Events of the past few days have reinforced several of our core views about the global economy, including our assessment of the Canadian economy: We see higher odds of a recession taking place in the second half of 2023, a development that in turn will likely dampen inflationary pressures as aggregate demand weakens.
The case for an extended BoC pause has been reinforced
Unlike the U.S. Federal Reserve (Fed), the Bank of Canada (BoC) had already paused its rate hike cycle based on its forecast for slowing economic growth and easing inflationary pressures ahead. At its March 8 meeting, the bank reiterated its decision to pause by leaving the overnight rate target unchanged at 4.5%. One factor likely reinforcing the BoC’s stance is that, unlike in the United States, the elevated level of household debt in Canada leaves the economy more sensitive to interest-rate hikes.
In our opinion, the events of the past weeks added another layer of concern for the BoC: financial stability. Indeed, the central bank needs to promote a stable and efficient financial system as part of its core mandate. So far, it’s reasonable to say that the contagion to Canada’s financial system appears fairly limited. That said, it’s fair to assume that all global central banks are more concerned about the potential effect that overtightening can have on certain sectors than they were just a few weeks ago.
"We see higher odds of a recession taking place in the second half of 2023, a development that in turn will likely dampen inflationary pressures as aggregate demand weakens."
We’ve noted previously that the real-world repercussion of recent events is likely to stem from tighter U.S. and European bank lending standards and, therefore, fewer loans. The issue here is the downstream impact on domestic growth if Canadian financial institutions were to do the same; that said, even if they didn’t follow suit, slower international growth, all else equal, will no doubt negatively affect Canada’s economic outlook. As such, where the BoC is concerned, we believe the bar for implementing additional tightening is now higher, and we continue to expect the central bank to cut rates by year end.
From a currency perspective, the current global turmoil in the financial markets is likely to continue to generate volatility in the Canadian dollar (CAD); however, considering the still-elevated level of commodity prices and our expectation for the U.S. dollar to weaken this year, we remain constructive on the CAD in the medium term.
Implications for Canada’s housing market
In our view, a sustained decline in bond yields could drive down mortgage rates, but that might not be enough to avoid a decline in the Canadian housing market.
In the days following previous episodes of global banking stresses, market participants were quick to change their expectation of central bank policy—and it’s no different this time: Global markets moved from pricing in pauses or rate hikes to expecting multiple rate cuts by the end of 2023, driving bond yields lower globally. These market movements could have important implications for Canadian mortgage rates.
Five-year mortgage rates, typically the most favored mortgage products among Canadians, usually follow the broad movements of yields on five-year Canadian government bond, which fell from 3.5% on March 8 to 2.8% by mid-March. This represented one of the largest weekly drops in decades.¹ If bond yields settle at these levels (or head lower should the global risk-off sentiment worsen), we believe a reduction in fixed-rate mortgage rates will follow.
Downside risks to 5-year fixed mortgage rate
Source: Bank of Canada, Macrobond, Manulife Investment Management, as of March 15, 2023. LHS refers to left-hand side. RHS refers to right-hand side. The gray area represents a recession.
Variable mortgage rates, however, typically track the BoC’s policy rate. For variable rate mortgages to fall, we would need to see the central bank follow through with the widely expected rate cuts later this year. If that were to happen, it would present a welcome breather for Canadian households, which are facing the steepest refinancing shock since the 1990s;² however, unlike the drop in fixed mortgage rates, which is likely to occur imminently, declines in variable mortgage rates tend to take some time to materialize.
Will the likely fall in mortgage rates be enough to lift the Canadian housing market? In our view, probably not; we continue to expect house prices to normalize downward. This is largely because the decline in rates must be taken within the context of the likely recession on the horizon.
In light of a more difficult economic outlook, the possibility of reduced working hours, and possibly a higher unemployment rate in the second half of this year, we expect to see a temporary fall in housing demand despite lower mortgage rates. What remains to be seen, however, is whether this can occur in an orderly fashion (we think so) or if additional material financial distress will come into play.
Volatility and uncertainty favor a flexible approach to portfolio management
It’s important to note that the banking system in Canada is very different from the United States, both from a regulatory perspective and in its composition. The Canadian system is concentrated on larger diversified banks, while the U.S. banking system is more decentralized, with a focus on regional banks for everyday banking needs. In that sense, the dynamics that led to the closure of three tech-focused U.S. lenders are less likely to affect large Canadian banks, which form the largest sector of the S&P/TSX Composite Index.
In our view, the events that transpired in the United States—and the resulting market volatility—have strengthened our conviction about the increased likelihood of a recession in both Canada and the United States. It also reinforces our belief that a bottom-up security selection approach to equity investing is most appropriate in an uncertain environment like the present, as opposed to only adhering to a specific geography or relying on a sector-based approach. We believe this is a better way to identify the individual opportunities and risks that may exist. Within fixed income, the need for active management of bond holdings remains paramount: Having the ability and flexibility to adjust the portfolio in response to rapidly changing trading conditions while maintaining a bias toward higher-quality instruments and mid- to longer duration could make a huge difference to returns.
1 Bloomberg, as of March 16, 2023. 2 Bank of Canada, as of December 12, 2023.
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