Monthly Economic Letter

November 2022
Feature article

What to expect from the coming economic downturn?

The economic outlook has darkened rapidly in the second half of the year. Soaring inflation and interest rate hikes by central banks around the world to address it are of growing concern to households, businesses and economists. In Canada, some financial institutions have already sounded the alarm about a looming recession.

Regardless of how you describe what’s coming, one thing is certain—the Canadian economy is set to slow down as we head toward 2023. What will the impacts be on the economy? This month's economic letter looks at the industries most likely to struggle.

What’s causing the slow down?

Unsurprisingly, the cause of the economic slowdown is the tightening of credit conditions. After more than a decade of low interest rates, households, businesses and governments are now faced with much higher financing costs, putting severe pressure on budgets already taxed by rising inflation.

Of course, this is not the first time the Canadian economy has faced a period of monetary policy tightening. So, the impacts are easier to see coming than when the decline in economic activity comes from an unexpected shock, such as the COVID pandemic.

The companies that are most likely to struggle in 2023 are those that depend on discretionary spending, debt-financed consumption or close ties to the U.S. economy.

Erosion of purchasing power

The consumer discretionary sector encompasses an assortment of unrelated sub-sectors that share a dependence on consumer confidence. The fortunes of these businesses fluctuate with the economy because consumers can put off making these purchases. They include consumer durables such as appliances, apparel and consumer services, including hotels, restaurants and retailers.

This sector is vulnerable because rising interest rates and inflation are eroding consumers' purchasing power, causing them to allocate more of their budgets to basic expenses such as food, housing and transportation—categories that are experiencing the most significant price increases. While today’s tight labour market is leading to significant wage increases, they’re not enough to keep up with the rising cost of living.

Adding to the downside risk is that many of these sectors are still benefitting from pent-up demand from the pandemic. The current craze for travel and going out on the town is expected to moderate as the impact of rate hikes continues to percolate through the economy, but the downturn is likely to be less abrupt and somewhat delay, were it not for the lockdowns of the past two years.

Canadians turn cautious on borrowing to spend

When financing costs rise, the first sectors to feel the effects are those involving large purchases that are typically financed by debt. The real estate and construction industries top the list.

Since the Bank of Canada's first rate hike in March 2022, residential property sales have fallen by 36% nationally and the average price is down 17%. The slowdown is expected to continue in the coming months.

Mortgage rates have experienced the largest increase in 30 years, which not only dampens demand for new mortgages, but also boosts payments for those who have taken variable rate mortgages or are up for renewal.

A national housing shortage and the scarcity of labour in the construction industry are mitigating the slowdown in housing starts that should have already begun. Starts jumped 11% in September compared to August. Nearly 300,000 units were started during the month on an annualized basis, the highest level in nearly a year.

Vehicle purchases also tend to decline rapidly during an economic downturn. However, once again, the post-pandemic environment is tempering the trend as consumers looking for a vehicle over the past two years have been faced with long lead times and limited selection.

Global slowdown—manufacturers on the front lines

Historically, manufacturing tends to be hardest hit in times of economic hardship, particularly if the downturn is global. Despite the proliferation of free trade agreements in recent years, 75% of Canadian exports still go to the U.S. of which 65% are manufactured products. This makes manufacturers even more vulnerable to the economic turbulence that is currently occuring.

The slowdown is being felt around the world and this will be reflected in economies on both sides of the Canada-U.S border. Energy problems in Europe and the real estate debt crisis in China are further clouding an already declining global growth outlook due to tighter financial conditions.

Demand is declining for durable goods and building materials. As a result, the metals and minerals, lumber, machinery, and furniture manufacturing industries will be most affected by the slowdown, while manufacturers of agri-food, pharmaceuticals, and transportation equipment should continue to enjoy good demand. The strength of the U.S. dollar could also marginally temper the slowdown in exports and thus in manufacturing.

The bottom line is that as interest rates rise, the Canadian economy will slow down. The downturn will not hit all industries at the same time or with the same force, but all businesses should be ready for what lies ahead. Register to our webinar to learn how to prepare your business for the economic downturn.

Canadian economy at a glance

The Canadian economy is still holding up

The Canadian economy surprised on the upside in August. Preliminary estimates from Statistics Canada had pointed to zero growth, but GDP ended up increasing by 0.1% compared to July.

The economy continued the trend in September with another similar monthly increase. Therefore, the country's economic activity likely reached 1.6% annualized growth in the third quarter.

The service sector was the big winner

Services industries enjoyed a strong summer season with the accommodation and food services sector benefitting from pent-up demand coming out of the pandemic. Demand is expected to moderate in the coming months, but the slowdown could take longer to materialize than in other sectors that reopened earlier.

GDP generated by retail trade rebounded in August by 1.2%. Inflation-adjusted retail sales had fallen significantly in July by 2.0%, but this decline was mainly due to lower sales at gas stations.

The drop in gas prices in August seems to have encouraged consumers to get back to their summer activities and spending. However, sales cooled once again in September in a sign that consumers are becoming more cautious in response to rising interest rates and inflation.

Construction declines further

Economic activity in the residential construction industry dropped for the fifth consecutive month.

However, housing starts were still high although down from recent record levels. They also rose again in September. This was surprising given the increasing interest rates. New construction is usually the sector that slows down the most during a tightening cycle.

The unemployment rate is still low

In October, 108,000 jobs were created (+0.6%), with most of the increase in full-time employment. These numbers more than compensate for the employment losses incurred between May and September. The unemployment rate held steady at 5.2%, despite the slowdown in economic growth. As the retirement wave continues and the number of job vacancies in the country remained high at just under 1 million in August.

Overall, labour shortages are not easing despite the downturn in the Canadian economy. Wage increases also continued their strong growth in October (+5.6% year-over-year, a new record).

Inflation still too high for the Bank of Canada

Inflation as measured by the consumer price index reached 6.9% in September (a slight drop from 7.0% in August). This is still too high for the Bank of Canada, which raised its policy rate by another 50 basis points on October 26. The rate is now at 3.75%, 350 basis points higher than where it started the year.

The bank’s Monetary Policy Report gave a mixed inflation picture for the last three months. Some categories of the consumer price index are easing, while others jumped higher over the period. Price pressures in the more interest-sensitive sectors, such as durable goods and housing, are easing, but this is not the case for food.

Although the Bank of Canada has slowed the pace of monetary tightening, there are still more rate hikes ahead. The central bank is expected to make a final hike for the year in early December.

What this means for businesses

  • The Canadian economy’s growth in the third quarter provided some comfort in the face of continuing uncertainty about the size of the current slowdown.
  • Consumers are becoming increasingly cautious, even though the job market remains strong. It’s in everyone's best interest to prepare for a possible slowdown in demand. Learn how to do this in BDC's upcoming webinar.
  • The Bank of Canada slowed the pace of rate increases in October, but that's not the end of tightening. Don't delay if you have projects that require financing as rates will rise again in December.
U.S. economy at a glance

U.S. growth makes a comeback

U.S. GDP increased by 2.6% in the third quarter, sufficient to completely offset declines in the first two quarters of the year. Early estimates for the fourth quarter suggest growth of 3.6%.

In light of continuing high inflation, the Federal Reserve isn’t expected to slow the pace of its interest rate hikes, despite lower demand for goods and a real-estate slowdown.

Goods consumption loses more ground

U.S. consumers have slowed their purchases of goods since the beginning of 2022 in favor of services. This trend continued in the third quarter, affecting both durable (-0.8%) and non-durable goods (-1.4%). The slowdown in U.S. demand for goods was reflected in imports during the summer.

International trade was the largest contributor to GDP growth in the third quarter with the gain coming mainly from trades of goods. Imports of goods fell by 8.7%, while exports rose by 17.2%.

The U.S. economy was already enjoying good net export growth in the second quarter, but the gains more than doubled in the third quarter. However, the U.S. dollar has appreciated significantly against most other currencies since September, which could hurt exports in the final quarter.

Real estate decline accelerates

Residential investment declined for the sixth consecutive quarter. It fell 26.4% due to declines in new single-family home construction and ownership transfers.

The reduction is similar to the decline experienced in the second quarter of 2020, in the heart of the COVID crisis. It’s the largest reduction since the global financial crisis of 2008. Residential investment had already fallen 18% in the second quarter of this year.

The Fed stays the course

While the Bank of Canada has already slowed its pace of monetary tightening, the Federal Reserve stayed the course by adopting a fourth 75-basis point increase at its November 2 meeting. The pace of rate hikes could begin to slow as early as December, but core inflation continues to surprise on the upside. It reached 6.7% in September, its highest level in 40 years.

In addition, many participants at the Federal Open Market Committee (FOMC) have stated they believe the risk of doing too little to contain inflation outweighed the risk of doing too much, too fast. Remember that even if the next rate hike was set at 0.50%, this is a historically high rate of tightening.

What this means for businesses

  • While economic growth has returned to the U.S., the economic gains for Canadian businesses will be more limited than in the past.
  • U.S. demand for goods and construction is dropping rapidly. Canadian exporters to the U.S., which are largely in manufacturing, raw materials production, and retail and wholesale trade, will find it more difficult to capitalize on renewed growth south of the border in the coming months.
  • U.S. inflation still seems harder to contain than in Canada. Interest rates in the U.S. are likely to rise faster than here, which should put additional downward pressure on the Canadian dollar.
Oil market update

Prices are slowly recovering

The major crude oil benchmarks both ended October slightly higher. Brent crude was trading at US$92 per barrel and WTI at US$86 at the end of the month. This is the first monthly increase in crude prices since May.

Renewed lockdowns in China

China is the world's largest importer of crude oil due to its large manufacturing sector. It is also the country where anti-COVID health restrictions are still very strict. A surge in cases in many cities has resulted (once again) in tough lockdowns.

China's economic growth rebounded nicely in the third quarter to 3.9%, but a stronger recovery will be hampered by the continuing zero-COVID policies, a real estate debt crisis and, of course, the global economic slowdown. These obstacles to Chinese growth will translate into lower demand for oil.

Oil could reach US$100 in the next few weeks

On the supply side, the Organization of Petroleum Exporting Countries and its allies (OPEC+) decided to reduce production by 2 million barrels a day, starting in November, despite the global economic slowdown. This was a signal for analysts that OPEC+ was targeting US$90 a barrel.

Will American supply fill the gap?

The divergence of interests between OPEC+ and the U.S. is clear. The former wants to keep oil revenues high while the latter wants to bring prices down to slow inflation. This creates a lot of uncertainty about the near-term supply outlook.

U.S. crude oil production rebounded in August, reaching 12 million barrels per day, the highest volume since the start of the pandemic.

This was surprising, considering that oil companies had not planned to increase production. If U.S. supply continues on this trend, it could partially counteract the cuts announced by OPEC+.

Beyond this increase, the Biden administration has been dipping into the U.S. Strategic Petroleum Reserve for the past year in an effort to moderate prices. This is a stopgap measure, but the end of the program has still not been announced. The reserve inventory is now 33% below where it was at this time last year and at its lowest level since 1984.

Bottom line…

The reduction in oil supply by OPEC+, as well as the possible termination of supplies from the U.S. strategic reserve, could push prices even higher next year. U.S. production has surprised on the upside recently, but pressure on supply could completely offset concerns about slowing demand from China. A US$100 barrel is a possibility even in the face of the global economic slowdown.

Other economic indicators

A 50 basis points increase and not the last one

The Bank of Canada slowed the pace of its policy rate increase on October 26, but this recent increase remains significant by historical standards. This is likely not the last hike that will affect the Canadian economy. In fact, October's employment data and significant wage increases suggest that the central bank will need to keep the momentum going a little longer to bring inflation under control, even though it knows that the effects of past increases take time to percolate through the economy. The policy rate is now at 3.75% and we expect it to peak at 4.5% by March 2023.

The loonie flies low

The slight recovery in oil prices that has begun will have limited the potential losses in the exchange rate that could have been expected in October. The Canadian dollar has held at US$0.73 for the past few weeks.

However, the interest rate differential between Canada and the U.S. should continue to put downward pressure on the Canadian currency in the medium term.

Business confidence is increasingly worrying

In the face of growing uncertainty, business confidence levels have changed little in recent months and remain low. Notably, in October, the Canadian Federation of Independent Business (CFIB) Business Barometer's long-term index recorded another marginal monthly decline. This brings the index one step closer to the 50-mark. An index above 50 implies that more businesses are optimistic about the future than the alternative. The index reached 51.4 in October.

Key indicators—Canada