We expect the Canadian economy to cool throughout 2018 at a time when trade risks could further complicate the global outlook. Canada’s economy can take some reassurance from the relatively firm growth in the U.S., but indebted households, weak domestic oil prices, still sluggish business investment and subdued exports all pose challenges.
Canada is a very different story than the rest of the world. The U.S. tax overhaul and public spending plans have boosted growth and earnings forecasts at a time when the U.S. economy is already humming, as we write in our outlook. This injects uncertainty into the global economic outlook: potential for greater capex and productivity growth, but also a risk of overheating and increased risk premia across asset prices. Yet we see the overall environment as positive for global risk assets, albeit with more muted returns and higher volatility than in 2017. The risks? U.S. protectionism (very real for Canada) and a renewed surge in global bond yields (a less immediate concern).
The Bank of Canada (BoC)’s decision in March to pause in its normalization campaign reflects economic risks that now skew to the downside. Gains from the global recovery in the energy and materials sectors look to have played out already. Our BlackRock Growth GPS for Canada points to lower growth ahead which is consistent with consensus estimates (see chart below). Domestic oil prices trading at a steep discount to global benchmarks because of pipeline limitations, and the uncertainty overhang from NAFTA negotiations alongside the risk of steel and aluminum tariffs (Canada is the world’s largest supplier of both metals to the U.S.) has restrained investment activity. As a result, the BoC may raise rates only once more in 2018.
We view the U.S. trade actions so far more as an opening gambit for negotiations than the start of a trade war, as we write in our outlook. We expect China to try to address its trade deficit with the U.S. by opening up its markets in the medium term. We take some comfort that talks are led by seasoned trade pros on both sides. We also see a decreased chance of the U.S. withdrawing from NAFTA. Yet things could spin out of control. Things to watch for include the U.S. announcing and implementing harder-hitting trade measures or the trade pros losing control of negotiations.
We see up to three more U.S. rate increases this year, decreasing the chances of any strengthening in the Canadian dollar. The loonie has already weakened against the U.S. dollar so far this year, whereas most other developed market currencies have appreciated. In addition, the loonie could struggle under the weight of trade tensions and weak domestic oil prices. Loonie weakness isn’t necessarily bad: Investors with unhedged exposure to international stocks tend to benefit, as do the earnings of multinational companies with sales outside Canada.
Decelerating economic activity and a slower pace of monetary tightening should help limit any weakness in Canadian fixed income as inflation recovers and global rates head higher. We don’t see Canadian rates across the curve coming under as much pressure as in the U.S., where inflation risks are higher because of the procyclical boost of the fiscal stimulus. Holding some duration and emphasizing credit makes sense at this point in the cycle for Canadian fixed income investors, in our view. Investors should also consider unconstrained strategies in global bond markets, we believe, as a way to increase the opportunity set and protect capital during a period of rising interest rates.
Canadian stocks have underperformed global stocks each of the past five consecutive quarters inclusive of the current one (see the chart below). Canadian earnings have held up reasonably well, pulling valuations versus U.S. and global equity markets to three-decade lows. Clearly, a lot of bad news is already reflected in the price. As long as conditions don’t get materially worse (a rather herculean assumption perhaps, given the trade tensions along the southern border), we believe Canadian stocks could start to post some better numbers on the boards.
We prefer emerging market (EM) equities and we recently upgraded U.S. stocks given the robust earnings prospects post tax cuts. We also favor the global technology sector, which happens to be underrepresented in the Canadian equity market but is the single largest sector weight in EM, the U.S. and the momentum factor. We like U.S. and Canadian banks, which offer decent earnings growth at relatively cheap multiples
Kurt Reiman is BlackRock’s Chief Investment Strategist for Canada