Canada is expanding slightly below trend, delaying a return to full employment.
Weakness among its trading partners has left Canada's economy reliant on private consumption and investment.
Low interest rates and western resource development will keep business investment strong near term.
Consumer debt burdens pose a significant downside risk should interest rates rise quickly.
Sudden deleveraging would spark a recession, but be less damaging than it has been in the U.S.
Weaker growth among Canada's principal trading partners has left the economy coasting on the momentum of domestic demand. Incorporating recent revisions to Canada's national accounts, Moody's Analytics projects the economy will expand just 1.8% over the four quarters of 2012, shy of its trend rate of 2.1%. With GDP growing near trend, the output gap and the unemployment rate are
relatively unchanged this year.
With Canada's economy tied to the uncertain pace of the U.S. recovery, households, firms and policymakers are all in wait-and-see mode. Growth will remain weak through the first half of 2013, as U.S. fiscal austerity is felt across North America. An accelerating global recovery by the end of next year will reinvigorate Canada's jobs engine, however, removing remaining labor market slack by early 2014. Regional imbalance will persist, with commodity-exporting provinces outperforming the rest.
Private investment spending was the largest growth driver over the first half, contributing two-thirds of the increase in demand through June. Residential construction remains strong, particularly in large urban areas with low vacancy rates such as Toronto and Vancouver, where high prices have brought a surge in multifamily construction.
Permitting trends suggest homebuilding will continue to boost growth next year. Weakening sales suggest demand for new homes is easing, however, which will slow the pace of homebuilding over the next several years. House prices in Vancouver, potentially Canada's most overvalued market, have begun to slip in recent months, but price trends suggest demand remains strong along Ontario's Golden Horseshoe.
Firms have remained optimistic amid sliding equity prices, squeezed profit margins, and downside risks from the U.S. and Europe. Canadian businesses continue to secure easy financing terms, exploiting cheap and plentiful capital flowing in from global investors seeking safety and stability. Investment in structures has outpaced equipment investment this year, providing a steady stream of construction jobs. Firms have also have buffered slowing demand by building up inventories this year, helping sustain employment. Growth in corporate profits is decelerating, however, constrained by weak productivity gains, rising wages and a strong currency. With
profitability an increasing challenge, demand for labor has remained soft, a trend that will likely continue well into 2013.
Household spending is growing more slowly this year than last, as higher food, energy and housing costs have crimped disposable income. As the largest component of demand, private consumption remains the critical determinant of the Canadian economy's ability to sustain its expansion against mounting headwinds from abroad. The near-term outlook for consumers remains favorable if somewhat
muted. Trend retail sales show slightly more strength in recent months, thanks to a pickup in auto sales. Real spending on durables, which declined in the second quarter, will likely contribute modestly to growth in the third.
The problem of household debt
The larger issue for households remains an increasing debt burden. Rising house prices and low interest rates have encouraged Canadians to add to mortgage and consumer credit balances roughly twice as fast as disposable income has grown. Newly revised balance-sheet data from Statistics Canada suggest the ratio of household debt to disposable income is even higher than previously
thought. Although homeowner equity has also been revised upward, the share of equity in real estate has been declining steadily.
U.S. and Canadian household debt and disposable income data are not directly comparable, yet it is at least worth noting that, prior to the financial crisis, U.S. household debt peaked relative to disposable income at around 130%, while consumer credit and mortgage balances for Canadian households now total more than 151% of disposable income. Extensive deleveraging by U.S. households following the crisis is the single most important reason for that country's deep recession and anemic recovery.
Leverage cannot grow indefinitely
Because of institutional and regulatory differences in real estate financing between the U.S. and Canada, there is little reason to believe Canada will experience a similar financial crisis. Nevertheless, there is an increasing risk that Canada could face a unique crisis if households need to adjust their balance sheets. Setting aside the sustainability of Canadian's current debt-to-income ratio, it is clear that leverage ratios cannot rise indefinitely; either income must grow faster or spending must slow. The well-known paradox of thrift dictates that efforts by individual households to save more will slow overall income growth. There also are few apparent ways for personal income growth to accelerate in the near term.
Because of tighter lending standards, government mortgage insurance, and Canadian homeowners' thicker equity cushions, a Canadian deleveraging crisis would play out more quietly, with fewer defaults, bankruptcies, and bank charge-offs. Households, not financial institutions, would have the greatest equity losses; this would contain financial contagion and help keep vital credit channels open. The adjustment process would be far from painless, however, producing a vicious downward spiral in household income and spending.
Policy options are limited
Should such a spiral emerge, Canada could still experience a soft landing if weaker domestic spending is offset by a sharp rebound in exports or if the government implements a fiscal stimulus. A rebalancing toward exports is necessary in the long run, but is unlikely to support growth near term. Continued strong terms of trade will help support income, but real net exports will contribute little to GDP growth over the next year.
Conversely, fiscal policy over the long run will likely be constrained by mounting health and retirement costs, but relatively small fiscal deficits and debt relative to GDP afford government scope to enact countercyclical policies.
Few options for the BoC
The Bank of Canada, the usual first line of defense against recession, will likely find itself with few good options, however. With its overnight rate target at 1%, the BoC has some scope for a monetary stimulus, but not much. Credit is flowing freely, and yields on longer-maturity debt are already low. This is the result of quantitative easing by the U.S. Federal Reserve and of financial market arbitrage, which ties Canadian asset prices closely to those in the U.S.
Most importantly, given concerns that easy monetary policy has fueled a credit and real estate bubble, it is not clear that Governor Mark Carney would embrace an even more expansionary policy as the appropriate response to consumer deleveraging.
By removing some pressure on the exchange rate, allowing a competitive depreciation of the loonie, a monetary expansion would certainly help spur exports and could head off a deeper recession. Because of the currency's dependence on commodity prices, such a move would likely have only limited effect unless pursued aggressively. An aggressive move toward currency depreciation is highly unlikely, however; not only would it be viewed unfavorably by Canada's trading partners, but it could also destabilize inflation expectations in financial markets.
Slow growth through mid-2013
Our baseline forecast sees continued slow growth in Canada through mid-2013, followed by a stronger recovery as the U.S. and Europe gain momentum. Before the economy reaches full employment in early 2014, the Bank of Canada will begin to gradually hike rates, continuing through 2015 as policymakers balance inflation risks with concerns about currency appreciation. Tightening credit will slow domestic spending, allowing households to rebalance their balance sheets. House prices will decline slightly in a few markets but remain relatively flat nationally, experiencing a downward adjustment in real terms as inflation accelerates. Core inflation will firm, but remain close to the Bank of Canada's 2% central target over the short and long runs.
About Moody's Analytics
Economic & Consumer Credit Analytics
Moody's Analytics helps capital markets and credit risk management professionals worldwide respond to an evolving marketplace with confidence. Through its team of economists, Moody's Analytics is a leading independent provider of data, analysis, modeling and forecasts on national and regional economies, financial markets, and credit risk. Moody's Analytics tracks and analyzes trends in consumer credit and spending, output and income, mortgage activity, population, central bank behavior, and prices. Our customized models, concise and timely reports, and one of the largest assembled financial, economic and demographic databases support firms and policymakers in strategic planning, product and sales forecasting, credit risk and sensitivity management, and investment research. Our customers include multinational corporations, governments at all levels, central banks and financial regulators, retailers, mutual funds, financial institutions, utilities, residential and commercial real estate firms, insurance companies, and professional investors. Our web and print periodicals and special publications cover every U.S. state and metropolitan area; countries throughout Europe, Asia and the Americas; and the world's major cities, plus the U.S. housing market and other industries. From our offices in the U.S., the United Kingdom, and Australia, we provide up-to-the-minute reporting and analysis on the world's major economies. Moody's Analytics added Economy.com to its portfolio in 2005. Its economics and consumer credit analytics arm is based in West Chester PA, a suburb of Philadelphia, with offices in London and Sydney. More information is available at www.economy.com.
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