While higher U.S. growth should be a boost to Canadian GDP growth in 2014, in our view, the cooling housing market and other domestic factors will keep Canadian growth at a modest 1.75%-2.25%. This forecast is a little below the consensus and lags PIMCO’s U.S. growth forecast of 2.25%-2.75%.
On a positive note, we see the composition of North American growth becoming more sustainable in 2014 than in the past few years. The U.S. is moving from government-policy-driven to private-sector-driven growth. This is good for Canadian exports, which we believe will be an upside surprise to Canadian growth.
Unfortunately, this push higher will likely be more than offset by two main headwinds: lower residential investment and lower consumption growth. These headwinds stem from our expectation that the Canadian housing market will finally roll over in 2014. While this should hinder short-term growth, in the long term, it is a necessary step to get the Canadian economy on the path to sustainable economic expansion.
Like many other developed countries, Canada experienced a bout of unexpected disinflation in 2013, but we see the key core inflation rate picking up slightly to 1.25%-1.75% from its current low level of 1.3% year-over-year.
In Canada’s case, we do not think the conditions are in place for disinflation to persist through 2014 for several reasons. First, inflation expectations are well-anchored; break-even inflation expectations observed in the bond market and the Bank of Canada’s (BoC) quarterly Business Outlook Survey both show expectations of future inflation around the BoC’s 2% inflation target. Second, the Canadian dollar has depreciated about 10% in the past year, and this should lead to higher import prices. Finally, one of the causes of last year’s disinflation was increased competition in retailing from U.S. companies, such as Walmart and Target, and in our view, adjusting to new retail competitors is a one-off event and unlikely to be a recurring process that would lead to multiple years of disinflation.
Canadian housing market: correction not a crash
There has been much media attention on Canada’s housing market lately, with some forecasters calling for “the bubble” to pop in 2014. While we think the housing market in Canada is overvalued and due for a correction, the correction will likely happen over several years.
There are two important assumptions that underpin our housing forecast. First, a correction is not a bubble bursting in a disorderly manner. Second, the correction will start in 2014.
In our view, for the Canadian housing market to “burst” in a disorderly manner, one of three events would have to happen in 2014: Interest rates would need to rise substantially, the unemployment rate would have to spike higher or the supply of mortgage credit would have to be disrupted. With real growth of about 2% and a relatively subdued inflation forecast, we see no reason for interest rates to substantially rise in 2014. Given this macroeconomic environment, it is also unlikely that the unemployment rate will spike to 8%-10% (which, we estimate, would be needed to cause a disorderly housing correction). Finally, the Canadian banking system continues to provide sufficient mortgage credit to keep the housing market financed.
At PIMCO Canada, we have been bearish on housing for a while from a secular perspective, but this is the first time we are forecasting a cyclical decline in the housing market. Our forecast reflects a number of factors. First, higher housing prices show the market is more stretched than in previous years. Second, the four rounds of mortgage credit tightening implemented by the federal government are now more clearly having the desired effect. Finally, we expect the cost of capital at Canadian banks to rise in 2014 due to regulatory changes and expect the banks to pass on these higher costs to consumers in the form of modestly higher mortgage rates.
Specifically, Canadian banks are attempting to meet new Basel III leverage rules that make low-yielding assets like mortgages less attractive and could therefore constrain mortgage lending. In addition, we expect Canadian banks to implement bail-in language in new senior debt offerings and issue non-viable contingent capital structures that will explicitly expose bond investors to the risk of conversion into equity during a crisis. Investors will likely demand higher interest rates to hold these securities, and banks are likely to pass along the increase in rates to their customers (including residential mortgage clients).
To summarize our view, the combination of modestly higher mortgage rates, tighter mortgage underwriting standards, a continued modest economic recovery and a housing market where valuations are stretched will result in a decline in housing activity and housing prices in 2014, but not a crash.
The Canadian dollar has depreciated by about 10% against the U.S. dollar in the past year. This was mainly due to broad strength in the U.S. dollar as U.S. interest rates rose in anticipation that the Federal Reserve would begin tapering its asset purchases. It also reflects recent weakening in Canadian economic data. At PIMCO, we are still secularly bullish on the Canadian dollar based on the country’s strong economic fundamentals, prudent fiscal situation and long history of the “rule of law.” These long-term trends should continue to make Canadian dollars attractive as foreign reserves to many government and quasi-sovereign funds. PIMCO expects to seek opportunities to “buy the dips” in the Canadian dollar in 2014.
In addition, we do not think the Bank of Canada will cut the overnight policy rate from 1% in 2014. Despite core inflation flirting with the Bank of Canada’s 1% lower band recently, well-anchored inflation expectations and higher import prices (caused by the weaker Canadian dollar) will likely cause core inflation to increase in 2014, preventing an easing of monetary policy.
We find 30-year nominal interest rates unattractive and favor real return bonds with break-even inflation rates at the BoC target of 2%. We also prefer 10-year bonds over 30-year bonds because they offer the potential to capitalize on the inversion of forward rates in the long end of the yield curve; this strategy can potentially generate capital gains as bonds “roll down” the steep part of the Canadian yield curve while the Bank of Canada remains on hold.
Despite the reasonably sharp rally in provincial credit spreads in 2013, we think that provincials will outperform federal government and corporate bonds in 2014. As Canadian banks issue senior debt with new bail-in provisions and contingent capital securities at higher spreads than existing securities, we also see value in existing senior and subordinated bank securities, which will effectively be grandfathered and have the potential to garner scarcity premiums.
Best wishes for a safe and prosperous 2014!