Unless you believe fervently in Dr Who or Marvel character Loki’s time travel, you’ll know no one can really predict the future. But rewind to the end of 2022 and analysts were forecasting recessions, hard landings, and interest rate cuts. They never happened. Instead, here we are, the TSX is up about 8% and the S&P 500 an eye-catching 21%, the economy has proved resilient, and many well-paid economists are admitting they got it dead wrong. But what’s next?
First, let’s address a common misperception that central banks want to cut interest rates asap and return them to “normal” levels of 0-1%. News alert: those historical lows we all got used to post the global financial crisis are the exception not the norm. Indeed, you have to go back to between 1935 and 1955, when the Bank of Canada kept the benchmark rate between 1.5% and 2.5%, to see similarly low rates.
By 1965 the overnight rate had seesawed its way to 4% but didn’t dip under that mark for 29 years, until January 1, 1994. It was only when the housing crisis of 2008 arrived that Canada’s rate subsequently plunged to 0.25%. Even taking these rock bottom rates into account, the Bank of Canada’s benchmark rate averaged out at 5.78% from 1990 until 2023, reaching an all-time high of 16% in February of 1991 and, as mentioned, a record low of 0.25% in April of 2009.
So, where are we now as we head for the turn of the year? The Bank of Canada has stayed put for three successive meeting at 5%, while the Fed have maintained its benchmark rate in the 5.25-5.5% range since July. It’s the biggest indication yet that the aggressive hiking cycle has come to an end, backed up by clear signals that financial conditions have tightened and the labour markets has softened.
Once again, people foresee a recessionary scenario and the start of a deep rate cutting cycle. But how much of that is optimistic yearning for a return to the low-rate years of the 2010s and how much of that is reality?
From a North American view, for this to happen, growth needs to collapse, unemployment needs to rise significantly, and inflation needs to return to sub 2% levels. There is no doubt higher rates are now having an impact in certain areas – speculative (read: profitless) tech firms have nosedived, and commercial real estate is struggling, for example. The Canadian housing market is finally experiencing a price drop and private markets are facing its own pricing wake-up call.
But other factors can offset these pockets of the economy, making dramatic rate cuts more unlikely. Wage increases have been healthy and renewed fiscal spending in healthcare, energy and infrastructure should help maintain growth – and, therefore, inflation – while ongoing geopolitical tension will likely spur many countries to further fuel capital projects like decarbonization.
All this sounds like the economy still has some legs, but the Canada caveat is that household debt levels are the highest in the G7. As of 2021, the country’s household debt is 7% higher than the country’s entire GDP, an increase from 2010, when household debt was about 5% lower than GDP. By comparison, household debt in the US fell from 100% of the country’s GDP in 2008 to about 75% in 2021, while the UK’s household debt as a share of its GDP also fell from 94% in 2010 to 86% in 2021.
Five-year fixed rate mortgages in Canada, which were negotiated during the low-rate period, are coming to an end at the same time of a softening jobs market, putting more pressure on those household debt levels. Throw into the mix the fact Toronto and Vancouver are among the most unaffordable cities in the world and Canada is more vulnerable than most to another financial crisis.
On the flip side, there is an argument that the post-COVID shutdowns income growth in Canada did not translate into proportional growth in spending, generating an “excess” of savings. The consumer has so far proved resilient, but risks prevail. The good news is that the US consumer, traditionally a huge support to the Canadian economy, has proved steadfast.
So, what does all this mean for the average investor? At the risk of adding another wrong outlook to the pile, while growth and continued inflation will rule out a return to near-0% interest rates, the path ahead appears less uncertain than during the pandemic. The imposed rate hikes are now finally slowing down the economy, discouraging spending and making loans more expensive. The result is inflation has cooled to 3.1% in October, down from a peak of 8.1% in June 2022.
The hiking cycle appears over, with the clock ticking to the first move lower. It’s likely we’ll see the first decrease arrive in 2024 but those predicting rapid, multiple cuts appear optimistic given the economic resilience still on show. The distinct pressures faced by indebted Canadians mean this higher-for-longer rates and inflation scenario carries more risk than in the US, but the reality is this is the new normal. Work with your advisor to discuss how this might affect your financial plan and investment strategy.