The recent inversion of the yield curve has intensified recession fears, both in the U.S. and in Canada. Paradoxically, in Canada, these tensions have coincided with mostly above-industry consensus economic data compared to global counterparts. While our baseline outlook does not include a recession in 2019, trade tensions and household indebtedness are testing the longevity of the current economic expansion heading into 2020 and may well force the Bank of Canada’s hand.

Canada market perspective

Canada is not an island

If the steady flow of consensus-beating economic data in Canada has not been impressive enough, what’s more striking is the magnitude by which domestic data has outpaced other developed countries. This divergence is best displayed by the strength of Citigroup’s economic surprise index for Canada, which measures macroeconomic data relative to consensus expectations versus its G10 counterparts (Figure 1). A positive reading means economic data have been above consensus on balance, and vice versa for negative. The relative strength of Canadian data is partly due to the lowered expectations as the Canadian economy sputtered over the second half of 2018. As well, the Canadian labor market has been exceptional, with the unemployment rate near historic lows. While we believe the Canadian economy is gradually recovering, we must keep in mind that Canada is not an island. By the Bank of Canada’s (BoC) own admission, the output gap, which measures actual growth relative to potential, has once again turned negative over the past two quarters. This means economic slack has emerged again.

Despite the output gap resurfacing, the BoC has held on to a very balanced outlook, one which stands apart from other developed market’s central bankers, who have become outright dovish. By way of example, the Reserve Bank of Australia cut its cash rate by 25 basis points at the June 5 policy meeting. We believe this divergence between Canada and other developed countries, both from the perspective of macroeconomic data and central bank rhetoric, cannot be sustained indefinitely. A precondition to the sustainability of further upside surprise in economic data would require improved globally conditions generally and in the U.S. specifically. Moreover, the World Bank’s recent downgrade to global growth and global trade for 2019 does not instill confidence. We believe these cross-currents mean the BoC will remain sidelined. Interestingly, the markets are looking through the recent strength in domestic data and, instead, are clearly flagging recession risks as indicated by yield-curve trend highlighted in Figure 2. The percentage of the Canadian yield curve that was inverted in early June is close to levels which have preceded recessions in the past. The balance of risks, then, is clearly tilted toward a rate cut as the BoC’s next move. Indeed, the markets as of June 10, 2019 are pricing roughly 45% probability of a rate cut prior to year-end.

The Canadian dollar has not much benefited from the relative strength in economic activity discussed above. A 20% decline in oil prices from their April 2019 highs have clearly weighed on the Canadian dollar, or loonie. In any case, we maintain our fair-value estimate for the CAD/USD exchange rate at $0.73 to $0.77.

Perhaps the measure which most clearly demonstrates that Canada is not isolated from global conditions is the Canadian 10-year Treasury yield which, similar to its U.S. counterpart, has declined spectacularly, from a high of 2.6% in October 2018 to 1.5% as of June 10, 2019. As noted above, the central bank has been dogmatic in its recent communications on the expected strength in the Canadian economy. Looking ahead, if economic conditions are as resilient as the BoC projects over the balance of 2019, markets would gradually price out a rate cut. In this scenario, bond yields would have modest upside from current levels. Conversely, the narrative currently reflected in market pricing, and one which we are more sympathetic toward, is for global conditions to continue deteriorating due to delays in U.S.-China trade resolution, for sentiment to erode further and force the BoC to cut its policy rate. In this scenario, a retest of the prior lows of 1% seen in 2016 is a possibility. Regardless of which scenario plays out, we place a low probability on the Canadian 10-year yield retesting its 2018 highs.  

Canadian equity outlook: holding pattern

In our previous quarterly outlook, we postulated that the run-up in Canadian equities over the first quarter was “too much too fast” and a pause was in order. Indeed, domestic equities have been restrained as U.S.-China trade tensions re-surfaced. 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:

Cycle: Earnings revisions remain negative and recent weakness in the BoC commodity price index is not encouraging. The positive offsets, however, are improved macroeconomic data and an accommodative central bank. Trade tensions and weaker global trade are key concerns which lead us to maintain our neutral perspective.

Value: After closing at an all-time high of 16,669 on April 23, 2019, the S&P/TSX Composite Index has trended lower. The pull-back has improved value, though both trailing and forward price-to-earnings ratios remain elevated relative to their respective January 2019 lows. Value overall is broadly neutral.

Sentiment: Momentum has cooled, although contrarian indicators are far from oversold. Sentiment therefore is also neutral.

Conclusion: We have previously cited business-cycle vulnerabilities, particularly home prices and household indebtedness, as reasons for remaining cautious on Canada’s market outlook. Although recent economic data has been encouraging, it still reflects an economy growing at a 1%-1.5% range. With global concerns escalating, valuations not yet compelling, nor sentiment indicators suggesting conditions are oversold, we remain neutral on our outlook for domestic equities.

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