The Canadian economy is chugging along, even as uncertainties build up around the outlook. Strong economic activity in the U.S., coupled with potential for upside surprises to consensus, is likely to sustain a roughly 2.0% pace of growth in the Canadian economy.
One of the three key themes of our Q4 Global Investment Outlook – a widening range of potential growth outcomes – is also relevant for Canada. Alarming headlines related to the renegotiation of the North American Free Trade Agreement (NAFTA) are in the rear view mirror, but global trade tensions are here to stay. And several longer-run domestic economic concerns complicate the outlook. Battles over interprovincial pipeline access have forced Canadian crude oil to trade at a substantial discount to international benchmarks, Canadian households remain highly indebted at a time of rising interest rates and a cooling housing market, and a mix of slowing economic activity and U.S. tariffs on industrial metals has weighed on non-energy commodities. These factors all argue for a greater focus on portfolio resilience, the third key theme of our Outlook.
Canadian monetary policy remains accommodative, with room for rates to move higher. The economy is operating above potential, businesses report capacity constraints across a range of industries and headline inflation is running above target. Given this, we expect the Bank of Canada (BoC) to raise interest rates for the third time this year in October. This echoes the second of our key Outlook themes – tightening financial conditions. Barring a complete breakdown in trade negotiations, we expect the BoC to maintain its approach of gradually moving towards the neutral rate into next year.
The Fed is poised to lift rates by more than the BoC over the next several quarters, but this is likely already reflected in foreign exchange markets (see chart below). The Canadian dollar may find support as long as oil prices remain firm and NAFTA negotiations reach a successful conclusion. But our view is that the loonie will likely remain in the range where it has traded for much of the past year.
Within fixed income, short-term real yields are positive after having languished in negative territory during much of the post-crisis period of accommodative monetary policy. Given this, we prefer the front end of the Canadian interest rate curve on a risk-adjusted basis. The flat shape of the yield curve and stable economic outlook make longer maturities relatively unattractive, except for those looking to explicitly hedge long-term liabilities. As a result of the recent indiscriminate repricing across emerging markets (EM) – examined in detail in this Global Investment Outlook – we see opportunities in selected EM debt as well as in higher quality investment grade corporate bonds.
Canadian stocks have endured many headwinds during 2018 and valuations currently reflect considerable bad news. Any good news on the trade front is likely to prompt a relief rally. We find that on a price-to-book and forward price-to-earnings basis, Canadian stocks are at one of the cheapest levels versus the U.S. in the past 30 years. Low relative price-to-book ratio often coincide with poor relative earnings prospects. Yet whenever relative forward P/Es fall to these levels, Canadian stocks have tended to outperform the U.S. over the subsequent twelve months (see chart below).
At this stage of the profit cycle, Canadian equities offer more limited earnings growth relative to the U.S. This is partly due to the smaller weight of the tech sector – where earnings growth has been strong – in the Canadian stock market. Other reasons include the U.S. corporate tax cuts and widening discounts for Canadian crude oil. Much of the negativity is already reflected in the price. We wouldn’t rule out a brief period of outperformance to end the year, but any recovery in Canadian equities is unlikely to persist until the fundamentals and earnings outlook improves. Overall, we retain our preference for U.S. and emerging market equities.