The story of the pandemic is now familiar.

The global economy faced a massive adverse shock from the sharp increase in COVID-19 cases early in the year. Like many other countries, Canada was on lockdown by the end of March through early May. It was a policy choice to lockdown the country in the first place to limit the spread of the virus that could overwhelm the health care system. It was also a policy response to subsequently go through a virus-dictated phasewise reopening (province by province).

Paradoxically, containment comes at an economic cost--in this case a sharp economic contraction not seen before in the post-World War II era. What began as a textbook supply-side exogenous shock that directly affected businesses that had to halt production also morphed into a weak demand response that affected sectors not directly affected. In every sector, employment was down in August compared with February.

Unprecedented policy response--from both fiscal and monetary authorities--has provided a bridge to recovery. Even though the nature of the shock meant they can't fully offset the severity of the recession, they lessened dislocations in the labor, products, and financial markets. The extraordinary monetary stimulus, in tandem with a still-growing number of fiscal measures, is an absolute necessity to help offset the worst-case impacts from the pandemic shock to the economy.

General lockdowns are now over, but lingering fear of the virus and localized capacity constraints remain. Nearly five months into the recovery since lockdown restrictions eased, the bounce in economic activity has surprised to the upside. Still, the level of activity remains one-third below normal, and the recovery has been uneven. The economy will continue to improve over the next quarters, but it will be more gradual and protracted. The upside for sectors quick out of the gates has diminished and sectors still below normal continue to face virus-related challenges.

The path of the economy still depends on interaction between mobility, capacity restrictions, and the speed of a vaccine. In our macro forecast, we assume a vaccine will be widely available in mid-2021, with a modest chance it could be earlier.

We do not foresee the Canadian economy getting back to its pre-pandemic level before the first quarter of 2022 following a 5.6% contraction in 2020 (was -5.9% in our June publication) and 4.9% growth next year (was 5.4%).

Table 1

The risk to our GDP forecast is balanced--reflecting a raft of more policy measures possibly to come and uncertain COVID-19 developments.

On the one hand, fiscal spending to protect small and midsize enterprises and those out of jobs has provided the bridge to recovery. Last week, Prime Minister Justin Trudeau minority government's much-awaited Speech from the Throne (SFT) came with an array of policy proposals that confirm the government is ready to take a far more ambitious approach to fiscal policy. Granted, the government still needs to gain support for its plan and then back it up with budgetary action, but this could lead to GDP growth being stronger than we expect in 2021 and 2022.

At the same time, the unusual nature of this service-centric shock makes the near-term recovery more uncertain than usual. The path of the virus remains highly unpredictable. The lifting of global containment measures is boosting demand-side factors, but a growing first wave of infections in some regions and the onset of a second wave are reducing the odds of a sustained lift in demand. The possibility of an economic stop-and-go with "false dawns" mean GDP growth could be weaker than in our baseline forecast.

There are also statistical modeling issues to consider. The halt and restart resulted in large swings in traditionally stable sectors of the economy and policy changes have never been sharper. The pandemic is also undermining reliability of survey-based economic data. Large deviations from historical trends have injected new uncertainty in interpreting data, leading to a disruption in adjustments to data seasonality and adjustments that will potentially be required to key variables--pre- versus post-recession--as we get a better handle on permanent structural shifts underway. For now, possible changes to macroeconomic variables emphasize the need to pair quantitative econometric analysis with qualitative understandings.

A Massive Hit To The Economy

Following a massive adverse shock, the Canadian economy--like the rest of the global economies--endured a sudden, sharp drop in economic activity. Strict social distancing measures, which were imposed to slow the spread of COVID-19 to keep cases from overwhelming the health systems, shaved off 18.2 percentage points from Canadian real GDP in March and April combined (the peak-to-trough decline from fourth-quarter 2019 to second-quarter 2020 was 13.4%)(1). By contrast, the economic shock of 2008 brought about a real GDP decline of 4.5% over eight months (see chart 1).

Chart 1

The pullback in economic activity during April led to the sharpest decline in real GDP on a quarterly basis since the beginning of the data series in 1961, even as May and June were recovery months. The economy contracted roughly 11.5% in the second quarter (-38.7% annualized), translating to 13% below its year-ago level and matching our June forecast (see "Canada’s Economy Faces A Patchy Recovery," published June 29). Canada's relatively widespread social distancing measures meant a sharper decline in economic activity in the second quarter when compared with its neighbor to the south, the U.S. (2).

A Quicker-Than-Expected First-Phase Recovery

After a reboot in May--albeit on safe mode--the recovery so far has surprised to the upside in the third quarter. Disciplined phased openings also meant a relatively better performance in managing the virus in the third quarter with little adjustments to openings, compared to other major economies (see charts 2-3). Emergency assistance deployed by the Canada Emergency Response Benefit (CERB) program also meant that the unprecedented drop in worker earnings through job-market losses have been offset.

Chart 2

Chart 3

Pent-up demand led to a rebound in retail sales (see chart 4), home resales, and housing starts that have surpassed their February levels. In August, housing starts rose to a 262,400 annual rate--the highest since 2007(3). Small business confidence, measured by the CFIB business barometer, is back to its pre-pandemic averages (see chart 5). No doubt there will be an impressive growth rate in the third quarter--we forecast real GDP will grow 43.5% (quarter-over-quarter annualized).

Chart 4

Chart 5

It Is A Disservice To Call It A "V-Shaped" Recovery

Although the dominant narrative in recent months has been the sharp "V"-shaped recovery associated with COVID-19 shut-downs and re-openings, the economic recovery is far from complete (4). Some sectors are currently outperforming thanks to pent-up demand, but others are struggling given higher risks of the pandemic's second wave and lower global demand. By the end of third quarter, our forecast implies that the economy will have recouped only a little more than three-fifths of its output lost in the first half of the year.

The rebound in consumer spending has seen an uneven recovery, with spending in goods (both durable and nondurable)--autos, household durables, computers and software, recreational vehicles, food for home, toys, and others--recovering handsomely, while services remain well under February levels. On the services side, necessities were the only categories to advance, with spending up on communication, housing, and insurance and financial services. Tourism services spending is down significantly, but the worst-off categories are transport services and recreational and cultural service, each down more than 45% compared with the last quarter of 2019.

It is not surprising that the service sector is taking longer to bounce back given the nature of the shock that puts people-facing businesses (about a third of the economy) under capacity restrictions and consumer unease. At the current pace, the average time to full recovery for small businesses is 17 months, according to the latest data by Canadian Federation of Independent Business (CFIB)(5).

Google mobility data suggests one-third of people are not going to their traditional workplaces, while the number of travelers going through airports and international tourists are naturally down. Manufacturing is still 12% below the February level despite a strong increase in auto production, and mining has yet to turn around (see chart 6). Nonresidential investment is soft, and Canadian exports are gaining but still well below pre-pandemic levels.

Chart 6

Chart 7

Employment shortfall from prerecession level remains high compared with previous business cycle recessions (see chart 7). Through August, the labor market regained about two-thirds of the 3 million jobs lost in March and April (compared to 48% in the U.S.). The labor market picture could have been worse if not for the Canada Emergency Wage Subsidy (CEWS) program, which incentivized employers to rehire or not lay off workers by providing employee wage subsidies for businesses whose revenues suffered because of the pandemic.

Summer Will Give Way To Slower Fall And Winter

Looking ahead, the recovery will likely continue, but more slowly. Why? Partly because of our assumption that a COVID-19 vaccine will be widely available not before mid-2021. That means people-facing activities will continue to see capacity constraints and reservations. Also, because over the near term, the recovery will lose steam as upside diminishes for sectors that recovered quickly.

In our baseline forecast, pent-up demand diminishes and loan deferral periods expire in the coming months, leading to lower consumer spending growth. CERB is now expiring in September, but the government announced a new mix of income support measures to households, which will in effect be about 20% less generous, but generous enough to avoid cliffs in household spending in the coming months. Lower demand drivers imply lower revenues for household-facing businesses, limiting their spending and their will to hire. It took four months to recoup two-thirds of the jobs lost in March and April, but the next third could take another 12 months or even longer. In addition, CEWS, which has provided some support to the labor market rebound thus far, may offer less of a boost going forward. The program is slated to deliver lower base rate subsidies from September to its conclusion at the end of the year.

We expect unemployment rate, after topping out at 13.7% in May, to come back down to a 9% monthly average by the fourth quarter of this year and 7.3% average by the fourth quarter of next year. The unemployment rate will likely not get back under 6% (pre-pandemic level) before 2024 (see chart 8).

Chart 8

Inflation as measured by the core Consumer Price Index (core-CPI) gets back to 2% sustainably only in 2023. Some observers have said larger fiscal spending and central bank asset purchases (also known as quantitative easing or QE) will lead to runaway inflation. We disagree. Weaker labor markets and business balance sheets in repair means the economy faces a period of deficient private-sector demand ahead. In such an environment, large fiscal deficits don't necessarily ensue inflation. In fact, in such an environment, we believe that large fiscal support is needed to offset deficiencies in private-demand-led growth in activity and inflation falling further from the 2% target (6). We believe the risk of sustained inflation is limited as the central bank can always tighten to offset overheating inflation.

In terms of QE and its effect on purchasing power, one also must consider what the Bank of Canada (BoC) is doing. The BoC has announced that large-scale asset purchases of at least $5 billion per week of government of Canada bonds will continue and be in place "until the recovery is well underway and will be calibrated to provide the monetary policy stimulus needed to support the recovery and achieve the inflation objective." Most of what the BoC is doing is buying government debt and turning it into central bank settlement balances (basically, reserves). That expansion of the BoC's balance sheet is largely a debt refinancing operation of the consolidated government (the government including the BoC)(7). It is just changing the profile of government debt. It's creating new reserves, not creating new purchasing power.

Because of the high bar to tighten monetary policy in the next few years, we anticipate the BoC will keep the overnight policy rate at the current effective lower bound of 0.25% through 2023. Long-term government bond yields, such as the 10-year bond, should also remain lower during this cycle in tandem.

Chart 9

Despite low mortgage rates, the scope for a snap back in unsustainable levels of housing starts is high. A house price reversal also remains in the cards, unchanged since our July publication, although the timing has been pushed back (see "Canadian House Prices Are Likely To Decline Sharply Into Next Year; Strong Fundamentals Restrain Broader Housing Market Risks For Now," published July 16). The combination of elevated unemployment this year and next, uncertainty about the pandemic's duration, stricter lending rules, and slower near-term flow of new immigrants will create headwinds for housing activity and prices. We now forecast a 5.7% annual average decline in house prices next year before a 2% gain in 2022 (see chart 9).

Chart 10

More Than Simply Retracing The Path

Underneath the macro story are lots of shifting sectoral dynamics. More than just retracing what was lost, there are structural changes to account for as the already ongoing digitalization of the economy was accelerated by the pandemic. Economist Joseph Schumpeter's idea of creative destruction is occurring perhaps in at a higher degree now where, for example, lots of traditional brick-and-mortar retailers have had to change business models or cede to so-called high tech companies like Apple, Amazon, and Netflix. Employment in restaurant and travel sectors will eventually come back once COVID-19 is no longer an issue. But white collar service workers and real estate footprints are likely to be scrutinized closely by businesses.

While in the long run this may increase the aggregate total factor productivity of Canada, this will likely also mean more destruction of jobs than creation in the adjustment period. This is especially true when creative destruction happens following a recession compared with creative destruction during normal times. Those who escaped the first pruning phase may not be so fortunate in the second pruning phase.

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The current consensus among health experts is that COVID-19 will remain a threat until a vaccine or effective treatment becomes widely available, which could be around mid-2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Table 2

Notes

(1) Using real gross domestic product (GDP) at basic prices by industry, which is available on a monthly basis. On a more standard expenditure-based GDP--data for which is available on quarterly average basis--the peak-to-trough decline from fourth-quarter 2019 to second-quarter 2020 was 13.4%.

(2) In the U.S., the economy contracted 31.7% annualized rate in the second quarter. This translated to a 10.25% contraction from fourth-quarter 2019 to second-quarter 2020.

(3) With strength in both July and August, real residential construction spending is expected to surpass year-earlier levels in the third quarter. Year-to-date housing starts are above 2019 levels in Ontario, Quebec, Saskatchewan, and New Brunswick.

(4) A V-shaped recovery means you have a sharp downward plunge in activity and that is followed by a pretty sharp rebound that comes quite quickly. The Canadian economy is only half way up that "V", but we anticipate the sharp first half to be followed by a flatter next half.

(5) https://www.smallbusinesseveryday.ca/dashboard/

(6) As has been the case in Japan over the past 25 years, large deficits over the coming years could be associated with weak GDP growth and below-target inflation.

(7) Eventually, when the crisis has passed and the BoC no longer wants to hold the assets, it can sell them back to financial institutions. This will shrink their deposits of settlement balances. Or the BoC can hold the assets until they mature and use the proceeds to reduce the amount of settlement balances. https://www.bankofcanada.ca/2020/08/our-covid-19-response-large-scale-asset-purchases/