Canada is close to recession – if one has not begun already. The powerful effects of higher interest rates are moving through Canada’s overextended real estate sector and highly leveraged financial system. Combined with its high gearing to global demand and an increasingly fragile domestic consumer, the Canadian economy is cooling off much faster than that of the neighbour it so often lags.
The question now becomes how deep and damaging the recession will be. On the verge of a forceful deleveraging process, the Bank of Canada risks keeping rates too high for too long in pursuit of its inflation mandate, potentially turning a recession into a crisis. We think the bank will need to ease financial conditions before the U.S. Fed. Therefore, Canadian government bonds are attractive on a comparative and absolute basis, while the loonie appears set to lose ground.
The sharp rise in interest rates and tightening financial conditions that have characterized 2023 are a global phenomenon, but Canada appears to be among the first to show clear signs of their effect on the real economy. After GDP contracted by 0.2 per cent on an annualized basis in the second quarter, Canada is one quarter away from meeting the popular definition of a technical recession. But given the slowdown in business activity, sentiment and price pressures (and once finalized data revisions are taken into account), future business-cycle-dating assessments may well conclude that Canada is already in a recession.
The national accounts numbers are worse than the headline expenditure growth rate suggests. Adjusting GDP for immigration (which provides a boost to overall expenditure but says nothing about underlying growth in economic capacity) suggests a recession is under way, with GDP per capita falling 1.7 per cent year over year. Real gross domestic income is already deeply recessionary, having fallen for four straight quarters, and was down 3.9 per cent year over year as of the second quarter. The non-residential private capital stock – which accounts for investment assets such as machinery and factories – has effectively stopped growing since 2015, and real business investment is back to where it was five years ago. Underlying all these trends is a worrying decline in productivity, which has fallen since the first quarter of 2022 and has been stagnant for five years.
We put this down to a quicker interest-rate transmission mechanism (in that Canadian mortgages roll over faster north of the border). About two-thirds of Canadian mortgages have fixed rates on three- or five-year contracts, meaning that the peak impact of the cumulative rate hiking cycle occurs two to three years after it starts. These lags are vastly shorter than those in jurisdictions such as the United States, where homebuyers have locked in historically low rates for 30 years.
To manage the effects of the sharp rise in mortgage rates they’ve been required to pass on to customers, Canadian banks have allowed borrowers to avoid unaffordable increases in monthly payments by extending their loan terms and increasing the interest portion of debt that their payments service. This has pushed the share of loans at major banks with 30-plus year amortizations to 24 per cent (according to bank filings), while 40-year amortizations on new mortgages have become commonplace. The negative amortization rate – the share of mortgages where installments do not cover interest charges, increasing the overall balance – has reached an unsustainable 20 per cent.
This leniency from banks explains why mortgage defaults have not yet risen. (In fact, arrears are hovering near record lows.) But to delay is not to prevent, and significant risks are building within the financial system. Banks are bracing for the inevitability of rising consumer stress by significantly increasing their reserves for defaults. Meanwhile, real estate prices have begun to fall as supply finally comes onto the market, spurred by deteriorating mortgage affordability.
Given that the Bank of Canada has been raising rates in the face of the most indebted consumer economy in Canada’s history – the household debt-to-disposable-income ratio was above 180 per cent at the start of the cycle, and roughly flat since – the deleveraging process that is starting will exert a powerful drag on the economy.
In light of rising debt burdens and low confidence, it’s perhaps no surprise that consumers report that they expect to reduce expenditures in real terms over the next 12 months. This will exert a direct drag on GDP growth and sustain the recession.
Digging into the outlook for Canadian business does not offer much relief. The flagging consumer sentiment is clouding the horizon for earnings. Meanwhile, tight monetary policy is weighing on the cost side and suppressing investment outlays. The effective interest rate paid by Canadian businesses has risen above 7 per cent, and has further to run. This has led bankruptcy rates to rise above prepandemic levels, further driving credit risk in the financial system.
The poor performance of the TSX this year may in fact be trying to tell us something. The Toronto bourse has underperformed its typical correlation with U.S. stock returns; the S&P 500 is up nearly 12 per cent on the year, with the TSX virtually flat. For the record, we still think convergence is likely, as the degree of separation is overdone.
Canadian businesses are tightly geared to global demand and manufacturing through their large commodity export base and manufacturing interlinkages with the U.S. From this perspective, the decline in global manufacturing purchasing managers indexes to recessionary levels, and the corresponding slump in global manufacturing input demand, will drag on growth. While oil price volatility seems inevitable given intensifying geopolitical tensions, the more muted base metals outlook does not bode well for Canada.
All of this translates to a deeply pessimistic business outlook (as measured in the BoC’s Business Outlook Survey), which – aside from the brief collapse in the second quarter of 2020 – is at the lowest level since the global financial crisis of 2007-09 and is clearly signaling a recessionary outlook.
The Bank of Canada’s communications remain focused on the inflation outlook, and markets are still pricing about a 30 per cent chance of another hike by early 2024. But with key measures such as CPI (excluding mortgages) now back within the target range of 1 per cent to 3 per cent on a year-over-year basis, the bank may already be fighting yesterday’s battle. A mild disinflationary recession is generally an acceptable trade-off for policy makers, but the deep and prolonged form of recession typically associated with a financial crisis and deleveraging process is much more costly. With the powerful impact of the steep hiking cycle now becoming evident, the bank would be flirting with the latter scenario if it holds rates too high for too long.
As this becomes clear, we have high conviction that Canada will see rates ease before the U.S. does. This has a clear effect on the major asset classes. An earlier easing favours Canadian sovereign bonds over U.S. Treasuries (in both absolute and relative terms), while the loonie will struggle to hold its current levels. On the equities front, the TSX appears to have priced in the outlook, but defensive sectors look more appealing than cyclicals.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave. Dylan Smith is senior economist with the firm.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.