CANADA – Recession Worries!

Probably the most noteworthy event in the first half of 2015 was the surprise rate cut issued by the Bank of Canada (BoC) in the first quarter. It was designed to provide “insurance against a downturn” in light of the sharp decline in oil prices.

The BoC was right to be concerned. Unfortunately policymakers underestimated the impact lower oil prices would have on the Canadian economy. GDP was negative for the first half of the year and is closing in on recession territory.

Most of that weakness was the result of an abrupt decline in business investment particularly within the energy and commodity sectors. Precious metals, base metals and textiles are all down on the quarter which economists attribute to slowing global demand and a strong US dollar. The latter point is particularly relevant as there is typically a high correlation between commodities and the greenback.

The challenge for many investors is syncing the positive employment numbers (unemployment holding steady at 6.8%) and inflation data which is within the BoCs’ 2.0% target. However when you take away the volatile food and energy components, core inflation is closer to 0.9%.

Unfortunately both of these metrics are lagging indicators. It is only be a matter of time before the effects of an economy moving away from its potential shows up in this data series. That is unless there is a change in business conditions or some kind of intervention by the BoC.

Like others I was of the opinion that Canadian manufacturing would pick up due to lower oil prices softening the impact lower energy prices would have of the economy. That has not played out as expected for reasons that have longer term implications.

The US has been gradually shifting more of their business to Mexico. While a stronger USD makes Canadian goods more competitive, those same forces are amplified when applied to the decline in the Peso. Couple that with lower labor costs and Mexican exports are simply more competitive.

To put some meat on this skeleton Canada’s share of US imports from North America has fallen from 75% in the 1990’s to 50% this year. The end result is that Canadian exporters will benefit from a weaker loonie and a strengthening US economy but its’ impact will be less than in previous expansions. So despite the view that a rising tide lifts all boats it looks like Canada will be getting a smaller piece of a bigger pie.

With respect to interest rates the BoC like their counterparts in the US, have stated that any decisions on interest rates will data dependent. Considering weak GDP data, lackluster business outlook, low inflation and weak manufacturing data one could surmise that another rate cut may be in the offing. Perhaps sooner than later.

One way to play Canada is to look in the consumer staples sector and search for companies that have a domestic focus. One that comes to mind is Alimentation Couche-Tard Inc. (TSX: ATD.B, recent price $58.00). This company operates a chain of convenience stores most of which are located in Quebec. Buying the ATD.B Feb 58 calls at $4.25 look interesting for aggressive traders.