Just because the economy outperformed expectations in the first quarter doesn’t mean it will continue to do so, said Oxford economist Michael Davenport.
It all depends on what you look at. Take the labour market for example. It is lagging indicator and says more about where the economy was in late 2022 than where it is heading, he said.
Oxford bases its recession probability model on leading indicators, such as financial conditions, how tight lending is, corporate spread, money supply and yield curves. All but one of its 12 indicators for Canada are flashing red.
Their model suggests there is an 84 per cent chance of a recession in the second half of this year. That’s the highest probability since 1981, and higher than the odds before four of the past six recessions.
Oxford’s model has now surpassed the threshold breached before four of the past five recessions (pandemic excluded) for nine straight months, said Davenport. Typically, recessions begin four months after the threshold is breached, “suggesting a recession is imminent.”
One of Oxford’s key leading indicators, financial conditions, like monetary policy, hits the economy with a lag. Financial conditions tightened in 2022 as the Bank of Canada and United States Federal Reserve aggressively raised interest rates. They improved slightly early in the year because of stronger equity markets and Canadian dollar, but then deteriorated again after the U.S. banking scare.
Oxford calculates that the financial environment in Canada is now the most restrictive it’s been since the global financial crisis — and since this tightening takes a while to work through the economy the full impact won’t be felt until the second half of this year.
This impact will be particularly acute in Canada, compared with other advanced economies, because of its high household debt and vulnerable housing sector.
“The deterioration in financial conditions is a key reason why we think the Canadian economy will slip into recession this year,” said Davenport.
This impact alone could shave almost a percentage point off Canada’s GDP by early 2024, Oxford predicts.
Oxford’s model also points to the Bank of Canada’s own senior loan officer survey out recently that showed tighter lending conditions for households and businesses. Lending conditions for business are the tightest since the start of the pandemic, and the tightest on records going back to 2017 for households.
“We expect lending conditions will tighten further as global banking stress lingers and the full impact of last year’s aggressive monetary policy tightening continues to flow through to the Canadian economy,” said Davenport. “This will constrict business investment, help drive another leg down in house prices, and restrain household spending, particularly for durable goods.”
Another source Oxford uses is the Organisation for Economic Co-operation and Development’s composite leading indicator. Built to detect turning points in business cycles, this indicator has also proven to be a good predictor of recessions, Oxford says.
The OECD’s indicator for Canada is now at its lowest level since the worst days of the pandemic, and before that the financial crisis, falling below a threshold that in the past has only been breached prior to recessions.
Oxford says, except for the pandemic and recession that followed the oil crash of 2015, its model has correctly predicted all recessions since the late 1970s.
“We put more stock in leading indicators to help guide our forecasts, and several key leading indicators continue to strongly suggest a recession is on the horizon,” said Davenport.
