Taking the long view

At a time of bleak economic data and high uncertainty about the spread of the virus, it’s natural to focus more heavily on the here and now. However, important structural changes to the economy and asset classes during the pandemic would argue for taking the long view.

This past week, the incoming economic data confirmed what we already know: the economy was brought to a standstill heading into the second quarter to contain the spread of the coronavirus and limit the humanitarian toll. On Friday, Statistics Canada announced that economic activity declined at an annualized rate of 8% in the first quarter, slightly better than its initial flash estimate of -10%. Unsurprisingly, a record drop in consumer spending drove the bulk of the slowdown, whereas business investment fell more modestly. But as bad as this reading was, the data are likely to worsen before they improve. The impact of widespread shutdowns is expected to weigh more heavily during the second quarter when economists expect real GDP to contract between 40%-50% on an annualized basis (see chart below).

Hypothetical annualized quarterly GDP changes for Canada, 2020-2021

Source: BlackRock Investment Institute, as of 1 June 2020.
Notes: The chart shows the hypothetical annualized quarterly GDP growth rate for Canada based on economist estimates from Canada’s six largest banks (TD, RBC, BMO, CIBC, Scotia, and National). There is no guarantee that any forecasts made will come to pass.These hypothetical scenarios are subject to significant limitations given the uncertainties surrounding the virus outbreak.

The Bank of Canada will therefore see no reason to alter its “zero” interest rate policy and rapid balance sheet expansion when it announces its policy decision on Wednesday under the new leadership of Tiff Macklem. Investors are awaiting details on the conditions the BoC would need to see materialize before it winds down its bond-buying program (see chart below) and normalizes short-term interest rates. But even before that happens, the BoC will eventually need to decide whether it intends to use asset purchases to ensure financial conditions are consistent with its price stability objective (the bank has so far avoided the use of the words “quantitative easing” as a descriptor of its asset purchases), especially if it hopes to contain any near-term backup of longer-term interest rates as the economy reopens.

Bank of Canada balance sheet assets, 2020

Source: BlackRock Investment Institute, with data from the Bank of Canada, as of 27 May 2020.
Notes: Securities purchased for resale includes the Bank’s Overnight Repo and Term Repo operations. Examples of “other" assets includes provincial money market securities, Canada Mortgage Bonds, banker’s acceptances, and commercial paper.

Supportive fiscal and monetary policy, together with optimism over both the prospects of reopening and vaccine developments, supported a 2.8% gain in the S&P/TSX Composite Index (TSX) in May and 1.9% in the last week alone. A renewed flaring of U.S.-China tensions nipped at the gains in stocks but did not short-circuit the weeks-long rally off the late-March lows (see chart below). Tech was the best performing sector in May after rising almost 15%, bringing the sector’s share of the Canadian equity market cap to 9.3%. Bank stocks rallied towards the end of the month following earnings results. Despite a sharp rise in loan-loss provisions which dented profits, strong capital and liquidity buffers allowed Canada’s “big six” banks to maintain their dividends in the face of a historic slowdown.

Asset class returns, 2020

Source: BlackRock Investment Institute, with data from Refinitiv Datastream, as of 29 May 2020.
Notes: The chart shows total returns in local currency, except for commodities, which are in US. dollars. Indexes or prices used: MSCI USA, MSCI Canada, MSCI Japan, MSCI Europe, MSCI Emerging Markets, DXY, Datastream China-A Total Market, Datastream 10—year benchmark government bond (U.S., Canada), S&P U.S. IG Corporate Bond, S&P Canada IG Corporate Bond, S&P U.S. HY Corporate Bond, spot gold, and spot Brent crude. Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index.

We’ve received several questions about the sustainability of the recent equity rally and whether the market has moved too far, too fast. While stocks could be susceptible in the near term to a slower path to reopening, and therefore earnings growth, the strategic case for stocks in the portfolio remains strong.

We recently updated our long-term expectations for asset class returns and risk (read more here). We find that Canadian stocks more than keep pace with global equities over the next five years and that stocks should handily beat the risk-adjusted return of government bonds (see chart below). While government bonds have been strong portfolio diversifiers in the current market environment – a benefit that is likely to persist as long as uncertainty remains elevated – low yields across the maturity spectrum combined with central bank bond buying programs raise questions about the long-term ballast properties of government bonds and their role as diversifiers.

Asset return expectations and uncertainty, April 2020

Source: BlackRock Investment Institute, as of 13 April 2020.
Notes: Return assumptions are total nominal returns. Canadian dollar return expectations for all asset classes are shown in unhedged terms, with the exception of global corporate bonds, hedge funds and global treasuries. Visit our website for more details on methodology. It Is not possible to invest directly in an index. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance.

Our Canadian dollar-based capital market assumptions assume a slight appreciation of the loonie versus the U.S. dollar over the next five years, consistent with further gains in risk assets and a normalizing in the economic environment. However, our currency view assumes the loonie appreciates to just below US$0.75, which is well below levels that prevailed pre-crisis (see chart below). Does this degree of expected loonie strength warrant hedging the currency risk in global equities, contrary to our strategic recommendation to hold global equities unhedged to lower equity volatility (see blog post on lowering vol)? Not exactly. The risk-adjusted return of unhedged U.S. stock holdings is still higher than for a hedged position even if the expected unhedged return is lower.

USD per CAD exchange rate, 2000-2025E

Source: BlackRock Investment Institute, with data from Refinitiv Datastream, as of 29 May 2020. Notes: The chart shows the historical USD per CAD exchange rate along with our 5—year expectation. We assume the Canadian dollar appreciates to roughly 0.746 USD by December 2024 based on a linear regression model that incorporates real interest rate differentials and purchasing power parity. This information is not Intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance.