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At the start of the year, we expected global economies to continue to recover from the effects of the COVID-19 pandemic but at a more modest pace than in 2021.However, changing geopolitical events and associated shifts in macroeconomic fundamentals such as inflation, growth, and monetary policy have been contrary to expectations.
Labor and supply-chain constraints were already fueling inflation before the year began, but Russia’s invasion of Ukraine and China’s zero-COVID policy has exacerbated the situation. Central banks have been forced to play catchup in the fight against inflation, ratcheting up interest rates more rapidly and possibly higher than previously expected. But those actions risk being too aggressive and cooling economies to the point that they enter recession.
In our opinion, global economic growth will likely stay positive this year, but some economies are flirting with recession, if not this year, then in 2023. Compared with the start of the year, Vanguard has downgraded its 2022 GDP growth forecasts for all the major regions, increased its inflation forecasts, and became more hawkish about monetary policy.
Here’s our outlook for Canada.
Canada’s GDP growth slowed to 3.1% annualized rate in the first quarter, versus a consensus estimate of 5.2% and from 6.7% growth rate in the prior quarter. It was driven by consumption and private investment, but partly offset by a larger contraction in exports. However, goods trade surplus widened to $5.3bn in May from $2.2bn in April, the largest surplus since 2008. A rally in oil prices and related export income drove the increase. The Bank of Canada expects that the Canadian GDP grew by about 4% during Q2’221.
As a net energy exporter, Canada is in a better position than most countries, getting an economic boost from higher oil and gas prices. But higher prices reduce consumers’ purchasing power, and the Bank of Canada is likely to further front-load increases to its overnight rate above the neutral rate (~2.5%) to curb inflation. We’ve downgraded our 2022 economic growth forecast from 5% at the start of the year to roughly 3%-4% primarily due to tighter financial conditions coupled with a higher inflation outlook.
Inflation. The Canadian and the U.S. economies are experiencing record inflation levels with respective central banks implementing monetary tightening measures. This increases risks of a policy misstep resulting in a hard landing or a recession with high inflationary pressures – stagflation.
Debt. 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 Bank of Canada, in three successive rate hikes in March, April, and July, raised the key interest rate to 2.5%. Moreover, the federal government recently announced budgetary measures to curb speculation and foreign investment in the Canadian residential real estate. Canadians are among the most highly indebted households among G7 the countries, and in a scenario of higher interest rates and housing price correction in an inflationary environment, it is a vulnerability.
Energy prices. An abrupt hike in energy prices, should the war in Ukraine push oil and energy prices to $130-$150 per barrel (of WTI oil) and results in higher inflation and slower economic growth while increasing market volatility.
The unemployment rate in Canada fell to a record low of 4.9% in June, down from 5.1% in May, beating consensus estimates of 5.1%, marking it the lowest reading since the data became available in 1976. However, the economy created only about 12,000 jobs in the second quarter, compared with 210,000 in the first, while labour participation rates remained stagnant at around 65% during the second quarter. Unemployment may rise in the second half of the year, but given high job vacancies and accelerating wage growth, the labor market will likely stay healthy despite rate hikes.
Canada’s consumer price inflation accelerated to a four-decade high, encouraging the Bank of Canada (BoC) on July 13 to deliver a more aggressive interest rate hike of one full percentage point (100 basis points), exceeding an expectation of 75 basis points. Annual CPI rose to 8.1% in June, up from 7.7% in May, which is the highest since January 1983 but below the consensus estimates of a 8.4% largely due to a smaller-than-expected increase in food prices. A month-over-month increase of 6% in fuel prices was responsible for an increase in transportation prices.
The month-over-month prices for housing declined as real estate commissions fell along with a slowing acceleration in housing prices. This shows that while inflation remains broad-based across goods and services, the pace of gains could be slowing. If this trend persists, it may help the central bank’s ability to move the economy into a soft landing. That said, the BoC may front-load further interest rate hikes and quickly withdraw stimulus from an overheating economy amid concerns of price pressures becoming entrenched in the economy.
Anticipated Bank of Canada rate hikes should help temper core inflation to about 4.5% to 5% by year-end before further normalization toward a 2% target in 2023 and 2024.
The Bank of Canada doubled the size of its rate hike on July 13, increasing the target for its overnight rate to 2.5%. The move, which pushed the rate target to a level around what Vanguard considers to be the neutral rate (the rate at which policy neither stimulates nor restricts an economy), followed two successive meetings where the Bank raised its policy rate target by 50 basis points each. The bank cited “higher and more persistent” inflation with a risk of high inflation getting embedded in price and wage contracts, as the key determinant for such an unusually large rate hike. The Bank also decided to continue the policy of quantitative tightening to reign in low interest rates at the long end of the yield curve.
Canadian interest rates have shifted higher across short, medium, and long ends of the yield curve, because of higher inflation expectations and anticipated tighter monetary conditions, pushing up the cost of borrowing for businesses and mortgages.2 The latter has already started to manifest its noticeable impact on residential real estate prices and sales volumes in Toronto, GTA, Vancouver, and other areas.3
The Canadian dollar remained rangebound during the second quarter, trading in a tight range of US$1.25-US$1.30 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 global economy, has supported the loonie. On the other hand, the same geopolitical risks have pressured the equity markets and the Canadian currency.
Similarly, as the Bank of Canada increased interest rates in lockstep with the Federal Reserve, it helped bolster the Canadian dollar. However, higher rates and tightened monetary policy increased chances of a recession fears in the near future, causing investors’ flight to the safety of the U.S. dollar. Overall, we believe that the Canadian dollar will be well-supported in the medium to long term against the U.S. dollar and other currencies due to the following factors.4
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 and energy prices.
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 US$1.20-US$1.40 range.
Next time: The outlook for U.S. and international markets
Notes
1. The Bank of Canada Policy Statement on July 13, 2022.
2. Change in the Canadian dollar interest rate swap curve between Dec 31, 2021, and July 19, 2022, using Bloomberg data and Vanguard calculations.
3. Source: Canada Real Estate Association data on July 15, 2022, indicates that home sales in June were down 23.9 per cent compared with the same month last year.
4. Source: Statistics Canada.
Bilal Hasanjee, CFA, MBA, MSc Finance, is Senior Investment Strategist at Vanguard Investments Canada.
Disclaimer
© 2022 by Vanguard Group. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared July 28, 2022, on the “Insights“ page of the Vanguard Group, Inc.’s website. Used with permission.
The views expressed in this material are based on the author's assessment as of the first publication date (July 2021), are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc. The author may not necessarily update or supplement their views and opinions whether as a result of new information, changing circumstances, future events or otherwise.
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