The Canadian economy hit a clear soft patch at the start of 2026, as confirmed by last week's gross domestic product, said Scotiabank.
GDP was essentially flat in Q1, coming in below all expectations and pointing to softer underlying demand pressures, noted the bank. This aligns with earlier signals from the labor market, including weak hiring and a rise in unemployment at the start of the year.
That said, the headline weakness should be interpreted with "caution," stated Scotiabank. The Q1 print was affected by several temporary factors that materially distorted the signal.
Large swings in gold imports should be largely ignored, as should the sharp pullback in government spending, which is likely to reverse in Q2. Encouragingly, the flash estimate for April GDP already points to a meaningful rebound next quarter. Looking ahead, the bank continues to expect activity to firm, supported by fiscal spending and a recovery in export growth.
While Scotiabank forecasts growth to average 0.8% in 2026, this headline figure masks a clear reacceleration in underlying momentum.
Quarter-on-quarter growth should firm meaningfully as government spending reconnects with planned outlays and the lagged effects of past rate cuts continue to support domestic demand -- particularly in housing, it pointed out.
External demand should also become more supportive over time. Export growth is expected to recover, although more convincingly into 2027 as the drag from tariffs fades.
As a result, GDP growth is projected to rise to 2.1% in 2027. Taken together, this profile places growth above Scotiabank's estimate of potential -- 1.2% this year and 1.6% in 2027 --allowing the economy to gradually move back into balance by late 2027.
Labor market dynamics are consistent with the broad activity narrative. While the unemployment rate has risen by 0.2 p.p. since the start of the year, this still marks an improvement relative to last summer. More importantly, the recent increase likely overstates underlying weakness, as a meaningful share reflects stronger labor force participation.
With activity set to firm in the near term, labor demand should stabilize, allowing employment to gradually catch up with growth, added Scotiabank.
Commodity prices provide an additional, although partial, tailwind. Elevated oil and non-energy commodity prices should improve Canada's terms of trade and modestly support investment and hiring. However, this support is being offset in part by tightening financial conditions, particularly tightening policy rates and rising long-term government bond yields.
On inflation, the recent data has been more encouraging. Core measures have softened since the bank's March update, pointing to some easing in underlying pressures, in line with weaker demand earlier in the year. However, Scotiabank cautions against over-extrapolating this improvement.
Pipeline pressures remain "significant." Elevated input costs, both energy and non-energy, are still expected to feed into final prices. The bank views inflation staying close to 3% for the remainder of the year, driven by energy prices, before falling back towards the Bank of Canada target as energy prices normalize.
At the same time, geopolitical risks remain elevated and could further disrupt pricing dynamics. In this environment, upside risks to inflation remain material, and Scotiabank estimates the BoC to remain focused on persistence.