Canada is a steady ship, but beware the risks - Nomura

Analysts at Nomura explained that the Canadian expansion continues, albeit at a slower pace. 

Their base case is for higher rates, but NAFTA remains a risk. 

Key Quotes:

"The Bank of Canada (BoC) remains data dependent."

"Annual GDP growth rates in Canada have taken a step down. However, this should be expected in view of the above-trend pace between H2 2016 and H1 2017, with excess capacity in the economy being absorbed and as tighter monetary conditions via higher interest rates and CAD appreciation flow through to the real economy.

Key forward-looking indicators such as the BoC Business Outlook Survey (BOS) point to solid growth continuing, with the maturing broad-based expansion self-sustaining. On the positive side, strength in the labour market and rising wage growth should support consumption in the face of higher mortgage costs, and higher oil prices and incomes should underpin non-residential business spending."

"By contrast, residential investment (as a proportion of GDP) remains near historically high levels, and the impulse looks set to be a modest headwind for the economy. Furthermore, the benefits for net exports from the synchronised global upswing should be constrained by CAD appreciation.

Beyond the base case, the NAFTA renegotiations remain a source of downside risk for the economy. To date, there have been few signs of discernible progress. Should the talks break down, the most pronounced effects are likely to be felt in sectors with the highest levels of integration with US production and trade, such as chemicals, metals and motor vehicles. 

Inflation: 

Various survey indicators suggest that capacity pressures are rising. Added to that, the reduction of slack in the labour market is causing a modest acceleration in wage growth. These trends point to core CPI inflation picking up over 2018. But at the same time, global structural forces, the potential for capacity expansion due to domestic economic improvements and CAD strength are offsetting forces.

Policy:

After having been on hold since September 2017, the BoC raised interest rates by 25bp to 1.25% at its January meeting. But the BoC maintained a pragmatic and data dependent approach, stressing that while the economy is expected to warrant higher interest rates over time, “some continued monetary policy accommodation will likely be needed to keep the economy operating close to potential and inflation on target. 

Uncertainties continue to cloud the BoC outlook. Our base case remains for the BoC to raise interest rates gradually by a further cumulative 75bp by the end of 2019. 

Risks: 

NAFTA renegotiations continue to be a source of downside risk, with a sharp fall in house prices, coupled with the large domestic imbalances also on the radar. By contrast, sustained higher oil prices and stronger global/US growth are upside risks."