4 Trends Canadian Investors Should Look Out for in 2023

A version of the following report was first published by the RBC Economics and Thought Leadership teams on Dec. 7, 2022, under the title “Navigating 2023: Canada in the cross currents."

Just as the global economy continues to navigate COVID-19 and its aftereffects, new headwinds appear to be emerging – structurally tighter labour markets, higher interest rates, increased costs of emitting greenhouse gases, lower gains from trade, and inadequate preparations for energy security and national defence.

But as much as 2023 is bound to be a challenging year, there are bright spots. Most likely inflation returns close to target with only moderate recessions in most advanced economies. Structural shifts present opportunities to invest now in climate, capital, and people. Co-operation within Europe and among Western nations may continue to regress Russia's position in Ukraine. Weak economic growth could also prompt countries to walk back from the precipice, recognizing the need to cool geopolitical tensions.

It adds up to a volatile 2023 as the global economy transitions to the post-pandemic era.

Top of mind is how Canada finds its way in the new economy, attracting talent in tight and shifting labour markets and establishing new growth industries in climate and advanced technologies. In some ways it will mean navigating the perennial challenge of fraught geopolitics between economic giants without being trampled or caught flat-footed.

Here are some themes to consider as we head into 2023.

Bank of Canada's toughest task lies ahead

Monetary policy making always involves a leap of faith. Economic activity reacts relatively quickly to policy changes long before their intended impact on inflation. It means the Bank of Canada will have to deftly stick-handle the task of keeping interest rates high enough to ensure core inflation targets are within sight, but throttling back before too many disinflationary pressures build.

That is a more difficult task these days. Canada has not seen such high inflation in 30 years nor the large drift upwards of inflation expectations. Households are much more indebted. For the first time in its history, the Bank is tightening policy at the same time as it's managing down its balance sheet through quantitative tightening. Government spending is strong. Various factors are contributing noise or signals, from high energy prices to misbehaving supply chains to tight labour markets.

We think the Bank is at or near the top of its tightening cycle. The year 2023 could see wriggles as the Bank recalibrates with incrementally tighter policy or a pullback in rates closer to neutral. Strong household and corporate balance sheets and further currency depreciation against the U.S. dollar may prop up spending and inflation. On the other hand, household consumption may show greater sensitivity to interest rate increases leading to more negative consumption in the near-term.

The most difficult decision will be when to pivot to an outright loosening cycle when rates are brought steadily back towards neutral. The Bank will want to avoid false starts. As negative growth data starts to roll in by early 2023, the Bank will be laser focused on hard inflation data and likely to stay put. But as the year brings further output losses, unemployment, and easing core inflation, the Bank will need to start considering taking the leap late in the year.

Could the housing sector face a reckoning?

Rising interest rates, slowing home sales, and lower growth will test the housing sector. The country's pandemic-era housing frenzy has amplified economic vulnerabilities. The share of highly-indebted new mortgage holders, variable rate mortgages, and domestic investors has jumped. House price multiples relative to average incomes have shot higher.

Housing activity and house prices have been in retreat since the spring. Further impacts are to come. Debt service ratios will climb higher through next year as mortgage renewals phase in higher interest rates. Higher unemployment will make debt servicing harder for a segment of households.

Highly-indebted households are more likely to curtail their consumption significantly and some may default—we expect an increase in household delinquency rates, which had fallen since 2020 to half the pre-pandemic rate. Along with high inflation, flagging confidence, and wealth effects from a decline in housing and equity wealth, spending and housing activity will fall further. But this is likely to be contained by the still strong overall balance sheet of the household sector and structural undersupply of housing in major cities.

More cracks could appear, especially if interest rates go unexpectedly higher. Sudden reversal of house price expectations, resets on variable rate mortgages leading to more borrower defaults, flagging confidence, or changing behaviour of speculative investors could lead to financial institutions and regulators adjusting to contain the damage. But, it's a rare, more significant negative income shock that could lead to an ugly outcome: sizeable borrower defaults and forced house sales that put significant downward pressure on house prices and economic growth.

A favourable climate for cleantech

Business is facing conflicting signals on investment. Tight labour markets, government incentives, and new opportunities versus higher interest rates, higher corporate tax measures, and some ongoing difficulties in doing business.

These mixed signals are more exaggerated in the climate space.

The eager climate talk of the past year may fade with hard realities. The macro environment will erode project economics that were already challenged. Clean technologies tend to be beset by technology, demand, and regulatory risks. The $10-20 billion in climate investment to date has been far short of the required $35 billion per year by 2030 and at least $80 billion per year by 2050.

Still there are signs that climate could outperform. Venture capital flows into cleantech are holding up despite market-wide declines. Companies and regulators have demonstrated more rigour around company disclosures and emissions commitments. Geopolitics is driving interest in clean energy.

The federal government is also intent on tilting the scales in climate's favour, and keeping in step with U.S. actions. It recently announced a slew of technologies eligible for new cleantech investment tax credits in addition to other tax, concessional finance, and regulatory initiatives that will come to bear throughout 2023. Indigenous communities are increasingly participating as partners in new green infrastructure, furnishing environmental credibility and predictability.

Climate may indeed outperform, but it will likely be highly technology specific, leading to further relative underinvestment in riskier abatement technologies needed in the future. Even investment outperformance may not bring nationwide climate spending to target. And at only a portion of the current $221 billion in annual business non-residential investment, fervent climate spending would be insufficient to rectify Canada's poor record on business investment.

Doubling down on skills

With the Canadian-born working age population in decline for more than a decade, immigration has been the release valve for labour market shortages. Next year should see governments and business doubling down on another policy measure: skills development.

Canada's labour shortages may be particularly acute as a result of the pandemic, but labour market tightness will outlive the next recession. Lack of working age people and shifting skills demand with the rise of automation, green investment and other factors will lead to chronic mismatches between jobs and workers.

The federal government has lifted immigration targets progressively since 2019 meaning an additional 2.7 million new permanent residents between now and 2035. Canada will need to attract these permanent residents in an increasingly competitive global landscape for talent. But bringing immigrants into the country is only one part of the process. Access to affordable housing and mobility, and integration into labour markets is another challenge.

With limitations to absorbing more immigrants beyond current targets, at least in the near term, 2023 should see enhanced focus on skills to better match qualified immigrant and domestic workers to labour market needs across the jobs and skills spectrum. Canada's workers have some of the best access to on-the-job training, but availability is much lower for older, lower-skilled and small business workers. Government incentives to encourage mid-career upskilling trail international leaders. Canada also has a range of untapped talent pools, from women, Indigenous people, immigrants, and visible minorities that could boost the size of the economy.

Read more about where the global economy could be headed in the RBC Economics and Thought Leadership team's full report, available at thoughtleadership.rbc.com.

Cynthia helps shape the narratives and research agenda around the RBC Economics and Thought Leadership team's forward-looking economic and policy analysis. She joined the team in 2020.