With the support of our Builder Member financial institutions, the OG100 Quarterly Economic Commentary takes an in-depth look at recent economic conditions with a lens specific to helping Ontario’s mid-sized companies make better-informed business decisions.
February 2022 with Builder Member TD Bank
Author: Rishi Sondhi, Economist, TD Economics
These past two years may have felt like 20 for many Ontario businesses. However, with a new year comes new optimism. As 2021 is firmly in the rear-view, we look ahead to 2022, and the challenges and opportunities it may bring. Overall, Ontario’s medium-sized business are expected to benefit from a solid growth backdrop, as the effects of Omicron eases on service industries. At the same time, supply-side constraints – the worker and materials shortages that became a growing issue last year, are likely to improve only slowly. Also, companies should prepare themselves for higher interest rates, even as inflation cools a notch from its current torrid pace.
Even with Omicron, Above-Trend Economic Growth in the Cards for 2022
Canada’s economy is expected to expand at an above-trend rate of 4% this year, marking the second straight year of recovery (Chart 1). This projection incorporates what should be a short-term hit to activity from the Omicron variant. Ontario’s economy should record even stronger growth than that of Canada, reflecting the release of more pent-up demand that was built-up by comparatively strict COVID-19 health measures over the past few years.
Consumer spending is likely to be the dominant driver, both in Ontario and the Rest of Canada. Households have accumulated as much as $190 billion in readily available excess savings (i.e., over-and-above what they would have saved) during the pandemic, which they will likely tap into to fund consumption. Labour markets are also strong, as is household income growth. There are some nuances worth paying attention to. For instance, when Omicron fades and provinces re-open, consumers are likely to resume rotating their spending towards services and away from goods. This will help to ease pressure on stressed supply chains.
On an industry basis, high-touch services industries like restaurants and gyms have plenty of room to recover post Omicron and should help lift Ontario’s economic growth. The same holds true for air transportation, although the recovery here could be more prolonged. We also see construction activity making an important contribution, driven non-residential spending and on-going homebuilding.
Ontario’s all-important manufacturing sector should see an improved year compared to a tough 2021. Crucially, we expect the U.S. economy to grow at a healthy clip of just under 4% this year, supported by strong household spending, rising investment in machinery and equipment, and inventory restocking efforts. As such, U.S. demand for Ontario’s manufactured goods should be firm, joining the sturdy demand coming from healthy domestic growth and strength in the rest of Canada.
A lack of inputs, due to global supply chain problems, was a major factor holding back Ontario’s manufacturing industry last year. In particular, semi-conductor shortages severely hampered auto production. In 2022, we expect these shortages to ease somewhat, paving the way for gradually higher auto production, particularly in the second half (Chart 2).
That said, this timeline is highly uncertain, and could be lengthened by Omicron and further COVID-19 outbreaks. In fact, the latest Bank of Canada Business Outlook Survey (BOS) revealed that many firms expect it could take more than a year for supply chains to return to normal. This suggests that it may take until 2023 to see these issues resolved.
Labour Shortages are Part and Parcel of the Solid Economy
The labour shortages plaguing industries across Canada are, in part, a by-product of the robust economic backdrop. They are also due to skills-mismatches, worker absenteeism due to COVID and longer-term issues, such as population aging. These shortages are pushing up wage costs and increasing the difficulty of meeting brisk demand.
Indeed, the share of smaller firms citing this issue as an obstacle to growth is near an all-time high, according to the CFIB (Chart 3). Notably, Canada’s job shortage problem isn’t as severe as it is in the U.S., where there are 1.6 job openings for every unemployed worker (versus 0.8 in Canada), and wages are growing more rapidly in response.
The situation in Ontario doesn’t appear to be quite as bad is in Quebec and B.C., which have recorded the highest job vacancy rates (a proxy for worker shortages) in the country. Still, Ontario had the third highest vacancy rate in the country late last year (Chart 4). Ontario’s manufacturing sector shares this challenge, with recent surveys suggesting that as many as 40% of Ontario’s manufacturers seeing employee shortages as a near-term growth obstacle.
Looking to 2022, we think this challenge won’t be as severe as in 2021, as wages pick up and government pandemic support programs continue to wind down, thus enticing more workers back into the job market. Our base case also assumes that COVID-19 becomes less of an issue, reducing the fear some people might have about working in high-touch industries. However, we don’t foresee a full easing in these pressures, as robust economic growth should keep labour demand elevated.
Stronger population growth should also support labour supply, although Ontario’s situation could come with a (potentially large) caveat. Migration to Ontario from other countries should pick up this year. However, in 2021, people left Ontario for other provinces at a rate not seen in over 40 years. Extremely tough housing affordability probably explains some of this trend, alongside the proliferation of remote work. With affordability likely to get worse in Ontario this year, interprovincial migration flows could be impacted (depending on how remote work evolves).
Cooler Trends Should Prevail on Inflation
Canadians are dealing with the fastest inflation in years. In fact, Canadian inflation hit 4.8% on a year-on-year basis in December, the steamiest rate since 1991. Supply chain challenges, frothy housing costs, rising energy prices, and pressures arising from re-openings have conspired to push inflation higher. Inflation is running at a hotter pace in Ontario than the country overall, stoked by faster growing rents and higher housing costs.
The Omicron variant could supply some upward pressure to inflation in the near-term. First, it may have caused a further re-orientation of purchases back towards goods, thus pressuring supply chains. Worker absenteeism from Omicron could also disrupt supply chains in the near-term. Price pressures could also intensify as high-touch industries reopen and demand outpaces their ability to ramp up.
That said, we still expect a cooling in inflation to take place (particularly in the second half of the year) as re-opening pressures fade, energy prices come off the boil and supply chain challenges improve somewhat (Chart 5). By the end of the year, we see headline inflation slowing to about 2.5% on a year-on-year basis. This is still above pre-pandemic trends, and the risks are likely tilted to the upside, given the potential for COVID-19 flare-ups and uncertainty as to when supply chain pressures will significantly improve.
Interest Rates Moving Higher, Although the Dollar Should Stay Put
Given the fastest inflation in decades, healthy job markets and the expectation of strong economic growth this year, the Bank of Canada is poised to push its policy rate off its emergency setting in short order, with the first hike likely to come in March. This should help take some steam away from consumer spending and slow housing market activity. It will also push up the cost of financing for businesses (Chart 6).
We anticipate 4 interest rate hikes taking place this year – one in each quarter. Ultimately, we think the Bank will take its policy rate to 1.75% in 2023, marking a total of six hikes and bringing the level of rates to an estimated neutral level. This, along with the hiking campaign taking place stateside as well as balance sheet run-off, will push interest rates higher across all maturities. In the U.S., we see the Federal Reserve also hiking rates 4 times in 2022, followed by 3 more in 2023.
The Canadian dollar will likely hold near its current level of about 80 cents through this year (Chart 7). Although oil prices (a big driver of the Canadian dollar) should move moderately lower from current levels as production revvs up, this is already priced-in to the Loonie’s value, and it would take a downside (or upside) surprise on oil to move it in either direction. Meanwhile, differences in Canada/U.S. interest-rate stances (another major driver) are negligible.