Q1 report had something for optimists and pessimists

The release of the Q1 Ontario Economic Accounts by the government on July 4th provided the most comprehensive and up-to-date picture of the provincial economy. While a quarterly update issued during the dog days of summer typically comes and goes without much of a whimper, this one generated considerable media attention.

For this analysis, we present many of the key historical indicators featured in the Accounts in the accompanying table along with TD Economics’ forecasts through Q4 2009. The upper part of the table provides an accounting of GDP, while the lower part includes gauges of incomes, prices, job markets, housing activity and production.

The headline Q1 result – a real GDP decline of 1.4% annualized – didn’t come as a shocker since we already knew that Statistics Canada had estimated Canadian real GDP at -0.3% in the same period. And Ontario was almost sure to do worse in light of its heavy bent on the struggling manufacturing sector. Nonetheless, the consensus-matching outcome didn’t make the report any less newsworthy. In particular, with the further setback, real economic activity in Ontario remains stuck below the level recorded in mid-2007. What’s more, the steady slippage in the real GDP profile over the past few quarters conveyed ominous signals about the economy’s near-term prospects.

How should one interpret the Q1 numbers? For one, the top-line rarely tells the whole story, so a more balanced assessment involves digging below the surface. A second caveat is that quarterly data are prone to volatility and the impacts of temporary factors which need to be disentangled. And Q1 was no different. Two short-term factors in particular left an imprint on the quarterly performance:

Looking beyond the impacts of these short-term factors, the Q1 GDP report presented a decidedly mixed picture, albeit better than at first glance. From a glass-half-full perspective, consumer and government outlays – which, together, account for more than three quarters of total economic activity – continued to turn in solid showings. In fact, any advance at all in personal expenditure in Q1 could have been considered a feat following the 9% explosion in outlays in Q4 (the fastest Q/Q rate in two decades!). So the 2.4% expansion chalked up in Q1 was consistent with an ongoing personal spending boom.

From the glass-half-empty perspective, two pockets of domestic spending that had been in overdrive throughout most of 2007 – notably, business investment and homebuilding – suffered significant setbacks. As such, final domestic demand stalled in Q1, although it remained up a brisk 4% on a year-over-year basis.

The news on income generation in the Q1 Accounts also shone a somewhat brighter light on the economy’s performance. Underpinned by further job creation and wage gains in early 2008, personal after-tax income – in both absolute and in real per-capita terms – soared. Indeed, this latest snapshot provides a good explanation for the staying power of household spending in Q1 despite soaring gasoline prices. Rising wages, along with upward pressure in other input costs, had contributed to lower business profit margins throughout 2007. However, corporate profits managed to rebound slightly in Q1, providing support to the modest expansion in nominal GDP.

Negative print on Q2 not a done deal

With one negative quarter in the books, the report fuelled even more chatter about the likelihood of recession, narrowly defined as two straight quarters of declining real GDP. Based on Q1 developments – together with preliminary readings on Q2 from a host of monthly indicators on retail trade, international exports et cetera – it appears that Ontario may have narrowly averted this fate in the first half of 2008. TD Economics’ base-case estimate for the April-June period is +0.4% annualized, although admittedly it wouldn’t take much to pull the GDP reading below water. Monthly numbers on exports and auto production point to a further drag from net trade in Q2, while consumer-oriented indicators augur a moderate bounce back in final domestic demand. Within the construction sector, a pull-back in non-residential activity likely went head-to-head against a rebound in homebuilding from its dramatic slip in Q1. Perhaps most importantly, the inventory correction meaningfully reduced the risk of a further contraction in economic activity in the April-June period.

Despite the widespread use of the simple two quarter recession rule, economists generally embrace a more sophisticated definition along the lines of that adopted by the U.S. National Bureau of Economic Research (NBER). According to the NBER, recessions involve more than a 2 or 3 quarter drop in real GDP, but “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” This broader notion would distinguish a period of profound economic softness with one where GDP falls victim to a temporary hit. For example, in mid-2003, Ontario real GDP fell for two straight quarters due to SARS and the Ontario power blackout. Yet under the surface, the economy remained fundamentally healthy, setting the stage for a rebound in growth once the impact of those temporary factors waned.

Fast forward to Ontario’s current situation. Even if the provincial economy did in fact record a further decline in real GDP in Q2, the other NBER conditions – with the exception of industrial production – were not met. Real income changes have been anything but recessionary, while real wholesale and retail trade activity has continued to expand. Above all, employment rose by 1.5% (annualized) in Q2, leaving the year-over-year reading at a healthy 2%.

The ongoing resilience of most of these key indicators can be chalked up the nature of the weakness in real GDP. The softness thus far has been so highly concentrated in one sector – net trade – that it has failed to infiltrate Ontario’s core domestic economy. What’s more, although the auto- and forestry-based markets across the province are visibly struggling, the more diverse metropolitan centres of Toronto and Ottawa (which, together, account for more than half of the province’s total economic activity) have remained relatively immune.

Still, as is apparent from our forecast profile, the broader definition of recession is probably going to be put to the test in the coming quarters. The argument has been for some time that domestic spending and exports can follow diametrically different paths in the short run, but a sizeable gap can’t last forever. Nor can the equally large schism witnessed between real GDP and job creation persist. And given that the conditions in the U.S. export market are expected to remain soft until the second half of 2009, this convergence is more likely to take place by way of a weakening on the domestic front.

Cracks forming in Ontario’s job market

June employment numbers served up the most convincing evidence yet that Ontario’s job market may have started to succumb to the pressures emanating from outside the province’s borders. Employment retreated by 24,000 total jobs in the month, although that headline tally concealed an even larger 46,000 drop in full-time positions. The jobless rate rose by 0.3 percentage points, to 6.7 per cent, while the increase in the median hourly wage slowed from 4.2% to 3.8%.

As shown in the table, we anticipate further bad news in Ontario’s employment pipeline over the next 18 months, with the jobless rate moving above 7% and personal income growth essentially stalling. Indeed, a closer look at the job stats by sector reveals a growing vulnerability in the job market. The manufacturing and the tourism-oriented service industries (i.e., accommodation and food & information, culture and recreation) have remained the most significant weak spots in Ontario’s labour market over the past year. Employment in the financial services industry has also been grinding lower since the eruption of the global credit crisis last summer. And while most other sectors have been rising to take up the slack – including professional services, wholesale and retail trade and transportation services – the aggregate job creation figures conceal the fact that some 90% of the total net new jobs recorded on a year-over-year basis have been concentrated in only two sectors: government and construction.

Looking ahead, it is unlikely that these two areas will be able to continue to pull beyond their weight. The outlook for the non-residential construction sector remains positive, particularly as funds booked for infrastructure in previous provincial, federal and local government budgets are spent. But recent data on the resale housing market indicate that the province’s over-heated housing sector has begun to simmer down. Housing starts continued to defy gravity in the spring of 2008, as condo projects got started this spring. But, in all likelihood, starts activity has peaked. And as we discuss on page 7, the slowing economy will not be lost on government coffers going forward, limiting the extent of further public-sector hiring.

Broad-based slowdown expected

The slackening in job market conditions is likely to continue into 2009, putting a damper on personal incomes and household spending activity in the coming quarters. Within the business sector, prospects for investment are not as negative as that implied by the dramatic pull-back registered in Q1. In fact, in the July 2008 Bank of Canada Quarterly Business Outlook Survey, a higher number of firms in Central Canada indicated an intention to raise machinery and equipment (M&E) spending in the near future for “reasons related to restructuring”. Still, with corporate profits likely tracking downwards, gains in overall business investment are expected to be minimal.

While consumers and businesses confront more challenging conditions, some offsetting relief will stem from a likely pull-back in crude oil prices to about US$100-110 per barrel by late 2008. The Canadian dollar is also likely to ease in tandem, to 95 US cents and 92 US cents in Q4 2008 and Q4 2009, respectively. TD Economics expects that the Bank of Canada will keep its overnight target rate at a reasonably stimulative 3% until midway through next year, before bumping it up to 3.75% in late 2009.

In sum, TD Economics expects Ontario to eke out some slight real GDP growth this year and next, but the margin between expansion and contraction in the forecast is razar thin. Moreover, the projected general softening in domestic and labour-market conditions in the near term will push Ontario closer to satisfying a broader definition of recession than any time since the early 1990s.

The use of the R-word tends to be avoided, and for good reason. Yet economic expansions followed by recessions are inevitable components of any business cycle. The fact that Ontario hasn’t fallen into recession in 15 years (twice the traditional 7-year cycle) can be attributed to a number of positive structural developments over the past few decades, including improved provincial and federal fiscal policies, stable inflation, low interest rates, booming trade with the U.S. following NAFTA and an increasingly diverse economic base. But, these factors have made cycles longer and less volatile, not eliminated them entirely.

Recessions often conjure up images of mass layoffs, but the hardship they inflict is fully dependent on their depth and duration. Consider the severity of the early 1990s recession in Ontario, which was brought on by the implosion of a domestic housing bubble in the late 1980s, surging inflation, double-digit interest rates, and large government deficits.