Canada isn’t expected to maintain its hot 2017 growth—but it will continue to grow at a more sustainable pace.
“We expect Canada’s economy to slow to 1.9%—a pace that is closer to potential, which we estimate at 1.6%,” says an RBC outlook report.
Relative to last year, more growth is expected to come from business investment and government spending, and less from consumers.
Along with regulatory changes, “rising interest rates will take a toll on the highly indebted household sector in 2018, but the softening should be limited by support from a healthy labour market and rising wages,” says RBC.
In contrast, the economy will get a lift as the federal and provincial governments ramp up spending on infrastructure projects. “Investment outside of the public sector will shift away from residential construction toward spending on machinery and equipment as businesses expand,” says RBC.
The bank’s outlook is for the Bank of Canada (BoC) to raise the overnight rate in each of the next three quarters against solid growth and “more robust global trade flows,” as the global economy expands.
The BoC’s pace is likely to be measured, though, says RBC. “That’s due to the impact that NAFTA uncertainty could have on exports and investment, as well as concerns about the ability of Canadian households to finance their elevated debt at higher rates.”
RBC further forecasts inflation in Canada to hit the central bank’s target of 2% this year, which, combined with rising short-term rates, will pressure 10-year yields higher.
BMO expects the BoC to sit on the sidelines a little longer.
For example, in a weekly financial digest, BMO deputy chief economist Michael Gregory notes that the annual change in household credit is 5.5% annualized—”well above any longer-run path for personal income growth.”
With the BoC concerned about interest rate sensitivity generally as well as in the housing market, Gregory says: “On balance, we judge the [central] bank has signalled that it will likely be on hold in April as well.”
What the Fed will do
With the U.S. economy on a firm footing, thanks in part to government spending and tax cuts, RBC expects the Fed to announce rate hikes each quarter this year.
“The strength of the underlying economy will outweigh concerns about the [recent] stock market correction, which some recent Fed speakers have referred to as a ‘healthy correction,’” says the RBC report.
For example, job creation is robust, unemployment remains low and wages growth is accelerating.
Yet, that in turn could cause inflation to pick up.
“Rising wages and increasingly stressed capacity tees up for inflation to rise sustainably at the Fed’s 2% target,” says RBC. “Looking ahead we expect rates to continue to move higher, albeit at a somewhat slower pace, and forecast the 10-year yield to end the year at 3.3%.”
In a weekly global equity report, BMO senior economist Robert Kavcic notes that the recent increase in U.S. labour force participation could dampen wage growth.
“For equity investors, this is a bullish outcome suggesting strong growth but no excessive inflation pressure. For the Fed, we believe this supports a March rate hike, and keeps us comfortable with a one-per-quarter pace through 2018,” he says.
A risk is a potential U.S. trade war.
The introduction of U.S. tariffs on steel and aluminum (for now, Canada and Mexico are excepted) could result in retaliation by affected countries—such as China—in the form of tariffs on U.S. exports.
Though such a trade battle could negatively affect the U.S., “the overall growth impacts to the large U.S. economy would be fairly modest,” says TD senior economist Leslie Preston in a weekly economics report. That would raise inflation only “a couple of tenths of a percentage point.”
The real fear for investors and businesses is a global trade war, says the BMO financial digest, with tariffs ultimately undermining U.S. competitiveness and productivity. “Look for forthcoming surveys on business confidence to take a step back from multi-decade highs,” says BMO senior economist Sal Guatieri.
But overall, U.S. economic data are positive. “A variety of forces are expected to push inflation higher this year; the only question is how quickly,” says Preston. “The risks that inflation will accelerate faster than the Fed currently expects are mounting.”
The Fed’s next announcement is on Mar. 21.
Says Preston: “A hike at the meeting is essentially a lock. We currently expect three 25-basis point moves in 2018, but the risks are skewed to more hikes rather than fewer.”
Cautious market outlook
In February rising interest rates and firming inflation expectations introduced volatility into the markets. Early last month, the S&P was down 10% from its Jan. 26 peak, and the MSCI world index lost 8.8%.
RBC puts the markets in perspective: “While the sell-off clipped 2018 gains, index levels remain well above year-ago levels. As a result, our forecast does not incorporate any negative hit to the global economy from this short sharp interruption in stock market performance.”
However, U.S. tariffs are a risk.
“For now, you can add the tariff row, if it escalates, to the list of things that might derail a nine-year old expansion,” says Guatieri.
Despite capacity supporting the bias to tighten over time, Canada exhibits some less-than-stellar economic indicators, notes Kavcic, such as weak trade and a still-correcting Toronto housing market.
“For equity investors, the TSX faces the reality of softer growth, less-than-friendly relative [to the U.S.] policy dynamics (be it on the fiscal or trade fronts), and an increasingly challenged domestic oil market,” he says. “So far this year, the [TSX] hasn’t shown any sign of reversing its underperforming path.”