ECONOMIC & FIXED INCOME COMMENT - WALKING A FINE LINE
While 2021 was a year of rebound and recovery in many developed countries, the pandemic is still very present in several parts of the world. The International Monetary Fund expects global growth to reach 5.9% in 2021, while 2022 will moderate to 4.9%. Currently, countries with developed economies have spare capacity, accumulated savings and central banks willing to remove monetary accommodation slowly. All of these conditions will help provide a solid backdrop for the global economy to post another year of above-trend growth. That being said, the new fast spreading Omicron variant could provide a few headwinds. Despite Omicron generally causing less severe illness, the sheer number of cases could overwhelm already fragile healthcare systems.
After hitting speedbumps in the second quarter, recent economic data in North America have surprised to the upside. US real GDP in Q4 is forecasted to grow by 6.5% (annualized). For the year, US GDP is expected to expand by 5.7%. Although this annual GDP number is lower than originally forecasted (5.7% vs. 6.5%), the “slower” growth rate is still exceeding pre-pandemic growth levels. Similarly, in Canada Q4 GDP growth is expected to be similar to Q3 which grew by 5.4% (annualized). Canadian GDP is expected to grow by 4.5% in 2021.Moving into 2022, economic activity will remain robust, driven by consumer consumption which has been supported by employment gains and built-up savings. Furthermore, above trend growth and strong demand for workers will continue to lower the unemployment rate further in 2022. However, the challenge will be the supply of workers as the pandemic has severely reduced immigration levels and the increasing number of workers reaching retirement age (i.e., baby boomers).
While the risks to the growth outlook have eased with increasing vaccination rates, risks to the inflation outlook have increased due to rising commodity prices, higher input costs, labour shortages and supply chain bottlenecks. Although some of these factors will subside, strong consumer demand and limited production capacity will likely keep inflation above central bank targets throughout 2022. Looking at the US, headline inflation surged 6.8% in November, the fastest rate since 1982. Price increases in food, energy and shelter accounted for most of the gains. Similarly, Canada has seen its bout of high inflation readings. November’s CPI reading remained at 4.7%; an 18 year high with energy and food price increases as the main culprits.
During the fourth quarter, we witnessed many central banks shift to a more hawkish tone by announcing the reduction/ removal of extreme policy measures put in place at the start of the pandemic. The Bank of England was the first G7 central bank to raise interest rates, despite growing Omicron risks. The Bank of Canada (BoC) ended their quantitative easing program (QE) in October and have started the dialogue for rate hikes in early 2022. The BoC’s decision has been driven by Canada’s strong labour market and solid economic growth outlook. Specifically, Canada’s unemployment rate fell to 5.9% in December and the levels of employment in Canada have exceeded pre-pandemic by 241,000. With respect to the US, the Federal Reserve (Fed) announced at their December meeting the accelerated tapering pace of their QE program. Inflationary pressures and further improvements in the labour market supported the policy change. Although the Fed announced it could raise interest rates sooner than forecasted, with the possibility of three rate increases during 2022 their employment level is still 3.6 million below pre-pandemic levels. For this reason, the Fed will take a relatively cautious approach to lifting rates as they have a dual mandate of maximum employment and an average 2% inflation target.
With the expectation of rising policy rates, elevated inflation concerns and the ending of QE programs in Canada and the US, we expect bond yields to increase over the balance of 2022. We anticipate Government of Canada 10-year bonds to trade in a range of 1.9%-2.25%. Although low by historical standards, US and Canadian interest rates are still higher than most developed countries. For this reason, foreign demand for government bonds will likely remain strong, acting as an anchor against a sharp rise in domestic rates.