Canadian Quarterly Economic Forecast

Canadian Outlook

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• The Canadian economy finally managed to snap out of a two-quarter slump with a rebound of nearly 4% (annualized) in the second quarter. But, much of the strength was due to one-time factors (i.e, an easing in oil output curtailment) and final domestic demand has contracted in three of the past four quarters. We see little durability to the prior quarter’s performance. 
• The Canadian economy is facing strengthening chill-winds on the external front. Trade tensions and associated uncertainty continue to cast a pall over investment and trade in this small open economy. 
• On the domestic front, fundamentals remain strong. Job markets are healthy, while housing activity and household credit growth have picked up in recent months. However, highly-indebted households have kept a fairly tight grip on their wallets. 
• The fundamentals will help push against external headwinds, but won’t be sufficient to prevent a slower expansion in the second half of this year. Our forecast of 1.5% growth for 2019, is followed by only a slight improvement to 1.6% in 2020 (Chart 1).
• At its September rate decision, the Bank of Canada held its policy rate steady at 1.75%, but left little doubt that global developments are looming larger than ever in its reaction function. Ultimately, we believe that the global backdrop will deteriorate sufficiently to prompt easing by the central bank over the next several months

Healthy labour market but little spending

• Canadian firms have defied the external trends with continued strong job creation. The year-on-year pace of net hiring hit a post-crisis high of 2.5% in August. At the same time, wage growth has come back to life, flattered by weakness in the latter part of 2018 and an encouraging shift of job growth towards higher-paying occupations.
• The weak link in the job market data remains hours worked, which are up a modest 1.2% year-on-year amid significant monthly swings. Even then, aggregate labour income growth sat north of 4% y/y in the second quarter. 
• The theme of divergence between incomes and household spending continues. Retail sales volumes have moved sideways for roughly a year, and new vehicle sales only broke a 17-month contraction streak in August. Real consumer spending, which includes services, grew at a paltry 0.5% q/q annualized pace in the second quarter and was up by a tepid 1.4% y/y. Notably, the softness in spending was fairly widespread, including an outright contraction in the non-durables category.
• The key to reconciling these signals is likely two-fold. First, debt levels remain high on average and the household saving rate remains low, at just 1.7% 
• With little buffer, households may be choosing to squirrel away their extra earnings. Second, Canada’s housing market recovery from a nadir late last year is still in an early stage and the flow-through benefits to consumption occur with lags. 
• Notwithstanding a likely pickup in purchases of housing-related durable items over the near term, we expect that caution will remain the watchword when it comes to the Canadian consumer. 

Housing turning the corner

• The latest data on housing activity have provided the most compelling evidence yet that the market has finally regained its footing after being hit over the past few years by a series of macroprudential policy changes, new government taxes and higher interest rates. 
• Resale activity roared back to life, up 23% in the second quarter (q/q annualized). And recent sales data suggest another healthy quarter is in store. On the new building side of the equation, starts hit 224k – the highest level since 2017. 
• While the bounce-back has been led by the Toronto market, even the recently-ailing Vancouver market has been finding its legs. 
• Low borrowing costs and solid population growth suggest that housing will continue to make gains. In 2020, we look for resale activity and average home prices to advance by 10.3% and 6.5% y/y respectively. 
• Significant growth in resale activity is expected in Toronto, Vancouver and Calgary, as these markets continue their recovery. However, sales levels should remain below recent peaks. Growth in other parts of the country, while still healthy, should be somewhat slower on account of less pent-up demand.

Business investment back in the doldrums

• The first quarter surge in business investment gave way to yet another contraction in the subsequent quarter. Non-residential investment has now contracted in four of the last five quarters.
• The details of the recent data are concerning. Some reversal in volatile categories, notably aircraft spending, was to be expected, but the weakness in machinery and equipment spending was widespread. This suggests business leaders remain very cautious on the economic outlook. Even allowing for the unique challenges of the energy sector, investment remains well below what historic trends and economic fundamentals would imply.
• Put it down to uncertainty. Major investments require a degree of confidence around future internal and external demand – something that has been in short supply of late. Canada may no longer be directly in the crosshairs of the U.S., but re-intensified global trade tensions are bound to weigh on business confidence. Even the recent uptick in oil prices in the wake of attacks in Saudi Arabia should have little impact on the energy sector outlook due to its temporary nature.
• Ultimately, we still expect business investment to play a role in growth going forward, helped by a few major projects (Kitimat, Trans Mountain pipeline, etc.). However, a below-trend pace of activity is likely.

External backdrop worsening

• Just like investment experienced a one-off jump at the start of the year, we believe a similar dynamic is at play with exports, which surged 13% in the second quarter. The key drivers were the highly-volatile “aircraft and other transportation equipment” category, alongside shipments of energy products. Momentum has already fallen off, suggesting a return to more modest trade volumes in the third quarter (Chart 2). Labour disruptions in the U.S. auto industry also present a risk: a long-lasting strike would put our expectation for a modest fourth quarter acceleration at risk.
• Further complicating matters is the re-intensification of the U.S.-China trade dispute. Canada has already seen collateral damage, most obviously via China’s moratorium on imports of certain agricultural products. In theory, Canada could gain market share due to U.S. tariffs on China. But, there are not many areas of product overlap and the opportunity for substitution appears limited given reports that importers engaged in significant inventory build-up in order to get ahead of prior rounds of tariff increases. Moreover, U.S. business investment has historically had a tight relationship with Canadian exports. This is a critical area of forecast downgrades in our U.S. outlook, leaving little near-term upside for Canada.
• It is not all bleak: new trade agreements are creating opportunities. For instance, exports of beef to Japan have accelerated markedly this year. Plus, the U.S. remains the biggest source of Canadian export demand. Despite the already discussed softer outlook, the U.S. economic outlook is still healthier than many other regions.

Bank of Canada likely to be pushed into action by mounting global risks

• At its September rate decision, the Bank of Canada kept its overnight lending rate unchanged at 1.75% and issued an accompanying statement that was less dovish than financial markets had anticipated. The central bank provided little direction regarding future moves, merely reiterating that the current level of monetary accommodation remains appropriate. 
• As rationale for bucking the global easing trend, the central bank cited the unexpectedly strong rebound in economic growth in the second quarter, which left the economy operating at close to full capacity. The Bank of Canada also pointed to a strengthening housing market, which if continued, could add to already-high household debt levels. 
• This hawkish language was balanced with the acknowledgement of many areas of weaknesses that we’ve already identified: business investment and the divergence between incomes and consumer spending. 
• And, just like every other central bank around the globe, the Bank of Canada did place more emphasis on disconcerting developments in trade and global growth, which will receive “particular attention” as they update forecasts for the October interest rate decision.
• The uncertainty generated by trade tensions has manifested in continual downgrades to the Bank’s growth forecast. As of July, the Bank was marking down its end-2021 GDP forecast by nearly a full percentage point (Chart 3). Another growth downgrade to 2020 appears likely in the wake of U.S.-China trade escalations and a weaker global growth backdrop.
• Although the central bank wants to maintain full optionality on policy direction, contingent on trade disputes remaining unresolved we expect the deterioration in global trade and economic conditions to prompt some backstop by the Bank of Canada in the form of rate reductions later this year and in early 2020. Should trade risks abate, rate cuts are less likely.

Uncertainty sending yields lower

• The Canadian 10-year yield has been caught in the global downdraft, dropping below the 1.10% mark in mid-August. Even as yields have regained some footing, there remains a deep inversion in Canada’s yield curve. By early September, the differential between 10-year and 3-month yields had swelled to -42 bps, the deepest inversion since 1992 and, prior to that, the late-1980s. It has since narrowed to -20 bps but still offers a cautionary tale (Chart 4).
• Yield inversion in Canada does not have the same accuracy in recession signalling of that south of the border, and the Bank of Canada believes the signal coming from the yield curve is “different this time”, due to the drop in long term yields absent a rise in the short-term policy rate. However, it would be a mistake to ignore the information being conveyed by the global shift down in yields. Markets are sending a clear message of lower economic growth expectations. 
  Global headwinds have not weighed on the Canadian dollar, which has held relatively steady within a trading range of 73-77 U.S. cents. This conceals a strengthening in the loonie against non-U.S. peers. Looking ahead, push and pull forces will remain in play, leaving the loonie moving sideways within that range.