CANADA ECONOMIC OUTLOOK 23 rd Feb. 2011

Transcription

1 CANADA ECONOMIC OUTLOOK rd Feb. Q Housing downturn to hit economic growth Overview Because Canada emerged from the global financial crisis largely unaffected, many Canadians now appear to believe that the economy is somehow invincible. This level of hubris is disconcerting when housing valuations have lost all touch with the fundamentals, driven up by a massive surge in household debt. We've seen this story played out in countless other countries and it never has a happy ending. The now inevitable downturn in the housing sector will severely constrain economic growth over the next couple of years, as consumption expands at a more muted pace and housing investment shrinks back towards a more normal size (Pages &.) Domestic Demand Consumption spending will lag real personal disposable income, as the housing downturn forces households to lift their lacklustre saving rate. We also anticipate that the end of the housing boom will lead to a marked decline in housing-related activity and employment. Employment gains will be modest this year and will slow as the economic recovery loses momentum next year. As a result, the unemployment rate will gradually rise this year and next. Business investment growth will remain solid, as businesses attend to worn-out capital equipment from the long recession and because of the need to improve the productivity of their labour work force. (Pages &.) External Demand A pick-up in external demand will help to buffer export growth this year, but the strong Canadian dollar and the composition of domestic demand and its propensity to import will mean that net exports will continue to be a drag on the economy. (Pages 7 &.) Prices The past run-up in crude oil and agricultural prices will lead to higher headline inflation later this year. However, this will prove to be temporary, as we expect commodity prices to fall in. Underlying inflation this year and next will remain subdued. (Pages 9 &.) Monetary & Fiscal Policy Underlying pressures affecting prices will remain subdued and inflation expectations remain well anchored. Financial risks abroad and at home are elevated, making the economic outlook unusually uncertain. Under those circumstances, we do not expect the Bank of Canada to risk jeopardising the economic recovery by raising interest rates. (Pages &.) North America Europe Asia Bloor Street West, Suite 7 Buckingham Palace Road #-, Collyer Quay Toronto, ON London Singapore 9 MW E SWW 9TR Canada United Kingdom Tel: + Tel: + () 7 Tel: Managing Director Chief International Economist Chief US Economist Canada Economist Roger Bootle (roger.bootle@capitaleconomics.com) Julian Jessop (julian.jessop@capitaleconomics.com) Paul Ashworth (paul.ashworth@capitaleconomics.com) David Madani (david.madani@capitaleconomics.com) Canada Economic Outlook Q

2 %q/q annualised (unless otherwise stated) Annual (%y/y) Q Q Q Qf Qf Qf Qf Qf Qf Qf Qf Qf f f f Demand GDP Consumption Private Fixed Investment Business Investment Machinery & Equipment Non-Residential Structures Residential Investment Government Expenditure Stockbuilding (Change, C$bn) Domestic Demand Exports Imports Labour Market Unemployment Rate (%) Employment (Av. Mthly Change, s) Labour Productivity Income & Saving Real Personal Disposable Income Saving Rate (As a % of Disposable Inc.) Prices (%y/y) Consumer Prices Core Consumer Prices Markets (end period) Overnight Target Rate (%) Year Treasury Yield (%) USDCAD Exchange Rate Other Trade Balance (C$bn) General Gov't Balance (As a % of GDP) Current Account (As a % of GDP) Bank of Canada Core Inflation. Canada Economic Outlook Q

3 Overview Housing downturn to hit economic growth The now inevitable downturn in the housing In contrast, business investment looks sector will severely constrain economic growth unusually depressed, leaving considerable over the next couple of years, as consumption scope for stronger growth, particularly in expands at a more muted pace and housing spending on machinery and equipment. (See investment shrinks back towards a more Chart.) normal size. Economic growth will rely increasingly on business investment and net The correlation between US economic growth exports (See Chart.) and Canada's exports is fairly high. As such, stronger US economic growth this year will Over the last several years, growth in provide some relief to Canada's exporters. consumption has far outstripped income gains, However, as the US recovery loses momentum as households have gone on a spending binge, in, growth in exports will slow once funded by credit growth and home equity again. (See Chart.) extraction. (See Chart.) While high energy and food prices keep With household balance sheets stretched and headline inflation elevated this year, we house prices expected to fall, however, we anticipate that excess capacity, persistently forecast that growth in consumption spending high unemployment, and little in the way of will lag income growth for the next couple of wage pressures will contain underlying years, as households focus on rebuilding their inflation. (See Chart 7.) saving rate. The economic outlook remains unusually House prices have been growing rapidly for uncertain. The upside risks to our outlook are nearly a decade now (see Chart,) and it has stronger than anticipated US economic growth reached the point where housing is so over- and higher commodity prices, which would lift valued relative to incomes that a downward Canadian exports and incomes. The biggest correction seems unavoidable. We fear that downside risk is that an adverse feedback loop house prices could fall by as much as % could develop, as it did in the US, with rapidly over the next three years. falling house prices leading to a contraction in both output and employment, which puts even Canada's economy has grown overly-reliant more downward pressure on house prices. on the housing sector in recent years, so any drop back in prices could lead to a sizeable Given our outlook for economic growth and contraction in housing investment, which is underlying (core) inflation, we doubt that the currently well above its historical average. (See Bank of Canada will risk removing any Chart.) In the aftermath of previous housing monetary stimulus. By year end, we expect the booms, housing investment has fallen by overnight policy rate to be still at %. (See roughly.% of GDP. Chart.) Canada Economic Outlook Q

4 Overview Charts Chart : Annual Contributions to GDP Growth (%) Consumption Housing Inv't Business Inv't Net Exports Chart : Household Spending & Financial Leverage H'hold Financial Leverage (Debt-To-Asset Ratio, LHS) 7 H'hold Spending + Invest. (As a % of GDP, RHS) Chart : House Prices (%y/y). Chart : Housing Investment (As a % of GDP) Avg = Chart : Business Investment (As a % of GDP) 9.. Avg = Chart : US GDP & Canada's Total Exports (%q/q Ann.) U.S. GDP (LHS) - - Canadian Exports (RHS) Chart 7: Inflation Outlook (%) Chart : Bank of Canada Interest Rate (%). Headline Core Sources Thomson Datastream & Capital Economics Canada Economic Outlook Q

5 Domestic Demand Household spending set to slow Because Canada emerged from the global financial crisis largely unaffected, many Canadians now appear to believe that the economy is somehow invincible. This level of hubris is disconcerting when housing valuations have lost all touch with the fundamentals, driven up by a massive surge in household debt. We've seen this story played out in countless other countries and it never has a happy ending. Relative to incomes, our calculations suggest that Canadian housing is now just under % over-valued, which is about the same level of excess that the US market reached before it collapsed. (See Chart.) We have pencilled in a % cumulative decline in house prices over three years, mirroring what happened south of the border. the saving rate could be achieved through stronger income growth. (See Chart.) Unfortunately, the end of the housing boom will have a serious detrimental impact on total employment and housing activity as well as asset values. As we noted earlier, the housing sector has become tremendously bloated during the boom. Construction now accounts for 7% of overall employment. (See Chart.) Even without big declines in house prices, we would expect that share to shrink back to its long-term average of about.%, which would involve the loss of, jobs. Housing investment will shrink as a share of GDP too, with the expected contraction in home renovation alone reducing GDP by %. Canadian household debt is now up to % of disposable income, well in excess of what we saw in the US. (See Chart.) Admittedly, low interest rates mean the servicing costs on that debt are not currently excessive. Since real estate (structures and land) accounts for slightly more than one third of household assets, substantial declines in house prices would hit household net worth hard, prompting households to raise their saving rate. (See Chart.) Rebuilding that saving rate will require a marked slowdown in consumption growth. (See Chart.) Admittedly, the recent strength in employment growth together with some modest improvement in average hours worked suggests that some of the expected rebound in The growth rate of business investment will slow a little from the red hot pace in the second half of. We nevertheless expect another strong performance in, as Canadian firms take advantage of low borrowing costs, a strong currency, and growing profits, particularly in the natural resources sector. (See Chart 7.) That additional investment should ensure a relatively decent productivity performance, at least for Canada. (See Chart.) We expect productivity to grow by % per year over the next couple of years. Overall, we anticipate that domestic demand growth will slow from.% in, to.% in and only.9% in. Canada Economic Outlook Q

6 Domestic Demand Charts Chart : House Price to Income Per Employee (Ave. = ) Canada US Chart : Household Debt (As a % of Disposable Income) 9 Canada US Chart : Net Worth & Saving Rate (As a % of Disp. Income) Chart : Consumption (%q/q Ann.) Net Worth (Inverted, LHS) Saving Rate (RHS) Chart : Monthly Change in Employment (s) Chart : Impact of Housing on Activity Change in Employment Three Month Average Home Renovation (As a % of GDP, LHS) Construction Employment (As a % of Total, RHS) Chart 7: Business Investment in Machinery & Equipment BoC Survey - Invest. Intentions Bal. (LHS) Machinery & Equip Invest. (%q/q Ann., RHS) Chart : Productivity (Output Per Hour Worked, %y/y) Avg = Sources Thomson Datastream & Capital Economics Canada Economic Outlook Q

7 External Demand Net exports to remain a drag on growth At the onset of the global recession, exports net exports on GDP growth, which also means and imports plummeted simultaneously a further widening of Canada's already large reaching a trough in early 9. Since then, real trade deficit. (See Chart.) trade has gradually improved, though the rebound in exports has been hindered by the High crude oil and non-energy commodity sluggish recovery in the US and the strong prices, together with a strong Canadian dollar, Canadian dollar. (See Chart.) are expected to support Canada's terms of trade in. (See Chart.) The export recovery has not been broad-based. While energy and other commodity-related Nevertheless, we predict that the price of exports have held up quite well, exports of (WTI) crude oil will end at closer to US$ autos, machinery and equipment, and also 7 per barrel, well below its current trading forestry products have languished. (See Chart price of around US$ 9 per barrel. We expect.) non-commodity prices to fall back too. These declines will also lead to depreciation of the Much of the weakness in auto and forestry Canadian dollar, from just above parity now to related exports are due to the constraints on US$.9 by end-. (See Chart.) household credit and structural problems in the US housing market. These structural factors Our outlook for real trade flows and the terms affect the composition of US demand, which of trade suggests that Canada's nominal trade will have additional unfavourable implications deficit will narrow somewhat this year, before for Canadian export growth this year and next. widening substantially after that. By the end of, it is quite plausible that Canada's trade We estimate that Canada's total exports will deficit could exceed C$ billion, almost advance at a modest pace this year, averaging double what it was in the third quarter of growth of close to % in. (See Chart.). (See Chart 7.) Next year will be a different story, as the US There will be a corresponding widening of the economic expansion loses momentum, once overall current account deficit as well. the latest round of policy stimulus fades. If we Expressed as a percentage of nominal GDP, are correct, Canada's overall export the current account is expected to remain performance in will be much worse than close to % in, before widening to in. (See Chart.) almost.% by the end of. (See Chart.) While our outlook for exports adds to economic growth in and (barely) in, it will simply be too weak to offset fully the negative contribution from total imports. Consequently, we see no end to the drag from Canada Economic Outlook Q 7

8 External Demand Charts Chart : Merchandise Trade (Real, C$bn) Chart : Selected Merchandise Exports (Real, C$bn) 9 Exports Imports Start of downturn Start of downturn Energy (LHS) Autos (RHS). 7 7 M&E (RHS) Chart : Total Exports (%q/q Ann.) Chart : Net Export Contribution to GDP Growth Exports Imports Net Exports Chart : Commodity Prices & Terms of Trade Chart : Canadian Dollar BCPI (LHS) Terms of Trade (RHS) Chart 7: Nominal Trade Balance (C$bn) Chart : Current Account Balance (As a % of GDP) Sources Thomson Datastream & Capital Economics Canada Economic Outlook Q

9 Prices Headline inflation boosted by commodity price surge The most recent pick up in headline consumer that we anticipate, would be enough to reduce price inflation mainly reflects the rise in energy the growth rate of housing costs in the CPI. prices. (See Chart.) We anticipate an even (See Chart.) The muted pace of unit labour more marked increase in headline inflation cost growth also points to low underlying over the next few months, however, as the inflation. (See Chart.) massive surge in agricultural commodity prices begins to feed through. (See Chart.) Canadian dollar appreciation has helped to keep import prices down, contributing towards The headline inflation rate will accelerate to low underlying inflation. This will continue in about % by mid-year. Nevertheless, with, but some depreciation of the Canadian wage growth slowing and excess supply dollar in could add to import price limiting potential price increases, we expect inflation. (See Chart.) underlying inflation to remain muted. Although raw material input and producer The rapid appreciation in world agricultural output prices are rising, there has so far been prices will have a substantial impact on CPI little impact on consumer prices. While it may food inflation. Given the typical lags in the be too early to tell given the lags, we think range of six to months, we expect food excess industry capacity and competitive inflation to rise from below % now to % or pressures are limiting the ability of many above later this year. (See Chart.) manufacturers to pass-through rising costs to consumer prices. (See Chart 7.) Core inflation will be more insulated from the impact of surging commodity prices, but it Another key indicator of longer-term inflation won't be completely exempt. In particular, the is growth in the broad money supply. Growth recent surge in cotton prices will lead to a in the broadest measure in Canada (M++) has marked pick up in retail clothing prices. (See slowed considerably in recent months. (See Chart.) Chart.) Nevertheless, there are a few reasons to The biggest upside risks to our inflation suspect that the rise in inflation won't get out outlook are that commodity prices continue to of control. The current headline CPI inflation rise or that the increases we have seen so far rate still includes the impact of the sales tax generate second-round effects, pushing up rises in Ontario, British Columbia, and Nova wages and the price of other goods and Scotia in mid-. Once those hikes drop out services. of the annual growth rate in mid-, it will take about.% off headline inflation. On the down side, the biggest risk is that commodity prices drop back more sharply More importantly, even a slowdown in house than we expect, which could temporarily push price inflation, let alone the outright decline inflation below zero. Canada Economic Outlook Q 9

10 Prices Charts - Chart : CPI Core & Headline Inflation (%) Target Range: -% Headline Core Chart : Food Prices (%y/y) GSCI Agri/Livestock Commodity Prices (Adv. m, LHS) CPI Food (RHS) Chart : CPI Clothing & Cotton Price (%y/y) Cotton Spot Price (Adv. m, LHS) CPI Clothing (RHS) Chart : House Prices & CPI Shelter (%y/y) Teranet House Price Index (Adv. m, LHS) CPI Owned Accommodation (RHS) Chart : Unit Labour Costs (%y/y) - - Chart : Import Prices & Exchange Rate (%y/y) Effective Exchange Rate (Inverted, LHS) Import Prices (RHS) Chart 7: PPI & Raw Materials Prices (%y/y) Industrial Producer Prices (LHS) Raw Material Prices (RHS) Chart : Broad Money: M++ (%y/y) Sources Thomson Datastream & Capital Economics Canada Economic Outlook Q

11 Monetary & Fiscal Policy Monetary policy on hold while fiscal stimulus fades In, the Bank of Canada unwound the last would expect longer-term government of its exceptional liquidity measures and raised benchmark bond yields to gradually drift lower the overnight rate from.% on June st of again. (See Chart.) last year to.% on September th. (See Chart.) Given the tightening bias priced into the market and the upward momentum in Since that time, however, the Bank has balked commodity prices, the Canadian dollar is at tightening policy further, for fear of expected to tread around par with the US jeopardising Canada s increasingly fragile dollar for most of this year. Next year will be a economic recovery. The Bank's recent policy different story, however, as tumbling statements have put most weight on excess commodity prices and further postponement of capacity, high unemployment, and the various interest rate increases lead to depreciation of financial downside risks to economic growth the Canadian dollar. (See Chart.) and projected inflation. (See Chart.) Federal and Provincial budget deficits point to Despite better economic data over the last few considerable spending restraint in the years months, the Bank has not materially changed ahead, some of which will be achieved its outlook for Canada's economic growth and through public sector jobs cuts. We anticipate inflation. Aside from the elevated financial that growth in real net government expenditure risks it mentioned (both home and abroad), the will be substantially reduced, with annual Bank is deeply concerned about the strong average growth of.% in and. Canadian dollar, net exports, and the (See Chart.) historically large current account deficit. Government capital investment will also begin Not only are measures of underlying inflation to ease this year and in. Taken together, subdued, inflation expectations are well government spending and capital investment anchored. According to the Business Outlook will contribute very little to real GDP growth, Survey, expectations remain well within the in stark contrast to previous few years. (See % to % target range. (See Chart.) Chart 7.) For all these reasons, we think the Bank of We expect the general government balance to Canada will not be in any rush to remove gradually decline over the forecast horizon, further monetary stimulus. As such, we predict from around -.% in to -.% in that the Bank will hold the overnight policy and -.% in. (See Chart.) rate at % this year, and the same in. The market consensus has priced in two - quarter-point policy rate increases this year. We think this is too high. If we are right, we Canada Economic Outlook Q

12 Monetary & Fiscal Policy Charts Chart : Bank of Canada Overnight Rate (%) Chart : Output Gap & Unemployment Bank of Canada Output Gap (%, RHS) Change in Unemployment Rate (Inverted, LHS) Chart : CPI Inflation Expectations (Two Year Horizon) Chart : Government Benchmark Bond Yields (%) 7 Q 7 Q Q Q -year -year -year Less than % Between -% Between -% Over % 7 9 Chart : Canadian Dollar ($US/$C) Chart : Government Net Expenditure (%q/q Ann.) Chart 7: Government Contribution to GDP Growth Chart : Government Balance (As a % of GDP) Sources Thomson Datastream, Bank of Canada & Capital Economics Canada Economic Outlook Q