Government will force Canadians on “debt diet”
While Canada’s economic news in 2011 will look a lot like it did in 2010 – the year starting with solid growth, a mid-year rate hike and year-end performance a little less than consensus – the growth drivers will be fundamentally more sustainable this year than last, finds the latest forecast from CIBC World Markets Inc.
The forecast calls for Canada’s economy to rely less on debt-financed government spending, homebuilding and consumer purchases for growth in 2011 and see a greater contribution from increased business investment that will enhance productivity. On the policy front, the federal government will be focused on not only cutting its own spending but also slowing that of increasingly indebted Canadians.
“Canada’s economic mix has been the polar opposite of the U.S., with last year’s winners featuring debt financed booms in consumption and homebuilding,” says Avery Shenfeld, chief economist at CIBC, in his new forecast entitled, Not Yet Heaven in Twenty Eleven. “But policy makers now have that credit buildup in their policy gun sights, and will use higher rates and regulatory changes to bring spending into better line with income, and cool mortgage demand.
“Canadians aren’t on the verge of a U.S.-style default crisis – not at these interest rates, and not with debt having been granted to stronger hands than was the case before America’s crisis, when subprime mortgages and credit cards were given out like candy. But maintain this diet of borrowing for five more years and debt obesity would indeed weigh down the household sector’s momentum. It’s time to start the borrowing diet now, and that means policies aimed at slower debt-financed consumption growth and a cooler housing market.”
Mr. Shenfeld notes that the slower build-up of government and private debt will cut into Canada’s GDP growth in 2011 which will otherwise see solid – and more sustainable – growth from a strengthening export market in the U.S. and increased business investment. As a result, he has raised his projection for Canada by about a half point but expects growth will still be just shy of 2 1/2 per cent.
“As in 2010, the best growth rates could come earlier in the year, the Bank of Canada will launch a tightening round but pause after raising rates a percentage point, the U.S. Federal Reserve Board will be unmoved, growth will be a tad disappointing overall, but equities will still outperform bonds as an investment class.
“Behind the scenes, however, the year will mark a changing of the guard as some of last year’s growth leaders falter, and a fundamentally superior mix of drivers takes their place,” says Mr. Shenfeld.
One of the key drivers that will provide a healthy lift to growth will be business spending on machinery and equipment by companies on both sides of the 49th parallel, a shift clearly evident in recent survey results. This increased investment by Canadian firms will be a payoff for recent cuts in corporate tax rates and a spur to much needed productivity improvements.
“All told, the economy will not ascend to heaven in twenty eleven, either in terms of the unemployment rate or the pace of growth,” adds Mr. Shenfeld. “But as we learned in 2010, asset returns can also be affected by optimism about the longer-term recovery ahead.
“Stocks handily outperformed bonds last year, and should do so again in 2011. Dividend yields are still closer to bond yields than they typically are, and even with a modest rise in 10-year Canada rates to 3.6 per cent, the future stream of dividends will still represent solid value at today’s low discount rates.”
He adds that bond fund managers won’t have as easy a ride in 2011, noting that the price decline on a 10-year bond could wipe out a lot of the coupon yield. He adds that while the front end of the Canadian curve reflects rate hikes beginning in the second quarter, it doesn’t yet appear to leave enough room for a full one per cent hike in four successive moves. That suggests upward pressure on two-year bond yields, and a bear market flattening.
The report calls for U.S. Treasuries to outperform Canada’s out to 5 years, given that markets are already way too early in pricing in some odds of a Fed hike by year end.
“With so much slack, why start to slow U.S. growth?,” says Mr. Shenfeld. “After all, the Bank of Canada didn’t raise rates until the unemployment rate was eight per cent.”
On the currency front, he expects the U.S. greenback to have the edge over most majors for the first half of the year. Europe’s fiscal woes and their banking implications will keep downward pressure on its currencies, while commodity currencies like the Canadian and Australian dollars should give back ground as resource prices come down from recent heights.
“But any pull back in the loonie won’t last long. The market isn’t priced for the further widening in short-term rate differentials that we expect, in part because it gives some odds to a Fed rate hike that in our view would be widely premature for an economy still facing massive unemployment. A more generous yield advantage in Canada should see a return to a near-parity exchange rate by year end.”
The complete CIBC World Markets report is available at: http://research.cibcwm.com/economic_public/download/fjan11.pdf
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For further information: Avery Shenfeld, Chief Economist, CIBC World Markets Inc. at (416) 594-7356, [email protected]; or Kevin Dove, Communications and Public Affairs at 416-980-8835, [email protected]