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The negative impact of lower oil prices is being felt in many sectors of the Canadian economy – from housing and the prices of goods and services, to employment levels, according to a report from Russell Investments.

“The most immediate shock was to the once-hot housing markets in the Prairies, where home sales have declined and price increases have moderated,” says Shailesh Kshatriya, associate director, client investment strategies at Russell Investments Canada Limited. “This occurred despite the Bank of Canada’s reduction in its target interest rate. Ironically, this same rate reduction may further support the buoyant Toronto and Vancouver real estate markets.”

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Also, the prices of many goods and services other than energy have been rising due to the lower value of the Canadian dollar. “When you exclude the price of gasoline, we saw a 2.5% rise in inflation. We believe the BoC will tolerate inflation approaching the upper threshold of its 1% to 3% inflation band in order to dispel worries about potential tightening of monetary policy,” adds Kshatriya.

The report notes employment will be the indicator most closely monitored going forward, and if labour market slack persists or accelerates over the next several months, an additional cut in the target rate should not be ruled out. Kshatriya believes the implications of the recent reduction in capital expenditures by the resource sector, and how that might impact employment, are more disconcerting. “This comes at a time when it’s unclear if employment has, in fact, improved as much as is implied by the official unemployment rate of 6.8%. When using the labour market indicator, the unemployment rate is closer to 7.5%.”

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With regards to the economy, “Although we expect modest growth, the ambiguity due to low oil prices keeps us cautious, but positive, on the business cycle over the medium term,” adds Kshatriya.

Across the globe

There are two key items to watch in 2015: The divergence in central bank policies, and the amount of spare capacity in the U.S. economy—both of which have been amplified by a 50% drop in oil prices since June 2014.

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According to the strategists, fears of deflation are underscoring the ECB and Bank of Japan’s intentions to make monetary policy even more accommodative, while the likely economic boost in the U.S. from low energy prices may result in an earlier start to Fed tightening. As for spare capacity in the U.S., the strategists’ current forecast of 230,000 average monthly U.S. job gains in 2015 would take unemployment to nearly 5% by year-end, adding pressure for wage gains.

“The most important indicator currently to watch is hourly earnings in the Bureau of Labor Statistics’ monthly employment report,” says Russell’s Global Head of Investment Strategy, Andrew Pease. “This will provide the first evidence that labour market conditions are tightening enough to hurt profit margins, push up inflation and make the Fed more hawkish.”

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The strategists are also on high alert for U.S. wage and inflation pressures, which threaten this modestly positive outlook. Wage gains would squeeze profit margins and generate fears of aggressive Fed tightening, which could lead to a spike in volatility and bond yields.

“We see a potential for higher market volatility through 2015, driven by both price momentum and the economic cycle. If wage gains jump, then equities, bonds and credit could all post negative returns,” adds Pease. “However, thus far, U.S. employment gains have not triggered wage gains, and our favored scenario of moderate inflation, jobs growth and profit gains is still on track.”

Originally published on Advisor.ca

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