Concerns about the European debt crisis – which have lingered for more than a year – flared in late summer and into the fall and now look as though they will weigh heavily on the global economic landscape heading into 2012. Increased worries about European banks have hit global financial stocks and undercut credit markets. Credit growth is essential for global economic growth, even if demand for credit in developed countries remains lacklustre. Reacting to the worsening economic backdrop, the Canadian dollar closed weaker than parity against the US$ in late September for the first time since January 2011.
As the crisis has grown in scope over the past few months and US economic data have slowed, we’ve downgraded our global growth forecast. We now expect the global economy to grow 3.6% this year and 3.5% in 2012, a marked deceleration from 5.1% in 2010. That compares with our call at the start of the year for 3.9% growth this year and 4.5% in 2012. Our outlook for Canadian growth was downgraded to 2.2% in 2011 and 1.8% in 2012, a far cry from the 2.7% and 2.6%, respectively, forecasted at the start of this year. The weaker growth picture has also prompted us to push back our call for the Bank of Canada’s next rate hike to January 2013. However, note that while we continue to differ from market expectations for a rate cut, we concede that the most likely near-term move would be an ease, though the bar for such a move is likely quite high, particularly with core inflation moving above 2%.
The Bank of Canada’s anticipated steady hand on policy is driven by a number of factors. In the near term, Governor Carney doesn’t appear keen on cutting rates with Canadian households already grappling with record high household as a share of personal disposable income. Concerns about overvaluation in the housing market are no doubt also reason for pause. Since cutting policy rates would juice debt growth, the Bank doesn’t want to contribute to potential financial instability. With respect to rate hikes, the stiff external headwinds battering the Canadian economy, the BoC’s expectation that the economy won’t return to full capacity until the end of 2013, and a reticence to diverge too far from the Fed funds target (as that would lift the loonie), all but rule out near-term tightening prospects.
Despite the European crisis, the Loonie held up remarkably well until late September due in part to Canada’s safe-haven status. Capital inflows remained very strong in the 12-months to August, totalling $102.2 billion (Chart 1). Those flows have slowed somewhat of late, amid a flight-to-liquidity (ie, US Treasuries), contributing to the slide in the Canadian dollar. It’s also important to note that commodity markets were hanging in as well until recently, taking a more positive view on growth. Clearly that’s changed with a significant commodity price correction in the late summer and a reversal isn’t likely until the economic data start to improve.
Global financial markets have sniffed out a sharply weaker global outlook, with equities and commodity prices plunging through September. Copper is down about 30% from the record high hit in February 2011. Oil prices have come down as well, with WTI briefly trading under $80 for only the second time in the past year.
BMO Capital Markets Economics is now looking for the Canadian dollar to weaken through the turn of the year towards C$1.075 (Chart 2), as we expect the European debt crisis to linger well into 2012, if not longer. Even if European leaders are able to satisfy markets with bold action, global growth isn’t likely to rebound quickly, which should weigh on commodity prices and the Loonie. Indeed, European economies are likely to be hamstrung by austerity measures and restructuring for at least the next few years.
The Loonie is expected to remain near C$1.05 until the second half of 2012, by which time the global outlook should start to improve as the extreme worries about the European crisis fade. Accelerating global growth will provide support to the C$, pushing it back to parity by the end of 2012. The currency is expected to appreciate modestly further early in 2013 as the Bank of Canada raises rates ahead of the Federal Reserve. However, once the Fed starts hiking rates in the second half of 2013, the loonie is expected to trend weaker, settling towards a long-run value of C$1.05 to C$1.10.
One bright side of the Loonie’s weaker outlook is that exporters will be provided a little extra competitive assistance. The export sector has been hit hard by the surging C$, with manufacturers bearing the brunt. Indeed, exports and manufacturing activity remain well below pre-recession levels, while much of the rest of the economy is in expansion mode. Imports, on the other hand, have recovered fully and hit new highs in recent months, boosted by solid Canadian domestic demand and the lofty Loonie. Unfortunately, it’s likely that a weaker dollar will be only modestly helpful for the trade sector, as the softer outlook is driven by slower global growth (including sluggish US demand). Indeed, the current account balance, which had an average deficit of 3.2% of GDP in the year to Q2, isn’t likely to return to surplus in the near term, suggesting the loonie is modestly overvalued from a longer-term perspective (Chart 3).
The risks to the outlook are especially important to highlight amid heightened uncertainty. Over the near term, the risks to our Canadian dollar forecast are skewed towards further weakness, mirroring the risks to the global growth outlook. Recall that the loonie hit C$1.30 in the months following the Lehman crisis, suggesting that there’s the potential for significant further weakness in the currency, while upside risks are likely limited.
Even if everything goes right globally, the Loonie isn’t likely to break beyond the C$0.94 peak hit in late July. European austerity will ensure that growth in the region remains lacklustre for at least the next couple of years. The US will face a similar headwind, with significant fiscal tightening in the offing with the budget supercommittee November deadline fast approaching. Meantime, China’s economy is poised to slow further in response to tightening measures designed to counter inflation pressure. No matter where the Canadian dollar ends up, expect the elevated level of volatility to persist as markets continue to debate whether or not the global economy is headed for recession.
Benjamin Reitzes is senior economist and foreign exchange strategist at BMO Capital Markets.