Canadian Quarterly Economic Forecast

Canadian Outlook

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• Here we go again. As widely expected, the Canadian economy’s barn-burning second quarter growth was doused in the third quarter, with activity increasing a modest 1.3% (annualized). However, beneath the headline lay a surprisingly strong 3.2% gain in final domestic demand.  
• The GDP report brought Statistics Canada’s annual revisions, which also delivered positive surprises. Business investment has been stronger of late than initially reported, as have household incomes. The latter means that the household saving rate is higher than previously thought.
• A similar modest pace of growth is likely to be recorded in the fourth quarter of 2019, partly owing to labour-related disruptions in the auto and transportation sectors. Including their ‘knock-on’ effects, we expect these temporary factors to drag down growth by about 0.3 p.p. in the quarter.
• Looking further ahead, there have been some positive international developments of late, notably the U.S.-China ‘phase one’ deal and CUSMA nearing the finish line. However, soft global growth coupled with still-lingering trade uncertainty is unlikely to offer fertile ground for exports and investment, while the factors that have been constraining consumer spending will remain in place. On the latter, however, there is a greater possibility for upside surprises. Notably, wage gains have been getting hotter and the rebound in home sales may feed through to lagged household-related purchases in the New Year. Federal tax changes should also support spending. We’ve slightly upgraded our outlook for consumer spending given these factors. However, when it comes to a meaningful acceleration of spending, for now, we maintain a ‘believe it when you see it’ approach.
• Looking through the noise, Canada’s economy is trending around its economic potential expansion rate of around 1.7%. We see no near-term catalysts to change this one way or the other (Chart 1). Regional growth divergences remain an important element of the outlook, as discussed in our Provincial Economic Forecast, also released today.
• The Bank of Canada has refrained from delivering precautionary rate cuts this year as it assesses the balance between external risks and domestic resilience, particularly in household borrowing. We still see the balance of risks tilted toward easing and have incorporated one 25 bp rate cut in 2020. One potential trigger for the cut could be an up-trend in global bond yields that dampens the domestic spending outlook. Still, we cannot dismiss the possibility that the current setting of monetary policy may be Canada’s new normal to address the high-leverage cycle.

Some Help For Cautious Households From Re-elected Liberals 

• PM Trudeau campaigned on a platform heavy on tax adjustments, most significantly an increase in the basic personal amount (roughly speaking, the amount of income one can earn before paying income tax). The December 5th speech from the throne reinforced this priority, alongside promised measures to support housing activity. Post-speech actions mean that the tax change will be in effect for the 2020 tax year.
• We expect these changes to be moderately growth-positive, adding about 5-10 bps per year to economic growth over 2020 and 2021. The modest impact relative to the size of government spending is due to an economy operating close to its potential (meaning a smaller fiscal multiplier), and cautious household behaviour of late. Notably, the household savings rate climbed more than a percentage point between the first and third quarters of the year.
• The other side of the announcement, related to housing and yet to be formally legislated, comes as the sector has been on an upswing, exceeding expectations of late. Resale activity is up nearly 20% from its February low, with prices coming along for the ride (up more than 14% on the same basis). Activity has been broadly-based across most key markets. Supported by strong population growth, low borrowing costs, and healthy income gains, the outlook for the housing sector remains healthy. As it has been for some time, more supply is needed to address affordability concerns in key markets.

Labour Market-Spending Disconnect Still at Play

• Even as the pace of hiring has come off of late, the trend in Canadian labour markets remains solid. Net employment is up a healthy 292.9k year-on-year through November, solidly ahead of the post-crisis trend. Over the past few years, gains have come largely from service-related sectors that have so far been spared the brunt of trade-related uncertainty. 
• More recently, employment has been shifting to relatively higher paying positions, helping to boost wage gains above the 4% mark. Even absent this shift, wages would be trending at a solid 3+% (Chart 2).
• And yet, even as labour markets have stayed healthy, consumer spending has disappointed. Total consumer spending may have ticked up a notch in the third quarter, but the year-on-year trend remained at just 1.4% while retail sales volumes continue to trend sideways. It is telling that the 1.4% y/y trend in consumption volumes falls a bit short of population growth.
• As discussed in a recent report, the reason for this disconnect is a hangover of sorts from past excesses. Auto sales are above population fundamentals, and adjustments in housing markets over the past few years have slowed the gains in housing wealth relative to the heydays of 2012-2017.
• More fundamentally, household finances remain stretched. The debt service ratio has been trending steadily higher, as have consumer insolvencies. 
• Ultimately, while we’ve upgraded the consumer spending outlook modestly to reflect recent developments, our view remains one of caution. Our roughly 1.7% trend pace of consumer expenditures is a good notch below the 2.4% post-crisis average. We see this forecast as consistent with the recent behavior of households to repair their balance sheets.

Investment Mired in Uncertainty

• Turning to investment, the (revised) trend of late has been better than expected. In its latest GDP release, Statistics Canada transformed six quarters of contractions in structures investment into just four (ending last year), marking the level of activity up nearly 6% in the process. This change was attributed to better than initially reported spending in the energy sector broadly defined, including the sizeable LNG Canada project in British Columbia.
• The key question is the durability of capital spending. Firm sentiment remains soft and the outlook for the energy sector remains highly uncertain. In terms of machinery and equipment spending, much of the gains of late have come from the more volatile categories, notably transportation equipment. Spending on industrial machinery continues to struggle to gain traction.  
• Discouragingly, the trend in imports of capital goods has been disappointing, with the domestic picture no better. Shipments of machinery, electrical equipment, and other key areas have flatlined. As a result, inventories remain elevated among manufacturers and capital equipment wholesalers. There appears to be little near-term appetite for a sustained increase in capital spending. 
• Indeed, from a fundamentals point of view, low interest rates, as well as accelerated capital depreciation and other tax breaks have done little to change the investment story. This suggests that until there is more clarity on the external backdrop we can only expect a sub-par pace of investment spending.
• We have undoubtedly received a bit more clarity of late: The U.S. and China appear to have reached a ‘phase one’ trade deal that includes a modest rolling-back of tariffs, and the ‘new NAFTA’ has almost reached the finish line. But with phase two of U.S.-China negotiations soon to be underway and other regions entering the U.S. trade war cross hairs, it appears that uncertainty will be with us for some time to come, limiting the upside to trade and investment.
• As mentioned, one bright spot continues to be LNG Canada’s Kitimat project. However, recent reports suggest that the bulk of investment activity is likely to occur later than anticipated, shifting some investment spending past 2020. 

Bank of Canada Sets A High Bar To Easing

• In contrast to its advanced economy peers, the Bank of Canada has kept policy rates stable. It now has one of the highest policy rates of any developed economy. The statement accompanying the December 4th decision to hold the overnight rate at 1.75% highlighted the improvement in domestic and international economic data, but also reiterated that external headwinds will remain a challenge for the Canadian economy. 
• Market odds of a rate cut by mid-2020 have bounced around between 1 in 3 and 1 in 2 (Chart 3) and it is admittedly a close call. Arguing in favour of holding rates steady, inflation is right where the Bank wants it, wage growth is healthy, and mortgage growth is reaccelerating. The Governing Council remains concerned about refueling a housing/debt binge. Arguing in favour of cuts, global growth appears unlikely to improve much, trade uncertainty is likely to continue and financial conditions have begun to tighten – the 5-year yield is up nearly 50bps from its August low. Further advances could send the already-elevated debt service ratio even higher and threaten even modest consumer spending growth. 

• With the current policy setting by the Bank of Canada now higher than that of the Fed, interest rate differentials between short-term Canada and U.S. government bond yields are tight. The spread between the Canada and U.S. 2-year yields now sits at -0.06%, up from -0.85% in March 2019. Typically, this would mean an appreciation of the Canadian dollar against the greenback (Chart 4). Instead, lower commodity prices and heightened global uncertainty has kept the loonie trading in a tight 74 to 76 US cent range. Should the trade environment and sentiment towards global growth improve, the loonie could test the 80 US cent level. This would be an unwelcome tightening in financial conditions at this point in the Canadian business cycle if it’s not met with much stronger external demand for exports.