Dec. 31, 2018
Let’s get into the outlook for 2019. It’s not pretty, but such is the math. The shocks to GDP are all to the downside:
- 0.75-per-cent hit from what the BoC has already done in terms of rate hikes;
- 0.75-per-cent hit to household spending related to housing and equities;
- 0.5 per cent from the receding global economy;
- 0.25 per cent from energy and auto production cuts;
- 0.25-per-cent drag from Ontario fiscal belt-tightening, but this will be offset by federal stimulus (so a wash).
The current trend on Canadian real GDP growth is 2 per cent. The negative shocks above come to 2.25 per cent. This leads to a mild recession next year. I realize the consensus isn’t there yet, but the consensus historically calls for the recession when we are already several months into it.
Let’s face the facts – the excess indebtedness is really the No. 1 risk, especially seeing as we have yet to see the full lagged impact of the 125 basis points of rate hikes the Bank of Canada has implemented. I am not sure it is well appreciated that Canadian household debt, in aggregate has expanded to $2.2-trillion, almost doubling in the past decade. That is equivalent to nearly 100 per cent of GDP or about $150,000 a household – an untenable number.
And it isn’t just consumer and mortgage debt – it is at all levels of society. Canadian debt in aggregate, including households, businesses and all levels of government, now sums to nearly 290 per cent of GDP. That is, in a word, stratospheric. China and Italy, renowned basket cases when it comes to excessive leverage, are closer to a 260 per cent all-in debt-to-GDP ratio. The United States, even with the gargantuan fiscal stimulus and wave of bond-financed share buybacks this cycle, has a debt ratio of 250 per cent. We are near the high end on the OECD ladder (ninth of 34) and let’s face it – it really is quite an accomplishment when you can make the Italians blush when it comes to stretched balanced sheets.
Meanwhile, we have bloated housing prices in the two largest residential real estate markets – Toronto and Vancouver. While both have corrected, especially the latter, reverting their home price-to-income ratios to the mean would entail a further 20-per-cent decline in average house values in both jurisdictions. This wouldn’t be a “national” issue if these two cities didn’t comprise one-third of the country’s housing activity.
The economy is attracting record immigration and creating impressive job growth, indeed. But the quality of the jobs is spurious at best. Wage growth is decelerating at the same time the labour market has tightened, which attests to the poor performance of productivity growth, which is practically stagnant. The government has spent no time on enhancing the capital stock or redressing the lack of competitiveness, owing to a tax system that is confiscatory on the personal side and provides incentives for businesses to stay small on the corporate side. The level of red tape, interprovincial barriers to trade and a balance of political power that is now tipped toward the environment and away from growth are palpable constraints on the economy.
Some things are beyond our control, such as the global nature of the economy, which leaves us vulnerable to shifts in global GDP. You can easily connect the dots between a 30-per-cent bear market in China in this game of dominoes to the slide in commodity prices and the impact this then exerts on Canadian securities, profitability, the currency and the economy.
But some things are within our control, although (1) it will require a shift in Bank of Canada policy, (2) it will require that people act the way they used to in decades past, which is living within their means, and (3) it will require developing a pro-growth energy and taxation policy. Of course, the last item may well require political change and a willingness for Ottawa to play tough with certain interest groups.
Global investors, including Canadian businesses, are voting with their pocketbooks, because net direct investment flows have been negative now for 11 of the past 12 quarters, a cumulative $150-billion of “bricks and mortar” investment that has packed up and left the country. It is against this backdrop that the Canadian dollar remains depressed, that Canadian interest rates continue to hover below their U.S. counterparts, and that the domestic stock market is trading with an emerging market-like forward price-to-earnings multiple of 13 times. This has only happened 5 per cent of the time in the past and compares with the multiple of more than 15 times in the United States, even after this recent corrective phase. But each market – currency, bond and equity – has reassessed Canada’s economic outlook.
On the positive side, Canada now is a deep-value turnaround candidate, but it needs a catalyst. Maybe it will be next year's federal election.
For an investing standpoint, energy and financials do have significant valuation floors at the moment. And the Canadian banks have some very tempting yields after this steep sell-off (which really has been global in nature). If history has taught us anything (including 2008-09) it is that in an increasingly unsafe planet, Canadian bank dividends are very safe. But ensuring you have upgraded the quality of the entire portfolio – minimizing cyclical sensitivity, focusing on value over growth, shifting toward non-correlated strategies (not correlated to the overall equity market) and hedging against recurring Canadian dollar weakness – will increase your chances of financial success in the coming year.
David Rosenberg is chief economist with Gluskin Sheff + Associates Inc.