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Canada economic outlook: a pocket of resilience

The Bank of Canada kept interest rates unchanged at 1.75% last week and suggested that it’s content to stay on the sidelines for the time being, even as the Canadian economy appears to be staging a remarkable recovery.

Canada economic outlook: a pocket of resilience

Gloom and uncertainty seem to have become the defining features of the global economy of late, but the Canadian economy finds itself in a rare bright spot where it should be the envy of many policymakers—growth is surprising to the upside, inflation is on track, and trade activity is contributing to GDP.

This, however, is no mean feat. According to the Citi Economic Surprise Index, the country hasn’t produced this level of upside surprise since 2007; a sharp contrast from the U.S. experience.¹ Q2 GDP in Canada is now expected to rebound heartily from the weakness recorded in previous quarters, with estimates closing in on 3.00%—significantly higher than the Bank of Canada’s (BOC’s) estimate of 2.30%.²

Over the next three months, we expect 

  • the Canadian curve to continue to flatten as the central bank keeps rates on hold for the rest of 2019, even if and when the U.S. Federal Reserve cuts interest rates.
  • a stronger Canadian dollar that will see it trade between the 1.28 to 1.32 band against the U.S. dollar.³

How has Canada managed to do so well against a backdrop of deteriorating global fundamentals? In my view, the short answer is that it has imported what’s good with the global economy (i.e., low rates) and managed to mostly avoid the fallout stemming from the “uncertainty shock” related to U.S.-China trade tensions—so far. It’s a combination that’ll continue to benefit Canada for the next three to six months, giving the BOC an opportunity to stay on the sidelines for a while.

Chart of Citi Economic Surprise Indexes: Canadian data sharply surprising to the upside. The chart shows that Canadian economic data has consistently surprised to the upside, relative to U.S. economic data. The divergence between the two indexes started to widen in mid-to-late 2018.

Looking at the bigger picture, it’s also clear to us that Canada is benefiting from five key economic developments:

  • Monetary policy is simply less restrictive. Canada’s still operating with negative real rates, unlike the United States, and will likely stay that way for some time.
Chart of Real Canadian policy rates remain in negative territory. The compares U.S. interest rates with Canadian interest rates, after adjusting for inflation. The chart shows that real policy rate in Canada is in negative territory while real policy rate in the United States is hovering just below 1%, as of May 15, 2019.
  • Despite a neutral central bank, Canada has imported, and benefited from, the global drop in yields; as a result, market-based rates have fallen for the Canadian household. That’s provided support for retail sales activity in the country and helped to stabilize mortgage credit activity. We expect housing activity will also reaccelerate shortly.
Chart of Canadian retail sales. The chart shows that retail sales in the country have started to grow again this year, in nominal and real terms.
Chart of Canadian mortgage credit. The chart shows that on a year on year basis, mortgage credit activity has started to stabilize after falling in the last year.
  • The Canadian job market has been exceptionally strong, not only in terms of quantity, but also in terms of quality. The country has already added more jobs in the first six months of the year than in all of 2018. It’s worth noting that these are mostly full-time, private sector positions that helped to push wage growth to 3.60% in June from a year ago (compared with 3.10% in the United States). This is, once again, supportive of consumption activity.
Chart of Canadian jobs created in the last 10 years (Jan 2009 - June 2019). The table shows that number of jobs created in the six months between January and June 2019 have already surpassed the total number of jobs created in all of 2018.
  • Business confidence is slowly improving, supported by the (near) ratification of the United States-Mexico- Canada Agreement and positive developments in the energy/pipeline sector. Clearly, the weakness we saw in Canadian business confidence last year didn’t slow hiring in the country, as it has more recently done in the United States. While investment has remained somewhat weak in the past year, we did see a sizable improvement in the first quarter, which is a trend we expect to continue. 
Chart of Business spending—contribution to growth. Chart shows that business spending has started to grow after slipping into the negative territory in 2018.
  • Export activity has rebounded sharply in the second quarter and is now expected to contribute significantly to Q2 growth. Depending on June figures, trade could add as much as four full percentage points to GDP. While much of that can be attributed to the “base effect,” and some of the rebound we’re seeing could unwind in Q3, it does suggest that Canadian trade hasn’t trailed off as a result of U.S.-China trade tensions. 
Chart of Canadian exports dating back to 2015, broken down into energy and nonenergy exports. The chart shows that Canadian exports in both categories have been accelerating in the last few months.

From a monetary policy perspective, however, all these constructive developments land the BOC in a tricky spot: Growth looks better, and inflation is right on target—actually, it’s above target. For an inflation-targeting, single-mandate central bank, the inflation outlook alone would suggest that the central bank should have a neutral-to-hawkish stance; indeed, in a different global environment, we should be looking at a rate hike. But Canada isn’t an island, and it has to approach monetary policy within the global context.

The chart compares Canada's measure of core inflation, core CPI, with the United States' main measure of inflation, U.S. core personal consumption expenditure. It shows that core inflation in Canada, on a year on year basis, is above the Bank of Canada's inflation target. Meanwhile, core inflation in the United States has fallen below the Fed's target since mid 2018.

There are, in our view, two important factors that are worth considering:

  • Global central banks have almost universally made a dovish pivot on fears of global trade weakness and elevated levels of uncertainty. In what’s increasingly looking like a currency race to the bottom, Canada—or, more specifically, the Canadian dollar—can’t afford to stick out as an excessive hawkish outlier. USDCAD has already fallen by over 3.00% in the past six weeks.1 This is fundamentally why we believe BOC Governor Stephen Poloz will continue to maintain a dovish tone even if the outlook appears favorable.
  • Although economic upsides have materialized over the course of Q2, there’re still sizable downside risks facing the Canadian economy, namely a deteriorating U.S. outlook that’s likely to drag Canadian growth lower, albeit with a time lag. When U.S. weakness begins to filter through, the BOC will need to respond. From our perspective, that suggests rate cuts in 2020, but not before.

Few can deny that the Canadian economy represents a rare bright spot in the global economy at the moment. Enjoy the sunshine while it lasts because the dark clouds could return within a couple of quarters. The sunny spell should last long enough to allow Canadian assets to sparkle brightly, even if only for a time.

 

 

1 Bloomberg, July 9, 2019. 2 Bank of Canada, July 10, 2019. 3 Manulife Investment Management, July 10, 2019.

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Frances Donald

Frances Donald, 

Former Global Chief Economist and Strategist

Manulife Investment Management

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