On this week’s conference call (playback details can be found at the end of the newsletter), we started off with a review of Canada’s recent economic and corporate results – both nothing to write home about. With the exception of the last few days, Canadian economic releases have been underwhelming compared to market expectations. Then we had quarterly results from Canadian Tire, Cargojet, and Cannacord that were behind what the street had forecast. Moreover, Canada is definitely underperforming the U.S. and while this divergence could narrow in the last quarter, it is unlikely. How this influences our portfolio decisions depends on the implications for monetary policy, commodity prices and the currency.

 

 

Let’s start with the economy.  The past four weeks have not been great. The Citi Group surprise index was looking so good from August to October, climbing from a level below minus 20 to plus 54 in October. Last week, the index had fallen to almost zero. Manufacturing shipments continue to rise, but at a moderated pace. Retail sales fell in the month of August, which contributed to a flat month for overall real GDP. To put this in perspective, third quarter GDP growth is going to be close to zero or four percentage points below the U.S. Employment has come off the boil and this is causing consumer confidence to slide. The wheels aren’t coming off the cart, but the cart is slowing down.

 

It's not that the U.S. economy looks wonderful. The index of leading indicators (which sadly Ottawa doesn’t prepare anymore) has fallen to the lowest level since June of 2020. The Citi surprise index south of the border has also peeled back in the last few weeks, falling to below the 40 level – the weakest since June. Weak, but far from the outright pessimistic signs we saw at the start of the year, when many analysts were calling for recession in 2023.

 

 

Consumer confidence is also sliding and the University of Michigan Sentiment index has reversed back almost to the lows of the second quarter. There is a resilience to the American consumer though and part of it stems from the fact that rising interest rates are having a smaller impact on spending behaviour than here in Canada. Debt to income ratios continue to hit records versus a situation in the U.S. where many households locked in low rates on long-term mortgages and are better able to weather the storm of higher rates.

 

So, we are watching both economies cool. That is good news. It offers us an opportunity to break or soften the positive correlation between stocks and bonds that we talked about last week. All things being equal, this should be supportive for bonds at a time when equities are flat. This is because a weaker economic environment should generally lead to compressed company revenues and earnings, but provide an opportunity for central banks to lower rates. 

If Canadian fundamentals are indeed weaker than the U.S., how should we position? At the last Bank of Canada policy meeting we heard that the output gap (the difference between the actual output of the economy and its potential) was going to close sooner than previously estimated. This accompanied the decision to maintain the official overnight rate target at the same level as the previous meeting. Yes, the Fed has also “paused” on further rate hikes, but the argument for a sustained pause is easier in Canada.

 

That doesn’t mean that we see a shift in guidance to near-term rate cuts at the December meeting, or the meetings in the first quarter, but the writing is on the wall for a Canadian economic fade that will require an agile shift in policy.

 

The portfolio prescriptions from this seem simple.  Overweight Canadian bonds versus the U.S. and go underweight on equities. Simple never existed and it doesn’t now. Ally and I remain of the view that bonds on both sides of the border are a sound investment and offer a better risk-adjusted return opportunity than stocks, at least over the next year. The problem on the Canadian side is that yields on government bonds have already dropped considerably – especially relatively to the U.S.

 

 

This past week, the gap between our 10yr government bond yield and the benchmark U.S. yield dipped below minus 0.8% (80 basis points, bps). That was close to the largest negative gap seen in 2019 and at the start of 2016 – both the tightest on record.  From a relative value perspective, this doesn’t look too enticing I admit. True, if I was back on the bond desk, I don’t think I would be playing a long CDN bond position vs a short U.S. treasury.  But, if you think the pivot to cutting rates is going to happen sooner in Canada, then I would suggest that the capital appreciation in bonds this side of the border will be better than what we will get in the U.S.

 

What if that bond spread compresses to a new record low?  Well, that means the bond position has done well. But a narrower spread to the U.S. curve means that Canadian bonds are less attractive on a yield basis. That could lead to an exodus from the Canadian market and if that exodus comes from outside of domestic investors, then we could see downward pressure on the value of the Canadian dollar. This week, the Loonie was holding above 72 US cents and we haven’t seen 70 cents since the start of the pandemic.

 

 

We broke through that level then and again at the start of 2016, which raises the question of whether we are about to break below 70 cents again. This could have an impact on any decision to cut rates, given the potential for higher imported inflation, but we are still far enough away from a first move for this to be an issue just yet. As for whether the cheaper Loonie will prompt the Bank to return to tightening, again I think that is a low probability.

 

If Canada’s economy follows a slower growth trajectory or even contracts, against a more stable U.S. economic landscape, then the portfolio prescriptions would shift from looking for higher income from equities (overweighting Canadian dividend stocks, for example) to overweighting Canadian government bonds and overweighting global growth-oriented equities.

 

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.   

Andrew Pyle

 

Conference Call Playback Details

 

Toll-free dial-in number: 1-800-408-3053

Participant Passcode: 8652295#

 

 

CIBC Private Wealth consists of services provided by CIBC and certain of its subsidiaries, including CIBC Wood Gundy, a division of CIBC World Markets Inc. The CIBC logo and “CIBC Private Wealth” are trademarks of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc.

 

This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2023.

 

Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. He and his clients may own securities mentioned in this column. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.

 

Yields/rates are as of November 17, 2023 and are subject to availability and change without notification. Minimum investment amounts may apply.

 

If you are currently a CIBC Wood Gundy client, please contact your Investment Advisor.

 

Canadian Tire Corporation, Ltd. 13, 2g, 7

Cargojet Inc. 2g, 7

 

Disclaimers

13 The equity securities of this company are non-voting shares.

2g CIBC World Markets Inc. expects to receive or intends to seek compensation for investment banking services from this company in the next 3 months.

7 CIBC World Markets Corp., CIBC World Markets Inc., and their affiliates, in the aggregate, beneficially own 1% or more of a class of equity securities issued by this company