Suncor to invest in an area that was almost totally disadvantaged against cheap Middle Eastern oil. Everything changed in 2005 after much of the industry became convinced that higher prices of coveted, light crude oil would be sustained.
Perhaps Sir John Cadman, the chairman of Anglo Persian (the predecessor company to BP), said it best, in 1928: “The time will eventually come when the world may have to look for a greater part of its supplies from secondary and synthetic sources, but he would indeed be an optimist who imagined that — on the reaching of such a stage — prices would remain as low as those existing in the past.”
Sir John's prophecy has come to pass in the wilderness of our oilsands. It's a prophecy that translates into greater prosperity for all Canadians.
Peter Tertzakian is chief energy economist at ARC Financial Corp. in Calgary.