Steady growth in Canada amid uncertain global environment: RBC Economics

Boost in commodity prices creates a net wealth benefit for domestic economy

TORONTO - Canada’s economy has been a frontrunner in the race to expansion with real GDP standing two per cent above its pre-recession peak and posting a 3.9 per cent annualized rate gain in the first quarter of 2011. Aided by a projected continued recovery in the U.S., Canada’s economy is forecast to expand by 3.2 per cent in 2011 and 3.1 per cent in 2012, according to the latest Economic Outlook released today by RBC Economics.

“With more than 50 per cent of Canadian exports linked to natural resources, higher commodity prices have provided a substantive and positive boost to our economy,” said Craig Wright, senior vice-president and chief economist, RBC. “Higher prices mean higher domestic income growth.”

Courtesy of an increased demand for commodities and a widening spread in short-term interest rates, the Canadian dollar broke parity with the U.S. dollar in early January. Canada’s currency remains strong and is likely to hold its current range for the remainder of 2011.

“The dollar has made a remarkable recovery from the all-time low we saw in 2002, to within six per cent of its all-time high,” explained Wright. “This improvement has caused a dramatic fall in the price of imported machinery and equipment and will likely drive Canadian companies to purchase imported goods to update their capital stock and improve Canada’s productivity performance.”

RBC forecasts a 7.1 per cent gain in imports; growing at about double the average pace compared to the previous decade. Strong demand for commodities and a revival in U.S. demand for autos will drive healthy gains in exports - at an average of nine per cent per annum for the next two years.

While the report notes that consumer spending was a key contributor to growth through the recovery, a record high debt-to-income ratio will restrain spending going forward.

Similarly, 2010’s surge in Canada’s housing market is unlikely to be sustained, meaning little support will be derived from the residential real estate market in 2011 and 2012. Housing affordability deteriorated earlier this year because of a combination of rising home prices and steady interest rates. Going forward, interest rates are expected to inch higher.

“Rising interest rates will largely be balanced by growing income levels and ultimately contribute to a stable home price environment,” explains Wright. “With interest rates heading higher, we anticipate that the volume of home sales will calm and prices will post very modest gains.”

Overall, RBC forecasts Canada’s economy to grow at a respectable clip over the next two years. The main support for growth will switch from being household-driven, as consumer spending slows, to business-driven, as investment by business strengthens. This forecast factors in the assumption that Canada’s output gap will be eliminated in the second quarter of 2012 as the headline and core inflation rates gravitate toward the Bank of Canada’s two per cent target.

“At this point, the level of uncertainty about the global economic outlook - worries about sovereign debt and fiscal balances - is driving the Bank of Canada to hold the policy rate at its current level of one per cent,” says Wright. “As concerns start to dissipate, attention will turn to domestic fundamentals.”

RBC anticipates the next rate increase will likely happen in the fall; the Bank of Canada is expected to raise the overnight rate to 1.75 per cent by the end of 2011 and to three per cent at year-end 2012.

At the provincial level, Alberta is the one to watch in terms of economic growth, with Newfoundland and Labrador following closely behind. The other Prairie provinces are also making their mark - Saskatchewan and Manitoba are expected to achieve above-average growth this year and be among the top-four. Again, Ontario is expected to hover close to the national average, while British Columbia’s growth is reduced in light of the somewhat sluggish start to 2011. The Atlantic Provinces continue to show mixed results at the lower end of the pack.

RBC’s report indicates that the U.S. economy is moving into expansion mode. In the first quarter of 2011, real GDP exceeded the pre-recession peak level by 0.6 per cent, although growth was moderate in comparison to the previous two quarters. Special one-off factors, like poor weather conditions, were to blame for this temperate growth. As these factors pass, RBC projects growth in the U.S. economy to increase, resulting in a 2.7 per cent gain this year and 3.4 per cent growth in 2012.

A complete copy of the forecast is available as of 8 a.m. ET, at www.rbc.com/economics/market/pdf/fcst.pdf. A separate publication, RBC Economics Provincial Outlook, assesses the provinces according to economic growth, employment growth, unemployment rates, retail sales, housing starts and consumer price indices.