Canada’s economic outlook—recovery delayed, not derailed

Next week will be an important one for Canada—Finance Minister Chrystia Freeland’s set to unveil the federal budget while the Bank of Canada’s (BoC’s) due to announce its latest policy decision. Meanwhile, juxtaposed against a painful third wave of the COVID-19 outbreak, the Canadian housing market is ablaze, the Canadian dollar (CAD) is strong, and the Canadian stock market is trading well above record levels. How does this story fit together? We present our response to frequently asked questions that we believe are most relevant to investors. 

In our view, the latest outbreak should be seen as a delay (as opposed to a derailment) in Canada’s economic recovery. We believe Canada is about three to six months behind the United States’ reopening. However, this implies that some of the improvements to the economy in March—including the 303,000 jobs added during the month¹—have to be viewed as somewhat stale information and that we’ll likely be heading back into a period of significant data distortions and enhanced downside risk, particularly in April and May. Canadian business confidence and investment levels, which have been underperforming for some time, remain areas of concern for us, both in the near term and from a longer-term perspective. 

However, we believe the economic impact of the latest COVID-19 outbreak will be mitigated by:

• Extraordinary and persistent fiscal support that has limited job losses and ensured that labor force participation in Canada remains robust, particularly relative to the United States. While we don’t expect momentum in job gains to accelerate in April and May, the upbeat trend is likely to stall.
• While Europe and several key emerging markets are also struggling with a surge in COVID-19 infections, the U.S. economy is displaying signs of a strong rebound as it reopens. This is likely to support Canadian growth through the export channel and provide relative value to the Canadian macro landscape vis-a-vis several other major developed markets. 
• The first wave of the COVID-19 outbreak might have sparked concerns regarding financial stability and a potential wealth shock as stock prices plunged (albeit briefly), but financial conditions have eased significantly since then. Ironically, the combination of higher home prices and a rising stock market is providing a positive wealth shock to a segment of Canadians. 
• Although vaccine enrollment in Canada is slow relative to the United States and the United Kingdom, the pace is now accelerating, placing a time limit on how long social mobility will be constrained. 

Number of people who received at least the first dose of a COVID-19 vaccine out of 100 

Ultimately, the third COVID-19 wave represents another pause on growth and brings elevated downside risks. However, financial markets, which are forward-looking by nature, will do what they’ve done in the last 12 months: look through to the other side (with some healthy support from policymakers).

Property prices in Canada are surging² and much of that can be explained by low interest rates, fiscal stimulus, and strong levels of employment among homeowners (versus low-income renters). In addition, longer-term strategic drivers such as demographics, immigration, and short-term supply issues remain in play. However, there’s also evidence pointing to price speculation extending beyond major cities such as Toronto and Vancouver, where the level of activity suggests we could be closer to housing bubble territory rather than being driven by market fundamentals. 

While we need to keep an eye on mortgage default activity (which remains extremely low) and the likelihood of financial contagion through sharp pullbacks in property prices in the future, we don’t expect such an event to materialize soon—interest rates are likely to remain low, fiscal support will continue to boost economic activity (which should continue to underpin the property market, at least partially), and we aren’t likely to see a large downside employment shock.

That said, surging home prices do carry important risks for the Canadian economy and could have secondary implications that are no less important. 

1. Surging home prices could challenge corporate competitiveness in major urban cities. As housing costs rise, it could become more challenging for firms to attract and retain workers. Similarly, companies may increasingly experience cost-push wage inflation as employees demand higher wages. Higher wages due to rising cost of living are generally associated with bad inflation since they often don’t translate into improvements in productivity or better growth. 
2. We expect to see growing pressure on the federal government and regulators to address the issue—once again, a development that would introduce uncertainty (and opportunities) into the macro picture. The Office of the Superintendent of Financial Institutions, Canada’s banking regulator, recently proposed to tighten the country’s minimum qualifying rate for uninsured mortgages.³ This is another attempt to keep risky borrowers out of the property market. However, it could end up pricing more first-time home buyers out, thereby addressing systemic risk but not the affordability crisis. In our view, any policy response will inevitably have to shift toward addressing the supply issue, which should include the construction of purpose-built rental units. While it’d be several years before they could be available, such an initiative would ultimately be growth-positive and could be a positive way out of an overheating housing sector.  
3. Higher housing costs in addition to higher childcare costs can also bring about more aggressive intra-provincial migration as workers move out of more expensive cities, such as Toronto, into cheaper neighborhoods. Between July 2019 and July 2020, 50,000 people left the Greater Toronto Area for other regions in Ontario⁴—we expect this trend to rise. In our view, it’s a development that could present risks for some regions and opportunities for others. From a longer-term perspective, this could have implications for real estate investment trust investors. 

"Canadian business confidence and investment levels, which have been underperforming for some time, remain areas of concern for us, both in the near term and from a longer-term perspective." 

The BoC has already telegraphed⁵ that it’ll probably announce plans to taper its asset purchases at the central bank’s April 21 meeting. While it makes sense to query the timing of the expected announcement given that the country is in the midst of another COVID-19 outbreak, ultimately, the central bank doesn’t really have much of a choice: The BoC owns over 30% of Canadian federal debt⁶ and without winding down its purchases, the central bank would be on track to owning 60% of all Canadian government bonds by this time next year.⁷ This is more than just an optics issue—it could unfavorably distort market functioning. Moreover, the BoC bought nearly 80% of the federal government’s bond issues in the last fiscal year.⁶ Given that the federal government is likely to announce plans to reduce the amount of its bond issuance in the next fiscal year, the BoC will have little choice but to reduce its purchases to maintain its current share of federal government bonds in the market.  

Central bank holdings of total government debt outstanding

Meanwhile, the recent rise in market rates in the United States has paused. Given the high correlation between Canadian interest rates and U.S. interest rates, this is a welcome breather. In addition, while CAD is about 5% stronger relative to the U.S. dollar (USD) than it was pre-COVID-19,⁶ the appreciation has stabilized recently at what we perceive to be comfortable levels. Perhaps, most importantly, the upcoming federal budget is likely to provide ongoing and better-targeted support for the Canadian economy versus asset purchases that are marginally suppressing broad interest rates.

That said, we believe the BoC will want to ensure that the expected tapering announcements are seen as a technical necessity as opposed to proactive monetary tightening. The BoC has done this before—it was the first global central bank to taper asset purchases last October⁸ and managed to effectively tweak its policy slightly by shifting the duration of its purchases further out the yield curve. In our view, if the BoC were to announce plans to scale down its asset purchase program on April 21, it’s likely to be accompanied by a “sweetener” that could include one or a combination of the below:

• Strengthened forward guidance aimed at keeping the front-end rates low and assuring investors interest-rate hikes aren’t likely until a certain time, for example, 2024. 
  
• Announce a shift in the average maturity of its asset purchases to flatten the yield curve, just like it did late last year. Similarly, the taper may be targeted toward the two- and three-year segment of the curve should the BoC feel that forward guidance can successfully keep rates low at this end by itself. 
• BoC Governor Tiff Macklem could also reference monetary policy tools such as yield curve control in passing during the press conference accompanying the policy announcement on April 21. Indeed, central banks want to avoid being tested by markets.

That said, we believe there’s a 20% to 30% chance that the BoC could choose to delay implementing the taper, opting instead to provide an additional six weeks or so of extraordinary support as Canada navigates the third wave of the COVID-19 outbreak. Regardless, taper or no taper, we believe the BoC will do its utmost to contain higher rates until the central bank is confident that the worst is over.  

Where this year’s budget is concerned, we’ll be focusing on three pieces of important information that will inform our views as an economic forecaster and as investors:

1. Where the rates market is concerned, it may well be more important to focus on how and when government spending is financed as opposed to what the government will be spending on. As such, the debt management strategy component of the budget may be the most relevant to markets. The federal government has implied it’s seeking to extend the maturity of its debt, so confirmation of this development will likely support yield curve steepeners. In addition, should spending need to be financed in the near term (i.e., in the next one to two years), then we should expect more near-term federal government debt issuance that is also supportive of the curve steepening. Understandably, the reverse would be true.
2. Infrastructure spending is generally looked on favorably because it tends to carry higher multipliers to growth over time. A greater share of funding allocated to growth-generating projects can certainly lift Canadian growth forecasts, just as large infrastructure bills in the United States are already lifting the economic outlook for the country. However, infrastructure programs are more likely to boost economic projections in 2025 (and beyond) than in the immediate term, and where the money is spent combined with what type of infrastructure can also have different implications for growth and inflation. As the International Monetary Fund has noted, infrastructure projects generally take three to seven years to implement.⁹ Shifting gears slightly, we believe it’s worth highlighting that childcare also qualifies as economic infrastructure because it has been empirically demonstrated to lift female labor force participation rates¹⁰ and support longer-term growth, and any initiative from the federal government on this front should be understood in this light.
3. We don’t think traditional fiscal anchors such as debt-to-GDP ratio as being essential in this budget, but markets will be looking for evidence of guardrails to government spending—perhaps ones that incorporate the cost of debt as opposed to the level of debt. Such metrics could include debt-servicing costs as a share of total revenue or debt-servicing costs as a share of GDP. By focusing on the cost of debt instead of the level of debt could enable the government to avoid constraining spending unnecessarily while also taking into consideration the current and future level of interest rates in a recovery. We suspect markets would respond as favorably to a new metric of restraint as they would to a traditional one.  

Despite some near-term economic challenges, we expect the CAD to strengthen modestly against the USD in the next 12 months. Our fair-value model suggests the CAD can strengthen from current levels of USD/CAD 1.25 to 1.20. In our view, supports for the CAD include:

• moderately higher oil prices
• the BoC begins tapering its asset purchasing program before or alongside the U.S. Federal Reserve, thereby keeping interest-rate differentials contained or favorable to the CAD
• stronger global trade activity
• a robust U.S. growth story that feeds through to Canadian growth
• more technically, our analysis suggests seasonals, current market positioning, and sentiment also support a stronger CAD in Q2 and Q3

The main risk to this view is a big shift in global risk sentiment—the CAD has traded very closely to risk proxies such as the S&P 500 Index and the Australian dollar throughout the pandemic. It’s therefore logical to assume that the CAD could struggle should global bullish sentiment weaken. And, as always, while we expect the CAD to strengthen against the USD in the year ahead, the path forward is likely to be dotted by bouts of volatility. 

In our view, absolutely. Canadian stocks, as represented by the benchmark S&P/TSX Composite Index, have rarely been solely about Canada’s underlying economic environment. Indeed, our perspective is based on the following factors:

• On a currency-adjusted basis, we expect the S&P/TSX Composite Index to outperform our already-favorable outlook on the S&P 500 Index in the next 12 months.
• As of this writing, the forward price-to-earnings ratio of the S&P/TSX Composite Index is at 16.3x, which is 23% lower than that of the S&P 500 Index⁶—a gap we’ve not seen in some time.

We also find Canadian equities attractive on a tactical basis. In the near term, we believe the Canadian stock market could benefit from its heavy exposure to the cyclical sectors, specifically, financials, materials, and energy. These sectors represent more than 50% of the S&P/TSX Composite Index but under 20% of the S&P 500 Index.⁶ Understandably, we expect financials to benefit from a higher interest-rate environment and the energy and materials sectors to benefit from the global reopening. It’s also likely that the current market environment could appeal to international investors who might have shied away from Canadian equities in recent years.

1 Statistics Canada, April 9, 2021. 2  “Canadian Housing Boom Raises Concerns, With Homes Selling Far Above Ask Prices,” Wall Street Journal, March 24, 2021. 3 “OSFI proposes new minimum qualifying rate for uninsured mortgages,” Office of the Superintendent of Financial Institutions, April 8, 2021. 4 Statistics Canada, January 18, 2021. 5 “Speech by Toni Gravelle, Deputy Governor of the Bank of Canada,” Bank of Canada, March 23, 2021. 6 Bloomberg, Macrobond, as of April 14, 2021. 7 CIBC, March 2021. 8 “Bank of Canada will maintain current level of policy rate until inflation objective is achieved, recalibrates its quantitative easing program,” Bank of Canada, October 28, 2020. 9 “Fiscal Monitor: Policies for the Recovery,” International Monetary Fund, October 2020. 10 “COVID-19 widens gender gap in labor force participation in some but not other advanced economies,” Peterson Institute for International Economics, December 15, 2020.