ECONOMIC & FIXED INCOME COMMENT - A Delicate Dance
The global economy is making progress in returning to its pre-pandemic growth trajectory however, supply chain disruptions in manufacturing, labour shortages in service sectors and increasing COVID-19 cases could jeopardize the speed of the recovery. During the second quarter, the US, UK and Euro area showed notable economic growth. Specifically, the US returned to its pre-pandemic level while the UK and Euro area trimmed their shortfall. However, Canada’s growth was dampened by more extensive lockdowns with the economy contracting by 1.1%. Excluding Canada, the strong rebound during the first half of the year reflects progress in vaccinations. On the other hand, growth in emerging markets has been mixed due to slower vaccination rollouts and limited access to vaccines.
During the third quarter the Delta variant impacted international supply chains and domestic spending behaviours which slowed the recovery in the near-term and shifted growth into 2022.In its most recent update, the International Monetary Fund (IMF) retained its 6% global growth forecast in 2021 and revised its 2022 forecast 0.5% higher to 4.9%. Many economists have revised their forecasts for global GDP growth in 2021 lower to a range of 5.5-5.8%. The growth downgrade should keep financial conditions highly accommodative for the remainder of 2021 as central banks allow their economies and labour markets to recover. Nonetheless, central bank policy makers will likely start to slowly withdraw emergency-level policy support.
The Bank of Canada (BoC) was the first central bank to initiate QE tapering while the European Central Bank (ECB) and the Federal Reserve (Fed) will likely start the process by year end. The policy shift is being driven by two factors: solid economic growth and a rise in inflation. However, clear guidance from policy makers is required to help anchor inflation expectations, maintain investor confidence and ensure adequate economic support.
As mentioned earlier, the Canadian economy unexpectedly contracted by 1.1% on an annualized basis in Q2 which was well below consensus expectations of a 2.5% annualized gain. As a result, the Canadian economy is still 2% below pre-pandemic output levels. The areas that negatively impacted GDP were a drop in exports due to chip shortages in the auto sector, other global supply chain disruptions and a cooling housing market. However, there were a few bright spots. Specifically, strength was found in business investments, government spending and new housing construction. In addition to the disappointing Q2 figures, preliminary StatsCan flash estimate for July GDP was negative. The weaker start to the third quarter has led many economists to downgrade Canada’s GDP for the year to 5.2% from 6%. The BoC has maintained an optimistic view of the economy despite the Delta variant with the expectation that the economy will fully recover in the second half of 2022.
Inflation continues to be a major topic of discussion. To date, central banks including the Fed and BoC still perceive the current pressures as transitory. However, many are concerned about rising wage pressures. In the US, there have been sizeable increases in wages in certain sectors that are now reopening (i.e., leisure and hospitality).On the other hand, inflation in Canada isn’t as high as the US, but should remain elevated over the remainder of this year. The difference between the US and Canada can be attributed to policy choices during the early stages of the pandemic. Specifically, Canada provided job retention incentives to help preserve the employer-employee relationship during the pandemic. This enabled firms to reopen to meet stronger demand by raising hours worked. On the other hand, the US did not use this strategy causing employee layoffs and recruitment issues as sectors reopened.
Mid-term interest rates (5-10 years) remained flat during the third quarter. As a result, bonds had a 0% rate of return. It is expected that Government of Canada yields will continue to rise driven by two factors: the first factor is the tone of many central banks that have become increasingly hawkish with several poised to taper bond purchasing programs over the coming quarter. The second factor is that inflation pressures are expected to be “stickier” than originally anticipated. The lingering inflation will likely cause investors to demand higher compensation for inflation risk. Market expectations suggest that the Government of Canada 10-year yield will likely be trading between 1.75-2.0% in the fourth quarter.