Currency of the Month – Canadian Dollar: Tattoos and Taxes. What’s Coming in Canada?

The cold winds of change have been blowing through Canada’s Parliament Hill, making this an opportune time to discuss the outlook for the Canadian dollar in this month’s Currency of the Month. The Canadian dollar, colloquially known as the “loonie,” due to the country’s dollar coin displaying a picture of the common Canadian loon on its backside, has been a “Pfennig Pfavorite” currency for some time. This is based on the country’s traditionally prudent fiscal policies, sound banking system, and rich natural resources.

The tag line above is in reference to the surprise victory by the new Prime Minister and Liberal Party leader, Justin Trudeau, ousting Prime Minister Stephen Harper’s Conservative Party that had been in power since 2006. The son of Canada’s charismatic former Prime Minister Pierre Trudeau, Justin Trudeau is no stranger to the Canadian populous. He provides a young, energetic, and familiar face to the country’s now leading Liberal Party, not to mention a little “ink” on his left shoulder in the form of a Haida raven.

For the Liberal Party, whose poor 2011 election results placed it in third place behind the Conservative and New Democratic parties, the shocking victory may have been as much a rejection of Prime Minister Stephen Harper’s Conservative Party as one for the rookie Trudeau, whose “Hope and Hard Work” and “Real Change” political slogans were juxtaposed to Prime Minister Harper’s heavy-handed perception, media withdrawal, economic stagnation, and focus on political issues important primarily to core conservative voters in the western portion of the country.1

Since taking the majority in 2006, outgoing Prime Minister Harper’s government had been characterized by the pursuit of conservative fiscal and monetary policies, including cutting corporate taxes and reducing government spending, successfully decreasing the Canadian Federal spending as a percentage of gross domestic product (GDP) from 24% in 2006 to under 16% in 2012.2 Moreover, after running emergency budget deficits in the wake of the 2008 financial crises, the Canadian government was in spitting distance from returning to a budget surplus in 2015 (Figure #1).

Fig. #1
Canada’s Budget Surplus/Deficit To GDP

Source:EverBank Research Team, based on an analysis of publicly available data from Trading Economics.Conversely, incoming Prime Minister Trudeau’s platform gained popular support for reducing middle-class taxes, and following suit with a growing trend for global governments to raise taxes on the wealthy and increase deficit spending on government entitlements and infrastructure,3 promising to run budget deficits of $60 billion CAD for at least three years to fund infrastructure projects4 (about 3.4% of GDP). Not the best scenario for an economy heretofore known for its balanced fiscal priorities, as likely indicated by the loonie’s year-to-date performance, which is down 10% relative to the U.S. dollar. (Figure #2)

Fig. #2
Canadian Dollar To U.S. Dollar Exchange Rate

Source:EverBank Research Team, based on an analysis of publicly available data from OANDA.

Canadian Economic Overview
Like most commodity-based markets, Canada’s economic growth has been adversely affected by the fall in commodity prices (Figure #3). In response, the Bank of Canada (BOC) joined most of the developed world in increasing monetary stimulus by lowering benchmark interest rates 25 basis points to 0.50% based on the weakness in oil prices and sluggish non-energy exports.5 This move placed further pressure on the loonie.

Fig. #3
As Oil Prices Fall, So Has Canadian GDP Growth

Source:EverBank Research Team, based on an analysis of publicly available data from The World Bank & Trading Economics.Despite weakness in the oil market, Canada’s proximity to the United States has provided a strong export market for a variety of energy and non-energy commodities, representing 76.8% of all exports for the economy.6 In addition to petroleum and natural gas, Canada provides the U.S. with products including motor vehicles and parts, industrial machinery, aircraft, telecommunications equipment, raw materials, lumber and wood pulp, and aluminum. And, as the U.S. economy expands, so goes the Canadian economy. Having a consumer-led economy as its closest neighbor, Canada’s current account balance has remained at manageable levels, most recently posting a $39.4 billion deficit during 2014, as compared to the U.S. budget deficit, which was $410.6 billion in 2014.7

The Canadian banking system is yet another notable point of strength for the economy, as illustrated by a Bloomberg Business ranking of the world’s strongest banks placing four of Canada’s largest banking institutions among a select group of the top 10 global banks.8 As an illustration, the United States has suffered 16 separate banking crisis events since 1790, while Canada’s banking system has not experienced a single banking crisis throughout this time period.9 Needless to say, the Canadian people are exceedingly proud of this distinction. Theories behind Canada’s recent banking strength today include its “universal banking” model, characterized by a differentiated banking system with stable retail and commercial deposits, healthy loan-to-deposit ratios, diversified and balanced risks, and diverse lines of business.10

How Does It Look For The Canadian Dollar?
The Canadian economy has clearly entered a challenging period, with oil prices remaining depressed and GDP contracting for the first six months of 2015. For investors considering allocations to the loonie, the resurgence of power for Canada’s Liberal Party, with its deficit-spending platform, could certainly provide grounds for avoiding exposure to the currency. However, a deeper view into the political workings of the country’s new majority party provides at least some measure of relief that the Canadian government may not be setting itself up to join the global “race to the bottom” currency circus.

While Harper’s Conservative Party has been commonly recognized for bringing balanced monetary and fiscal policies to the country’s finances, much of the credit is actually due to the Liberal Party under the leadership of Prime Minister Jean Chretien who implemented Canadian austerity measures by cutting expenditures on social and defense programs in order to reduce federal spending levels during the mid-1990s.11 Chretien’s Minister of Finance during this period, Paul Martin, supported these austerity measures by implementing large cuts to the country’s annual budget.12 As it turns out, Martin has been engaged as a key advisor to incoming Prime Minister Justin Trudeau, providing at least some degree of confidence that the new government will pay credence to Canada’s historically prudent reputation.

It would seem unlikely that Trudeau’s Liberal Party would be willing to reverse nearly two decades of success in balancing fiscal and monetary policies, despite gaining a popular mandate for implementing stimulus programs through deficit spending. The fact that the Canadian economy was one of the most stable markets throughout the great recession provides further support that the Canadian government would not risk long-term economic stability for short-term gains. Then again, nothing is ever certain when politics are concerned. Yet, as long as Martin continues to provide sage advice for Liberal Party budget planning, the loonie should continue to be a currency worth close consideration.

Until the next Daily Pfennig® edition…

Chuck Butler
Managing Director
EverBank Global Markets Group