PIMCO’s recent Secular Outlook, “Pivot Points,” discusses five key policy pivots that could affect the global economy and Canada over the next three to five years. While our baseline global forecast is relatively benign for Canadian growth, we do highlight a number of risks that could cause external shocks to Canada’s small, open economy. In particular, we will be keeping a close eye on the evolution of monetary policy in the U.S., the renegotiation of the North American Free Trade Agreement (NAFTA), China’s economic development following this year’s 19th National Party Congress, and how populist movements play out – particularly in Europe, where the politics of monetary union without fiscal union make the eurozone vulnerable (though a breakup is not our base case outlook).
Canadian growth: a tricky pivot
All that said, Canada’s most critical pivot over the secular horizon is domestic: the handoff from its debt-fueled, consumer-oriented growth model to a more balanced and sustainable growth model. Canadian consumers, who have been the engine of growth since the financial crisis, are now tapped out. Skyrocketing home prices in Toronto and Vancouver prompted policymakers to implement rules to curb mortgage lending and foreign buying. While the vast majority of Canadians can afford their current mortgages, some of the most indebted Canadians may have trouble handling even modest increases in mortgage rates. This is particularly concerning as interest rates are currently near all-time lows, and we expect the Bank of Canada to follow the U.S. Federal Reserve (with a one- to two-year lag) on a cautious rate hiking cycle. So our baseline secular forecast is for residential investment and consumption to be headwinds to Canadian GDP growth.
In theory, the secular tailwinds to Canadian growth should be business fixed investment and exports. However, both of these growth engines face considerable uncertainties over the secular horizon.
Exports: While our baseline forecast is that a renegotiated NAFTA will not lead to a significant drop in Canada/U.S. trade, it is a risk, and in the meantime the uncertainty may hold back exports and investment in export-oriented sectors of Canada’s economy.
Business fixed investment: We expect business investment to lag after a major financial crisis, but the lags can be long and uncertain. Given it has been over eight years since the crisis, we expect business investment to pick up over our secular horizon. Unfortunately, Canada is also dealing with the fallout from the oil price shock, which has also depressed investment in energy and energy-related industries.
Government spending: Canada’s ‘spare tire’ in the event of a downturn
The federal government has shown it has both the will and the wallet to spend if the Canadian economy falters. Prime Minister Justin Trudeau’s administration is rolling out an infrastructure bank, and it implemented a fiscal stimulus package worth about 1% of GDP during the recent oil price shock. Given Canada’s low debt stock and modest fiscal deficit, we believe the Trudeau government stands ready to act again in the future.
Given the relative fragility of the Canadian economic recovery relative to that of the U.S., and the divergence of monetary policy over the next one to two years, we expect the Canadian dollar to remain weak in the near term – but it should strengthen near the end of the secular horizon.
The Bank of Canada’s relatively accommodative monetary policy suggests Canada’s credit markets should continue to provide attractive opportunities for investors. We suggest focusing on industries with strong balance sheets and pricing power, such as utilities and infrastructure; we are cautious on consumer-oriented sectors, such as credit cards and retail. As always, we are concerned about valuation relative to risk, and in exuberant markets – such as we’re seeing currently – this calls for building up defensive positions in order to exploit opportunities when markets become more volatile.
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Ed Devlin is PIMCO’s head of Canadian portfolio management and a contributor to the PIMCO Blog.