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One year after the onset of the pandemic, the Canadian economy has come a long way from the depths of economic slowdown, registering an average growth of more than 18% over the last three quarters.1 However, total economic output remains well below its pre-pandemic level. We have upgraded our 2021 forecast for the Canadian economy to 7% growth, with improved employment and consumption.
Positive healthcare developments and strong fiscal support in the United States are likely to drive full-year economic growth of at least 7%, stronger than we had anticipated at the start of 2021. Activity will likely peak in late Q3.
After a faltering start, vaccination rollout has accelerated in the Euro area, supporting full-year growth of around 5%, and possibly higher. Supportive policy underpins our view, which is largely in line with our expectations at the beginning of 2021.
Growth and output. The Canadian real gross domestic product (GDP) grew at 5.6% annualized rate in the first quarter of 2021, about 1.7% below the pre-pandemic GDP levels but a significant improvement (nearly 14 percentage points higher) from the depths of the pandemic-led slowdown in first quarter of 2020. Based on recent strength in consumption, job opportunities, and employment, we have upgraded our base case growth forecasts for the Canadian GDP to 7% in 2021, from a prior estimate of about 6% at the end of the first quarter.
Canadian businesses and consumers exhibited confidence during the last quarter. Retail sales marked a record increase in April, growing 58% year-over-year (YoY), reaching approximately C$55 billion. Auto sales surged nearly 52% in the second quartre YoY, marking the second-best quarter since the start of the pandemic. The Bank of Canada's Business Outlook Indicator rose to 4.2 from 3.0 in the previous quarter, a record level that will stoke expectations that households and businesses will be in a spending mood as pandemic restrictions are removed.
Labor market data for June showed a marked improvement with strong job growth and a reduction in unemployment. A housing boom and higher commodity prices are expected to boost economic activity, for some time, as the vaccination drive succeeds and case counts normalize.
Risks to the outlook. The biggest risk to our base case scenario could be from increased number of cases, virus variants, and another wave of business restrictions. In such a scenario, economic activity will lose speed and push growth lower for the third quarter and beyond. That said, higher employment, consumption and a sustained improvement in the U.S. economy and the resulting impact on the Canadian trade can generate growth surprises on the upside.
Secondly, highly-levered Canadian households and elevated housing price levels remain a cause of concern. Canadians are among the most highly indebted households within G7 countries, and in a scenario of higher interest rates, housing price correction and relatively high unemployment, it is a vulnerability.
Unemployment. The Canadian economy saw 231,000 jobs added in June, much higher than the consensus expectation of 175,000, a rebound from May’s 68,000 drop and following a cumulative decline of 275,000 over the previous two months.
The unemployment rate in June fell to 7.8%, from 8.2% in May, which is considerably lower than the recent peak of 9.4% in January 2021 and the record high of 13.7% in May 2020.
Inflation. Headline inflation crossed the 2% threshold in the second quarter. However, we believe that this is a transitory spike in prices driven by a combination of factors: 1) Uneven supply and demand pressures, i.e., production bottlenecks leading to tighter supply conditions and pent-up savings generating higher demand; 2) base effects; and 3) higher energy costs. The latest CPI print for May came in at 3.6%,6 the highest level in a decade and up from 3.4% in April. For the remainder of 2021, after the May report, we now expect inflation to remain in the range of 2.5% to 3.5%. However, substantial fiscal support, higher energy and commodity prices, and recovering economic activity domestically and in the U.S. may exert further upward pressure on prices in Canada.
Interest rates. In its July meeting, the Bank of Canada kept its policy rate unchanged at 0.25% while adjusting its quantitative easing (QE) program downward, targeting a pace of $2 billion per week (down from $3 billion per week earlier). This adjustment echoes sustained advancement towards economic recovery. We may continue to see the BOC gradually tapering off the QE as the economic recovery gains traction.
In our opinion, the interest rate environment in Canada will continue to remain supportive for the economy at least until mid-2022. After the QE tapering announcement, we expect the Bank of Canada to keep rates on hold for the rest of the year and begin signalling their position on future rate hikes in early 2022.
We believe that in the near term, Canadian interest rates will remain low on the short end of the curve due to low policy rates. On the medium and long-end of the curve, yields have been pulled lower across maturities during the last quarter owing to transitory inflation expectations and a lower risk of interest rates increasing in its response. As a result, medium and long-term swap rates (5-year, 10-year, and 15-year) descended by 40 to 50 basis points over the past three months.2
Canadian dollar. The loonie continued its advance against the greenback during the second quarter, rising 2.6% during the first half of the year, ranking as the top-performing currency year to date.3 Many factors played in favour of the Canadian dollar’s strength:
1) The Canadian economy generated a trade surplus of C$ 1.2 billion in the first quarter of 2021, a solid improvement from a deficit of $7.3 billion at the end of the fourth quarter 2020, due to prices increases in Canadian export commodities including oil, base metals, and precious metals, driven by an anticipated global growth in coming months.
2) Robust vaccine distribution in the U.S. and the ensuing economic growth and demand for Canadian exports.
3) With wider vaccine distribution, the government’s fiscal and monetary support, recent easing of lockdown restrictions, and resulting strength in consumption, employment, and unusually high sales volume and price gains in the housing real estate has created a virtuous sentiment for the Canadian currency.
Key risks to the loonie are (1) the Delta and other coronavirus variants, potentially resulting in lockdowns and business restrictions and (2) highly-levered Canadian households.
Considering these factors, and acknowledging uncertainty associated with any currency forecast, our near-term (three to six months) outlook for the currency is to trade in a 1.15 to 1.35 range against the U.S. dollar.
Growth activity in the U.S. has continued a strong pace through the second quarter as income support (stimulus plus enhanced unemployment insurance) and positive health developments drive a broader reopening of the economy. Vanguard expects the pace of growth to remain strong as positive health outcomes drive a wider revival of the economy. We continue to foresee full-year growth of at least 7% in 2021.
U.S. inflation. Headline inflation unexpectedly increased to 5.4% YoY in June, the biggest jump since 2008. Core consumer price increases printed at 4.5%, also beating forecasts. Our baseline forecast has moved higher driven by a stronger month-over-month number of 0.6% for Core PCE. However, some volatility in inflation is expected as energy prices recovered faster than anticipated and one-off supply constraints may drive sector level prices higher.
Key risks. The risk to our view is that inflation could prove to be more persistent if its sectoral drivers remain strong. Recent ISM data point to a persistent supply shortage of labor while the new orders index remains elevated suggesting that supply-demand imbalance could take longer to adjust. In this case, we may realize an inflation upside scenario where Core PCE does not fall below 2% by end of 2022.
Vanguard believes that growth in the Euro area hasn’t peaked yet. We expect that to occur in the third quarter, with the region achieving a full-year growth of around 4% to 5% in 2021. We anticipate an economic recovery led by a substantial rebound in consumption in the coming months, propelling the regional GDP to reach its pre-pandemic level in the first quarter of 2022.
In China, the fading of support from export and investment sectors, alongside the delays in consumption normalization has posed headwinds to the economic rebalancing process, leading us to downgrade our full-year growth forecast to around 8.5% from 9% previously.
Emerging market economies are expected to grow by 6.3% in 2021 compared with global growth of 5.5%. Emerging market Asia was supposed to fare the best among other regions with an expected 8.3% growth, but the region now represents the worst global Covid-19 hotspot, threatening the health of emerging markets’ growth engine. India’s Covid crisis continues to deepen with possible spill over implications for the rest of the region. Latin America’s forecast growth of 4.1% in 2021 is not enough to close the output gap caused by the worst regional contraction (-7.4%) in 2020.
Looking ahead, our fair-value projections continue to reveal a global equity market that is neither grossly overvalued nor likely to produce outsized returns over the next 10 years. Similarly, bond return expectations have subdued over the past quarter.
Canadian and global equities. We have further moderated our stock market outlook during the second quarter of 2021 due to growth in prices across Canadian and international markets. Our median 10-year returns expectations for Canadian equities as of June 30, 2021 are in a range of 3% to 5%, about half a percentage point lower than our first-quarter 2021 estimate. This is primarily due to about 8% growth in the Canadian equities5 during the quarter. Likewise, our median 10-year returns expectations for global stocks (ex-Canada, unhedged) at the end of the second quarter have fallen to a 3% to 5% range, representing a one percentage point drop.
Canadian and global bond. At the end of the second quarter 2021, we anticipate that median 10-year returns for both Canadian and global bonds will range from 1.0% to 2.0%, compared with an approximate range of 1.5% to 2.5% in the first-quarter 2021 – about half a percentage point decrease over the next 10 years. This is because of flattening yield curves across Canada and other developed markets during the second quarter as inflation expectations abated coupled with reassurances from global central banks on maintaining low interest rates and quantitative easing programs until economic recovery gains traction.
We take a long-term view on investing, and we encourage our clients to do so as well. While the ranges of our expected 10-year median returns are below recent returns, global equities are anticipated to continue to outperform most other investments and the rate of inflation.
Notes
1. Average of YoY annualized growth rates, calculated quarterly from Q3 2020 to Q1 2021 using Bloomberg data and Vanguard calculations.
2. Change in the Canadian dollar interest rate swap curve between March 31, 2021, and June 30, 2021, using Bloomberg data and Vanguard calculations.
3. Among G10 and based on both total and spot returns from Jan 1, 2021, to Jul 21, 2021, using Bloomberg data and Vanguard calculations.
4. All returns are annualized median expected returns over the next 10 years, as of June 30, 2021, using Vanguard Capital Markets Model.
5. Change in S&P/TSX Composite Index between March 31, 2021, and June 30, 2021, using Bloomberg data and Vanguard calculations.
6. June CPI was printed at 3.1% (YoY), lower than both April and May thus reinforcing our transitory inflation views.
Bilal Hasanjee, CFA, MBA, MSc Finance, is Senior Investment Strategist at Vanguard Investments Canada.
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© 2021 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 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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