The firm is watching multiple slumping indicators and challenges on both economic and market fronts
Those observing the Canadian markets have grown concerned over several flashing signals of softness, including rising debt levels, a greater-than-expected slowdown in 2018 GDP growth, and an inverted yield curve that hints at recession. And while one firm doesn’t see recession in the cards, it’s still expressing modest concern for the near term.
“Even though we expect the Canadian economy to avert an outright recession, the first half of the year concerns us,” Russell Investments noted in its newly published Q2 outlook.
Reading the economic tea leaves, the firm noted that widening credit spreads, persistent manufacturing weakness, deteriorating trade are contributing to a slump in its slumping Financial Conditions Indicator (FCI).
Still, recession is not its central scenario for 2019 as it expects better financial conditions in the second half. Early signs point to a bottoming of the FCI, and the Fed has grown more dovish when it comes to the pace and magnitude of rate hikes, so the US is expected to allow financial conditions to stabilize over the year. Aside from that, Chinese stimulus for the US will also support broader emerging economies, providing demand for commodities.
“Nevertheless, the weak start to 2019 leads us to … expect GDP to grow in the range of 1.0% to 1.5% in 2019, versus the previous range of 1.7% to 2.1%,” the firm said.
Longer-term, it pointed to persistent competitive challenges impeding Canada’s productivity growth. In spite of a rapid, immigration-driven increase in the working-age population, it projected increasing odds of the Bank of Canada (BoC) downgrading its potential growth trend, which implies a lower “neutral” policy rate.
“This cascades into a lower fair-value range for the Canadian 10-year government bond yield, which we now project to be in the range of 2.1% to 2.5%, versus 2.4% to 2.8% previously,” the firm said, adding that it’s modestly downgrading its fair-value estimate of the CAD to USD exchange rate to $0.73 to $0.77, compared to the previous $0.73 to $0.79.
Turning to Canadian equities, the firm took note of a “melt-up” that allowed the market to return within the first two months of 2019 what it had been expecting for the whole year. While Canada was not alone in this movement, Russell argued that the pace is unsustainable and requires a healthy pause.
Looking at Canada’s equity markets from a cycle standpoint, the firm pointed to a considerable decline in the 2019 earnings-per-share (EPS) growth estimate from a high of over 12% to less than 5% as of March 5. That downgrade was driven significantly by weakness in commodity prices, though that seems to be in the rearview mirror as the BoC Commodity Index has stabilized. And while the economic cycle has deteriorated, monetary policy is in a holding pattern as the BoC will likely not raise rates anytime soon. “Overall, we are neutral on the business cycle,” it said.
The strong start to 2019 has also eroded some of the value in Canadian equities, though the weighted average for dividend yield is still healthy at 3.4%. Profit margins trended lower over the second half of 2018, and are worth watching as the firm expects some support from its constructive outlook on commodities. The upshot, the firm said, is a modestly positive view of value in Canadian stocks.
“Momentum is positive, however some of our contrarian indicators are approaching levels that signal further gains from here may be limited,” the firm said, adopting a neutral stance on momentum for Canada’s stock markets.