Connor, Clark & Lunn, the manager of our Savings Fund and Income Fund, produces an outlook every month on the economy and capital markets. Their recent commentary on Canada is particularly clear, candid, and sobering. CC&L’s views on the US and China, on the other hand, are more optimistic. Below are a few excerpts from the report that, although lengthy, investors may find informative.
“Oh Canada” — one of the best places on the planet to live. Besides our civil society, Canada is a bastion of ﬁscal prudence and sound economic planning ... A lot of our good fortune has come from previous sound ﬁscal practices and we’ve been a big beneﬁciary of rising commodity prices which has shown up in our national accounts, employment trends and terms of trade. However, a closer look shows some cracks in this ﬁscal facade. Take for instance Canada’s debt picture. It is true that net federal debt as a percentage of GDP is only 33%, compared to an average of nearly 80% for the G7 countries, but when provincial liabilities are added into the equation the gross consolidated ﬁgure jumps to 103%. This puts Canada ahead of the UK, Germany, France and Spain and just behind the US at 105%.
Unfortunately, it appears that the ﬁscal situation is not going to get better any time soon … A weakening in commodity prices, a struggling manufacturing sector, and structural revenue issues related to previous cuts in the GST are largely to blame. Also, provincial governments are increasingly between a rock and a hard place because the vast majority of Canada’s social programs, such as health care, social assistance and education, fall under their jurisdiction. Rising costs in these sectors continue to run ahead of revenue gains at a time when the public has no appetite for tax increases.
Another crack in the ﬁscal facade is the state of the Canadian consumer who is increasingly becoming overleveraged (too much debt). This has largely come about because of the housing market. House prices have been on a rampage for over a decade, increasing by over 100% thanks to cheap and easily available ﬁnancing. It has now got to the point that household debt to income ratios in Canada are well in excess of the levels reached in the US prior to the burst in their housing bubble … Of course any rise in interest rates will only exacerbate the situation and the virtuous circle of falling interest rates, rising home prices and increased economic activity will come undone.
The third crack in the ﬁscal facade is on the revenue line. From a historical perspective the secular move in commodity prices is extended in terms of its magnitude and duration and it increasingly appears that the secular bull market is coming to an end. The supply/demand equation is deteriorating and it appears that the ﬁnancial demand for commodities as a hedge against depreciating currencies has largely run its course. Over the long term, relative pricing power has not resided with commodity producers but with those entities that bring the highest value added to the supply chain. These factors point to the eventual regression of prices back to the long-term declining trend that has occurred in real commodity prices over the past 200 years.
The bottom line is that the state of Canada’s ﬁscal house is not as rock solid as one might think. Longer term this could have some negative ramiﬁcations if things continue on their current track. As such, we need to be vigilant in monitoring the housing market, commodity prices, productivity gains and the level of the Canadian dollar. All of these factors will impact the country’s ﬁscal position and in turn our future rate of economic growth and ﬁnancial market returns.
The US and China
In terms of the US, while the looming ﬁscal cliff has the potential to push the economy into recession, we are still of the opinion that saner heads will prevail even if negotiations drag out to the very last minute. In the meantime, the underlying fundamentals for the US economy are relatively good. The Federal Reserve is in an accommodative mode and will remain so because there are no impending capacity constraints. Pent-up demand is huge, the housing market has turned, the employment picture is improving and consumer conﬁdence is rising. In addition, American manufacturers are very competitive because of strong productivity gains, a weak dollar and low energy costs relative to the rest of the world. Finally, even the ﬁscal cliff may turn out to be a net positive (psychologically) if its resolution leads to the US budget being put on a sustainable path without unduly impeding economic growth.
A pickup in US growth will also be of beneﬁt to China where there are now some early signs that the country will experience a soft landing. Money supply and credit growth have improved, monetary policy remains accommodative, investment in ﬁxed assets is picking up, trade numbers are ﬁrming thanks to strength in both domestic demand and exports and the political leadership transition appears to have gone relatively smoothly.
While CC&L’s views on Canada’s fiscal house are temperate, the manager nonetheless has a positive outlook for stocks at home, and more so, abroad. They feel that valuations are attractive and the outlook for global growth is improving. The Canadian market outpaced many global markets over the past decade, but the tide always turns at some point, which is why geographic diversification is key. This is a message we have repeatedly been emphasizing and is reflected in the make-up of our funds.