While trade policy has dominated headlines, we believe investors should focus on the collapse of Western Canadian Select (WCS) oil prices relative to global benchmarks, which represents the biggest exogenous risk to the Canadian economy.
Canadian oil plunged from a peak of $58 (U.S. dollars) in May 2018 to a low of $21 earlier this month (source: Bloomberg) even as global prices were roughly unchanged or higher due to a combination of pipeline capacity, increased oil sands production and extra refinery maintenance in the U.S. Midwest. Until major pipeline projects are completed (late 2019 by our estimate), WCS will likely be prone to big price declines versus the broadly watched benchmark West Texas Intermediate (WTI) oil prices.
In 2015, this kind of oil price decline led the Bank of Canada (BOC) to cut the overnight interest rate twice. While we expect the drag on Canadian GDP to be more muted this time, it is still likely to be significant. Oil price declines could detract 0.25%–0.5% from annualized GDP growth compared with 1% in 2015. One reason the outlook is different in 2018 is that oil prices are starting at lower levels and thus investment in the energy sector is already lower now than in 2015, so the negative impact of cancelling investments should also be diminished.
While Canada’s economy is stronger now than it was in 2015 (the output gap virtually closed, core inflation at the 2% target, and the unemployment rate almost a full percentage point lower), the decline in oil prices makes us question whether the BOC can raise the overnight rate from its current 1.5% to 2.5% at the pace implied by the market. Currently, the market has priced in the same number of rate hikes for the U.S. Federal Reserve and the BOC through 2019 even though U.S. growth has been stronger and more diversified than Canada’s consumer-leverage-driven growth.
Given that risk/reward profile, we believe the front end of the Canadian yield curve looks attractive relative to the U.S., especially shorter-dated bonds relative to those with maturities over 10 years given the flatness of the Canadian yield curve.
Learn about our oil price outlook in light of the renewed Iran sanctions.
Ed Devlin is a generalist portfolio manager and head of Canadian portfolio management. Vinayak Seshasayee is a generalist portfolio manager. Michael Kim is a Canadian bond portfolio manager.