The Economic Club of Canada’s panel of economists’ annual forecast was once again held virtually in the first week of January thus highlighting one of the continuing economic risks for 2022; the Covid Pandemic. Other economic headwinds include supply chain disruption, labour shortages, inflation, geo-political tensions, and increasing environmental issues due to climate change. In the interest of time and space, this article will not attempt to address all the above. Just note that the headlines could start with any one of these influencing themes.
The following comments were gleaned from presentations made by Chief or Deputy Chief Economists from the Canadian Banks: BMO, TD, RBC, CIBC, Scotia and National.
Looking back to 2021, all were surprised by the resilience of the global economy and labour. No doubt the collective government support programs contributed to this resilience, but so did the services side of the economy which quickly adapted to remote working conditions. Clearly those impacted negatively the most tended to be on the entertainment side of services such restaurants, theatres, bars, gyms, and music venues. Continued waves of Covid infection and corresponding restrictions has kept this part of the economy muted.
Inflation is now the largest concern from the disrupted supply chain leading to scarcity of certain products and commodities. Demand simply did not diminish during lockdowns and its acceleration has been faster than the supply chain’s ability to respond. It could take a number of months to find its balance. Reshoring manufacturing, in the interest of not being caught without or framed as “in the national interest” also contributes to inflation. Had China’s growth not cooled as it had, commodity demand could have run much hotter. As such, expect inflation to peak around 7% in US, 5% in Canada, and gradually reducing 2.5%-3% by year end.
The inflation-response monetary tool for central banks is to raise interest rates. The biggest economic risk is rate of change. Raise rates too slowly and risk ineffective inflation management. Raise rates too aggressively and risk recession. The forecast is three rate increases for 2022 for a total of 75 basis points and an additional 75-100 basis points in 2023 if needed.
Impact of interest rate increases?
Housing prices are not expected to be impacted much in the early stages of rate increases. Keep in mind the stress tests already in place for mortgage qualification. Likely the bigger test for mortgagees will come in 2023-2025 with renewals as borrowing rates feel the full effect. Anecdotally, the BMO economist suggested that investment borrowing on anything but new builds should be discouraged as the supply side needs support, not the secondary market. Supply-wise Canada added 280,000 units in 2021 but experts concede that is not enough.
Equities are not necessarily negatively impacted by rate increases unless the central bank (i.e. BOC, Fed) becomes too aggressive and stalls economy. Expect the normal ebb and flow of market pricing with year ending with positive returns albeit more modest than experienced for 2021. The consensus is that income producing assets will be favoured over the growth story which prevailed from the bottom of 2020. Companies with a lot of leverage on the balance sheet have higher risk. Free cashflow to pay dividends or buy back shares will be a great focal point.
Bonds will likely see 10-year maturities rising to 2.5% by year-end. After years of dropping rates and flattening rates we are now witnessing a rise. Low risk investors will be delighted with the higher yield, but we are in for further price disruption as that represents roughly a 50% increase from current levels. Expect bond pools to start buying along yield curve to positively participate in a market with negative price pressure for the next number of months.
Finally, a word on currency: interestingly, the 6 economists were split on the direction of the Canadian Dollar; half felt it would rise relative to the USD, the other half felt it would fall, illustrating how difficult it is to predict.
As always, unforeseen events have a way of blindsiding us and the market. Continued focus on investing your capital in a balanced fashion and maintaining risk free (albeit anemic returns) capital for short term objectives will serve your wealth goals every time.
Let’s make 2022 the best year.