Can Canada execute a post-rate hike soft landing?

CIO expects commodities, financial sectors to provide support, driving Canadian equity outperformance

Can Canada execute a post-rate hike soft landing?

Even after the Bank of Canada’s aggressive campaign of policy tightening last year, which saw rates soar from 0.25% to 4.25%, the country might be able to avoid the worst-case scenario of a hard landing, according to one chief investment officer.

“The Canadian economy will probably show some degree of slowdown, similar to a lot of other Western economies, as central banks take off stimulus,” says Greg Taylor at Purpose Investments. “There could be a little more of a buffer in Canada as these commodities provide a little backstop.”

Because of global supply-chain challenges, partly due to Russia’s invasion of Ukraine, Taylor says energy has done quite well and continues to be a sector to watch. In the year ahead, he says that positive performance could broaden out out to other areas of the commodity complex, with a possible pickup in both agricultural and base metal resources.

From Taylor’s perspective, any potential recession this year is likely to be more controlled than other past hard landings. Like many other prognosticators, he argues that the firehose of government and monetary stimulus unleashed during the pandemic crisis set the stage for record inflation in 2021, and central banks’ recent rate increases are part of a costly bid to flush that inflation out.

The weirdness in the economy is clear in the latest job numbers, which showed continued strength even amid a broader slowdown. On balance, Taylor believes the prospective Canadian recession could be one in name only rather than the likes of what happened in the ‘80s.

“It definitely feels like uncharted territory,” he says. “The question really is whether the central banks will be successful in getting rid of inflation. And with that, will they be ready to start being a little less hawkish in the second half of the year?”

The economic sirens are blaring loudest in Canada’s housing market, which reached fever pitch during the buying frenzies and blind bidding wars of the pandemic. In 2021, total investment in residential real estate increased 31.3% on an annual basis to reach $248.5 billion in nominal value.

But that bubble has since popped under the pressure of dramatically rising mortgage rates. The Canadian Real Estate Association reported yesterday that the country’s benchmark home price fell 1.6% in December to $730,600. That brings the total decrease from February’s peak to 13.2%, the largest peak-to-trough falloff since the CREA started compiling the data in 2005.

“I think Canada did well to escape the housing problems that the US experienced the global financial crisis, and there is a hope that we'll able to sidestep that again this time. But to me, the biggest wildcard is that people have taken on too much debt,” he says.

According to data from the Bank of Canada, Canadians’ outstanding residential mortgage debt was roughly $2.1 trillion in October, equal to the country’s GDP print for the month. The Office of the Superintendent for Financial Institutions (OSFI) has identified the rising cost of debt as a key risk heading into the year.

On December 8, it raised the capital buffer financial institutions must maintain by half a percentage point to 3%. Last week, it initiated a consultation on possible beefed-up mortgage underwriting rules that would complement its already-existing stress test requirements.

“Canadian banks are definitely going to have to look at their housing exposure,” Taylor says. “The good news is that coming out of the Global Financial Crisis, banks across the board started to become much more selective in their lending activities, and the regulator seems to be much more attuned to making sure that they’re provisioned for it.”

Taylor encourages investors to factor in the possibility of a consumer spending pullback this year, due to either rising interest rates or inflation, as well as a staider capital market environment. With those in mind, he says the next few years could bring restrained growth in banks’ earnings, dividends, and price-to-earnings multiples.

Notwithstanding the clouds on the horizon, the financial sector could still play an important role for the Canadian stock market’s performance in the near-term future.

 “It feels like the S&P/TSX index is set up for a few years of outperformance versus the US market,” Taylor says. “This period of rising interest rates has pressure on the multiples for high-growth tech stocks and some of the other more speculative parts of the market.”

Amid a continued pendulum swing from growth to value, he believes technology and other high-growth stocks will underperform cyclical sectors. Those include banks, the materials industry, and energy – all areas where the TSX benchmark is broadly overweight.

“It could be setting the broad Canadian equity space up for a decent period of outperformance similar to what we saw in the environment coming out in the early 2000s,” Taylor says.