Vanguard Canadian Quarterly Overview & Outlook: July, 2020
24 July 2020 | Markets and economy
Commentary by Bilal Hasanjee, CFA®, MBA, MSc Finance | Senior Investment Strategist, Vanguard Investments Canada
The global COVID-19 pandemic and associated lockdowns have caused the sharpest and deepest short-term economic contraction in modern history. Even as countries in Asia and Europe brought the number of cases under control in early July, the count continued to grow globally, fuelled by increased outbreaks in emerging economies and parts of the United States. The twin crises of health and economics are far from over.
Our estimate of an unprecedented peak-to-trough drop in global GDP, compared with pre-virus levels, is about 9%. Comparable collapses in economic activity are difficult to find outside wartime. In particular:
- The global financial crisis saw global GDP fall by 6.0% peak to trough1
- The Great Depression of the 1930s saw global GDP fall by 12.1% peak to trough2
- The global recession that followed the oil price shock of 1973 saw global GDP fall by 1.8% peak to trough3
Vanguard expects a moderate recovery in the global economy in the second half of the year as supply gradually comes back online after interruptions owing to COVID-19 containment efforts. But we expect economies to lag behind pre-virus trends as shocks to incomes and contagion fears limit demand.
In this article, we discuss our economic views on Canada, the US and other international economies; our long-term expected returns forecasts across equities and bonds for both Canadian and international assets; and our forward-looking scenarios of $ 9 trillion spending and debts undertaken by the world's largest economies.
Growth & Output
As a result of the pandemic-induced sharp decline in global demand for oil, virus-induced lockdowns, and a sharp increase in unemployment, we expect Canadian GDP to fall significantly compared to our 1.8% growth expected at the beginning of the year. We now anticipate the GDP to fall between 5% and 6% in 2020, based on our probabilistic scenario analysis (compared to 6%-7% contraction at the end of Q1). We anticipate three scenarios: Baseline, Upside and Downside (see Figures 1 & 2).
Expansion of fiscal support, notably the CERB (Canada Emergency Response Benefit), has been a major driver in limiting the severity of the slowdown and a key reason for our upwards revision (along with higher commodity prices). Fiscal support so far seems adequate to avoid a large default cycle among highly-levered Canadian households, though this remains a key risk.
Figure 1: Canadian GDP Growth Scenarios
Source: Vanguard. As of July 2020.
Figure 2: Key Economic Forecasts
Source: Vanguard. As at July 2020
Canadian CPI is expected to remain under pressure due to reduced demand and depressed commodity prices. Our baseline forecasts showed both headline and core CPI will face significant downward pressure and remain at or below 1% for much of the crisis. For 2020, we expect headline CPI to be between 0% and 1%, with a brief dip below 0% likely during the summer months.
Canada reported back-to-back stronger-than-expected job gains in May and June, adding over 1.1 million jobs, in the last two months of the quarter, as opposed to survey forecasts of 200,000 job losses, highlighting the potential for a swift resumption to work as the country demonstrated relative success in taming COVID-19. However, challenges remain as rising new virus cases in the U.S. accentuate risks to the prospects of reopening the economy, while indirect impacts on confidence may persist for a protracted period. The June unemployment rate is still in double digits at 12.3% and slightly higher than expected. Vanguard expects increasing job gains in the coming months, with uneven recovery and considerable data revisions.
Interest Rates: Monetary Policy and Asset Purchases
The Bank of Canada (BOC) maintained its target for the overnight rate at 0.25% at its policy meetings in March, April, June and July. The BOC said that short-term funding conditions had improved, allowing it to scale back term repurchase operations to weekly. It said its programs to purchase federal, provincial, and corporate debt were continuing at their present frequency and scope. The baseline expectation for asset purchases has been revised higher to total between $300 and $450 billion this year.
We believe that Canadian interest rates will remain under pressure across both the short and the long end of the curve due to unprecedented monetary easing (impacting the short end of the curve) and BOC's asset purchases (affecting the medium to long term interest rates).
The Canadian dollar demonstrated relative strength compared to other commodity currencies after the initial Covid-19 related market shocks. As an immediate aftermath of the pandemic-induced flight to quality and liquidity crunch during March, the loonie traded over 1.45 against the greenback, depreciating almost 12%, from its peak levels at the beginning of the year, but managed to recover ten cents over the course of Q2 to end Q2 above 1.35.
The loonie's relative métier against other commodity currencies is attributable to the economy's 4 relative strengths: (1) Political stability; (2) The government's credibility for substantial and decisive corrective action in the wake of the pandemic relative to other commodity economies; (3) Its energy & mining sector constitutes a comparatively smaller portion of its GDP; (4) Canada's ability to attract foreign capital inflows even during the pandemic, bringing in a record $49 billion, during April, to Canadian securities.4
On the downside, however, we are concerned about these key factors that may play to the Canadian dollar's weakness during the months ahead: (1) Weak, global oil demand and its negative impact on the Canadian jobs, consumption and GDP; (2) Lower real estate prices that could reduce consumption and real estate activity; (3) Stressed consumer balance sheets due to housing and other consumer debt; (4) Substantial dependence on foreign investors to finance budget and current-account deficits. Our medium-term (2 to 3 years) outlook for the currency is to trade in a 1.30-1.45 range against the USD.
In the U.S., we expect output to fall in the second quarter of 2020 before staging a slow and gradual recovery. We expect the recession to be short-lived (in fact, the shortest ever), with recovery likely starting in Q3. And there are already signs—such as a stronger-than-expected May and June jobs report and the retail and food services report showing sales rose 17.7% in May and 7.5% in June —that economic activity is picking up. U.S. GDP is not expected to get back to its pre-virus level until the end of 2021, and it likely will be well beyond that before it closes the output gap.5
Vanguard's outlook for 2020 includes a U.S. economic contraction in a range of –7% to – 9% and as per our estimates, US GDP contracted in the second quarter by as much as –30% to –40%. But we foresee positive growth rates starting in Q3 and growth potentially reaching double digits in the second half of the year. We also recognize that significant risks to the economy remain.
We foresee global growth falling by about –3% in 2020, the largest ever recorded outside wartime. With that view, Vanguard is more bullish on the global economy than the International Monetary Fund after the latter's most recent economic outlook, though we're less optimistic than much of the industry.
Only in China do we expect the recovery to be faster and more V-shaped, with an expected second-quarter rebound in GDP in the high single digits compared with a quarter-on-quarter contraction of –9.8% in the first quarter.
Given the severity, variety and volatility of the COVID-19 impact on global economies, Vanguard has taken the unusual step of releasing a fully comprehensive mid-year update to our global economic and market outlook.
Future Expected Returns (Our Median Forecasts)
We take a long-term view on investing, and we encourage our clients to do so as well. This is part of the reason we look at annualized returns over a ten-year period. Equities have generally rallied from the bottom they experienced at the onset of the broad market sell-off in March, leaving moderate room to grow before they reach their fair value. Looking over the next ten years, our stock market outlook has moderated due to the role that currently extended valuations have played in our long-term forecast, in which we see fair value moving lower as interest rates and inflation begin to normalize.
Our median 10-year returns expectations for Canadian Equities at the end of Q2, 2020, ranges from 5% to 7%, compared to a 6% - 8% range in Q1, 2020 – one percentage points per annum drop in returns, over the next ten years.
Similarly, our median 10-year returns expectations for global stocks (ex-Canada, unhedged) as of June 30, 2020, hovers in a range of 5% - 7%, as opposed to a 7% - 9% range expected at the end of March, 2020 – a 200 basis points reduction on a per annum basis over the next decade.
Our models also indicate a drop in bond returns across the board for Canadian and international bonds. Longer term expectations for fixed income have moderated further as a result of the lower interest rate environment. Despite a lower expected total return for fixed income, the role of bonds in a balanced portfolio has not changed in our view. The diversifying properties of bonds to provide ballast to equity volatility remains.
At the end of Q2, 2020, we anticipate that median 10-year returns for Canadian bonds will range from 0.50% to 1.50%, compared to a 1.00% - 2.0% range in Q1, 2020 – nearly half a percentage point per annum drop in median expected bond returns, over the next ten years.
Similarly, our median 10-year returns expectations global, ex-Canada bonds as of June 30, 2020, hovers in a range of 0.5% - 1.50%, as opposed to a 1.00% - 2.00% range estimated at the end of March, 2020 – a 50 basis points reduction on a per annum basis over the next decade.
What about Growing Government Debt?
In a coordinated global effort to thwart the economic impact of the pandemic, governments and central banks in the world's largest economies opened flood gates to monetary and fiscal stimulus packages, resulting in more than $9 trillion in spending, loans and loan guarantees. A key question asked by investors is how this massive debt will impact these economies in the coming years? Here is our view:
- Much of this outlay is unlikely to recur, and the structuring of much of the fiscal response as loans rather than grants makes such bold moves more palatable. These loans and equity stakes can be thought of as government investment in those assets
- Thus, any increase in debt from those disbursements could be reversed as those equities are sold or as the loans mature, except for a small percentage of possible bankruptcy losses. According to the IMF, more than half the total fiscal response in the largest developed and emerging economies belongs to these categories6.
- The debt-to-GDP ratio for these economies jumped 24 percentage points in about two months, this compared to a similar increase in the ratio during the 2008 global financial crisis that took two years. The average debt level for these economies is at 154% of GDP (see Figure 3). As striking as these figures sound, most policymakers and market participants understand that debt sustainability—the cost of servicing debt compared with economic growth—is far more important than the cold, hard headline number. In that respect, although the health shock led to unprecedented emergency spending, our low-interest-rate environment is a favorable backdrop. It's more than conceivable that developed-market economies can grow out of their newfound debt.
Figure 3: A Multitrillion-Dollar Global Fiscal Commitment
Note: The bars show announced fiscal measures in selected G20 countries as a percentage of GDP. Source: International Monetary Fund, as of May 13, 2020.
- With solid, yet realistic, growth rates in coming years as economies bounce back from pandemic-induced contractions, we could see debt in these economies returning to pre-COVID levels by the end of the decade (Scenario 1, Figure 4). Moreover, even more muted growth assumptions are enough to put debt on a sustainable downward trajectory, thanks to the sub-1%, 10-year yields at which governments are issuing their debt (Scenario 2, Figure 4).
- Although fiscal consolidation—raising taxes, cutting spending, or both—is the tried and tested method for tackling debt challenges, these scenarios don't depend on draconian assumptions. Only modest fiscal austerity, in the form of budget deficits not larger than 2% or 3% of GDP, is required alongside modest growth to reduce debt-to-GDP levels. But some fiscal discipline is needed. Not even sub-1% yields would be sufficient for a grow-out-of-debt strategy if fiscal deficits remained systematically above 3%.
Figure 4: The Fiscal Math behind Debt Sustainability
Notes: Countries included in the calculation are Australia, Canada, France, Germany, Italy, Japan, Spain, the United Kingdom, and the United States.
Scenario 1 represents 4% nominal GDP growth, an average 10-year yield of 1.2%, and a 2% budget deficit.
Scenario 2 represents 3% nominal GDP growth, an average 10-year yield of 1.2%, and a 2% budget deficit.
Scenario 3 represents 3% nominal GDP growth, an average 10-year yield of 1.2%, and a 5% budget deficit.
Source: Vanguard calculations based on data from Thomson Reuters Datastream.
Important: The views and estimates discussed herein are as of July 24th and are subject to change due to the rapidly changing economic and financial market dynamics.
1 See Llaudes, Salman, and Chivakul (2010).
2 See Maddison (1991);
3 See Maddison (1991).
4 According to the data released by Statistics Canada June 16, 2020.
5 The output gap is the difference between actual GDP and potential GDP.
6 International Monetary Fund, as of May 13, 2020.
The views expressed in this material are based on the author's assessment as of the first publication date (July 24, 2020), are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc. The author may not necessarily update or supplement their views and opinions whether as a result of new information, changing circumstances, future events or otherwise.
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