The near-term investment outlook remains somewhat murky. Investors are grappling with numerous issues: the war in Ukraine, COVID-related lockdowns in China, volatility in commodity markets, inflation at multi-decade highs, rising bond yields, the path of corporate earnings and higher short-term interest rates. We will provide our thoughts on most of these issues over the months to come. For the purposes of this commentary, however, we will focus on issues at home.

 

The Canadian equity market has stood out among its peers. It is one of the few global equity markets in positive territory year-to-date. Commodity sectors have led the market higher. In contrast, most parts of the Canadian bond universe are lower, and the current opportunity set looks more attractive as a result. Domestic economic trends have been strong through the first quarter of the year, despite below-par activity in some industries (such as hospitality and travel). The unemployment rate has reached its lowest level since 1976.

 

Canada is dealing with capacity and pricing pressures, like the rest of the world. Recent business surveys suggest that many Canadian businesses continue to face challenges with labour shortages and limited capacity to meet their orders. The most recent inflation reading stood at 5.7%, or 3.9% with food and energy excluded. The latter figure is well above the Bank of Canada’s long-term target of 2%. As a result, Canada’s central bank has been telegraphing the need to raise interest rates to more neutral levels; the range where monetary policy neither stimulates nor restricts the economy. The Bank of Canada unsurprisingly raised rates by 0.5% last week, and confirmed that its balance sheet, which it has used since the start of the pandemic to stimulate the economy through bond buying, will begin to shrink later this month. More interest rate hikes are likely as the year progresses.

 

One of the key concerns on the minds of most investors is whether the Bank of Canada may become too aggressive in its approach to restraining inflation. Rising interest rates, if implemented too quickly and too far, could eventually restrict economic activity and lead to a meaningful slowdown, or worse, a recession.

 

The Canadian economy may arguably be more sensitive to rising interest rates than other economies. In contrast to the U.S., which has largely been deleveraging since the financial crisis over a decade ago, household debt levels in Canada have risen meaningfully over the past fifteen years. The housing market has been a beneficiary of this longstanding trend. Nevertheless, mortgage rates have nearly doubled over the past year to levels last seen in 2019, and may still rise further should inflationary pressures fail to recede over time. At some point, consumers and households will have to think carefully about taking on more debt given higher servicing costs. This readjustment would be a normal feature of an economic cycle, with demand for credit that rises and falls inversely with interest rates. In some ways, lower demand for credit may be welcomed by policymakers, who have been concerned for some time about the amount of household and consumer leverage and overall housing affordability.

 

The investment outlook for Canadian equities has become more complicated. So too has the outlook for the Canadian dollar. There remain some clear positives: an economy that is starting from a position of strength, tailwinds for the commodity complex, less vulnerability from the geopolitical conflict overseas, and an overall equity market whose valuation is more reasonable than others. At the same time, inflation and an aggressive rate hiking cycle pose risks to the outlook for consumers and households, whose debt levels have never been higher. For this reason, we are prioritizing diversification in our Canadian portfolios to ensure that they are prepared for a wide range of future outcomes.

 

If you have any questions, please feel free to contact us.

Drew M. Pallett LL.B. CFP

Senior Portfolio Manager and Investment Advisor

RBC Dominion Securities

Email: drew.pallett@rbc.com

Website: www.pallett.ca