Ontario Economic Update: Defying expectations
The July 2017 Economic Update for Ontario covers several broad categories: economic growth, labour market indicators, the housing market, consumer and business indicators, inflation, and international trade. The Institute provides a brief analysis of significant findings, followed by summary tables with the most recent economic data for Ontario and other regions.
- The Bank of Canada increased its overnight interest rate for the first time since September 2010
- Ontario’s real GDP grew one percent in Q1 2017, rooted in broadening growth across several industries
- Household consumption and residential activity are powering the economy forward but will be dampened by rising interest rates
- The economy added 54.8 thousand net full-time jobs and lost 20.4 thousand part-time jobs in the first half of 2017
- Diminishing wage growth in the service sector and core age labour force are major contributors to weak wage growth in the economy
- Exchange rate fluctuations, NAFTA renegotiations, and demand from the US will impact future trade activity in Ontario
Bank of Canada raises key policy interest rate to 0.75 percent
This month, the Bank of Canada (BoC) raised the overnight rate target (also known as the key policy interest rate) to 0.75 percent, the first increase in the rate since September 2010. A strong Canadian economy and encouraging prospects for future growth both domestically and internationally (especially in the United States) are among the primary motivations behind the decision according to the BoC.
Economic growth in Q1 2017
The 0.9 percent growth in real Gross Domestic Product (GDP) that Canada experienced in the first quarter of 2017 was a pivotal factor behind the interest rate hike. As Canada’s largest economy, Ontario’s economic growth was influential in this strong showing. Ontario’s economy grew one percent over the same period – an impressive 3.9 percent annualized growth rate. Household consumption expenditure and investments in residential assets continue to dominate overall contribution to GDP growth, making up the bulk of the overall increase in real GDP. Residential investments grew 7.9 percent in Q1 of 2017, the highest growth rate in this category since the last quarter of 2009. Investments in non-residential assets should play an increasing role in growth throughout the rest of 2017, as highlighted in the Institute’s May Economic Update. Still, debt-fuelled consumption, housing activity frenzy, and housing prices removed from market fundamentals are unsustainable in the long run. These components are expected to slow down over time, weighed down by rising interest rates. Another interest rate hike is anticipated in October, with further increases at six-month intervals from then onwards.
Despite a concentration of growth coming from consumption and residential activity, Ontario’s strong economic performance appears to be underpinned by broadening growth across several industries. After excluding finance and real estate, more than two-thirds of the weighted share of industries were expanding in Q1 of 2017 (Exhibit 1). The BoC cited similar trends in their optimistic review of the Canadian economy in its latest monetary policy report.
Economy generates 34.4 thousand jobs in the first half of 2017
In the last two months, the economy added 13.8 thousand net new jobs in Ontario, mostly in part-time jobs (14.9 thousand) while full-time jobs dropped by 1.2 thousand. Since December 2016, total employment rose by 34.4 thousand as full-time employment increased by 54.8 thousand while the economy shed 20.4 thousand part-time jobs. In general, employment levels are on an upward trajectory. The unemployment rate sits at 6.4 percent, slightly below the national average of 6.5, and has bounced back up since hitting 5.8 in April as the number of individuals actively looking for work returned to normal levels.
Weak wage growth a blemish on an otherwise booming economy
Subdued wage growth in the wider economy continues to puzzle policy makers and economists. Frail wage growth was among the justifications the BoC used to keep interest rates steady earlier this year. Even though they remain low, the BoC likely had other factors, such as projected inflation and robust economic growth, behind their justification to finally raise the key policy rate.
Hourly wage growth (nominal) in Ontario lags the Canadian economy, with year-over-year changes of +0.85 percent and +0.65 percent in May and June, respectively, extending the run of growth below one percent to eight consecutive months. Median hourly wage growth has performed even worse, averaging roughly 0 percent year-over-year growth in 2017. The service sector is driving the slowdown in wage growth, as it accounts for the bulk of total employment in Ontario by sector (80 percent). The manufacturing sector has experienced a similar decline over the same period. Although an aging demographic and slow growth in wages for older workers have been attributed by many as one reason behind this phenomenon, the core age labour force (25 to 54 year olds) have been the largest contributing age group (Exhibit 2). Only time will tell if low wage growth is in fact due to labour slack (underutilized labour in the economy which can be measured by the gap between actual hours worked, unemployment rates, underemployment and the potential of the economy) as cited by the BoC or if other structural changes in the labour market are to blame.
Consumer spending defies expectations
A chain of interest rate hikes will likely dampen consumer spending over the next year or so, but current economic data shows that strong consumption expenditure is supporting economic progress yet again in the second quarter of 2017. Retail sales in Ontario grew for the third month in a row, following the pattern seen in the wider Canadian economy. Canadian manufacturing sales also saw its third consecutive month of growth, driven by a 2.6 percent rise in the value of goods manufactured in Ontario. Nominal manufacturing sales have now returned to pre-recessionary levels and sales in May are the highest level ever recorded in the series (Exhibit 3). While the real value of sales (adjusted for inflation) was declining leading up to the 2008-2009 recession, it is now trending upwards. Better than expected Canadian economic data reinforces BoC’s decision to increase the key interest rate and increases the possibility of another hike in October. The simultaneous hot streak in consumer expenditure and a sustained slow-down in wages nationally and especially in Ontario suggests that much of this additional spending is fuelled by debt.
Trade outlook is dependent on exchange rate, NAFTA renegotiations, and strength of US economy
Poor export performance has held back Ontario’s economy since Q2 of 2016. However, domestic exports made a sharp recovery in May, increasing 13 percent year-over-year since May of 2016. Roughly half of this uptick in export value can be linked to an increase in metal and non-metallic mineral products, which grew by more than 40 percent since the previous year. A 12 percent rise in the exports of motor vehicles and parts since May 2016 made up the majority of the remaining gains.
Three factors are critical to Ontario’s export volumes going forward: the Canadian-US exchange rate, NAFTA renegotiations, and US domestic demand. The anticipation of the rise in the key policy interest rate influenced the rally of the Canadian dollar against the US dollar. The exchange rate recently hit 80 cents and could climb further in the wake of further interest hikes along the road and solid economic conditions. This appreciation is likely to weigh down on export numbers in the coming months.
Secondly, there is much uncertainty surrounding the nature of trade with the US as NAFTA renegotiations are officially set to launch on August 16th in Washington. US President Donald Trump has already revealed a summary of objectives for NAFTA renegotiations, some of which Canadian negotiators will find highly objectionable. This includes the removal of the dispute settlement mechanism and allowing for “Buy America” provisions and policies. Ontario Premier Kathleen Wynne continued her active engagement with leaders in the US as she attended the National Governors Association this month, alongside Prime Minister Justin Trudeau. Only time will tell what “NAFTA 2.0” could look like and if it can translate into considerable gains for Ontario’s economy and its residents. Finally, given that more than 80 percent of exports from Ontario head to the US, the future outlook of domestic demand in the US is critical in determining Ontario’s export performance.
Higher interest rates and increased regulations to moderate housing market
In its latest Financial System Review, the BoC highlighted imbalances in the Canadian housing market (especially in and around Toronto) yet again as a key vulnerability in the Canadian financial system. Since the Ontario government announced its Fair Housing Plan and corresponding measures to help cool the housing market in April, the housing market remains hot. The New Housing Price Index rose by almost 7.5 percent in May relative to prices during the same month last year. Additionally, Ontario led the growth in housing starts in Canada, growing 44 percent in June, while the six-month moving average in housing starts reached its peak since almost five years ago. However, home sales have actually fallen in Toronto and surrounding cities.
The latest interest rate decision is potentially the first of a string of hikes to come. Additionally, the leading Canadian bank regulator, the Office of the Superintendent of Financial Institutions (OSFI) recently proposed tighter mortgage rules, which would require non-insured borrowers to prove they can afford to pay two percent above the contractual mortgage rate. Both factors are expected to suppress housing market activity, although the magnitude of a potential correction in the market, if any, remains to be seen.
Written by Saad Usmani