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The possibility of a soft landing for the world economy in early 2023, with steady growth and decreasing inflation, has diminished amidst a persistent high inflation, and continued financial sector instability. Although headline global inflation has descended from historically high levels in 2022, core inflation gauges, particularly services inflation remains stubborn along with tight labor markets in many countries.
Central banks in major economies are emphasizing the importance of adhering to a tight monetary policy to meet their inflation targets. This policy stance along with stress in the banking sector, to a lesser extent, will likely constrain global growth through 2023 and the first half of 2024. However, growth is expected to increase in 2025 as the effects of policy tightening fade.
We continue to foresee 2023 GDP growth of around 1% in Canada, with risks to the downside, and a mild recession late in the year. Leading indicators1 for economic activity, as shown in Figure 1, have continued to deteriorate, which has caused us to lower our overall growth expectations. Real GDP was largely unchanged in the fourth quarter of 2022 compared with the third, i.e., a 0% growth during the quarter, driven by higher interest rates and its knock-on effects on consumption and spending. The Bank of Canada projects the GDP growth to be 1.4% in 2023 and 1.3% in 2024. However, it is expected to reach 2.5% in 2025 as the economy adjusts to higher interest rates and inflation returns to the 2% target, in the interim.
As the Bank of Canada decided to pause interest rate hikes for two straight meetings in March and April, it provided an impetus to the Canadian home buyers waiting in the sidelines to enter the market, particularly in Toronto/GTA and Greater Vancouver, which are Canada’s two of the most expensive housing markets. But there’s more to this phenomenon than what meets the eye.
Supply shortages. With increasing sales and low supply as inventory levels plummeted, we observed the highest sales to inventory ratios in 14 months, with the lowest inventory levels since June 20222. In addition, Canada’s March 2023 housing starts number printed 11% lesser than the February number, down 14% quarter-over-quarter and below consensus expectations.
Population growth. January 2023 marked the first 12-month period in Canada’s history where population grew by over one million, a growth rate of 2.7%, the highest since 1957, the year representing a post-war baby boom and high refugee immigration following the Hungarian Revolution of 1956. This rate of population growth also ranks the highest among the Organization for Economic Co-operation and Development (OECD) countries and within the top 20 globally.
As a result, the national average home price in April 2023, although 10% down from its March 2022 peak level, was up around 17%, or over $100,000 higher than its January 2023 level.
Vanguard expects price stability in the Canadian residential real estate in the medium term, barring resumption of rate hikes or a deep and prolonged recession.
The pace of headline inflation increased in April for the first time since June 2022. The Consumer Price Index rose by 4.4% compared with a year earlier, higher than the 4.3% pace in March, driven by higher rents and mortgage interest costs. The pace of core inflation, which excludes volatile food and energy prices, edged down to 4.4% from 4.5% in March but remained well above the BoC’s target. Services inflation was 4.8%, lower than a 5.1% year-on-year increase in March.
Inflation of goods prices is rapidly easing, attributable to the impact of tighter monetary policy on interest rate sensitive sectors, improvement in global supply bottlenecks and decrease in energy prices. However, services price inflation, wage growth, and inflation expectation remain stickier and less responsive to restrictive monetary policy. Consequently, the BoC expects inflation to decline rapidly to around 3% in the middle of 2023 and then reduce more gradually, reaching the 2% target by the end of 20243. We anticipate that inflation to continue moderating this year. But upside risks to inflation remain from higher shelter costs.
Risks of a global recession are rising and may have a spillover impact on the Canadian growth given its reliance on energy exports. The BoC and other major central banks’ policy stance may prove to be too hawkish and may lead to a more than anticipated fall in demand, causing recession risk to rise
Highly levered Canadian households and 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, and recent moderation in prices, a further reduction in prices may occur because of a recession. 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 exasperation of inflationary tensions may put pressure on the economy through lower discretionary consumption and tighter monetary policy. It may result in the Bank of Canada pushing the rates further to rein in inflation.
The Bank of Canada wrestled at its April 12 policy meeting with a choice of raising its overnight rate target or keeping it steady for a second consecutive month, meeting minutes show. In the end, the Governing Council voted to keep its rate target at 4.5% to give itself “the opportunity to accumulate more evidence that a higher policy rate is in fact required.”
Among the rationales for raising its rate target was the idea that, although the pace of inflation has edged down, getting from 3% inflation to the bank’s 2% target was likely to be the hardest increment. The Governing Council considered that a further rate hike might be required to create financial conditions restrictive enough for the task at hand.
Complicating the BoC’s calculus is that Canadian homeowners are among the most indebted in developed markets. Rising interest rates can pose challenges for household budgets in a country where variable-rate mortgages are popular, especially if the labour market softens and unemployment rises. The pause in rate hikes may have been reinforced by a weak GDP report for the fourth quarter of 2022.
The Canadian dollar remained rangebound during the fourth quarter of 2022 and the first quarter of 2023, trading in a tight band of 1.32 to 1.35 against the U.S. dollar, a notable weakness from a stronger parity range of 1.25 to 1.30 observed during second and third quarter of 2022. The loonie was the top-performing G10 currency against the U.S. dollar for the most part of 2022, but other currencies caught up as the U.S. dollar peaked in the fourth quarter of 2022.
One of the key drivers of the Canadian currency’s weakness was its central bank’s announcement to pause interest rate hikes in January at 4.5%, taking away the interest rate differential advantage vis-à-vis other currencies. Another reason for the loonie’s weakness is the impact of interest rates on the housing market and its knock-on effects on the GDP.
Canada’s fourth quarter 2022 GDP growth was flat (0% quarter-over-quarter). Further slowdown in the economy may result as mortgages are repriced at higher interest rate levels. That said, we do not expect a major recession, because a gradual repricing of loans should mitigate the reduction in disposable income due to higher loan payments and lessen the impact on the economy.
Lastly, fears of a U.S. recession are also weighing on the Canadian dollar, the U.S. being the largest trading partner for the country. On a brighter side, demand for commodities is expected to recover as Chinese and European economic activity continues to improve, leading to demand for the Canadian goods and the currency.
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 1.25-1.45 range against the U.S. dollar.
The labor market remains resilient. The Canadian economy created over 206,000 jobs in the first quarter of the year, 35,000 in March, higher than the 22,000 created in February and continuing the trend, over 41,000 jobs were created in April. However, part-time positions accounted for all net new jobs more than making up for the decline in full-time employment by 6,200, during the month.
The unemployment rate remained at 5%, still hovering just above the record low of 4.9% in June and July 2022. The participation rate remained constant at 65.6%, in April. Average hourly wages rose 5.2% compared with a year earlier, slower than the 5.3% pace in March but a level unlikely to comfort the BoC.
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 job losses in the coming quarters.
Next time: The outlook for U.S. and international markets.
Bilal Hasanjee, CFA, MBA, MSc Finance, is Senior Investment Strategist at Vanguard Investments Canada.
Notes
1. VLEI is Vanguard leading economic indicator. The VLEI index is a tool to track overall economic activity and health with a roughly six month lead time. The model tracks and summarizes indicators from every sector of the economy (consumers, businesses, manufacturing, housing, financial markets, hard data and survey based data) with 85 underlying indicators being included in the end index. Highest weight is given to indicators which show stronger correlation and longer lead time to growth activity.
2. Canada Real Estate Association sales to new listing ratio data in April 2023.
3. The Bank of Canada Monetary Policy Report, April 2023.
Disclaimer
© 2023 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 May 18, 2023, on the “Insights“ page of the Vanguard Group, Inc.’s website. Used with permission.
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