BMO Economic Briefing: A look ahead to 2023

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Douglas Porter | November 22, 2022 | Economic Insights

BMO Economic Briefing: A look ahead to 2023

Douglas Porter | November 22, 2022 | Economic Insights

BMO recently held a virtual event to explore the current economic conditions across Canada. BMO's Chief Economist, Douglas Porter, provided his perspective on the current state of the economy, including inflation, interest rates, and a look ahead to 2023. You can watch the replay here.

Transcript

Doug Porter: Well, thank you very much, and hello, everyone. Thanks for joining us today. As mentioned, I'm going to basically spend about the next 15 minutes taking a look at the big picture view before handing it over to Robert for the regional drill down. I have to say, when we look at the overall picture of the economy, this is one of the more complex economic environments, certainly, I've seen in my career. We've been dealing with extremely high inflation a very sharp backup in interest rates. There's all kinds of, frankly, talk about note right downturn for the Canadian and the global economy in 2023, so that's a lot to unpack.

Let's get started with a very big-picture view of financial markets in 2022, and frankly, it's been a tough year for financial markets. If we start with what really triggered a lot of the concerns, of course, it does go back to inflation and much of that relates to the sharp run-up in energy prices that we had at the start of the year, partly of course, as a result of Russia's invasion of Ukraine. I do want to just step aside for a moment though, and just drive home the point that we had a very serious inflation episode on our hands even before Russia's invasion of Ukraine.

If you go back to February, we were looking at a US inflation rate of roughly 8% and a Canadian inflation rate of 6%. That's not terribly different from where we are today. In fact, if you look at that chart on the left-hand side of oil prices, you see that, as we speak today, oil prices are actually somewhat lower than they were before Russia's invasion of Ukraine. It's not just oil prices. If we look at a broad basket of commodity prices, most are actually a little bit lower than they were back in February, so we can't really pin this all on Russia's invasion of Ukraine.

We've got a much broader inflation episode that we're dealing with and as a result of that, central banks have come roaring off the sidelines and raised interest rates at a pace that frankly, we haven't seen in decades. Now, I've just picked one interest rate here, the 10-year US government bond yield. Just as a reminder, that yield started the year at about 1.5%. As we speak today, it's closer to 4%. That is an enormous move in a short period of time and there are many, many interest rates that I can point to that have risen much more than that run up in the 10-year yield.

Meanwhile, up until recently, we've had the US dollar just steamrolling over every currency in the world. First, against the Yen, then the European currencies, and in the last couple of months, against the Canadian dollar, and the reason why this is important is that's leading to a double-whammy of inflation pressures for the rest of the world. So, when you think of economies like Japan, Britain, Europe, Canada, we had our own domestic inflation pressures, and then on top of that, we've been dealing with a weak currency, which means we've been importing inflation pressures from the US.

Now, in recent weeks, the US dollar does look like it has come back a bit. It has come down a little bit. The Canadian dollar has made a bit of a comeback, but again, the bigger picture here is that the US dollar has generally strengthened against all currencies. Now, when we add all these things together, an energy price shock earlier this year, a big backup in interest rates, a strong US dollar against almost all currencies, well, that's been a real problem for equity markets as a whole.

Again, we've seen some recovery, an encouraging recovery in recent weeks in equity markets, but I think the big picture is, not just in the US but globally, we're looking at a pretty severe downturn for equities since the start of the year. So, when you add those conditions up, we've had a big rise in interest rates, weakness in equity markets, it certainly does point to cloudy weather ahead for the global economy and the North American economy. We'll start with the big picture, with the global outlook. If you look at the table in the middle of this chart, you can see we've got the global economy going from a nice rebound last year of 6% to 3% growth this year, and then a bit of a further cooldown in 2023.

Now, to us, a normal year, quote normal year, for the global economy would be a growth of about 3.25% to 3.50%. So, we're a little bit below what I would view as an average year for the global economy in 2022, and I have to say, I consider that to be a big disappointment. Because when you think about it, we came into this year believing that we're going to have an above-average year for the global economy as tourism reopened, as entertainment reopened, and travel got back to normal, we thought we'd have a fairly strong year for the global economy, and we did get that reopening in tourism and entertainment, but unfortunately, we also had two big draws on the global economy.

One is that China dealt, the second largest economy in the world, dealt with a rolling series of lockdowns that led to growth of about half of what we were expecting in China, and then the rest of the world was dealing with that very big backup in interest rates and high inflation, and that clipped consumer spending almost everywhere else. Now, looking into 2023, we do see a further slowdown. We think that that backup in interest rates will bite down a little bit more deeply on global growth, and so we see the global economy slowing to just a little bit more than 2%.

Our view is that anytime the global economy dips below 2% growth, we would call that a global recession. So we're just a little bit shy of a recession, however, I do think that one more shock, one more negative shock would tip global growth into an outright downturn in 2023. That's a very big-picture view, let's drill down North America. What do we see with Canada and the US?

Starting with Canada, when we look at this here, this will actually end up being a fairly strong year for the Canadian economy. It looks like our growth will be about 3.25% this year. A normal year for the Canadian economy is something closer to 2% or maybe even a little bit less than that. So, we are looking at a fairly solid year for the Canadian economy, and a lot of that just goes back to the fact that we did get the reopening in Canada. We did get that big rebound in tourism and entertainment. On top of that, it now looks like we had a very strong rebound in the grain crop in Western Canada after the terrible drought in 2021, and also the big bounce in commodity prices at the start of the year did support a number of key regional economies in Canada this year.

Now, relative to the US, there are a couple of advantages that we had over the US in this year. One is we had a reopening this year. I would suggest that the US really reopened last year. You know, for all intents and purposes, COVID was almost over, at least in their view, in 2020, so our reopening happened a little bit later. Also, the relative strength of commodities did support Canada more than the US. So, those were two big relative advantages on why grew faster than the US in 2022.

Unfortunately, both of those relative advantages are now fading. The reopening has basically happened. As I mentioned earlier, commodity prices have come down from those strong highs we saw earlier this year, and meanwhile, we've got a relative negative that's starting to move to the forefront. That relative negative is the size of the housing sector in the Canadian economy.

When you think of-- you add together renovation activity, new building activity, and real estate agent fees, those account for a little bit more than 7% of the Canadian economy. In the US, when you add those three things up, it's about 3.5% of the US economy. So, housing is about twice as important to our economy as it is to the US economy. Thus, when housing is going in reverse as it fairly clearly is, that's a much bigger drag on the Canadian economy. We've got two advantages that are now fading and one negative that's moving to the forefront and that's why we see both the Canadian and US economies basically moving in sync in 2023.

Our view is that we are likely looking at a shallow recession for Canada and the US. In the next year, we actually see an outright decline in GDP in both economies in the first half of the year before a small recovery through the second half. When you tally that together, it looks like we're essentially looking at no growth in Canada and the US over the year ahead.

That's not to say there aren't some positives. By the way, I don't think a downturn is locked in stone, I think there is still a narrow path by which the economy could avoid an outright downturn. I think that still is a possibility if a lot of things went right. However, I also think there's the risk that we could see a more severe downturn than the shallow recession that we're officially projecting.

One positive I would point to, there's no question, we're still looking at one of the tightest job markets, one of the healthiest job markets that we have seen in generations. For instance, we just heard, recently, that Canada had more than 100,000 jobs in the month of October, that kept the unemployment rate at just 5.2%. That's one of the lowest jobless rates that we have seen since the early 1970s.

In the US, arguably, the job market is even tighter. Even with a small increase recently, the US is also looking at an unemployment rate of just a little bit above 3.5%. That's one of the lowest jobless rates they've seen since the late 1960s. This is not just a North American story, if you look at that table on the right-hand side, you can see many, many major economies are looking at one of the lowest jobless rates that they've seen in many decades. In almost all cases, they've now got a lower jobless rate than they had before the pandemic.

If anything, the job market is even tighter than that headline unemployment rate would tell us. On top of that, there are also many, many job openings. In the US, there's almost 11 million open jobs. In Canada, there's almost a million vacant jobs. Right now, we have about a million people unemployed so we effectively have one open job for every unemployed person. I've never seen that before. That, to me, is the very definition of full employment. If you think that's tight, it's even tighter in the US where they have almost two vacant jobs for every unemployed American. As I said, that's one of the tightest job markets we've seen in generations.

Now, as a result of that, naturally, we're beginning to see a lot of wage pressure on both sides of the border. It really began in the US earlier. They saw a tighter job market earlier than we did and they're starting to see some sustained upward pressure on wages. There's lots of different measures of wages, the ones we look at suggest that the average worker in the US is now seeing wage gains on the order of about 6% to 7%. That's strong, no question about it, but it's actually a little bit below headline inflation. The latest inflation reading came in at close to 8%.

In Canada, we're also seeing some upward pressure on wages, depending on which wage measure you look at. A typical Canadian worker is seeing a wage gain of about 5%. Again, that's a solid number, one of the better gains that we've seen in quite some time, but headline inflation is around 7% now, so the average worker is trailing far behind inflation.

Take those two elements together, we've got on the one side, one of the strongest, healthiest job markets that we've seen in generations on the one side, and on the other side, we've got wages that are actually trailing behind headline inflation. To me, that's the very recipe for labor market unrest or strife or conflict, and that's exactly what we're beginning to see. We're beginning to see strike activity, public sector and private sector workers agitating for bigger wage increases. Perfectly understandable, given the fact that it is such a healthy job market and their wages have been trailing behind inflation.

When we look back at the long sweep of history, the chart on the left looks at headline inflation in Canada and the US going back to 1960, the only episode where we really had serious labor market strike activity in North America was during the 1970s and early 1980s, when we had very high inflation. Now, there's a lot of information on this chart but a couple of things I would point to is, first of all, you very rarely see much separation between Canadian and US headline inflation. In other words, where the US leads, Canada does tend to follow.

We really can't tend to do a whole lot better than the US. In the last year, we have done somewhat better than the US. As you can see from the table on the right-hand side, or the bar chart on the right-hand side, Canada is at the lower end of the spectrum globally when we look at inflation, but again, this is a very uncomfortably high inflation rate that we're looking at.

Now, looking over the next year, the chart on the left-hand side does look like we've got inflation coming down and coming down very fast in the next 18 months, and we do have inflation backing off from these extraordinarily high levels that we're dealing with right now. However, we still expect inflation to average almost 5% in Canada and in the US next year. By the end of 2023, we've still got inflation in the 3.5 to 4% zone. That is just too high for Central Bank comfort in the year ahead, even with considerable improvement over the next year.

Now, let's just stand back for a minute and take a look at what has caused this inflation. How do we go from years and years of 1.5% to 2% inflation to roughly 7% inflation now in Canada? On the right-hand side, we're taking a look at, in the consumer price basket of goods and services, what's gone up the most in price in the last 12 months. Frankly, I think there's five different stories here. There are five different themes that have driven inflation to the level we've reached, and very briefly, one is energy prices.

You see natural gas and gasoline prices have gone up a lot. Second is the reopening play. Last year no one was traveling. This year everyone was traveling. That's pushed up hotel rates and airfares from very low rates. Third story is the supply chain issue we've all heard a lot about. We've seen pressure on things like furniture and appliance prices. Fourth is the global food crisis. You can see grocery prices have gone up by double digits. That is not a Canadian story. We're seeing double-digit increases in grocery prices almost everywhere. Story number five was the housing boom that we went through.

Now, home prices don't enter directly into the basket they enter indirectly through real estate agent fees, new home prices, and rent but home price boom does work its way into the consumer price basket. My main message to you is there are five different things that have caused this inflation burst. That's five things that have got to stop going wrong or even start going right over the next year. Frankly, there isn't just one light switch that policymakers can flick off and make inflation go away. We need a lot of things to stop going wrong. That's one of the reasons why central banks have been so aggressive in raising interest rates over the past year. They're trying to avoid this buildup of inflation from getting what they call entrenched or locked in and changing consumer psychology on a sustained basis. That's why they're being so aggressive in terms of the rate hikes.

Now, Mr. Malcolm recently indicated that not that the end is near, but the end is getting within sight. We still believe that the Bank of Canada is likely to raise interest rates by a total of another 75 basis points or three-quarters of a percentage point. From here our official call is another half-point increase at their next meeting in December, and then another quarter-point hike in early 2023. Then we see them holding interest rates through 2023 at that level. If you think back to our inflation forecast, we still have inflation around 3.5% by the end of next year. That's why we think rate cuts are more a story for the year after. We think that's a story for 2024. Meanwhile, in the US we think they've got a little bit even further to go. The Fed has now leapfrogged the Bank of Canada a little bit. They've hiked rates by a quarter point more than the Bank of Canada. We see another full percentage point of interest rate increases from the Federal Reserve. We do think they'll slow down to a half-point increase at their next meeting in December but then we see two more rate hikes in 2023 lifting the US interest rates a little bit further above Bank of Canada interest rates in the year ahead.

Now, you may be wondering, well, if you've got US interest rates going up by more than Canadian interest rates, isn't that going to put a lot of downward pressure on the Canadian dollar? The short answer is yes, but I would assert that that has already been built into the Canadian dollar. This is the main reason why the Canadian dollar weakened so much in late August and September and early October is because the financial markets were building in this view that US interest rates would go up by more than Canadian interest rates in the year ahead. That's why the Canadian dollar did sag specifically against the US dollar.

Now, as you can see from this chart, the old-standing relationship between the Canadian dollar and oil prices, which worked like a charm for about 15 years really has gone astray in 2022. The dominant story, the dominant driver of the Canadian dollar over this past year has been the flip side of the US dollar itself. In other words, as the US dollar was rising against everybody, that's what steamrolled the Canadian dollar this year. Our view is that the US dollar is close to a peak, if not already there, and will tend to lose a little bit of altitude in 2023 against all currencies. The flip side of that is we do see the Canadian dollar making a little bit of a comeback next year.

Don't get me wrong, we don't see a big backup in the Canadian dollar, but our core view is that the Canadian dollar is currently a little bit below what we would consider to be fair value and we do see it somewhat strengthening over the year ahead. That's it for the big-picture view. I'm now going to hand the baton off to my colleague, Robert Kavcic, to give you a drill down to the regional view, and I'll be back for the Q&A. Thank you very much.

Robert Kavcic: Great, thank you very much, Doug. To start off, I guess the first thing I'll say here is that when you look at the Canadian economy, typically you have to zoom in to the regional level to really get the story. What's unique this cycle is that really, every province went into this pandemic together, every province came out of it together, some a little bit ahead of others, obviously, but a lot of the big picture themes that Doug discussed, like inflation, like the extreme tightness in the labor market, all of that applies when we zoom down to Toronto and Ontario as well. What I'm going to do is kind of try and just differentiate a little bit some of the factors that are maybe tilting our forecasts in Ontario, and then focus a little bit more specifically on some issues like what we're seeing in the real estate market, and on the demographic front and with fiscal policy as we go through the view of Ontario in the GTA.

I guess the first thing I'll say here is that when you look at the forecast for Ontario over the next year or two, like the national average, we are coming off a very strong period of recovery coming out of the pandemic very strong, almost 3% growth print expected this year but we do expect Ontario to lag in 2023. Doug pointed out one thing in the comparison of Canada versus the US where Canada has a relatively high proportion of residential investment versus the US. Well, if you take that a step further, Ontario, as well has a relatively high proportion of residential investment relative to the rest of Canada. I'll get into the housing market story in a few minutes but the reality is, as we go through this real estate correction, our view is that Ontario is going to get hit relatively hard on that front and that's one of the factors that contributes to the underperformance in GDP growth over the next year or so.

On the inflation front, I mean, as I mentioned, a very similar story here in Ontario versus the rest of the country and a historically tight labor market as well. We are expecting to come off the lows with respect to the jobless rate over the next 18 months or so but like the national story, we are just seeing unprecedented numbers of job vacancies and upward pressure on wage growth as well. A lot of the inflationary issues in the labor market that are leading to labor action and some disruption in the bargaining process, we've seen pretty clear examples of that on the ground in Ontario just over the last two weeks or so.

That is the backdrop. I think the one thing that everybody seems to be keyed in on here is what's happening in the real estate market, so we'll spend some time on this. The reality is that I mean, where we are now, this isn't a question of if or when we're going to be seeing a correction in real estate, it's very much underway right now. We have fresh sales and price data for the country as a whole this morning and they continue to show that the market is correcting and that sales volumes are very weak and prices are coming down.

For some context, when you look at what we saw through the pandemic, and I know there was a lot of debate on this over the last two years or so. Do we have excess demand, or do we have a lack of supply? The reality is if you look at sales on the left-hand side of the screen here, we saw an unprecedented explosion in demand for housing in this country and in Ontario, specifically, during the pandemic. A lot of people were moving out, picking up houses with more space and we saw a pretty dramatic increase in the share of homeowners that were buying multiple properties so a lot of investment activity.

The reality is when we look at what was happening on the ground, and with prices, there was just a lot of speculative activity and a lot of fear of missing out going on that drove sales 50% or 60% above the baseline of what was normal before the pandemic. Of course, that was not sustainable and while we do have some longer-term supply-side issues, the reality is that there's just a lot of froth to clean out of the market here. When you look at what happened very early in this year, the minute the Bank of Canada started to raise rates, just that initial 25 basis point move by the Bank of Canada was enough to really stop the housing market overnight.

That kind of told you there was a big psychological component with respect to what was going on in housing and since then, we've actually seen national house prices fall exactly 10% from the February high. You can see here that regionally, it's spread pretty wide across the country. Now I will say that Ontario does look most exposed to this downturn and this will give you a little bit of color as to why we say that. Historically, when you look at house price growth in Canada, going back to the early 1980s, we've seen about 3% per year real inflation-adjusted house price growth. That's the left-hand side of your screen there. That's the long-term trend of about 3% inflation-adjusted. The middle chart here shows you the difference between where prices are and that underlying run rate of real house price growth, and so you see episodes here like the late 1980s where house prices got extremely stretched. That was what we all now, when you look back in history, would unquestionably call that a housing bubble, especially in southwestern Ontario.

We've also seen periods around, say the early two thousands when housing in Canada was exceptionally cheap. That was after a 10-year bear market and housing was very affordable and valuations were extremely depressed relative to long-run baseline, but look at where we ended up at the height of the pandemic boom back in February. We were at price levels that pretty closely resembled the deviation or the extremes that we saw back in the late 1990s, the late 1980s. That's at the national level. When you take that peak deviation and you break it down at their regional level, you get a little bit more color here and you can see that one of the markets that was pretty clearly most exposed was Ontario, the GTA as well but more specifically the exurban markets and the recreational property markets across Ontario where we're looking at historically very significant deviations from what can be considered normal.

Markets one to two hours outside the core of the GTA, and we're talking now areas like London, Berry, Collingwood, other parts of southwestern Ontario that were typically outside the reach of home buyers that were really tied to the core of the GTA, but as we shifted in the pandemic and as this ability to take on hybrid work or fully remote work opened up, a lot of people really just bailed on the core of the GTA and fled out to some of these markets. That drove a lot of the success of price growth and it brought a lot of froth with it, so that's the process and that's the extreme froth that we're in the process of cleaning out of the market right now today.

Our view here is that, as Doug mentioned, interest rates are still pushing higher through the first quarter of next year and the mortgage market is very much reflecting that. One of the things we have to be mindful of here is when we're trying to assess maybe how big the price correction is going to be, is just look at the swing that we've seen in mortgage rates. First thing I'll focus on here is just the change in mortgage rates and what that has done to housing valuations.

Through the real height of the boom in 2021, the majority of Canadians were taking out variable-rate mortgages at around 1.5% or so. In fact, about 20% of the outstanding mortgage market in Canada today is variable rate mortgages that were taken on at around 1.5%. What happens when you take a market that's very fully priced at 1.5% mortgage rates and you reset those mortgage rates very quickly up to around 5% like we're seeing on the ground today? Well, if you're going to hold down payment sizes constant, incomes constant, amortization links, all those other factors constant, if you're going to absorb this increase in mortgage rates, you're going to have to pull about 20% to 25% off the price of the house itself and that's just to maintain the conditions that were in place before the interest rate shock. Right away we're dealing with just strictly from evaluation perspective, about a 20% to 25% haircut on house prices nationally, and that is technically our forecast if you look out over the course of the next year and a half or so.

Housing is not alone on this. If you look at what's happened with equities, with commercial real estate, and various other asset classes, the wide spectrum is adjusting to the reality that we've moved to higher interest rates, so residential real estate's not alone on this front. The other thing I'll point out here is that when we look beyond just the impact on the asset price itself, we're expecting a bit of a slowdown for the consumer and possibly a significant slowdown for the Canadian consumer over the next 18 months or so because of this interest rate situation.

A lot of Canadians are seeing interest rates and their debt payment burden rise in real-time today. Because of the structure of the mortgage market where a lot of variable-rate mortgages actually have fixed payment features, what is actually happening on the ground is not necessarily a big shock to payment today but amortization links are getting stretched out to the point where we're actually seeing a lot of households now that took out 1.5% variable looking at mortgages now that are almost interest only and starting to see some trigger payments and things like that but the reality is that like the bigger issue is going to be three or four years down the road when a lot of these mortgages come to renewal, depending on what happens to interest rates in the back end of this cycle but if we're renewing into this higher interest rate environment, there's gonna be a pretty significant headwind on the consumer still coming down the pipe.

I would describe this as rather than a really significant hammer blow to Canadian households, this looks more like a very heavy wet blanket that's going to sit on the household sector for a number of years going forward as they absorb this higher interest burden and the leverage that they took on during the pandemic.

That's the second part of this is the drag on the household sector. The third thing I'll say here is that I want to differentiate between the correction in the asset price itself, which which we discussed, and just the underlying the underlying stability of the household and the financial system in Canada. Because remember that when you were going into the bank in 2021 and taking out a mortgage at 1.5%, at a federally regulated institution, you were still qualifying up at around 5.25%.

Back at the time, a lot of people were like, well, why are we qualifying at 5.25% when mortgage rates are 1.5%? Well, it's a good thing that we did because from a capacity to pay perspective, that stress test that was in place that looked maybe a little bit too arduous through the pandemic when we were at record low interest rates, is hopefully going to come back and help save us a little bit during this period where we actually now do face that that rising interest burden. From a capacity-to-pay perspective, I think Canadians are in a pretty decent position here.

Step back again and look at some housing corrections that we've seen in the past, and believe it or not, because we've been conditioned to see house prices just steadily rise year after year in Canada and especially in the GTA, the reality is that housing corrections are somewhat common and we have seen a number of examples since the mid to late 1980s where house prices, at least at the regional level, have corrected. When we do the work and we look at the historical precedent for housing corrections in Canada, what you tend to see is that every cycle is different, yes, but on average, house price declines of about 15%, peak to trough, are very normal.

Typically seeing markets take two to three years to find a bottom is also very normal.

Real estate's a relatively slow-moving asset class, and just look at what we're seeing on the ground today, as an example, where you have buyers that can't qualify for, or can't just from an affordability perspective, pay prices that were in the market six months ago, but at the same time, you have sellers that don't necessarily need to sell. They still have very strong labor market conditions to fall back on. Rents are rising if you're an investor, so there's no forced selling going on in the market. You have this standoff where sales are extremely low because the market is just not clearing right now, and so the discovery process for prices takes a long time. In a lot of cases, it tends to take at least a couple of years.

Then historically, seeing a market take three, four or five years to actually get back to peak levels is very common. The real bad cycle that we saw coming out of the late 1980s took more than a decade for prices in Ontario to get back to peak levels. We don't think it's going to be this bad this time around just because a lot of other things went wrong for Ontario in the late 1990s that we don't see today, but we do see, again, roughly 20% peak to trough decline nationally. Some pockets turning out quite a bit worse than that. The reality is some markets already off 20% from their high and it playing out through the later stages of 2023.

The other takeaway here from this chart that I'll leave you with is that with the exception of Calgary, which as we know is a very oil-driven market, the common denominator behind all of these housing corrections historically has been increases in interest rates and so that's just the reality of a market having to reprice itself to a higher cost of capital. It's just something we can't really step around again, this time around during this cycle.

With all that bad news out of the way, what's good here? Well, I guess the one thing I'll point to is the demographic situation in Ontario is historically very, very strong. There are three main pieces to the demographic story that I like to focus on just for simplicity. One is, the one everybody knows about and everybody talks about is international immigration. We saw the federal government actually ramp up those international immigration targets recently, targeting about 500,000 people per year, a few years down the road. Those flows tend to find their way pretty uniformly across the country, but ultimately, they gravitate towards the stronger job markets and where the best employment conditions are, and the GTA tends to be one of those. From that perspective, I think we have pretty significant support there.

The other thing we don't hear much about is, or maybe enough about, is the millennial cohort, the peak demographic. The peak single-year age group of that millennial group is about 32 or 33 years old right now. Of course, when you get into your mid-30s, mid to low 30s, this is the story we've been telling for probably a decade or so, you start moving out, you start having your second or third kid, and you start looking for more space in a bigger house and a family home to raise your family. We are reaching pretty peak demand from that perspective on the demographic front. That's going to be with us for a number of years still going forward as well.

Those are two major demographic supports in Ontario that are driving population growth in the 25 to 40 age group at the strongest rate we've seen since the late 1980s. I use that age group because that is a pretty good age group that's indicative of incremental housing demand.

Just to wrap up. Then I think one of the other issues here is the fiscal situation. I think coming out of the pandemic, we just saw a dramatic fiscal shock, both federally and down to the provincial level. We all know about just the massive amount of fiscal stimulus that rolled out through the pandemic, almost $300 billion at the federal level. On its own, I know that doesn't mean much, but it's more than 10% of GDP. It's really the biggest single round of fiscal stimulus that we would've seen since World War II, just a dramatic increase in stimulus.

When you look at the fact that those programs have now started to roll off and spending is gradually finding its way back down to normal, the other side of the ledger here is the revenue side, and revenues at the federal level have actually come back very, very strong. This is maybe one area where inflation actually does help a little bit, where it's driving stronger normal GDP growth and is driving stronger revenues from things like personal income taxes, corporate income taxes, sales taxes.

What we actually saw was that the historic budget deficit in Canada close down relatively quickly. We're still looking at about $30 billion on the budget deficit, but that's not too much more than 1% of GDP at this point. Canada, I would say, has come out of what looked like a really tough fiscal situation relatively well in part because of that resurgence and revenues.

Then when you drill down to the provincial level, I think the big takeaway that we see through this period is that the provinces as a whole actually came out very well. As a whole, we're looking at budget surpluses at the provincial level for this fiscal year that would've been almost unheard of based on forecasts that we saw in place about two years ago.

This chart here just very quickly stacks up how the provinces rank from a fiscal perspective. As you go up the vertical access, that's increasing budget deficit, and as you go out across the horizontal access, that's an increasing debt burden, both as a share of GDP. Where you want to be on this chart if you're a provincial finance minister is down in the bottom left corner. As you go up into the right, you get worse and worse and worse. Not to pick on Ontario, but you can see who stands out up in the top right corner. It is actually us here in Ontario, the biggest debt burden in Canada relative to GDP and still the widest deficit. These numbers were fresh as of yesterday's fiscal update.

I will say two things to maybe soften this image a little bit. One is that recent history has shown that Ontario tends to significantly outperform their fiscal targets. Last year's a great example of this where the province actually ended up running a surplus in fiscal '21/'22. Second thing I'll say here is that if you were to rewind this chart about 18 months or so, Ontario would've literally been up off the screen up in the top right corner there in the blue section of your screen. We've actually come down to the left very quickly versus what was expected at this point about one and a half or two years ago.

Again, just to reiterate that, yes, on a relative basis, Ontario still doesn't look all that great from a fiscal perspective versus its peers, but the peer group overall being the group of provinces has actually come through this in incredibly strong fiscal position, and they can lean on that going forward over the rest of this cycle.

With that, I think I will wrap it up there. I think the key takeaways here for Ontario is, yes, we're probably going to see some underperformance over the next 18 months or so because of what's happening in real estate, but longer term from a demographic perspective, from an industry composition perspective, and the overall labor market perspective, I think Ontario is still a strong place to be in a driver of economic growth in Canada. Once we can come through the other side of this cycle on a relative basis, we'd remain relatively optimistic on the Ontario economy. I will leave it at that and I believe I'll turn it back over to Sheri, and we can open it up for some Q&A.

Sheri: Thanks, Robert. Appreciate it. Thanks, Doug, appreciate both of you. I'd like to welcome Steven into the conversation now as well. We're going to move into the Q&A portion. As I said earlier, we had some great questions come in ahead of time so we've got those ready and there's a few in the chat that I've seen as well so we'll start to bring those to the conversation too.

Steven, I'm going to kick off with you, seeing as you're joining us here. The news cycle can be pretty ominous at times with what we're hearing, I'd love for you to share your observations from how our clients are feeling when they're digesting this news.

Steven Jensen: Thanks, Sheri, I appreciate it. This is such a planted question because I think if I were to capture one theme from all our customers, and the Canadian entrepreneur, the North American entrepreneur for that sake is that the news cycle is so dark. At times I feel like it's that scene from Lion King when Scar is holding on to Mufasa at the edge, and he's about to fall off the cliff. I believe that's the Canadian entrepreneur feeling it, like Doug said it right then and there, one more shock would push us over the edge. When you hear things like that it creates a precariousness. There's a lot of information out there and I think the new cycle isn't capturing all the incredible good things that we're seeing.

One thing that I've seen right now is a rationalization of price. When we have the Canadian entrepreneur buying something right now, they're able to ask more questions, there's more due diligence, and it just creates honesty in those conversations. Doug walked us through the labor market and it's incredibly tight but we continue to see some elements, some glimmers of light where it loosens up in certain segments. That's been an incredibly healthy thing in certain markets. Again, this is just little glimmers and it continues to be very tight.

The one thing I would just say is coming through this, the part the new cycle isn't capturing is how our Canadian entrepreneur is more agile, stronger, and better prepared to manage what's in front of us coming out whatever's in front of us. The pandemic taught us so much in regards of the importance of showing that freedom to make adjustments, to be challenged, and to come out the other side stronger. I just have to say there's a lot of negative news out there but there's also a lot of good things that I don't think are really effectively captured. Apologies for the Lion King reference. I watched it this weekend with my daughter, and it was just fresh in my mind. Over to you, Sheri.

Sheri: [laughs] Thanks, Steven, you can always be counted on for a great analogy there somewhere but I think you're right. I think that as much as it's ominous, I think there is a lot of positive things that we're hearing and seeing as well so I couldn't agree more. Doug, I'd like to maybe turn the next question over to you. How has the significant rate of inflation impacted the various sectors and input costs that our business owners are seeing?

Doug: Well, all I can say is it's been incredibly broad-based. Initially, it began with the surge in energy prices and food, traditionally in the past what's fired up inflation, and then it spread to goods. It initially was a supply chain issue and our view, by the way, is this is as much a demand story as it was a supply issue. Basically, none of us could buy services for a year you couldn't go to a Leaf game even if you wanted to. You couldn't go to a show, you had a hard time traveling, so we're basically channeled into buying goods. It was almost like the entire world wanted to buy a dishwasher all at once, and of course, that stressed the global supply chain.

I actually think that that issue is now fading. We're seeing lots of indications that the supply chain is improving. Don't get me wrong, it's not back to full health, certainly, not in the auto industry, but more broadly speaking that's really not the story driving inflation anymore. It's actually more into a services story. Whether it's pressure from labor costs because of that very tight job market, or what I was talking about the pressure from the housing boom over the past couple of years as well. That's really become more of the story, so we've morphed from a supply chain goods inflation story to more of a services inflation story.

I think depending on the business, the supply chain or the cost chain pressures have really changed. Frankly, a lot of that's happened just in the last six months or so. It's not so much the input parts that are the big story, it's more the labor costs that are now and labor availability that's actually pressuring businesses. It really does depend on the sector and the industry. Do you depend more on imported parts and goods or are you more reliant on wages and labor? Essentially, different industries are facing very different cost pressures at this point.

How does this sort out for the consumer? What does it mean for inflation overall? We do think that we're probably past the peak inflation in the last couple of months we have seen it start to come down, but as I alluded to in my presentation, we think this is going to be a slow grind. Yes, we got a very nice report last week from the US, we saw inflation really did moderate quite a bit in October, but we need a whole series of that. One swallow does not make a spring and one good inflation reading does not mean inflation's going away. We need a whole series of better reports and our view is like I said, even by the end of 2023, we're still looking at inflation in the neighborhood of 3.5 to 4%.

Sheri: Thanks, Doug. I appreciate that I was actually one of those folks that needed a dishwasher last year, so I felt that pain. [chuckles] A great segue to a question that actually I think is top of mind for everyone around labor. You mentioned it, Doug, and maybe I'll turn it over to you, Robert. In labor shortages, rising labor costs continue to be an issue, and certainly is a challenge for a lot of business owners right now. Do you see this trend continuing into 2023 and beyond? What are your thoughts?

Robert: I think this is something that is going to remain pretty persistent. To really answer it, we got to ask why are we in this situation. Part of it is that the economy has just been allowed to run extremely hot, so there's a lot of demand for labor out there because the economy has been allowed to run so hot. I think as the impact of higher rates starts to bite and slow down economic activity, we should see some of that demand start to back off. Think of construction as one example where you cannot find a skilled trade anywhere and the industry is building at maximum capacity.

As the market cools off and construction theoretically dials back down a little bit, that should take some of the strain off that part of the labor market, but that's just half the story. The other half is this question we get all the time, and that is where have all the workers gone? Some of it was pandemic related where if you think of somebody who may have been working in a restaurant or at a bar and they just said, "Look, my job is gone, it's not coming back for a year or two, I'm going to pack up and find something else to do." When businesses turned their lights back on and said, "Okay, everybody, come back to work," well, a lot of people weren't there anymore.

Things like that are pretty marginal issues around the edges of the labor market. I think the biggest factor that's going on here on the supply side is just the demographics, and if you look back as an example and look at where the peak birth rate was in Canada during the baby boom, it was almost exactly 62 or 63 years ago. There is a massive cohort of labor right now that's pushed into the low 60 range, in other words, at or near retirement, and they've been dropping outta the labor force at about 300,000 people per year or so.

This is a major demographic drag on the labor force that was always coming at us anyway and I think maybe the pandemic pulled some of that forward, maybe exaggerated a little bit, but to answer your question, I think it's very hard to get away from the demographics and it's going to remain an issue going forward regardless of how this actual cycle plays out from a longer-term perspective over the next decade, this is going to be something that we're going to have to deal with.

I think from an immigration perspective, too, I think policymakers are very well aware of this, hence why we're bringing in such a high number of people from outside the country to try and backfill some of this void. The challenge is going to be just trying to match up the skills that we're losing in the labor force with those coming into the country to fill that hole. Those are some of the issues we're dealing with and I think it's going to be with us for a number of years, so yes.

Sheri: Thanks, Robert. Appreciate it. Steven, I'm going to come back to you, I think, around supply chain. That disruption has really impacted many of our customers, I don't think any of them are untouched by the supply chain disruption that we've seen. Do you see any themes or strategies that businesses are implementing to manage their supply chain?

Steven: It's difficult when you talk about the entire economy or an entire portfolio, and something as broad as supply chain because I'll say everyone was touched by it, but the acuity in some segments were really quick and deep, but the common theme across the entire broad base called the portfolio in customers was that say, discovery, build-up of inventory, and then diversifying.

The discovery piece was I think there was a time and place where a lot of business owners felt they didn't have supply chain concentration, and then when the disruption occurred, they quickly found out I was obtaining this screw from Malaysia and this other screw from China, but they were actually all connected in the same place and they thought they had three different sources, but it was really the same source.

That first step was discovery where they found out how precarious their supply chain was and started to find out what we need to do to simply survive during this acute pain is a build-up of inventory. I still see that now when I'm talking to customers and walking through their business where I see a place called a cardboard warehouse and I see six months of supply, which isn't a great use of capital, but they need it because it's required to operate their business. There was that buildup of inventory.

Now the real work has come in, where it's really around diversifying that supply chain and truly understanding, asking deep questions about that entire supply chain to ensure that concentration, which was masked, depending on where you're buying, to really understand how resilient that is. Discovery, build-up of the inventory, and diversify.

One thing I would say is, through the pandemic, and into the amount of supply chain disruption, I think that build-up of inventory is here to stay for a while. Not at the same amount originally experienced, but the safety and importance of having key components in your supply chain protected for a period of time to ensure that you're able to step up for your customers. Back to you, Sheri.

Sheri: Thanks, Steven. Thank you. I'm going to go to one of the questions in the chat that came in. Doug, I'm going to pass it to you. What gives you comfort that there will only be another 75 basis points and not more?

Doug: Well, frankly, I don't have that much comfort in any of our forecasts. As I said at the start, this is a very complex environment, and frankly, markets, economists, the consensus, central banks, largely got things wrong this year. They underestimated the underlying persistence of inflation and just how high rates were going to rise. It's interesting if you go back to the start of the year and you look at where the consensus was looking for the Bank of Canada and the Fed, they were looking at maybe half to one percentage point increase in interest rates this year. In hindsight, that looks quite quaint given the fact that we're going to end up with interest rate hikes of almost four percentage points when all is said and done.

To answer the direct question, our view is that if we're going to be wrong, it's that we'll be surprised the high side. That the bank may well need to do more than that. What does give me a little bit of comfort is, some of the language we're hearing from the central banks that it does take time for an interest rate increase to work its full effect. They know they moved a lot on rates in a very short period of time and I do believe that in some point in the not-too-distant future, they will want to stand aside, at least temporarily, to see how inflation and growth unfolds, but yes, I would allow that the risk is that they might have to do a little bit more.

I think the key point would be, I think during the spring, has inflation really is going to come down by the springtime or not. If it is not coming down in a meaningful fashion by the spring, that's when we're going to see the Central Bank start to talk about the possibility of a little bit further into interest rate increases through that period to really crack inflation.

Sheri: Thanks, Doug. Appreciate it. Thank you both Doug and Robert. I know I've learned a lot today. I'm always interested in the questions and the commentary, and it certainly relates to the conversations we have with our clients every day. I'm going to pass it over to Steven now to bring us to a close and go from there. Over to you, Steven.

Steven: Thank you, Sheri, really appreciate an incredible job hosting us today. I feel bad, I'm looking at my phone and up on the screen here I see lots of questions coming in. I think that just really speaks to what Doug and Robert have been telling us regards to the complexity and the amount of information that's out there. Please talk to your BMO person and they'll be glad to forward the question to us to just make sure that we address it fully if you're just writing in small notes on the screen. We'd love to follow up and answer those questions for you.

I just want to take a moment. The complexity, the velocity of what's going on just really heightens the importance of the work that Doug and Robert are doing. It's not an easy job at any time, let alone right now, and so, I just want to say thank you. The importance of your work is just felt by us and felt by our customers, so a huge thank you. To all our customers and soon-to-be customers out there, I just want to say thank you. You guys are doing an incredible job. There are a lot of good things happening out there, and day in and day out, I'm really impressed, so a huge thank-you to you.

Please take the time. You'll see a link on the screen down below, provide us feedback about areas you may want us to do a deeper dive, put more research onto, or something that you're looking for. We'll be glad to help and continue the conversation. Thank you and have a great day. Take care.