In the mood for a super quick preview of the analysis, start here:

• Canadian banks are bracing for rising loan defaults, indicated by doubling loan loss provisions over the past year. This signals economic weakness and hardship for consumers.
• GDP contracted in Q3 2022 and has been declining on a per capita basis, pointing to increasing recession risks. The job market and consumer sentiment are also weakening.
• The Bank of Canada has been raising rates aggressively but may need to cut rates in 2023 if conditions deteriorate. However, high inflation limits the scope for monetary easing.
• Global supply constraints and geopolitical risks pose threats, though demand destruction seems the bigger concern. Stagflation could emerge, requiring policy support but also restraint.
• While policymakers and banks are taking prudent actions, Canadian households will still face hardship. The economy appears headed for a protracted slowdown, with risks of contraction.

But let’s dive a bit deeper…

Canadian banks are bracing for impact as the economy shows increasing signs of weakness. Earnings reports this week from Royal Bank, TD Bank, Bank of Montreal and Scotiabank revealed ballooning loan loss provisions, indicating the big banks are girding themselves for defaults as rising interest rates put pressure on heavily indebted Canadians. Loan loss provisions at Canada’s big banks have nearly doubled over the past year, rising from $2.4 billion in Q3 2021 to $4.6 billion in Q3 2022. This rapid increase in provisions signals the potential for significant credit losses as economic headwinds mount. With debt-laden consumers stretched thin by higher borrowing costs, bank earnings hinted at gathering storm clouds.

Background on Bank Earnings

This week saw quarterly earnings reports from several major Canadian banks, providing insights into the state of the banking sector and wider economy.

The big Canadian banks including Royal Bank of Canada (RBC), Toronto-Dominion Bank (TD), Bank of Nova Scotia (Scotiabank) and Canadian Imperial Bank of Commerce (CIBC) reported higher profits driven by rising interest rates. However, they also set aside larger provisions for credit losses, signaling concerns about consumers’ ability to service debt as rates continue climbing.

RBC beat forecasts with quarterly profit up 6% and hiked its dividend, but doubled provisions for credit losses year-over-year to $719 million. TD profit rose 8% but set aside $351 million in provisions, up 148% from last year. Scotiabank meanwhile reported profit down 12% and more than doubled its provisions to $1.23 billion.

CIBC was the outlier, beating estimates with flat provisions of $243 million versus the same quarter last year. However, analysts noted the muted provisioning seemed overly optimistic compared to peers bracing for higher loan losses.

The mixed results highlight banks navigating a cloudy economic outlook, facing headwinds from inflation, rising rates, high consumer debt and a potential downturn. Their provisions signal concern about customers’ ability to service debts if conditions deteriorate further.

Key Takeaways

The key takeaways from the recent bank earnings reports in Canada are:

• Loan loss provisions increased substantially across most major banks. Royal Bank of Canada nearly doubled its provisions year-over-year to $720 million, while Scotiabank had a massive jump to $1.2 billion. This indicates the banks are bracing for higher credit losses in a weakening economy.
• Several banks announced job cuts in the thousands, including TD cutting “thousands of jobs”. Layoffs are another sign of preparations for an economic downturn.
• Banks are rapidly shedding riskier mortgage assets. For example, unnamed banks were mentioned as having sold off their auto loan and RV loan books. This demonstrates concerns about consumers defaulting on debts amid rising interest rates.
• Negative amortization rates on mortgages are declining from around 20% to 16%, showing some borrowers are using excess savings to pay down mortgages faster than scheduled. However, this leaves less discretionary cash available for consumer spending.
• On net, bank earnings paint a picture of rising recession risks, with banks taking defensive actions like raising loan loss provisions, cutting jobs, and offloading higher risk mortgage assets. Consumers also appear to be pulling back on leverage.

Economic Impacts

The earnings reports from Canada’s major banks provide important insights into the health of the broader Canadian economy. As major lenders to consumers and businesses across the country, the banks have a unique vantage point into economic activity.

Recent earnings highlighted growing concerns about the economic outlook. The major banks have set aside billions in loan loss provisions to prepare for higher credit losses as the economy slows. This is a notable shift from last year, when provisions had declined as the economy recovered from the depths of the pandemic.

The higher provisions reflect increasing risks of a recession. Canada’s GDP fell at an annualized pace of 1.1% in Q3 2022, indicating the economy is losing steam. The Bank of Canada has warned about slowing growth, though its forecast of 0.8% growth for Q3 proved too optimistic.

Rising interest rates are squeezing household budgets. With debt levels at all-time highs, Canadians have less discretionary income as more is allocated to debt servicing. This is causing consumer spending to stall, with seven straight quarters of declining real per capita retail sales.

The weakening economy is showing up in the job market. While employment remains relatively strong, the unemployment rate has drifted higher in recent months. Job growth is not keeping pace with population growth as labor force participation also rises. This demonstrates the economy is operating below its potential.

Overall, the bank earnings results translate into a more cautious outlook for economic growth. As lending conditions tighten and rates remain elevated, the risks of a recession are rising. The banks are bracing their balance sheets, and consumers and businesses may need to follow suit.

Mortgage Market

The mortgage market in Canada plays an important role in the consumer economy. Most mortgages in Canada are either fixed rate or variable rate. With a fixed rate mortgage, the interest rate stays the same for the term of the mortgage, usually 1-5 years. This provides payment stability but means borrowers can’t take advantage if rates fall. Variable rate mortgages fluctuate based on the prime lending rate. Payments go up or down as rates change. This provides flexibility but uncertainty on payment amounts.

Many Canadian mortgages are structured with negative amortization, meaning the principal payment doesn’t cover all the interest owed. This results in the principal amount owing slowly increasing over time rather than decreasing with each payment. This can leave borrowers owing more than the original mortgage amount even after years of payments, especially if home values fall.

While negative equity – when the amount owing exceeds the home value – is still relatively rare in Canada, it is a growing risk. Rising interest rates mean higher payments on variable rate mortgages and renewals of fixed rate terms at higher rates. This is resulting in more stretched borrowers who risk falling behind on payments. Proactive borrowers are converting variable rate mortgages to longer fixed terms to lock in rates, but often at much higher levels than a year or two ago.

Overall, the trends in the Canadian mortgage market reflect the broader economic risks. While rate hikes were intended to cool an overheated housing market, they are now weighing on highly indebted consumers and risking a downward spiral. This mismatch of policy timing could necessitate dramatic rate cuts to stabilize the situation.

Interest Rate Forecast

The Bank of Canada has been aggressively raising interest rates in 2022 to curb high inflation. The overnight rate started the year at 0.25% and has climbed to 4.25% as of December 2022.

However, there are growing expectations that the Bank of Canada may need to reverse course and start cutting interest rates in 2024 if economic conditions deteriorate significantly.

Financial markets are currently pricing in rate cuts from the Bank of Canada in 2024. The market consensus is that the bank could cut rates by 50 basis points by the middle of 2024 and 100 basis points by the end of 2024.

These rate cut expectations are based on forecasts for slower economic growth and rising recession risks. The Bank of Canada and private sector economists have warned that the rapid pace of rate hikes could tip the economy into a recession.

Higher interest rates are already weighing on the housing market and consumer spending. If job losses mount and economic output contracts, the Bank of Canada will likely feel compelled to support growth through lower interest rates.

The timing and magnitude of potential Bank of Canada rate cuts will ultimately depend on how quickly inflation falls back towards the 2% target. If high inflation persists, the bank may delay rate cuts even in a slowing economy.

Recession Risks

Many indicators are pointing to increasing recession risks for the Canadian economy. GDP growth turned negative in the third quarter of 2022, declining at an annualized rate of 1.1%. This follows 7 consecutive quarters of declining GDP per capita, indicating that economic growth is not keeping pace with population growth.

The job market remains relatively strong, but higher interest rates are clearly impacting the economy. Retail sales have been flat or contracting when adjusting for inflation, and consumer confidence has fallen significantly. Business sentiment is weakening as well, with surveys like the CFIB Business Barometer Index falling below the 50 expansion/contraction threshold.

Loan loss provisions at the major Canadian banks have been ramping up steadily, nearly doubling over the past year at some banks like RBC and TD. This shows the banks are bracing for higher credit losses in a slowing economy. The percentage of mortgages in negative equity has declined slightly but remains very elevated. Many overleveraged Canadian households will struggle as rates continue to rise.

Recessions in the early 1980s, 1990s and 2008 were triggered by global events and shocks. This time around, many of the risks are homegrown. Canada has never faced a recession caused primarily by high household debt levels. With debt-to-GDP and debt-to-income ratios at all-time highs, Canada is vulnerable to an economic contraction caused by the burden of elevated debt service costs. The impact would likely be most acute in cities like Toronto and Vancouver, which have experienced the largest run-ups in home prices and household leverage.

While the recession may be relatively mild and unemployment could remain low, overly indebted households will need to divert more income to interest payments and principal repayment. This headwind to consumer spending could restrain growth for an extended period, even if a severe financial crisis is avoided. Monetary policy may have limited ability to stimulate growth, since higher immigration and large deficits are already fueling inflation pressures.

Expanded Summary

Policy Response

With signs of economic weakness persisting, policymakers may need to take action to support the economy. Both fiscal and monetary policy could potentially be deployed, though there are limitations and risks associated with each approach.

On the fiscal side, the federal government has already run large deficits since the pandemic began, leaving less room to provide additional stimulus. Direct household aid like temporary tax cuts or rebates could provide some relief, though would add to the deficit. Infrastructure spending may boost growth longer-term but takes time to implement. The government also faces pressure for restraint amid high inflation.

Monetary policy also has constraints, with the Bank of Canada’s policy rate already relatively high after rapid hikes over the past year. Markets are pricing in rate cuts in 2023, but the BoC may be hesitant to ease aggressively while inflation remains well above target. However, if the economy enters recession territory, the BoC could opt for small rate cuts to spur growth. The BoC is also continuing its quantitative tightening program, limiting its ability to provide monetary stimulus.

Ultimately, policymakers will likely take a gradual approach, providing limited targeted stimulus while monitoring how ongoing rate hikes and QT filter through the economy. Avoiding policies that could exacerbate inflation will be a priority. Significant fiscal or monetary easing may have to wait until clear signs of deflation emerge. Policy support could help cushion the downturn, but may not prevent slower growth overall.

Policy Response

With signs of economic weakness persisting, policymakers may need to take action to support the economy. Both fiscal and monetary policy could potentially be deployed, though there are limitations and risks associated with each approach.

On the fiscal side, the federal government has already run large deficits since the pandemic began, leaving less room to provide additional stimulus. Direct household aid like temporary tax cuts or rebates could provide some relief, though would add to the deficit. Infrastructure spending may boost growth longer-term but takes time to implement. The government also faces pressure for restraint amid high inflation.

Monetary policy also has constraints, with the Bank of Canada’s policy rate already relatively high after rapid hikes over the past year. Markets are pricing in rate cuts in 2023, but the BoC may be hesitant to ease aggressively while inflation remains well above target. However, if the economy enters recession territory, the BoC could opt for small rate cuts to spur growth. The BoC is also continuing its quantitative tightening program, limiting its ability to provide monetary stimulus.

Ultimately, policymakers will likely take a gradual approach, providing limited targeted stimulus while monitoring how ongoing rate hikes and QT filter through the economy. Avoiding policies that could exacerbate inflation will be a priority. Significant fiscal or monetary easing may have to wait until clear signs of deflation emerge. Policy support could help cushion the downturn, but may not prevent slower growth overall.

One Last thing to consider

On top of the domestic headwinds, global recession risks are rising. While a commodity supply crunch could emerge as a countervailing inflationary force, demand destruction seems more likely in the near term. Overall, the outlook points to a protracted period of stagflationary weakness for the Canadian economy. Both policymakers and households will likely need to brace for this bumpy road ahead