Recent Activity Hints At An Economy Turning The Corner

Since our last economic forecast update, Canada's economic growth has performed in line with S&P Global Ratings' expectation. Although still well short of the country's potential growth, there are hints of positive effects of past interest rate cuts to begin the fourth quarter as we had expected.

Consumer spending likely increased in the third quarter as indicated by September retail sales. Retail sales rose by a healthy 0.4% month-over-month (m/m) in September and were even stronger when adjusted for inflation (in per capita terms, real retail sales likely weakened further). Statistics Canada's advance estimate for October points to another solid increase of 0.7% m/m, setting up healthy momentum heading into holiday season. The recently proposed tax holidays could provide a significant boost to consumer spending during the exemption period from mid-December to mid-February.

Increased activity in the home market is also likely to add to consumer spending. Residential investment appears to have picked up as well during the third quarter given the rise in home resales in August and September. Moreover, existing home sales climbed 7.7% m/m in October, placing sales above their pre-pandemic level for the first time since early 2022 when interest rates started to rise.

The combination of a spike in sales and falling listings led the sales-to-new listings ratio to rise 6 percentage points (ppts) to 58.0%--effectively at its long-run average. Canadian average home prices increased 2.2% m/m in October, boosted by higher gains in more expensive regions. The MLS home price index, which corrects for such compositional effect and is a more "like for like" measure, declined by 0.1% m/m. Condo prices were down 4.5% year over year (y/y), while detached homes were down a smaller 2.1% y/y.

Canadian housing starts came in at 241,000 annualized units in October, representing an 8% m/m increase from September. The six-month moving average of starts was flat at 244,000 units. Healthy starts set up homebuilding activity to positively contribute to overall economic growth in the fourth quarter.

On the labor market front, jobs reports came in better than expected in the last two months. The economy added 14,500 jobs in October, following a 47,000 gain in September. Full-time employment gains carried the weight in both months, leading to a favorable full-time/part-time job mix. Total hours worked jumped 0.3% m/m, while wages were up 4.9% y/y (from 4.6% in September).

The unemployment rate held steady at 6.5% in October but for unfavorable mix—a fall in labor force participation rate (to 64.8% from 64.9% in September and 65.1% in August) and a sharp pullback in unemployment among younger workers (20- to 24-year-olds) that offset increases across other age groups.

The fall in participation rate this year has been broad-based, affecting all age groups and genders. The only increase has been among immigrants. The decline in participation rate this year, after immigration kept it steady the last two years (as immigrants have a higher participation rate on average), has it back near its pre-pandemic downward trend, which reflects the aging of the population (as rates are lower among older people). While some of it is structural, the broad-based decline suggests this is partly also reflecting the cyclical weakness of hiring, which means that the labor market is weaker than the unemployment rate alone might suggest.

Headline consumer price index (CPI) inflation increased in October to 2.0% y/y as expected, up from 1.6% y/y from September. Excluding food and energy, inflation eased to 2.3%, slightly down from 2.4% in September. Inflation in service continued to edge down--to 3.6% y/y in October from 4% in September--but remains above normal as shelter cost (which includes mortgage interest costs) continues to drive much of service price pressures. The Bank of Canada (BoC) prefers to look at the momentum (annualized three-month moving average) of core measures, CPI-trim and CPI-median, which rose to 2.9% and 2.7%, respectively. However, both have been trending lower from earlier this year.

It isn't raising any red flags yet, but it can't be ruled out that October inflation data means a slower pace of easing (compared with 50-basis-point [bps] interest rate cuts).

Table 1

Forecast Update: New Immigration Targets Are A Key Force To Consider

While we kept our forecast for 2024 intact, we lowered our 2025 forecast by 30 bps to 1.7% given the changes to the federal government's immigration targets. The balance of risk to our GDP forecast is squarely to the downside.

The 2025-2027 Immigration Levels Plan revealed the admission targets for both permanent residents (PRs) and nonpermanent residents (NPRs) (see table 2). The federal government's projections show a modest decline in population over the next two years before flipping back to positive territory in 2027. Compared with last year's immigration target for permanent residents , this year's update calls for almost a 19% pullback, even as the net PR flows will remain higher than in the years leading up to the pandemic.

Table 2

Table 3

For the NPR population (international students and temporary foreign workers), the government set out to reduce their share of the total population to 5% by the end of 2026 (currently at over 7%). The bulk of the population surge over the past couple of years reflected an uncontrolled inflow of international students and temporary foreign workers (NPRs). Therefore, changes to NPRs are particularly meaningful.

Given the time it takes to implement reforms and the inherent complexity of the immigration system, we have taken a more conservative approach. We assume that population growth will decelerate sharply but not shrink altogether. Still, this represents a meaningful slowdown, which will impart a drag on aggregate demand and labor supply. The new population plan necessitated a downward adjustment to our labor force growth forecast in both 2025 and 2026, relative to our prior baseline forecast.

We think an eventual rebound in the participation rate will emerge with cyclical recovery. This could help partially offset the drag on labor force growth from the abrupt halt in immigration implied by the government's new immigration targets. Consequently, a rebound in the participation rate means the unemployment rate might not fall as quickly from mid-2025 as we are currently anticipating. In contrast, with the economy still struggling, the participation rate could fall further in the short term and is a risk to our view that the unemployment rate will rise to a peak of 6.8% in early 2025.

We expect the negative impact on growth to be mitigated by a number of influences, including less upward pressure on rents, lower interest rates, and increased per capita real income. Our sense is that a reduced supply of low-wage temporary immigrants will incentivize businesses to invest in productivity-enhancing capital.

The direct impact on ownership housing demand will likely be small, given that both nonpermanent and permanent residents largely rent when they first come to the country. However, flat population growth for a few years will offer an opportunity for builders to close the sizeable gap between housing completions and population-based underlying demand for new homes reported in the last two years.

Still, the new immigration targets are likely to limit the potential for future home price gains and rent growth. It is likely that housing starts will edge down slightly over the next couple of years, even as we still see scope for existing home sales to rise and for renovations spending to pick up as interest rates fall. Although building permits point to a pickup in housing starts, it will likely be short-lived as developers contend with falling rent growth.

Monetary Policy

The Bank of Canada recently accelerated the pace of rate cuts, with inflation stabilizing around the 2% target. October's inflation report is a reminder that further 50-bps cuts per meeting are not a slam dunk. We have penciled in another 50-bps cut in December (taking the policy rate to 3.25%), but the risk of only a 25-bps cut has risen materially since the higher-than-expected inflation momentum of the past few months. The November labor survey data--out before the meeting--will be crucial.

Regardless of the magnitude of the cut in December, we expect the bank to continue to cut rates over the first half of next year to below its range for neutral inflation (2.25%-3.25%), to accommodate for weak growth in the economy.

With declining job openings and rising unemployment indicating continued softness in labor markets, we had already been expecting price growth to drift broadly lower. With less pressure on housing and infrastructure, inflationary pressure will fall further, supporting the BoC's efforts in normalizing its policy rate. We expect both of those shelter components to see slower growth in the months ahead. With the mortgage interest component growth slowing in the wake of BoC interest rate cuts and signs that asking rents are softening, recent home rent price growth in the CPI is unlikely to continue.

Moreover, if productivity gains don't offset reduced labor, we would revise lower our expectations for potential output in Canada's economy. From this standpoint, the BoC's estimate for the neutral rate would likely be revised downwards, suggesting lower rates over the medium term.

Implications From U.S. President-Elect Trump

One key area of uncertainty for our forecast is the U.S. election. We have not assumed any tariffs by the U.S. on Canada or any changes to USMCA. If U.S. President-elect Donald Trump puts tariffs on imported goods, Canada would likely be exempt because such a tariff would be inconsistent with USMCA, which Trump helped negotiate.

Still, we acknowledge that Canada's main exports to the U.S., energy and autos, are at risk of threats. Case in point, the president-elect tweeted (after our forecasts for this publication had been locked in) that on day one of his presidency, he would impose import tariffs of 25% on all products imported from Canada and Mexico, which would include oil imports. He also pledged an additional tariff of 10% on China above and beyond any other tariffs that he may impose. Trump is explicitly returning to his first-term playbook of using tariffs to extract concessions on specific issues. In this instance, he is using them to extract concession on antinarcotics. That doesn't exclude him using tariffs in the future with broader aims, such as protecting domestic industries or raising revenue, but the implication from the recent threat seems to be that the countries could avoid these tariffs by presenting credible plans to take action to reduce drug supply or secure their borders, much like how Mexico staved off a similar threat from Trump in 2019.

Canada runs a large goods trade surplus with the U.S. at over 7% of GDP, mainly led by energy exports. Our sense is that Trump is unlikely to want to send gasoline prices higher by imposing tariffs on energy imports. In addition, USMCA has a provision that exempts the first 2.6 million motor vehicles imported from Canada from Section 232 tariffs (National Security threat), which limits the potential damage.

That said, the provisions in USMCA will count for little if Trump decides to withdraw altogether. About 78% of Canada's goods exports, worth 21% of GDP, go to the U.S.--and many cross the border more than once due to the complex supply chains that span the continent. So the end of the USMCA would be hugely disruptive. The motor vehicle sector could face a double whammy if Trump follows through with his pledge to roll back the U.S. Inflation Reduction Act, which has supported the transition toward electric vehicle manufacturing in Canada and helped to incentivize investment in related technologies.

Financial markets also face implications of new leadership and policy in the U.S. Considering the incoming administration's stances on trade and fiscal policy, prospects for the U.S. dollar to strengthen further has increased. With the Federal Reserve now likely to ease monetary policy more gradually, we view the contrast between slower easing from the Fed and faster easing from BoC as the driving force of our outlook for U.S. dollar strength. As these monetary policy dynamics unfold, interest rate differentials should move in favor of the greenback and strengthen the currency.

The recent weakening of the loonie against the greenback already has implications for imported goods inflation. There is a renewed chance goods prices will rise from a weaker exchange rate even before the president-elect takes office. The Canadian dollar weakened 3% since September at the time we locked in our forecasts (from widening expected interest rate differentials and Trump reelection risk premium). On an exposure share-based calculation, assuming a complete pass-through, that would add around 0.8 percentage points to core goods inflation, based on wholesale import prices making up about 25% of the overall retail cost of core goods. With core goods making up roughly 30% of the CPI basket, that would add around 0.2 percentage points to overall inflation.

In the worst-case scenario, in which Trump included Canada in his planned universal tariff and ultimately withdrew from USMCA, our sense is that the BoC would have to accept a period of high import inflation and cut interest rates anyway to support demand (investment outlays would take a hit).

That said, over the past couple of decades, Canada's economy has shifted away from manufacturing and toward services. In that context, we believe the Canadian economy is sufficiently diversified to avoid a recession in such a scenario.