Canadian Quarterly Economic Forecast

Canadian Outlook: Now Is The Winter Of Our Discontent

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• Canada has faced a ‘perfect storm’ of events in recent months that has ground economic activity to a halt in Q4 2018 and Q1 2019. Production curtailments in Alberta’s energy sector unfolded in tandem with soft housing markets and consumer spending in the rest of the country. The former occurred to shore up oil prices due to a supply glut, and the latter reflected the sting of more stringent mortgage qualification rules and higher interest rates (Chart 1). 
• As 2019 progresses, a relief valve should get turned on as the combination of these downward influences lift. Material to this view is an easing in Alberta’s mandated oil output curtailment plan amid the recent rebound in heavy oil prices and supply draw down. 
• Although the upside to domestic household spending and housing markets will remain more limited due to  debt pressures, there are nascent signs of stabilization occurring on both fronts. Outright capitulation of households contradicts the dynamics coming from ongoing strength in job markets, continued population growth, and a relatively stable interest rate environment this year. 
• However, in terms of the balance of risks, our greatest near-term concern resides with the resiliency of Canadian household spending. Recent months have produced larger than expected disappointments, particularly with purchases that tend to be more hitched to interest rates. We had always built a soft deleveraging cycle into the forecast, and we are looking for reassurance the solid job market and more benign path for interest rates will remain supportive factors. 
• Putting the pieces together amidst a choppy quarterly pattern, we have downgraded our 2019 GDP outlook to 1.2% (from 1.8% in December). Slightly better growth prospects should be on deck for 2020 in the absence of those one-off economic hits. 
• In light of the downgrade, there is little reason for the Bank of Canada to pursue additional rate hikes until the economy demonstrates a return to an above-potential pace. In other words, we have removed any prospect of rate hikes from the forecast. The burden of proof will rest squarely on the data.  
• With the economy maintaining a thin margin for error, discussions of recession risks have been reignited. Our analysis suggests that the risk is one of a ‘technical’ nature at most, with the external conditions not supporting a true, broad-based recessionary downturn.

Consumers take a knee

• Consumers are in the driver’s seat when it comes to the underlying health of the economy. Comprising just shy of 60% of GDP, the speed of Canada’s growth will ultimately be decided by household spending decisions. 
• All signs point to a more cautious consumer relative to the heady pace in 2017 and early 2018. It’s been a long time coming, but high debt levels, higher borrowing costs and tighter mortgage qualification rules have finally conspired to constrain consumer spending and housing markets. This is particularly noticeable within the spending components that have a strong correlation to home sales (i.e. building supplies, furniture, appliances) or are interest-rate sensitive (such as cars, big-ticket purchases in general). 

• The historical relationships suggest limited scope for any data upside surprises from these segments of the economy. The more probable path will be steady-as-you go in behavioral patterns (Chart 2). 
• Digging into the details, there has been a rise in consumer proposals (insolvencies) on the back of higher borrowing costs, but context is important. A disproportionate share of the rise is chalked up to Alberta’s tough economic climate (Chart 3). Higher proposal activity within other provinces is occurring at a more even keel, and although the recent increase in Ontario is concerning, the overall level remains historically consistent with the reality of higher borrowing costs.  
• Labour market developments will be key in dictating the path for consumer spending and insolvencies. On this front, the data are still holding firm. Both job and wage growth accelerated at the start of the year, and the unemployment rate remains close to a 40-year low.  We forecast a more modest pace of employment gains going forward, reflecting tighter labour markets and an aging population. However, it should be sufficient to hold the unemployment rate at around the 5.9% mark, while generating some modest upward wage pressure.
• In light of softening consumer spending, there is greater focus now on wage growth as a key fundamental. It has been fairly constrained relative to the low unemployment rate and reports of increased scarcity of labour. However, Bank of Canada research indicates that, here too, Alberta has been a catalyst, while the rest of the country maintains stronger trends. 
• Overall, the pace of real consumer spending will remain contained at about 1.5% this year and next. With a slim cushion on the downside, this may cause some hand-wringing, marking the slowest pace since 2009 and a large step-down relative to the past decade. 
• However, after nearly a decade long credit-binge, this is a necessary step to stabilize consumer credit growth at around 2.0% to 2.5% in nominal terms. A credit path below aggregate income gains is the mechanism that  allows for a ‘soft deleveraging’.
• To be sure, threading the needle will not be easy – a downside surprise on income or a (less probable) upside surprise in interest rates could spark an outright deleveraging cycle, sapping consumer confidence.

Housing caught in the middle

• The adjustment on the consumer side is closely integrated with trends in the housing market. Macroprudential measures have impacted major markets and continue to reverberate. The narrative of ‘three markets’ continues to hold (Chart 4).  
• The first of these markets is the Greater Toronto Area. After declining steadily since September, activity appears to be stabilizing.
• Resale activity ticked up in both December and January, alongside increased listings. Homebuilding activity also remains solid, as evidenced by starts and permits data. This is a relief in many respects because it is reinforcing the push and pull factors on the market that should lead to healthier, more stable dynamics, but not necessarily an outright resurgence or collapse. On the ‘pull-up’ factors there is strong population growth, rising employment and solid income. On the ‘push-down’ factors there is higher borrowing costs and stretched affordability. 

• Dynamics in the Greater Vancouver Area (GVA) are quite different. Supply has climbed sharply and the pipeline suggest more is on the way. Meanwhile resale activity remains depressed, still trending at its lowest level since the 2008 recession. Affordability has always been stretched in this market, made worse by more heavy-handed macroprudential provincial policy. Added to this recipe is weakened confidence and slower global growth, which is particularly meaningful for this West-coast market that displays more sensitivity to these forces. We expect price growth to remain negative as a result in 2019 at roughly -4.5%.
• Elsewhere in Canada, it is a mixed bag on supply and demand dynamics. Alberta’s key markets are in buyer’s territory, reflecting idiosyncratic features hitting its economy. By contrast, housing markets in Quebec remain solid, buoyed by relatively favourable affordability and a solid job market (Chart 5). 
• Largely reflecting a downgrade to Vancouver’s market, we envision a modest downward revision to 2019 national sales and price forecast, to approximately 0.6% and -1.2%, respectively. The broader story of overall market stabilization at a lower, more sustainable level still holds. 

Energy sector improving, investment steady

• Alberta is suffering through some near-term pain, but the oil curtailment plan imposed by the province is having the desired benefit of higher prices. Indeed, since the plan was implemented in January, the discounting of heavy oil prices has overshot expectations. It has narrowed to an unsustainably thin margin relative to WTI,  which has created its own challenges (Chart 6). This makes crude-by-rail shipments uneconomical for some firms (costs to ship by rail tend to be in the $15/bbl to $20/bbl range), generating new issues around margins. We anticipate WCS prices will settle to around $42/bbl later this year, about $20 below our $62/bbl call for WTI. 
• The higher prices have already prompted the Alberta government to start easing its curtailment plan, which is good news. Still, investment and growth expectations in both, Alberta and Saskatchewan, will remain challenged, in part due to ongoing pipeline bottlenecks.
• Outside of the oil patch, Canadian business spending prospects are more positive. Indicators of business sentiment remain well-grounded, while some support will also flow through from the full expensing of many forms of investment introduced in the Federal Fall Economic Statement. However, we are not expecting an outsized lift from this influence. The economic literature, our analysis, and past experience all suggest the impact from the tax changes will be modest, adding roughly 20 basis points to our investment growth profile over the coming year, relative to our September expectations. 
• More important to the forecast for spending is the dearth of investment post-2015. Canadian firms are currently underinvested, relative to employment levels and long-run trends. This effect will play off against a softer domestic backdrop. The net result is a modest acceleration of the pace of investment in 2019 and, in particular 2020, with the latter year helped by anticipated work on the LNG project in Kitimat. However, we do not expect outsized ‘catch-up’- style growth given the domestic challenges: investment growth in 2019 and 2020 is forecast to trend below historic norms.

Bank of Canada back to ‘wait and see’

• The Canadian yield curve has shifted dramatically lower over the last few months. After the Canada 10-year government bond yield hit a near-four year peak of 2.60% in early October 2018, it has now dropped roughly 85 bps to 1.76%. This swift move came as a result of deteriorating global growth and a downgrade to the consensus view of the Canadian economy. With Canada’s economic pace skimming 1% in 2019, the output gap is larger than previously expected and this sets a high hurdle for another rate hike by the Bank of Canada. We anticipate no further rate hikes by the central bank, meaning the current policy rate of 1.75% is as good as it gets. 
• Even with the eventual confirmation of a GDP growth-rebound in the second quarter (as we expect), there is little in the way of new growth-impulses to prompt a sustained period at an above-trend pace that would materially press on the inflation drivers.  
• It’s possible that a global-growth impulse could come from a lifting of geopolitical risks as the year goes on (i.e.  Brexit and U.S.-China-EU trade tensions), but given the uncertainty on that front, we are in the ‘I’ll believe it when I see it’ camp. In turn, this should keep the Canadian dollar range bound at between 74-76 US cents in 2019.