How investors should play Canada's dismal economic outlook

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For the moment, and there's no real way to sugar-coat this, the outlook for the Canadian economy is terrible.

Emanuella Enenajor, Bank of America's economist for Canada, recently dropped her target on the Canadian dollar from 92.5 cents (U.S.) to 85 cents. In her report, Ms. Enenajor neatly summarized this country's economic dilemma: "[C]ontinued disinflationary pressure in the economy, deteriorating balance of payments, and competitiveness issues will hinder a return to export led growth." She advised "stay long USD-CAD."

The basis of this argument, echoed by Goldman Sachs and Bank of Montreal's Doug Porter, is that global demand for Canadian goods, services and investments is declining sharply.

In previous economic cycles, a weakening Canadian dollar provided a boost to domestic exports – led by the auto sector – that cushioned the economic blow from slower resource demand. But this time there's a problem and that problem's name is Mexico.

In short, Mexico is eating our lunch in the global auto sector. Since 2009, Mexico has increased auto production by 90 per cent while Canada has seen a far less robust 25-per-cent improvement.

Including light trucks, Canada still produces more vehicles than Mexico but this may not last. Consulting firm IHS Automotive predicts Mexico's overall vehicle production will surpass Canada's in 2015.

Global auto makers, including Volkswagen AG, Nissan Motor Co. Ltd., General Motors Co., Mazda Motor Corp. and Honda Motor Co. Ltd., have invested a total of $10-billion in Mexican production facilities in recent years. Mexico, not Canada, is clearly the destination of choice for auto sector investment.

The Ontario and federal policy response to the hollowing out of this important domestic industry will be interesting, and likely expensive for taxpayers. For investors, the key point is that a weaker domestic currency may not provide the benefits to exporter profits that it has in the past. Mexican exporters get the same benefit – the peso has also declined against the greenback – while paying far lower wages.

Canada is simply not competitive in old economy industries like manufacturing. Beyond the auto sector, the pending closings in Ontario of H.J. Heinz Co.'s Leamington facility and Kellogg Co.'s London plant in 2014 provide further, if unwelcome, evidence.

Canada's competitiveness could improve markedly with huge investments in efficiency. But even if this investment occurs, the benefits won't be felt for many years. Also, increases in productivity involve initial job losses by their very nature – productivity is measured by output per employee.

In the short term, the Canadian economy is faced with slowing resource demand from the emerging markets, a household credit situation widely viewed as a dangerous bubble by potential global investors and an uncompetitive manufacturing sector.

The consensus forecast for 2014 domestic gross domestic product growth is currently 2.3 per cent. This is significantly lower than the 2.8-per-cent estimate for the U.S. economy, but still not terrible. But, I expect Canadian GDP estimates to decline as economists incorporate the weakening data from China and the emerging markets.

Canada is a proud, talented, well-educated nation and in the mid-term we will adjust to economic problems we face. This is inevitable even if BlackBerry Ltd., the domestic flagship for innovation in the new economy, is in the middle of a fight for its life.

As Ms. Enenajor points out, however, the immediate future will likely be more problematic than many believe. Domestic investors should prepare their portfolio accordingly, whether it's moving more assets into cash, conservative U.S. equities, or both.