July 17, 2023
Its demographic growth strengthens its economic fundamentals
The wide variety of commodities is a growth asset
Inflation remains high and Canada's central bank is trying to curb it
Credit risk could weigh on the financial system and market performance

CHART OF THE WEEK: "Commodities command the symphony of fortune"


The first Europeans to explore Canada were the Vikings, followed by French and British explorers. European colonisation began in the 16th century and led to conflicts between the colonial powers, mainly France and Great Britain. Canada became a British colony in 1763 and gained independence in 1867. Since then, the country has industrialised thanks to its vast natural resources, notably oil, gas, minerals and forests, and has developed a diversified economy in financial services, information technology and the agri-food sector. Today, Canada is one of the world's leading economies, with a high standard of living, as killed workforce and extensive international trade

Its demographic growth strengthens its economic fundamentals

Like most developed countries, Canada's working population is ageing. Prime Minister Trudeau has decided to take action and has set a target of welcoming 500,000 new permanent residents to Canada every yearby 2025, well above the annual average of around 300,000 over the last twenty years (see Fig. 2).One of the advantages of immigration is that it lowers the average age of the population. Of the newresidents arriving in Canada in 2022, only 3% were over 65 and 77% were of working age (see Fig. 3). Theratio of working people to pensioners is there fore 26:1 for immigrants arriving in 2022. This ratio iscurrently close to 4:1 (working people per pensioner) compared with 7:1, 50 years ago.

Fig. 2 - Annual number of immigrants to Canada

Fig.3 - Ages of immigrants to Canada in 2022

The arrival of more than 50% "chosen" immigrants is boosting GDP growth. These new arrivals find better paid jobs than most of the local population and support growth in consumption. They also help to increase technological innovation, entrepreneurship and the production of goods and services.

The wide variety of commodities is a growth asset

In 2021, the natural resources sector will account for 17.1% of Canada's GDP (see Fig. 4) and more than51% of merchandise exports, or nearly $319 billion. The S&P/TSX Composite Index is the main index for Canadian equities. Its composition reflects Canada's exposure to natural resources. The energy and commodities sectors account for 17% and 12% of the index respectively (see Fig.5),and have a major impact on the index's performance (see this week's chart). The financial sector accounts for almost a third of the index (31%), making the market more cyclical than other developed markets. Defensivesectors (consumer goods 4.2% and utilities 4.5%) account for less than 9% of the index, and pharmaceuticals (0.3%) are virtually absent.

Fig. 4 - Weight of commodities in GDP

Fig. 5 - Sectoral breakdown of the TSX index

Canada's 10 largest market capitalisations include banks (Royal Bank of Canada, Toronto Dominion Bank,Bank of Montreal, Bank of Nova Scotia Halifax), an asset manager (Brookfield Corporation), and energycompanies (Enbridge and Canadian Natural Resources). To transport its commodities, Canada has alsobecome a leader in rail transport with Canadian Pacific Kansas City and Canadian National Railways.Finally, more recently Shopify, an online commerce platform, has increased the volatility of the index.

The Bank of Canada has resumed its fight against inflation

The Bank of Canada was one of the first central banks to raise interest rates in March 2022. It had suspendedits rate hikes temporarily between January and June 2023. However, in response to recent data pointingto a booming economy, the Bank of Canada raised its key rate by a further 25 basis points to 4.75% on 7June (see Fig.6) and stated that it needed to continue tightening monetary policy to bring inflation down. Afurther increase (+25 bsp) was therefore announced on 12 July, setting the key rate at 5%.Canada's gross domestic product grew at an annualised rate of 3.1% in the first quarter, beatingeconomists' expectations as Canadians continued to spend. Inflation came in above expectations at 4.4%in April, slightly higher than the March figure. In May, inflation slowed to 3.4%, in line with expectations.

Fig. 6 - Rate hike curve since 2022

Fig. 7 - Canada's trade balance ($Mn)

Canada's trade deficit in May was the highest since October 2020 (cf. Fig.7). Goods sectors such asagriculture and mining could post weaker-than-expected figures in the second quarter, as exports of thesegoods have fallen. On the import side, real growth points to strong consumer demand during the quarter.As a result, the sharp rise in the trade deficit did not move the forecast for annualized real GDP growth,still estimated at 2% for the second quarter, but rather altered the main cause of this deficit, whichreverted to domestic demand. The Bank of Canada therefore had no choice but to resume its monetarytightening policy.

Credit risk could weigh on the financial system and market performance

The banking sector is a heavy-weight in the Canadian index. Fitch expects financial parameters todeteriorate in 2023. While net interest income (NII) will continue to benefit from the rise in interestrates, an increase in non-performing loans and a rise in corporate bankruptcies could lead to asignificant increase in loan loss provisions and therefore a contraction in banks' net results.Rising mortgage repayments and inflationary pressures, combined with rising unemployment, poserisks to credit quality. The pace at which house prices are falling, although slowing down, could continue.However, high immigration and low housing supply do not point to an end to housing affordabilityproblems beyond the current rate hike cycle.Although the sector outlook for Canadian banks is deteriorating, asset quality, profitability, capitalizationand liquidity are at historically high levels, offering some resilience in the event of an economicdownturn. In addition, Canada's financial regulator (OSFI) has decided to increase the amount of capitalthat the country's major banks must hold to cover potential losses. It believes that the vulnerabilities ofthe financial system remain high and, in some cases, have continued to worsen. The increase in the safetymargin will raise the capital adequacy ratio of the major banks from 11% to 11.5% (see Fig. 8), a thresholdthat they already exceed. This ratio is a key indicator of a bank's financial strength, measuring its capitalin relation to its total risk-weighted assets.

OSFI has also taken measures to strengthen the balance sheets of Canadian banks in the face of the riskof deterioration in mortgage lending. The regulator wants to ensure that banks cover themselves againstthe 12% of mortgages that are currently uninsured in Canada. The banks have been instructed to ask theircustomers to reduce the loan-to-value ratio to 65%. What's more, property prices have fallen sharply inrecent quarters (see Fig. 9) in the face of rising interest rates, putting even more pressure on the mostindebted households.

Fig. 8 - Banks' capital ratios

Fig. 9 - Change in house prices


Canada has many assets. Its natural resources, the size of its territory and its demographic growth makeit a unique and resilient country. The structure of its market index, the S&P TSX, is still heavily exposed tothe financial sector, energy and commodities, but it contains quality stocks. It has its place in diversifiedportfolios, and its highly cyclical nature gives it a position to favour when the economy picks up again orif the commodities super-cycle is confirmed


Investigación financiera