Canadian Quarterly Economic Forecast

Tariffs Impart a Chill Wind on Green Shoots

Date Published: June 17, 2019

French version available here.

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Summary

Global economy: At a crossroads

  • The global economy has been unfolding largely as we had anticipated in March. Following last year’s steep deceleration, high-frequency indicators suggest that global growth has stabilized, albeit at a below-trend rate of just above 3%.  
  • Next year, however, the growth outlook has been downgraded by 0.2 percentage points to 3.3%, in part reflecting the recent escalation in trade tensions. 
  • Signs of bottoming in growth have reflected a mix of factors. Recent trade-induced gyrations aside, global financial conditions have eased broadly, driven in part by expectations of lower policy rates. This and other stimulus measures – notably in China – have supported a firming in economic activity. Green shoots have appeared across emerging Asia as well as a number of advanced economies, including core Europe and Canada. 
  • The overall picture masks a continued divergence between manufacturing and service sectors. Global manufacturing activity remains in the doldrums, largely related to trade uncertainty and the knock-on effects of declining auto production in Europe. In contrast, service industries have remained comparatively resilient, particularly in advanced economies. 
  • Trade tensions represent a clear and present danger to the global economy. Our outlook embeds tariffs that have already been implemented, but the threat of further actions – and the potential for an unexpected severe bout of risk aversion – remain key downside risks to the forecast.

Other Forecasts

U.S. economy: Outperformance, but risks loom

  • U.S. economic growth outperformed expectations early in 2019. Real GDP advanced at a 3.1% (annualized) pace in the first quarter, boosted by temporary factors including a significant inventory build. With some reversal, growth is expected to slow in Q2. Still, the first half of the year is tracking 2.5%, roughly a half a percentage point above our prior expectation.
  • This places the 2019 annual average at 2.6% (previously 2.4%).  Economic growth is expected to slow to 1.8% in 2020, as capacity constraints bind.
  • The White House has raised its tariff rate from 10% to 25% on the second tranche of Chinese imports subject to tariffs. Taken by itself, the impact is likely to be relatively small (we estimate a drag if a little over 0.1 percentage points), but much will depend on how spending and investment react to the continued ratcheting up of trade conflicts. Manufacturing sentiment has already begun to converge to lower levels seen abroad. This raises the prospect that another round of tariff action could have a larger impact on economic growth and sentiment relative to last year when both were at higher starting points. 
  • Markets have recently priced as many as four rate cuts  between now and the end of 2020. This aggressive positioning reflects worries of further tariff escalation alongside low inflation and slowing economic growth (both globally and domestic). We believe the market has over-priced the extent of accommodation the Fed will ultimately need or be willing to provide absent a significant deterioration in the economic data. However, the persistent elevated risk environment opens the door for the central bank to take a risk management approach and provide a modest accommodation (50 basis points in cuts) later this year as “insurance”.
  • We expect some semblance of a deal with China to occur this year. Critical to this outcome will be developments that occur from discussions between President Trump and President Xi at the G-20 meeting at the end of June. However, even in the event of a trade deal, it’s unclear at this stage whether the weight on the economy and market sentiment would fully lift. Importantly for the former, a deal would need to unwind the 25% tariffs placed on China in May. In addition, global trade concerns may quickly return to the spotlight with Trump having already signaled a desire to quickly pivot to Europe (a larger export market for the U.S.). 

Canada economy: Between a rock and a hard place

    Economic & Financial Forecasts
      2018 2019F 2020F
    Real GDP (annual % change)      
    Canada 1.9 1.3 1.7
    U.S. 2.9 2.6 1.8
    Canada (rates, %)      
    Overnight Target Rate  1.75 1.75 1.75
    2-yr Govt. Bond Yield  1.86 1.55 1.75
    10-yr Govt. Bond Yield  1.96 1.65 1.95
    U.S. (rates, %)      
    Fed Funds Target Rate  2.50 2.00 2.00
    2-yr Govt. Bond Yield  2.48 2.00 2.20
    10-yr Govt. Bond Yield  2.69 2.30 2.55
     WTI, $US/bbl 59 59 62
     Exchange Rate (USD per CA 0.73 0.77 0.77
    F: Forecast by TD Economics, June 2019; Forecasts for oil price, exchange rate and yields are end-of-period. Source: Bloomberg, Bank of Canada, U.S. Federal Reserve.
  • Canada’s economy has been mired in a soft patch, with real GDP growing just 0.4% (annualized) in the first quarter, following 0.3% in the final quarter of 2018.
  • The weakness in broad output trends has concealed a better story underneath the surface. Notably, domestic demand (spending by households and businesses) rebounded in Q1 and the job market has remained resilient. However, the external backdrop continues to deteriorate in the wake of ongoing trade disputes. 
  • We expect the gap between soft real GDP growth and robust job growth to close over the next few quarters, as output growth picks up somewhat while employment eases to a more sustainable pace. For 2019 as a whole, we anticipate a 1.3% real GDP expansion, while the unemployment rate remains below the 6% mark.
  • It is not assured that the Bank of Canada will follow the Federal Reserve in the event of rate cuts, as markets so often expect. Absent clear evidence of domestic economic deterioration, easing in Canada is unlikely. We hold this view for several reasons. First, after an extended soft path, the domestic data is coming in better than expected in Q2, tracking 2%. This is above the Bank of Canada’s expectation. Second, housing is showing signs of stabilization, and the Bank will want to avoid the risk of re-fuelling leverage dynamics. Third, the policy rate is already lower relative to south of the border.

Canadian Outlook

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    Chart 1: Soft headline tracking masks domestic demand recovery
  • The soft patch that characterized Canada’s economy in late-2018 persisted into the opening months of 2019. Real GDP advanced by a soft 0.4% (annualized) in the first quarter, held back by falling construction (both residential and non-residential) and exports. Despite the soft headline, domestic demand – spending by households and businesses – accelerated, breaking the downtrend through 2018.
  • We forecast a pickup in the economic expansion in the second quarter. The key factors driving our forecast are healthy household income, a recovery in housing markets, and a resumption of export activity.
  • Conversely, the extent of the near-term bounce-back will be partially blunted by a large buildup in business inventories that will likely be worked down. Notably, stock-to-sales ratios among manufacturers and wholesalers stand near multi-year highs, and the impact of production curtailments on energy sector inventories have been smaller than anticipated. 
  • Bringing it all together, real GDP growth is expected to average 1.3% for all of 2019, before strengthening to 1.7% in 2020. Underlying demand is expected to be healthier than the headline numbers would suggest (Chart 9). 
  • Underlying this status-quo view on GDP is a picture of notable cross currents, and in some cases, data contradictions. We hone in on these key themes and how these story lines will play out. 

Divergence One: Stagnant Output Growth and Robust Employment

    Chart 2: Canadian business investment well below U.S. levels
  • Last year saw a marked deceleration of economic activity, particularly final domestic demand (i.e. excluding trade and inventories). Yet, employment has been robust, with hiring accelerating as economic activity moderated.
  • This divergence appears to be driven by two components. The first is the shift towards service-sector employment. Professional services (which includes many IT firms), transportation, and health/social services have led the climb in employment, and output among the service industries has remained solid at around the 2% year-on-year mark. The overall pace of activity has moderated due to softness in goods-producing industries, where there is evidence of hours worked being reduced as hiring remains modest. 
  • A further explanation is likely businesses reacting to elevated uncertainty. An uncertain trade backdrop may have incented firms to favour labour over capital investment. This can be seen in the soft investment figures over recent years, even as hiring has been on a tear. Somewhat concerning is that this is also evident in ‘new economy’ investment in intellectual property products, which remains well below U.S. levels (Chart 10).
  • An unexpected surge in machinery and equipment investment at the start of 2019 (up 39% at an annualized pace) was driven in large part by spending in the volatile aircraft and other transportation equipment category, creating the risk that the first quarter strength was a ‘one-off’.
  • The divergence between hiring and output, together with tepid trend investment, has manifested in very weak productivity growth over the last two years (Chart 11). A brief period of stagnation is not unusual, but is not sustainable.
  • This divergence will be resolved by the expected pick-up of activity as 2019 progresses and a moderation of the pace of hiring towards longer-term fundamentals. Our outlook envisions a ‘sweet spot’ where productivity improves, helping drive wage gains and holding the unemployment rate below its longer-term trend for some time. 

Divergence Two: Employment and Spending

  • While employment growth has diverged from output, spending has diverged from employment gains. Canadian households pared back expenditures in the latter part of 2018. And, even with the rebound in spending in Q1, consumption is up only 1.9% year-on-year, barely ahead of employment gains and down from a peak pace of 3.9% at the end of 2017. 
  • Market turmoil late last year is likely a contributor. However, the bigger factor appears to be the lagged effects of higher interest rates and tighter mortgage rules put in place in 2017/2018. These have driven a marked deceleration of spending on rate-sensitive items (autos, furniture, electronics, etc.) alongside a moderation in housing activity. This has manifested in an unintended inventory buildup and slower household credit growth.
  • Although consumer spending and national housing activity are finding a firmer footing, we remain skeptical that the first quarter’s spending growth will be repeated. Market volatility has returned, albeit to a lesser extent, and the household savings rate is low, at just 1.1% of disposable income. On top of this, even as borrowing costs have come down recently, credit growth suggests highly-indebted households remain cautious.
  • The result is an elusive ‘soft landing’ captured by a convergence between nominal spending, credit growth, and household incomes to a modest but sustainable 3.0% to 3.5% rate, or 1.0-1.5% in real terms. This would set the stage for continued stability in the household debt burden, albeit at elevated levels, and for a modest increase in the saving rate. At the same time, our projection for modest real spending gains will enable the gradual absorption of excess inventories. 

Divergence Three: Curtailment, Higher Prices, but Still High Inventories

Chart 3: Strong hiring, weak output leaves productivity moving sideways
  • Late last year, the Alberta government announced mandatory energy production curtailments to address significant pricing discounts, as output outstripped takeaway capacity and inventories hit extreme levels.
  • On the first goal, curtailment has been a success. The spread between heavy Canadian oil prices and the U.S. WTI benchmark averaged an unusually narrow -US$10/bbl in the first quarter, after touching a low of -$50/bbl last October. But, success in this goal has created challenges in the second.
  • The low discount on heavy oil has made shipping oil by rail uneconomic (effectively the only option for marginal barrels given pipeline capacities). This has led firms to maintain inventories relatively unchanged from December levels even as production has been curtailed. This is corroborated by the export data, where energy product volumes fell more than 6% in the first quarter. This dynamic means that more of the drag on GDP is yet to come. 
  • As discussed in a recent report, decreasing curtailment stringency, pipeline delays and steady inventories all augur for a re-widening of Canadian price spread to the US$15-$20/bbl range. Some evidence of this has already been seen. U.S. benchmark WTI prices are expected to hold in the US$50-60 range over the forecast horizon, down modestly from our prior forecast. 

Divergence Four: Investment and Sentiment

  • Businesses may have kicked off 2019 with an investment splurge in aircrafts (Chart 12), but investment in structures has now contracted for five straight quarters in a likely reflection of the challenges still facing the energy sector.
  • With capacity utilization off recent highs for several categories we expect some payback in the second quarter.
  • The soft outlays come despite generally decent business  sentiment, a disconnect that was particularly notable over 2018. Trade uncertainty is the likely culprit; firms may have remained optimistic that a resolution was forthcoming even as negotiations dragged on. Sentiment has softened somewhat of late, suggesting some closure of the gap, but the May 10th escalation in the U.S.-China trade war means that some disconnect will likely persist. The impact on Canada will depend on the length of the dispute, the degree to which Canada is impacted by potential trade diversion (i.e. Chinese goods shipped via Canada) and, critically, the reaction of market and business sentiment.
  • The same holds true with the potential for U.S. conflicts with the European Union and Japan.
  • Given this backdrop, we continue to expect only a moderate pace of investment at around 3.5% per quarter in the coming years (less than half its post-crisis average), domestic-focused and helped by ongoing activity related to the natural gas terminal in Kitimat B.C. 

Divergence Five: Feds versus Provinces

Chart 4: Volatile aircraft category drove first quarter investment surge
  • New governments bring new budgets. In contrast to the federal government, where the most recent budget saw almost all the new fiscal space eaten up by spending measures, the Ontario government’s first budget aims at consolidation (see report). Outright spending cuts are few and far between, but a markedly slower pace of spending is planned relative to the prior trajectory. The newly elected Albertan government has also indicated that it plans to eliminate budget deficits.
  • Fiscal restraint is warranted, particularly in Ontario, given a significant debt burden. The change in fiscal stance does mean, however, that government spending will provide less of a growth lift, most notably in 2020. We have reduced the contribution from overall government spending by about 0.2 p.p. (The hit to Ontario’s 2020 growth, all else equal, is about 0.4 p.p.). The downgrade to government spending is offset by slightly higher consumer spending, resulting in only a slightly downgrade of our overall Canadian growth outlook for next year (for provincial details, see the Provincial Economic Forecast).

Steady as she goes for the Bank of Canada

  • Canadian data divergences and the uncertainties they generate have moved the Bank of Canada to adopt a cautious stance. The Bank’s communiqué in May signaled a steady-as she goes approach, recognizing the recent improvement in economic conditions, but remaining mindful of the external sector downside risks.
  • The biggest external factors are the latest escalation in the U.S.-China trade war and a re-thickening of North American trade barriers despite the removal of steel and aluminum tariffs. In a recent press conference, Governor Poloz noted that a ‘new shock’ may be a compelling factor to motivate a policy interest rate cut. Canada will be negatively impacted by the recent dispute escalation, but the scale of the impact is unlikely to materially alter the economic forecast unless further deterioration in sentiment takes hold. Likewise, we expect the loonie to trade around 74 to 77 U.S. cents over the forecast horizon.

Forecast Tables & Research

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Contributing Authors

  • Beata Caranci, Chief Economist | 416-982-8067

  • Derek Burleton, Deputy Chief Economist | 416-982-2514

  • James Marple, Director & Senior Economist | 416-982-2557

  • Fotios Raptis, Senior Economist | 416-982-2556

  • Leslie Preston, Senior Economist | 416-983-7053

  • Brian DePratto, Senior Economist | 416-944-5069

  • James Orlando, Senior Economist | 416-413-3180

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