SUMMARY

  • Our baseline expectation of a recession in the U.S. over our secular horizon makes for a concerning backdrop for Canada’s economy, but the rudest awakening facing Canada is likely a domestic one: Over-indebted consumers, no longer supported by ever-rising home prices, may cease to be the driver of real GDP growth.
  • That said, we do not expect a U.S.-style housing correction in Canada, given our view that mortgage underwriting is much stronger than it was in the U.S. before the crisis and that Canada has not overbuilt relative to growth in household formation.
  • If consumption and residential investment lag consensus forecasts (our base case), we believe terminal levels of interest rates will be lower than in past business cycles.
  • We expect to see steeper Canadian yield curves, as the front end remains anchored by the Bank of Canada, but term rates may rise for some time as U.S. rates respond to Fed moves and deficit-financed fiscal stimulus.

What do the next three to five years have in store for Canada’s economy? PIMCO’s recent 2018 Secular Outlook, “Rude Awakenings,” summarizes our global outlook over this horizon – including our baseline expectation of a recession in the U.S. We believe a recession would likely be shallower than a standard post-World War II recession, as there are few signs of overinvestment and overconsumption in the U.S. economy. But it may well be longer and riskier, as lower starting levels of interest rates, a bloated central bank balance sheet and larger fiscal deficit limit the policy space to fight it.

This makes for a concerning backdrop, given that the U.S. is Canada’s largest trading partner, accounting for about 25% of Canadian GDP. Yet we believe the rudest awakening facing Canada is likely a domestic one: Over-indebted consumers, no longer supported by ever-rising home prices, may cease to be the driver of real GDP growth in Canada.

Is Canada’s growth engine breaking down?

Consumption and residential investment have accounted for more than 92% of Canada’s real GDP growth since the global financial crisis (see Figure 1), against an average of approximately 80% for the previous 25 years. By borrowing more and more money at ever-lower interest rates, over-indebted consumers have propelled the Canadian economy forward.