Canada market perspective
The Fall Guy
It’s not as though the BoC didn’t get the invite to join the “dovish” central bankers club: the BoC is simply not interested – at least not just yet. Second quarter GDP (gross domestic product) came in at a robust 3.7% annualized rate, blowing past the BoC’s estimate of 2.3%. The Labour Force survey for August reported employment growth of 81,000 jobs and a steady, nearly historic low unemployment rate of 5.7%. Meanwhile, inflation measures are roughly in line with the BoC’s 2% target. Given such data, the BoC’s assessment of the Canadian economy “operating close to potential” so that current policy remains “appropriate”, as noted in their September 4th policy announcement, is hard to attack. Central bank policy, however, is about calibrating present conditions with the projected forward path – and therein lies the problem.
The complexity of the U.S.-China trade war makes the projected path hugely uncertain. In a speech following the September announcement, Deputy BoC Governor Lawrence Schembri noted the trade war is “the biggest risk to our forecast” and that “weakness in consumption”, despite a healthy labor market, is a concern. Pertaining to the latter, final domestic demand, which is a better gauge of domestic spending in the economy, has contracted three of the last four quarters – hardly a show of strength. Moreover, year-on-year GDP growth is trending at a slower pace of 1.5%, less than half the rate of the second quarter. Trade (exports) and consumption are big chunks of the economy and therefore any slowing in these factors is a cause for alarm. Complicating the BoC’s projected path for the economy is the rebounding housing market and rising household debt due to lower bond yields. This is both a blessing and a curse. While a healthy housing market boosts confidence and is positive for growth over the near term; higher household indebtedness from already high levels is a structural handicap for the longer term.
The BoC therefore has the unenviable task of calibrating policy given this underlying complexity. Still, just as the season changes from summer to fall, data for the second half of 2019 is expected to transition to a cooler pace. Ultimately, sustained trade uncertainty raises recession risks: with roughly 75% of the Canadian yield curve inverted1 as of September 6, 2019, the margin for policy error is diminishing. As such, BoC Governor Stephen Poloz, however begrudging and conflicted, will be forced to join the dovish central bankers club – or risk being the fall guy.
Canadian equity outlook: Energy fatigued
The BoC Commodity Price Index is up nearly 16% year as of September 11, 2019, lifted by a 22% rally in the price of crude oil as measured by West Texas Intermediate (WTI). Such an outcome should be a tailwind for domestic equities generally, and the energy sector particularly. That has not been the case, however. The energy sector has underperformed the broader market year-to-date. Pipeline woes and unexceptional earnings prospects for the energy sector are partly to blame. Moreover, the energy sector’s influence on the broader market has waned, with its share of the benchmark S&P/TSX Composite Index slashed roughly in half, from greater than 30% in 2008 to roughly 16% in August 2019. Commodity prices, however, still matter. As the chart below illustrates, the correlation of returns of commodity prices to domestic equity is elevated and above the longer-term average. Therefore, despite the energy sector’s apparent fatigue, healthy commodity prices will remain crucial to the outlook for domestic equities. That said, for a look ahead, we rely on our investment decision-making building blocks of cycle, valuation, and sentiment to assess the current state of Canadian equities at the end of the third quarter:
Cycle: The resiliency of the Canadian economy will be tested as economic growth in the U.S., Canada’s largest trading partner, is showing signs of slowing. Weak external conditions coupled with soft domestic demand are a concern. The industry consensus expectation for earnings growth has been trending lower and the severity of the yield curve inversion is a headwind to the profitability of the critical financial sector. Overall, we believe the business cycle is neutral to slightly negative.
Value: The S&P/TSX Composite Index is trading at a forward price-to-earnings ratio of 14.4, roughly in line with its long-term average. However, profit margins have been trending lower and may be further challenged in a slowing economy. We rate value as neutral.
Sentiment: Momentum continues to moderate, while our contrarian indicators are neither over-bought nor over-sold. Sentiment therefore is neutral.
Conclusion: Canada’s economy has traversed well in a hostile global growth environment. But domestic stability is at risk, with the economy expected to slow sharply over the second half of 2019. This uncertainty surrounding the business cycle keeps us neutral on the outlook for Canadian equities.
Correlations of Commodity prices to Canadian equity
Source: Rifinitiv DataStream, Russell Investments. Based on monthly data as of August 2019. Canadian equities = S&P/TSX Composite Index, Commodities = BoC Commodity Price Index. Correlation is measured using annual returns over rolling three years.
1Yield curve refers to short and long term government interest rates plotted on a graph. It usually curves up as long-term rates are generally higher than short-term rates. When short-term rates are higher than long-term rate, the yield curve inverts, which is often viewed as the precursor to a recession.