Canadian Quarterly Economic Forecast

Canadian Outlook

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• 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

• 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

• 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

• 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.