As the signs of domestic economic weakness pile up, the Canadian stock market is curiously resilient.
Investors have been pummelled with a barrage of bearish indicators so far this year, from a stalled economy to record household debt to plunging corporate earnings estimates to bond-market red flags.
And yet, Canadian equities are off to their best start to a year in nearly two decades, with the S&P/TSX Composite Index clinging to a lofty 12-per-cent gain, even as falling long-term bond yields stoked global recession fears and stirred up market volatility over the past couple of trading days.
While the stock market and the broader economy tend to move in the same direction over the long term, it’s not unheard of for the two to diverge significantly.
“The Canadian equity market is a bit of an odd one, because we have so much concentration in banks and energy, and not a lot in anything else,” said Robert Kavcic, an economist at Bank of Montreal. “A lot of the sectors that would typically be a good sign of what’s coming down the road for the economy, like technology, industrials and consumer discretionary, we’re pretty light on those.”
Domestic equities, as a result, can be more attuned to global rather than local economic conditions. And that could spell trouble ahead for the TSX, as a rare U.S. yield curve inversion has once again brought recession fears to the fore.
On Friday, the yield on 10-year U.S. government bonds sank below the yield on 3-month Treasuries, which has historically served as advance notice of a recession. It was the first such occurrence since 2007, and it caused major U.S. and Canadian stock benchmarks to fall by 1 per cent to 2 per cent, making it the worst day in more than two months.
The Canadian yield curve also inverted on Friday, although it was hardly the first hint of domestic frailty.
Recent revisions have pushed first-quarter Canadian GDP growth forecasts into negative territory, which could amount to a technical recession if the previous quarter’s growth rate of 0.4 per cent is revised downward.
Much of the slowdown at the national level has to do with the mandatory cuts to oil production in Alberta, which were designed to ease the pipeline bottleneck.
But the weakness has also spread from the oil patch to consumer spending and the housing market. “Deflationary home prices and psychology have spread pretty much everywhere west of Winnipeg, while Toronto’s market is still in a dogfight,” Mr. Kavcic said.
Retail sales fell by 0.3 per cent in January over the previous month, marking the third consecutive contraction. “Household spending can no longer be counted on to drive above-trend economic growth in Canada,” RBC senior economist Nathan Janzen wrote.
In addition, consumer insolvencies have started to tick higher, household debt levels reached a historic high relative to disposable income in the fourth quarter, and rising manufacturers’ inventory levels point to cooling demand.
The consensus economists’ view, however, is for the Canadian economy to actually improve through the spring and summer.
“Even then, when we do see a rebound, higher interest rates will still be working their way through the system,” said CIBC economist Katherine Judge. Between July, 2017, and last October, the Bank of Canada hiked policy rates five times, which in turn has increased the debt servicing costs for many Canadian borrowers.
All of which makes this year’s equity performance that much more remarkable, but not necessarily unexplainable.
For starters, Canadian equities were poised to rise at the beginning of the year as an offset to the selloff that ended 2018. The catch-up in valuations alone was responsible for a good chunk of the gains.
Additionally, the rebound in oil prices has made the energy sector one of the year’s top gainers, as the S&P/TSX Composite Energy Sector Index has risen by 15 per cent. Canadian crude prices have stormed back by 68 per cent over that time, as production curtailments have shrunk the discount on Western Canadian Select.
Rate-sensitive sectors have also pitched in to elevate Canadian stocks. Both utilities and real estate are among the leading sectors, as they have responded to an overall decline in bond yields.
And perhaps most importantly, U.S. economic data has held up relatively well this year, which along with the U.S. Federal Reserve’s dovish turn, has set both U.S. and Canadian stocks on an upward trajectory.
But the U.S. economy is clearly decelerating. Growth forecasts through the rest of year are declining, as the boost from fiscal stimulus is expected to fade.