Governor of the Bank of Canada, Tiff Macklem, speaking before the Canadian Club Toronto at the Royal York Hotel in Toronto on Dec. 15.Carlos Osorio/The Globe and Mail
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The first step in solving a problem is acknowledging its existence. Yet, that seems lost on the Bank of Canada (BoC) and the federal government given the looming economic challenges facing this country. In turn, Canadian investors should re-examine their well-documented home bias and mitigate the coming risks by allocating a significant portion of their assets outside Canada.
Since the global financial crisis, Canada’s economy has been heavily reliant on extreme levels of personal and corporate debt. The personal debt to disposable income ratio stands at a staggering 187 per cent – the highest among the G7 nations – putting individuals under a hefty financial burden.
Corporations are not immune, often resorting to debt issuance to maintain high dividends. Bay Street, long a facilitator of this precarious economic path, needs to acknowledge its role in this narrative.
That party is now coming to an end. The BoC’s aggressive interest-rate hiking campaign, which has taken the overnight rate to 5 per cent from 0.25 per cent, looks set to steer Canada’s economy toward financial hardship.
Homeowners and corporations face the daunting reality of refinancing at these much higher interest rates. Specifically, the wave of mortgages due for refinancing at current interest rates could affect economic growth significantly for the rest of the decade and render the BoC impotent.
There’s emerging evidence Canadian households are already feeling the increased financial strain. The debt service ratio rose to 15.22 per cent in the third quarter, marking the highest point on record dating to 1990, according to Statistics Canada data.
In fact, total mortgage interest payments have risen by 90 per cent since Q1 2022, while the amount of mortgage principal paid during this time has declined by 16.8 per cent. Canadians are now allocating 9.26 per cent of their disposable income to interest payments, the highest since 1995. Upcoming mortgage renewals pose a potential payment shock for homeowners, exacerbating the situation further.
Canada needs a substantial industrial policy
The BoC has misdiagnosed the economic conditions and potential outcomes. The main concern should not be inflation but secular stagnation and deflation.
The Canadian economy is alarmingly reliant on credit and real estate. Furthermore, Canada’s productivity growth is disappointingly declining 2.2 per cent year-over-year, while the U.S.’s is at an encouraging 5.3 per cent. Taking these factors into account, the growth of the Canadian economy may be hindered for years to come.
As a result, Canada needs a substantial industrial policy to aid its transition into the digital age. This country must have the necessary tools for the new world of artificial intelligence and blockchain with an industrial policy similar to U.S. President Joe Biden’s CHIPS and Science Act or the U.S.-Japan Digital Trade Agreement.
Canada’s demographic quagmire
Canada also finds itself in a demographic quagmire as international migration accounted for 98 per cent of the population growth in 2022-23. The surge in population, reaching 40.5 million people as of Oct. 1, marked the highest growth rate since 1957 and surpassed any previous full-year period since Confederation in 1867.
While new participants in the economy are expected to drive economic expansion in the medium term, the short-term strain on social services, housing markets, and productivity growth presents additional challenges, exemplifying the complexities of fiscal and monetary policies working at cross purposes.
The intensified pressure caused by immigration on housing and rental markets has exacerbated existing shortages. Paradoxically, the BoC’s high interest rates have suppressed housing supply, contributing to inflationary pressures.
Those too quick to respond may say these trends will force the central bank to maintain interest rates at a high level or raise them further, but a more nuanced approach, taking into account that interest rates are the price of credit and can constrain supply, would suggest that this should force the BoC to cut interest rates.
Considering a reduction in interest rates to stimulate housing supply may be a crucial nuance for the BoC to integrate into its monetary policy decisions. This demographic quagmire is front of mind for investors when evaluating Canada in 2024.
Policymakers’ denial is being noticed globally
Current economic data suggest that Canada is heading toward a recession. Yet, the BoC, Ottawa, Bay Street, and Canadian investors are in denial as they have yet to fully acknowledge Canada’s distinct economic landscape compared to the U.S. Given the prevalent extreme home bias in investment portfolios, investors must consider diversifying away from overemphasizing Canadian assets.
International investors are already reconsidering their Canadian investments. Canadian policymakers’ denial is being noticed in global capital markets. The sooner the BoC and Ottawa adopt a realistic, fact-based perspective of Canada’s financial situation, the better for everyone involved.
If the BoC does, indeed, come to this realization, interest rates could be cut more aggressively than many believe. By the end of 2025, the BoC’s overnight rate could drop below 2.5 per cent. However, before any recovery can start, a bottom must be hit. Therefore, it would be wise for Canadian investors to brace for impact and prepare for the challenging times ahead.
James Thorne is chief market strategist at Wellington-Altus Private Wealth Inc. in Toronto.
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