Canada Needs a Productivity Revolution

Text transcript

Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Avery Shenfeld, chief economist at CIBC. 

We’re still on a fairly lacklustre track in terms of Canadian economic growth. While we are seeing growth and it would look reasonable by historic standards, we have to remember that we’ve had very strong population growth over this last year and a half. So, in per capita terms, you can still say that economic output growth is weak.  

And where that shows up is if you track what’s happening to the unemployment rate, it’s gradually drifting higher. So, we’re not growing fast enough to keep the unemployment rate from escalating.  

And I suspect that, from here to the end of the year, while we might see the jobless rate level off, we’re probably not yet going to see the kind of pickup that would bring us back to the lower unemployment rate we had a year ago.  

To some extent, the good news for Canada is that inflation, if you strip out one key item, is already running near 2%. And that one item is mortgage interest costs. So perversely, when the Bank of Canada raises interest rates to contain inflation, there’s one part of Canada’s price basket, which is measuring the cost of mortgages, which actually escalates, and it’s running at over 20%, in terms of annual inflation. If you remove that one item, inflation actually has been running roughly in line with the Bank of Canada’s 2% target over the past year. And that’s a key reason why the Bank of Canada has felt comfortable starting the process of bringing interest rates down, because they can reasonably expect that as that happens, and those mortgage interest costs actually decelerate, the overall headline inflation number will also return to that 2% target.  

There’s always some doubt in terms of when the Bank of Canada will deliver each individual rate cut, in part because the economic outlook over the next year-and-a-half won’t really be that sensitive to the precise timing of those rate reductions. From our perspective, we still see the need for a substantial dose of interest rate relief, given how slow the Canadian economy is, and the sluggishness that we’re seeing in some interest-sensitive sectors, like housing, for example.  

But that said, we did have a bit of an uptick in inflation in terms of the report for May. And as we speak, we were still waiting to see what the June numbers look like. If they are reasonably contained again, the Bank of Canada will have the green light to cut in July. And there are some reasons to expect that that is the Bank of Canada’s leaning, that having started to cut interest rates, they don’t want to deliver a mere quarter-point reduction and say that that’s going to really help. It does take multiple interest rate reductions to really have any impact on the economy. And the Bank of Canada has been clear that when they did that first cut, their expectation was, well, not in any given month or any given meeting that there would be further cuts coming.  

And for most Canadians, that’s what’s really relevant here. Not the timing of each and every move, but the prospect that a year from now, interest rates will be low enough to get the economy moving again.  

There are issues related to the business cycle for the economy, which is soft now, but we do expect it to recover as interest rates come down next year. But also important longer-term issues in terms of growth and particularly standards of living. And basically, productivity is the key to growing the economic pie, particularly on a per capita basis. We need to increase output per hour in order for workers to actually get paid more per hour, particularly paid more on inflation and generate an improvement in what they can buy.  

If you look at Canada’s track record, our productivity has been extremely poor in the last year-and-a-half or so. I think that’s because of economic softness, and we’ll recover some of that. But there’s a more pressing issue in that if you go back over the last couple of decades, we’ve still been trailing the U.S. over that period. And that’s a stickier and tougher problem. We need to see more business capital spending, we need to see Canada play a bigger role in some of the innovative industries, the tech space and so on where you get big productivity gains. In other words, we need more of a revolution a bit in terms of what we do in the Canadian economy, what incentives there are for business investment, and so on, if we’re going to actually start to play catch up with the U.S. in terms of growth and output per hour, and therefore, as I said at the outset, growth in our standard of living. 

The U.S. economy has really stood out in this period of rising interest rates globally as the one country that has shown a lot of resilience to those higher rates of interest. So, in contrast to the slowdown that we’ve seen in most parts of the world, including Canada but also lots of European countries, the U.S. economy actually managed to accelerate in terms of economic growth in 2023, which came as a surprise even to our above consensus forecast for the U.S. for last year.  

If we look at what’s happening in 2024, however, there are some signs that growth, while still healthy, is starting to moderate. So, high interest rates may now be finally starting to bite in some parts of the U.S. economy. Employment growth, still fairly healthy, but obviously moderating from what we saw last year. There aren’t as many vacant jobs. And inflation has come down in the U.S., both in terms of prices and wages. So, that easing in inflation is good news. It does mean that while we do expect the economy to continue to slow a bit further into the second half of the year, that the Federal Reserve doesn’t have to really stand by and let that slowing get out of hand.  

With inflation easing off, once they do get more confirmation that the economic growth is easing off, and that inflation is continuing to decelerate, they can start to give the U.S. economy a bit of relief in interest rate reductions.  

So, we are expecting to see a slowdown in the U.S. economy over the balance of 2024, extending the deceleration we’re already seeing in the numbers. But we do think that the benefit of that for inflation will be that the Federal Reserve can deliver a couple of rate cuts before the end of the year. And that should set the stage for growth, again, to gradually pick up over the course of 2025. We’ll need more interest rate reductions that year, but the bottom line here is that the Federal Reserve is in a good position to protect the U.S. economy from a more serious downside now that inflation is coming under better control. 

For investors, we may not be in as buoyant an economic climate over the next few quarters, particularly in the U.S. economy that has helped make the U.S. equity market a big winner.  

Of course, some of that has been led by enthusiasm over the tech space, not necessarily driven by quarterly economic growth but by longer-term prospects for the adoption of AI across the economy.  

But economic growth does feed into earnings, and we do face I think a period where earnings growth might slow a bit in conjunction with that slowdown we’re expecting to see in the second half in the U.S.  

But the flip side of that is that if the Federal Reserve does step up with some interest rate relief, then on the fixed-income side of people’s portfolios, there could be some capital gains on bonds as interest rates start to ease off. And more generally, we do expect that a balanced portfolio offers some pretty good protection right now, in terms of what happens if the economy surprises to the downside.  

Because we’ve had yields move up over the last couple of years, there’s now room for bonds to provide a good return if we were to get a steeper slowdown than we expect in the economy — one that dented equity returns and the offset would be that bonds would be a better performing asset class than they have been.  

So, we always counsel, you know, diversification in a portfolio. But unlike what we saw, say, in 2022 when there were periods where rates were rising quickly, and both bonds and stocks showed some weakness, we’re in a period now where that balanced portfolio does promise to offer some reasonable returns. And if we do manage to achieve the soft landing in the economy with only a slowdown and then a beginning of a pickup in global growth over 2025, there should be another leg higher in equities down the road as well.