Why investors should brace for sluggish Canadian growth in 2023

Senior investment strategist at Vanguard Canada highlights three risks that could impact the country's economy

Why investors should brace for sluggish Canadian growth in 2023

After a year spent grappling with inflation and continued increases in interest rates, Canadians should prepare for significantly weaker growth in the year ahead, with an outside risk of stagflation in the worst case, according to Vanguard Canada’s senior investment strategist.

“We believe that Canadian growth for 2023 is going to be less than 1% expectation for the year,” Bilal Hasanjee told Wealth Professional.

According to Hasanjee, there’s a rising risk of recession around the world as central banks in the U.S., Europe, and parts of emerging markets tighten monetary policies to fight inflation. After months of those policymakers pumping the brakes on their respective economies, the firm’s most likely expected scenario is for tepid global growth of less than 1% next year.

“The risk of global recession is rising, and it may have a spillover effect on Canadian growth given its reliance on energy exports,” he says.

Following the latest announced 50-basis-point hike by the Bank of Canada, Hasanjee says there’s a “glimmer of hope” that it will stop there. That will rely heavily on what key indicators of economic strength and inflation bear out in the coming months, as the central bank has said it will be more data-dependent in making its interest-rate decisions going forward.

One data point that Hasanjee expects will have an impact is the latest strong PMI print coming out of the U.S. If that leads to a high inflation number, and the U.S. tumbles into a recession because of tighter monetary policy, it could have a knock-on effect on the Canadian economy as the U.S. is Canada’s largest trading partner.

“The Canadian and U.S. economies have both experienced record inflation levels, and both the Federal Reserve and the BoC have been implementing tighter monetary policies,” he says. “That increases the risk of a policy misstep, resulting in a hard landing or recession with high inflationary pressures, also known as stagflation, which would be our worst-case scenario.”

Vanguard also recognizes the developing risks from highly levered Canadian households and still-elevated housing prices. Hasanjee noted that Canada’s housing sector is vastly more expensive compared to other developed markets. With the BoC’s successive rate hikes this year, there’s a concern of a disorderly reduction in housing prices, which would have a knock-on effect on overall housing finances and amplify the risk of a hard landing.

“We believe that real estate prices are going to soften going forward from dampening demand, because of the worsening state of housing affordability,” he says. “There are pockets of borrowers who are now finding it difficult to pay their mortgages, and our concern is that we may see some defaults on mortgage loans because of high interest rates.”

The real estate sector is already slowing down, and a further correction in housing prices can be expected to impact the economy overall given the sector’s outsized role in Canadian GDP and how much of the labour force it represents. The combination of lower real estate prices and higher interest rates will be acutely painful for home buyers who entered the market at its peak, Hasanjee says.

“That said, we all know that real estate prices have been on the higher side of the spectrum for a long time,” he adds, pointing to factors such as the low interest rates and supply-chain challenges that came with the Covid-19 crisis, as well as immigration, bottlenecks in issuing building permits, and foreign investment flows.

“In the long term, we think it’s going to be a better situation for a larger number of people in terms of affordability of housing if prices keep coming down.”

The trajectory of energy prices poses another key risk. If they keep decreasing as they have over the past many months, it could create a drag on Canadian government revenues as well as corporate revenues. Equity markets and the Canadian dollar, Hasanjee adds, could be similarly impacted.

A drastic move in the other direction could also be detrimental to the Canadian economy. While Canada is an exporter of energy to different countries, Hasanjee says a sharp rise in energy costs may fan inflation.

“While this could prove a positive catalyst for Canadian exports, its exasperation of inflationary tensions may put pressure on the economy through lower discretionary consumption,” he says.