The possibility of growth surprising to the upside in Canada is increasing. Despite quite high valuations, the Canadian housing market remains robust as consumers are able to take on more debt at very low rates, which in turn could drive overall economic growth to levels potentially higher than anticipated. It sounds like investors should be happy, right?
Well, maybe not. All growth is not created equal. Since the financial crisis, economic growth in Canada has been driven by consumers borrowing money at incredibly low interest rates to buy ever-larger houses and to fuel consumption. This is not exactly healthy growth, but when the economy is in a free fall post a financial crisis, any growth is better than none.
In search of healthy, sustainable growth
Today, over five years after the crisis, Canada is in a different situation. What the economy needs is good, healthy growth: a sustainable economic recovery. This is what the Bank of Canada (and for that matter, PIMCO) is looking for. However, Canada’s economy grinds along in a sustained, yet distinctively dissatisfying, modest recovery. The unemployment rate has dropped to 7% (near the historical average) and GDP growth has been modest, but not high enough to close the output gap. Also, despite the recent trend of increasing inflation, the Bank of Canada (BoC) continues to worry about disinflationary risks as it looks through “one time” inflationary events. The BoC’s underlying rationale here is its “risk management” approach: Because core inflation is currently below the 2% target (see Figure 1), the BoC believes we should worry more about disinflation than inflation.
BoC Governor Stephen Poloz has been dealt a difficult hand; the BoC has to be very careful of the trade-off between growth and financial stability. Given the “serial disappointments” in the robustness of the economic recovery, the BoC has stressed downside risks to inflation in order to depreciate the Canadian dollar and in turn spur economic growth via increased exports. The objective is noble, but the problem with talking down a currency is that if the talk is not followed up by actions, the speculators who are shorting the Canadian dollar today will likely close their positions, leading to an inevitable short covering rally. To target a sustained depreciation of the Canadian dollar, the BoC has to cut rates or the economic data have to weaken, or both. While the BoC seems most concerned about serial disappointments, at PIMCO we see the recovery gathering speed as exports pick up.
Longer-term effects of accommodative policy
The ultra-accommodative monetary policy the BoC implemented during the depth of the crisis worked as intended: Low rates spurred consumers to borrow and spend on both housing and nondurable goods. This was the correct policy to help Canada prevent what could have been another Great-Depression-type scenario, but this benefit had a corresponding financial stability cost. Canadians are now more indebted than ever, and housing prices are extremely elevated (see Figures 2 and 3). Governor Poloz has appeared more concerned with disinflation and growth than financial stability, but the most recent BoC statement did note the housing market is reaccelerating.
We think the growth shown in this year’s second-quarter GDP print (see Figure 4) will be more representative of the economy going forward. We expect a combination of “bad” growth (i.e., residential consumption and debt growth, which has the potential to increase financial instability), and “good” growth that should rebalance the economy (i.e., exports, which have been a significant drag as the U.S. economy has struggled to recover from the crisis, and business investment growth, which has been largely absent in the past year). The combination of these contributions to GDP growth suggests a strong hand-off to third-quarter GDP, which we believe should significantly beat the BoC’s 2.5% forecast.
With growth stronger than expected, inflation near the 2% target and financial instability increasing due to asset price inflation (specifically, in the housing market), we think it would be prudent for the BoC to indicate that it will begin removing the punch bowl in the not-too-distant future. If real GDP growth reaches 3% or higher starting in the third quarter, we can expect the BoC to move to a hawkish stance. That said, we would not expect actual rate hikes until sometime in 2015.
The New Neutral in Canada
In our opinion, while the bond market focuses on the first rate hike, we at PIMCO think the important question is not when will they start hiking, but when will they stop? In other words: What is The New Neutral rate in Canada? Given the aging society, productivity issues and the massive accumulation of consumer debt, we believe the neutral rate is meaningfully lower than the pre-crisis level of 4% nominal – it is likely closer to 2.5%–3.0% nominal (or 0.5%–1.0% real, assuming 2% inflation).
This is our baseline forecast based on an orderly resolution to the inflated housing market. If the housing market were to collapse, the neutral rate would be substantially lower (probably even lower than our 2% nominal forecast for the U.S. economy, which is recovering from the housing crash and other fallout from the financial crisis).
Investors should be prepared for long-term bond yields in Canada to rise over the balance of this year (and possibly next year too), but given our expectations for a substantially lower New Neutral rate, we believe the Bank of Canada will tighten very slowly and cautiously. We do not expect a great bear market in bonds, and we see value in 10-year yields, when they likely rise to a modest 3%–4% over the coming year(s).
Active investors should be willing to trade tighter trading ranges. Yield curve positioning and credit spreads should help bond investors guard against losses as underlying government rates move modestly higher. Floating rate, high quality bonds issued by provinces look attractive; Ontario and Quebec in particular stand to benefit from the improving economic environment.