Canada: Economic slowdown will be mild, not major

Following the Bank of Canada’s (BoC’s) more dovish tone in December and our view that the Federal Reserve will take a pause on tightening policy in the first quarter, Canada’s 1Y swap rate has been experiencing downward pressure. It currently (below) indicates there’s around a 60% chance of one full rate hike in the coming year, whereas back in October, markets had two full rate hikes priced in.

Following the Fed

We have projected a modest slowdown in the US this year for some time, but the unexpected arrival of the government shutdown suggests growth risks are moving to the downside (read our in-depth analysis of the shutdown here). This reinforces our view that the Federal Reserve will take a pause in the first quarter.

Canada tends to track its neighbour relatively closely when it comes to economic trends, hence why market expectations on the Federal Reserve’s policy decisions influence that of the BoC, and forms part of the explanation why Canada’s 1Y swap rate has shifted quite dramatically.

The commodity story

In the last few months of 2018 there was a sharp decline in world oil prices, particularly in Western Canada; the price differential to Western Texas Intermediate (WTI) reached US$50/bbl in mid-October. The latter can be largely attributed to delays in oil pipeline projects - namely TransCanada’s Keystone XL, where construction has been paused due to ongoing legal battles.

To alleviate the pressure on crude producers, OPEC+ agreed to curb its output – starting 1 January. Along with this came action in Alberta, where compulsory production cuts were also activated in January. As a result, oil prices have been lifted - Western Canada Select (WCS)/WTI price differential narrowed to below US$10/bb, and our commodities team sees this trend carrying on throughout 2019 (here’s 5 reasons why).

• The good: The support the Alberta production cuts have given to WCS led WCS/WTI to recently reach the narrowest price differential since 2009 (less than US$7/bbl).
• The bad: Reducing output isn’t all good news though. The cuts should leave Canada’s energy sector substantially weaker this year, which will likely result in a lower contribution to growth.
• And the ugly: Canada is a large net-exporter of oil, so this was a significant factor in our downward growth revision in 2019.

A slowdown is on the horizon, but it won’t come as a surprise – nor will it be extensive. That said, this year won’t go without turbulence, and in light of the risk environment, we’ve recently revised our annual 2019 growth forecast down from 2.1% to 1.8%. Here are a few more reasons why…

Based on current data, business momentum is fragile with specific focus on two key factors: Business spending in the third quarter of 2018 disappointed considerably, and the long-awaited pick-up in wage growth is yet to arrive; it stayed at 1.5% YoY in December for full-time workers.

Still, we are optimistic about 2019. In the BoC’s most recent Business Outlook Survey, the investment indicator remained positive (despite receding slightly) due to expectations that sufficient demand will be sustained. Firms also reported that they will be pushing wages higher as a strategy to attract workers, as labour-related production constraints were frequently cited as an issue.

Higher rates and tighter mortgage rules are likely to see further declines in housing resales. This is also likely to feed back into more muted residential investment given excess supply issues, which will weigh on growth. Signs of stabilisation already in the housing market will be a mild concern for policymakers.

Household activity could be under pressure as home owners start to see one of their largest financial assets lose value

The BoC has indicated it wants to take the policy rate to its neutral range (2.5%-3%, based on-at target inflation), to achieve the inflation target. However, the lagged effect of rate hikes - the central bank's workhorse model states it takes around six quarters until the full impact of an increase is felt- suggests the housing market correction is far from over. As a result, household activity could be under pressure, as homeowners start to see one of their largest financial assets lose value.