By Michael Ryval

Drastically lower oil prices and a drop in capital investment in the energy sector conspired to weaken the Canadian economy last year, yet 2016 is shaping up to be considerably stronger. Although better economic prospects will eventually lead to rising interest rates and put pressure on the cost of mortgages, the prognosis remains fairly positive.

“We’re expecting that growth will accelerate in 2016 and are forecasting 2.2% real GDP growth in Canada,” says Robert Hogue, Toronto-based senior economist at RBC Royal Bank. “That will be a significant improvement over the 1.2% growth we expect to see for 2015.”

Performance last year was weighed down by a poor first half due to a combination of factors such as severe weather, supply chain issues emanating from western U.S. ports, and the re-tooling of vehicle assembly plants in Ontario, Hogue notes. “Those factors exacerbated the shock in the energy sector that was due to lower oil prices, which led to a dramatic decline in capital investment in the sector.”

In 2016, Ontario is expected to grow by 2.1%. “The province was not affected by the big shock in the energy sector, which really impacted Alberta,” says Hogue. “In fact, Ontario will be a net beneficiary of low prices, because it’s a net importer of oil. Lower crude oil prices mean lower gas pump prices, which benefit households and businesses.” Concurrently, the sharp drop in oil prices, which resulted in a weak Canadian dollar, is also improving the competitiveness of export-oriented manufacturers.

The first half of 2015 was disappointing, Hogue admits, as the expected so-called “lift-off” in non-energy exports did not occur. “Nonetheless, the lower dollar will be a strong boost to Ontario’s export sector. Over the second half of 2015 and into 2016 we’ll see exporters respond to the lower Canadian dollar and a stronger U.S. economy, which should be in full flight in 2016.” RBC is forecasting that the U.S. will see 3% GDP growth next year, compared to 2.6% in 2015.

Monetary policy is a key factor that shapes economies, and the U.S. Federal Reserve was expected to finally start raising the so-called Fed funds rate of 0.25% by the end of 2015. “These are still emergency-level interest rates,” says Hogue. “The Fed ended their quantitative easing program some time ago. The next phase will be gradually removing the conventional monetary stimulus.”

With the U.S. economy at close to full employment, Hogue believes that the Federal Reserve will gradually hike interest rates to 2% by the end of 2016.

In a similar vein, rates are expected to move up again in Canada. Hogue forecasts that the Bank of Canada, which twice cut its overnight rate in 2015, will move the rate back to 1% by the fourth quarter of 2016. While he does not believe that variable-rate mortgages will be impacted, fixed-rate mortgages, which are tied to five-year bond prices, “will likely face some upward pressure before the end of 2016.”

A benign interest rate environment and supply-demand dynamics helped Ontario’s home-building industry in 2015, as there were an estimated 64,900 housing starts in 2015. That was a 9.8% increase over the 59,134 starts in 2014. “In large part this reflects what is happening in the existing home market,” says Hogue, adding that the forecast for 2016 is 64,300 housing starts. “There is very strong demand and not enough supply. The market is quite tight and absorption has been surprisingly strong. In short, the market is calling for more units to be built to satisfy all that demand.”

Hogue argues there is a two-tier market. On one side there are single-family detached homes that are in short supply and command seven-figure prices in some parts of the Greater Toronto Area. On the other side is the condo market, which accounts for about 75% of building activity in the GTA. “That segment is more balanced since prices have not increased as much as single detached homes.”

When figures are reported, home prices in 2015 are expected to be about 8% higher than in 2014. But the rate of increase is expected to moderate to about 4% to 4.5% in 2016. “We expect that demand will start to cool as affordability is being stretched in the GTA. As interest rates start to rise, it will exacerbate affordability pressures,” says Hogue, noting that currently 59.4% of household income would be required to carry mortgage costs, utilities and property taxes for a single-family bungalow at current prices and interest rates in Toronto. “We expect household income to rise, but at a moderate pace. Past price increases have put pressure on affordability.”

Hogue argues that 2016 will be the start of a transition toward a higher, more “normal” interest rate environment. “It will likely take a number of years. The dynamics of the market will adjust to the change when interest rates start rising.