Rachael Moir is a Quantitative Investment Analyst with the Investment Management and Strategy team at MD Financial Management. She is responsible for supporting strategic and tactical asset allocation and alternative investment mandates.
Heightened recession fears amid lingering U.S.-China trade tensions and disappointing data have led to another round of bond yield declines and fuelled expectations of further central bank easing globally, including by the Bank of Canada.
But we believe Canada could outperform other developed economies amid a slowing global expansion. Canada could also continue to beat economists’ expectations about domestic growth, which should prevent the Bank of Canada from following in the footsteps of the Federal Reserve with a rate cut this year.
In fact, Canada could prove to be a good hedge for investors believing a global recession is coming.
DIVERGING MOMENTUM
We see diverging momentum over the next 12 months, with U.S. GDP growth slowing while Canadian GDP growth is more likely to pick from current levels.
Earnings momentum in Canada has outpaced the U.S. and most other developed markets over the last nine months. Over the next 12 months, a stable U.S. economy and the lagged effects of the weaker loonie will help support the Canadian economy and earnings.
Canada has been relatively unscathed by the trade war because of our smaller manufacturing sector than most major economies such as the U.S., China, Japan, Germany and Italy, several of them facing troubles of their own, including Germany, where the economy contracted in the second quarter and the auto sector is struggling.
Canada has also been among countries, alongside the U.S. and Australia, to register manufacturing PMIs above 50, signaling growth.
BEATING EXPECTATIONS
Not only has the Canadian economy showed resilience relative to most major countries, but it has performed better than economists’ expectations: the Citigroup Economic Surprise Index for Canada has had a positive reading all year, while the global index has been negative since the second quarter 2018.
Going forward, Canada could continue to surprise as we believe housing risks are overstated, while oil isn’t having the drag on the economy that most analysts expect.
In the oil sector, headwinds will persist until transportation issues are resolved, and investment will be further restrained as energy companies struggle to access credit markets. However, even with these challenges, the rest of the Canadian economy has been able to pick up the slack.
NO HOUSING BUBBLE IN CANADA
On the housing front, data don’t signal any bubble. House price increases in Canada, Toronto and Vancouver in particular, have been supported by a lack of supply. Canada Mortgage and Housing Corporation also estimates that housing market vulnerability is now moderate in Canada, following 10 quarters of high vulnerability. Most notably, Vancouver is now moderate after three years of high vulnerability.
While we don’t expect a recession in Canada, it would be the biggest threat to the housing sector through the unemployment channel that would affect households’ ability to repay their mortgages.
We believe concerns over Canada’s high amount of household debt and the ability to repay it are exaggerated: the unemployment rate remains near its record low despite its increase to 5.7% in July, while interest rates are likely to decline further, and wage gains over the past year have kept pace with housing price increases.
GLOBAL RECESSION RISK INCREASES BUT NOT THE BASE CASE SCENARIO
Overall, while the risk of a recession has increased, we still believe the Canadian economy will continue to grow.
Our recession indicators have picked up recently, as the recent revisions to U.S. GDP have highlighted weaker investment and declining corporate profitability. However, the sharp decline in bond yields globally, across the curve, should diminish recession risks by supporting economic growth.
If a recession were to occur in the U.S. or on a more global scale, all bets would be off for the Canadian economy. Yet, it would hold up better relative to Japan, the euro zone, and the U.K., which have been hit harder than Canada by the trade war and idiosyncratic risks.
As a defensive stock market, Canada would hold up better than other major developed countries. The U.S. being Canada’s largest export market, the likely depreciation of the loonie against the greenback in a recession scenario would mitigate the impact of weaker economic activity. This all means that the Canadian market would be a good hedge if you think we’re headed for a global recession.
Still, before moving to an overweight in Canadian equities from our current neutral position, we will wait for confirmation from data that the Canadian economy will pick up. In the meantime, we prefer to take exposure via the currency and remain long the Canadian dollar.