On Wednesday of next week, the Bank of Canada will announce its decision on interest rates. The market is leaning toward another cut, while policymakers have a delicate balancing act ahead.
“With higher interest rates, spending has cooled, and businesses have scaled back their hiring plans. Strong immigration has also helped the supply of workers catch up with demand, bringing the labour market into better balance,” said Bank of Canada Governor Tiff Macklem, in a June 24 speech at the Winnipeg Chamber of Commerce. “But it’s now getting harder to find a new job.”
The mixed outlook has Macklem looking for wage growth to moderate further. “Labour shortages have mostly vanished and, as such, wage growth should temper,” says Dominique Lapointe, CFA, director of macro strategy for Manulife Investment Management.
Canadian Labour Market Concerns
The job situation in Canada indicates there is some slack in the labour market, said Macklem. “It also matters for household financial stress. People who find it hard to get a job often find it hard to keep up with their credit card and other debt payments,” said Macklem. “The further softening in the Canadian labour market should be a significant concern to the Bank of Canada,” said Mike Archibald, CFA, CMT, CAIA, vice president and portfolio manager at AGF Investments Inc.
“Many indicators of financial stress declined during the pandemic, but they are now back up near pre-pandemic levels,” cautions Macklem. “And late payments on credit cards and auto loans are above pre-pandemic levels. We see this stress particularly among renters. These are often younger workers and newcomers.” Macklem asserted that a key ingredient for the price stability that policymakers want to see is a healthy labour market: “One in which Canadians have the jobs they want, employers have the workers they need, and real wages grow in line with productivity.”
Key economic data since the last cut has shown a “mixed” picture says Archibald. Canadian gross domestic product readings show “slightly more strength than consensus,” he says, while on the softer side, June jobs data showed a reduction in countrywide employment, as well as an uptick in the unemployment rate to 6.4% from 6.2%.
Look Back to What Led to the Last Canadian Interest-Rate Cut
A potentially conflicting Canadian economic output has some in the market referring to what led to the inflection in interest rates. “To understand what the Bank of Canada will do on July 24, you have to go back to the June 5th decision to cut interest rates,” says Lapointe, “Back then, Canadian inflation had moderated significantly relative to last year. Across many measures, especially if excluding shelter components, Canadian inflation seemed to be back to target. Meanwhile, the Canadian economy underperformed relative to expectations. Household spending looked increasingly geared toward staple items, not discretionary.” He also noted that Canadian “excess savings” have been maintained rather than spent. “In that context, given elevated interest rates, the Canadian economy had little scope to meaningfully reaccelerate. This weak economic backdrop also reduced the odds of a pickup in inflation. Therefore, the Bank of Canada elected to lower its policy rate and start its easing cycle in June.”
The Bank of Canada faces another important interest-rate decision in the coming days, “this time with a little more policy uncertainty,” says Archibald.
Bank of Canada July Interest-Rate Cut Probability
Despite the conflicting data, the market is now pricing in 75% odds of a cut on July 24 based on Bloomberg’s World Interest Rate Probability screen as of July 12, notes AGF’s Archibald. “The Canadian economy remains under a fair amount of pressure due to elevated rates, and the BoC is likely to cut at least two more times before the end of 2024 to alleviate some of the consumer stress being felt on mortgage renewals, in other areas of unsecured lending and on the consumer spending and retail sales front.”
Manulife’s Lapointe says their view remains anchored in the broad Canadian economic context: “Businesses don’t have the same pricing power as they enjoyed in the aftermath of COVID-19 and demand is weak.”
Macklem still sees a “narrow path” toward a soft landing for the Canadian economy but that “we have yet to fully stick the landing. Looking forward, the unemployment rate could rise further.”
The holistic and cautious outlook from the BoC including labour and debt trends also has Lapointe seeing cuts around the corner: “By signalling more rate cuts to come, the Bank of Canada, in our opinion, moved a little away from pure ‘data dependence.’ Cutting rates should be expected at nearly every meeting, barring any major changes to the economic outlook.”
What Does Canada Need to Do to Stay on Track?
A key component to a positive Canadian economic outlook is healthy growth going forward. “Beyond the near term, a healthy labour market is critical to strong non-inflationary growth in Canada,” Macklem says, “Our Achilles heel is productivity. We have been very good at growing our economy by adding workers. We have been much less successful at increasing output per worker. And this is catching up with us.” Macklem echoed earlier statements from Bank of Canada senior deputy governor Carolyn Rogers this year on the productivity problem that can contribute to a cycle of higher and uncertain price environments.
“Low, stable, and predictable inflation allows Canadians to spend and invest with confidence. It lowers uncertainty and encourages long-term investment. And it contributes to sustained job creation and greater productivity. This in turn leads to improvements in our standard of living. That’s why price stability is our number one priority,” said Macklem. Among ways to address worker productivity, “we need to keep investing in an inclusive labour market, smart immigration, and a strong and accessible education system, said Macklem.
What Should Canadian Investors Do?
While investors wait to see if the Canadian business community responds to calls for productivity improvements, Archibald has his eyes on a few sectors for opportunities: “Commodity sectors rallied sharply after the first BoC rate cut in June with materials and energy leading the way in the days after the decision, and I would expect to see cyclical and interest rate sectors act positively over the coming months as rates are further reduced,” he says. “Some of the interest rate-sensitive sectors like utilities and REITs, both significant underperformers over the past 24 months as rates were quickly increased and left at elevated levels to fight inflation, look to be trying to bottom in anticipation of easier monetary policy in the coming year.”
With Canadian markets lacking significant exposure to technology and the artificial intelligence theme, a move higher in the cyclicals is required for the S&P/TSX to perform well said a June note from Greg Taylor, Chief Investment Officer at Purpose Investments. “While the commodity markets have had a mixed to slightly positive performance for the year, the financials and utilities that comprise a large part of the market have struggled with higher interest rates."
As for Macklem’s view on easing inflation to help with the higher interest rates: “We are not yet back to 2%, and we can’t rule out new bumps along the way. But increasingly, we look to be on our way.”
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