Kurt and Daniel discuss why effective policy coordination is key to supporting a swift economic recovery and avoiding a protracted slowdown, as well as some of the investment implications.
Last week’s March Labour Force Survey provided the first glimpse into the impact of widespread containment measures and materially lower oil prices on the Canadian economy. The Canadian labour market shed over two million jobs in March and the unemployment rate rose 2.2 percentage points to 7.8%, representing the largest one-month increase in more than four decades, according to Statistics Canada. Including those who kept their jobs but worked less than half of their usual hours, we can infer that around three million Canadians (almost 10% of the population) have so far been financially impaired by the containment measures.
A sharp drop in economic activity is already being assumed and priced into risk assets. Based on a range of estimates from Canada’s largest banks, economists expect GDP to contract at an annualized pace of between 18% and 45% in the second quarter (see chart below). The incredibly wide range of forecasts speaks to the level of uncertainty surrounding the outlook. Most forecasters assume a steep decline in growth for the third quarter, which implies that lockdowns end in a few months and that consumer and business spending normalizes. What’s noteworthy is that the expected upturn has an even wider range than the downturn. Engineering a sharp rebound is possible, given that social restrictions are self-imposed. However, economists may be split on when and how the lockdowns begin unwinding and whether there will be any longer-lived pain for the Canadian economy.
Given that financial markets are a discounting mechanism, arguably the important question for investors is whether the virus-induced shock will be short lived, or if it propagates over a much longer period of time. A potential wave of bankruptcies, namely in the Alberta oil patch, and a deleveraging of Canadian households could create economic damage that lasts longer than the containment measures themselves. While the energy sector is in a very tough position even after the announced global production cuts over the weekend, massive government stimulus packages are aimed at bridging incomes through the crisis and minimizing to the greatest extent possible the increase in long-term unemployed and destruction of the capital stock.
Policy measures aimed at facilitating the flow of credit and covering lost incomes significantly reduce the chance of longer-lasting economic disruptions. So far in Canada, we have seen coordinated efforts from policymakers, regulators, and crown corporations who are committed to providing sizeable relief to groups most impacted by the pandemic and ensuring businesses have access to bridge financing to survive mandated shutdowns.
Since March, the Bank of Canada cut the overnight rate to the effective lower bound, started a bond buying program, and introduced credit easing measures alongside the Canadian Housing and Mortgage Corporation. With respect to the banking sector, the Superintendent of Financial Institutions reduced capital buffers and Canada’s largest banks began offering mortgage deferrals. The accompanying fiscal response has been nothing short of aggressive, with Ottawa providing a combination of loan guarantees, direct income subsidies, and tax deferrals to households and small businesses. So far, the incoming fiscal support is expected to amount to 8.5% of GDP, doubling the response to the global financial crisis and reaching a level unseen since the mid 1980s (see chart below).
With nearly C$200 billion in proposed spending on the table, the Federal government has shown it can provide sizeable fiscal support to carry Canadians to the other side of a temporary crisis. However, the next challenge is whether new policies can be rolled out fast enough in order to be effective. There’s a strong case for swift implementation given that large rounds of layoffs have already occurred. The emergency parliamentary sitting over the weekend, which resulted in the approval of the 75% wage replacement program, is an example of how seriously the Federal government is taking this issue.
Despite significant progress on the policy front, we’re moving into a period that will likely be dominated by grim headlines on economic data and earnings releases. Since the start of the year, 2020 fiscal year earnings growth estimates for the S&P/TSX Composite Index (TSX) have fallen from 8.5% to -9%, according to data from Refinitiv. TSX earnings estimates have fallen at a much faster pace compared to the S&P 500, likely because the Canadian market is more dominated by cyclical sectors. Moreover, companies have begun suspending forward guidance, reflecting that the outlook remains incredibly clouded. The energy sector, which we view to be in a particularly tough spot, is expected to face a 40% decline in earnings for the upcoming fiscal year, according to consensus estimates from Refinitiv. Since the start of the crisis, Alberta producers quickly started paring back capital expenditures, employment, and dividends as the sustainability of many companies comes into question at sub $30/barrel WTI (read more here).
Investors are beginning to demand greater compensation for taking equity risk, evidenced by both stock prices and bond yields falling sharply in tandem on a year-to-date basis. As the number of daily infections slows and large-scale stimulus measures move closer towards implementation, opportunities should emerge in risk assets. For now, we prefer an up-in-quality bias in portfolios and a preference for global credit over global equities from a tactical perspective. We recently upgraded our view on corporate credit and U.S. large cap stocks on recently announced stimulus measures and the large quality bias and ample allocation within U.S. equities to secular growth sectors, such as technology and healthcare. The Canadian market may be presenting pockets of opportunities for investors with longer time horizons, such as in the financials sector where we view bank dividends to be relatively secure (read more here).
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