Explaining the current state of the Canadian economy is simple. Economic growth in Canada has been a one-trick pony since the financial crisis in 2008: Consumer debt has fueled expansion, with consumption and residential housing investment accounting for approximately 93% of real GDP growth since the crisis.
Forecasting economic growth and structuring bond portfolios for 2019 are much more difficult, however, because an elevated share of growth built on consumer debt and housing is ultimately unsustainable. Will the Bank of Canada (BoC) be successful in its plan to rotate the growth model to business investment and exports? We are skeptical – and our investment outlook for Canada this year is cautious as a result.
Reasons to be skeptical
The BoC is forecasting (perhaps hoping) that the transition to higher business investment and exports will be relatively smooth. We are less optimistic for four reasons:
- Housing markets look vulnerable. Our main concerns are the overheating markets in Toronto and Vancouver, which are facing new local regulations designed to cool them. Also, new federally mandated rules are intended to tighten mortgage credit. And finally, policy rates are higher, which has lifted some mortgage rates. The mix of these three developments already slowed Canadian housing markets in 2018, and although the path of house prices in 2019 is unclear, we think the risk is weighted to the downside (see Figure 1).
- The risks tilt toward a more notable deceleration in consumption. With housing markets cooling, we expect less consumption based on a reverse wealth effect (see Figure 2). In addition, the most indebted consumers will likely have to tighten their belts due to higher rates, and overall wage growth has been falling over the past six months or so. The BoC recognized this in early January when it revised down its forecast for consumption growth in 2019. Again, we see more downside than upside risk to this forecast.
3) Disruptions and low business investment in the oil sector should be headwinds to real growth. In January, the BoC estimated that lower oil prices would detract 0.5% from real GDP growth (on the high end of our 0.25%—0.5% estimate). Lackluster business investment, meanwhile, has been a global issue since the end of the financial crisis. While there are positive signals in the BoC’s Business Outlook Survey, we think that BoC Governor Stephen Poloz’s term “serial disappointments” will continue to apply to this sector in 2019.
4) The BoC’s 2019 real GDP estimate relies upon a robust export forecast, which we think may be too optimistic. While the new NAFTA (aka USMCA) has been agreed by political leaders, it faces challenges passing the U.S. Congress, with the potential for more drama in the U.S. before it becomes law. Even more important are the trade talks between the U.S. and China, which have broad implications for global trade, asset prices and business/consumer confidence. We do not see “clear sailing” on the trade front for Canada in 2019.
Despite our skepticism, two upside risks to growth could change the picture. First, strong employment growth is a key tailwind. The unemployment rate of 5.6% is a multi-decade low, and monthly employment growth has been robust, averaging over 20,000 new jobs over the past three years. If this were to continue or accelerate, it would represent a meaningful upside risk to the economy. That said, Canada has been accepting more immigrants (with a goal of 340,000 by 2020, up from around 273,000 in 2017), which may be a reason wage growth has not accelerated; in fact, average hourly wage growth for permanent workers has dropped from almost 4% in May 2018 to 1.5% in December.
Second, we should expect fiscal stimulus in the election-year federal budget. The incumbent government is likely to hand out goodies before voters go to the polls this fall. Part of this stimulus may be offset by consolidation in Ontario, but our overall view is that we should see a net modest fiscal stimulus this year.
What will the Bank of Canada do?
For bond investors, this is the key question. To predict the answer, we have to decide whether the BoC believes it is propping up a weak economy, slowing a strong economy, or simply trying to keep economic growth and inflation where they are.
Crucial to this determination is an interest rate that we cannot observe: the “neutral rate,” which is the theoretical interest rate that will keep the economy steady, with inflation at the BoC’s target of 2% and full employment (or the non-accelerating inflation rate of unemployment, NAIRU).
In April’s Monetary Policy Report (MPR), the BoC will update its estimate of the neutral rate, currently 3% +/- 0.5% (or 2.5%−3.5%). In our view, this estimate is too high. We find it compelling that inflation expectations and term premiums have fallen in recent years. Canada’s demographics and immigration are strong, but the apparent slowdown in productivity growth is a significant offset. More important, Canada’s massive stock of debt (particularly consumer debt) makes it highly unlikely to us that a sustainable neutral rate could be as high as 3.5%. We believe the economy would buckle under the strain of an overnight rate this high.
Our research leads us to a neutral rate estimate of 2%−3%, with a bias to the lower end of the range.
While this may seem academic, it is very important in the real world of investing. By hiking 0.25% five times since July 2017, the BoC may have taken out most (if not all) of its monetary stimulus, in our view, and if so, future rate hikes will not be taking the foot off the gas but rather applying the brakes to the Canadian economy. The effects of interest rate changes tend not to be fully observed until 12−18 months afterward, so in 2019, we should be able to see if the rate changes in 2017−2018 were appropriate.
We will pay very close attention in April to see if the BoC changes its neutral rate estimate and the rationale behind the decision. Often the devil is in the details when it comes to bond investing.
We see headwinds to the economy and the confining effects of a lower neutral interest rate limiting further rate increases by the BoC. In this context, we think interest rates should be range-bound, with a recession still unlikely over the next year. Low oil prices and the Federal Reserve’s more dovish stance of late make us cautious on the Canadian dollar, as both should limit any hawkish rhetoric from the BoC.
Despite our expectation for modest inflation this year, the breakeven inflation rate has dropped to 1.40%, making real return bonds relatively attractive as a hedge against upside surprises in inflation. Within the credit markets, our more cautious view on the fundamentals of the Canadian economy and high leverage in the system (both consumer and corporate) lead us to a bias for higher-quality investments and for avoiding highly cyclical sectors and those that are heavily levered to the consumer.
Since October, front-end bond yields have dropped 50 basis points, and we no longer see value in the front end of the yield curve. In this range-bound market, we are focused instead on opportunities at higher yields.