Lindsay Patrick
Hello and welcome to Strategic Alternatives, the RBC Capital Markets Podcast, where we uncover new ways to raise capital, drive growth, and create value in an ever-changing world. With insights from our capital markets experts. I'm your host for this episode, Lindsay Patrick, Head of Strategy, Marketing and Sustainability. And today I'm joined by RBCs, chief economist, Francis Donald. In this episode, we'll dive into the forces shaping Canada's economic outlook. From geopolitical conflicts and shifting US trade policy to the climate transition and the role and impact of immigration, including what's next for interest rates, inflation, central bank policy, and of course, Canada's ever important housing market. Francis, welcome to the podcast.
Frances Donald
Thanks for having me.
Lindsay Patrick
So there are no shortages of events happening around the world. As we head into 2025, we have ongoing geopolitical conflicts. There's a new US administration that's set to reshape the global trade order. China's economic growth is still slowing, and the climate transition continues to unfold in the background of all of this, and Canada is impacted by all of the above. How are you thinking about top priorities for Canada heading into 2025? What are your big themes?
Frances Donald
Well, Lindsay, we're certainly thinking about Canada a lot, in part because there's so much going on, but also because it's year-end outlook time. So we're putting together our core themes for 2025. And I have to tell you, I've been doing this for a while, this is probably one of the hardest 2025 outlooks I've put together for the country in a while. In part because there is so much uncertainty not just within the country's own borders but also, what's happening abroad and also because my goodness, there are so many conflicting economic narratives going on at the same time. When you put the whole story together, I think there's kind of three main stories that are coming up more frequently. The first one and little economist secret, we tend to put this one in every year-end or year look-ahead outlook, is that it is probably going to be a year of two halves. And by that we mean that in the first half of the year for Canada, this is a country that's going to continue to struggle with the weight of those higher interest rates and, it's still going to struggle with a rise in the unemployment rate and some of the damage that was done by restrictive monetary policy. But as you and many recognize interest rates are starting to decline in Canada and we think by the second half, maybe tail end of 2025, there'll be some relief around the corner. So always darkest before dawn, but I think that'll be a key part of the 2025 story. It's hard to talk about Canada and 2025 though and not think about divergences, especially with the United States. We often say if you want to be a Canadian economist, first you have to be a US economist. You have to know what's going on in the US before you can get a handle on what's happening in Canada or as the expression goes, if the US sneezes Canada catches a cold. But the two economic stories are becoming very different in a way that we haven't seen for literally many decades. And in 2025, I think we'll spend a lot of time talking about how Canada's economy has fundamentally and maybe permanently shifted away from the US model. We're going to see the Bank of Canada and the Federal Reserve diverge quite a bit. The fiscal stories will look very different. We've got some fiscal restraint now on the Canada side, whereas the U.S. is still going pretty strong with large pro-cyclical fiscal spending and the inflation story is going to look different as a result. So divergence between Canada and the US and also maybe Canada and the rest of the world will come into play. Thirdly, hard for us to put together an outlook for Canada that doesn't continue to emphasize the structural challenges that exist underneath, and hopefully we can talk a little bit more about that today. And they're really broad. There's of course the productivity challenge. We hear a lot about that, the reliance on the US economy and some issues with demographics, very low fertility rates in Canada. And these are impactful not just in the long term, the five to 10 year outlook, but also impacting us on a year to year basis. So that's a lot and I'll add in a little asterisk to this, an honorable mention for a theme that might not make it into a report but bears monitoring. And that is our data in Canada is being heavily distorted by immigration policies. So we've spent the last couple of years talking about how Canada has avoided a recession on the surface, and that's largely because we've had big immigration flows. That's going to reverse in the next few years. Canada will actually look worse on the surface than it is underneath. Part of the Canadian economist's job in 2025 will be to look beyond the surface and tell a lot more of the Canada story or, I should say stories, because there'll be a lot of them.
Lindsay Patrick
So Frances, in addition to all the dynamism that's happening within Canada, and as you note the divergence within Canada, we have a pretty different picture about to unfold with the US election that has taken place. And in fact, that's probably one of the most frequent questions we get from our clients in Canada is what will be the impact of a Donald Trump presidency and a Republican sweep on the economic landscape for Canada?
Frances Donald
Certainly has taken a significant amount of our focus in the past couple of weeks, but problematically, we don't have full clarity on what policies are going to be impacted. So instead of making material changes to our outlook or saying this is the definite outcome associated for Canada, what we've done is have to adjust probabilities of certain outcomes. So the short answer is that following the US election results, we did downgrade our Canadian GDP forecast. We pretty much had to because most of the policies that have been suggested, they increase the risk that Canada does a little bit worse in the next one to four years and we had no choice but to adjust that on the surface and yet there's so much more happening beyond those election outcomes and we're going to have to spend a lot of time dissecting which channels will matter most to Canada right now based on what we know now, I think there are three main direct channels that will impact Canada in the next couple of years. And the first one of course, we all know this is trade. At risk for Canada. If the US moves more protectionist is looking more at tariffs, energy products, motor vehicles, manufacturing, and that means certain areas of the country are also more exposed places like Ontario and Quebec and Manitoba, which produce more and sell more of these products to the United States. At the same time, Canada also produces a lot of things that the US can't get elsewhere and can't produce at home like critical minerals. So they'll have to be very careful about not tariffing things that they can't move away from anyways. So we'll have to go product by product. I'm sure economists will spend a lot of time in the Excel spreadsheets trying to get a much better understanding from the bottom up. Of course we have Kuzma renegotiations as we call it here in Canada in the US SMCA. Now on that, I have to say I am not a political expert, but there is agreement or longstanding trade agreements between Canada and the United States on the auto sector and that might suggest that blanket tariffs are maybe a little less likely in these areas that we might've thought in the past, but we still have to run the numbers. So when you do that and you look at a 10% blanket tariff on all goods, it would hit exports by 2% to 3% in Canada. Now again, there's so many elements to these retaliatory, which products are being imposed, but the balance of risks is that exports now compared to before have to be marked down just a little bit there. So trade is the first direct channel. Energy is another one. And of course President-elect Trump has talked a lot about wanting low energy prices for US consumers, so it wouldn't make too much sense to tariff Canadian energy that would work against some of these goals. Perhaps more interesting from my vantage point is Canada has invested publicly and privately a significant amount in the energy transition in the country. If the US moves in another direction, that might change some of the dynamics here on Canadian soil at home as well. The third lens for which we're looking at the US election impact on Canada is the immigration lens. We can talk a lot about Canadian immigration, but there is a push in the US to engage in a deportation policy to reduce the amount of immigration. One thing we need to be focused on is whether we see an increase in asylum seekers in Canada and how we might process these. So these are the columns and rows and the spreadsheets that we use to look at this impact. But I might, if you don't mind Lindsay, just take a step back here, which is when we get too focused on the numbers and the dollars and cents, I think we lose what might be even more impactful to Canada and it's the same stories that are impactful to many countries around the world as we enter this more protectionist environment. First and foremost, what's good for the United States is good for Canada typically in terms of growth. If policies are boosting US growth, they tend to help Canadian growth and vice versa. So sometimes we miss the forest for the trees when we look through those direct channels. It might also be fair to recognize that this protectionist era, which isn't just in the United States, this started in 2016 with Brexit and a variety of other policies, it's inflationary for everybody. It lifts prices for everybody around the entire globe. And so we can talk about tariffs on Canadian goods, but if we see a protectionist move globally, then we are talking about new structural inflationary pressures that central banks, not just in Canada but abroad have to look through as well. And yet as an economist I like to say on one hand and then on the other, if we do see greater trade frictions between the US and China, we may actually see some closeness between US and Canada. There are too many moving pieces, and I like to think as an economist that freight and rail and road is still something that matters a huge amount to economies, and Canada could actually see some benefit from this rise in protectionism as we move away from global supply chains and towards more regional trading blocks. So at the end of the day, I think we can get caught up on a lot of the individual policies, but having a balanced perspective between what will be directly impactful and how the global order is changing and that matters to Canada is maybe another way to think about this very giant question facing Canada and its economy.
Lindsay Patrick
Well Frances, I really appreciate the glass half full approach because as we go through the risks and you look at a combination of potentially lower growth for Canada and a rising global inflationary environment, that doesn't sound very encouraging.
Frances Donald
Well, often with economics what we see is that where there's one benefit, there also tends to be a risk on the other side, but if we uniquely focus on the downside risk, we may miss some of the opportunities that arise from these new developments. And we've certainly heard from many politicians who have talked about some upside that could occur from some of these negotiations. So it's not to be ignorant to some of the challenges that Canada may face in the next four years, but to also recognize that a Canada is not alone in these challenges, and B, when we enter these economic inflection points, there are occasionally opportunities for policymakers, for Canadian entrepreneurs, and for Canadians to adjust towards a new order that sometimes can benefit them.
Lindsay Patrick
That's terrific. So the hot button topic everywhere in the world seems to be immigration right now and in Canada we are not immune to that. We welcomed a lot of newcomers for the past few years. There was a deliberate policy to do so and that has helped tremendously with labor shortage issues. But inadvertently we've also found that it has put some capacity constraints on sectors such as housing and has led to a little bit of a shift in public sentiment to Canada's approach to immigration as a result. We've seen a recent correction course from the federal government, and they've set out to lower targets over the coming years. It really seems to me that we are going to be on a path where we have to try to balance the economic benefits from immigration with some of the constraints they've created in our economy. How important is immigration at this very moment to your outlook and what do you see unfolding?
Frances Donald
Immigration has a significant impact to our 2025, but all the way out to our 2027 and 2028 outlook. But let's take a pause, Lindsay. I remember prior to 2019 I was in a global role, and I would travel all over the world, Asia, Europe, the us, all across Canada, and I remember proudly speaking to how Canada had found one of the solutions to low fertility rates. Canada for many years had the highest population growth in the OECD. It focused on economic immigration, and it was lauded not just by Canadian economists, by the global environment as saying this, the way to offset low natural population growth and to really help strengthen your labor force. It was also viewed of course, and this is outside my realm as a really interesting element of Canada's social and cultural fabric. So it was viewed as a major economic positive and most economists viewed it that way, especially because Canada's fertility rate is extraordinarily low. It's 1.3 births per woman, and a reminder the replacement rate is closer to 2.1. Economists think a lot about demographics and fertility and immigration even though it seems like it's a long-term issue and it's not relevant to maybe day-to-day folks who are trading the Canadian yield curve. An economy operates like a burger joint and the growth or GDP of an economy is kind of like the number of hamburgers that a burger joint produces. That's always a function of just two things. How many people are working behind the counter And how fast each one of them makes a hamburger. It's labor force and productivity. These are the two most important keys to an economy and they're actually how we calculate long-term growth. Now you might remember Canada has a little bit of a productivity problem, so our ability to produce hamburgers per hour, very, very low, and we were offsetting this with very high immigration or a lot of folks behind the counter. This is why it's so critical for us to have an understanding of where immigration is going, especially in the context of very low productivity. So back in 2019, we had about 500,000 immigrants per year that were coming through. That policy was very successful. Everybody loved this policy, and when the labor shortage started to amplify over Covid, that number was raised to one and a quarter million. So we more than doubled the amount of immigrants coming in a very short period of time, and there were some very strong positive results from this. Namely it solved some of the labor shortage issues, not all because there was some mismatch between skills and openings, but it was viewed as a very successful policy, particularly over that pandemic era. Then as you noted, challenges started to arise. The big one, housing of course already Canada suffering from significant housing shortages. I remember this chart that came out in April of 2024 from the Bank of Canada, and they show this one line that's basically stagnant at about 200,000 homes being made every year on a four quarter moving average. But the change in immigration policy meant that demographic demand was over 500,000, at the exact same time. So every quarter we were growing this divide between needs by almost double. And a lot of housing economists will highlight, we just can't move faster on the amount of homes that were being built. This was the beginning, I think, of recognition that the supply side of the economy just couldn't withhold it. Then we started seeing the challenges in our data. In the past two years, the Canadian economy has effectively been called resilient. No recession here, the policy makers have said, but on a per capita basis, each individual Canadian, that number has actually been declining for two and a half years. The only reason that Canada hasn't been declared in a recession is because we've been growing the pie. But the piece of pie that each Canadian has been getting has been shrinking, and we've seen economists highlight this and many other folks who've said, wait a second, the numbers aren't telling the real story. And then more recently in the past few months, we've noticed in our data that the unemployment rate for new arrivals has actually been much higher than it is for the rest of Canadians. So we're clearly absorbing more immigrants than we can actually take in the economy, and this is why the situation has become more problematic. So that's why just in the past month we did see this sizable change in immigration policy, we're going to cut permanent resident targets down by 20% in 2025 and then continue to see that number growing down to or falling over the course to 2027. What's so shocking about this, Lindsay, is that basically reduced immigration targets will wipe out population growth in Canada for the next two years. So our population growth will go down to effectively nothing. And just a reminder, we haven't solved productivity growth either. So if you go back to this burger joint now, we have no new people working behind the counter and they're not making hamburgers faster. If everyone who wants a job has one and businesses are thriving the way they want to back in 2023, that number was 2.5% GDP growth in part because of this change in targets and population growth collapsing, our new potential is 0.6 percentage points. We have basically through this one policy collapsed the ability of the economy to grow and yet choose your villain because we have to address the affordability issue that has happened in housing and we have to adjust the policy, but there will be a period here that at least on the surface data makes the Canadian story appear worse. Now, underlying that, as I said earlier, there could be some really good stories and people's size of the pie may start to grow again even as the pie itself gets smaller.
Lindsay Patrick
It does sound actually like a recipe for growing inequality in the economy, which in and of itself could be problematic.
Frances Donald
That's a big theme for us, and we've talked about this in the United States economy as well. This concept of a K shaped economy and the difference in those who have benefited from home ownership they already acquired would be mortgages that are paid off, high stock prices who are more resilient to those high interest rates and those who haven't had the benefit largely because they were just born a few years later or didn't buy a house before 2016. So this K shape or haves and have nots is going to be a theme that persists. I think one of the jobs of economists in Canada and the United States will be to point out that even though the aggregate economy may look in one way, it's not representative of necessarily every single business or every single Canadian. And if you're running a business in Canada, you'll want to be aware of what is the economic state of your customer base because it may be very different than what you see when you turn on the news at night and hear retail sales or job numbers.
Lindsay Patrick
In that context, it doesn't really lead to a stable political environment, and I think that's exactly what we've seen unfold to the south of the border, but also in other countries around the world too. I'd like to move on to the concept of divergence, but particularly on the topic of productivity that you've highlighted, because as a Canadian I do find it a little bit worrisome. Looking through your research, you've highlighted that real GDP per capita controlling for inflation and rising population growth, real output per person in Canada from 2019 to midyear has lagged that of the US by over 10%. What happened over those years and how can Canada start to close that gap?
Frances Donald
The issue with productivity in Canada has been discussed even before I was born. It is many, many, many decades of discussion in Canada as being a big challenge for this country, but I'm not sure that we think about productivity the right way. I think the term productivity gets used to encapsulate all of Canada's structural problems. The way that I think about the divergence in productivity between the United States and Canada is a little bit like an immune system. the stronger our immune system, the less susceptible we are to the virus when it comes through as a shock. There will always be viruses running through our bodies and through our economies. It's about the strength of our economic immune system that matters. So effectively what's happening is Canada has lost most of its growth engines and there's so much work on this. We repeat the same things, but that doesn't make them less true. Far too much regulation in Canada. We've hollowed out our energy patch. This was a highly productive area of the economy. We likely invest too much in housing. Housing isn't a high productive type of investment. The public sector is growing and some of that will have to continue as our population ages. Tax competitiveness isn't great. These are all contributing to the lack of growth and underlying support in our economy so that when we get hit with much higher interest rates or an inflation shock or it could be a range of other issues, there really isn't a buffer underlying the economy that's so substantially different from the US story where they've had a major productivity boom likely due to or in part driven by the tech boom and the big investment in research there. There's a substantially more diversified business backdrop. So if one sector gets a little weaker, then they have the ability to buffer it. I mean, the US economic system has such a strong immune system that's been developed over a decade, whereas Canada just doesn't have that buffer. Now, the solutions to productivity, again, a lot of research, probably more sector by sector than economists are capable at least on the macro scale of supporting. But I wish we would frame the discussion around these structural issues being these big problems for us because when the cyclical issues hit, we can't deal with them to the same extent. So this divergence between the US and Canada is likely to persist, I think not just in the next year, but probably for the next decade and is going to require some significant realignments before we can say we've improved the general health of the economy.
Lindsay Patrick
It's an interesting analogy, the US certainly has some strong muscle built when you think of their tech sector, their defense sector, and just the structural support for those sectors in the global economy today.
Frances Donald
Hugely. And we tend to compare ourselves to the United States, which is by far the winner here in terms of economic immune systems and productivity. We're not as far behind when we compare ourselves to our European peers, for example, or other developed nations in the country. We're comparing ourselves against the best in class or the strongest kid in gym class. And so maybe we should give ourselves just a little bit more credibility, a little bit more grace that we don't always have to compare ourselves to the United States on this one.
Lindsay Patrick
I think that's a great perspective. Again, another glass half full perspective, but particularly when you think of our resource independence, when you think of the value of those resources over time, that is going to become increasingly important.
Frances Donald
I completely agree.
Lindsay Patrick
So with this economic backdrop that you've outlined, that takes us now to potentially growing divergence on central bank policy. And while this is not entirely new, we've seen times in the past where the Bank of Canada and the Fed have gone their own ways. What do you think is going to happen today and can the Bank of Canada continue to lower rates in an environment of potentially increased inflation as well as the Fed going their own way?
Frances Donald
So our RBC forecast in partnership with our rates team is that the Bank of Canada can and will bring rates down to 2% over the course of 2025, but the Federal Reserve may get stuck around 4%, and we get pushback on this forecast. We've been told one of your forecasts must be wrong, but that's not actually the case in history supports this. As you mentioned, the Bank of Canada and the Federal Reserve have diverged many times. In fact, the only times when they actually are aligned is when they experience the same shock. So for example, tech bubbles or commodity booms or the great financial crisis, otherwise, we've seen them diverge as much as 200 basis points in one direction. The BOC lower or 200 basis points in the other direction, the BOC higher. So the economies should run on their own monetary policy system. So what is driving this divergence? So we talked about productivity, meaning that the potential between the two economies is very different. We see potential in Canada really dropping off towards 0.6% in the next few years. I can't even believe I'm saying that. I would never have imagined Canadian potential being so low, but the United States is still at 1.5% to 2%. They haven't really changed. So monetary policy has to calibrate the two. Productivity is a big part of that. So is fiscal spending, the US is spending more compared to the size of its GDP or its growth than it ever has outside of a recession. And debt to GDP in the United States is going to in the next two to three years be its highest in the country's entire history. That pro-cyclical fiscal spending is juicing the United States economy in a way that Canadian fiscal spending, which is relatively reserved compared to the United States and all of its peers is just not. The US can probably do that more than Canada. They are the reserve currency. The bulk of trade and commodities is priced in US dollars. There's more flexibility. It's the most liquid treasury market. I'm not necessarily concerned that the United States is going in ultimately the wrong direction. But the divergence between these two fundamental factors in the economy is really significant and it necessitates the Bank of Canada going in a different direction than the Fed. The Fed has to offset huge fiscal spending in the United States. The Bank of Canada is not, their inflation profile is fundamentally different. The unemployment rate is rising swiftly in Canada. It's not in the United States. We will probably bear a weaker Canadian dollar as a result of it. But again, it's a pick your poison. I think most policy makers and most Canadians would choose a weaker Canadian dollar over a substantial rise in the unemployment rate. It might cost more to bring things in from the United States, and inflation matters and is real, but it's more painful when you don't have a job associated with it. So we will have to talk more about what the structural shift means for a lot of the comparisons for currency, for rates, trades, that will matter a lot in 2025. It will also matter between 2025 and 2030 because these stories aren't going to change.
Lindsay Patrick
Frances, I can't believe we've gotten this far in our conversation without talking about Canadian housing, which we know is number one in the hearts and minds of all Canadians. There have been a lot of policy changes over the past few years that have with the intent to bring in more supply and housing and also extension on amortization periods to help with mortgages and in particular the affordability of mortgages given the higher level of interest rates than over the past five years. So with all this dynamism in the housing market, what is your forecast overall on housing, what's your outlook for housing and also housing affordability and near term? Do you see this being a tailwind for Canada or more of a headwind?
Frances Donald
I really appreciate how you frame the question because often we get asked, how's Canadian housing doing? Is it going to blow up the whole country? That's really the question that most of our global clients will ask us. But maybe a more important question is housing impacting the basic fabric of the Canadian economy when it comes to people's ability and willingness to buy a home? And to me that's far more important than are we going to see a short-term correction in home prices? We probably won't by the way, but affordability is more central to the idea of can Canada attract and retain labor? How does Canada pay wages? Can companies be competitive in a country where folks can't afford homes or need wages to be substantially higher? When we talk about the productivity problem in Canada, people say, oh, we got to address the tax system. We also have to address how expensive it is to live in this country, and affordability is a big part of that. So I appreciate the framing of your question, and as we think about affordability for 2025, we have two significant new factors that we need to think about. The first one is declining interest rates. That's of course very, very important that's going to make the housing market busier in 2025. And when we talked at the beginning about 2025 being a year of two halves for Canada, that housing market comes back to life a little bit more in the second half of the year. Now that's set. Keep in mind, long-term rates or five-year rates have already incorporated a good deal of the Bank of Canada easing into their story. So for those who are going to be taking out mortgages and 85 to 90% of originations in Canada are fixed mortgages at that five-year pace, they're probably not going to get a lot more relief than what they're getting right now. So that story is largely baked. And the other side is we have these easing of mortgage insurance rules. So we will see longer amortization from 25 to 30 years, and they're going to raise the cap on the home value that can be insured from 1 million to 1.5 million. So these are going to be significant. We actually think that that's going to solve about half of the problem in affordability that's accrued since the pandemic. So you're going to be able to walk back about half of that. That still leaves us in deeply unaffordable territory, much worse than it was before the pandemic, but a little bit of a comeback on there. And I think this is the challenge with housing. When we talk about wanting to solve the housing issue in Canada, just like with broad prices, we're likely not going to be an environment where we get back to prices that existed in 2020 or 2016 or 2014. We're talking about trying to slow the price appreciation so that wages at least on a year over year basis can start to catch up just a little bit more. So there's many things at play in that story effectively. In our view, the solution to Canada's housing market crisis, and I do call it a crisis because as I said, it filters through so many elements of the Canadian story is going to be to tackle the supply side. But there the challenges have less to do with interest rates and certainly not demand side measures from government, but we need more people. We need them skilled to do the right job, we have to be able to increase productive capacity. So you said you can't believe we got this far without talking about housing. I think it's because housing is actually part of every single one of the stories that we talked about today. Housing is an immigration story. It's a productivity story, it's a fiscal story, and it's a monetary story. So it flows through every part of the Canadian fabric. The challenge is this affordability crisis and the challenges with housing won't be solved in 2025. They're a long-term, part of Canada's economic DNA. We still have yet to find a solution and tackle the problem head on.
Lindsay Patrick
That's a great point to end on. Frances, thank you so much. This has been really insightful, and I've enjoyed our time together.
Joe Coletti
Thanks for listening to Strategic Alternatives, the RBC Capital Markets Podcast. This episode was recorded on November 20th, 2024. You can listen and subscribe to Strategic Alternatives on Apple, Spotify, or wherever you get your podcasts. See you all next time.