June 2023 Quarterly Economic Commentary with CIBC

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.

June 2023 with Builder Member: CIBC

Author: Andrew GranthamExecutive Director and Senior Economist| Economics | Capital Markets

Defying Gravity…but for how long?

The Ontario economy so far appears to be defying the gravitational pull from higher interest rates, echoing the resilience that has been seen in theoverall Canadian economy. Growth has been much stronger than anticipated to start 2023, the unemployment rate remains extremely low, and house prices have even started to edge up again.However, this apparent resilience is likely being flattered by some unique characteristics of the post-pandemic economy. The true test of how the economy fares in a higher interest rate environment is yet to come.

Levelling the land

A common mistake made in economic forecasting during and after the pandemic was to think too much about growth rates rather than the level of economic activity. For example, since interest rates started rising early in 2022, the volume of consumer spending in typically interest rate sensitive sectors has risen by 10%. It’s very easy to look at such a statistic and think that interest rates are still not high enough to slow the economy – a judgment that the Bank of Canada appears to have made in hiking interest rates again.However, these typically interest rate sensitive areas of consumption include some of the areas that were hit hardest by the pandemic. Auto sales, for example, were lower than they should have been due to supply chain disruptions, while discretionary services such as travel and restaurants were impacted by social distancing restrictions that were in place until the spring of 2022. While inflation-adjusted consumer spending in these normally interest rate sensitive sectors has risen, on average, by 10% over the past year, the levels of consumption are still marginally below their end-2019 levels. In other words, interest rate hikes are working, but they are working to slow the rate of recovery post-pandemic, rather than necessarily resulting in outright declines in spending.

The export performance of the economy over the past year has also been a demonstration of forecasters forgetting about the level of economic activity. Due to supply chain disruptions in key industries such as autos, Canadian exports performed poorly in relation to global demand during most of 2021 and early 2022 (Chart 1). As supply chain issues have improved more recently, export volumes have surged. The Ontario economy has clearly benefited from higher auto production and exports.

However, much of the catch-up in consumer spending and exports is now complete, which means that the true test of how the economy will respond to higher interest rates is only just beginning. For the Ontario economy in particular, this will prove to be a tough test. While rapid house price inflation during the pandemic saw household debt levels rise across the country, in most areas, aggregate incomes kept pace (Chart 2). For Ontario households, though, the rise in debt since 2019 has gone above and beyond the increase in incomes, suggesting that some households will struggle to maintain current spending levels when interest rates are reset at higher levels.

Chart 1: Export volumes have caught up with global demand

Source: Bank of Canada, Statistics Canada, CIBC

Chart 2: Ontario households in a riskier position due to debt levels

Source: Statistics Canada, CIBC

Immigration providing less of a boost than elsewhere

Chart 3: Labour force growth has accelerated the most in prairies and Atlantic Canada

Source: Statistics Canada, CIBC

The high cost of housing in Ontario relative to many other provinces may also be making it harder to attract and maintain immigrants into the province. While immigration has been strong and is one of the main drivers behind an acceleration in labour force growth relative to 2019 (Chart 3), it could have been stronger. With workers in the service sector now less tied to live and work near their head office, many are choosing less expensive areas of the country, such as Atlantic Canada and the prairies.

And missing out on some additional immigration also means missing out on the extra growth that newcomers into the country are bringing relative to the pre-pandemic norm. With new immigrants landing jobs in higher paying sectors than in the past, their average earnings have moved much closer to the national average (Chart 4). This extra spending power is adding to the growth potential of those areas that have seen the biggest increases in immigration.

Chart 4: Average earnings of new immigrants have converged closer to national average

Source: Statistics Canada, CIBC

Defying gravity…for now

Growth in Ontario, and across Canada more broadly, has held up much better than anticipated so far this year. Unfortunately, it has held up so well that the Bank of Canada recently raised interest rates again, and it could follow up that move with one more 25bp rate hike to take the overnight rate to 5.0%.That would be a tough adjustment for households in Ontario, particularly as more homeowners who bought just before or during the pandemic see their mortgages reset at higher interest rates. Combined with the boost to exports from an easing in supply chain issues starting to fade later this year and into 2024, the next twelve months may see little or no growth in the economy. The good news is that, after that period of adjustment, inflation will likely be close to 2%, enabling the Bank of Canada to start trimming interest rates by June 2024.