The Year Ahead

How the world will weigh on Canada’s economy in 2013

The Globe and Mail

Trade, housing and the labour market will help shape Canada’s economy in 2013 – but how they’ll do that is yet to be seen. (DARRYL DYCK For The Globe and Mail)

It was a bumpy year for the Canadian economy, as concern over European debt and the U.S. “fiscal cliff” cast a shadow over growth. Canada’s economy hit a soft patch in the second half of the year, and see-sawing trends in job creation weren’t enough to budge the unemployment rate much. So what will 2013 bring? Here are two economists – an optimist and a pessimist – on what the coming year heralds for Canada.

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What will be the main factors generating growth – and what are the chief risks?

Craig Wright, chief economist at the Royal Bank of Canada, Toronto, predicts the Canadian economy growing about 2.4 per cent next year.

As the cloud of economic uncertainty lifts in Europe and the U.S., we expect economic activity in Canada to strengthen modestly through 2013. Support for economic growth will be relatively balanced, with contributions from consumer spending, investment (outside of residential real estate) and exports. This support will be offset by weakness in housing-related activity and a slowdown in government spending. One key factor supporting growth is the relative health of corporate balance sheets.

Risks to the outlook are roughly balanced. On the downside, any back-tracking by policy makers in Europe or the U.S. will continue to hold down confidence and the economy – particularly given the consumer deleveraging needed in Canada. On the upside, monetary conditions are extremely accomodative and could translate to an acceleration in growth as confidence in the global economy improves.

Joshua Dennerlein, U.S. and Canada economist with Bank of America Merrill Lynch in New York, sees the economy growing by about 1.4 per cent next year.

Consumer and business investment have been the primary drivers of the Canadian economy since the recession ended. We expect that to continue in 2013, although we look for weak foreign demand and a slowing housing market to weigh on growth. Domestically, the biggest risk is high household leverage ratios, which increase risks to the financial system and can amplify shocks. External risks to growth include the resolution of the U.S. fiscal cliff and the European sovereign debt crisis.

Much of Canada’s outlook for next year rests on the outcome of talks over the U.S. fiscal cliff. What is your base-case scenario for how those events will affect Canada?

CW: Our base case for the U.S. economy is one of growth continuing at the 2 per cent to 2.5 per cent pace. Implicit in this forecast is a view of a fiscal curb rather than a fiscal cliff – meaning that support from fiscal policy is expected to be a step lower, rather than falling off a cliff.

The restraint should take away a little over a percentage point from economic growth in 2013, consistent with a gradual path towards fiscal consolidation. This restraint will moderate economic activity in the U.S. and act as a headwind for Canadian exports. A rough rule of thumb: every percentage point reduction in the U.S. growth rate translates into about 1/2 of a point hit to Canadian economic activity.

JD: Our U.S. team expects a fiscal tightening of 2 percentage points of GDP to weigh on U.S. growth. Since Canada’s economy is highly sensitive to the U.S., we expect this weakness to spill over the border primarily through trade and confidence channels.

Exports have been hampered by uneven global demand and persistent strength of the Canadian dollar. How do you think trade will fair next year?

CW: Canadian exports rose in 2012 despite headwinds from the sluggish U.S. recovery and the strength of the Canadian dollar. While we expect similar growth in the U.S. in 2013, the composition of growth should prove to be more favourable to Canadian exports. The sectors that Canada exports to – autos, housing and equipment and software – are where we are looking for stronger growth over the course of 2013. This suggests that the support from trade will turn in to an addition to overall activity in Canada.

JD: Trade is unlikely to return as the engine of the Canadian economy in 2013. The biggest headwind remains weak foreign demand, especially from the U.S., Canada’s largest trading partner. The strong Canadian dollar and poor productivity growth of the last several years should persist in 2013 as well.

Our jobless rate is 7.2 per cent. How will the labour market fare in 2013?

CW: The Canadian labour market has tracked better than expected with the majority of jobs being full-time and private sector, while unemployment has fallen below its long-run average of 7.8 per cent. Moving through 2013 we expect monthly employment gains to average around 20,000. New entrants into the labour market will limit improvement in the unemployment rate from here, however, easing to 7 per cent by the end of the year.

JD: Labour market healing will likely stall for most of the first half as the U.S. fiscal cliff induced slowdown spills over into Canada. We expect the unemployment rate to rise over the next several months as weak growth stunts hiring. We forecast growth to pick up beginning in the second half of the year, helping to reverse much of the earlier rise in the unemployment rate; however, unemployment is likely to remain at or above 7.2 per cent at the of the end of 2013.

The Bank of Canada still says it plans on hiking interest rates “over time.” When do you think that will happen, and how quickly will they increase?

CW: The Bank of Canada’s ‘low for now, but not low forever’ policy stance is likely to remain in place over the early part of next year. As downside risks continue to fade through the year, growth will move slightly above its speed limit, driving the economy toward capacity. We expect the overnight rate will hit 1.5 per cent by the fourth quarter of 2013.

JD: Our base case assumes one 25-basis-point hike in the Bank’s overnight interest rate in the fourth quarter, but in our view, risks to this forecast skew toward an even longer on-hold period, or even a rate cut. Our forecast is highly dependent on global developments such as the resolution of the U.S. fiscal cliff. A bad outcome could push Canada back into recession, requiring additional easing. A better-than-expected outcome would result in stronger Canadian growth and an earlier rate hike.

Who do you think will replace Mark Carney?

CW: I am certain the Bank of Canada’s Board of Directors will find a very suitable candidate to replace Governor Carney. I am not a betting person but if I was, I would put my money on Senior Deputy Governor Tiff Macklem. … He is ideal for the job given his education, skills, deep understanding of the Canadian economy and monetary policy, and exceptional ability to communicate.

JD: We do not have any particular insight on who will replace Carney, but we expect his departure is unlikely to materially impact the course of monetary policy in Canada. First, the Bank of Canada is mandated to target inflation of 2 per cent, so the BoC’s credibility is unlikely to change with his departure. Second, monetary policy decisions at the BoC are made through consensus by the governing council, so a new governor has limited power to dramatically change course.

Record household debt is still seen as the biggest domestic threat to the Canadian economy. How do you think household finances will fare next year?

CW: The oft-mentioned debt-to-income ratio continues to set record highs, though the cost of servicing debt is near record lows. The level of the ratio itself doesn’t cause a crisis, but it does leave the economy vulnerable to a shock. The shocks one has to be particularly worried about include: a deterioration in the labour market, a marked decline in housing, or a spike in interest rates. Barring any of these shocks, we expect continued slowing in the pace of debt accumulation.

JD: We expect the household debt-to-income ratio will continue to rise in 2013. With mortgage interest rates at all-time lows, more households are choosing to become homeowners. As interest rates normalize and tighter mortgage rules kick in, marginal home buyers will be priced out and there will be downward pressure on the household leverage ratio. In our opinion, the rise in household leverage is largely sustainable because households have not had to strain their budgets to support the rise in debt. We expect household finances will weather the weakness in the first half of the year, but the risk remains of a bad U.S. fiscal cliff outcome dragging Canada back into recession.

Canada’s housing market is already cooling after a boom in recent years. What’s in store for activity and prices next year?

CW: Our view of the housing market is one of a cooling, rather than any sort of U.S.-style crash. Our housing affordability measures are pointing to some signs of strain which, alongside the numerous rounds of regulatory tightening, suggests a softer trend in housing as we move through 2013. We expect home resales to decline by 2.5 per cent in 2013 following a flat trend in 2012. Prices are also expected to decline, dropping 1.5 per cent following a gain of nearly 5 per cent in 2012.

JD: The odds are pretty high that the Canadian housing market slows further. We expect home prices to be down 5 per cent nationally and housing starts to slow to their long run trend of 180,000 over the next 12 months. In our opinion, the slowdown in housing starts will be focused in the multi-family segment, where the majority of recent construction activity has been.

Comments have been condensed and edited.

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