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Canada Outlook: Firing on Fewer Cylinders

  • A weak global environment has slowed Canada’s economic growth to a pace below potential.
  • Energy and commodity exports were responsible for a quarter of GDP growth over the past year.
  • Financial services and real estate are key growth drivers despite worries about an overheated property market.
  • Commodity demand, a safety premium, and tight monetary policy relative to the U.S. are propping up the loonie.

Slowing momentum in Asia and weakness in the U.S. and Europe have taken their toll on Canada’s expansion, slowing growth to a pace below potential. Moody’s Analytics forecasts 1.6% annual growth for 2013, widening the Bank of Canada’s measure of the output gap in 2013 to a deficit totaling 1.2% of potential output, from 0.6% in 2012.

The increase in economic slack has stalled progress temporarily in the labor market, leaving the unemployment rate stuck near 7%. Firms also face an increasing profit squeeze as the strong loonie reduces pricing power while domestic production costs rise.

The loss of momentum also increases the consequences of a potential adverse shock to global trade and financial markets, such as the recent threat of default by the U.S. government. The risk remains high that elevated political uncertainty and further fiscal austerity will drag on the U.S. recovery. This would postpone Canada’s return to full employment as well, since nearly a quarter of Canadian output is sold in the U.S. Other risks include a potential hard landing in China, and extended stagnation in Europe or Japan.

As output growth slows, moreover, Canada has also grown more reliant on a few pivotal industries. Energy and commodity exports are the main growth drivers in the western provinces, and were responsible for roughly one-quarter of GDP growth nationally over the past year. The Alberta energy boom and Asian demand for natural resources powered broad-based job growth across the western provinces, but this dependence has also heightened the risks posed by volatile global commodity prices.

Financial services, including real estate, are another key growth driver, as is construction, despite mounting concerns that urban property prices have become overvalued. Affordability is clearly a concern, as is the potential balance sheet risk created by Canada’s unusually high ratio of household debt to disposable income. Low rental vacancy rates in the near term, and urbanization trends over the long term, will provide price support in expensive markets such as Vancouver and Toronto, however. Moreover, low interest rates have kept mortgage service costs low even as balances grow.

Risk of a housing bubble

Prudent lending practices and strict regulatory oversight greatly reduce the financial and economic contagion that would result from a crash in Canadian housing prices. Still, the importance of homebuying and construction in recent years poses a significant risk: Interest rates are already beginning to creep upward, which will likely cool demand and produce a real, if not a nominal, correction. As with commodity exports, a sudden reversal in the real estate market would undercut a major pillar of demand. For the time being, however, house price trends remain stable, and construction is surprisingly robust.

The Canadian dollar will continue to trade within a few cents of its U.S. counterpart over the medium run, stronger than its historical average in both nominal and real terms. The loonie has been propped up largely by three factors: strong commodity demand from emerging markets, the safety of Canada's financial markets, and the Bank of Canada's tight monetary policy relative to that of the U.S. The BoC has held short-term interest rates in Canada more than 75 basis points higher than equivalent U.S. rates for three years.

Stuck behind a strong currency

The strong loonie weighs on Canadian exporters, however, and poses a particular concern for manufacturing. It has also softened retail spending, as more Canadians make cross-border shopping trips to the U.S. This consumer tourism appears to be slowing, but the currency is keeping a lid on domestic prices, both by constraining producers' pricing power and by lowering import costs.

Inflation will remain weak in the near term, allowing the Bank of Canada to keep rates low in tandem with the U.S. Federal Reserve. The Fed has promised to hold its benchmark rate near zero until slack in the U.S. economy is significantly reduced, which likely means until mid-2015. Because of the slowdown in Canadian growth and the widening output gap, the Canadian economy will likely not return to full employment until early 2015, much later than the BoC projected a year ago.

Although Moody’s Analytics expects the central bank will still begin to raise rates before the Fed does, the timing will be closer than previously anticipated. As a result, the exchange rate will remain stable, with inflows of foreign capital supporting cheap and available domestic credit, at the expense of continued trade imbalances.

Both Moody's Analytics and the BoC expect growth to accelerate in 2014 and 2015 as the global economy recovers, bringing Canada back to full employment. The forecast hinges on two key assumptions, however. The first is that easy credit will support continued growth in household and business investment. High levels of household indebtedness, a cooling housing market, and profitability concerns among Canadian firms present significant downside risks to private domestic spending, and belt-tightening by federal and provincial governments will also add fiscal drag this year and next.

The second and more crucial assumption is that the strengthening global recovery will boost export demand, reducing Canada's reliance on domestic spending. Despite some positive signs, the trajectory of many emerging markets is becoming less certain. Stronger auto sales and an improving U.S. housing market will help many Canadian exporters, but the weight of fiscal austerity will prevent the U.S. from roaring back.

Commodity prices remain stable, buoyed in part by an increase in oil prices, but Canadian energy exports have flagged this year. The dependence of Canada's energy industry on the U.S. market also presents challenges. Longer-term prospects for growth in primary commodity exports hinge on substantial improvements in transportation infrastructure from the Prairies to the Atlantic and Pacific coasts.

Mark Hopkins is an Associate Director at Moody's Analytics.

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