Canada Outlook: Taking the Lead

View the Moody's Economy.com Canada Forecast.

• Canada's recovery is well under way, and a return to potential rates of GDP growth is expected for 2010.
• Housing is recovering robustly, but beyond the current surge, sustainability is in doubt, given high consumer indebtedness and deteriorating affordability.
• The job market will recover faster in Canada than in the U.S. as business optimism and relatively well functioning credit markets facilitate hiring.
• The Bank of Canada will begin to tighten monetary policy in the third quarter of 2010, ahead of the U.S. Federal Reserve. However, inflation pressures will remain subdued for most of the year.

Canada's economy emerged from recession in unspectacular fashion during the third quarter of 2009, posting only a 0.4% gain. A strong pull from net trade offset the robust domestic performance; final demand grew 4.7%. Monetary policy has been effective at propping up the housing market; since March, sales and prices of existing homes have soared dramatically, such that in December, existing-home sales were at an all-time high. Buoyed by the availability of credit and rising net worth, consumer spending has also recovered since last summer.

Business optimism has improved sharply, and investment in machinery and equipment has benefited from a high Canadian dollar, since a significant portion of machinery and equipment used by the country's businesses is imported. Net trade was a huge drag in the third quarter, but the evidence for the fourth quarter points to a hefty contribution from net trade to growth, as rebounding U.S. industrial production raises demand for commodities. As such, GDP is on track to advance a robust 4.1% in the fourth quarter. The outlook for 2010 has improved, with growth now expected to return to potential. Moody's Economy.com expects Canada's GDP to grow 2.6% in 2010 and 3.7% in 2011.

Housing will show moderation

Consumers have been central to Canada's recovery. With mortgage rates near record lows, credit still flowing, and major improvements in affordability at the beginning of the year, homebuyers have seized the opportunity to invest massively in real estate. Canada's housing recovery has thus gotten off to an early start; sales-to-listings ratios have increased in nearly every major metro area, indicating tighter housing markets across the country. The result has been a robust recovery in existing-home prices (up 11% y/y on a fixed-weight metro average basis).

In 2010, we expect housing to remain in sound shape, although two factors argue for some moderation ahead. First, Canadian consumers appear overleveraged. With debt-to-income ratios reaching 1.45 and bankruptcies on the rise, growth in outstanding credit will inevitably decline, weighing on consumer spending. As rates begin to trend up by the end of 2010 and into 2011, the ensuing increase in household debt burdens represents a non-negligible risk to domestic growth.

Second, pent-up housing demand is nearly exhausted, and the market is quickly turning less affordable. A key positive will nonetheless be the resurgence in homebuilding. Housing starts rebounded in the fourth quarter of 2009 to levels equivalent to the rate of household formation (about 175,000 per year). Moody's Economy.com expects the housing starts recovery to carry through 2010. Residential real estate investment will thus turn back into a positive contributor to GDP in 2010, growing 4.5%, after the 8% decline of 2009.

More jobs than the U.S.

The Canadian job market is looking better than its U.S. counterpart. After a spectacular gain of nearly 80,000 jobs in November, employment barely moved in December. Even this represented an improvement over most of 2009, when occasional months of job gains were usually followed by huge losses in succeeding months. Meanwhile, the U.S. shed about 70,000 jobs per month on average during the last three months of 2009, a 0.6% monthly decline in annualized terms. By contrast, Canada added 11,000 jobs per month on average between October and December, for a 0.9% average annualized monthly gain.

A key to Canada's quicker recovery is its better functioning credit market. The U.S. is still in a credit crunch, as securitization markets remain frozen. Canada's financial system has remained solid throughout the downturn. Although growth in business credit has stagnated recently, the Canadian situation is benign compared with the contraction in commercial and industrial loans outstanding in the U.S. The Bank of Canada's latest business outlook survey points to strong hiring intentions for 2010, and more businesses now feel credit conditions have eased, as reported by the bank's senior loan officer survey for the fourth quarter.

As such, there appears less downside risk in Canada's labor market outlook than in the U.S. In addition to easier credit conditions, the robust housing market recovery is boosting household net worth, leading to a positive wealth effect; consumer spending growth exceeded expectations in the second and third quarters of 2009, averaging 2.4% annualized growth. This compares with only a 1% annualized gain in consumer spending in the U.S. on average for these two quarters. Moreover, a significant portion of U.S. growth was due to the cash for clunkers program, which was not implemented in Canada.

We foresee stronger job growth in Canada in 2010, with employment growing 0.7%. The unemployment rate, at 8.5%, will end 2010 within the 8% to 8.5% range.

During the Great Recession, Canadian companies drastically cut spending on structures and machinery and equipment. We estimate that total private fixed capital formation declined more than 13% in 2009, the worst contraction since 1982. While residential investment is estimated to have fallen 8%, declines in nonresidential structures (12%) and machinery and equipment (18%) were enormous drags on private investment in 2009.

Such cuts were justified, however. Despite massive reductions in capacity, the capacity utilization rate fell to a new record low of 67.5% in the third quarter. As the Canadian economy exited recession last summer, industrial production had fallen 15% on a year-ago basis. Despite an acceleration in inventory reduction since last summer, inventory-to-sales ratios remained above normal. Thus, the cutbacks were simply a matter of survival for Canadian businesses. In the first quarter of 2009, operating profits for nonfinancial firms were down more than 50% from the fourth quarter of 2008 on an annualized basis.

Through the first half of 2009, businesses adjusted and reorganized while waiting for the global recovery to take hold. In the third quarter, operating profits were up again after three quarters in decline. More dramatically, net profits, which take into account cuts to payrolls, were back up to 22.5% of GDP in the third quarter, near prerecession levels, after dipping to 12% in the first quarter. (Nonfinancial net profits as a share of GDP peaked at 28% in the first quarter of 2006).

The outlook for Canadian capital spending is encouraging. The Bank of Canada's business outlook survey for the fourth quarter of 2009 showed near-record optimism in the business community; 70% of executives expect sales to pick up within the next 12 months, while only 21% anticipate a slowdown. The 49-percentage point gap is the widest since the beginning of the survey in 1998. While doing better than last year will be fairly easy, the sharp change in business sentiment is nonetheless promising.

In addition, the bank's loan officer survey reveals that lending conditions for businesses are easing for the first time in more than two years. This suggests that, along with lower corporate bond spreads and massive amounts of liquidity favoring initial public offerings, the pieces are in place for a sustained recovery in business investment in 2010. This recovery began last summer; in the third quarter, machinery and equipment investment surprised with an 8.9% annualized gain.

In 2010, we expect machinery and equipment investment to grow 2.1%, as industries continue to take advantage of a strong currency to import more equipment from abroad. Investment in structures is not expected to pick up until 2011, because of continued weakness in the commercial component. Some delayed exploration projects in Alberta's tar sands will be restarted, given favorable energy prices and rising global demand. The return of business investment will be a positive for Canada's job market; we expect the unemployment rate to peak at 8.6% in the first quarter of the year and employers to add about 120,000 positions on net.

Rates outlook

We expect the Bank of Canada to begin lifting rates ahead of the Federal Reserve, since Canada's domestic economy and job market seem to be a step ahead of those of the U.S. In addition, the central bank faces a clearer exit path than the Fed, the European Central Bank, or the Bank of England, having ventured less deeply into unconventional monetary policy.

Despite the need to act prudently to prevent a shock to the currency, inflation targeting remains the main focus of central bank policy. With the economy expected to fare well in the first half of 2010, inflation expectations could rise, in which case the BoC will respond by hiking rates in the third quarter regardless of where Fed policy stands at that point. Although that could further push up the Canadian dollar, pressures on the currency may be offset by a resurgence in the U.S. dollar that we expect to begin in the second half of 2010. Our baseline forecast assumes the Canadian dollar will approach $1/$1 parity with the greenback by the end of this year but that the U.S. dollar's recovery will prevent this threshold from being surpassed on a sustained basis.

Concerns about the impact on exports of earlier rate hikes may be overblown. At this stage of the cycle, the global recovery will likely be a more powerful driver than currency fluctuations, provided that the latter do not deviate dramatically from expectations. In the last months of 2009, demand for Canadian commodities strengthened, and net trade looks to have contributed strongly to GDP in the fourth quarter, despite a strong loonie. We view this as the central theme for Canadian exports in 2010, as recovering global industrial production will drive commodity prices and volumes.