Since Stephen Poloz was announced as the new Bank of Canada Governor, I have discovered that we have something in common: We are both Star Trek fans. My wife and I saw the most recent film, Star Trek: Into Darkness, directed by J.J. Abrams, and thought it was one of the best Star Trek movies yet.
Many investors seem to think that the Canadian market will also be moving into the darkness over the coming years. Based on our observations, bearish trades on Canada, commonly referred to as the “great white shorts,” are gaining popularity among hedge funds and other investors as the U.S. economy picks up steam while Canada’s economy lags. Many investors are buying Canadian federal government bonds, shorting Canadian bank stocks and selling Canadian dollars in anticipation of a prolonged downturn. Are these investors right in thinking that Canada is about to move from relative champion to chump?
At PIMCO, we meet annually to update our secular (three- to five-year) view of the global economy. While our volatile New Normal secular view is morphing, and significant risks are clearly facing the Canadian economy, our baseline forecast does not justify positioning our portfolios for a prolonged Canadian downturn.
Domestic headwinds: housing and excessive consumer debt
Canada has been praised for its response to the financial crisis in 2008–2009, but as we all know, there are no free lunches. When the Bank of Canada cut interest rates to historical lows, and then implemented policies in an effort to ensure the banks could profitably lend to consumers at ultra-low interest rates, consumers reacted logically: They borrowed money to buy houses, cars and other things. Now, Canadian consumers are highly indebted (see Figures 1 and 2), and housing prices are near peak levels (see Figure 3).
The pessimists generally believe that Canada is in for a major housing correction soon that could impair the banking system and cause another recession. At PIMCO, we recognize that a major correction is a risk, but we believe it’s relatively remote.
Our assessment is that construction could potentially detract approximately 0.2–0.3 percentage points per year from economic growth over the secular horizon as it returns to the long-term average of approximately 5.5%–6% of the Canadian economy. Why not a bigger correction? Because some of the above-average construction activity of the past 10 years was making up for the underinvestment in the housing stock during the 1990s and early 2000s (see Figure 4).
Why don’t we think a major housing correction is around the corner? Because in general, Canadians do not make a residential investment, they “buy” a mortgage payment they can afford – and Canadian mortgage payments are the most affordable they’ve ever been (see Figure 5). In our view, for Canada to have a major housing correction (or crash), Canadians need to have trouble paying their mortgage, which means one of these things would likely have to happen:
1. The unemployment rate increases significantly. Since 2011, it has held steady between 7% and 8% (see Figure 6), and barring an external shock, we find it hard to see this meaningfully rising.
2. Mortgage interest rates need to significantly rise. Given PIMCO’s secular view that global central banks will remain in “lower for longer” mode, plus the strength of the Canadian dollar, it is hard to see the Bank of Canada meaningfully hiking rates.
3. Consumers’ access to mortgage credit gets impaired. This is what happened in the U.S. when the asset-backed securities (ABS) market seized up. Canada does not rely on the ABS market to fund mortgages; these usually stay on banks’ balance sheets. As a result, mortgages generally have been well underwritten, as the low delinquency rates demonstrate (see Figure 7).
Our secular view is that housing in Canada is overvalued and due for a correction. We believe a 10%–20% real decline in national housing prices over a five-year period is very realistic, with much sharper corrections in some local “hot” markets such as Toronto, Vancouver and Montreal. This would potentially be an earnings event for banks (not a solvency event) and a headwind to economic growth as consumption grows in line with income and construction activity declines relative to the rest of the Canadian economy.
Global tail risks: Europe and disorderly deleveraging/imbalances
Our secular view is that Europe will struggle to grow over the next three to five years (our baseline is about 0.5% real growth per year). This will only make it harder for the EU to implement the needed structural reforms (economic, banking and political). It seems likely that Europe will continue to provide bouts of market stress over the secular horizon that could potentially impede Canadian business investment and consumer confidence.
Another global flashpoint is the resolution of trade imbalances, primarily those between the U.S. and China. China is trying to rebalance its growth model to be more domestically focused and less export driven. This will be a challenge as it attempts the middle income transition of doubling GDP per capita while being the world’s second-largest economy – an unprecedented task. There is clearly a risk that this process won’t go smoothly, which could lead to market stress washing up on Canadian shores.
Global tailwind: Private sector U.S. growth should drive Canadian exports
The main tailwind for Canada is the revival of the U.S. private sector (Canada’s biggest customer). Since the financial crisis began, modest U.S. growth has been policy-driven as U.S. fiscal deficits hit 10% of GDP. While PIMCO continues to forecast modest U.S. GDP growth of approximately 2% (not much different from the past few years), the composition of U.S. growth will likely be much more favorable to the Canadian economy. Canadian net exports have been a drag on economic growth since the financial crisis as U.S. growth was fueled by federal and state fiscal stimulus (Canada does not sell many goods to Uncle Sam or the states). While we do not forecast that U.S. aggregate real growth will pick up meaningfully, we do see a meaningful pickup in private sector growth that could more than offset fiscal contraction. This is good news for Canada because exports should benefit from a bounce in U.S. housing (good for softwood lumber), auto (where Ontario/Quebec are major suppliers), manufacturing, etc.
Domestic tailwinds: Business investment is catching up with the business cycle
Canada, like many other developed markets, is suffering from a lack of business fixed investment during the recovery since the crisis. Why? Because generally CEOs are still wary that we are not yet out of the woods when it comes to potential flashpoints in Europe, China, the U.S. and the Middle East. That said, unless and until one of these events materializes, we expect that Canadian businesses (which are also further removed from these potential flashpoints) will step up their investments and hiring as profit opportunities present themselves over the business cycle and over the secular horizon.
Policy implications: Stay vigilant, and get working on plan B now, just in case
With many potential “T-junctions” (as we discussed in our 2013 Secular Outlook) ahead, Canadian policymakers should be working on plan B now. Balancing federal and provincial budgets is important because it allows for counter-cyclical fiscal policy should a left tail event occur. Also, Canada critically needs infrastructure investment (transportation, energy, pipelines, etc.), which are long-term projects that require approvals across multiple levels of government (federal, provincial, municipal). Getting these projects approved now should allow for highly productive counter-cyclical spending in the future. In our view, Canada weathered the crisis relatively better than other developed countries because of the prudent policies (monetary and fiscal) that it implemented before the crisis. Policymakers need to act today to get prepared for the next crisis.
Investment implications: Exploit the volatile New Normal environment
For a number of years we have been secularly bullish on the Canadian dollar based on Canada’s better fundamentals. As we see China’s growth slowing, and the commodity density of future growth slowing, we are now more neutral on the Canadian dollar. Current low interest rates translate into the potential for low-single-digit bond returns for many investors. The good news is that high volatility may be a tailwind for active managers working to outperform their benchmarks. We think that high-quality credit spreads, such as provincial bonds, can enhance return potential as bond investors try to escape the financial repression of low nominal yields.
Finally, while we believe the Bank of Canada will continue to be a credible inflation-targeting central bank through the secular horizon, there is the potential for global inflation to reach Canada. We expect the U.S. Federal Reserve (among other developed market central banks) to continue its extraordinary loose monetary policy for a long time. Though the markets have recently reacted as though the Fed will be tightening and not just tapering, we expect the Fed to err on the possibility of generating too much inflation rather than snuffing out a fragile recovery. For Canadians, that may mean more expensive imports and slightly higher inflation. We believe real return bonds look to be secularly attractive relative to nominal bonds in this environment.