Vanguard’s economic outlook for Canada – November 2022 quarterly update
Downside risks are increasing
The global economy is decelerating, and there are many factors attributable for the slowdown. In North America, the Bank of Canada (BoC) and the U.S. Federal Reserve (Fed) are facing the challenge of cooling off four-decade-high inflation using tighter monetary policy, whilst trying to avoid a long and deep recession in the process. Here’s our outlook for Canada.
Growth and output
We maintain our forecast for full-year 2022 economic growth in Canada in a range of 3% to 4%, but downside risks are increasing with our expectation that tightening financial conditions will contribute to lackluster growth. Real GDP increased at an annualized rate of 3.3% in the second quarter, the fourth consecutive quarterly increase. But our proprietary leading indicators index suggests that growth slowed in the third quarter, as shown in Figure 1.
According to the BoC: “Economic growth is expected to stall through the end of this year and the first half of next year as the effects of higher interest rates spread through the economy. The Bank projects GDP growth will slow from 3¼% this year to just under 1% next year (2023) and to 2% in 2024.1”
Prospects for energy prices are an important wild card for Canada. As a net energy exporter, Canada benefits from higher prices through increased government revenues, but the households bear the inflationary pressures of higher prices. A multitude of factors keeps us focused on energy price dynamics.
Energy prices will be driven higher because of supply constraints due to the Ukraine war and OPEC output reductions. However, global economic slowdown would be a headwind for energy prices. For 2023, Canada’s growth will depend in large part on the BoC succeeding in its balancing act of reducing inflation using tighter monetary policy, while achieving a soft economic landing (or avoiding a deep and prolonged recession).
Risks to the outlook
Risks of a global recession are rising and may have a spillover impact on the Canadian growth given its reliance on energy exports. The Canadian and the U.S. economies are experiencing record inflation levels while respective central banks implement monetary tightening measures. This increases the risks of a policy misstep, resulting in a hard landing or a recession with high inflationary pressures – a.k.a stagflation.
Highly levered Canadian households and elevated housing price levels remain a cause of concern. Higher interest rates threaten a housing sector that’s vastly more expensive than in other developed markets. Even with population trends that support demand, a moderation in prices could be at hand. Recently, the BoC, in five successive rate hikes in March, April, July, September, and October, raised the key interest rate to 3.75%. There is a concern that elevated policy rates will cause a disorderly reduction in housing prices and knock-on effects across household finances to magnify the risk of a hard landing.
An abrupt rise in energy prices could lead to additional inflationary disruption. While this would prove a positive catalyst for Canadian trade growth, its contribution to inflationary tensions may put pressure on the economy through lower discretionary consumption and tighter monetary policy.
Canadian housing market
With rising interest rate and rapidly falling affordability across Canadian residential real estate, we see a downside risk. This is highlighted by substantive deterioration across leading indicators, including sales and construction, despite positive long-term fundamentals driven by immigration.
Residential sales have slowed down in the second and third quarters by 24% and 29%, respectively, year-over-year.2 The BoC in its recent press release also noted that “the housing activity has retreated sharply” as the effects of recent policy rate increases by the BoC are becoming evident in interest-sensitive areas of the economy.
Canada’s consumer price inflation accelerated to a four-decade high, forcing the BoC to deliver a series of aggressive interest rate hikes. Headline CPI in August and September dropped to 7.0% and 6.9%, respectively, from 7.5% in July, largely driven by lower gasoline prices. Core CPI (trimmed) fell to 5.2% in August and September from 5.4% in July led by transportation and shelter.
Thus, price pressures remain broadly based, with two thirds of CPI components increasing more than 5% over the past year. Even as housing prices fell, mortgage interest costs rose as homeowners initiated or renewed mortgages at now-higher rates, simultaneously pushing rental rates higher.
Vanguard expects that the BoC rate hikes will ease supply-demand imbalances and lower oil prices should help temper core inflation to between 5% to 6% by year-end 2022, before further normalization toward a 2% target in 2023 and 2024.
The Bank of Canada raised its target interest rate to 3.75% on October 26, 2022, the fifth rate increase this year. Through successive rate hikes, the BoC has already pushed the target overnight rate above what the central bank considers to be the neutral rate, the rate at which policy neither stimulates nor restricts an economy.
The BoC was one of the first developed market central banks to cite a need to front-load rate hikes to rein in inflation. In our opinion, the BoC may also be one of the first to pause its hiking cycle.
Its strategy of raising rates sharply and swiftly was based on the view that it would likely result in an economic soft landing and avoid even higher rates and more economic pain down the road. In case of an economic slowdown, the BoC may decide to pause the interest rate hiking cycle and assess the economic situation. Vanguard believes the BoC will raise rates to a range of 4% to 4.25% by the end of 2022 and potentially pause there in case of signs of economic slowdown.
The Canadian dollar remained range bound during the second quarter and most of the third quarter, trading in a tight band of C$1.25-C$1.30 against the U.S. dollar until mid-September. There has been a recent selloff versus the U.S. dollar in tandem with most major currencies, pressured by risk-off sentiment, a moderation in energy prices, and rapidly rising U.S. Treasury yields. Despite this, the Canadian dollar has outperformed all its G10 counterparts except the Swiss franc, year-to-date. The relative strength in the loonie can be explained by multiple factors:
Current account surplus. Canada achieved a current account surplus of $2.65 billion and $2.69 billion in the first quarter and second quarter of 2022, respectively, marking the largest trade surpluses in 14 years. The balance of trade shifted from a deficit of $39.8 billion in 2020 to a surplus of $5.2 billion in 2021 and it stands at approximately $23 billion year-to-date,3 primarily because of higher energy and commodity prices. However, total exports continued a downward trajectory in August as energy prices moderated (see Figure 4)
Tightening monetary policy. The Bank of Canada’s monetary policy tightening is being implemented in lockstep with that of the Federal Reserve. To some extent, this has shielded the Canadian dollar from a selloff driven by interest rate differential vis à vis the Treasury curve, unlike many of its peers. That said, as inflation levels taper off faster in Canada than in the U.S. (see Figure 5) and interest differentials further fall against the Canadian dollar, the loonie may lose further ground against the greenback.
Key risks to the loonie are: 1) Higher interest rate differential in favour of the U.S. dollar; 2) risk of global recession, impacting energy prices and Canadian trade; 3) an unexpected fall in energy and commodity prices due to supply chains and geopolitical adjustments; 4) unexpected knock-on effects on growth due to highly levered Canadian households in a rising rate environment.
Considering these factors, and acknowledging uncertainty associated with any currency forecast, our near-term (3-6 months) outlook for the currency is to trade in a C$1.25-C$1.45 range against the U.S. dollar.
The economy lost more than 49,000 jobs in the third quarter as opposed to about gains of 210,000 and 12,000 in the first and second quarters, respectively. As a result, the unemployment rate in Canada rose to 5.2% in September from 4.9% in June, slightly lower than the consensus estimate and August print of 5.4%, while labour participation rates remained stagnant at around 65% during the third quarter.
However, it should be noted that starting from the first quarter of 2021, the economy has enjoyed record low unemployment rates since the data first became available in 1976. With tighter financial conditions resulting from higher interest rates, a slowdown in business activity may result in further job losses in the coming quarters.
Next time: The outlook for U.S. and international markets.
1. The Bank of Canada Policy Statement on October 26, 2022.
2. Source: Canada Real Estate Association data on October 27, 2022.
3. Source: Statistics Canada and Bloomberg as of August 31, 2022.
Bilal Hasanjee, CFA, MBA, MSc Finance, is Senior Investment Strategist at Vanguard Investments Canada.
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