In line with our expectations, the Canadian economy entered a slower growth phase in the fourth quarter following a burst of activity in the summer. Colder weather and easing of social distancing measures have recently brought about a resurgence of the coronavirus. The relaxed social distancing measures spurred solid economic momentum in the third quarter, but such measures have started to now tighten again.

This means the outlook for the economy this holiday season is dimmer. But at the same time, the increased likelihood that an effective vaccine will be rolled out widely by the middle of next year, or even sooner, has increased the prospects for the economy in the second half of next year. Most of the remaining consumption gap lies in virus-sensitive industries such as entertainment, travel, and food services, and a vaccine should accelerate the recovery as consumers increase their spending in these sectors.

Our macroeconomic forecasts for Canada have changed little since our September publication (see "Despite A Bounce In The Summer, Canada's Economic Recovery Is Far From Complete," published Sept. 28, 2020). We maintain our forecast of real GDP contracting 5.6% in 2020, before rising 4.5% (was 4.9%) in 2021 (see table 1).

Table 1

The Economy Burst Back To Life In The Third Quarter

In Canada, the economy--as measured by the inflation-adjusted expenditure measure of GDP--expanded a strong 40.5% (quarter over quarter annualized) in the third quarter, following a lockdown-induced record decline of 38.7% in the second quarter(1).

While all the expenditure components rebounded strongly, consumer spending in goods and residential investment was particularly stronger than expected(2). Inflation-adjusted consumer spending on durable goods in the third quarter was 7.7% above the level in the fourth quarter of 2019--a reflection of ongoing shift-share of expenditure from services to durable goods and a robust housing market (see charts 1 and 2).

Chart 1

Chart 2

Moreover, as the pandemic has shifted sales online, web-based retail sales (in nominal terms) were up a whopping 74.3% compared with a year ago, even as overall retail sales were up just 8% from last year (see chart 3). On the other hand, with demand for people-facing services limited by capacity restrictions and consumer caution, total spending on services was still well below pre-pandemic levels (-12.4%).

Chart 3

A Shortfall Remains As Industry Output Remains Highly Uneven

As strong as the third-quarter growth was, real GDP was still 5.3% below its pre-pandemic level after recouping three-fifths of the earlier loss in output. Nominal GDP, which includes price fluctuations, was 4.6% off the level in the fourth quarter of 2019.

From an industry output perspective, for which data is available on a monthly basis (versus the expenditure measure of GDP available on a quarterly basis), total output was 4.6% below February's level, with touch-sensitive service industries, transportation and warehouses, and mining and oil extraction industries in double-digit holes (see chart 4). The industries that are still short of pre-pandemic levels by double-digit percentage points are unlikely to close that gap until the economy moves beyond the virus-induced stop-go growth pattern for good.

Chart 4

Since these industries--information, arts, entertainment, recreation, accommodation, and restaurant trades--are labor intensive, they continue to face the worst effects on the labor market as well. Nonetheless, thanks in part to a policy framework that has helped businesses keep employees despite the extraordinary impact of COVID-19, Canada's labor market is on a sturdier recovery path than what the growth numbers suggest, with strong employment rebounds across industries, and especially compared with its neighbor to the south. Three-fourths of lost employment has been recovered in Canada, a much better outcome than in the U.S., where the comparable metric is a little above half (see chart 5).

Chart 5

The labor market picture could have been worse if not for the Canada Emergency Wage Subsidy program, which created incentives for employers to rehire or not lay off workers by providing employee wage subsidies for businesses whose revenue suffered because of the pandemic. The program has been extended to next June(3). As of Nov. 22, 1.7 million workers--9% of the pre-pandemic employed--benefited from this program.

Canadians also remain much more engaged with the labor market when compared with the U.S. The labor force participation rate for the prime age population (25 to 54 years old) was 87.6% in Canada in October, well above the 81.2% stateside (see chart 6). In the U.S., the employment rate of the prime age population was 4.4 percentage points below the pre-pandemic level in October, while in Canada the comparable metric was 1.7 percentage points. Unlike in the U.S., public-sector employment, led by the education and health care sectors, has contributed to this higher engagement.

Chart 6

Economic Momentum Weakened To Start The Fourth Quarter

The Canadian economy is already showing signs of weakness this holiday season amid climbing COVID-19 infection rates and increasing "circuit-breaker" restrictions (those set for a short period) on touch-sensitive sectors.

Compared with other G-7 countries, Canada has the second-lowest number of new cases per million people (with Japan having the lowest), but the recent rise in actual and expected hospitalizations and deaths is concerning (see charts 7 and 8).

Chart 7

Chart 8

To stop an accelerating spread, Quebec and Ontario have both reimposed restrictions recently, and it is increasingly likely elsewhere that we will see more closings of bars, restaurants, theaters, concert venues, and gyms in many affected regions. Such increasing capacity constraints signal a weaker finish to the year, most likely bleeding into the start of next year.

Statistics Canada's flash estimate of real GDP, measured by industry data, implies growth faded in October to a mere 0.2% (month over month) amid the initial rollbacks of reopening in high-risk people-facing services in Ontario and Quebec. Real-time high-frequency data from restaurant reservations and mobility data have also rolled over since October (see charts 9-11). If the European experience is any indication, activity in people-sensitive sectors like restaurants is bound to face a harsher setback in December.

Chart 9

Chart 10

Chart 11

We assume December and January will experience reduced activity, although the declines may be modest relative to those in March and April, when lockdowns were more widespread. We forecast fourth-quarter growth at 1% (quarter over quarter annualized). Although consumer spending looks set to pull back in the coming months, especially in December and January--when the restrictions should peak--industrial and other non-virus-sensitive sectors should help eke out growth with fewer restrictions imposed (see chart 12).

Chart 12

While this soft patch will likely persist through the winter months and weigh on first-quarter growth, we expect consumption to accelerate soon after phasewise openings are reinstated. Moreover, frontline workers and long-term assistance facilities for older and vulnerable people should start receiving vaccines in January-February, with optimism in the wider population surging as the light at the end of the tunnel gets bigger.

S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic. Reports that at least one experimental vaccine is highly effective and might gain initial approval by the end of the year are promising, but this is merely the first step toward a return to social and economic normality; equally critical is the widespread availability of effective immunization, which could come by the middle of next year. We use 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.

Shapes Of The Recovery

Our latest forecast shows real GDP returning to its pre-virus peak near the beginning of 2022, but the depth of the shock from COVID-19 on people-facing services means the Canadian economy will endure permanent loss of activity. In turn, the economy is set on a path lower compared with the pre-virus trend (which was close to the long-run sustainable growth rate), even as we assume (for now) no change to the sustainable long-run growth rate. The gap between these two levels serves as a benchmark to estimate the cost of the COVID-19-induced recession, at 1.8% of the pre-pandemic trend in our recovery forecasts.

Chart 13

We expect the unemployment rate, after topping out at 13.7% in May, to fall to an 8.8% monthly average by the fourth quarter of this year and a 7.2% average by the fourth quarter of next year (see chart 14). From 2022 onward, employment growth will likely slow to a pace close to normal business cycle expansion, dependent on new job openings to get workers who lost jobs beyond temporary reasons to regain employment. The unemployment rate will likely not return to under 6% (the pre-pandemic level) until the last quarter of 2023. Inflation as measured by the Consumer Price Index should get back to 2% sustainably only in 2022.

Chart 14

Because of the high bar to tighten monetary policy in the next few years, we anticipate the Bank of Canada (BOC) will keep the overnight policy rate at the current effective lower bound of 0.25% through 2023. This is consistent with our unemployment and inflation forecast (see table 2) as well as what the BOC has been communicating.

Since our September publication, the BOC i) maintained the policy rate at the effective lower bound of 0.25%, ii) reiterated its forward guidance that it "will hold the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved," and this time added that, based on its current projections, this means "until into 2023," and iii) announced that it will trim its pace of asset purchases, from a minimum of $5 billion per week to a minimum of $4 billion.

The BOC justified the trimming of asset purchases on the basis that it is also shifting its purchases to longer-term bonds that more directly influence private-sector borrowing costs. Long-term government bond yields, such as the 10-year bond, should also remain lower during this cycle. They will gradually move up as inflation expectations move up with brighter news on growth prospects, but an active quantitative easing policy will temper the rise.

After shrinking for some weeks (as demand for its emergency repo loans subsided), the BOC's balance sheet has started to expand again. It will likely see a sharp decline in the spring of next year, when the 12-month maturity repo loans are repaid, but aside from this temporary factor, we continue to assume the balance sheet will be bigger by the end of next year. A decline in holdings of government bills should be more than offset by its purchases of longer-term bonds.

Chart 15

Chart 16

As with lower long-term government bond yields, home mortgages should also stay low, thus helping the housing market. Still, we think the scope for a snap back from unsustainable levels of housing starts and sales to more sustainable levels is high. A modest reversal in home prices 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, 2020).

Table 2

Risks To Our Baseline Forecast

The path of the virus and the potential timing and effectiveness of any vaccines naturally present risks to our forecasts in both directions.

The possibility of an economic stop-and-go with "false dawns" beyond December-January means GDP growth could be weaker next year than in our baseline forecast. The strength of lockdowns also matters. A survey of Canadians conducted in October by Nanos Research showed 70% of Canadians either support or somewhat support closing nonessential businesses, such as gyms and places of worship, and only allowing restaurants to offer takeout. This kind of majority support suggests policymakers will remain quick to close businesses.

On the other hand, the possibility of a vaccine being available widely sooner than we assume means the capacity normalization of all industries may begin sooner. The government also raised its policy support in its Fall Economic Statement (which came after we completed our baseline forecast exercise), with increased wage support (to 75% from 65%), larger government-backed loans at low interest rates available to highly affected sectors, and allowances for small businesses that are forced to close to claim back most of their fixed costs.

For this fiscal year ending in March, an additional $50 billion was allocated to combat pandemic damages, and the BOC announced $70 million to $100 million (or up to 4.3% of GDP) in its fiscal plan over the next three years as a post-pandemic (once a vaccine is rolled out) investment spending placeholder. All combined, this could mean stronger growth than in our baseline forecast in 2022 and 2023. This may lead to the BOC moving to raise rates from the effective lower bound sooner than in our baseline.

It is also worth noting that there are statistical modeling issues to consider. The economic halt and restart resulted in large swings in traditionally stable sectors, and policy changes have never been sharper. The pandemic is also undermining the reliability of survey-based economic data. Large deviations from historical trends have injected new uncertainty into interpreting the data, leading to a disruption in adjustments to data seasonality as well as potential adjustments 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.

Notes

(1) The 40.5% annualized expansion in the expenditure measure of GDP was weaker than the 47% consensus estimate, based on the initial monthly production measures. That difference was mainly due to revisions to the monthly data during the spring lockdown, which now imply the drop in GDP was smaller than first estimated, and therefore the subsequent rebound was lower as well. Nevertheless, the hit to the economy in the first three quarters of the year was still much larger than in the U.S. While U.S. GDP recovered to 3.5% below its pre-pandemic level in the third quarter, in Canada it was still 5.3% lower.

(2) Residential investment was up by 187% annualized, while nonresidential business investment rose by 25.8%. Machinery and equipment (+91.8%) and intellectual property products (+30.8%) contributed to the pickup, while investment in nonresidential structures continued to decline (-1.2%). Net trade weighed on GDP growth, given the larger rebound in imports, but that was offset by a stronger contribution from investment in inventories.

(3) Finance Minister Chrystia Freeland stated in the Fall Economic Statement that the Canada Emergency Wage Subsidy rate will be raised back to 75%, from 65%, and there will soon be a Highly Affected Sectors Credit Availability Program to offer larger government-backed loans at low interest rates to firms that have suffered the largest hits to their revenue. These measures are in addition to the recent news that the Canada Emergency Rent Subsidy will be extended, with an additional Lockdown Support Program for those firms forced to close. (https://www.canada.ca/en/revenue-agency/services/subsidy/emergency-wage-subsidy/cews-what-changes.html)