Bracing for impact: The looming hard landing of Canada’s economy

This article was produced in partnership with Franklin Templeton

If you’re in search of comfort on the prospects of a gentle economic deceleration of the Canadian economy, you may find this disconcerting. Garey Aitken, Head of Canadian Equities, Portfolio Manager, at ClearBridge Investments, a specialist investment manager of Franklin Templeton, predicts a rough descent. He projects a likely hard landing for the Canadian economy—a prediction not yet reflected in the Canadian equity markets.          

Canada is grappling with persistent structural challenges in the aftermath of the pandemic, marked by inflationary pressures, lackluster investment, and sluggish growth in productivity. Additionally, Canadian families are confronting continual economic difficulties in both the short and medium term, struggling to cope with the escalating cost of living.

Aitken, provides insights into this scenario, focusing on the effects of rate pauses and potential shifts in market sectors.

Inflation trends and economic implications

Aitken says, “While inflation has moderated, we believe a hard landing for the Canadian economy is a likely scenario, given the magnitude of monetary tightening over the past 18 months. This stance has yet to be discounted by Canadian equity markets.

“We are more bearish on cyclical sectors such as materials and energy, due to the potential for weakening global demand, and financials, which are already discounting a recession. We expect to remain underweight these sectors but will continue to monitor them for selective opportunities.”

The surge in real estate investment is siphoning essential capital from other industries, exacerbating affordability issues for households, and making the economy highly sensitive to interest rates. As the real estate sector grapples with the impact of increased rates, further challenges are anticipated. Despite being unable to curb inflation, the real estate market's current situation may limit the Bank of Canada's ability to implement further rate hikes, making a cautious approach more likely.

Ordinarily, a booming oil sector would strengthen the loonie, but it remains weak even amid recent advancements. This weakness can be attributed to a decreased domestic focus on the oil industry, regulatory uncertainties, and a general lack of global investment in commodities.

The Canadian economy, in contrast to the U.S., appears significantly more vulnerable. The heavy monetary tightening, unparalleled in recent history, suggests a looming hard landing scenario that the equity markets have yet to factor in. The unique nature of the COVID-19 pandemic and subsequent government interventions further complicates the economic landscape, potentially delaying the effects of policy changes.

Aitken maintains, “While better-than-expected GDP growth has caused the soft landing chorus to grow louder in the U.S., the Canadian economy is in a meaningfully weaker position. We remain of the view that a hard landing is a likely scenario, given the magnitude of monetary tightening over the past year and a half, a stance yet to be discounted by Canadian equity markets.”

Defensive sectors: A new constructive outlook

Defensive sectors such as communication services, utilities, and real estate, previously hit by rate tightening, now present a more attractive investment opportunity. These sectors, along with midstream energy, have seen reduced valuations amidst a still-fragile economy. This shift offers a more constructive outlook for these areas of the market.

The utilities sector’s steady growth, especially in supporting the renewable energy transition, suggests profitable opportunities ahead. However, the broader selloff in defensive areas may be overdone, presenting potential re-rating opportunities.

Conversely, the outlook for cyclical sectors such as materials, energy, and financials is more bearish. The energy sector, despite its strong performance recently, is vulnerable to a potential global demand slowdown, especially with looming uncertainties in major economies like China and Europe. Banks, having experienced a sell-off over the last few quarters, are trading at valuations that hint at a challenging environment but do not fully account for a significant recession. These sectors, therefore, are approached with caution.

Aitken underscores its investment approach as being firmly rooted in a bottom-up strategy. This approach prioritizes identifying and capitalizing on market inefficiencies and is supported by a patient and diligent investment culture. This strategy allows for informed decisions, particularly in areas of the market that have not kept pace with more favored sectors. The focus remains steadfast on valuations and lower beta, with a selective pursuit of growth opportunities.

While the equity markets demonstrated resilience in 2023, despite challenges; this resilience, however, is set to be tested in 2024, with the path of inflation and its influence on short-term interest rates playing a pivotal role. Investors are encouraged to navigate this landscape with a blend of caution and opportunism, keeping an eye on defensive sectors while maintaining a wary stance towards cyclical ones.

^{Important Legal Information} 

^{This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.} 

^{Commissions, trailing commissions, management fees, brokerage fees and expenses may be associated with investments in mutual funds and ETFs. Please read the prospectus and fund fact/ETF facts document before investing. Mutual funds and ETFs are not guaranteed. Their values change frequently. Past performance may not be repeated.} 

^{Franklin Templeton Canada is a business name used by Franklin Templeton Investments Corp.}