Monthly Economic Letter
The economy looks healthy. Why all the talk about a recession?
According to many indicators, the Canadian economy is doing well. Unemployment is at an all-time low, quarterly profits are strong, housing construction is on track, retail sales continue to rise and gross domestic product is growing solidly.
Yet, the question of whether the economy will soon enter a recession is of increasing concern to many Canadians. Some economists have already sounded the alarm for 2023. What could trigger the next recession? Could it have already started?
What starts a recession?
A common definition of a recession is when economic growth is negative for two consecutive quarters. However, a more generic and less inflexible definition is now preferred.
The C.D. Howe Institue’s Business Cycle Council defines a recession as a pronounced, persistent and widespread decline in overall economic activity. It considers GDP and employment as the primary measures for judging whether a recession has occurred. This is why C.D. Howe views a slowdown in 2014-15 as a “technical recession.” While it met the definition of two quarters of negative growth for the overall economy, the decline was concentrated in the oil and gas sector.
Using the broader definition, Canada has had five recessions since 1970. The last one in 2020 was caused by the COVID pandemic. It was among the most unusual because it was caused by an unforeseen event and was the shortest on record.
Usually, recessions are triggered by a series of interest rate hikes or a shock to the economy, such as an oil shock or the bursting of a financial bubble. The Canadian economy is currently facing some of these trends.
The Bank of Canada has just started an interest rate tightening cycle and the price of a barrel of crude oil is above US$100. At the same time, the average price of a house in Canada has risen by 50% in two years and the stock market indexes by 35%. Will the convergence of these trends cause the next recession? Let’s look at them one by one.
The threat of an oil shock
Two of the last five recessions in Canada were linked to an oil shock. In the last year, the price of a barrel of crude oil has rocketed by 60%. Could this extraordinary increase lead us into a recession?
The past year’s oil price increases have clearly been a huge contributor to the galloping inflation we’ve seen in Canada and other developed economies. Oil price shocks are a recessionary threat because they fuel inflation and hit consumer pocketbooks hard.
For some large oil producers, including Canada, the dynamic can be even more pronounced. The economy faces the same inflationary pressures and negative impacts on consumption. But when the global economy slows down and oil prices fall, it hits Canada harder because of sector's large share of the country's economic activity.
However, the vulnerability of the Canadian economy to sharp price declines is much lower today. The oil sector's share of investment in the economy is half what it was in 2014.
While investment in the sector will increase this year to bring more supply to market, it’s highly unlikely the Canadian oil and gas sector will experience another massive wave of investment that would leave the economy vulnerable to a price correction. The transition to a low-carbon economy and accompanying regulations will continue to limit the appetite for fossil fuel project development.
A financial bubble?
Financial imbalances caused by overvalued assets can also cause a recession when the bubble bursts. A bubble is not just a rapid rise in the price of an asset. It’s a rapid increase in price driven by demand that is disconnected from fundamentals and unsustainable.
Since the pandemic, concerns about real estate bubbles and other excessive asset valuations have made headlines time and time again. But while the timing of a recession is notoriously difficult to predict, the existance of a bubble (and the timing of its bursting) are equally difficult to evaluate.
Mortgage rates have risen dramatically in recent months, which should temper activity and price growth in the housing market moving forward. But there remains a glaring housing shortage in the country and this problem will not be solved overnight, especially considering the current high immigration targets. Thus, higher interest rates should slow housing market activity without leading to an economic crash like we saw in the U.S. in 2008.
In the financial markets, the stocks of many tech giants have already come back to earth from the sky-high valuations they reached during the pandemic.
As recession risks increase, investors tend to prefer safer assets over riskier bets. In a rising interest rate environment, it is natural for highly valued growth stocks, such as those in the technology sector, to become less attractive to investors. Nevertheless, the diffusion and adoption of technology is unstoppable. The industry will continue to grow, but stock valuations are likely to continue moving to more sustainable levels as competition in the industry increases.
From boom to bust, are central banks always to blame?
A recession is always accompanied by significant job losses. In the current Canadian context of labour shortage, such a situation is difficult to imagine. Companies are struggling to meet demand due to a lack of inputs—both physical and human.
Yet, it’s the very strength of the economy that often holds the seeds of a recession. That's because there is an important difference between a fast-moving economy and one that’s overheated.
Today, Canada's unemployment rate is very low and inflation is very high—two signs the economy may be too hot. Recessions are not the result of overheating directly, but of interest rate hikes imposed by central banks to temper demand in hopes of tamping down inflation.
Many observers believe central banks (especially the U.S. Federal Reserve) have waited too long to raise rates. As a result, they are now accelerating the fight against inflation at a speed rarely seen before.
On April 13, Governor Tiff Macklem made a rare half a percentage point (50 basis points) increase in Canada's policy rate, doubling the bank's target rate in one fell swoop. The outlook is for another 50 basis points increase at the next announcement on June 1, and another one could come in July.
On May 4, the Fed followed suit with a 50 basis points hike with more increases expected in coming months.
The risk of the Bank of Canada and the Federal Reserve pushing their respective economies into recession is increasing. However, our base case is still for the Canada and U.S. economies to avoid that outcome.
The reason is simple. Interest rates are increasing from a very low level, much lower than in past tightening cycles that culminated in recession. This gives central banks plenty of room to maneuver before they choke off economic growth.
So, when is the next recession going to happen?
Our analysis leads us to believe the risk of a recession has indeed increased recently. But let's be clear—we don’t believe a recession is in the cards. The Canadian economy should continue on its current path for at least several more months.
In fact, many of the leading causes of recession are less of a threat today than in the past. Households have high savings and sustainable debt levels, corporate profits continue to be robust, workers are in high demand and interest rates remain reasonable.
Inflation, higher interest rates and lower government spending than during the pandemic years will slow growth in 2022 and 2023, but we are not talking about a recession (unless there is an unforeseen shock like COVID-19, of course). The economy simply needs to take a breather.
Reopening momentum fuels Canadian economy
The pandemic is not over, but the momentum that the Canadian economy has enjoyed in recent months is undeniable.
While the U.S. was facing a decline in GDP in the first quarter, the Canadian economy was booming. At least, that's what Statistics Canada's first estimates suggest. The strong results have probably reinforced the Bank of Canada's belief it must continue to increase interest rates.
Towards a stronger than expected first quarter
Monthly GDP growth continued in February with a gain above expectations (+1.1% from January). This is the ninth consecutive month of growth in the country.
Preliminary estimates from Statistics Canada suggest a 0.5% increase in March, indicating strong growth for the first quarter. Monthly growth of this magnitude would mean annualized growth of 5.6%, well above the Bank of Canada's forecast of 3.0%.
This would make Canada one of the few countries that has not experienced a downward revision in economic growth since the Russian invasion of Ukraine. Among other things, the country is benefitting from the soaring prices for resources and agricultural products, reflecting the imposition of sanctions on Russia and disrupted supply from Ukraine.
Not every sector has fully recovered
Notwithstanding the strong performance in the first quarter, we are still far from a generalized economic recovery.
Sectors that involve closer contact with consumers rebounded strongly in February as the Omicron-related health restrictions eased. However, accommodation and food services still have a long way to go to recover their pre-COVID level of activity, which is still 11 percentage points below the February 2020 level.
The good news is that in February 2022 international visitor numbers had quadrupled from 2021, although they were still well below pre-pandemic levels. COVID-related requirements for international travelers were relaxed only at the end of February. As a result, businesses in the tourism sectors should continue to benefit from the recovery in international travel in the coming months.
Employment boom came to an end
Labour shortages have begun to weigh on employment. The Canadian economy continues to create jobs, but only marginally. About 15,000 new jobs were created in April. About 965,000 new jobs were created in the last twelve months, the majority being full-time (65% of new jobs). The involuntary part-time employment rate fell to 15.7% – the lowest level on record according to Statistics Canada.
The unemployment rate fell to just 5.2%, suggesting employment gains will prove increasingly difficult in the coming months since there are fewer workers to fill available positions.
Policy rate expected to reach 1.5% in June
The economic news in Canada is good, perhaps too good. Demand outpaced the country's production capacity even more in March, pushing inflation to 6.7%.
The Bank of Canada began its monetary tightening cycle on March 2 by raising the policy rate by 25 basis points. This was followed by a 50 basis points hike on April 13. As a result, the rate went from 0.25% to 1.0% in just six weeks. We expect the bank to raise the rate on June 1 by another 50 basis points to bring it to 1.5%—only a quarter of a point below its pre-pandemic level.
The impact on your business
- Unless there is a major new development, COVID variants are having less and less impact on the economy. This means demand will be strong this summer, prepare your business accordingly, especially if you are in a tourism industry.
- The strong performance of the economy increases the likelihood the Bank of Canada will raise its key rate by another 50 basis points in June. Lock in your rate as soon as possible if you are planning investment projects.
- Workers will become increasingly difficult to find. If your company is still looking for employees, check out this study for advice.
U.S. GDP declines unexpectedly in the first quarter
The U.S. economy contracted in the first quarter of the year at an annualized rate of 1.4% from the last quarter of 2021, according to initial estimates. The last time U.S. quarterly GDP growth turned negative was two years ago, when the COVID-19 pandemic began.
While many economists had expected the pace of economic activity to slow due to effects of the Omicron variant and rampant U.S. inflation, most were still expecting positive growth. The news of a slowdown was unsettling but hid an important positive element—domestic demand remained very strong.
Economy’s underpinnings remain solid
Despite the decline in GDP, the U.S. economy is still on solid footing and should continue to support Canadian exports.
Domestic demand remains strong, growing by 2.6% in the first quarter with no sign yet of a downturn in consumption, despite record price increases. Consumer spending (responsible for two-thirds of the economy) grew at a rate of 2.7% while business investment was even stronger with growth of 9.2%.
Domestic demand is so robust, in fact, that U.S. businesses are struggling to meet it. And that explains much of the decline in GDP. The U.S. trade deficit has been growing since the pandemic as consumers and businesses increasingly buy outside the country. Imports of goods and services are growing while exports are still struggling to recover from the COVID shock.
International trade has slowed the nation's economic growth for seven consecutive quarters as the U.S. trade deficit widens.
Labour market is also slowing down
Employment rose by 428,000 in April, the weakest gain since September when the U.S. economy was struggling to contain a large COVID wave caused by the Delta variant.
While we don’t expect a reversal like the one we saw in first-quarter GDP growth, U.S. labour market gains are likely to trend downward in the coming months.
Nothing to make the Fed back down
Even if the data point to a first-quarter GDP decline, it won't shake the Federal Reserve's plans to raise interest rates to fight inflation. Last Wednesday, Jerome Powell announce a 50 basis points increase in the policy rate. The Bank of Canada will most likely make its second such announcement in the coming weeks.
Both central banks started their tightening cycles at roughly the same time and will have rates moving in tandem this summer. However, the impact on the economies of the two countries may differ. Not only is U.S. inflation higher than Canada's, but the U.S. economy has proven to be more robust in the face of the pandemic, even though employment has been slower to recover. Therefore, in terms of economic recovery, the Bank of Canada's tightening policy is ahead of the Fed's.
The base effect seems to have finally started to work in the Fed's favour. The 8.5% inflation that U.S. consumers experienced in March may have been the peak of the current inflationary wave. The general price level was up 8.3% from a year ago in April and rate hikes will temper demand in the coming months.
The impact on your business
- Employment continues to perform well and will support consumption for several more months.
- While the decline in real U.S. GDP may not bode well for Canadian entrepreneurs, domestic demand is in fact too strong in the country, which should continue to benefit Canadian exporters.
- Rising interest rates and the start of quantitative tightening in the U.S. will keep the Canadian dollar low against the greenback, which should also benefit Canadian exports.
Crude oil remains above US$100 a barrel
The price of oil hovered between US$100 and US$110 per barrel in April as uncertainty continues to loom over the market.
Several cross-currents are affecting oil trading. The Chinese economy appears to be slowing down, the European Union is balancing its energy needs with a desire to punish Russia and non-OPEC+ crude supply is expected to increase in the coming months.
The situation in China helps maintain prices
Aggressive COVID containment measures in China are causing a bigger than expected slowdown in the world’s second largest economy. Chinese manufacturing activity contracted for a second consecutive month in April and its zero tolerance policy towards COVID is impacting the global economy by aggravating supply issues.
China is the world's largest importer of crude and an economic slowdown would normally translate into lower prices globally, providing some relief to consumers who are struggling with high fuel costs.
However, there are concerns that supply will be further constrained by the war in Ukraine as the European Union once again weighs the possibility of banning Russian oil from its territory by the end of the year. The European Union buys almost half of Russia's oil exports and would have to replace this supply from elsewhere.
Opening the taps proves difficult
OPEC+, made up of the Organization of the Petroleum Exporting Countries and its allies including Russia, agreed to another marginal increase in production as early as June at its May 5 meeting. Several countries are pressuring the organization to increase production more quickly to lower prices.
However, the group has been struggling to meet its existing production targets for several months. As of March, it fell 1.45 million barrels per day short of its target. About 300,000 of the missing barrels can be explained by the decline in Russian supply due to economic sanctions.
Despite a Western embargo on Russian oil, India has been taking large shipments from Russia and has enjoyed a significant discount on purchases as a result. The impact on the global oil supply has thus far been moderate.
Canada's role remains limited
Production in Canada should begin to increase, but it will only have a marginal impact on tight global markets.
Canadian production is already high by historical standards with exports recently reaching record levels. For many in the industry, it’s not clear the industry currently has the capacity to significantly increase supply.
According to Natural Resources Minister Jonathan Wilkinson, the Canadian industry will increase its daily production by 200,000 barrels of oil, and the equivalent of 100,000 barrels of natural gas, by the end of 2022.
Of course, this increase alone will not meet Europe's energy needs in the event of an embargo on Russian oil. For now, Canadian oil will likely continue to be traded at the U.S. border as the U.S. itself attempts to replace the half million barrels per day it had imported from Russia until recently.
Bottom line
Although price volatility continues, the slowdown in China's economy has limited the effect of the European Union's threat to ban Russian oil completely by the end of the year could have had on the oil market. Prices are likely to remain high despite efforts by non-OPEC+ countries to increase production.
Bank of Canada doubles down on inflation
The Bank of Canada raised its key interest rate by 50 basis points on April 13. This is the second increase this year, bringing the rate to 1%. The Canadian economy and labour market enjoyed strong momentum in recent months as more health measures have been lifted across the country. We expect the Bank of Canada will announce another half-percentage-point increase in June and odds that July rate announcement will follow suits are increasing.
The loonie is losing ground
When it comes to the exchange rate, risk aversion dominated over increasing commodity prices. The safe-haven greenback has been supported against most currencies, including the Canadian dollar, as interest rates pick-up steam. Despite a mild step back recently, the loonie is holding up better than other currencies in those highly uncertain times. In April, the dollar traded at 0.79 $US on average on the back of increasing oil prices. Oil market volatility, reduced risk appetite and an aggressive monetary policy tightening in the U.S. should keep the Canadian dollar between US$0.77 and US$0.80.
No change in tone among businesses
Despite labour shortages, inflation, supply delays and the war in Ukraine, business confidence remained virtually unchanged between March and April. The Canadian Federation of Independent Business (CFIB) Business Barometer long-term index indicates that business leaders are optimistic about the future. This suggests that the lifting of health restrictions is outweighing the uncertainty and challenges businesses are facing–at least for now.
Effective rates are back to their 2019 levels
Since last March, the Bank of Canada's policy rate has increased by 0.75 percentage points to reach 1.0%. Effective interest rates charged to households and businesses appear to have risen a bit faster—they have reached 3.9% and 3.6% respectively, up a full point from their end of February levels. This is the level reached in 2019 when the policy rate was at 1.75%. More policy rate increases are expected in the coming months, so effective rates charged to households and businesses could reach levels not seen since the financial crisis of 2008.
