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Our outlook for 2021 focused on the impact of Covid-19 health outcomes on economic and financial market conditions. Those health outcomes remain important, but the impacts of macroeconomic policy will be crucial as support and stimulus packages enacted to combat the pandemic-driven downturn are gradually removed. How these policy measures evolve is perhaps the critical determinant of our economic and market outlook, though the macro impact of the war in Ukraine will increase as the tensions persist.
There is less unevenness in our cyclical growth outlook across regions for 2022, although there is more uncertainty associated with policy related missteps by governments and central banks. We expect an annual growth of 4%-5% in Canada; 3%-3.5%, in the U.S., 4%-5% in China, and 2.5%-3% in Europe.
Vanguard models suggest the pace of growth may have slowed in Canada in the first quarter. The government is scheduled to release first-quarter GDP data on Tuesday, May 31. In our base case, we foresee economic growth around 4%-5% for full-year 2022. Real GDP grew by 1.6% in the fourth quarter compared with the third, and by 4.6% for all of 2021. Vanguard is closely watching interest rates, inflation, and housing prices for clues about Canada’s economy. We expect more interest-rate hikes to raise mortgage rates further, which in turn could curb fast-rising housing prices that have fueled the growth.
Economic growth is strong, and the economy is moving into excess demand. Labour markets are tight, and wage growth is back to its pre-pandemic pace and rising. Businesses increasingly report they are having difficulty meeting demand and can pass on higher input costs by increasing prices.
The global economy is gradually recovering; however, the path is unlikely to be a smooth one:
(a) Risks in the developed world are centered on an increasing likelihood that changes in policy rates and balance sheets may be more abrupt as inflation is proving more persistent, increasing the risk of a hard landing.
(b) Concerns over safety, adoption and distribution of vaccines (particularly in emerging markets) as well as virus mutations.
(c) Should the impact of the invasion of Ukraine push oil and energy prices to $125-$150 (per barrel of WTI oil) and increase market volatility, our conviction of above-trend growth deteriorates significantly.
(d) Highly levered Canadian households and elevated housing price levels remain a cause of concern.
Recently, the Bank of Canada, in two successive rate hikes in March and April, raised the key interest rate to 1%. Moreover, the federal government announced budgetary measures to curb speculation and foreign investment in Canadian residential real estate. Canadians are among the most highly indebted households within G7 countries, and in a scenario of higher interest rates and housing price corrections in an inflationary environment, it is a vulnerability.
The Canadian economy created 210,000 jobs in the first quarter of 2022, with strength in both the public and private sectors. The unemployment rate continues to fall but labour participation rates have remained stagnant. The unemployment rate fell to 5.5% in March from 6.5% in January, marking the lowest jobless rate since the onset of the pandemic.
Canada’s inflation rate rose to 6.7% in March, far higher than economists were projecting and a full percentage point higher than February’s already 30-year high print. Statistics Canada reported in April that all eight categories of the economy that the data agency tracks rose, from food and energy to shelter costs and transportation. While the cost of about everything is going up fast, transportation costs are leading the way, up 11.2% in the past year. A big reason for that increase is the 39.8% rise in gasoline costs since March of last year.
As widely expected, the Bank of Canada raised its policy rate by 50 bps, to 1%, ended its reinvestment program, and began quantitative tightening on April 25, citing the war in Ukraine, supply interruptions, and rapid prices increases in commodities as key drivers for change in their inflation outlook.
Canadian interest rates have shifted higher across short, medium, and long ends of the yield curve, because of higher inflation expectations, pushing up the cost of borrowing for businesses and mortgages.1 The latter has already started to manifest its impact on residential real estate sales volumes in Toronto, the GTA, and Vancouver.2
The Canadian currency has experienced a volatile period since the beginning of the year due to a multitude of factors. On one hand, a rise in oil prices, buoyed by risks of supply shocks due to the Russia-Ukraine conflict and higher demand in a post-Covid reopening of the global economy, have supported the loonie. On the other hand, the same geopolitical risks have pressured the equity markets and the Canadian currency.
The Bank of Canada’s aggressive monetary policy stance initially supported the loonie, however, as the U.S. Federal Reserve showed an equally aggressive resolve to hike interest rates, the interest rate differential advantage for Canadian dollar gradually waned. That said, with oil, industrial metals, and materials prices remaining strong, we may see the loonie regain strength in the medium to long term.
Key risks to the loonie are: (1) a higher interest rate differential in favour of the U.S. dollar; (2) highly levered Canadian households; (3) an unexpected fall in energy oil prices.
Considering these factors, and acknowledging the uncertainty associated with any currency forecast, our near-term (3-6 months) outlook for the currency is to trade in a $1.20 - $1.40 range against the U.S. dollar.
Next time: U.S. and global outlook
Notes
1. Change in the Canadian dollar interest rate swap curve between Dec 31, 2021, and May 6, 2022, using Bloomberg data and Vanguard calculations
2. Source: Canada Real Estate Association data in March indicates that home sales in March were down 16.3 per cent compared with the same month last year when they hit an all-time record
Bilal Hasanjee, CFA, MBA, MSc Finance, is Senior Investment Strategist at Vanguard Investments Canada.
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