Time to reduce Canadian stock exposure, says analyst

Canada’s economy has been red hot in the last couple of months, but analysts at Bank of America Merrill Lynch are skeptical the country’s growth story will last much longer.

Neil Dutta, U.S. and Canada economist for Bank of America, warned that dependence on the U.S., weak oil prices and poor labour productivity are all about to catch up with Canada.

“Canada’s business cycle bounce appears to have run its course,” he said.

Recent economic data has shown the Canadian economy continues to generate impressive numbers. Housing starts, along with hiring, both beat expectations in March and April. But as Mr. Dutta points out, the Canadian economy is following a typical growth cycle following a recovery.

He said the country is now facing several demand and supply-side challenges, including the impact of consumers cutting back on debt and spending, a strong Canadian dollar and weak labour productivity.

On top of those challenges, Canada is experiencing what Mr. Dutta calls a “novel” oil price situation.

While Canada is a net oil exporter, the eastern half of the country imports oil outside of Canada, due mainly to a lack of infrastructure to move and refine oil from production centres like Alberta to provinces like Ontario.

Ironically, the provinces importing oil are now paying more for it, while the provinces exporting are getting paid less. That’s because a glut of oil has developed in Canada’s traditional export market, the U.S. Midwest, as a new oil boom has occurred in states such as Minnesota and North Dakota. Eastern provinces, meanwhile, are forced to import more expensive international oil.

“This dynamic weakens Canada’s terms of trade, reducing domestic incomes,” Mr. Dutta said. “The price differentials between Western Texas Intermediate (North American oil prices) and Brent (international prices) will continue until the infrastructure is put into place to move the excess oil supply to coastal refiners.”

All that means investors should be reducing their exposure to Canadian risk assets such as stocks, Mr. Dutta said.

“In broad terms, this means moving away from riskier asset classes like equities and into safer investments like Canadian government bonds,” he said.

There is the risk that bond investors could be burned, however, if the Bank of Canada moves to raise interest rates. The recently impressive economic data of the past two months have led to some speculation of a rate hike this year, but Mr. Dutta is doubtful that will happen.

“We expect several false alarms of BoC tightening over the next year and half before the BoC actually moves. This should create near-term trading opportunities in the short-end of the bond market,” he said.