COVID-19: Economic Perspective
By Benjamin Tal, Deputy Chief Economist, CIBC Capital Markets
The following comments provide a summary of our current observations and working assumptions regarding the economic impact of COVID-19.
COVID-19: The Immediate Future
We are now where Italy was a month ago. But the demographic composition of Canada is different (we are a younger society), and we started preparing for the spread of the virus earlier, suggesting that we might be able to avoid the rate of infection seen in Italy. However, it is still clear that the situation in Canada will get worse in the coming weeks, with the infection curve expected to steepen notably.
With society already responding to that eventuality, the economic impact will be very significant. We expect 2nd quarter real GDP in Canada to fall by roughly 30% on an annual basis (roughly 8% on a quarterly basis), with the unemployment rate rising to over 11%, as a result of job losses slightly north of 1.5 million in the coming months.
Perspective
Having said that, perspective is very important here. While many talk about the current situation as being equivalent to the Great Depression of 1929, there is one significant difference. The COVID-19 crisis has an endgame. That endgame is a vaccine. This is not a free fall with no end in
sight. We have had numerous conversations with experts in the field and the question is not if, but when, a vaccine will be found. The consensus is that an effective and tested vaccine will be available within 12-18 months. The minute we have a vaccine, the crisis will come to an end. So what we are doing now is simply buying time until we reach that point. That realization is crucial to the response functions of governments, central banks, commercial banks, and individuals, which will be discussed later in this commentary.
Between now and then there is another line of defense- antiviral treatment. There is currently a global race underway to find such a treatment from the pool of existing treatments. And here again, there is reason to expect some success, likely in the coming months. While the effectiveness of such a treatment is still a big question mark, there is growing optimism that the combination of it, and the response by society, will eventually work to flatten the curve in a few months, as we have seen in China and more so in South Korea.
Flattening the curve should work to ease the pressure on the healthcare system, which will reach unprecedented levels in the coming few months. But it will not be a green light to go back to normal. In fact, the most significant risk facing China at this point is a secondary wave of COVID-19, if workers go back to work too early.
Beyond the Coming Quarter
Accordingly, we see a very slow recovery following the next quarter. Many Canadians will continue to work from home, and many establishments such as restaurants and personal service facilities will remain closed. Factories might adjust by working at reduced capacity, utilizing shift work, and alternating hours to reduce the risk of infection in the workplace. At this point we see real GDP growth rising by roughly 15% in the 3rd quarter of the year, and 10% in the 4th quarter, as more businesses resume (reduced) activity. For 2020 as a whole we expect real GDP to fall by 3.9%, with growth rebounding to 4.7% in 2021.
Policy Response and Its Effectiveness
In this context, and with the realization that this crisis is temporary in nature, the reaction curve of governments, central banks, and commercial banks as well as individuals, is crucial. Being equipped with the experience and knowledge of the subprime crisis, governments and central banks have been swift and decisive in their reaction. The Bank of Canada has exemplified that by cutting policy rates to the effective lower bound, starting a quantitative easing program (QE) with a commitment to continue it until the recovery is well underway, purchasing insured mortgages, expanding term repo operations, and establishing new facilities including the Standing Term Liquidity Facility (STLF) and the Bankers’ Acceptance Purchase Facility (BAPF), which have been very effective in ensuring that there is enough liquidity in the system. And there could be more to come. The Bank of Canada could expand QE beyond government bonds and mortgage-backed securities, potentially into the corporate bond space like the Federal Reserve has done. The reality is that the central bank has an unlimited capacity to provide the system with liquidity and allow commercial banks to extend credit.
However, given the nature of the crisis, central banks cannot lift demand via lower interest rates. And that’s where the fiscal stimulus announced by the federal government is so important. It so far includes $105 billion in direct transfers of money to individuals and qualified businesses, and $85 billion via tax payment deferrals, which amounts to roughly 5% of GDP. Again, the goal here is to buy time and keep as many Canadians as possible in a reasonable financial position. Note that all of the measures announced by the government are reversible, due to the temporary nature of the crisis. We will not be surprised if more fiscal actions are taken in the coming weeks or months.
One important additional action we would like to see is partial loan guarantees on commercial loans to banks, given the increased level of risk in the system. So far, the government has chosen to rely on the Business Development Bank (BDB) and the Export Development Corporation (EDC). However, with so much volume in the system we are already seeing a situation in which those institutions are deferring business loan requests to commercial banks, while providing 100% guarantees. That makes sense. Commercial banks have the know-how and the experience to deal with that situation. Expanding such an arrangement and providing banks with partial guarantees (so that banks also have skin in the game) can go a long way to ease the pressure on the system.
Commercial banks also have an important role in buying time. As things stand now, small business owners can expect to see payment holidays of up to six months, GIC holders can redeem with no penalty, unsecured loans (such as credit cards) can skip two payments, and for mortgages, many borrowers may qualify for up to six-months of payment deferral. Note that banks will continue to record those deferred payments as income. As well, depending on the ability of the system, some banks will be able to capitalize deferred payments and add them to future monthly payments when the fog clears. Others will postpone the payment to the end of the term and/or increase mortgage amortization. Importantly, that will limit the speed of the recovery as we get the all clear.
Impact on Households
The household sector was not ready for COVID-19. Elevated debt levels, a high debt service ratio, and a low savings rate, worked to increase households’ sensitivity to economic shocks. While for years that sensitivity was masked by low interest rates, the current crisis is exposing that vulnerability. The direct injection of cash to households, as well as debt payment deferrals, will therefore play an important role in easing the pain for households. Also note that households will reduce consumption in a very significant way over the coming months as social distancing means less spending. Overall, with all of the accommodation available at this point, we expect a more modest increase in household insolvencies than might be implied by the expected rise in the unemployment rate.
COVID-19 and Housing
The housing market started the crisis from a very strong position. Inventory levels in centers such as Toronto, Montreal and Ottawa, were extremely low, and Vancouver was in a late stage of a strong recovery. Clearly, that was not the case in Alberta for obvious reasons.
Zooming in on the resale market, up until a couple of weeks ago it was relatively active, but since then things have changed. With no showings and appraisers unable to inspect the interiors of houses, the market is not functioning. With demand and supply frozen, prices are also frozen. That is very different from any “typical’’ recession when reduced demand leads to a fall in prices. We expect the market to remain frozen in the coming few months.
The main impact will be felt in the new construction market. While many low-rise units in major centers will be able to close transactions, the situation in the high- rise segment of the market is more complex. 2020 was supposed to be a record year for completions, mainly in centers such as Toronto and Montreal. But there is now a significant question mark around the ability of developers to deliver, given reduced productivity as sites try to cope with the impact of the virus. It is very reasonable to assume that in the very near future, most construction activity will come to an end.
While that will reduce supply, the reduction in demand will be more significant. Due to economic hardship, it’s reasonable to assume that some buyers of presale units will not be able to close. In that case, we expect developers to be more than willing to take those units back and return the deposit, given the significant increase seen in condo prices over the past few years. Another source of softening demand will come from condo investors. Historically, the level of activity in condo investing has been highly correlated with the stock market. With the recent correction in that space, we expect reduced investor activity.
But the most significant impact of the crisis will be felt in the rental market. One third of Canadian households are renters. The rental market has been very tight, with only recent months starting to show some levelling off in rent inflation due to increased supply, in part due to increased purpose-built activity. We expect to see a significant reduction in demand for rental units in the coming months and beyond. One factor is of course the deep recession that we are in, but another important factor is the reduced number of immigrants and non- permanent residents coming to Canada, which stood at roughly 450,000 a year prior to travel restrictions. Given the nature of the crisis, with Canada closing its borders, it’s reasonable to assume that this number will be reduced dramatically, and it might take a while before it rises back to pre-crisis levels. This of course will have a significant impact on the economy as a whole, the housing market in general, and the rental market in particular, since most newcomers and non-permanent residents are renters.
On the issue of rent, while landlords are now prohibited from evicting, the question is to what extent those landlords will be able to ride the wave with no rental income. Our research suggests that most condo investors do not rely on their rental income for their livelihood, and if needed they might qualify for mortgage payment deferrals. As for the owners of rental apartment buildings, to the extent that they face a major reduction in rental income, they might also need some support to bridge that gap since otherwise they will not be able to service the buildings, which is de facto an eviction.
Overall, we expect new construction activity to soften notably, with housing starts falling from an annualized level of 200,000 to around 70,000 in the coming quarter, the lowest level of activity seen in any recession in recent history.