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COMMENTS

Economic Research: Canada's Economy Faces A Patchy Recovery


Economic Research: Canada's Economy Faces A Patchy Recovery

In Canada, the data currently support that the spread of COVID-19 has been largely contained and a tentative recovery has begun. Real time mobility and activity data have started to rise, and more important, the labor market added 290,000 jobs in May, when shutdowns were initially eased, recouping about 10% of the 3 million jobs lost in March and April.

Chart 1

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The rise in jobs and hours worked in May likely means the economy troughed in April, after contracting more than 8% in the first quarter (quarter-over-quarter annualized). The first-quarter decline was slightly more than we had forecast but showed how even two weeks of shutdown could bring the economy to its knees.

The pandemic came just when Canada was already prone to a downturn. The transition from 2019 to 2020 was already weak to begin with; high household debt levels, soft consumer spending, plant closures, and labor disruptions were setting up the economy for a subpar year. The energy price decline after the Saudi-Russia spat made things worse, and the pandemic was the last straw to break the camel's back.

The toll from shutdowns is likely to see the second quarter take the brunt of the hit to the economy. Reflecting a further 39% annualized contraction in the second quarter, the economy likely fell near 13.4% cumulatively from peak to trough, from fourth-quarter 2019 to second-quarter 2020 (was negative 11.3% in our April forecast).

The Shape Of Recovery

The macroeconomic environment has a high degree of uncertainty. Assuming the likely subsequent waves of COVID-19 are not overwhelming, we expect an economic recovery in two stages: a near-term bounce in aggregate demand and employment activity as lockdown restrictions are eased, followed by a more gradual, protracted, and uneven improvement. The downturn is unlike any other past recessions because it was driven by public policy actions to contain the coronavirus through strict lockdowns, and the recovery path will also depend on public health outcomes, public policy response, and the impact on private-sector (both consumers and businesses) confidence.

Chart 2

image

S&P Global Economics forecasts real GDP to contract 5.9% in 2020 (was negative 5.3%) before rising 5.4% in 2021 (was 6.0%). We don't expect real GDP to regain its pre-pandemic level until the fourth quarter of 2021 (was third-quarter 2021).

Table 1

S&P Global Economics -- Canada Forecast Overview
June 2020
2019 2020f 2021f 2022f 2023f
Key Indicators
Real GDP (year % change) 1.7 (5.9) 5.4 3.1 2.6
Real GDP (Q4/Q4 % change) 1.5 (2.8) 2.7 3.3 1.9
Real consumer spending (year % change) 1.6 (6.5) 6.5 3.4 1.9
Real fixed business investment (year % change) (0.4) (10.3) 8.4 8.8 6.3
Real residential investment (year % change) (0.5) (7.9) 6.9 6.2 1.7
Core CPI inflation (year % change) 2.1 0.9 1.0 1.8 2.2
C$ per US$ 1.33 1.36 1.37 1.34 1.34
Unemployment rate (%) 5.7 9.2 7.3 6.4 5.8
Housing starts (annual total in '000) 209 185 200 203 204
MLS Home Price Index (Dec. to Dec. % change) 2.4 (4.9) 3.3 6.1 4.4
10-year benchmark bond yield (annual average %) 1.6 0.6 1.1 1.8 2.3
Bank of Canada Policy Rate (year-end %) 1.75 0.25 0.25 0.50 0.75
Note: All percentages are annual averages percent change, except for real GDP Q4/Q4. f--forecast. Source: Oxford Economics, S&P Global Economics forecasts.

The unprecedented government response, which is intended to maintain employer-worker relationships, should help labor market recovery (see table 2). Federal aid now totals 14% of GDP, of which direct federal spending is 6.9%--the bulk of which continues to be allocated through the Canada Emergency Response Benefit (CERB) and Canada Emergency Wage Subsidy (CEWS) (1). After topping out at 13.7% in May, the unemployment rate should fall to 8.5% by the end of 2020 and 6.8% by the end of next year. The unemployment rate will likely reach below 6% (pre-pandemic level) only in 2023.

Table 2

Canada Federal COVID-19 Economic Response Spending
Measure (Mil. C$) (% of GDP)
Direct spending 159,485 6.9
Canada Emergency Response Benefit 60,000 2.6
Canada Emergency Wage Subsidy 45,000 2.0
Other direct spending 54,485 2.4
Tax deferals 85,000 3.7
Loans and other credit measures 86,450 3.8
Total 330,935 14.4
Doesn't include provincial government support. Source: Oxford Economics, Department of Finance, and provincial finance departments.

Lingering scars in the form of COVID-19 infection fear, bearish outlook for oil prices, bankruptcies, and regulated social distancing will limit capacity utilization and growth for more than a fourth of the economy (see chart 3). There may be an initial first wave of "back to work" activity this summer, but the momentum will likely be tempered thereafter. Some of this is visible in the small business optimism snapping back in May and a modest extension of gains thereafter in June, as more businesses were allowed to reopen (see chart 4).

Chart 3

image

Chart 4

image

The CFIB Business Barometer, a measure of small business confidence, clocked in at 54.6 in late June, rising two points above May (see chart 4). While this is an improvement from the late-March lows, the index still remains about five points below its pre-pandemic two-year average performance, and we think social distancing rules and other restrictions will continue to weigh on business profitability. Businesses that have re-opened are operating at only 58% of capacity, a nine-point improvement relative to May.

Most industries reported results close to the national average. However, the natural resources, agriculture, and arts and recreation sectors stood out as the most pessimistic. A bearish outlook for commodity prices and related investment--which have long been important drivers of overall business investment and productivity--will put a lid on capital investment (which had already been on a declining trend before the recession).

The unusual nature of the service-centric shock makes the road to recovery more uncertain than usual. This shock also makes for more permanent losses as there is no going back in time for pent-up demand for that missed haircut, manicure, gym workout, camp, and other personal services. The economy returns to its pre-pandemic size by sometime in fourth-quarter 2021, but remains below our pre-pandemic December baseline path by 2.5% at the end of 2023 (our forecast horizon). In the process, the economy loses close to C$56 billion (inflation-adjusted) permanently, but starts to converge back to its pre-pandemic sustainable longer-term growth path--of slightly less than 2%--in 2023 and beyond.

Chart 5

image

Monetary Policy Measures To Remain Ultra-Accommodative

The trajectory of the coronavirus remains highly uncertain, meaning economic stop-and-go with "false dawns" tilts our view of the risk to the baseline forecast squarely to the downside. Considering the lasting impact from the pandemic with lingering negative output gap, we anticipate the Bank of Canada (BoC) will keep the policy rate at its current level of 0.25% through late 2022. We anticipate lift-off from current levels in 2022-2023, consistent with our inflation forecast of sustained 2% and unemployment rate below 6% (the top end of pre-pandemic levels). Subdued commodity prices and lingering labor market slack are likely to keep price inflation at a sub 1% rate the rest of the year but Inflation expectations remain well anchored. As the economy starts to slowly return to normal levels of economy activity, inflation should also climb back to its 2% target trend by mid-2022.

There is a high bar to tighten monetary policy in the next couple of years. New BoC Governor Tiff Macklem picked up right where Stephen Poloz left off, reiterating a commitment to continue large-scale asset purchases until the economic recovery is well underway. The Bank's balance sheet has more than tripled in size since the onset of the pandemic, sitting just above C$500 billion in mid-June, about 22% of 2019 GDP. The Bank also announced plans to scale back its short-term operations as stress in financial markets has dissipated. It will be reducing repo operations to once a week and bankers' acceptance purchases to bi-weekly. However, the Bank will continue purchasing federal, provincial, and corporate debt at the current pace.

Chart 6

image

House Price Correction Likely

Accommodative policy will help keep a lid on interest rates across the yield curve. Still, we believe a house price correction is likely in Canada. Before the pandemic, the country was already overdue for a house price correction, and the pandemic's hit basically created that last nudge for it. The combination of historic income and job loss, virus fear and uncertainty, new stricter Canada Mortgage and Housing Corp. lending rules, and an effective pause on immigration will strain demand for housing, despite historically low borrowing rates (2). Another real risk is that Canada is approaching a mortgage deferral cliff. The pending end of the six-month deferral of mortgage payments this fall could impose great hardship on financially strapped households and derail any housing recovery underway.

We expect home prices (as measured by the MLS home price index, which corrects for compositional bias) to dip 9% on a year-over-year basis by the first quarter next year. We view this as a temporary phenomenon rather than a multiyear slump (such as in the US 2007-2011), but risks are tilted to the downside. Should employment recovery fail to meet our baseline expectations, the risk factors mentioned above could morph into an endogenous loop with the economic recovery, creating a diminishing wealth effect from lower housing prices, which would further constrain household spending and lead to a slower recovery in the second stage.

Increasing Concerns For Longer-Term Growth Potential

We hesitate to place shape-based descriptions for the recovery, since they are prone to varying interpretations. The economy will face headwinds throughout the recovery, but we do not yet assume material long-term shifts in the sources of longer-run potential growth--in labor supply and quality, capital investment, and multifactor productivity. Risk to this central assumption on long-run potential growth is to the downside, very much related to "negative duration dependence".

For what it's worth, short (two-quarter) recessions around the world have typically been followed by snapback recoveries--back to the prerecession path. Longer recessions usually accompany drawn-out recoveries, with a hangover effect (or "hysteresis-like" dynamic) that leaves GDP permanently lower and risks eroding the structural longer-term potential growth of the economy.

That means the risk to our current central assessment of a long-term potential growth rate hinges on the evolution and duration of the spread of COVID-19, and how the mitigation policies and consumer concerns interact with them. The longer this situation lingers, the greater the risk that we would revise our forecasts to show a wider bottom trajectory for the economy or some form of stop-and-go saw-tooth trajectory. In such a scenario, there is also a higher risk of scarring the labor force, capital formation, and the efficient, eventual allocation of the two, thereby eroding sustainable growth rates that maintain low and stable inflation (3). The stranded asset problem would magnify, and drawn-out, slow balance-sheet repair would ensue. The recovery, in such a scenario, would be flatter even after the pandemic abates.

Table 3  |  View Expanded Table

S&P Global Economic Outlook -- Canada Baseline Forecasts (June 2020)
2019 Q4 2020 Q1 2020 Q2f 2020 Q3f 2020 Q4f 2017 2018 2019 2020f 2021f 2022f 2023f
Real GDP and components*
GDP growth 0.6 (8.2) (38.8) 33.9 18.7 3.2 2.0 1.7 (5.9) 5.4 3.1 2.6
Final domestic demand 0.8 (6.0) (29.9) 21.8 5.9 3.3 2.1 1.3 (4.7) 4.7 3.5 2.2
Household final consumption 1.8 (9.0) (40.0) 36.0 10.0 4.1 1.3 1.7 (4.9) 5.2 2.8 1.7
Government final consumption 1.5 (3.8) 23.2 1.1 (12.6) 2.3 3.0 2.1 2.9 0.0 1.4 1.3
General government gross fixed capital formation (3.6) 3.3 2.7 1.9 1.9 6.3 5.2 (0.3) 4.4 2.7 (0.7) 1.6
Business gross fixed capital formation (2.6) (1.4) (50.1) 14.3 23.4 7.3 (4.5) 2.4 (8.7) 10.2 5.6 3.6
Residential construction 1.2 (0.4) (51.4) 17.7 13.4 2.2 (1.6) (0.6) (8.0) 6.3 6.2 1.7
Non-residential construction 0.7 4.1 (52.5) 16.8 26.9 0.6 (0.6) 0.7 (7.8) 8.0 8.1 5.0
Machinery and equipment purchases (11.1) (8.6) (46.9) 6.4 39.5 7.1 4.5 (1.7) (13.5) 8.1 9.4 7.5
Intellectual property products (3.7) 4.0 (50.3) 7.6 29.7 3.6 4.2 (1.8) (7.9) 18.9 9.8 8.5
Total exports (4.5) (11.3) (51.3) 39.6 18.3 1.4 3.1 1.3 (10.8) 7.3 3.7 2.1
Total imports (3.2) (10.7) (50.7) 45.7 23.4 4.2 2.6 0.6 (10.2) 8.4 3.1 2.3
Other economic indicators
CPI inflation (%) 1.7 0.5 (6.3) (0.7) 1.8 1.6 2.2 2.0 (0.4) 1.2 1.7 1.9
Core inflation (%)§ 1.1 1.4 (1.1) 0.5 0.8 1.6 1.9 2.1 0.9 1.0 1.8 2.2
Employment (000's) 19,124.5 18,639 17,179 18,208 18,471 18,420 18,659 19,050 17,800 18,696 19,192 19,526.4
Employment (% Y/Y) 1.8 (0.4) (13.0) (7.1) (5.7) 1.9 1.3 2.1 (6.6) 5.0 2.6 1.7
Unemployment rate (%) 5.7 6.3 12.8 9.1 8.7 6.3 5.8 5.7 9.2 7.3 6.4 5.8
Average hourly earnings (% Y/Y) 2.7 3.7 (0.8) (1.0) (0.2) 1.7 3.3 2.7 0.4 2.9 2.4 2.3
Household credit market debt (% Y/Y) † 4.2 4.0 3.8 3.5 3.3 5.2 3.9 4.2 3.3 4.8 4.4 4.2
Household credit market debt (% of disposable income) † 178.0 177.9 184.1 188.8 190.6 177.8 179.5 178.0 190.6 182.3 181.5 181.2
Bank of Canada overnight rate (%) 1.75 1.5 0.25 0.25 0.25 0.70 1.40 1.75 0.56 0.25 0.28 0.6
Government of Canada three-month T-bill yield (%) 1.66 1.4 0.23 0.23 0.23 0.68 1.36 1.66 0.51 0.23 0.26 0.6
Government of Canada 10-year bond yield (%) 1.52 1.2 0.35 0.37 0.46 1.78 2.28 1.59 0.60 1.09 1.80 2.3
Exchange rate, US$-C$ (period average) 1.32 1.34 1.39 1.38 1.39 1.30 1.30 1.33 1.38 1.37 1.34 1.35
Exchange rate, US$-C$ (end of period) 1.30 2.79 2.85 2.79 2.78 1.25 1.36 1.30 1.39 1.35 1.34 1.34
Current account balance (% of nominal GDP) (1.6) (1.9) (3.4) (3.4) (3.2) (2.8) (2.5) (2.0) (3.0) (2.6) (2.2) (2.2)
Merchandise trade balance (% of nominal GDP) (0.5) (0.7) (2.4) (2.4) (2.2) (1.1) (1.0) (0.8) (1.9) (1.7) (1.4) (1.4)
Crude oil (US$/bbl, WTI) 56.9 42.0 25.0 25.0 25.0 50.9 64.8 57.0 29.3 43.8 50.0 56.0
Household saving rate (%) 3.6 6.1 16.6 9.1 6.4 2.1 1.8 3.0 9.5 7.7 8.0 8.6
Housing starts (mil.) 201 208 160 180 192 220 214 208.7 185 200 203 204
Government fiscal balance (% of nominal GDP) ‡ (0.6) (2.1) (32.4) (10.1) (4.4) (1.1) (0.8) (0.5) (11.6) (2.6) (1.9) (2.4)
Notes: *Chained (2012) dollars, quarterly change annualized and year-over-year growth for annual data. §Total CPI excluding food and energy. †Households excluding non-profit institutions serving households at quarter- and year-end. ‡Net lending/borrowing by federal, provincial and local governments. f--Forecast. Source: S&P Global Economics.

Related Research

Endnotes

(1)The Canada Emergency Response Benefit (CERB) gives financial support to employed and self-employed Canadians who are directly affected by COVID-19. Eligible applicants can receive $2,000 for a four-week period (the same as $500 a week). Canadian employers whose businesses have been affected by COVID-19may be eligible for a subsidy of 75% of employee wages for up to 24 weeks, retroactive from March 15, 2020, to Aug. 29, 2020. The federal government is also set to release a fiscal "snapshot" on July 8, which should provide further clarity on its near-term spending plans, and projections for the federal deficit and debt levels.

(2) A lot of it is a locational story--Vancouver and Toronto had been the overvalued regions, and that generally has larger weights in the composition of home price indexes.

(3) Specific risks to long-term equilibrium growth will also depend on how consumers' behavior and businesses' operations change once the pandemic has ended. Businesses optimized for a world without pandemic risk could now lean toward resiliency more than "just-in-time" efficient operations. That could mean higher inventories, less willingness to outsource operations to specialists, and fewer economies of scale from concentrating production and employment in specific offices or factories. Households, too, could operate at higher savings rates as a precaution, which means lower marginal propensity to consume.

As a result, a feedback loop could ensue in which less spending by Canadian consumers could push businesses to produce less, which means lower income and employment across the economy, unless the government and the rest of the world pick up the slack.

This report does not constitute a rating action.

Senior Economist:Satyam Panday, New York + 1 (212) 438 6009;
satyam.panday@spglobal.com

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