Canada is in uncharted economic territory

Why a broken market cycle mechanism is making the means of a recession unknown

Andrew Willis 9 April, 2019 | 2:00PM

Both Canada and the U.S. are experiencing economic trends that are changing the game. A tight labour market while wages aren’t rising, a fruitless pursuit of inflation and some odd yield curve behavior has investors wondering if, how and when a recession will arise.

Previously, we made the case that Canada was not headed for a recession. This remains true, for the near term at least, according to economists, but they caution that the established indicators around market cycles and recessionary signals are being broken.

As a result, we’re headed into uncharted territory. The outlook in the short term looks weak, yet stable, depending on answers to atypical questions. In the long term, it’s uncertain and policy-sensitive in unusual ways that are worth watching out for.

The yield curveball

“It’s a warning that the economy is at increased risk of recession,” says Sal Guatieri, Senior Economist at BMO Capital Markets, “but [now] likely more a sign that the economy will stay weak for some time.”

Benjamin Tal, Deputy Chief Economist at CIBC World Markets agrees. “Rates have been so low that it’s easy to invert,” Tal said, adding that this time it occurred for such a short period of time it doesn’t provide a particularly useful signal. Usually, it is a significant predictor when it inverts for multiple weeks, if not months.

“The question around this yield curve is not related to a recession. The question is, has this been priced into equities?” says Tal, “It’s the bull market that’s right about growth.”

Meanwhile, the S&P/TSX composite hit a 2019 high last week. Businesses are still growing – albeit moderately – but the wages they pay do not appear to be impacting inflation.

Wage weirdness

Another paradox is the stagnant wage situation, something Tal refers to as “the biggest piece of the puzzle” that we’re in.

“The conundrum is why wage growth remains depressed despite tight labour markets,” adds Guatieri.

Although experiencing some softness in employment figures in March, the labour market has been going strong for the past year – up 1.7% year over year and more than double the labour growth in the U.S. Meanwhile wage growth is modest, at best.

“Maybe we’re running out of people,” Tal muses. At the 2019 Exchange Traded Forum last week, he pointed out a few key facets of the labour market worth considering. Canada’s demographics are getting older, but they aren’t retiring like they used to.

“Older people are working more, but with fewer hours,” said Tal, keeping wages down. They’re not asking for raises when close to retirement. And on the other end of the age spectrum, younger labour market entrants are finding a disconnect when they try to turn their degrees into jobs. Fine arts degrees are getting hard to apply in today’s job market.

Guatieri suggests low productivity and global competition are helping to keep wages the way they are. He also points to ‘automation anxiety’, where for all the benefits brought from rapid technological evolution, elements of economic stagnation arise.

Although it appears we are far from entering another Great Depression, a quote from renowned economist John Maynard Keynes in 1930 sums it up well:

“We are suffering, not from the rheumatics of old age, but from the growing-pains of over-rapid changes, from the growing-pains of over-rapid changes, from the painfulness of readjustment between one economic period and another. The increase of technical efficiency has been taking place faster than we can deal with the problem of labour absorption."

Wage growth is supposed to lead to inflation, and inflation is supposed to lead to high interest rates. But the nature of the market cycle is being broken by these wage woes, says Tal.

A market cycle stuck on repeat – until it breaks

“The wage mechanics are changing the nature of the cycle,” says Tal, “It’s not a normal cycle.” Expect this late phase to be a very long one, he adds.

When and how we’ll reach the end of the cycle is still uncertain. The focus of investors should be how dangers may emerge in this uncharted territory, and what tools would be available to policymakers if we do enter a recession.

Debt levels have been a big concern for Canadians, but we’re starting to see that become less of a factor, only deepening the market cycle mystery.

Guatieri finds it less of a concern now given that the household debt/income ratio has stabilized due to the slowest credit growth in 35 years, and interest rates have likely peaked at historically low levels. Tal agrees, finding the overall economic predicament we’re in also a cure for the debt disease as rates sit so low.

While these economic peculiarities and a broken market cycle do not mean a recession is on its way, it does mean the economy is more vulnerable to shocks that could throw off the odd equilibrium we’re in.

“An oil shock, liquidity issues, cyber issues,” Tal names a few. Fiscal policy shifting from positive to negative – less stimulus, tax cuts or incentives - would also cause problems. “If the feeding were to stop” it could also tip the market into recession, Tal adds.

And what happens if we enter a recession? Tal says the new nature of the market cycle may leave fiscal policymakers with fewer – if any – tools at their disposal.

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Andrew Willis

Andrew Willis  Andrew Willis is a content editor for Morningstar.ca.