Central bank still underestimating risks to economy.

So far, 2018 is proving to be quite the challenging year for investors, with the S&P/ TSX losing more than eight per cent and bond markets losing more than 1.5 to two per cent. As a result, most Canadian balanced portfolios have fallen nearly six per cent this year.

It is at least encouraging to see that those in charge of the country’s economic policy are finally starting to take their heads out of the sand and are moving away from using terms such as “welcome symptoms of normalization” to describe higher bond yields and volatile stock markets, and “solid momentum” when assessing the economic outlook.

However, despite the recent acknowledgment in the Bank of Canada’s December update that there are some risks “to growth and inflation from financial vulnerabilities” — after stubbornly defending their position since October — we think they are still underestimating the extent of what potentially lies ahead.

First, take a look at the Canadian dollar. Despite the aggressively hawkish positioning by the Bank of Canada, our dollar has still nosedived more than six per cent this year against the U.S. dollar. Interestingly, nearly all of the gains in the Canadian dollar since the bank started hiking rates in 2017 have now dissipated.

Currency traders aren’t the only ones worried about the economy — our boots-on-the-ground business leaders are, too. According to the Duke University/cfo Global Business Outlook survey, 86 per cent of Canadian CFOS believe the country will be in recession no later than the end of 2019, compared to only 67 per cent of CFOS in Europe.

Then there is the yield curve, in which the spread between the two- and five-year yields recently turned negative for the first time since September 2007, in the early stages of the financial crisis. The spread between the two- and 10-year is also currently flirting with inversion.

This is a very important development and shouldn’t be taken lightly as it means capital and money flow could become impaired as banks typically borrow at short-term rates and lend at long-term rates. According to a paper by Michael D. Bauer and Thomas M. Mertens analyzing historical data, almost every single time the curve inverts an economic contraction has followed.

“Every U.S. recession in the past 60 years was preceded by a negative-term spread, that is, an inverted yield curve,” they wrote in Economic Forecasts with the Yield Curve. “Furthermore, a negative term spread was always followed by an economic slowdown and, except for one time, by a recession. While the current environment is somewhat special — with low interest rates and risk premiums — the power of the term spread to predict economic slowdowns appears intact.”

Perhaps this explains why our still very profitable Canadian banks and lifecos have seen their share prices collapse by 10 per cent to 25 per cent this year as investors worry about the sustainability of earnings growth.

Finally, oil prices are an especially important indicator for our resource-based economy.

While the WCS differential narrowed considerably thanks to intervention by the Alberta government, the fact of the matter is the top-line WTI oil price had its largest one-month drop in October since 2015. We can also see the impact in our oil stocks, with the Capped Energy index selling off by a whopping 25 per cent this year.

Not surprisingly, our economic leaders say things are different this time. The impact, they suggest, won’t be as great as in 2015, as foreign capital has already left the oil industry and oil and gas production is not as big a part of the economy as it was in 2014.

Fair enough, but there is no denying that the energy sector has been a good barometer of the state of the global economy and certainly of Canada’s, given that oil and gas extraction currently contributes more to GDP than the entire finance and insurance sectors combined.

In conclusion, a weaker Canadian dollar, a depressed business outlook, an inverting yield curve and collapsing oil prices should not only be a cause for concern, but should be factored more deeply into both our fiscal and monetary policies.

The acknowledgment that they are just a potential “financial vulnerability” does not go far enough.

DOLLAR HAS NOSEDIVED MORE THAN SIX PER CENT THIS YEAR.