Canadian Economic Outlook - Transcript

Speaker 1 (00:05):

Hello and welcome to Strategic Alternatives, a podcast from RBC Capital Markets. I'm Vitos Peduto, global head of Mergers and acquisitions for longtime listeners of the podcast. You'll know Strategic Alternatives as an investment banking podcast focused on mergers and acquisitions. In the year ahead, we'll be expanding our scope and releasing a few special episodes with a focus on the forward macroeconomic outlook in key regions around the globe. Today we're joined by Nathan Janssen, assistant chief Economist for the Canadian Market. Nathan, what's the long-term outlook for Canada and what dynamics do you anticipate will set the scene for the economy in 2024?

Speaker 2 (00:46):

Great. Thanks for having me veto. In terms of the Canadian economic outlook in the near term, certainly there's growing evidence that the economy is softening. We've had a pretty aggressive interest rate hiking cycle, and those higher interest rates are still passing through to household debt payments and business debt payments and slowing activity with a leg. We're seeing growing evidence that the economy is softening. So GDP growth has been soft year to date. It's been much softer when you account for significantly stronger population in growth in Canada. So on a per capita basis, GDP growth looks like it's declined for five straight quarters as of the third quarter of this year, labor markets appear to be softening from very strong levels, but they are softening. The unemployment rate has increased by about almost three quarters of a percent since the spring. Again, labor markets are still fairly strong right now.


The unemployment rate is historically still very low, but the increase we've seen to date has been statistically significant. This is the kind of increase that you typically do see in the early stages of a labor market downturn and only really in the early stages of a labor market downturn historically. So the question becomes how bad can the economic outlook get? I think from our perspective so far, the economic data is tracking in line with a mild economic downturn. So we have the unemployment rate peaking at about six and half percent next year. That's not dramatically higher than the 6% rate that we would view as consistent with a normal full economy unemployment level, but it is softer than where it is now. I think the good news is that inflation growth has been slowing, and we've seen that not just in Canada but elsewhere as well.


Much of the slowing that we've seen has been related to global factors. So energy prices are lower, but we are also seeing broader signs that broader inflation pressures are easing. So the share of consumer price basket that's growing in a rate well above the bank of Canada's 2% target is shrinking. So I think central banks do look like they're being successful at getting inflation back under control. That's true in Canada as well as it is elsewhere. So it means that further interest rate hikes from this point forward, we still view as unlikely and not impossible, but certainly less likely. And so you start to consider when will the first cut in interest rates come. We think the Bank of Canada is still going to be very cautious about taking their breaks off of the economy. We've had a pretty significant inflation scare over the last couple of years, and they want to ensure that inflation is really truly getting back to a 2% target rate on a sustained basis, but it is increasingly likely that the next move will be a cut in interest rates rather than a hike.


I think one of the concerns still going forward is that even with the central bank's not hiking interest rates further, we still haven't felt the full pain from interest rate hikes to date interest rate increases will continue to pass through the household debt costs with a lag, particularly in something like the mortgage market where a lot of mortgages that were five-year fixed rate in 2020 won't renew until 2025 and even into 2026. So we'll still be feeling the impact of interest rate hikes with a leg even into those years further out in the future. You still have some downside risks out there. We still haven't felt the full impact of interest rate hikes to date. I think households in Canada in the early stages of interest rate increases in inflation soaked up those costs surprisingly well, and they did that by in some cases taking on more debt.


But households spending held up very well in the early stages of this interest rate hiking cycle. But what's happened is that's left households very vulnerable at this point to a labor market downturn. So over the first half of the year in Canada, the household debt service ratio, so the ratio of debt payments to disposable household incomes was already close to record levels, and that's against a context of historically very strong labor markets. So the question is what happens to households as the unemployment rate starts to increase? And there are still downside risks out there that as labor markets start to soften, household incomes aren't growing as quickly and potentially are even declining, that a mild economic downturn can still turn into something worse. But I think to date, what we've been seeing is consistent with a mild downturn in labor markets and a mild downturn in the economy into next year, there are still very large GDP growth tailwinds in Canada from higher population growth.


So every time you add a new unit of population to Canada and that growth has becoming mostly VA immigration, you're adding an additional source of labor supply, additional hours worked. You're also adding a new consumer. So that's part of why slow GDP growth numbers now are concerning because they look significantly worse on a per person basis, but it is easier for the economy to grow given pretty significantly positive structural tailwinds from population growth as well with inflation coming down and it becoming more likely that the Bank of Canada and other central banks globally will be able to pivot to at least moderate rate cuts in the year ahead. There is reason to think that we get back to modestly positive GDP growth rates in 2024. I think one of the big questions for Canada is what happens with our housing markets. We do have a highly leveraged population.


Our housing prices are very high, and interest rates are significantly increasing the carrying costs of housing. So what we've seen, I think to date is housing markets have kind of flattened out over the spring and into the summer, even into the fall, despite still very high interest rates. That also is tied to significantly positive population growth in Canada and limited availability of housing. But we have seen some softening in housing markets more recently. I think a base case assumption is still, if we get a mild economic downturn, central banks don't need to hike interest rates further. Then tailwinds for population growth can help offset some of the headwinds that remain from higher interest rates washes out to a fairly flattish forecast for housing markets going forward. But obviously that's a key risk factor for Canada to huge share of household net worth is in the form of equity in real estate markets.


So the strength of household spending is to an extent also tied to the strength in housing markets. I think we start to think more about beyond the next year or two from a long run perspective, we do think, well, the Bank of Canada and other central banks are going to be potentially shifting to rate cuts next year. They won't be cutting interest rates overly aggressively, and we think the level of interest rates in the longer run will probably remain higher than what households and businesses have been used to pre pandemic. So the Bank of Canada's overnight rate peaked pre pandemic at about 1 75. We don't expect them to cut back to those levels. There are numerous reasons for that, and a lot of those are related to structural longer run changes in the economy. So for one, the economy continues to age, so we're adding a lot of new workers into Canada via immigration.


But overall, the share of the population that's over the age of 65 is continuing to grow. When you think about what that does to prices, you have still a larger share of people that are hitting retirement age. They're still consuming, but no longer producing in the economy. So all else equal, that means you have more demand growth than supply growth, potentially upward pressure, longer run on wages, and that's potentially adding to these underlying structural rates of growth in inflation and persistent labor shortages. Also, if you look at globalization, that's been a pretty significant disinflationary force over recent decades. We don't see rapid unwinding of globalization in Canada. Supply chains are incredibly integrated globally. It would be very expensive to unwind those quickly. But at a minimum, the pace of globalization has slowed and has probably started to reverse a little bit. So that's one of those factors that has been putting downward pressure on goods price inflation, and that won't be repeated in the decade ahead.


You can add to that there are still significant issues in terms of geopolitical risks out there. There are still risking having an impact on things like global commodity prices. So I think it's not that we expect a dramatic change in the approach of central banks to targeting inflation, but we do think there are a number of factors that had been doing some of the central bank's job for them in terms of keeping inflation under control that aren't being repeated going forward. And all of that means central banks will probably have to be a little bit more responsive to inflation than they have been in the past and argues that the exceptionally low interest rates that we saw really in the decade pre pandemic won't be repeated going forward in the long run. There's also significant risks related to the energy transition, and I think both downside and upside, the energy transition will cost a lot of money.


Our own estimates have been something like $2 trillion by 2050 for Canada to hit net zero ambitions. That's a lot of new investment dollars. It also potentially puts upward pressure on interest rates, but it's also very GDP positive if you think about the amount of new investment activity that would be required to achieve that goal. But we in Canada have had a renewed push on the fiscal side to try and support an acceleration of the transition in energy. I think we're still lagging the size of the supports that have been announced in the United States in the Inflation Reduction Act, but they are coming in Canada. Canada has a record over the last decade of really underperforming in terms of adoption of renewable energy growth. We're one of the few countries in the world that hasn't seen a significantly increased share of energy coming from renewable sources overall, but we do expect that to change going forward.


There are some government supports in place, but also the cost of these new energy sources continues to decline relative to the costs of conventional energy. So government supports as well over time are expected to become less of a factor in terms of driving that transition. They may accelerate a transition that's already taking place, and we do expect some of that to happen in the next couple of years. But really from an economic growth perspective, the amount of investment dollars that are required to facilitate that transition are quite large and will be a tailwind for business investment, not just in Canada, but elsewhere as well.

Speaker 1 (11:45):

That's a great point to end on. Nathan, stay tuned for more insights and future episodes of Strategic Alternatives. And thank you for joining us. You have been listening to Strategic Alternatives, the RBC podcast. This episode was recorded on November 23rd, 2023. Listen and subscribe to Strategic Alternatives on Apple Podcasts, Spotify, or wherever you listen to your podcast. If you enjoyed the podcast, please leave us a review and share the podcast with others. Thank you.

Speaker 3 (12:22):

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