ECONOMIC & FIXED INCOME COMMENT - The Great Unwind
The year 2022 proved to be one of the most challenging years in the past decade for investors as multiple headwinds (high inflation, Russia-Ukraine war, lockdowns in China) hit the economy and capital markets. As a result, central banks globally initiated an aggressive rate tightening cycle to restrictive territory in order to combat these headwinds (Figure 1). Consequently, global GDP deteriorated and is forecast to expand 3%.The slowdown has been most pronounced in Europe, led by the energy crisis, and China, where property woes and the restrictions of zero-COVID policy have challenged the economy. As we move into 2023, global growth will continue to deteriorate and is forecast to expand 2%, with weakness front loaded in the first half of the year. However, the outlook for the latter part of the year is more encouraging, as falling inflation, a pause/ shift in global monetary policy and a rebound in China’s economic growth could allow for a modest recovery.
Despite the challenging backdrop, the Canadian economy has remained resilient. Growth has been sustained by a strong labour market (unemployment 5%), household savings, high commodity prices and a strong demand for services after COVID-19 restrictions. As a result, the Canadian economy is forecast to expand 3.5% in 2022. The resilience of the Canadian economy required the Bank of Canada (BoC) to raise interest rates 400 basis points in 2022; which is the most in any calendar year on record. However, the economic landscape will be challenging throughout 2023 due to elevated inflation and higher interest rates. Furthermore, changes in monetary policy work with a time lag (12-18 months) and will take time to permeate through the economy. Currently, Canadian GDP is forecast to expand 0.8% in 2023.
Following prior rate hikes, the BoC is nearing the end of its historic interest rate tightening cycle as there is growing evidence that higher interest rates are restraining economic demand. Capital markets are currently expecting one additional 25 basis point rate hike in the first quarter of 2023 after which the BoC will hold policy at 4.5% for the balance of the year (Figure 2).
With respect to the U.S., it is forecast to expand 1.9% in 2022, despite starting the year with two consecutive quarters of negative growth. Consumer spending and non-residential investment have remained robust. Moving into 2023, economic growth is expected to decelerate further to 0.5%, as monetary policy moves further into restrictive territory. The Federal Reserve (Fed) will continue its rate tightening path in 2023; albeit at a slower pace. Specifically, the Fed believes the current Fed Funds rate at 4.5% is not yet sufficiently in restrictive territory and is anticipated to raise the Fed Funds rate another 75 basis points to 5.25% through 2023.
The bond market had a sharp repricing in 2022 as central banks globally tightened monetary policy to tame inflation. Additionally, central banks have maintained their tightening bias despite jeopardizing economic growth. As a result, both the Canadian and U.S yield curve inverted in 2022; indicating a heightened recession expectation (Figure 3). An inverted yield curve occurs when long-term rates (10-year) fall below short-term rates (2-year).
However, a “growth recession” may better describe 2023. This is a scenario where unemployment rises slightly; job growth moderates; and GDP growth expands below trend (0-2%) for a prolonged period. In our view, the current yield curve inversion indicates current policy rates are not sustainable over the long-term.
Our expectation remains that rate cuts will be appropriate in the medium-term. As the bond market is forward looking, both short-term and long-term bond yields are likely to decline over 2023 as the weak economic backdrop causes increasing expectation for policy rate cuts. Lastly, the inverted yield curve should become less inverted as short-term rates will decrease faster as it is associated with central bank policy expectations.