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Monthly Economic Letter

February 2019
Feature article

When will the next recession be?

The most frequent question economists hear these days is: When will the next recession be?

After 10 years of growth, many people believe a recession is inevitable. The growing level of uncertainty in the global economy and the choppy performance of the stock market have contributed to the unease.

However, recessions don’t happen just because the economy has been growing for a decade. Looking back at past economic cycles in Canada, we see that recessions have been caused by either aggressive interest rate hikes or by some sort of a shock to the economy.

So, are we going into a recession, or is the economy headed for a soft landing?

Learning from the past four recessions

By looking back at Canadian economic history, we can learn much about what causes recessions. The graph shows that the Canadian economy experienced four recessions over the last 40 years.

The first one, in 1981, was caused by a sharp increase in interest rates. When the inflation rate hit 12%, the Bank of Canada responded by boosting rates to 19%. The strategy worked; inflation subsided, but the high interest rates caused a serious recession.

In 1991, the culprit was a spike in oil prices, causing a worldwide recession. More recently, a housing bubble in the United States created a financial crisis in 2007-08 that was followed by another serious global recession. Finally, a 60% plunge in oil prices in 2014 sent Canada into a six-month recession.

With inflation under control, interest rates will remain low

As we have seen, recessions are caused by significant rounds of interest rate hikes or by a shock to the economy—most recently depressed oil prices or financial imbalances. What will cause the next recession?

Over the last two years, interest rates have been increasing but at very modest pace by historical standards. Indeed, as we can see in the second graph, inflation is currently below 2%. This is good news! It means there is no pressure on the Bank of Canada to significantly boost interest rates to control inflation.

With no inflationary pressure, the bank can continue to increase rates in keeping with the economy’s growth prospects. Currently, the economy is gearing down, and the Bank of Canada has responded by slowing the pace of its rate increases.

The risk of sharply higher inflation is low, and therefore, we can expect interest rates to remain relatively stable. On this front, there is no reason to believe a recession is in the offing.

The threat of oil shocks

As mentioned above, two of the last four recessions in Canada were caused by an oil shock. However, Canada’s vulnerability to sharp price drops is smaller today because the oil sector’s share of investment in the economy is half of what it was in 2014.

Moreover, oil prices have been recovering from their most recent fall and are expected to continue to rise in 2019.

Is there a danger from financial imbalances?

Financial imbalances caused by over-valued assets can also provoke a recession. The significant increase in housing prices in Canada over the last decade created imbalances in different parts of the country, especially in Toronto and Vancouver.

Consequently, the consumer debt ratio of Canadians has increased significantly. With interest rates rising, Canadians are spending more of their income to repay interest, and this has the effect of reducing their spending on other things.

Still, higher interest rates and new federal regulations intended to cool the housing market, particularly in Vancouver and Toronto, have had their effect. The Canadian housing market is rebalancing, and so far, it has been a soft landing.

The economy is slowing, but no sign of a recession

A look back at the last four decades of Canadian recessions suggests that several of the most important causes are less threatening today.

After ten years of growth, inflation is under control, easing pressure for higher interest rates. Oil prices have improved and should continue to increase slowly in 2019. And housing prices in once-hot markets are moderating after years of significant growth.

These positive factors should help the economy keep growing this year and assuage the recession fears of Canadians.

Canadian economy at a glance

Canada’s economy slows but is still growing

The Bank of Canada expects Canada’s economy to grow 1.7% this year. While that’s slower than last year, it’s still relatively healthy for an advanced economy with an aging population.

Gross domestic product declined in November compared to the previous month, but was still up 1.7% year over year. This means the economy is losing momentum, but still growing.

Construction, in particular residential construction, has been the biggest drag on the economy with the sector contracting each month since June, compared to the same months in 2017.

Rising interest rates are the main reason for the slowdown. The Bank of Canada’s policy rate is 1.25% higher than in July 2017. And while banks haven’t fully passed on the central bank’s increases yet, their rates are nevertheless about 1% higher. This is reducing home affordability for some buyers.

Other factors are also affecting the housing market, such as the B-20 federal guidelines that are forcing people seeking uninsured mortgages to prove they can afford higher interest rates. In addition, provincial regulations in British Columbia and Ontario are limiting foreigners’ purchases in those provinces.

Household debt weighs on households

Interest rate hikes are also hitting other sectors of the economy. We can see this in the debt service ratio of households. This ratio measures the share of disposable income required for current and future debt payments. It’s been rising steadily and stood at 14.5% in the third quarter of 2018 (the latest data available). This means that for every dollar of disposable income, 14.5 cents goes to debt service.

While the increase is not as dramatic as before the financial crisis of 2008-09, it’s still quite high.

Higher interest payments mean less cash available for shopping, especially for big-ticket items like cars and electronics, which were in high demand in 2017. Indeed, motor vehicles sales have been contracting every month since March on a unit basis.

Even when we exclude major purchases, retail sales still contracted by 0.4% in November compared to a year ago. And slowing sales have not been restricted to home-related items like construction materials and gardening equipment. They have also affected other sectors, including clothing, sporting goods and food and healthcare stores.

Consumer confidence plays an important role

Consumers’ confidence about their financial well-being has trended a little lower recently, according to the Nanos-Bloomberg survey. Canadians’ expectations, while steady for the last few weeks are considerably lower than in October. These results help to explain Canadians’ slowing purchases.

Job growth has been steady with 327,000 jobs created over the 12 months to January 2019, with jobs roughly split between full-time and part-time. Job growth has been strongest in non-oil producing provinces.

While job growth certainly supports consumer confidence, stronger wage growth, which has been lacklustre, would encourage greater confidence and spending.

As of January, wage growth nationally was only 2% higher than a year ago. Services industries are seeing stronger growth than goods-producing industries. Minimum wage increases implemented in many provinces are likely responsible for stronger wage growth in sectors such as retail and hospitality.

More slack in labour market

According to the Bank of Canada, there is likely more slack in the labour market than we realize using the official unemployment rate. This is because there are many people who would like to work full time but only have a part-time position. When we account for these involuntary part-timers, the national unemployment rate rises to 7.5% versus the official unemployment rate of 5.8%, as of January 2019.

Thus, as slack is absorbed, wage growth ought to perk up, and this will help households feel more confident to spend.

What does it mean for entrepreneurs?

  1. Interest rates are likely to remain steady for the next few months as the Bank of Canada evaluates the impact of hikes on the economy.
  2. Consumers are slowing their spending and retailers will feel the impact. Differentiate your product lines when possible to appeal to more budget-conscious shoppers.
  3. The slowdown in the housing market means residential construction and other industries related to housing may be in for a rough ride for some months to come.
U.S. economy at a glance

After a strong 2018, U.S. economic growth is slowing

While the data is a bit sparse this month, by most accounts the U.S. economy is performing well, especially in comparison to other developed countries. This year the consensus forecast is for growth of 2.5%. Job creation continues to be stellar, with 304,000 new jobs created in January, and the unemployment rate remaining low at 4.0%.

However, economic growth will be slower this year compared to last for two key reasons: the government shutdown, and a slowing global economy.

The shutdown’s effects will continue to be felt

The U.S. federal government shutdown, which lasted 35 days, was the longest in history. The government temporarily reopened on January 25 for three weeks, and on February 15, Congress agreed to a deal on border security, which President Donald Trump signed. He subsequently declared a national emergency at the southern border to divert defense department funding to build the wall.

The shutdown will have a lasting impact on the economy, slowing growth by about 0.5% mostly in the first quarter of the year, according to the Chair of the White House Council of Economic Advisers. The Congressional Budget Office anticipates the economy to recover some of that lost output later in the year.

The shutdown affected nearly five million workers directly—800,000 federal employees did not get paid during the shutdown, though more than half of them still had to go into work, and over four million contractors to the federal government were not paid.

In addition, the Small Business Administration stopped approving loans, meaning investment decisions had to be postponed or cancelled. As well, travellers cancelled or postponed trips due to the shortage of security staff at airports.

A slowing global economy

Meanwhile, the U.S. economy is also facing the effects of a global slowdown. Leading indicators for developed economies such as the G7 nations, and China are showing a deceleration in economic activity.

Citing international economic and financial conditions, the Federal Reserve chose to be patient in January, holding its policy interest rate steady at 2.5%. A pause in the rate hiking cycle should moderate the strength of the U.S. dollar against other currencies.

A slightly weaker dollar will be welcomed by countries and companies carrying high U.S. dollar debt. And other central banks now face less pressure to raise interest rates to maintain the strength of their currencies.

While the Fed did not explicitly say it, China’s slower growth and on-going trade tensions between it and the U.S. are starting to weaken global economic and financial conditions.

While China’s growth slowed last year to 6.6%, this is still exceptionally strong for a country as developed as China. But due to the size of China’s economy and its interlinkages with other countries via global supply chains, any small change in growth has an outsized impact on the rest of the world.

What does it mean for entrepreneurs?

  1. Stable interest rates in the U.S. should keep the Canadian dollar steady or, possibly, lead to some appreciation.
  2. Longer-term Canadian interest rates, such as those for a five-year fixed rate mortgage, should stay relatively stable because they are based in part on the yield on five-year U.S. treasury notes, which are in turn partly based on the Fed’s policy rate.
  3. A solid job market in the U.S. should permit consumers to keep shopping. Canadian exporters, especially of consumer goods—a bright spot for Canada’s trade picture—should continue to do well.
Oil market update

Despite supply cuts, global prices not yet rebounding significantly

West Texas Intermediate and Brent—the global price benchmarks for oil—are trading five dollars above the average price in December, at US$55 and US$63 a barrel, respectively. While it's an improvement compared to November, it is still about $20 a barrel below October prices.

An agreement in early December by the Organization of Petroleum Exporting Countries (OPEC) and a number of other oil-producing countries, including Russia, to reduce production by 1.2 million barrels a day (b/d) from January to June, has had a marginal effect on prices to date.

While technically the deal began in January, OPEC demonstrated its commitment to remove oil supply in December when it reduced production by 750,000 b/d. Of that amount 400,000 b/d was cut by Saudi Arabia as it slowed production to 10.6 million b/d. In January, Saudi Arabia pumped 10.2 million b/d and recently committed to reducing to 10.1 million b/d.

By contrast, Russia’s production increased in December to 11.8 million b/d. Recent comments by the Russian energy minister suggest the country will gradually reduce its output over the deal’s six months and will not achieve its full reduction target of 240,000 b/d until later.

Russia’s compliance with the new deal is debatable. The reason: Russia can manage its fiscal deficit when global oil prices are below US$60 a barrel. Many countries in the Middle East depend on higher oil prices to cover their spending programs, including providing energy subsidies to the population.

U.S. production keeps rising

A key factor in the global supply dynamic is strong U.S. production, averaging 11.7 million b/d since November. With production hitting 11.9 million b/d in January, the U.S. has become the world’s largest crude oil producer. Production grew by a massive 2.2 million b/d during 2018—quite a remarkable feat!

The U.S. Energy Information Administration expects production to continue to rise in 2019, although more slowly, at 500,000 b/d. This increase will continue to put downward pressure on prices, in particular WTI, which is trading at about US$8 a barrel below Brent.

Production cuts support Western Canadian Select

After falling precipitously to US$13 a barrel in November, Alberta’s decision to enforce production cuts of 325,000 b/d, starting in January, pushed the price for Western Canadian Select (WCS) up to US$42 a barrel at the end of January. The improvement allowed the province to reduce the production cut by 75,000 b/d for February.

As the chart below shows, the gap between WCS and West Texas Intermediate (WTI) has narrowed significantly from an average of US$42 a barrel in October to US$10 a barrel in January.

There are two factors driving the narrowing of this gap. The first is that U.S. production continues to grow and this puts downward pressure on the price of WTI. The second is that the demand for Canada’s heavy oil has risen. There are three reasons for this: the production cuts, less heavy oil globally due to faltering production in Venezuela, and higher demand by American refiners following the end of their maintenance programs in mid-November.

Bottom line

While global benchmarks are slowly rising, we should not anticipate a quick return to last year’s highs. When OPEC and Russia committed to removing 1.8 million b/d of oil supply from the global market in November 2016, prices gradually moved up over the course of the following 10 months, but did not hit their peak for nearly two years.

This time around, a smaller amount of oil is coming out of the market amid a surge of U.S. production, and a slowing global economy. Moreover, compliance seems less likely, especially with Russia able to manage its fiscal budget at US$60 a barrel.

Other economic indicators

The Bank of Canada likely to remain on hold in March

The Bank of Canada maintained the overnight interest rate at 1.75% on January 9th. The Bank’s next decision regarding the overnight rate is scheduled for March 6th. At the time of writing, most analysts expect two more rate hikes during 2019. Given the Bank’s comments regarding inflation trending lower for most of 2019, a rate hike in March seems unlikely.

The loonie slowly recovered in January

The Canadian dollar continued to appreciate against the greenback in January. The loonie gained two cents during the month and closed above US$0.76. The rise in crude oil prices and the Fed's more accommodating tone towards U.S. interest rates allowed the loonie to slowly recover over the last month.

Confidence among Alberta SMEs continues to deteriorate

The Canadian Federation of Independent Business’ Barometer Index shows a slight increase in optimism among entrepreneurs for January. However, this increase did not offset the loss recorded in the last month of 2018. Overall, business confidence increased by 2.5 points at the national level. On the other hand, confidence deteriorated for a second consecutive month in Alberta and reached 37.5 despite the rise in crude oil prices. The province has not seen such a low level of optimism in more than two years. Moreover, the natural resources sector has the lowest level of confidence following a 6.5 point loss in January.

Business credit conditions have eased

The effective household interest rate remained unchanged in January, still at around 4%. On the other hand, the effective business interest rate has recently eased, falling to 3.75%, the same rate companies faced last October. To date, the effective household and business interest rates have risen by about 100 basis points despite the policy rate rising by 125 basis points.

Key indicators–Canada