Canada's 2017 Economic Outlook: A Tale of Two "Tails"

Investors need to prepare for more extreme economic outcomes – both good and bad.

At the risk of entering the realm of cliché, we couldn’t help but draw parallels with Dickens’ classic novel, “A Tale of Two Cities,” when forecasting the Canadian economy in 2017. As he wrote, “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity.”

The key theme of income inequality running through the heart of the novel rings as true now as it did a century-and-a-half ago, manifesting itself globally in 2016 with the U.K.’s Brexit vote, Italy’s constitutional referendum and the election of Donald Trump as president of the U.S. And we face the spectre of more political volatility in 2017 with the upcoming elections in France and Germany.

It is within this global environment that Canada’s small and open economy must navigate, and we believe 2017 will be a tale of two "tails". More specifically, we believe the tails of the distribution of economic outcomes have become fatter – that is, the probability of more extreme outcomes (both good and bad) is higher than in a normal distribution (see Figure 1).

There is nothing particularly earth-shaking about our baseline forecasts of 1.5%-2.0% real GDP growth and core inflation of 1.5%-2.0% for Canada, or our view that the Bank of Canada will hold the overnight rate at 0.5%. What is worth noting is that with fatter tails comes less certainty about our baseline view. And we believe active investors’ success in adding value in 2017 will hinge on how well they navigate the potential risks and opportunities we see for Canada.

Left-tail risks: “The worst of times”

Protectionist U.S. trade policy

During his campaign, Donald Trump railed against “terrible” U.S. trade agreements and promised to renegotiate NAFTA. But will he follow through with this campaign promise? There are congressional proposals to impose a destination tax on goods crossing the U.S. border that could be devastating to Canadian exports. Renegotiating NAFTA will be a lengthy and complicated process; it is unclear whether it can be successfully completed. We may see the Trump administration looking for immediate results by targeting specific companies and industries within the World Trade Organization framework.

Mexico and China have been the main targets of Trump’s trade concerns, while Canada has been relatively under the radar (except for the revival of the Keystone XL pipeline, which former President Barack Obama had rejected in 2015). Canadian Prime Minister Justin Trudeau has elevated a former PIMCO Secular Forum speaker, Chrystia Freeland, to foreign minister with the explicit task of ensuring that Canada does not become collateral damage in new trade deals. We will continue to monitor this fluid situation, which remains a major left-tail risk to our baseline forecast.

Debt-laden consumers and a housing correction

Canadian consumers could face a very difficult 2017, with the potential for higher interest rates when net debt-to-income ratios are at an all-time high of 167%. Most housing markets in Canada have never been more expensive, and governments are implementing policies to reduce (or reverse) house price inflation. Vancouver has put a 15% tax on foreigners buying homes, and the Canada Mortgage and Housing Corporation (CMHC) and Office of the Superintendent of Financial Institutions (OSFI) are implementing policies to slow mortgage credit growth. While our base case is that housing price inflation will slow in 2017, there is a risk that prices could contract. Higher interest rates and lower house prices could detract from GDP growth by lowering consumption and residential investment.

An oil price collapse

Oil prices have been highly volatile of late, with Canada’s Western Canadian Select trading as low as $13.80 per barrel before closing the year at $37.60. This oil price shock damaged the Canadian economy and was a main reason the Bank of Canada cut the overnight rate to 0.5% from 1% in 2016. Looking ahead, we think OPEC’s decision in November to cut oil production has probably truncated the downside risk to oil prices for 2017. This means the energy sector will likely be a contributor to GDP growth this year (given the low base effects). That said, if oil prices were to move substantially lower, Canadian GDP growth would likely suffer.

Right-tail opportunities: “The best of times”

Robust U.S. economic growth fuels Canadian exports

Canadian policymakers have been holding their breath waiting for robust exports to propel the country’s economic expansion. The Bank of Canada recently released its Winter 2016-17 Business Outlook Survey, which, compared with the previous quarter, showed that more Canadian firms expected the November election to lead to strong U.S. economic growth.

While considerable uncertainty remains about U.S. fiscal policy, with Republicans controlling both houses of Congress and the presidency, we expect a positive fiscal impulse over the next couple of years. Moreover, financial and energy markets have interpreted Trump’s preference for less regulation positively. We see a clear possibility that a pro-growth agenda from Washington could lead to increased consumer and business confidence and in turn spur more investment and consumption. Historically, a strong U.S. economy has translated into strong Canadian exports – and this could be a meaningful positive upside to our baseline forecast for 2017.

An increase in business fixed investment

One of the hallmarks of the global economic recovery since the financial crisis has been the absence of robust growth in business fixed investment. Faced with high degrees of uncertainty about everything from government policy to Asia and Europe, businesses’ fixed investment has lagged levels seen in past cycles. If a pro-growth U.S. agenda leads to a rise in what John Maynard Keynes called “animal spirits,” then we could see investment-led growth in both the U.S. and Canada. A virtuous cycle of export growth and investment could in turn enable Canada to outperform PIMCO’s 2017 real GDP forecast of 1.5%-2%.

Investment implications

We forecast that both the U.S. Federal Reserve and the Bank of Canada will continue to pursue accommodative monetary policies. While the Fed may raise the fed funds rate multiple times in 2017, it will likely be cautious to avoid making a “hawkish mistake.” As U.S. rates rise, we would expect Canadian rates to rise and for the yield curve to steepen. However, the Bank of Canada’s more accommodative stance would likely translate to a slower pace of increases than in the U.S.

Such accommodative monetary policies should continue to support the credit cycle and credit spreads. We think a number of geopolitical, economic and policy events will contribute to continued volatility in the markets. This could lead to bouts of spread widening in the credit markets, and we would look to buy high quality income-generating bonds during those periods.Finally, as the U.S. economy recovers and Fed policy normalizes, we expect the U.S. dollar to strengthen against a basket of currencies (including the Canadian dollar).

Here’s to a happy ending to this tale of two tails.

The Author

Ed Devlin

Head of Canadian Portfolio Management

View Profile

Latest Insights



Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd- Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam and Italy Branches are additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH(Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-, Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products provided by PIMCO Switzerland GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (8 Marina View, #30-01, Asia Square Tower 1, Singapore 018960, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia) offers products and services to both wholesale and retail clients as defined in the Corporations Act 2001 (limited to general financial product advice in the case of retail clients). This communication is provided for general information only without taking into account the objectives, financial situation or needs of any particular investors. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1° andar, Rio de Janeiro – RJ Brasil 22210-906.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2017, PIMCO.