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In the first quarter of 2026, Canada has found itself navigating an evolving set of geopolitical and trade-related headwinds that continue to complicate its domestic economic outlook. Last time we looked at whether a recession was imminent, the Bank of Canada’s monetary policy options, and the outlook for inflation. We’ll continue our Q2 update with a look at expected GDP growth and the impact of the labour market.
Canada’s real GDP expanded by 1.7% in 2025, driven primarily by domestic demand, with trade headwinds and weak productivity partially offsetting growth. According to the Bank of Canada’s January 2026 projections, household consumption, government spending, housing activity, and modest business investment together contributed roughly 1.7 percentage points to growth, while net exports provided little support.
Household consumption proved resilient as declining inflation boosted real wage growth, reinforced by a positive wealth effect stemming from the strong absolute performance of the markets, particularly Canadian equities. Government spending also made a meaningful contribution, supported by infrastructure programs and targeted public investment, even as private‑sector investment remained subdued. Lower interest rates further supported consumer spending and helped stabilize interest‑sensitive sectors.
Net exports, however, were a drag on growth. While Canada’s status as a net energy exporter provided some offset, headline GDP was mechanically supported by declining imports, an adjustment that reflects weaker domestic demand rather than improved competitiveness. Export performance was constrained by sector-specific tariffs on lumber, steel, aluminum, and non‑CUSMA‑compliant auto parts.
Although Canada made some progress diversifying its export exposure away from the United States as illustrated in Figure 1, with the U.S. share of exports declining to 68% in January 2026 from 76% in December 2024, the broader picture remains challenging. Total exports fell by approximately 10% over the same period, underscoring the difficulty of translating diversification efforts into aggregate export growth.
Against the backdrop of the current Middle East conflict, Figure 1 suggests that the impact on Canada’s GDP is modest, albeit slightly positive. Prolonged periods of elevated oil prices tend to disproportionately benefit energy-producing regions such as Canada, but these gains are increasingly offset by weaker aggregate demand elsewhere in the economy. GDP is expected to peak under a moderate scenario in which the conflict persists for three to six months. Beyond that horizon, sustained high oil prices, while supportive of the energy sector, begin to weigh more heavily on consumption and non‑energy activity.
Structural changes in Canada’s energy sector further constrain the upside. Oil and gas investment is now less than half its level a decade ago, and major new energy projects require not only high prices but sustained price certainty over long periods. As a result, the GDP impact of higher oil prices is likely to materialize primarily through higher corporate profits and government royalties rather than a meaningful pickup in capital investment.
Canada’s Q4 GDP contracted by 0.6%, driven largely by inventory drawdowns as firms sold down existing stock rather than expanding production. The more encouraging signal came from final domestic demand, which rebounded as consumer spending, accounting for more than half of GDP, proved resilient. Canadians continued to spend on travel, recreation, and other in‑person services, helping to offset weakness elsewhere in the economy.
Canada’s GDP per capita has been rising in recent quarters, as illustrated in Figure 2. A key driver has been a marked slowdown in population growth, which appears to have turned negative on a net, semi-annual basis in the second half of 2025 by roughly 75,000, removing a significant drag on per-person output. Earlier in the cycle, rapid population gains consistently outpaced job creation and output growth, depressing GDP per capita even as headline GDP expanded. By mid-2025, population growth had effectively flattened, easing the arithmetic dilution of output and allowing GDP per capita to recover.
Fiscal support is also beginning to play a larger role. Public-sector hiring and infrastructure spending, including projects tied to defence and green initiatives, are injecting incremental demand at a time when private‑sector investment remains soft. Combined with expectations for above-trend global growth, we forecast Canadian real GDP to expand by 1.8% in 2026. That outlook, however, remains sensitive to external risks, most notably the outcome of upcoming CUSMA negotiations.
Early 2026 delivered an unexpected shock to the labour market, with Canada shedding nearly 110,000 jobs, even as population growth had already flatlined in the second half of 2025. The two-month decline was broad-based and concentrated in private-sector and full‑time employment, an unhealthy composition for labour market dynamics.
Average hours worked also fell sharply, to 31.1 in February from 32.9 in January. While the Labour Force Survey is inherently volatile and monthly readings should be interpreted with caution, the underlying trends are concerning. Consecutive job losses effectively erased most of the employment gains recorded in late 2025, with the bulk of the decline occurring in the private sector, reflecting cutbacks by firms facing weaker demand and rising cost pressures. In February, the unemployment rate rose to 6.7% from 6.5% (see Figure 3).
We expect a demographic slowdown to shape the outlook over the next few years as population growth moderates. Rising full-time employment, real wage growth, limited job losses, and positive wealth effects from financial markets should provide a solid floor under household consumption, helping to offset softness in business investment.
Over the past year, the manufacturing sector has been hit hardest, reflecting the toll of trade turmoil and weaker foreign demand. Significant job losses have also been recorded in business support services, agriculture, and retail trade. In contrast, health care and social assistance stands out as a key source of employment growth, as hospitals and long-term care facilities have ramped up hiring to meet rising demand, making it by far the largest contributor to overall job gains.
Despite signs of softening in the labour market, wage growth has remained resilient. As of early 2026, average hourly wages were rising at a pace modestly above inflation, allowing real wages to turn positive again for the first time since 2020.
A defining feature of Canada’s current labour market is the abrupt slowdown in labour force growth. After several years of rapid population expansion, growth has stalled following a deliberate pullback in immigration and non‑permanent residents. Federal policy changes aimed at reducing the number of international students and temporary workers are now clearly visible in the data, as shown in Figure 4, with study permit holders declining across multiple recent quarters.
As a result, Canada’s population could contract modestly in 2026, placing downward pressure on labour force participation and shrinking the available pool of workers. While this dynamic may help keep the unemployment rate lower by reducing the number of job seekers, it also constrains labour supply and lowers Canada’s potential GDP over time.
Looking ahead, we expect labour market conditions to gradually improve as uncertainty recedes, slower immigration tempers population growth, and steady consumer demand supports solid real wage gains.
The Middle East conflict is likely to have a disparate regional impact, with energy producing regions benefiting from elevated oil prices, while higher inflation pressures could restrain hiring in more interest and cost sensitive sectors if the conflict is prolonged.
We expect the unemployment rate to decline toward approximately 6.5% by year end, supported by accommodative policy settings, slowing population growth, and a resilient household sector.
Ashish Dewan CFA, CFP is Senior Investment Strategist at Vanguard Investments Canada. Excerpted from Vanguard’s “Canada 2026 Q2 Outlook: Resilience amid geopolitical crosscurrents.”
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