• GDP output slid by 0.1% in August, defying expectations for a move into the plus column for the second moth in a row. Slumping manufacturing, wholesale trade and oil and gas activity weighed down output in the month.
• The economy pared back the number of employed by 43,200 in October — the first decline in employment in three months. However, because of job gains in August and September, there was a net gain of 14,500 positions created during the three-month period.
• Retail sales rose by 0.8% in August, more than retracing the surprising 0.5% decline in July. Strong retail sales combined with increased automotive manufacturing and an improving housing market suggest monthly GDP growth of about 0.4% in August after the surprising flat read in July.
  
• The pace of housing starts picked up in August, totalling 150,400 at an annualized pace. The pop in resale home sales in July and the 53.2% (annualized pace) rise in starts in July/August augur well for residential construction to support economic growth in the third quarter.
• The merchandise trade balance for August deteriorated to C$2 billion from a C$1.3 billion deficit in July. Upward pressure on imports and downward pressure on exports will likely result in net trade acting as a drag on economic growth through next year.
• Overall prices were flat in September; the year-over-year rate stayed in negative territory and the pace of decline increased marginally to 0.9% following August's 0.8% drop. Core prices increased 0.3%, with the year-over-year rate edging down to 1.5%.
  

Dawn Desjardins
dawn.desjardins@rbc.com

back to top 

Financial markets ...View full report (PDF)
The turning point

The tide has turned for the global economy with U.S. real GDP posting a stronger-than-expected increase and China recording a breathtaking 8.9% jump in output, both in the third-quarter. Canada, the United Kingdom and the Eurozone have yet to produce clear indications that their economies are out of recession, but conditions are improving and we expect reports of positive growth soon.

United States bounds out of recession

• The U.S. economy grew at a 3.5% annualized pace in the third quarter backed by a rebound in consumer spending and surging residential investment, which ended 14 consecutive quarters of decline.
• Early reports on fourth-quarter activity point to another increase in output, with the ISM manufacturing index driving solidly into expansionary territory in October and housing indicators pointing to firming sales against a shrinking inventory overhang.
• However, consumer confidence reports showed that households became less optimistic early in the fourth quarter, thus raising alarm bells that they could retreat again.
• Emerging from the deepest recession since the Great Depression, the U.S. economy remains fraught with uncertainty about the health of the financial system and pockets of weakness outside of housing.
• Real U.S. GDP is forecast to expand by just 2.5% in 2010, a modest recovery by historical standards, and then to pick up pace, growing by 3.4% in 2011.
• Our forecast is that the first rate increase will come late next year with the funds target ending 2010 at 75 basis points and then rising to 2.75% by year-end 2011.

A mixed bag of Canadian data

• •Unlike the United States where the data point to the end of recession, Canada’s numbers are less clear-cut. The economy shrank by 0.1% in August after posting no growth in July. We think that the economy will skate back into positive territory in September, but the risks are that the rebound will fall short of the consensus forecast for a 2% annualized gain. Our reckoning is that on an expenditure basis, real GDP growth was 0.5% to 1% at an annual rate in the third quarter.
• We expect economic momentum to build, spurred by a strengthening U.S. economy, low interest rates and a steady influx of government spending. We forecast that the economy will grow by 2.6% in 2010 with the unemployment rate peaking early in the year and then drifting lower.
• Against a backdrop of firming global growth and rising commodity prices, Canada’s economy will pick up pace with real GDP growth of 3.9% in 2011even as both fiscal and monetary policy stimulus starts to dissipate as long as credit conditions continue to improve.
• For the Bank of Canada, the road to the normalization of interest rates will be long. Our forecast is that the Bank will boost the overnight rate to 1.25% by the end of 2010 with further increases in 2011, yielding a policy rate of 3.5% by year-end.

Dawn Desjardins
dawn.desjardins@rbc.com

back to top 

• Housing affordability improved in Canada for the fifth consecutive quarter during the second quarter. RBC’s affordability measures at the national level fell modestly for all housing types — down 0.4 percentage points to 26.9% for standard condominiums and 0.6 percentage points for each of detached bungalows (39.1%), standard two-storey homes (44.4%) and standard townhouses (31.5%). (The lower the measure, the more affordable is homeownership.) This follows the biggest quarterly declines on record in the first quarter when a steep drop in mortgage rates and softening housing prices significantly lowered the cost of homeownership.
• The latest improvement in affordability was widespread across the country and housing types. The only exception among major cities was the standard condominium segment in Vancouver, where RBC’s measure rose marginally for the first time since early 2008. Ottawa posted some of the largest declines, likely playing catch-up with other cities since it joined the improving trend later than in most areas in Canada. At the national level, affordability has now been restored to pre-housing boom levels (that is, those prevailing in late 2005-early 2006).
• However, this restorative phase of the affordability cycle is likely running out of steam. The two major contributors to the significant improvement during the past year or so — the decline in mortgage rates and the drift down in prices — appear to have reached turning points. After hitting generational lows (in nominal terms) in the spring, some mortgage rates (including those of five-year fixed mortgages on which the RBC measures are based) rose modestly in the summer. Also, the earlier generalized weakness in property prices has largely dissipated in recent months in most parts of the country — some areas have even begun to register gains again.
• While those shifting trends will cease to drive affordability improvements, the next phase in the coming quarters will not necessarily be one of wholesale deterioration with continued expected growth in household income providing some offset. More likely the period ahead will be marked by a certain levelling off in affordability.
• This flattening to levels close to historical averages overall is, therefore, not expected to derail the current impressive resurgence in housing activity. After sinking late last year-early this year to the deepest depths in ten years, the number of existing homes sold through the Multiple Listing System has surged by more than 60% through the spring and summer.
• Figures in June and July for Canada showed the first year-over-year increases since the end of 2007. In fact, July sales were the best on record for the month. This renewed activity is now drawing down the earlier build-up in properties for sales. The Canadian Real Estate Association reported that total listings in Canada have fallen below year-earlier levels in May, June and July. With the supply of properties for sale diminishing just as demand is bouncing back, any slack in the market is being quickly removed. This is working to heat up prices again in many parts of the country (though not everywhere).
  

Robert Hogue
robert.hogue@rbc.com

back to top 

The impressive employment advances in August and September — the first back-to-back gains in almost a year — have been a welcome sign that Canada’s economy is starting to pull itself out recession’s grasp. For some of Canada’s major cities, however, the return to earlier levels of employment will be a long process given how far they have fallen during the recession.

A look at employment since last year’s peak

While virtually all regions of Canada have been hit by the recession, the depth of the downturn has been uneven across cities. Since the employment peak at the national level in October of last year, the biggest job losses have been registered by cities in Ontario, British Columbia and Alberta — incidentally those provinces that experienced the sharpest decline in economic activity. London, Sudbury, Victoria, St. Catharines, Thunder Bay, Abbotsford and Windsor all posted job losses greater than 4%. Other cities where employment fell by more than the national average include Oshawa, Kingston, Kitchener, Quebec City, Calgary and St. John’s.
At the other end of the scale, cities in Atlantic Canada, Saskatchewan, Manitoba and parts of Quebec have tended to fare comparatively better. In fact, there have been employment gains in Saint John, Saskatoon, Halifax, Winnipeg and Sherbrooke.

Jobless rates have surged across the country

With jobs falling in most cities, the jobless rate has risen across the board in the past year, with substantial increases not only in the cities suffering the largest job declines but also in others such as Edmonton, Hamilton, Toronto, Vancouver and Montreal where the labour force has grown vigorously. Saint John has been the only city in Canada that bucked the trend; its unemployment rate fell by close to one percentage point.

Robert Hogue
robert.hogue@rbc.com

back to top 

Provincial budgets ... View full report (PDF)
Ontario’s fall 2009 economic statement

While the broad economic picture in the earlier-released March budget was already dismal for Ontario – overall activity was projected to contract by 2.5% this year, the most since 1991 – developments since then have shown an even grimmer reality for the province. Indeed, in the first quarter fiscal update released in July, the Ontario government further downgraded the economic projection to a decline of 3.3% in light of the severity of the downturn during the first half of the year, as well as the extreme turbulence experienced by its key auto sector. The resulting greater-than-expected loss of revenues and financial aid to the auto sector had prompted a revision in July to the projected deficit for this fiscal year from $14.1 billion in the budget to $18.5 billion. Additionally, the closing of the books on 2008-09 last month revealed a much higher deficit for that year ($6.4 billion versus $3.9 billion as previously estimated).

It is against this backdrop of generally poor economic conditions and a weaker “hand-off” from last year that the Ontario government provided its fall update on the economy and its fiscal situation. Given the context, expectations going into the update were clearly skewed towards further downward revisions (upwards in the case of the deficit). Indeed, Finance Minister Dwight Duncan today confirmed that due to a combination of sharper-than-expected drop in revenues and a stronger rise in expenses, the deficit will balloon to $24.7 billion in 2009-10, or more than 75% higher than the original projection.

Robert Hogue
robert.hogue@rbc.com

back to top 

Provincial budgets ... View full report (PDF)
Quebec’s fall 2009 economic statement

The significant upward revision to Ontario’s deficit last week sent shockwaves not only for what it reveals about the financial situation of Canada’s largest province but for what it might signal about other provinces that had presented their budgets many months ago in the spring. Quebec being next in line to provide an economic and financial update, concerns had accordingly risen that the $3.9 billion deficit projected for 2009-10 in the March provincial budget would be marked up substantially.

Quebec Finance Minister Raymond Bachand did indeed confirm on October 27 that the financial picture had deteriorated but, overall, not quite as much as feared. The deficit for 2009-10 is now expected at $4.7 billion, an increase of $749 million or 19% relative to the March budget. The Quebec government also raised its projection for 2010-11 from $3.8 billion to $4.7 billion, a 24% bump higher. While, these are meaningful revisions, they are much less dramatic than the roughly 80% ballooning reported in Ontario – and, for that matter, the 66% surge in this year’s federal deficit since the federal budget in January. A significant factor in the deterioration in Ontario, and federally, was large financial aid to the auto sector, which has been absent in Quebec.

In contrast to Ontario, which is now facing its highest deficits on record, the upwardly revised budget shortfalls in Quebec remain smaller than those posted during the first half of the 1990s. Relative to GDP the deficits in Quebec measure 1.6% and 1.5% in 2009-10 and 2010-11, respectively, or less than half the of 3.4% achieved in 1994-95 and the modern-day high of 3.9% in 1984-85.

Robert Hogue
robert.hogue@rbc.com

back to top 

• The global economy posted a sharp decline in early 2009, but the economic downturn slowed in the second quarter.
• The global economy is now exiting recession, with recovery expected in the coming quarters.
• “Cash-for-clunkers”-type rebates give a lift to growth, both directly and indirectly, in the United States, Germany, France and Canada.
• The staying power of the recovery is still a risk, but momentum is likely to build as financial markets continue to recover and stimulus flows
• Central banks to keep policy accommodative until the recovery is well entrenched and unemployment starts to retreat.
• Interest rates to remain low in 2009; gradual increases are expected in 2010.
• U.S. economy contracted in the second quarter, but at the slowest pace in more than a year.
• Spending on durable goods and inventory rebuilding to support economic growth.
• Core inflation to ease given excess capacity in the economy.
• Unemployment rate to peak in late 2009 and remain high in 2010.
• Canada gets a lift from U.S. auto demand, thus positioning the economy for positive third-quarter growth.
• Modest growth in 2010 is likely to result in only a modest improvement in labour markets.
• Inflation worries are on the backburner as continuing slack in the economy wards off upward price pressures.
• Bank of Canada policy rate to hold at extraordinarily low level until mid-2010.

Paul Ferley
paul.ferley@rbc.com

back to top 

We are now seeing some positive signals that the Canadian economy is poised to return onto a recovery track as we had forecast last quarter. However, on the provincial side, the picture is somewhat more tainted. There have been recent indications that the contraction of economic activity this year is more widespread on a provincial basis than earlier thought. We now see nine provinces posting negative growth this year, including the economies of two of the only three provincial economies that we had previously expected to expand. Our forecast for Saskatchewan’s economy — the growth leader last year — has been revised substantially lower to reflect poor crop conditions this summer, a sharp drop in potash production and softer-than-expected residential investment. Similarly, Nova Scotia’s economy is now projected to shrink due to weakness in capital spending. Even our forecast for Manitoba’s economy, the lone remaining provincial economy expected to be in positive growth territory in 2009, has been revised down from our June forecast and is now expected to barely hold above water.

Forecast adjustments have also been made to other provincial economies as well, mostly to the downside — including to British Columbia, Alberta, Quebec and New Brunswick. However, these adjustments wash out on an aggregate basis. The main offset is that we have boosted our call for Ontario in light of the lifting of a large portion of the uncertainty in the auto sector, although it remains in contraction mode. In fact, Ontario’s economy is still expected to show the second biggest decline in activity in the country after Newfoundland & Labrador, which is weighed down by large drops in crude oil and mining production. Also, we have significantly cut the rate of decline in Prince Edward Island, reflecting surprisingly strong exports of potato products and aircraft components.

With all but one province projected to contract in 2009, this recession is shaping up to be one of the most widespread and synchronized in memory. By comparison, the early 1990s downturn bypassed most of western Canada, while that of the early 1980s spared the Atlantic region.

Like the recession, next year’s recovery is expected to be widespread. All 10 provinces are projected to expand in 2010 with western Canada leading the way. With the end of the global financial crisis, signs are sprouting up across the country — including the impressive rebound in existing home sales — that point to an end to the recession in the third quarter of this year. This is setting the stage for increased spending by businesses and consumers from coast to coast in the period ahead. Relatively aggressive public sector spending is providing a hefty dose of economic stimulus in most jurisdictions and this will carry over to next year. Indications that the U.S. economy is on its way to recovery will boost demand for Canada’s exports next year and will re-invigorate commodity markets, both heating up prices and rekindling interest in developing new production capacity.

Our forecast of stronger performance in the western part of the country in 2010 will reflect in large measure the rebound in commodities and related increase in spending on major capital projects. In the case of British Columbia, activity will get a boost from the 2010 Winter Olympic and Paralympic Games.


Robert Hogue
robert.hogue@rbc.com

back to top 

Special report ...View full report (PDF)
Auto sector: The dawn of a new era?

Battered by the financial and economic crisis, the global auto industry has just gone through its darkest days since the Great Depression. Plunging sales have pushed industry giants over the edge, causing widespread plant closures, employee layoffs and ripple effects throughout the supply chain. Now that Chrysler and parts of GM have emerged from bankruptcy protection in the United States, in a series of "Q&As, this report analyzes what it all means for the auto sector from a Canadian perspective? Here are some key points

Q: Are we out of the woods yet?
Chrysler and GM have won some significant breathing space, but uncertainty will persist until motor vehicle sales recover meaningfully from recent deeply depressed levels. Equally important is the situation of parts manufacturers, who are still very much on shaky ground (they have been under intense pressure for a number of years). Several large players have filed for bankruptcy protection in recent months in the United States (including Visteon, Metaldyne, Hayes Lemmerz, Noble International and, in early July, Lear) and a host of others are said to be in trouble. Given the symbiotic relationship between the large motor vehicle manufacturers and their parts suppliers, risks in the overall sector will remain elevated until both have returned to health.

Q: Is this a permanent change in the Canadian auto industry or a cyclical episode?
Both. The North American industry had excess production and distribution capacity, primarily among the Detroit Three owing to their protracted market share loss since the mid-1980s. Some culling of capacity had to occur — this is the process now under way. At the same time, the financial and economic crisis, particularly in the United States, destroyed motor vehicle demand. Thus, a large portion of the decline in Canadian motor vehicle and parts production is attributable to the recession/financial crisis. Once the U.S. economy begins to recover, which we expect during the second half of this year, and consumer confidence bounces back more firmly, and with financing availability and terms improving, U.S. motor vehicle sales should pick up and production in Canada should initiate a cyclical rebound.

Q: What is the outlook for auto sales and production?
We expect auto sales in the United States to rise very modestly during the second half of this year, totalling 10.2 million units overall in 2009, and continue to move higher to 11.5 million units in 2010. This would compare to 13.2 million units in 2008 and an average of 16.6 million in the previous five years. Similarly, in Canada, sales of new motor vehicles are expected to move modestly higher starting in the second half of this year, totalling 1.5 million units in 2009 and 1.6 million units in 2010 compared to 1.7 million in 2008 and an average of 1.6 million in the previous five years. In the medium- to longer-term, the “new normal” for sales in North America is likely to be a little lower than the average of 18.5 million units (perhaps in the 17.5 to 18 million range) recorded in the 1999-2007 period due to a slower projected growth in the driving-age population.

The implications for auto production in Canada is that 2009 will probably be the low point of this cycle — indeed, this will be the worst output performance since 1982. Over the medium-term, annual production rates in Canada could well return to the range of 2.2 million units that has often been achieved this decade. However, moving much above such levels — to, say, earlier peaks of 2.7 million units — would be quite unlikely in light of the reduction in capacity that has just taken place.

Q: What is the impact of the turmoil in the auto sector on Ontario’s economy?
The crisis in the industry has both structural and cyclical components. This means that, as the cycle turns upwards, activity will, indeed, pick up again in the province. Ontario will remain a leading auto manufacturing hub in North America, benefitting from the presence of world-class players, a well-established supplier base, strong skills and expertise, excellent infrastructure and advantageous geographic location. However, growth will be constrained by some loss in productive capacity, mostly on the parts manufacturing side. This is a key reason behind our forecast of Ontario lagging the rest of the country in the recovery. That being said, the resumption of production at the Chrysler plants (idled during May and June while the parent company worked through the bankruptcy procedures in the United States) and other facilities during the summer is likely to produce a certain pop in real GDP mid-year, helping the province move towards positive growth overall during the second half of this year.

back to top 

Special report ...View full report (PDF)
The good and bad news for Canada’s housing market

The good and bad news for Canada’s housing market Canada’s housing market sagged in late 2008. The number of units sold fell steadily from May 2007’s record pace and that the pace of decline picked up significantly in the fourth quarter of last year. Prices peaked in December 2007 and were off 13% from that peak a year later. Activity was slower in all regions; however, British Columbia stands out as the market that has come under the most significant downward pressure and Ontario’s housing market has also slowing significantly, with sales running at 37% below the July 2007 peak July 2007 and prices off 11.7% from their December 2007 high. Is Canada headed for a U.S. or U.K. housing market slump? While we expect Canada’s housing market to soften some more, we see limited scope for the correction to mirror the record-breaking housing slump in these other economies.

The bad news

• Some of the arguments favouring a continued deterioration in Canada’s housing market are compelling.
• The economy is in recession with significant pockets of weakness, including Ontario.
• Consumer confidence is at an all-time low, and,
• The labour market is easing, with a record-breaking 129,000 jobs lost in January alone.
• Households have been acquiring debt at a rapid pace. As a percentage of personal disposable income, Canadians are carrying the largest debt load on record.
  

The good news

• Canada’s debt-to-disposable income ratio stands at a much lower level than in either the United States or the United Kingdom.
• While the debt load has increased, the cost to service that debt has started to decline and is well below the 10%-plus rates during the early 1990s recession.
• The prospect that mortgage rates will continue to decline as credit markets stabilize and spreads narrow sets up for debt service costs to continue to ease in 2009.
• Policy actions by central banks to increase liquidity are starting to have traction and there is evidence of a moderate improvement in credit markets.
• Canadians have significant equity in their homes with the real estate equity-to-asset ratio standing at 69.2%, very close to historical highs.
• The supply of unsold homes is up but still well below levels of past recession.
• The percentage of mortgages in arrears (payments late by three or more months) stands at 0.29% of all mortgages outstanding, below the average for this decade of 0.32% and the 1990s average of 0.5%.

Is there room for conditions to worsen?

• While the good news appears to outweigh the bad, we still see room for Canada’s housing market to slow in 2009.
• RBC’s base-case scenario for the economy is that the 2008-09 recession will be relatively short-lived.
• The risk of a deeper and more prolonged global recession, however, cannot be discounted and raises the downside risk to our projection of a moderate, cyclical downturn in Canada’s housing market in 2009 and modest recovery in 2010.

Dawn Desjardins
dawn.desjardins@rbc.com

back to top 

• Technological advances, globalization, the lessening of regulation and the high Canadian dollar have upped the ante for small businesses in a wide spectrum of industries during the past decade. These factors have exerted increasing pressure on small businesses to take steps to become more competitive - including combining with other organizations.
• Consolidation in the manufacturing sector has led to a generalized loss of small businesses. However, there is evidence that average firm size has grown in the majority of industries. A similar “bulking up” of firms is also found in sectors outside manufacturing.
• Small businesses in sectors directly exposed to foreign exchange, such as tourism, have been most affected. Suppliers of goods or services to larger, export-dependent organizations also felt the effects, but to a lesser extent, of the sharp appreciation in the Canadian dollar.
• Within the broad small-firm category, there appears to be a shift in composition towards larger organizations, suggesting that many “micro” businesses are taking steps to scale up their operations in the face of increasing challenges. Only the hardest-hit manufacturing industries, such as textiles and clothing, fail to show a gain in average firm size.
• While consolidation in the manufacturing sector has led to a loss of small businesses, there is evidence that average firm size has grown in most manufacturing industries. Through the challenging markets of the past several years, the decline in the number of small manufacturing firms might actually be a positive sign if it reflects a movement towards them becoming larger in size. Larger firms tend to be in better position to make the investments necessary to become or remain globally competitive.
• Whether this size expansion is a result of smaller firms becoming bigger, or larger firms gaining heft, or both, we see this as positive news for our economy. Productivity performance tends to get stronger the larger the size of enterprises.
• Looking ahead, the slower growth trend in the number of small firms is likely to persist as the “soft patch” in the economy dampens opportunities for new business formation in the near-term and the forces of consolidation and restructuring restrain any pick-up in the pace once economic activity re-accelerates. Similarly, the increase in average firm size is likely to continue.
• While definitive judgment will await the availability of more comprehensive data, the evidence to date is encouraging. Signs of small businesses in Canada gaining heft across the spectrum of industries underscore important, positive structural adjustments taking place in our economy, enhancing its longer-run prospects.

Robert Hogue
robert.hogue@rbc.com

back to top