Looking beyond the U.S.

A fragile recovery, high unemployment and household indebtedness make America a friend in need. But as a country known more for permanent interests than friends, the U.S. is being increasingly seen as a poor choice for friendship.

Even Canada, its biggest trading partner, is quickly learning that as a weak market the U.S. has poor long-term prospects for the Canadian economy.

Not surprisingly, then, a growing number of industry watchers north of the border are beginning to wonder if it’s time to end the relationship before any more of the flotsam and jetsam of the U.S. economy are washed up on the Canadian shores.

Historically Canada rises and falls with the U.S.; however, there’s an opportunity now for Canada to look elsewhere, says David Andrews, director of investment management and research at Richardson GMP.

“Canada can and must try to diversify its export stream outside of that of the U.S.,” says Andrews. It will take time, he admits, but it’s doable. “It’s in Canada’s best interest to do that if it wants to continue to be autonomous. Otherwise, we’re going to continue to be at their beck and call.”

Andrews is not alone in seeing the baton being passed. In fact, to some extent the process has already begun, says Michael Gregory, senior economist at BMO. “[About] 20 years ago, the U.S. economic cycle largely determined the commodity price cycle; so when the U.S. went into a downturn they bought less commodities. That hurt Canada, and in doing so prices fell. That hurt Canada again.”

But that, Gregory says, has changed. “Now it’s a little bit different, where prices are set within a global framework; so the impact of a sluggish U.S. economy on Canada’s natural resource centre is not as bad as it would have been, simply because prices are largely determined in a global context.”

Diversifying exports into China and other emerging economies is something that has become a bit of a priority, he adds. Prices, therefore, reflect not only the demand of the U.S., but the BRIC (Brazil, Russia, India and China) economies and other emerging markets.

Similar sentiments are echoed by Paul Ferley, assistant chief economist at RBC Economics Research. The weakening demand in the U.S., a key market for a number of Canadian manufacturing outputs, is making manufacturers look elsewhere. “Now, there have been attempts to diversify supply and product to other markets, including emerging markets,” says Ferley.

“Given the geographical proximity, Canada is largely geared towards responding to demand in the U.S. Some attempts have been made to diversify that will temper the impact from a still-sluggish U.S. recovery,” says Ferley.

The Canadian domestic economy has performed relatively well, but if it weren’t for the U.S. things could have been better. “[The] overall growth in Canada is pretty lacklustre, in part because of the headwind coming from the U.S. side,” says Gregory. “That is probably the legacy: the U.S. not being the kind of robust consuming machine it was in days gone will be a persistent drag for Canada going forward.”

With no short-term solutions in sight to its domestic problems, the sub-par U.S. recovery has the potential to throw the spanner in Canada’s economic growth. For instance, far from bouncing back, the U.S. housing market, at best, is stabilizing at very low levels. This in turn has stifled demand for items like Canadian lumber. “That’s one channel through which the subdued recovery in the U.S. is sort of contributing to a similar pattern of growth here,” says Ferley.

He asserts the sluggish recovery in the U.S. would temper demand for those natural resource commodities. That weakness is getting offset, although not nearly enough, from growth in a number of emerging economies.

This doesn’t detract from the fact that the economies of Canada and the U.S. are joined at the hip, and that might bring Canada to its knees. “I think the U.S. is definitely hampering what’s happening in Canada,” says Andrews. The Bank of Canada has said as much. After trying to put back a few points on the interest rate, the BoC finally stopped at one percent thanks to the softening data from south of the border. “Even the Bank of Canada has said that our fate, at least from an interest rate perspective, is going to be determined by what transpires in the U.S,” he says.

Exports to the U.S. are down 20% from where they were in 2008, a fact that is responsible for Canada swinging from a $50 billion trade surplus to $10 billion deficit very quickly. “So clearly the receptiveness of the U.S. market for everything that Canada can put on a truck or a rail car and send south is not there the way it was before.” Not surprisingly, then, China has assumed an even bigger role in our scheme of things. Trouble is that even though China recently replaced Japan as Canada’s third largest trading partner, it still accounts for only three percent of the total. “We still send 75% of our exports to the U.S.,” says Andrews. “That percentage relationship is not going to change very quickly.”

From Canada’s perspective, if the U.S. continues to crawl along at a slow pace we do have to find new markets, he says. After all, the world is increasingly short of the resources abundant in Canada.

Another issue is a weaker U.S. dollar, which by default makes a strong Canadian dollar. A strong Canadian dollar means that the growth of Canada’s exports will continue to be sluggish. But even this sounds like good tidings compared to the future implications of inevitable changes to the U.S. fiscal policy.

In a few years to come, as the memory of things like historic unemployment, deleveraging and balance sheet restructuring begins to fade, the other shoe will drop. Once things get back to normalcy, says Gregory, then it’s the fiscal austerity that’s going to have to normalize. “And that’s going to involve significant tax increases in the U.S. to help deal with the lingering budget problem.”

The long litany of woes in the U.S. economy will continue to impact Canada’s own economy. Experts are unanimous in asserting that Canada hedge that risk by looking further afield.

Like a tactically balanced portfolio, they say, Canada needs to establish some diversity in its trade relationships to reap rich returns in a future that looks anything but certain.