With Canada’s Economy in Transition, the Neutral Rate is Key in 2019
- Since the financial crisis, consumer debt has fueled Canada’s economic expansion, but we expect it to provide less support for growth in 2019.
- The Bank of Canada is forecasting that the transition to higher business investment and exports will be relatively smooth, but we are less optimistic given vulnerable housing markets, a likely drop in consumption and low oil prices.
- We expect Canadian interest rates to be range-bound, and we have a bias toward higher-quality securities.
Explaining the current state of the Canadian economy is simple. Economic growth in Canada has been a one-trick pony since the financial crisis in 2008: Consumer debt has fueled expansion, with consumption and residential housing investment accounting for approximately 93% of real GDP growth since the crisis.
Forecasting economic growth and structuring bond portfolios for 2019 are much more difficult, however, because an elevated share of growth built on consumer debt and housing is ultimately unsustainable. Will the Bank of Canada (BoC) be successful in its plan to rotate the growth model to business investment and exports? We are skeptical – and our investment outlook for Canada this year is cautious as a result.
Reasons to be skeptical
The BoC is forecasting (perhaps hoping) that the transition to higher business investment and exports will be relatively smooth. We are less optimistic for four reasons:
Housing markets look vulnerable. Our main concerns are the overheating markets in Toronto and Vancouver, which are facing new local regulations designed to cool them. Also, new federally mandated rules are intended to tighten mortgage credit. And finally, policy rates are higher, which has lifted some mortgage rates. The mix of these three developments already slowed Canadian housing markets in 2018, and although the path of house prices in 2019 is unclear, we think the risk is weighted to the downside (see Figure 1).
The risks tilt toward a more notable deceleration in consumption. With housing markets cooling, we expect less consumption based on a reverse wealth effect (see Figure 2). In addition, the most indebted consumers will likely have to tighten their belts due to higher rates, and overall wage growth has been falling over the past six months or so. The BoC recognized this in early January when it revised down its forecast for consumption growth in 2019. Again, we see more downside than upside risk to this forecast.