The key question in front of investors these days is simple: When – if ever – will the recent surge in interest rates begin to slam the brakes on the economy?
The Bank of Canada has boosted its policy interest rate by nearly five percentage points in little more than a year. That constitutes the most rapid and overwhelming set of rate hikes in four decades. Yet, to most experts’ shock, the economy is still powering ahead despite the galloping increase in borrowing costs.
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The jobs market remains robust, home prices have resumed rising and the recession that everyone expected to materialize around now is missing in action.
What’s not so clear is what to make of this surprising resilience. It could be a fool’s paradise – an illusion that will vanish as higher interest rates begin to bite and drag the economy into recession. Alternatively, it could be the real deal. Perhaps inflation will continue to painlessly fade away and the economy will keep on chugging along.
In announcing its latest rate hike this week, the Bank of Canada came down on the side of the optimists, boosting its outlook for economic growth this year. It also predicted that growth would slow next year but remain at least decent through the end of its forecast window in 2025.
Investors are looking on the bright side, too. The S&P/TSX Composite Index has gained a solid 4.4 per cent so far this year. The market apparently doesn’t see any big reason for worry.
Neither do consumers. Canadians may not be increasing their spending at quite the same rate as earlier this year, but we are still spending freely, according to a report this week from Carrie Freestone, a Royal Bank of Canada economist. We’re travelling, we’re going out to restaurants, we’re celebrating in bars.
Our collective nonchalance in the face of rapidly rising interest rates reflects a job market that continues to hum along. It also reflects the amount of liquid (or easily tapped) savings that households accumulated during the pandemic years.
These “liquidity buffers,” as the Bank of Canada quaintly calls them, have soared for three out of every four households. A household of average income now has liquid savings equal to about eight times its monthly expenditures. Before the pandemic, it had liquid savings of only about twice its expenditures.
This increase in savings is genuinely good news. But before concluding that a soft landing for the economy is in sight, investors may want to consider what history has to say.
Policy-makers have delivered an interest-rate jolt of the current size only twice in the past half century. The biggest shock came at the start of the 1980s, when the central bank hiked rates more than 10 percentage points in a little more than a year to rein in runaway inflation. The other came at the end of that decade, when the bank boosted rates more than six percentage points between 1987 and 1990.
On both occasions, the economy toppled into recession. The stock market swooned.
It seems reasonable to think something similar may happen this time around.
A few warning lights are already flashing yellow. The most worrisome is the stubborn refusal of core inflation to fall. While headline inflation has plummeted in recent months, its decline owes a lot to falling gasoline prices. Core inflation, which excludes more volatile elements, has not been so obliging.
Measured over three-month intervals, it has remained stuck in the 3.5-per-cent to 4-per-cent range since last autumn, well above policy-makers’ 2-per-cent target. “All this suggests increased risk that the progress toward price stability could stall,” the Bank of Canada’s Monetary Policy Report warned this week.
At the very least, persistently high core inflation increases the chance that interest rates will remain elevated for some time – not good news for the growing number of people who have fallen behind in payments on instalment loans, car loans and credit cards. While overall delinquency rates remain low, “the share of borrowers moving from 60 to 90-plus days late on any credit product has risen and is now close to a historical high,” the central bank noted.
That isn’t the only ominous sign. Consider the yield curve, a measure of how short-term bond yields compare with longer-term ones. It is inverted, meaning that we are in an unusual situation in which short-term bonds are paying more than long-term ones. In the past, such inversions have been an excellent indicator of economic downturns to come.
What does all this mean for investors? National Bank of Canada suggests it’s time to get cautious. The bank’s equity strategy team this week reduced the weight of Canadian stocks in its model portfolio to 18 per cent from the previous 20 per cent.
The trim reflected the bank’s dour outlook for oil prices and the loonie, as well as its glum assessment of the North American economy. Its model mix is now 51 per cent invested in fixed-income securities and 9 per cent in cash.
It is a stodgy mix, to be sure, but one that should do well if, as National Bank expects, U.S. and Canadian growth hits the skids in the months ahead.
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