2016 started with a bang, as a surge in exports and residential investment led the way to a 2.4% expansion (annualized) in the first quarter. Unfortunately, both fleeting momentum at the end of the quarter as well as the more recent wildfires in the area surrounding Fort McMurray Alberta are setting the stage for a pullback in economic activity in the second quarter (Chart 1). Significant production capacity was taken offline in May, dragging down output for both the month and the quarter as a whole. As production comes back online in the third quarter, activity is expected to bounce back, but not sufficiently to prevent a meaningful downgrade in our 2016 growth outlook to a tepid 1.3%.1
Looking through the noise, the underlying picture is one of modest growth. The Canadian economy remains in the midst of a large scale, commodity price precipitated economic rotation. As this adjustment moves into a more growth-friendly phase in 2017 and the boost from fiscal stimulus kicks into higher gear, real GDP growth is expected to rebound to 2.0%.1 Even with this rebound, the economy is likely to operate with more slack than we had forecast in our March forecast. As such, we are more steadfast in our view of no rate increase by the Bank of Canada during the 2016-17 period.
Exports to Remain a Key Growth Support Despite Near-Term Volatility
Net exports were a significant driver of growth in the first quarter, responsible for nearly three quarters of the expansion in activity. A closer look shows that growth was extremely front loaded in January, with data for February and March pointing to a subsequent reversal. In the near-term, this volatility will no doubt be further amplified by oil supply disruptions resulting from the May wildfires. We have built more caution into the outlook in light of these noisy trends, but still believe that export growth will punch above its weight in Canada’s expansion. Looking ahead, an environment of strengthening U.S. demand (Chart 2), and a still supportive Canadian dollar in the 75 to 78 cent U.S. range are likely to spur continued solid real export gains of about 4% annualized in the second half of 2016 and in 2017.1 Consistent with our past analysis,2 we expect products related to housing, such as wood products, plastic and rubber products, and furniture to deliver strong export performances.
Chart 1: Steady Growth in Store Following Wildfire-Led Volatility
Source: Statistics Canada, TD Economics
Residential Investment Going Strong, But the Party Will Come to an End
While we have become somewhat more cautious in our view on exports relative to our March forecast, this has been partly offset by an upgraded near-term forecast for housing. The first quarter saw a marked acceleration in residential activity, recording its fastest rate since 2012. Growth was widespread, with both new construction and resale activity growing strongly. Momentum has shown no sign of letting up in the second quarter.
Beneath these national moves, however, remains a story of three markets. The Vancouver and Toronto areas continue to lead the way in price gains (Chart 3), whereas Alberta and other commodity producing regions are experiencing declining prices and activity. The remaining markets fall somewhere in between with little or no price growth.
There is little debate that Canada’s hottest housing markets are ripe for a correction; the difficulty is predicting its timing. Over the second half of 2016, some moderation in resale activity and price growth should become evident as bond yields pull off their lows and stretched affordability leads to a cooling in domestic and foreign housing demand. However, barring significant new government regulatory measures to curb housing market speculation later this year, more concrete signs of a housing market slowdown are unlikely to be seen until 2017. Even then, there tends to be a lag before weaker resale demand translates into a moderation in building activity.
Consumer and Government Spending Help Offset Weak Investment
Looking at the domestic outlook more broadly, the drivers of household spending are delivering mixed signals. Household indebtedness remains elevated, which should constrain spending. At the same time, an increasingly older population implies a deceleration in the trend pace of consumption gains. On the other side of the coin, net worth is high, and interest rates are likely to remain well below historic norms, even with a modest upward push.
The net result is a pace of consumer spending slightly below 2% over 2016 and 2017, a far cry from historic growth patterns (consumption growth has averaged 2.9% since 2000). While below the historic pace, with overall GDP growth of 2% or less, consumption will nevertheless continue to play an important role in the Canadian economy, providing a reliable (if unremarkable) impetus to overall growth.
Similarly, government spending will kick into higher gear as outlays from the federal budget gradually make their way into the economy. We have long argued that this is likely to provide a bigger lift in 2017 than this year, especially given its focus on infrastructure spending, which is slow to diffuse and in many cases will require negotiations with other levels of government.
At the provincial level, jurisdictions have ambitious infrastructure plans of their own to take advantage of low borrowing rates to ramp up capital spending in transportation and other public assets. With federal assistance, Alberta, in particular, will need to allocate significant new funds to rebuild Fort McMurray following the wildfires. These plans will add to this support, but again, the impact is likely to take some time to be felt.
Chart 2: Foreign Activity Supportive of Continued Export Growth
Source: Bank of Canada, Statistics Canada, TD Economics
Accordingly, total government spending growth (including operations) will appear relatively weak on average in 2016, but this is due to a decline in the fourth quarter of last year. Spending is expected to accelerate through this year, growing by 1.4% on a fourth quarter over fourth quarter basis, and accelerating further in 2017.1 This comes after restraint earlier in the recovery in which the impact of government spending was minimal or slightly negative.
In contrast, the biggest weak spot in the Canadian economy will remain non residential business investment. The third quarter of 2016 is likely to mark the start of an investment recovery, with help from some post-wildfire rebuilding and production resumption activities. Still, the turnaround is expected to be tepid at best, with the level of capital spending likely to remain almost 20% below its peak in late 2014 (Chart 4).
To a large extent, weakness in business investment is not unique to Canada. Many countries are struggling with inadequate private capital spending, which may partly reflect heightened uncertainty and lofty debt levels. In Canada, the challenge has been accentuated by the woes of the resource sector, which in 2014 represented as much as one-third of the country’s overall tally. Within the oil sector, the rebound in oil prices to the US$50 per barrel level has helped to alleviate some financial strain, but not high enough to significantly improve the near-term outlook for new oil-related investment. Even as oil prices move gradually higher in 2017 to about US$55 on average,1 more cost effective projects with quicker turnaround times, notably in the U.S. shale sector, are likely to be first in line to attract funding.
Medium-term prospects for manufacturing investment are brighter. With the Canadian dollar remaining relatively competitive and likely to pullback slightly as markets refocus on the Fed’s gradual rate hiking cycle, manufacturing activity should continue to move higher. Eventually, this will also manifest in faster business investment, but with capacity utilization still below pre-crisis levels, this channel is not expected to be a meaningful investment driver until late 2017/early-2018.
Wildfires Push Provincial Divergence Even Wider
2016 was already expected to mark a wide divergence among provinces, with nation leading B.C. and Ontario on track to top the growth charts with solid gains of close to 3% while a second straight year of significant contraction was in store for Alberta.1 The onset of the Alberta wildfires are poised to further deepen Alberta’s near-term recession and widen the gap with the out-performing regions this year. While it’s hardly consolation for the destruction suffered, the rebuilding efforts will provide a boost to growth in the province over the latter half of 2016 and into 2017. This development, along with a nascent recovery in its underlying economy, will help to catapult Alberta to the upper end of the provincial leaderboard next year.
Chart 3: Home Prices in Toronto and Vancouver Continue to Outperform
Source: CREA, TD Economics
Economic Rotation to Keep Bank of Canada on Hold
With an expected pace of growth only modestly above potential, it will take some time for existing economic slack to be absorbed. As a result, fundamental inflationary pressures will remain muted, relieving the Bank of Canada of any near-term cause to raise interest rates. Indeed, given recent economic weakness and the ongoing adjustment process, we believe the Bank of Canada will likely want to keep its foot on the accelerator for as long as possible, and is not likely to begin raising its policy interest rate until 2018.
While all economic forecasts involve the weighing of risks, the current environment presents an unusually elevated level of uncertainty. Beyond our borders, the possibility of Brexit is a key near-term event that could have ripple effects via exchange rates and financial flows.1 Another risk arises from oil prices, which have recently trended higher, outpacing our expectations and strengthening the Canadian dollar. Should prices continue to rise, associated currency strength would likely pose a headwind to exports, sapping economic momentum. While not our base case, such a scenario would undoubtedly lead to weaker growth, and the potential for further easing from the Bank of Canada, or additional fiscal stimulus at the federal level.
On the other side of the coin, we have been somewhat surprised by the continued resilience of Canadians’ willingness to spend, both on consumption and housing. While the long-term trends are clearly towards a slower pace of growth, near-term momentum may prove stronger than believed.
Chart 4: Non-Residential Investment Likely to Remain Well Below 2014 Peak
Source: Statistics Canada, TD Economics
1 This article was originally published on June 16, prior to the United Kingdom’s decision to leave the European Union on June 23. Forecasts are likely to be revised on the back of the surprise referendum result.
2 See “Push Me Pull Me: The Outlook for Canadian Manufacturing”, February 17, 2016. https://www.td.com/document/PDF/economics/special/MfgPushMePullMe2016.pdf