ECONOMIC & FIXED INCOME COMMENT - Economic Recovery Continues

The global economy is set to expand 6% in 2021which would be its strongest post recession pace in 80 years. The expansion is being driven by stimulus spending, COVID-19 vaccinations and improved consumer and business confidence. In the near -term, the strength of the global recovery is largely being fuelled by two major economies, the U.S. and China. Specifically, both countries are each expected to contribute over one-quarter of global growth in 2021, with the U.S. contribution nearly tripling its 2015-19 average. On the other hand, many emerging market and developing economies, including Canada are lagging behind due to differences in infection control, vaccination speed and stimulus scale. Nevertheless, Canada’s vaccination rollout continues to gain momentum and its vaccination rate has now become one of the best in the world (see graph).

Central banks and governments are keeping a close eye on re-openings as they are committed to supporting the global economic recovery. Interest rate increases are not anticipated for 2021. However, a few central banks will likely adjust non-traditional monetary policy tools (i.e., Bank of Canada (BoC) & Federal Reserve) as economic activity has surprised to the upside. In the next few years, we expect global central banks to embark on varying paths toward normalization (reversing the extraordinary monetary policy measures). In the longer term, the challenge for central bankers will be to slowly raise interest rates without causing markets to panic, so that central banks have room to manoeuvre in the next crisis.

The Canadian economy grew by 5.6% in the first quarter, below the BoC forecast of 6.5%. However, the economy continued to show resilience with GDP output within 1.1% of its peak pre-pandemic quarter (Q4 2019). The second quarter took a pause due to public health measures with the third wave of COVID-19. Consequently, even with weakness in April and May, Canada’s economy should recover its COVID-19 related losses in the third quarter. The reopening’s of provincial economies are well underway and will accelerate spending and employment recovery in the second half of the year. April and May job losses are expected to be short-lived given additional hiring by hard-hit industries as they begin to reopen. The BoC is forecasting the Canadian economy to expand by 6.0% in 2021.

The BoC has stood out internationally as being the first central bank to start the tapering process of its bond purchasing program (Quantitative Easing) in April. In addition, the BoC adjusted its forecast on the first-rate hike moving it into the second half of 2022 from 2023. However, the BoC continues to reiterate that there is tremendous economic slack (output gap) in the economy and therefore it will continue to hold policy interest rates at their lower effective bound (0.25%) until the slack is absorbed. The chart below illustrates Canada’s output gap as of December 31st, 2020. The output gap is defined as the difference between actual GDP by expenditure and the economy’s pre-pandemic projected GDP.

In the U.S., economic activity continues to expand at a strong pace following a solid first quarter. This is attributed to an ambitious vaccination rollout, a faster broad-based reopening schedule and $2.8 trillion in stimulus packages. The U.S. is forecast to expand by 6.7% in 2021. Despite the improved outlook, the job market still has a long way to go before it recovers the jobs lost from COVID-19. The recovery in U.S. jobs remains soft with 9.3 million people still unemployed. The Federal Reserve’s latest policy meeting maintained its current policy stance (i.e., continue its bond purchasing program and maintain its current Fed Funds Rate). Furthermore, the Fed does not forecast a rate hike until 2023. The Fed believes the economy is still far from maximum employment. Also, current high inflation readings are transitory and attributed by supply chain bottlenecks, pent-up demand and labour constraints. Inflation pressures should subside by year end.

Mid-term interest rates (5-10 years) declined during the second quarter. As a result, bonds had a positive return of 1.6%. For the balance of 2021, bond yields should remain in a trading range between 1.4 to 1.9% as most of the good news in the economy has been priced into the bond market.