The Canadian economy was brought to a near standstill early in the second quarter on efforts to contain the spread of the coronavirus. An Activity restart is underway as new cases decline steadily nationwide. The reopening could prompt an increase in infection rates. It’s also unclear to what extent consumers and workers will reengage as lockdowns ease, given changed behaviors and heightened risk aversion. Our research shows services suffered a worse hit than manufacturing and are likely to restart slower than they collapsed. An oversupplied oil market is another factor adding to the uncertainty. According to the International Monetary Fund, the Canadian economy is set to return to its 2019 level only in 2022 after contracting 8.4% in 2020.
A coordinated, decisive and timely response from the Bank of Canada (BoC), the Ministry of Finance and regulators represents a Policy revolution to stave off a more severe economic downturn and a full-blown financial crisis. The Parliamentary Budget Office estimates pandemic-related spending to bridge household and business cashflows through the shutdown at roughly C$170 billion (8% of GDP), roughly equivalent to the initial economic shock (see chart below). This unprecedented emergency spending will rapidly send Canadian debt-to-GDP ratios above 100%, but Canada remains in an enviable fiscal position relative to other developed countries (see chart below).
Canadian monetary policy also went into overdrive. The BoC cut its policy rate three separate times in March and also quadrupled its balance sheet during the first half of 2020 to more than C$500 billion (nearly 25% of GDP), in part through government-backed and corporate bond purchases (see chart below). We expect the BoC’s next step under the new leadership of Governor Tiff Macklem is to use its growing balance sheet to prevent an unwanted increase in interest rates and tightening of financial conditions amid heightened bond issuance to finance larger deficits and an expected pickup in economic activity.
The accelerated structural trends are reshaping the investment landscape and will be key to investor outcomes. We believe portfolios need Real resilience to achieve diversification and reduce risk in this new environment. As we outline in our report, this means raising allocations to inflation-protected securities, positioning assets in the direction of sustainability, identifying opportunities in private markets and paying greater attention to country, sector and factor exposures (pages 12-14).
The Canadian government bond market proved its diversification credentials this year, rising nearly 8% against a Canadian equity market that is down a similar order of magnitude (see chart below). We like longer-maturity Canadian government bonds for their increasingly scarce positive yields and potential to deliver some protection in a renewed risk-off scenario. These same macro underpinnings would also augur for limited upside for the Canadian dollar unless the economy’s reopening proves more robust than is currently expected.
We see the role of government bonds changing over time, however, as yields approach perceived lower bounds and inflation risks rise amid deglobalization, reregulation and deficit spending. As a result, we believe nominal government bonds will become less effective as portfolio ballast against equity selloffs on a strategic basis.
We like global credit on both a tactical and strategic basis. The asset class is underpinned by central bank purchases in the short run, and we believe this past year’s sizeable spread widening compensates for the risks of defaults and downgrades on a strategic horizon.
We maintain our overall neutral posture on equities on both a tactical and strategic basis. We have upgraded European equities tactically as we see them offering the most attractive exposure to any cyclical upswing. We have also cut emerging market equities to underweight.
Canadian stocks already reflect an anticipated 50% hit to earnings in 2020, and are among the cheaper options within the developed markets, with a multiple of 17x 12-month forward earnings. Despite improving coronavirus trends and prospects for a steady reopening, we prefer a selective approach in Canadian stocks given high household debt and energy volatility. In a yield-starved world, we highlight the well-capitalized Canadian banks that have ample room to increase payout ratios, if needed, to maintain their dividends. And we like Canada’s nascent but growing technology sector (see chart below), which has risen nearly 60% in 2020 on accelerated trends favoring e-commerce and has considerable runway given Canada’s leading innovation and research capabilities.
Read our Canadian Midyear Outlook here.