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The announcement that the New Democratic Party is splintering from its coalition with the Liberals served as a reminder of what a colossal mess the government has left the national economy. The imbalances are shocking and numerous.
For one, Canada is in a debt crisis. Not necessarily in the government sector, but for whatever reason, someone at the helm thought it prudent to allow the household sector to run up an extraordinarily leveraged balance sheet.
Total debt-to-income sits at 177 per cent, which is double the government sector debt load and nearly 40 percentage points above both the historical norm and the peak of the credit market bubble in the United States in 2006-2007. We all know what happened next.
Canadians, in the aggregate, are shelling out 15 cents in debt service for every after-tax dollar earned
With the Bank of Canada’s prior aggressive tightening cycle bumping against this debt burden, Canadians, in the aggregate, are shelling out 15 cents in debt service for every after-tax dollar earned, which is a level that presaged each of the past four official recessions.
Second, we have had a government that has not been at all focused on capital formation and productivity, camouflaging the underlying weakness in the economy by promoting the most aggressive immigration policy on record — to a point where population growth is running at a hot 3.5 per cent annual rate.
But the multiplier impact on the economy has been so nonexistent in that it has only managed to spin out a real gross domestic product growth trend of less than one per cent year over year. Real per capita GDP has sequentially contracted in each of the past five quarters and is now down 2.4 per cent on a year-over-year basis.
Third, and this is a product of No. 2, productivity in Canada is in secular decline — down 0.8 per cent from a year ago versus the 2.7 per cent uptrend south of the border. The question is, why?
Well, in Canada, the government has built up such a machinery that it represents 26 per cent of GDP. The business sector, the area that is there to support growth in the productive private capital stock, now commands just a little over 10 per cent share of GDP, which is about three-quarters of what it is in the U.S.
Productivity crisis
In case you’re wondering how it came to pass that the productivity differential between the two countries has reached such disturbingly high levels, we have concentrated so much on government that the ignored productive private sector capital stock has completely stagnated over the past decade.
Ergo, we have a crisis in Canada of capital investment and productivity, which is why we have been so reliant on immigration, but even here, the population boom is lagging well behind the economy’s output and income-generating capacity.
Fourth, by stretching the limits of the economy’s resources with an overly aggressive immigration stance these past few years, we have created a housing crisis that is underscored by the fact that the homeowner affordability ratio is 45 per cent more stretched today than the norms of the past five decades — this ranks as the top five per cent most onerous affordability ratios for Canadian wannabe homeowners on record.
This will only be redressed by a combination of more home price deflation (just getting started) and much lower interest rates (ditto), because rising unemployment will weigh against any revival in work-based income growth.
Job market weakens
Fifth, the labour market is dramatically weakening. While there has yet to be a net contraction in employment, the growth in part-time jobs has outpaced that of full-time employment by a factor of two to one over the past year. The pace of hiring has stalled completely and job postings are being pulled dramatically in a sure sign of waning labour demand. The unemployment rate (6.6 per cent) has risen 110 basis points in the past year and 180 basis points from the cycle low — both have never happened before without there being an official recession.
Only 50 per cent of new entrants to the labour force over the past year have managed to land a job, and that compares to more than 80 per cent a year ago and over 100 per cent two years ago. As the slack in the labour market widens further, nominal wage growth, while elevated now, will recede with a lag. That is the denominator in the debt ratio and will make household balance sheets even more fragile than they are today — notwithstanding the Bank of Canada’s attempt now to contain the damage.
Sixth, and certainly one of the more troubling aspects of the Canadian macro outlook, is that only half of residential mortgages have thus far reset to what remains an elevated interest rate climate relative to the past five, 10 and 20 years (the policy rate is still more than 200 basis points above the averages of these time periods).
Mountain of mortgage renewals
The Bank of Canada estimates that average monthly payments have risen nine per cent since the onset of the aggressive tightening cycle two years ago, and that burden will rise by 17 per cent by 2027.
The numbers you need to keep top of mind are: first, that just under 50 per cent of the existing fixed-mortgage stock will be renewing by the end of 2026 (and 76 per cent of all categories of mortgages, including variable-rate mortgages with fixed payments, per the Office of the Superintendent of Financial Institutions); and, second, two-thirds of mortgages have a loan-to-value ratio of more than 65 per cent and that share goes up to 80 per cent for first-time buyers.
The Bank of Canada’s conclusion was rather stark, but it tells you why the easing cycle will be impressive in terms of both magnitude and direction: “This increase directly reduces disposable income.” It didn’t say the “growth,” but rather the “level” of income. And that spells recession, which is a haircut to GDP. In the past two years, households with a mortgage have already seen their purchasing power decline by three per cent and this is just the thin edge of the wedge.
And then there was this bombshell from the Bank of Canada staff report: “A key insight from our analysis is that the downward pressure on consumption from rate hikes could last longer than the rate hike cycle itself.”
To repeat, we have a crisis on household balance sheets, and it is going to take a lot of time and a whole lot of central bank easing to prevent a delinquency/default cycle from coming to the fore. Consumer insolvencies in July were already 24 per cent above year-ago levels, and such proposals have shot up 23 per cent. As for the business sector, failures have soared 37 per cent on a year-over-year basis. To even be debating whether Canada is in recession or not is laughable (though not at all funny).
But let’s close on a more positive note. The Bank of Canada is late, but it now realizes that it is behind the curve and is addressing the situation, albeit not that aggressively. Governor Tiff Macklem mentioned “excess supply” not once, but twice in his short post-meeting comments in front of the press after last Wednesday’s policy meeting. Code for a disinflationary output gap. The midpoint of the range of this resource gap is minus 1.25 per cent (the gap between the current level of GDP and the level of GDP consistent with a fully employed economy).
When we trace out what all this means in a classic Okun’s law framework, it suggests that by the end of 2026, we will be sitting at eight per cent unemployment (6.6 per cent now — deep recession coming) and zero per cent inflation (2.7 per cent now). You read that right — zero inflation. That is how a lingering gap between the supply side and demand side of the economy will trigger sustained disinflation.
So, we believe that (a) there is no chance we end this cycle higher than the mid-point estimate of neutral, which now sits at 2.75 per cent, (b) the historical record shows that the appropriate policy rate for an economy in an excess-supply backdrop is two per cent, and (c) going even further, the “real” or inflation-adjusted policy rate has averaged less than one per cent, so we could well end up being back there before the cycle is over … very bullish for the front end and mid-part of the Government of Canada yield curve.
Lest you think this is a radical forecast, the policy rate in Canada got as low as two per cent or lower in each of the past four Bank of Canada easing cycles over the past quarter-century.
One final point: The Bank of Canada has the cover from the most important inflation data point, the CPIX price metric, which excludes the eight most volatile components of the consumer price index. It eased to 1.7 per cent from 1.9 per cent in June and 3.2 per cent a year earlier, and that is below the midpoint of the central bank’s target band for inflation.
On a month-over-month, seasonally adjusted basis, this key price statistic came in very light at 0.1 per cent for the second month running (and has posted a microscopic number such as this in seven of the past eight months as well). The six-month trend is running close to a 1.5 per cent annualized rate, having been sliced in half over the past year.
Even as the Bank of Canada cuts nominal rates, they are still rising in real terms, which means that not only will the central bank not be skipping any meetings for the foreseeable future, it may have to start increasing the size of these interest rate reductions before long.
David Rosenberg is founder and president of independent research firm Rosenberg Research & Associates Inc. To receive more of David Rosenberg’s insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.
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