ECONOMIC & FIXED INCOME COMMENT - Show me the Data!
The global economic outlook has improved significantly with renewed fiscal stimulus, particularly in the United States. Economies are demonstrating resilience and adapting to social distancing measures. Vaccination rollouts are gaining traction. The International Monetary Fund (IMF) expects the global economy to grow 5.5-6% in 2021 (revised upwards). However, the brighter outlook depends on the race between a mutating virus and a successful vaccination rollout to achieve global herd immunity and end the pandemic.
The Canadian economy started 2021 on solid footing and showed its resilience through a second wave of restrictions and lockdowns. Fourth quarter GDP was 9.6% on an annualized basis leaving the output gap at 3.2% (The output gap is defined as actual GDP growth versus potential GDP growth). GDP growth in the first quarter of 2021 is now expected to be positive, rather than a contraction that was forecasted in January. Consequently, Canadian GDP for 2021 has been revised upward and is forecast to expand by 6%. As a result, the output gap should close in the third quarter. To date, growth has been primarily driven by the industrial sector (manufacturing) and professional services. Consumption services like restaurants and travel remain dampened due to public health measures. Nevertheless, as vaccination rollouts continue and the economy begins to reopen, consumption services, which account for 30% of Canadian GDP, will improve. However, with the third wave upon us, the brighter economic outlook could be jeopardized as health concerns continue to weigh on consumer and business spending.
Central banks around the world continue to provide accommodative monetary policy as they are dedicated to supporting the economic recovery. Although quite aware of high indebtedness, central banks will err on the side of caution with respect to normalizing policies. Many institutions were criticized for having tightened monetary policy too soon after the 2008/2009 Financial Crisis. Both the Federal Reserve and the Bank of Canada (BoC) have provided strong forward guidance that policy rates will remain low until 2023.
The BoC continues to reiterate that it will remain accommodative to help support the Canadian economic recovery. However, the emergency market support programs put in place last spring to help the financial market function properly are no longer needed as there is ample liquidity for financial institutions. Specifically:
The Provincial Bond Purchase Program will end May 7
The Corporate Bond Purchase Program will end May 26
The Commercial Paper Purchase Program will end April 2
Term repo operations will end May 10
The BoC’s Quantitative Easing (QE) program is still in place, with purchases of Canada bonds currently continuing at a pace of at least $4 billion per week. Although the economy has improved, there is still considerable damage in the labour market. As of February 2021, more than 590,000 jobs remain lost with unemployment sitting at 8.2%, well above pre-pandemic levels. The unemployment rate is expected to trend down to 6.6% by early 2022, but could stay above 6% for years to come. As a result, QE will remain in place until the economic recovery is well underway although the amount of bond purchases will be scaled back accordingly. Essentially, the BoC wants to avoid taking ownership of too large a share of the outstanding bond market. Currently the BoC owns a little more than 35% of the total market of outstanding government of Canada bonds. If that rises to more than 50% market functioning could become distorted.
Since our last writing, there has been growing concern with respect to inflation. A study conducted by CIBC found that 60% of Canadians listed inflation and the rising costs of goods as their greatest financial concern in 2021. The BoC expects inflation will rise to the top of its 1-3% target band in the near term, but has expressed limited concern about sustained price pressure. The BoC will overlook these “transitory” inflation prices (largely driven by energy prices) as they do not want to short circuit the economic recovery. The BoC will be concerned if rising prices start to push wage rates higher (similar to the 1970’s). However, given the current high unemployment rate, this is not considered to be an immediate concern.
Looking at the bond market, the first quarter can be characterized as bipolar. On one hand you have central banks remaining accommodative and cautious while on the other hand, you have markets pricing in an overly optimistic economic recovery. During the quarter, the midterm bond index (5-10 years) increased from 1.14% to 1.88%. As a result, bonds had a negative return of -4.5%. 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 has been priced into the bond market. The rise in longer term bond yields has been a reflection of confidence in the strength of the recovery as well as the growing view that inflation has turned a corner and could rise sustainably. There is a noticeable disconnect between the BoC and the bond market. Below is where they differ in opinion:
The BoC noted that global economic momentum is improving, but with continued unevenness across regions and sectors. Conversely, the bond market is pricing in a full steam ahead rebound similar to the one experienced in the Roaring Twenties.
The BoC continues to reiterate there is still considerable slack and a great deal of uncertainty about the evolution and path of the virus and the economic recovery. In contrast, the bond market has completely discounted the risk of a third wave and further lockdowns and restrictions.
The BoC forecasts near-term inflation data will move temporarily above their 1-3% target band. The bond market believes inflation pressures will continue to build.