ECONOMIC & FIXED INCOME COMMENT- The path to recovery is still unclear
Six months have passed since COVID-19 was declared a global pandemic and it has taken a tremendous toll on the global economy. Without the prompt and effective policy support introduced by governments and central banks, the global economic collapse could have been considerably worse. The Organization for Economic Co-operation and Development (OECD) is forecasting global growth to contract by 4.5% in 2020 and recover to 5% in 2021. Although the initial recovery has been impressive following the easing of strict containment measures and the reopening of businesses it won’t be enough to absorb the economic slack inflicted by the pandemic until 2022 (see chart). The question for many economists is whether sufficient support can be maintained until there is a vaccine that eradicates or contains the spread of COVD-19.
At this time, signs indicate that the recovery is losing momentum with rising COVID-19 case numbers in several countries. If a stronger resurgence of COVID-19 takes place (i.e. second wave) there could be severe ramifications to global GDP in both 2020 and 2021. The OECD worst case scenario could see global GDP for 2021 slashed by 2% to 2.5%. However, many economists believe that the sudden rise in COVID-19 cases does not change their fundamental economic forecast as of yet. There are two main reasons behind this rationale. Firstly, the public health response will be more targeted as there have been lessons learned in how to slow the spread of COVID-19 as compared to the initial broad-based shutdowns. Secondly, hospitalization and mortality rates remain below spring levels (mainly due to demographics of those with COVID-19) so concerns of overwhelming the health system are not immediate.
In Canada, Q2 GDP contracted by a record 38.6% (annualized) with consumer spending, residential and business investment and government spending declining sharply in the quarter. The pull-back was widely expected however, it was not as negative as originally forecast by the Bank of Canada (BoC) at -43% in its July Monetary Policy Report. The strong fiscal support from the Government of Canada has been a major contributor to keeping the economy running. Both Q3 and Q4 GDP forecasts have been revised upward due to a better than expected early recovery (40% annualized in Q3 and 6% annualized for Q4.) As of July 31st, Canadian GDP is down 5.8% from pre-pandemic levels in February. Most private sector forecasters don’t anticipate a full recovery before 2022. The OECD is forecasting 2020 GDP for Canada to be -5.8% and 4% in 2021.
Turning to the outlook for fixed income we see both the Federal Reserve (Fed) and the BoC keeping its policy rates unchanged for at least the next 24-36 months. The magnitude of the recession and constraints surrounding the recovery are expected to cause output gaps to linger well into 2022 on both sides of the border. The constraints include:
persistent labour market slack- recent job losses becoming permanent and unemployment rates remaining noticeably above their pre-pandemic levels. As of September, US unemployment was 7.9% and Canada’s unemployment is 9.0%
larger private-sector debt burdens
restrained business and consumer confidence
Furthermore, it is estimated that inflation will remain below the 2% target for both Canada and the US until the end of 2022. This should keep the short end of the yield curve well anchored.
The bond market had positive returns during the third quarter. In the short-term market, Government of Canada bonds returned 0.28% while provincial and corporate A bonds returned 0.49% and 1.51% respectively. In the mid-term market, Government of Canada bonds returned 0.27% while provincial and corporate A bonds returned 1.00% and 1.99% respectively. The strong relative performance of the provincial and corporate sectors have been driven by improved liquidity through Quantitative Easing programs provided by the BoC. Furthermore, credit spreads have continued to narrow in the third quarter in both Canada and the US. Specifically, US investment grade corporate bonds have retracted 90% of the spring widening while Canadian corporate investment grade bonds have retracted 75%.
Our strategy for the balance of the year is hold the duration slightly above benchmark as interest rates will remain fairly stable. Furthermore, we will continue our yield tilt portfolio strategy as we believe both the Provincial and Corporate sectors will continue to outperform federal bonds in Q4. However, the pace will be slower than witnessed in the previous 6 months.