Threatened by Inflation: A Canada Macroeconomic Update

Sluggish GDP growth in the first half of 2021 accelerated later in the year as the Canadian economy began to recover from the COVID-19 (coronavirus) pandemic as vaccinations were widely administered. In turn, Canadian GDP increased 3.0% in the second half of 2021. While some setbacks were presented amid the onset of the Delta and Omicron variants of the virus, growth was largely driven by easing restrictions and a reopening economy. Despite a strong recovery in 2021, mounting inflationary pressures and ongoing supply chain disruptions, further accentuated by the developing war in Ukraine, presents an uncertain outlook for 2022.

Labour market

• 156,800 jobs were added in the second half of 2021, driven by the continued easing pandemic-related restrictions and increased vaccinations. Total employment exceeded prepandemic levels in November 2021.
• Despite strong growth, 200,000 jobs were lost in January 2022 alone. These were primarily part-time positions in accommodation and food services particularly affected by new public health measures implemented amid the onset of the Omicron variant. While employment approached prepandemic levels in November 2021, accommodation and food services exhibited the largest decline since the first wave of the pandemic in 2020.
• Although public health measures eased in the fourth quarter, capacity limitations and closures for retail stores, restaurants, bars, concert halls and gyms were put back in place. Some jurisdictions also returned to online learning for schools.
• As employment dropped in January 2022, the unemployment rate increased 0.5 percentage points, reaching 6.5%, marking the first increase in nine months. This was driven by an increase in temporary layoffs amid reinstated public health measures.
• Average hourly earnings increased to $30.95 as companies raise wages to fill jobs and retail existing staff, driving concerns for wage inflation.

Consumer spending

• Household consumption expenditure (HCE) in Canada continued to increase in Q4 2021, with consumer spending higher than prepandemic Q4 2019 spending. Further, overall HCE was up 8.9% in the second half of 2021 relative to the first half of 2020. Overall, year-over-year spending increased 9.7% in 2021.
• Increased consumption trends in Q4 2021 were led by spending on clothing and footwear increasing 26.8%, spending on education rising 15.2% and spending on furnishings and household equipment growing 7.6%.
• Despite an overall increase in HCE, growth was pressured by transportation falling 5.4% compared with Q3 2021. Additionally, spending on transportation remains below prepandemic levels.
• Spending on housing, water, electricity, gas and other fuels increased 3.1% in Q4 2021. Overall spending on these segments increased 6.6% for the year. This was largely driven by spending on electricity and gas significantly increasing at the end of the year, rising 30.2% and 268.3% respectively.
• As the Ukraine-Russia war continues to evolve, the price of food and gasoline for Canadians is expected to increase, which will likely affect HCE patterns. For example, increasing interest rates in response to high inflation, has caused the price of homes to increase in early 2022.

Inflation

• Inflation, measured by the consumer price index including food and energy, was up 5.7% as of February 2022, representing the largest increase since August 1991. Increased inflation has been driven by significantly rising gasoline and energy prices, which increased 32.3% and 24.1% year-over-year as of February 2022, respectively.
• Although gas prices were already trending upward, the Ukraine-Russia war has caused prices to skyrocket due to the sanctions placed on Russia, decreasing the world supply of oil. These sharp gasoline and energy price increases are expected to cause inflation to continue growing, further limiting consumer spending power moving forward.
• Additionally, the year-over-year price of food increased 6.7% in February 2022, contributing to further inflation increases. As the Ukraine-Russia war continues, the price of food for Canadians is expected to continue increasing as agricultural inputs for domestic industries and food imports are pressured.
• Since energy and food prices are especially volatile, inflation is also measured excluding these volatile items. Year-over-year inflation excluding food and energy was up 4.8% as of February 2022.

Construction: Canada

• Construction activity is often a leading indicator of business investment and consumer activity. Growth and decline have an effect on loan portfolios and investment strategies. ​Specifically for commercial lending clients, construction trends present potential risks for loan exposures and probability of defaults, especially during economic downturns.
• Residential construction was hit the hardest by the pandemic-induced slowdown, as homebuilders backed off significantly. This primarily comes amid the stay-at-home orders for consumers, as well as steep declines in consumer sentiment. However, as per capita disposable income rose and interest rates fell in 2020, residential construction grew above prepandemic levels, peaking in July 2021.
• While construction activity increased in Q3 2021, fuelled by low interest rates and an expanding economy, total construction has been decreasing since August 2021. This decline has been driven by decreased residential construction activity over the five years to 2022.
• However, nonresidential construction has increased at a moderate rate since April 2021. This trend is primarily a result of a slow reopening of the economy, as investors consider long-term expansion and growth prospects.

Construction: Ontario

• Ontario has been especially affected by the negative results of the lockdown, pressured by the temporary lockdown of the automotive industry and slower easing of restrictions in the province. Accordingly, the overall rebound has been more moderate in Ontario than in other provinces.
• Additionally, total construction has increased more rapidly in Ontario than in Canada overall, even though construction activity declined in the second half of 2021. Over the six months through January 2022, total construction declined 10.4% in Ontario, while construction across Canada declined 12.8% during the same period.
• Although nonresidential construction activity in Ontario surged past prepandemic levels in 2021, reboundingconstruction may temper moving forward as Canada’s central bank increases interest rates.

Financial markets

• The Bank of Canada increased interest rates in early March 2022 to rein in inflation for the first time since 2018. The central bank raised rates from 0.25% to 0.50% and is expected to raise them again in April.
• S&P/TSX index produced a price return of 21.7% in 2021. Energy was the best performing sector, driven by spikes in demand for oil and natural gas drove gains, and it is anticipated to continue as countries source alternative oil due to Russia’s actions.
• The Bank of Canada saw a small increase of asset purchases to smooth the transition of a recovering economy in the second half of 2021. However, it has again reduced the rate of asset purchasing, particularly government bonds, as the economy reopened later in the year and in 2022 to fight inflationary concerns.
• Canadian banks are expected to fare well in 2022 as net interest margins are likely to rise.

Distribution of risk ratings

• 2019 risk ratings were close to normally distributed, albeit elevated due to rising economic concerns.
  • 2% of industries rated as medium-high or greater risk.
• Risk in 2020 was concentrated at the higher end of the scale.
  • 1% of industries rated as medium-high or greater risk.
• While risk in 2021 is expected to be more moderate, it is still elevated.
  • 7% of industries rated as medium-high or greater risk
• The risk outlook is expected to improve significantly by 2022, once the economy is fully reopened.
  • 5% of industries rated as medium-high or greater risk.
• This may shift based on the outlook of the current crisis in Ukraine.

Outlook

Despite new variants of coronavirus in the second half of 2021, easing restrictions late in the year and early 2022 point to a rebound in food and accommodations, events and tourism. Expanding tourism and economic activity may drive improvement in consumer and business spending. However, this is expected to be offset by interest rate hikes driven by rising inflation and supply chain issues.

Supply chain disruptions and rising global crude oil prices in early 2022 brought inflation to the highest level in more than 30 years. Rising prices of many commodities also tempered construction spending in the second half of 2021, demonstrating a bleak outlook for continued investment. With the Bank of Canada increasing interest rates, borrowing costs will also rise, limiting large construction investment for both residential and nonresidential markets in 2022.

Additionally, the ongoing war in Ukraine poses an additional threat to Canada’s agriculture and manufacturing sector due to additional shortages of key inputs, such as fertilizer and certain metals. Sanctions placed on Russia has ultimately decreased global oil supply, driving up prices and further contributing to inflation. Conversely, rising raw materials prices may push the mining and agriculture sectors to ramp up production to meet demand and benefit from high prices in the near term. However, the outlook of the war and its effect on the Canadian and global economies in 2022 remain uncertain.

Sector highlights

• Accommodation and Food Services – Sector employment remains far below prepandemic levels, particularly as new virus variants in 2021 led to restrictions being reimposed. Consumer spending has remained elevated in service industries, including at food service establishments, driving growth in the Full-Service Restaurants industry. Additionally, a broad reopening of the economy and easing travel restrictions in 2022 will likely benefit tourism and drive demand for the Hotels and Motels industry.
• Finance and Insurance – The Bank of Canada raised interest rates for the first time since 2018, hinting at additional rate hikes in response to the war in Ukraine. Rising interest rates will likely benefit banks as it enables banks to increase the charge associated with borrowing for customers, resulting in higher net interest income and revenue. As the cost of borrowing increases, the Commercial Banking and Loan Administration, Cheque Cashing and Other Services industries stand to benefit.
• Manufacturing – Manufacturing activity faltered in late 2021 and early 2022 as supply chain disruptions and shortages limited supply of key inputs. However, government consumption expenditure and business investment in machinery and equipment increased overall in 2021, maintaining demand for manufacturing industries. As production has not been able to keep up with demand, prices have increased. The ongoing shortage in microchips has continued to hamper car production, in particular, having the strongest effect on the Car and Automobile Manufacturing and SUV and Light Truck Manufacturing
• Construction – Construction weakened in the second half of 2021, with residential construction activity peaking in mid 2021. Still, residential and nonresidential construction activity continued despite interest rates remaining low in 2021. However, rising interest rates in early 2022 pose a threat to construction activity moving forward as borrowing costs increase, tempering growth for industries such as the Home Builders and Apartment and Condominium Construction industries.