2011 Economic Outlook
After the sharp bounce back from recession, Canada’s economy lost some of its swagger expanding at a sluggish 2.3 per cent annual rate in the second quarter of 2010 and a meager 1.0 per cent in the third quarter. To be sure, recessions that are associated with financial crises or that are highly synchronized have historically been followed by weak recoveries. The most recent recession was associated with both, creating a perfect storm.
So what does 2011 hold for Canada’s economy? There is general consensus that the pace of growth will be subdued. Canadian output growth is expected to fall below 2.5 per cent, following an estimated 2.9 per cent gain in 2010. Strong headwinds are buffeting the economy.
On the home front, Canadian households are expected to spend more prudently as they focus on repairing their finances. They borrowed heavily during the recession and recovery phase racking up unprecedented debt levels. A softer employment picture and tepid wage gains will also add to consumer caution.
Canada’s red-hot housing market is also cooling. Many home sales were pushed forward in advance of new tighter mortgage insurance rules, anticipated interest rate hikes and the introduction of the Harmonized Sales Tax (HST) in Ontario and British Columbia. With housing demand retreating, housing starts receded from their April 2010 peak but should stabilize in 2011, albeit at a lower annual average than 2010.
Fiscal stimulus will also wind down and governments will begin to focus on constraining annual program spending growth to balance their books by mid-decade. Government spending will make a considerably smaller contribution to overall real GDP growth in 2011.
On the external front, sluggish U.S. demand and the high Canadian dollar will likely constrain exports. The rate of growth in imports should cool reflecting the expected moderation in Canadian household spending. Nonetheless, with the level of imports remaining above exports, the trade balance is expected to remain in deficit.
Business investment is the bright spot in the outlook and will be a major driver of economic growth as firms focus on enhancing productivity and competitiveness. Low borrowing costs, high corporate cash balances, the elimination of tariffs on a range of machinery and equipment (M&E) and the accelerated capital cost allowance rate for new manufacturing and processing M&E acquired in 2011 will support increased capital investment. The high Canadian dollar will also stimulate purchases as most of the cutting-edge M&E employed in Canada is imported, primarily from the United States.
Overall, Canada’s economy is projected to grow a modest 2.4 per cent in 2011. Although some improvement is expected in 2012, it too will likely be a year of sub-par growth, with real GDP projected to expand about 2.7 per cent.
All provincial economies are projected to expand in 2011 led by Canada’s resource-based provinces in the West and East (i.e. British Columbia, Alberta, Saskatchewan and Newfoundland & Labrador). Firm commodity prices and resource-sector investments are anticipated to push real GDP growth above the nation average in these provinces.
Manitoba’s economy is also expected to post real GDP growth above the national average. It has a well diversified economy. Its agriculture and mining sectors provide good long-term growth prospects. Large-scale investments by Manitoba Hydro and its partners will continue to provide economic support.
For manufacturing-intensive provinces (Ontario, Quebec and New Brunswick), the strong Canadian dollar and sluggish demand in the United States will temper production and exports. Real GDP growth of slightly below the national average is projected for these provinces.
Economic growth in Nova Scotia and Prince Edward Island will be on the soft side reflecting weak investment spending and slower global growth that will weigh on exports.
Canadian dollar breaking through parity
On November 3rd, the U.S. Federal Reserve announced a second round of quantitative easing (dubbed QE2) primarily targeted at lowering mid-term real interest rates (i.e. 5 ½ to 10-year yields) to spur borrowing and spending to stimulate the U.S. economy.
Wider Canada-U.S. interest rate differentials should result in an increase in foreign investment flows to Canada, putting upward pressure on the Canadian dollar.
Quantitative easing also raises inflation expectations and, in turn, commodity prices because commodities are considered an effective hedge against inflation. The Canadian dollar is also likely to receive a lift through this channel because Canada is a large net exporter of key commodities (like crude oil, nickel, and potash).
Once QE2 ends (by the end of the second quarter 2011), the Bank of Canada is expected to resume its rate hikes. The U.S. Federal Reserve is unlikely to increase rates before early 2012. Widening interest rate spreads should draw more capital north of the border, lifting and supporting the loonie.
On the other side of the coin, European sovereign credit concerns are positive for the U.S. dollar (which is perceived as a safe-haven currency) and negative for the Canadian dollar. Canada’s relatively strong fundamentals—an enviable fiscal position, a strong banking system, widening interest rate differentials and favourable commodity prices—will save the loonie from excessive downside pressures. These forces should hold the Canadian dollar near and slightly above parity in 2011 and 2012.
Bank of Canada is expected to remain on the sidelines until the summer of 2011
The Bank of Canada raised rates by a quarter of a percentage point on three occasions in 2010 (June 1st, July 20th and September 8th) bringing the overnight rate to 1.00 per cent. Since the last increase, Canada’s central bank has moved to the sidelines citing slower domestic growth, the uncertain global outlook and below target inflation.
By the summer of 2011, the global economy should be on a more stable footing and U.S. growth prospects moderately brighter. Canada’s central bank is expected to resume increasing rates in the third quarter of 2011, likely in July, bringing the overnight target rate to 2.00 per cent per cent by year-end 2011 and 3.00 per cent by year-end 2012.
Risks to the outlook
These are very uncertain times for the global economy and risks abound.
First, the sovereign debt situation of some euro zone countries could have adverse implications for financial market stability and potentially derail the global recovery. European banks hold significant government debt, increasing the risk of a liquidity crisis in the banking system if a sovereign nation defaults.
Second, while G20 leaders have agreed to refrain from competitive currency devaluations, no firm targets or timetables have been agreed upon. Disagreements about exchange-rate policies may threaten economic stability and trade, stoke protectionism and put the recovery at risk.
A weaker external environment coupled with the possibility of a stronger than projected appreciation in the Canadian dollar would act as a significant drag on exports and curtain economic growth more than anticipated.
On the domestic front, the major risk relates to high household debt levels. Canadian households—especially low-income Canadians—are more vulnerable to rising interest rates, job loss and asset price declines than in the past.
Not all of the risks to the outlook are on the downside. The recovery in the United States may be stronger than anticipated resulting in higher demand for Canadian exports. Additionally, borrowing by Canadian households may continue to exceed income growth providing a greater impetus to domestic demand than expected.
Tina Kremmidas is the Chief Economist of the Canadian Chamber of Commerce