Economic Research:

Canadas Economic Recovery Is Likely To Keep Sputtering In 2014

Global Fixed Income: Robert Palombi, Managing Director, Toronto (1) 416-507-2529; robert.palombi@standardandpoors.com

Table Of Contents
Employment Growth Is Still Slow Consumers Are Saving More, But They Still Owe A Lot Income Gains Continue To Be Small Interest Rates Are Likely To Remain Low Governments Continue Their Battles Against Deficits The Real Estate Market Shows Signs Of Cooling More Subpar Growth Ahead Is Likely

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Economic Research:

Canadas Economic Recovery Is Likely To Keep Sputtering In 2014

Canada is shuffling along the slow growth path it's been on for more than a year. Since the beginning of 2012, a number of factors have undercut the economy's momentum, including slower growth in consumer spending, business investment, residential construction, and exports. In that time, Canada's federal and provincial governments have also been introducing measures to restore balanced budgetary positions. And with the government sector no longer spending as freely as it was in the early phase of the recovery, the economy isn't getting much uplift either from fiscal policy. As such, average annualized real GDP growth of just 1.3% since the beginning of 2012 is notably weaker than increases in the 3.1% range from the end of 2009 to 2011. The economy's growth trajectory to date has been broadly in line with the baseline assumptions Standard & Poor's Ratings Services made earlier in the year. As such, we haven't made a substantial revision to our outlook for Canada. The country's sluggish growth is affecting labor market conditions and consumers' purchasing power. We believe interest rates will continue at their historic lows through at least 2014. As well, we expect governments at all levels to continue reining in their deficits and believe the housing market is in for a cool-down. Overview Canada's economic performance has largely been in line with our expectations from earlier this year. We expect the slow recovery to continue for Canada. We believe the employment picture will remain murky, with debt-saddled consumers saving more money.

Employment Growth Is Still Slow

We expect real GDP growth to average 1.7% in 2013, 2.5% in 2014, and 2.9% in 2015 (see table). Against this backdrop, we think labor market improvements will continue to be slow, so we see Canada's unemployment rate in 2014 averaging 7%, little changed from 7.1% in 2013. Canada Forecast Summary
(%) Annual real GDP growth Unemployment rate Annual CPI inflation Annual average exchange rate (per U.S. dollar) Short-term annual interest rate (%, nominal) Long-term annual interest rate (%, nominal) Annual merchandise trade balance (% of nominal GDP) 2009 (2.7) 8.3 0.3 2010 3.4 8.0 1.8 2011 2.5 7.5 2.9 2012 2013e 1.7 7.3 1.5 1.7 7.1 1.1 2014f 2.5 7.0 1.8 2015f 2.9 6.6 2.0

1.1415 1.0301 0.9893 0.9994 1.0234 1.0500 1.0300 0.3 3.3 (0.4) 0.6 3.2 (0.6) 0.9 2.8 0.0 1.0 1.9 (0.7) 1.0 2.3 (0.3) 1.1 2.7 0.2 2.1 3.3 0.4

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Economic Research: Canadas Economic Recovery Is Likely To Keep Sputtering In 2014

Canada Forecast Summary (cont.)

Annual fiscal balance (% of nominal GDP) e--Estimate. f--Forecast. (4.5) (4.9) (3.7) (3.4) (2.4) (1.3) (0.6)

Employment has been expanding at an average monthly rate of about 21,000 workers since the beginning of 2012, similar to the pace from 2009-2011. But there's been a shift in hiring practices, with part-time work becoming more readily available at the expense of full-time employment growth, which has slowed. Moreover, because the pace of new hiring is barely keeping up with the growing number of job seekers entering the labor force, Canada's national unemployment rate still has a long way to go before returning to prerecession lows of about 6%. Nearly 600,000 workers have been added to the ranks of employed Canadians since the end of 2008. With this 3.5% increase in employment above its prerecession peak, some measures of household financial distress are easing (see chart 1). For instance, by June 2013, the number of residential mortgage delinquencies (mortgages in arrears 90 days or more) declined nearly 30% from the recession's high mark.
Chart 1

There's also been little change in the duration of unemployment -- the average 18-week period that laid-off workers are unemployed remains well above the prerecession average of about 13 weeks. This suggests underemployment is still

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Economic Research: Canadas Economic Recovery Is Likely To Keep Sputtering In 2014

constraining some household budgets.

Consumers Are Saving More, But They Still Owe A Lot

With the employment picture still cloudy, we think Canadian consumers are going to remain cautious with their spending. The slower pace of household debt accumulation reflects the shifting consumer attitudes. Annualized growth in residential mortgage credit (5.1%) is now back into the mid-single-digit range. This is the slowest pace since 2001, when the prolonged upturn in housing demand was just in its infancy. The pace of credit card borrowing is similarly ebbing and by the middle of 2013, annualized increases were running in the low single-digits (2.2%) after declining from a high of about 10% at the end 2009. Consumers are also saving more now. Since the beginning of 2012, Canadians have been saving about 5.1% of their disposable income, up from an average of 4.5% from the end of 2009 to 2011. When consumers were spending more freely, for instance in the 12 months leading up to the recession at the end of 2008, the personal savings rate averaged only 3.3%. So consumers are saving more at a time when historically low interest rates are constraining incentives to save. The greater emphasis on saving, therefore, might indicate that consumers are taking a closer look at how to reduce the debt burdens they've accumulated through increased borrowing in the past. By the middle of 2013, Canadian household debt reached a new high of 163.4% of disposable income, the result of income growth easing more quickly than the slowdown in debt accumulation because low interest rates have continued to support debt-service affordability. At this high level of indebtedness, however, we think consumers' willingness to keep accumulating debt will increasingly depend on their perceptions about job security and income growth -- and the potential for higher interest rates to undermine debt-service affordability. Consumer confidence has been steadily improving since 2011 but remains below prerecession highs and might therefore reflect Canadians' tentative willingness to borrow. U.S. households, in contrast, have been reducing their financial leverage since 2009 and their indebtedness has declined to 136.5% of disposable income from a high of 163.8% at the end of 2007 (see chart 2). Similarly measured, Canada's debt ratio drops to 151.8% from 163.4%, but even so is about 15 percentage points higher. As such, we think there's greater headroom for a pick-up in U.S. consumer borrowing in the coming year while Canada's consumers focus more on paying down debt. At the beginning of 2013, the U.S. debt ratio increased for the first time since 2008 -the gap between household debt ratios in Canada and the U.S., therefore appears poised to narrow in 2014.

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Economic Research: Canadas Economic Recovery Is Likely To Keep Sputtering In 2014

Chart 2

Income Gains Continue To Be Small

With the slowdown in business spending contributing to slack labor demand and underemployment remaining a feature of labor market conditions, personal income gains have been stuck in low gear. Annualized growth in disposable income per worker has slowed to an average of 2.5% since the beginning of 2012, down from 3% in the early phase of the recovery and lower by a wider margin than average gains nearing 4% in the 12 months leading up to the recession. Adjusted for inflation, Canadians are seeing even less improvement, as real disposable income per worker has slowed to slightly more than 1%, which means Canadians' debt-servicing capacity isn't expanding significantly. We expect slow income growth to persist through to mid-2014. We see this as a vulnerability to the economy's growth potential and a potential catalyst for the economy's return to recession, if interest rate increases that accompany the withdrawal of monetary policy stimulus do not follow the gradual trajectory we're assuming in our base-case outlook for Canada's economy.

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Economic Research: Canadas Economic Recovery Is Likely To Keep Sputtering In 2014

Interest Rates Are Likely To Remain Low

Domestic inflation is unlikely to drive interest rates sharply higher. Price increases associated with most of the major GDP spending categories -- including consumption, business investment, residential construction, exports and imports -- aren't signaling an inflationary build-up in the economy. Rather, annualized price increases in these areas are well within the Bank of Canada's 1%-3% CPI target range. In fact, for most of these spending categories price increases are tracking in the lower half of the bank's target range, as are headline and core CPI inflation (1.1% and 1.3%, respectively). Headline inflation factors in food and energy costs, among other categories that core inflation doesn't measure. Other measures we watch for signs of potential inflationary risks include, capacity utilization rates, unit labor costs, and commodity price trends. These indicators aren't signaling a build-up in input-cost pressures that could threaten Canada's benign inflationary environment. The Bank of Canada's decision not to use asset purchases, or so-called quantitative easing (QE) to support the economy, has curtailed the growth of its balance sheet and amount of excess liquidity in the banking system. So the withdrawal of monetary stimulus in Canada is likely to follow a conventional process familiar to most financial market participants. The ending of QE in the U.S., however, will involve a larger shift in the size of the central bank's balance sheet once the U.S. Federal Reserve begins to taper the size of its asset purchases. This could become a source of interest-rate volatility as financial market participants try to anticipate the potential consequences of the U.S. Fed being a smaller buyer of securities. The U.S. Fed shocked markets in September 2013 by not announcing a "tapering" of its open-ended, results-oriented program of buying US$85 billion of longer-term Treasuries and mortgage-backed securities per month (for more information, see "The Market's Shocking Shock At The Fed's Non-Taper Shock," published Sept. 20, 2013, on RatingsDirect). Although we expect uncertainty around the ending of QE to contribute to interest rate volatility, in our base-case assumptions, we see inflationary expectations remaining anchored to the Fed's 2% inflation target, and that's something should help to contain upward pressure on long-term bond yields -- we don't expect a return to severely restrictive financing conditions and interest rate volatility to derail North America's economic recovery. We expect the Bank of Canada to keep its policy interest rate unchanged at 1% for the remainder of 2013 and through most of 2014. We think one or two 25 basis-point increases in the rate could come in the final quarter of 2014, if Canada's recovery continues to build, with improving international trade and a tail wind from stronger export growth. This could be the catalyst for stronger business spending, healthier employment gains, and bigger personal income growth for Canadians. However, in our baseline assumptions, we see the global recovery's uneven pace limiting upside potential in international trade; and without the impetus from stronger exports, we believe gains in domestic spending in Canada will continue to be subdued as the country's consumers focus on reducing their financial leverage. In this base-case scenario, we don't expect the Bank of Canada to hike its policy rate until 2015.

Governments Continue Their Battles Against Deficits

Canada's governments have been making steady but gradual progress in restoring balanced budgets. Canadian federal

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Economic Research: Canadas Economic Recovery Is Likely To Keep Sputtering In 2014

and provincial governments went into the recession with balanced budgets. Revenue declines during the recession and fiscal stimulus spending opened up a general government budgetary deficit, that at its widest (by June 2010) totaled C$95 billion or 5.8% of nominal GDP (see chart 3). Most of the recent narrowing in the deficit to C$58 billion, or 3.1% of GDP comes from the federal government's deficit reduction progress. Federal initiatives have reduced budgetary expenditures to 14.9% of GDP from a high of 17.2% in 2010. This brings federal spending as a share of GDP back to prerecession levels, whereas provincial governments have made less progress and their budgetary expenditures (22.6% of GDP) are still above those levels. The timetable for restoring balanced budgetary positions varies across the country so the additional fiscal restraint needed to eliminate the remaining C$58 billion deficit will take a few years. For instance, Ontario's deficit is the largest among provincial government peers, and its fiscal plan maps out a timetable that wouldn't see its budget back in balance until 2018. In our base-case assumptions of continued, if modest, employment gains in 2014 and 2015, we think the economy is fairly well-positioned to absorb the additional fiscal restraint -- we're not expecting fiscal policy actions to undermine consumer and business confidence, or significantly impede the economy's growth potential.
Chart 3

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Economic Research: Canadas Economic Recovery Is Likely To Keep Sputtering In 2014

The Real Estate Market Shows Signs Of Cooling

Canadian residential real estate investment trends point to cooling activity. Since the beginning of 2013, housing starts have slowed to an annualized rate of 183,000 units, nearly 30% below the 12-year high of 253,000 in April 2012. The slowdown is evident in both the single-family and multiple-unit dwelling category, which includes condominiums. This brings new home construction back in line with the pace of household formation, which points to a better balance between supply and demand. Inventories of unsold new single-family homes were increasing along with strengthening construction activity in 2012, but since March 2013 inventory levels have been declining. Unsold inventories of condominiums remained high longer than those of single-family homes, but even in this segment of the real estate market inventory levels are ebbing and reducing the risk that a supply overhang leads to a sharp downturn in home prices. Home renovation activity is also slowing to low single-digit growth from double-digit increases in 2009 and 2010. This may suggest fewer homeowners are readying their homes for sale. It might also indicate that homeowners now see greater downside risk than upside potential for home prices and the value of their real estate holdings. Still, home prices remain high relative to household incomes, which continues to be a potential vulnerability for Canada's economy. In our base-case assumptions, we expect home price appreciation to fade and the Teranet-National Bank Home Price Index to decline up to 5% in 2014. We think a sharper housing correction involving declines in the index of 15%-20% could happen if a faltering global recovery exposes Canada to recessionary forces and rising unemployment. Since the U.S. is Canada's largest trading partner, our downside scenario is tied to assumptions of the U.S. recovery falling back into stagnation.

More Subpar Growth Ahead Is Likely

In our downside scenario for Canada (which we believe has a 10%-15% probability of occurring), we would expect increases in the country's unemployment above 9% to more severely restrict consumers' debt servicing capacity. In addition to triggering a sharp rise in loan delinquencies, we would also expect a big jump in the supply of homes available for sale as some cash-strapped homeowners try to manage down their debt burdens by selling their properties. The increased supply of homes in the resale market relative to demand would accelerate house price declines and reduce consumer wealth. Collectively, forced deleveraging and declining consumer wealth would contribute to generalized weakness in consumer and business spending. With our upside scenario (which we give a 15%-20% probability), we assume Canada would gain from an optimistic scenario in the U.S. that sees stronger consumer and business confidence and an improving jobs market. Spending in the U.S. economy would benefit from pent-up demand and the improved purchasing power from the financial deleveraging of U.S. consumers. In the absence of strengthening global demand for natural resources and rising commodity prices, we think Canadian real GDP growth in this scenario could still lag U.S. real GDP growth because Canadian consumers might continue to increase savings to work down their debt burdens. As such, growth in consumer spending could still be constrained. Overall, the Canadian economy looks like it's headed for another year or two of subpar real GDP growth of below 3%.

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Economic Research: Canadas Economic Recovery Is Likely To Keep Sputtering In 2014

Some of the headwinds holding stronger growth back could begin to dissipate as the global recovery builds and international trade normalizes. We think the way Canadian consumers manage down the large debt burdens they've built up in the past decade will continue to influence potential vulnerabilities and downside risks to the outlook. In our base case for the economy, we don't expect to see a sharp rise in interest rates or unemployment, outcomes that could undermine consumer confidence and create debt servicing problems for households. Increased household savings and slower accumulation of residential mortgage and credit card debt are among the signs indicating more subdued momentum in consumer spending. Cooling housing demand and less buoyant consumer spending are central to our assumption that real GDP growth in Canada is likely to underperform that of other advanced economies, for instance the U.S., where household deleveraging is more advanced.

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