Canadian technology sector performance and valuation
The Canadian dollar’s recent gains aren’t all about speculators shifting hot money across borders. There’s also the mundane transactions associated with payments for traded goods and services, interest, dividends and some even more obscure current account line items.
These may seem like a snoozefest to foreign exchange players, but recent developments in such flows have been part of the backdrop for an appreciating Canadian dollar. Will those favorable flows last? Let’s have a look.
A Shrinking Shortfall
Last year ended with a shrinking shortfall in Canada’s overall current account balance. Relative to what we saw in 2019, the quarterly headline deficit in that measure of trade and income flows was roughly $5 bn
Chart 1: Swing to Surplus in Primary Income, Services, Outweigh Larger Goods Deficit
Source: Statistics Canada, CIBC
lighter (Chart 1). That implies less net selling of the loonie to cover these flows than we experienced in the year prior to the pandemic.
But one huge distortion underpinned much of the shrinkage in the current account gap: the collapse of international travel. The other major positive was a turn to surplus in “primary income” flows, with Canada now earning more on its investments abroad than it is paying out to foreigners owning assets here. But there too, there are reasons to think some of this is too good to last.
Good News Ahead on Goods
On the goods side of the trade ledger, the news ahead looks brighter, and we got a taste of that in a strong report for January. Exports jumped 8%, helped by both firming prices for energy and other products, and volume gains in line with the improving global economic picture. True, that included a one-off export of used aircraft that won’t show up in production or GDP, and won’t be repeated in the future. But goods trade would still have been roughly in balance that month ex-aircraft.
Energy exports were still light in Q4 relative to 2019 (Chart 2), and firmer prices and volumes will propel them higher through the first half of 2021. Canadian consumer spending will rebound as pandemic restraints ease, so we might not get quick relief from the wider deficit in consumer goods. However, we expect the gains in consumption will be more tilted to services.
Chart 2: Larger Deficits in Consumer Goods, Energy, in Q4 2020 vs 2019 Average
Source: Statistics Canada, CIBC
with household spending on goods already running above its pre-recession trend (Chart 3, left). In contrast, nominal oil exports have been far from normal, and even assuming WTI oil prices settle back to the US$60/bbl level as OPEC+ restores output later this year, nominal exports could be around $2 bn a month higher than end 2020 levels come 2022 (Chart 3, right).
The Staycation Effect
The broad commodity story has some getting very bulled up on the implications for the Canadian dollar. Every extra dollar spent by foreigners to buy Canadian oil, copper, or building materials shows up as a net purchase of the loonie, and much of that will stay in that currency
Chart 3: Consumer Goods Imports Could Have Already Peaked (L), Room For Oil Exports to Rebound Further (R)
Source: Statistics Canada, CIBC
as it’s paid out to workers, tax authorities, or domestic shareholders.
Wood product prices could ease from current elevated levels, and we expect somewhat softer US homebuilding come 2022 as we feel the pinch from higher mortgage rates. But the oil trade balance could easily be $5-6 billion higher per quarter in 2022 than it was in Q4 of 2020.
Unfortunately, there’s an equivalent, or even larger offset coming when the world shifts from staycations at home to vacations abroad, when it becomes safe to do so in 2022. Desolate airports and land crossings meant that Canada’s persistant deficit on travel and air transport disappeared by Q4 of last year.
Yes, as Covid fears lift, there will be cruise ships docking in Halifax, Americans roaming the streets of Toronto or Montreal, and foreign skiiers in Western Canada next winter. But in normal times, those inflows are swamped by Canadians going abroad. That’s particularly true in the winter quarter where the travel deficit normally balloons to a full 1% of GDP. Returning to the average travel and overall services defict we saw in 2019 would entail about a $5 bn total adverse swing in the quarterly current account balance (Chart 4).
Oil demand and prices will be lifted as everyone drives and flies the way they used to, but that same driving and flying is going to create about as big a negative for Canada’s current account as an offset. In terms of timing, we’ll see the benefits from higher oil prices and volumes in 2021, but much of the payback on the travel account won’t show up until very late this year and in 2022.
Chart 4: Lack of Overseas Travel Drove Services Into Surplus
Source: Statistics Canada, CIBC
Chart 5: Unlike Services Trade, Primary Income Balance Was Trending Towards The Black Pre-Covid
Source: Statistics Canada, CIBC
So for the loonie, that mix will be more supportive in the next couple of quarters, but less so by the end of 2022 when we look for the joint nominal goods and service trade balance to have almost returned back to its Q4 2020 level.
Borrowing Every Year, But You’d Hardly Know It
Having run a perennial current account deficit since 2008, Canada has by definition been a steady net borrower from the rest of the world. But Canada has managed the trick of seeing faster gains on what it earns on its foreign assets than the growth in its payments of interest, dividend and investment income to the rest of the world. The pandemic accelerated the timing, but unlike the services trade balance, the primary income balance had been trending towards positive territory even before Covid-19 struck (Chart 5).
That largely reflects a major difference in the make up of Canadian investment abroad versus foreign holdings in Canada. Foreigners have for the most part been lapping up Canadian bonds in either domestic or foreign currency issues. A multi-decade decline in bond yields has meant that the flow of interest on each dollar of these securities has tumbled. Canada has had plenty of domestic issuance to meet investor’s fixed income needs, so the assets accumulated by Canadians abroad reflect a need to diverisify equity holdings into sectors underweighted in Canada, or direct investments, including those by Canadian multinationals in sectors like financial services and mining (Chart 6).
Chart 6: Foreigners Hold Low-Yielding Debt, Canada Investing in Higher-Yielding Assets Abroad
Source: Statistics Canada, CIBC
These assets have yielded surperior annual income returns in the form of rising dividends and profits.
The past year has amplified the gap. Although the Bank of Canada has absorbed much of the increase in federal debt, Canada’s swelling deficits have necessitated a spike in net borrowing from abroad, with foreigners buying roughly $150 bn in Canadian debt securities, but paring back their equity holdings in a year in which Canada’s underweight in the tech sector, and overweight in energy, dulled its attraction. Canadians read the same signals, increasing purchases of foreign stocks, and despite the global recession, added to foreign direct assets (Chart 7).
Chart 7: Pandemic Resulted in Even Higher Foreign Purchases of Canadian Debt
Source: Statistics Canada, CIBC
Chart 8: Decline in Payments on Foreign Direct Investment in Canada Flattered Primary Income Balance in 2020
Source: Statistics Canada, CIBC
And in terms of performance, the sectoral differences between Canada’s equity and direct investments abroad, versus what foreigners own in Canada, also meant that flows of profits and dividends on the latter were more adversely impacted by the Covid-19 recession (Chart 8).
That sectoral difference is the one element of this story that could see Canada’s investment income balance look a bit less favourable in the coming two years. Canada should do well in its net asset position in the financial services sector, but we would expect a larger turn in deep cyclicals like manufacturing and oil, where foreign investors own more here than what Canadians have abroad (Chart 9). Still, on balance, Canada’s tilt to equity and direct assets abroad, and fixed income debts to the rest of the world, should be enough to keep the overall investment income balance in the black.
The Message from the Current Account, On Balance
The near-term outlook in the current account, on balance, still looks to be supportive for the Canadian dollar. Nominal exports will get a nice lift from a run of mid- $60 oil prices, and a general firmness in other resources. Meanwhile, the investment income balance will benefit from the mix of equities and direct investment versus low yielding bonds in our international assets and liabilities.
Chart 9: Sectors Where Foreigners Invest Among Hardest Hit, But Should Rebound Post-Pandemic
Source: Statistics Canada, CIBC
But, further out, we see oil and some other commodity prices abating as global supply responds, while a rush to get back on airplanes and see the world in 2022 and beyond sees the travel deficit balloon to its former heights. That would see the current account deficit widen out again (Chart 10). In addition to our view that there’s more room for the market to bring forward expectations for Fed hikes than for the Bank of Canada, that underpins our view that the C$ has some near term gains in store, but will be giving those back come 2022.
Chart 10: Current Account to Narrow Further This Year, But Widen Again Thereafter
Source: Statistics Canada, CIBC
