A Publication of BMO Capital Markets Economic Research
By: Sal Guatieri, Senior Economist, BMO Capital Markets
- The Canadian economy is running near potential. Real GDP slowed to a 1.6% rate in the second half of 2017, and likely held near this pace in Q1. Temporary support from the oil recovery, enhanced child benefits and Southern Ontario’s housing boom has faded, while financial conditions have tightened. With the economy essentially at full employment, sustaining faster growth will require improvements in productivity and competitiveness.
- Following a 3.5% splurge in spending last year, consumers are slowing in response to rising interest rates. Household credit has rolled over, up 5.3% y/y in March versus 5.9% last summer. Though improving in March, retail sales have slowed, while auto sales have plateaued.
- After rebounding last year, investment will slow in response to trade policy uncertainty and diminished competitiveness. Direct capital flows have shifted toward the U.S. with a net outflow of nearly $70 billion last year. Canada posted a record trade deficit in March, despite the low-valued currency and rising oil prices. In fact, export volumes have gone nowhere for three years. The bulk of the deficit is with China and in autos, the latter being a notable shift from earlier decades when large surpluses were the norm. Trade likely subtracted from real GDP for a fifth straight quarter in Q1.
- Rising interest rates, stricter mortgage rules and provincial policy measures have corralled Vancouver’s and Toronto’s housing boom. Still, the more affordable condo market remains piping hot in these cities, especially at the low end (studio and one bedroom). In the rest of the country, where all property types are affordable, activity remains healthy. The fastest population growth in a quarter century and prime-age-buying millennials are supporting demand. Ottawa and Montreal are strengthening amid healthy valuations and increased demand from non-resident investors. However, Alberta and Saskatchewan continue to struggle with elevated inventories, though this should not last long if oil prices continue to rise.
- Stronger U.S. demand, higher oil prices and federal infrastructure spending will support an improvement in Canadian growth in Q2. In fact, manufacturing has turned up after a lengthy hibernation, with shipments up 6.4% y/y to March amid broad industry gains outside of autos. Expected GDP growth of 2.0% in 2018 should reduce the jobless rate to 5.5% by year-end, the lowest since 1974.
- All provinces will downshift this year. Alberta could see growth sliced to 2.2% this year from a province-leading 4.9% rate last year (albeit after two years in recession). This would allow B.C. to reassert itself as the nation’s leader, benefitting from exports to fast-growing Asia. However, after four straight years of cruising above 3%, even B.C. will moderate to 2.4% amid a flurry of tax increases (corporate, personal, housing, carbon and payroll). Following the fastest pace (3.1%) in 17 years, Quebec is expected to moderate to 2.2% this year. Nonetheless, with companies ramping up investment amid tax relief, la Belle Province should once again top Ontario (2.0%), where business confidence has sagged.
- The Bank of Canada has kept policy rates steady since January amid slower economic growth, trade policy risks and tougher mortgage rules. However, with the economy running close to capacity, rates are likely to increase in July, assuming some clarity on the trade front. While elevated household debt warrants a go-slow approach to rate hikes, inaction can also heighten financial risks by encouraging more debt accumulation, according to Governor Poloz. We expect the current policy rate (1.25%) to reach the low end of the Bank’s estimated neutral range (2.5%) in late 2019.
- Like the economy, the Canadian dollar remains stuck in low gear. After motoring above 81 cents (US) earlier this year, it has spun its wheels in the 76-to-79 cents range. That’s close to “fair value” on a purchasing power basis for goods in the two countries, estimated by Statistics Canada at 77.5 cents. Record trade deficits, NAFTA uncertainty and a resurgent greenback have offset higher oil prices to hold down the currency. Still, if NAFTA talks end well, a relief rally could lift it to 80 cents by year-end.
- The U.S. economy is poised to speed up this year. While GDP slowed in the first quarter, the economy didn’t weaken. Here’s why: First, measured GDP almost always downshifts at the start of the year given quirky seasonal adjustment. Second, at 2.3%, growth still exceeded potential. Third, the slowing was mostly contained to two areas that posted big gains in Q4—consumer spending and residential construction. Fourth, exports and capex remained strong, rising 4.3% and 6.1%, with the latter spread across most industries (i.e., it wasn’t just an oil story).
- Firmer retail sales and industrial production in April flag a better second quarter, even as softer machinery orders indicate some moderation in capex. With fiscal stimulus likely to add around 1% to GDP this year, growth should strengthen to 2.8% from 2.3% last year. Although late-cycle imbalances are emerging, the current expansion (now the second longest since at least the middle of the 19th century) is on track to surpass the decade-long stretch from 1991 to 2001 to become the longest ever by next summer. This should push the current 3.9% jobless rate to a 48-year low of 3.5% by next year.
- The fiscal jolt has put a spring in the Fed’s tightening step. Policy rates are widely expected to rise in June, and we see further moves in each quarter until mid-2019. With core PCE inflation (1.9%) almost bang on target and the jobless rate just a hair above its half-century low, the Fed’s dual mandate is a fait accompli. The focus for policy makers should now be on returning policy rates to neutral (closer to 3%) to prevent the economy from overheating.
- The 10-year Treasury yield has risen above 3% to seven-year highs on concern that rising oil prices will spark inflation. Accordingly, we raised our year-end call to 3.25% (from 3.10% previously), while keeping the 2019 year-end forecast unchanged at 3.50%.
- The trade-weighted dollar’s 10% depreciation in the past year ended with a 3% jump in the past month, as fiscal stimulus and firmer inflation warrant a more deliberate Fed response, while many other central banks are still looking for the exits. Although rising trade and budget deficits will restrain the dollar, the risks skew to the upside.
- NAFTA talks continue to drag on in a two-steps forward, one-step back process. If talks fail, the consequences could range from the status quo (should Congress veto a repeal), to a so-called Zombie NAFTA (that’s held up in the courts for years), to an outright termination. In the event that NAFTA is repealed, the outcomes range from just modestly weaker growth should governments abide by WTO trade rules, to a recession in Canada and Mexico and weak U.S. growth if they resort to more punitive protectionism.
- Business surveys cite growing concern about rising material costs and supply chain disruptions due to import tariffs on steel and aluminum and the U.S.-China tariff tiff. While the duties proposed to-date are insufficient to materially harm either economy, several rounds of retaliation could quickly escalate the damage.
- Trade protectionism, loose fiscal policy and above-$70 oil imply heightened risks for inflation and interest rates, the usual cause of past recessions.
- Oil prices could climb further if the U.S. imposes sanctions on Iran and Venezuela. This would raise inflation risks and weaken the U.S. expansion. Historically, a 10% increase in oil prices has tended to slow U.S. growth by just under 0.1 ppt. The 50 cents run-up in gasoline prices in the past year could shave just over 0.2 percentage points from GDP growth this year, offsetting just over half of the estimated lift from tax cuts.
- With the U.S. budget deficit nearing $1 trillion next year (about 5% of GDP), the government will have less flexibility to cushion the next downturn without avoiding a credit-rating downgrade.
- Brexit uncertainty has undermined U.K. growth and could slow the European economy. Pro- and anti-Brexit forces within the U.K. parliament are debating whether to pull the region out of the EU customs union. This issue will largely determine whether the U.K. faces a “soft” or “hard” Brexit.
- In Italy, a coalition government of two populist parties with plans to expand fiscal policy and the budget deficit has put upward pressure on Italian bond yields.
- On a more positive note, North and South Korea have agreed to a denuclearization deal, allaying tensions between North Korea and the U.S. ahead of a scheduled June 12 Summit between the two leaders.
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