Canada / Analyst Insights
Winter Is Coming: A Macroeconomic Update and Risk Outlook

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by Mario Ismailanji, Senior Analyst
Oct 02 2020

Dating back to 1961 when comparable economic data began to be recorded, never has the Canadian economy contracted at a sharper rate than now. US gross domestic product has declined at an annualized rate of 38.7% in the second quarter of 2020. This is opposed to the decline of 8.2% in the first quarter. The effects of the COVID-19 (coronavirus) pandemic have been pervasive, with most measures of economic activity showing unprecedented decline. Notably, quarterly growth was particularly poor despite actually showing signs of improvement in May and the following months due to the depth of the contraction in March and April. While improvement continued into the third quarter, the initial recovery was low-hanging fruit. The recovery has stagnated in recent weeks, as a spike in daily cases and stringent measures taken to slow the spread of the virus effectively inhibit a full and self-sustaining recovery.

Incomplete labour recovery

While the labour market shed an unprecedented number of jobs in April and May, the next few months set the stage for a rapid, though incomplete rebound. In April, total employment was 84.6% of what it was at the end of 2019, yet total employment as of August was only back up to 94.6% of year-end 2019. With July total employment having been at 93.3% of year-end 2019 levels, it is clear that the recovery in the labour market has slowed tremendously.

These job losses disproportionately hurt sectors that rely on interactions between people and other nonessential activity. For instance, accommodation and food services and retail trade were down to 50.0% and 77.1% of their pre-COVID employment levels, respectively. Notably, both sectors exhibited strong rebounds, with total employment in the two sectors at 77.1% and 93.4% of their pre-pandemic levels, respectively. Despite regaining over half of all the jobs lost during the lockdown, accommodation and food services will likely remain significantly below pre-pandemic levels for the foreseeable future, particularly in the indoor dining and entertainment spaces. Moreover, with winter fast approaching, the ability of some businesses to adapt and transition to outdoor activities will be significantly hampered. This will likely place further downward pressure on the labour market. Businesses are expected to continue to face extreme difficulties until the successful deployment of a vaccine. Therefore, full job recoveries in these business models are expected to lag other areas of the economy.

Household spending

Like many indicators, real personal consumption expenditure growth has varied wildly since the onset of the recession. After declining drastically in April, consumer spending has been on the upswing. However, quarterly household consumption expenditure was still down an annualized 43.0% in Q2 due to the depths of the decline at the start of the quarter. In contrast to other recessions, services spending has been the primary driver of consumption declines, with particularly sharp declines occurring in recreation, transportation and food services and accommodations. Services expenditure was down an annualized 51.8% in Q2, while goods expenditure was down an annualized 29.6%. The disproportionately sharp decline in these categories coincides with activities that remain restricted. Therefore, spending on services such as recreation and food services is expected to lag other services, particularly as colder months arrive and outdoor dining and activities become less viable.

Consumption trends have largely tracked changes in the personal savings rate. Consumer spending declined at its sharpest rate in Q2, while the household savings rate rose to 28.2%, significantly higher than the prior peak of 21.6% from the first quarter of 1982. Since then, the savings rate has declined, but remains significantly higher than pre-pandemic levels. While declines in the savings rate have begun to plateau, the initial release of pent-up demand boosted retail trade sales past pre-pandemic highs in June. It remains to be seen whether the uptrend will continue, as consumption growth is expected to decelerate in Q4. With household savings expected to remain elevated for years to come and a labour market that will likely take several years to reach near-full employment, a return to pre-pandemic levels of consumer spending is not expected until 2022.

Weak inflation

While consumption trends have been recovering, price levels have remained fairly stagnant. While an unprecedented level of stimulus from both monetary and fiscal policy helped prop up markets, other factors have countered what would typically be upward inflationary pressure. For instance, the economy remains sensitive to energy price fluctuations, and a collapse in local prices has kept inflation down. Furthermore, restrictions on economic activity remain strict in relation to measures taken by Canada’s southern neighbours, limiting money velocity.

Moving forward, the direction of price levels is uncertain due to the overwhelming uncertainty regarding the spread of coronavirus in the fourth quarter. Daily cases have already begun to surge in some regions, which may necessitate some reversal of economic reopenings. With some employment insurance benefits set to wind down in Q4, key support for household consumption may dissipate as well. These factors highlight the uncertainty facing the economy in the short term.

Building trends

As anticipated, there were similar pullbacks in construction spending in Q2, particularly at the start of the quarter amid stringent shelter-in-place orders. Residential construction fared worse than nonresidential construction, as unprecedented job losses lowered potential homeowners’ willingness and ability to pay for mortgages. This was exacerbated by mortgage regulations implemented by the Office of the Superintendent of Financial Institutions to limit excessive risk-taking. Overall, residential construction declined 48.8% in April, before bouncing back 61.9% and 12.1% in May and June, respectively.

Similar to nonresidential construction, weakness in the economy weighed on nonresidential construction. In fact, changes in behavior in response to the coronavirus pandemic pose difficult questions related to the working environment for services industries. With many industries having work-from-home capabilities, demand for structures such as office buildings is likely to be structurally lower than in previous years. Somewhat surprisingly, nonresidential construction declined less and rebounded more than residential construction. Nonresidential construction declined 38.5% in April before increasing 63.7% and 11.1% in May and June, respectively. Nonresidential spending in June surpassed pre-pandemic levels, while residential construction spending remained below. This is not expected to persist, as recovery in nonresidential construction tends to lag broader economic recovery. With an incomplete economic recovery likely until a vaccine is successfully deployed, an event unlikely to occur until mid-2021, nonresidential growth is expected to lag behind residential growth considerably.

Risk outlook

Quite clearly, 2020 has been an extremely challenging environment for many business models. While industry risk was distributed fairly normally across the economy in 2019, risk in 2020 has skewed highly negative. However, considering the depths of the contraction, insolvency filings have been lower than expected. A significant factor behind this has been an abundance of liquidity, as businesses have been able to borrow at relatively cheap rates and remain afloat. Closures of nonessential court activity and deferrals of debt payments have also provided support for businesses. The level of government support will likely continue to wane over the next few months, however, and so a reading of the tea leaves suggests a period of elevated solvency issues in the near future.

Exposure, however, differs depending on the sector at question. While the environment in 2020 has been particularly poor for the transportation and warehousing sector, the risk outlook is expected to improve rapidly. In fact, it is expected to be the second least risky sector in 2021 and least risky in 2022. Much of this is owed to the expectation of a significant rebound in tourism and trade, which the sector is sensitive to. Conversely, while the level of risk in the finance and insurance sector has been the fourth lowest in 2020, the risk outlook for the sector is expected to worsen in 2021, as a near-zero overnight rate target and an increase in both consumer and business bankruptcies are expected to weigh on the sector.

On the goods-producing side, while manufacturing tends to be the second most risky sector under normal economic conditions, the increase in sector risk in 2020 has been more muted than the increase in most service sectors. This is an expected outcome considering that the current recession was led by a much larger decline in services than goods spending. The depreciation of the loonie provided some support for Canadian manufacturers as well.

Looking forward, while the overall 2021 risk outlook is more favourable than in 2020, conditions are projected to remain riskier than in 2019. Successful vaccine deployment is not anticipated until mid-2021, which entails that some restrictions on economic activity will remain in effect. Moreover, residual effects from the recession are certain, as the labour market is likely to remain below pre-pandemic levels until 2022 at the earliest, with uncertainty remaining for a period of time. To that end, the risk outlook is forecast to improve significantly in 2022, reflecting the likelihood that the economy will be in the early expansion phase of the economic cycle.


Edited by Tafannum Rahman