S&P Global Ratings expects the Canadian economy will continue to exhibit slower GDP growth for the rest of this year and next year. After a mild contraction in the second quarter, and with preliminary estimates by Statistics Canada pointing to a flat third quarter at best, the Canadian economy is already flirting with a technical recession (as defined by two consecutive quarters of contraction). We maintain our view that this is just the beginning of a drawn-out, sluggish growth path for the next several quarters as the cumulative lagged effect of higher interest rates and a slowdown in global demand work through the economy.

We revised down GDP growth for this year by 10 basis points to 1.1%, and we expect a sharper slowdown to 0.8% next year (revised down by 0.4 percentage point from our September forecast). Domestic demand is on track to contract 0.7% this year and expand only 0.2% next year, weighed down particularly by decelerating consumer spending.

The unemployment rate has risen by 0.7 percentage point since the beginning of the year to 5.7%. The increase owes partly to a rise in the labor force--fueled by a rising immigrant population--but employment gains have also slowed sharply over the past few quarters.

With subpar domestic demand in store, the job market will remain sluggish. As more people join the labor force, the unemployment rate is likely to increase further to 6.1% on average next year, after averaging 5.4% this year.

The Bank of Canada (BoC) in its October policy meeting held the overnight rate unchanged at 5%. However, the bank maintained its tightening stance, given elevated core inflation. Just when the last mile of disinflation was proving difficult, details of the consumer price index (CPI) inflation report out Oct. 21 showed further moderation in the amount and scope of domestic price pressure.

The Canadian headline CPI dropped to 3.1% in October, just a touch above the BoC's 1%-3% inflation target range, with the consumer basket (excluding shelter), which was facing near-term inflation above a 5% annualized rate, falling below 35%--half as much as its peak in summer 2022 but still higher than the approximate 20% share in 2019.

Ongoing signs of deterioration in consumer spending and labor market conditions support our expectation for inflation to keep moderating in the quarters ahead. We now assume the BoC is done with rate hikes and will cautiously pivot to cuts starting in the second quarter of 2024. We expect 100 basis points in rate cuts next year.

Economic Activity Deteriorating Faster Than Expected

Economic activity remained muted in the third quarter following a mild contraction in the second quarter, per the latest available data from Statistics Canada. Demand in interest-rate-sensitive sectors, particularly for home sales, durable goods spending, and increasingly many services, has been softening (see chart 1). Business and consumer surveys point to further stalling of GDP. Stronger-than-expected net exports might have helped the economy eke out growth in the quarter.

Chart 1

That said, recent business and consumer sentiments also stayed underwhelming. The composite purchasing managers' index (PMI) from S&P Global Market Intelligence suggested deteriorating operating conditions in Canada. The headline composite index (manufacturing and services) fell to 46.7 in October from 47.4 in September--underpinning persistent weakness in output and new orders. A PMI reading of under 50 indicates a contraction. Manufacturing PMI came in at 48.6, slightly up from 47.5 in September, amid modest improvement in new orders. Meanwhile, the services PMI worsened to 46.6 in October from 47.8 in September.

In addition, the BoC's Business Outlook Survey for the third quarter indicated weaker business activities (see chart 2). The survey suggested a broad-based slowdown. Rising interest rates are weighing on firms' sales and investment plans in the next 12 months. As domestic demand stays sluggish, hiring also appears relatively low.

Chart 2

Consumers are also feeling the pressure from rising interest rates as they push borrowing costs higher. The consumer confidence index from Ipsos registered at 47.3 in November and has been below 50 for 13 of the past 14 months.

Housing Activity Still In Flux

Canadian housing activities have slowed more than any other major component of GDP, reflecting the BoC's rate hikes, which pushed mortgage rates higher and housing affordability to its lowest since the 1980s. Home sales have plunged. As a result, residential investment has now contracted six quarters in a row.

On the other hand, housing starts and building permits picked up in the past three months (though both these indicators are quite volatile). The six-month moving average of starts was also up 1% month over month at 256,3000 annualized units. Lofty home prices, low unsold inventories, and a surge in rental construction have supported the solid pace.

In fact, housing inventory also edged up, to 4.1 months in October. The federal government's announcement that it would eliminate the goods and services tax on the construction of new rental apartments (intended to create incentives for housing supply and address affordability) might have helped.

Meanwhile, the home resale market continued to decline through the start of the fourth quarter as mortgage rates increased. Home resales fell 5.8% in October from the previous month to 35,410 units, leaving them 17% below their pre-pandemic level (see chart 3). This was the fourth consecutive monthly decline in home sales, according to the Canadian Real Estate Assn.

As sales dropped more than new listings, the sales-to-new-listings ratio hit 49.5% in October--a touch above its long-term average. The MLS Home Price Index, a more like-for-like measure, declined 0.8% month over month.

Chart 3

The deterrent for homebuyers remains elevated home prices, though they have dipped 11% since the BoC started to raise rates in the first quarter of last year. But compared with 2019, home prices are 41% higher--no wonder potential homebuyers continue to rent.

In our view, another bout of home price declines might be in the offing (perhaps in single digits, versus a 15% year-over-year decline in first-quarter 2023). Past declines in home sales should lead starts lower through 2024.

Labor Market And Inflation Continue To Cool

Meanwhile, the labor market has continued to add jobs, but the pace of job gains has slowed markedly in the past few months. The monthly employment gain has averaged 26,000 in the past six months and 40,000 year to date. The employment rate has dipped to 61.9%, from 62.5% at the start of the year, while the 5.7% unemployment rate in October was up by 20 basis points from September and the highest reading since January 2022.

Conversely, labor supply has increased sharply, averaging 59,000 per month so far in 2023. Labor supply has outpaced labor demand this year. Job vacancies are also falling, but the pace is slowing.

Average hours worked remained unchanged in October relative to the previous month, translating to 2.1% growth year over year. Year-over-year wage growth remained elevated at 4.8% in October, though slightly down from 5% in September. With deceleration in headline inflation, real wage growth has been in positive territory for the past eight months.

Chart 4

Chart 5

Inflation in Canada came a long way from last June's peak of 8.1% to this June's 2.8% (year over year), though it gave back some of the decline in August when it bounced back to 4.0% amid increasing gasoline prices. Since then, headline inflation has continued declining--to 3.1% in October (see chart 6).

Chart 6

Higher mortgage costs due to rising interest rates contributed to one-fourth of the total headline inflation in October. Core inflation also stayed above expectations. Core CPI inflation (excluding food and energy) ticked up to 3.4% (year over year) in October. The three-month average rate of month-over-month increases (a measure watched closely by the BoC) slowed to an annualized 2.7% for the CPI median and 3.1% for the trim measure. The BoC's CPIX (excluding mortgage interest costs, seven other volatile components, and indirect taxes) has grown just 2.1% over the past three months.

Rate Cuts Expected In 2024

The central bank hinted it would raise rates again if needed at its latest monetary policy meeting. However, given price pressure and the weakening economy, we don't expect any rate hikes until next year. We think the weakness in the economy will allow the BoC to start cutting rates in the second quarter. Meanwhile, we expect core inflation to average 3.6% this year and 2.4% in 2024, as depressed demand helps price pressure subside.

A large share of variable-rate mortgages that need to be renewed at higher rates in the coming three years (more so in 2025 and 2026) will likely tilt the BoC toward quicker rate cuts in the latter part of 2024 and 2025, especially as the labor market and consumer growth slow. Canada's household sector is highly leveraged, with household debt to disposable income still significantly high (180%-plus of disposable income) compared with other G7 countries. Rising mortgage rates have lifted the costs of mortgage debt service in the past few quarters, leaving households more vulnerable (see chart 7).

Chart 7