After spending the past month traversing the country and meeting with business leaders, Peter Hall has come away with two distinct impressions that don’t quite mesh with each other.
First, business has never been better.
Second, everyone is uneasy.
“What they’re nervous about is NAFTA,” said Mr. Hall, the chief economist at Export Development Canada, the government’s export credit agency. “A lot of concern about protectionism and a lot of concern about Canadian competitiveness.
“But people at the same time were saying their order books are full, they can’t keep up,” he said. “They’re saying, ‘We’re looking at the future and we’re quite worried about that. But the present is going really well.’”
This is the curious crossroad at which the Canadian economy finds itself this Canada Day weekend. After enjoying a year of successes, the economy is running at full capacity, jobs are plentiful, wages are surging, and exports are booming. Nevertheless, a cloud of uncertainty is darkening the outlook for next year amid an eroding trade relationship with the United States, pressing questions about Canada’s tax competitiveness, rising interest rates and heavy consumer debt loads.
“There’s a huge amount of concern about the future direction of the economy,” said Matthew Stewart, director of national forecasting at the Conference Board of Canada.
The unease seems at odds with the economic success story that Canada has put together since it celebrated its 150th birthday last July 1. Frankly, the country celebrates its 151st on a high.
Real gross domestic product climbed 3 per cent in 2017, by far the strongest growth in the G7. What’s more, it was widely shared: Every provincial economy expanded, as did 18 of the country’s 20 major industrial sectors. Exports are at a record high and have been expanding at a blistering annualized pace of more than 20 per cent since January. Business investment in machinery and equipment is up almost 11 per cent year over year.
The country has added 240,000 net new jobs in the past 12 months; the unemployment rate, which was 6.5 per cent a year ago, is a slim 5.8 per cent today, the lowest in more than a decade. And this tightening of the labour market has ignited wage growth: Average hourly pay was up almost 4 per cent year over year in May, a nine-year high.
But all that good fortune has changed the complexion of the Canadian economy. A year ago, it was operating well below its employment and output potential; today, it is producing at or very near full capacity. Companies are increasingly constrained by shortages of skilled labour. The lack of economic slack has fuelled inflationary pressures and prompted the Bank of Canada to raise interest rates three times since last July. The bank’s key rate, 1.25 per cent, is more than double what it was this time last year, lifting lending and mortgage rates with it and moving the goal posts meaningfully for borrowers – no small thing for a country already saddled with record levels of household debt.
Meanwhile, a new set of worries has moved to the forefront of the Canadian economic discussion. Chief among them are the increasingly acrimonious trade actions and rhetoric coming out of the United States, with Canada now a prime target – raising considerable uncertainty about Canada’s access to its biggest export market. U.S. corporate tax reforms have also created a new urgency for policy changes to address Canada’s competitiveness issues. And it’s still unclear how hard Ottawa’s tougher mortgage regulations, introduced in January, will hit the housing market, which has been an important driver of economic growth for years.
“There’s a huge amount of concern about the future direction of the economy.”
— Matthew Stewart, director of national forecasting at the Conference Board of Canada
These issues have made forecasting the future of the Canadian economy particularly cloudy, even for the experts and their sophisticated systems for modelling growth.
“There is always a degree of uncertainty when using economic models, but these days there is a litany of things we simply do not know,” Bank of Canada Governor Stephen Poloz said in a speech in Victoria last week.
That sense of the unknown has begun to weigh on public sentiment. The Conference Board of Canada reported last week that its June consumer confidence index slumped to its weakest level in four months, while noting that consumer confidence has generally eroded since the end of last year.
Still, putting those readings into a longer-term perspective, the index is still hovering near 10-year highs – evidence that the country’s high employment levels and rising wages continue to underpin the bigger-picture mood.
“Where we’ve seen a bit of a weakening [in the confidence index] is around future job prospects,” Mr. Stewart said. “I think it’s around concern around NAFTA and the impact of those negotiations on the Canadian economy.”
There’s also a homegrown, self-inflicted component to the sense that Canada may be losing some of its economic mojo. Tougher mortgage regulations and higher interest rates have combined to cool Canada’s hottest housing markets, crimping growth in personal wealth. Household net worth dipped 0.2 per cent in the first quarter, its first decline since 2015. Given net worth’s close historical relationship with consumer confidence and willingness to spend – the so-called “wealth effect” – this slowdown is bound to have an impact on Canadians’ personal sense of economic well-being.
Consider, too, that the newest generation of borrowers has never lived in an environment of rising interest rates; for them, the past year represented uncharted territory. After a decade of extremely low rates that spurred unbridled borrowing, Canada has entered this upward phase in the rate cycle with unprecedented consumer debt. How Canadians will deal with this shift of the playing field may be the biggest question hanging over the economy over the next couple of years.
The Bank of Canada has pledged to stick to “a gradual approach” to raising rates; it has repeatedly expressed its concern that, given households’ heightened debts, Canadians will feel the impact of rate increases more acutely than in typical past cycles. Still, predicting how this heightened sensitivity will play out in consumer behaviour, and how that will weigh on the broader economy, is little more than a semi-educated guess – a black hole at the centre of Canadian economic forecasts.
“The consumer is 60 per cent of our economy,” Mr. Hall said. “As we’re looking 12 months out, some of the interest rate increases that we’ve seen to date are going to start to bite. It will be interesting to see how it actually affects our consumer and domestic economy side of things.”
What is clearer to the central bank and other observers is that the rising uncertainty, especially on the trade front, is causing businesses to hesitate on major capital investments – even as many sectors are in dire need of new capacity to meet high and still-growing demand.
“There seems to be a significant amount of holding back of investment money,” Mr. Hall said. “There’s a need to invest. All of these orders are putting pressure on capacity. But folks are saying, ‘If we don’t know what the trade architecture is going to be, we can’t make our next big play.’”
The Bank of Canada’s quarterly Business Outlook Survey, released Friday, shows that although companies’ spending plans on machinery and equipment over the next 12 months “remain buoyant,” the number of firms planning to increase their spending has declined for the second straight quarter. Notably, the survey indicated that some exporters are actually talking about reducing their spending.
And economists note that while businesses have shown a willingness to upgrade their machinery and equipment, they are resisting the higher-cost, longer-term commitments – building new plants that will substantially and permanently expand capacity.
“There’s no lack of money – they seem to have it on the bottom line,” Mr. Hall said. “The economy has the capacity to create capacity, but it doesn’t have the willingness at the moment.”
Without more investment in new capacity, economists say, the economy will be hemmed in. That constraint is a key reason why economic growth is expected to slow from last year’s brisk pace, likely drifting back into the middle of the pack among G7 countries.
“I think firms are going to be forced to increase investment ... their order books are full and they’re running at full capacity,” Mr. Stewart said. “But if we don’t see a continued pick-up in investment, then we’re going to see much slower growth in the next couple of years.”
David Parkinson