Macklem makes his third cut with more likely to come, what does that mean for housing, fixed income, and advisors?
The Bank of Canada has now made three interest rate cuts on the bounce. Each cut at 25 basis points has been backed up by data — signs of falling inflation, weakness in the economy, and slack in the labour market. Each cut was also expected, priced in, and predicted by investors. The expectation is that cuts will likely continue, so long as data supports them, until we hit a neutral rate of around three per cent. Now that Canada’s interest rate cutting cycle is fully underway, what risks and opportunities does that open up for Canadian investors and advisors?
Canada’s cuts have opened up a few key areas of risk, from the housing market to fixed income there are some areas where underperformance or imbalance could emerge as a result of these cuts. They’ve also opened up opportunities in other sectors and asset classes. Advisors now face the challenge of client expectations, and two portfolio managers emphasized the risk that a key inflation component could come roaring back thanks to these cuts.
“The biggest concern for inflation right now is shelter. Shelter costs are running at 8 per cent as a part of CPI,” says Rohan Thiru, VP and portfolio manager at Canoe Financial. “Our concern is that the Bank of Canada is cutting and we are going to reach a 3 per cent interest rate by the end of next year and shelter cost could pick back up. That’s why they did not cut by 50 basis points. The housing market has not yet weakened significantly, rental inflation is still there, and shelter cost is running at eight per cent.”
Thiru and his colleague Derek Johnson, portfolio manager at Canoe Financial, explained that their worry is around the re-introduction of froth in the housing market. While some have noted that interest rate cuts can be disinflationary by lowering carrying costs on shelter, they note that there is such a deep lack of supply in Canadian housing that acceleration appears to be the only likely course forward.
Immigration is key to their view of the Canadian economy and the housing market. High rates of immigration have driven up demand for housing. At the same time, immigration has introduced slack into the labour market. While analysts and the Bank of Canada may cite an uptick in unemployment, Johnson and Thiru note that we haven’t seen widespread layoffs yet. Rather, labour market participation rates have ticked up, meaning the demographics with the highest unemployment rates are new immigrants and new graduates.
Johnson connects the flaws in our immigration system with the ongoing lack of housing supply. “There are structural shortages in housing, but there are also structural shortages in construction labour, which is not being addressed by immigration,” he says.
Dylan Wilson, portfolio manager at Verecan Capital Management Inc. shares a similar concern around cuts reinflating the housing market and a lack of new housing starts. He notes that these cuts are having an immediate positive impact for any clients with variable rate mortgages. From an asset allocation standpoint, however, he is not advocating for any significant deviations in his plan.
Despite what they see as a major risk to the housing market coming out of these cuts, Thiru and Johnson are far more bullish on the Canadian economy than most. Two years ago, they claimed we would not fall into a recession, and recent GDP numbers seem to have borne out their prediction.
The cutting cycle now also validates the use of fixed income over high interest savings accounts, GICs, or other cash equivalent products. Thiru and Johnson note that imbalances in the fixed income space open up opportunities in actively managed funds. Moreover, they firmly believe that there is more opportunity to be found now in US bonds. Given the US has not yet begun its cutting cycle — though the US Federal reserve is widely expected to make a cut at the next FOMC meeting later in September — there may be much more opportunity for upside in the US bond market.
As he talks his clients through some of the risks and opportunities in this cutting cycle, Wilson is careful to manage the weight of their expectations. For many younger clients, or the children of clients, high interest rates were a key barrier to homeownership. While that barrier may be coming down, he notes how important it is for advisors to manage euphoria and plan for the prospect of more challenging outcomes.
“Part of the conversation that my team is having with clients is that inflation may rest at 2.5 or three per cent,” Wilson says. “When we’re looking at things from a borrowing perspective and in the financial plan, we need to make sure there’s enough slack. We need to make sure that there’s enough capacity in cash flow that if rates revert our clients are not going to be in a situation where they have to make difficult decisions.”
