Why Canada's economy is in trouble

Analysts are beginning to raise concerns about Canada's near-term economic growth. The nation's central bank is holding the overnight rate at 1% and will likely maintain this level for some time to come.

Toronto Star: - The [central] bank’s current stance reflects the weak performance of the economy in the last months of 2012. Canada’s gross domestic product (GDP), which measures total output of goods and services, grew by a meagre 0.6 per cent on an annual basis in the final three months of last year. For 2012 as a whole, Canada’s economy recorded growth of 1.8 per cent, down from 2.6 per cent in 2011.

This weakness in Canada's economy is clearly visible in the relative performance of the Canadian and the US equity markets. The two markets, which have traditionally moved fairly closely together, have diverged recently.

S&P/TSX (Canada): blue, S&P500 (US): red

A number of somewhat related factors are driving this weakness in Canada's growth. Here are some of them:

1. Canada's exports are heavily concentrated in energy with a big focus on the nation's largest trading partner, the US. And as discussed before, the US energy markets are now quite well supplied. The US has a tremendous domestic source of natural gas, while crude oil inventories are high relative to historical levels - reducing demand for Canadian energy product in the US.

Source: EIA

2. Over the past decade the Canadian dollar has strengthened dramatically, and in spite of some temporary weakness during the financial crisis is still close to parity with the US dollar. This makes Canadian products more expensive on a relative basis.

Number of Canadian dollars per one US dollar (USD/CAD)

3. As discussed before (see post), Canada's housing market may be facing some headwinds going forward. Valuations have materially outpaced those in the US.  There is a great deal of debate on this topic, but it's quite clear that Canadians have been pumping significant capital (materially higher than 6% of GDP) into residential housing over the recent years - even as the US housing expenditures collapsed.

Source: DB

4. Over the past decade Canada's manufacturing labor costs have sharply outpaced those in the US, making Canadian firms less competitive.

Canadian unit labor costs: blue, US unit labor costs: red

5. Mexico, with its cheaper labor and a growing manufacturing base, is increasingly taking Canada's export share into the US.

Source: Deutsche Bank

6. Driven in part by the strength of the Canadian dollar as well as worsening labor competitiveness, Canada's current account has been in the red for some time now. What's particularly troubling is Canada's deterioration of the current account outside of energy exports. The trend is making the nation increasingly reliant on its energy export just as the demand from the US declines.

Source: Deutsche Bank

These developments don't bode well for Canada's economic expansion and for the valuation of the Canadian dollar in the near-term.

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