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Why I think Canada will avoid a recession next year and the loonie will outperform

This article appears as published in the Globe and Mail and Rachael Moir is the byline

While the risk of a U.S. and global recession has increased, Canada should avoid a downturn in 2020.

In fact, the loonie should outshine its G10 counterparts over the next 12 months.

Here is why.

A moderate recession risk

The weaker U.S. economy has slowed global growth momentum as trade tensions have pushed the manufacturing sector into a downturn.

Now, the global economy is closer to a recession, although the risk is moderate.

But we think a recession will be avoided next year.

In the manufacturing sector, the lagged impact from global monetary easing and Chinese stimulus measures is likely to lead to a global upturn in purchasing managers’ indices (PMIs). Trade tensions could also moderate as 2020 looks to be a politically critical year for both the U.S., where presidential elections take place in November, and China, which is managing an economic slowdown. A stabilization in the auto sector after a period of sustained weakness could also help manufacturing recover.

In fact, the effect of coordinated monetary policy easing should be felt beyond manufacturing as lower interest rates work their way through economies.

And with inflation levels still low, policy makers have further room to maneuver.

Canada holding up well

In Canada, the economy has been holding up well, although it is not immune to the risk of a global recession.

The Bank of Canada’s Fall Business Outlook Survey found that sales expectations were positive in most regions, except the Prairies. This translates into “healthy” hiring and investment plans in non energy-producing regions.

In the energy sector, supply and demand should keep oil prices rangebound: lower production in OPEC countries should offset higher U.S. production amid moderate demand.

Meanwhile, housing activity is seeing the light at the end of the tunnel. In its Fall Housing Market Outlook, Canada Mortgage Housing Corporation projected stabilizing housing starts in 2020 and 2021, ending two years of declines as GDP growth recovers. Existing home sales are expected to strengthen, with prices picking up again.

On the external front, foreign demand supports export prospects despite trade tensions, according to the BOC survey.

Converging U.S. and Canadian rates

In fact, the IMF expects Canadian growth to accelerate to 1.8% in 2020 from 1.5% in 2019, while it will slow to 2.1% in the U.S. from 2.4% this year. The Bank of Canada expects the pace of Canadian growth to pick up to 1.7% from 1.5%.

Against the backdrop of a resilient Canadian economy, the Bank of Canada, which held its policy rate unchanged at 1.75% in October, has no incentive to ease its policy. So we expect the overnight rate target to remain on hold throughout 2020.

At the same time, the Federal Reserve responded to slower growth by cutting its policy rate to a range of 1.50% to 1.75%. We now expect the central bank to pause as long as economic data stabilize at a decent pace.

Financial conditions would have to tighten significantly to see further cuts from the Fed. Not to mention that monetary policy becomes less effective as we approach the zero bound, also reducing the odds of further easing next year.

The loonie should outshine other G10 currencies

Converging policy and long-term rates between Canada and the U.S. should continue to support the loonie.

Generally, our indicators favour the Canadian dollar due to favourable GDP growth expectations, rates and terms of trade.

In fact, we expect the loonie to outperform G10 currencies at least into the first half of 2020.

That being said, the Bank of Canada is unlikely to let the currency appreciate too much and an excessive increase could trigger a rate cut. Back in mid-to-late 2017, when the central bank surprised with its rate hikes, it later tempered its tone when the Canadian dollar traded into the 0.80 to 0.83 range against the U.S. dollar. So we will be watching this range closely.

What it means for our investment strategy

While the global economy will avoid a sharp economic downturn, its recent weakness justifies some caution.

As a result, while maintaining a mild risk-on stance, we favour defensive stock markets, including the U.S., Canada, Australia and France, relative to more cyclical markets like Germany, Italy, Hong Kong and Sweden. We are also underweight emerging markets as earnings continue to contract amidst the global slowdown and trade tensions.

Within fixed income, we are expecting the yield curve to steepen. On the short end of the curve, we expect the bond market to continue to price in easy monetary policy from the Fed. At the long end, we expect some rebound in growth and inflation expectations, resulting in higher yields.