S&P Global Ratings expects the Canadian economy will remain resilient but slow in the second quarter of 2023 after a surprisingly strong first-quarter rebound. Healthy consumer spending and exports have led the economy's resurgence amid above-average employment figures. But the labor market showed signs of loosening in May, and the Bank of Canada (BoC) raised its overnight rate in June with another hike likely in July. We expect first-half resilience will yield to second-half weakness this year, though for the full year, we have revised up our economic growth forecast.

Even as inflation pressures have eased somewhat, they remain well above the BoC's target, forcing the bank to maintain its tightening stance in the near term. As the lagged effects of previous policy rate hikes (with one more hike assumed for July) take hold, the economy will grow well below its longer-run potential in 2024. We see the Canadian economy gradually returning to its potential growth rates later in 2024 and 2025 as inflationary pressure recedes and the central bank's stance eases.

A Resurgent Economy

The Canadian economy bounced back 3.1% (quarter on quarter, annualized) in the first quarter--well above consensus expectations and the strongest growth among G7 countries. Domestic demand increased by 2.6% during the quarter, well above the trend rate. Consumer spending (see chart 1) and exports propelled the growth, with better-than-expected vehicle sales at home and parts for production abroad (linked to the NAFTA auto industrial complex). Stronger-than-expected growth in the U.S., a key trading partner, has helped. With the relatively strong growth in the first quarter, total employment grew 4.8% annualized, higher than the 4% average of 2022.

At the same time, fixed business investment was yet again a drag on growth, with residential investment--both resale and new construction--as well as equipment spending contracting another quarter (see chart 2).

Chart 1

Chart 2

The flash estimate for April's economic growth, an early indicator for the second quarter, showed 0.2% month-on-month growth, translating to a respectable 2.4% growth rate to begin the quarter in annualized terms. Canada's merchandise trade account registered a $1.9 billion surplus in April, marking the largest Canadian trade surplus since June 2022. It appears net exports (on a volume basis) will extend their positive contribution to real GDP growth in the second quarter.

A firm handoff to the second quarter was also evidenced in retail sales reported by Statistics Canada, which beat expectations in April (up 1.1% month on month) with growth powered not only by pent-up demand for cars but also by strong gains in core categories--pointing to continued spending momentum. Statistics Canada's advance estimate for May indicates a 0.5% month-on-month gain. Robust employment gains and inflation-matching wage increases this year enabled Canadians to keep spending despite higher interest rates.

Strong population growth (led by a surge in immigration in the past two years) and a healthy jobs market continue to put a floor on demand. Canada had the fastest population growth in the G7 at 1.84% in 2022--its fastest pace since the 1950s (see chart 3). Labor force participation rates among prime-age workers remain very high compared with peer countries, led by record-high participation rates from women (see chart 4).

Chart 3

Chart 4

Home sales were up from February through May, helped by the strong population and employment growth. This coincided with the BoC's pause in its rate hikes. The MLS Home Price Index, a quality-adjusted measure, increased by 2.1% month on month but was still down by 8.6% year on year. The ratio of sales to new listings was 68%, indicating a seller's market, and the supply of inventories ran below the long-run average at 3.1 months--providing supply-side support to home prices even as demand has fallen from the unsustainable highs of late 2021 and early 2022.

How Long Will It Last?

After adding jobs for eight consecutive months through April, the economy shed 17,000 positions in May. Granted, it was a small loss after an impressive streak of gains, but total hours worked were also down--0.4% month on month--which tells us perhaps the labor market is finally starting to loosen.

The unemployment rate rose 0.2 percentage point to 5.2% in May, and the participation rate dropped 0.1 percentage point to 65.5%. Job openings in the first quarter (latest available data) were down 14% from peak levels (in second-quarter 2022) in Canada (see chart 5). There were 1.3 unemployed persons for each job vacancy on average in Canada in the first quarter, up from 1.2 in the previous quarter and from 1.1 in the second and third quarters of 2022.

Chart 5

There are also signs that consumers are starting to feel the pinch of higher interest rates. Delinquencies on credit cards and auto loans have been rising for months and are now higher than their pre-pandemic levels.

Housing starts continued their downward trend in May: The six-month average of starts was 230,000 units in May, down from 240,000 in April (see chart 6). On a monthly basis, after a strong one-month pop in April, starts declined 23% to 202,500 annualized units, back to pre-pandemic levels. The decline in May was completely due to the decline in the multifamily sector, while single-family home groundbreaking moved up.

Chart 6

After seeing the resurgence in economic momentum despite higher interest rates and prices, and with inflation still running above its target rates, the BoC got off the sidelines to raise the overnight rate by 25 basis points to 4.75% in June and stated it would continue quantitative tightening (to be sure, it didn't pause quantitative tightening when rate hikes were paused). Its key inflation measures have eased but remained stuck since the fourth quarter of last year near 4%, which is above the top end of the 1%-3% target control range (see chart 7). Shedding half of the peak inflation rate (8%) was easy due to lower energy prices, but further deceleration has been difficult. Goods prices have increased lately and services prices remain elevated, reflecting strong demand.

Chart 7

You Can Only Delay, Not Avoid, The Slowdown

Even as we have revised up our forecast for overall annual growth to 1.6%, we expect first-half resilience to give way to second-half weakness. Broadly, there are two primary reasons for that.

First, the impact of interest rate hikes since early 2022 has yet to fully flow through to borrowing costs, but it will weaken growth in the coming quarters. We pencil in one more BoC rate hike in July (parallel to the Federal Reserve in the U.S.), bringing the policy rate to 5%. Debt servicing costs will continue to rise this year, given interest rates are expected to rise and remain elevated for longer. This will add to headwinds for households with high sensitivity to interest rates (such as variable-rate mortgageholders) and could result in higher delinquency rates.

Second, we forecast U.S. growth will slow to below 1% in the second half of the year and remain there for four quarters, thus weakening the contribution to growth from the trade channel in Canada (see more in "Economic Outlook U.S. Q3 2023: A Sticky Slowdown Means Higher For Longer," published June 26, 2023). The exchange rate versus the U.S. dollar will likely be narrowly range-bound as interest rate differentials remain close to steady in the near term, while the influence on exchange rates from energy prices will diminish, given the U.S. has also become a net energy exporter.

With economic momentum slowing materially in the coming quarters, we see the unemployment rate climbing above 6% by the first quarter of next year. We revised up our forecast for consumer price inflation, which we now anticipate returning below 3% at the beginning of next year and falling further to 2% by fall 2024.

Near-term positive growth surprises will only delay, rather than prevent, an ultimate slowdown.