ECONOMIC & FIXED INCOME COMMENT - Cautiously Optimistic... Long Road to Recovery
We started the second quarter in a very unique situation - a global shutdown. Around the world aggressive containment measures were put in place to combat the spread of COVID-19. In several developed countries, containment measures reached a peak in April and by May many countries were able to get their coronavirus outbreaks under control. This has allowed easing of lockdown restrictions and the reopening of several major economies. It is important to note that globally, there has been a consistent approach (social distancing remaining imperative, the reopening being staged and gradual and finally the importance of daily testing and contact tracing). To this end, the International Monetary Fund (IMF) is expecting the global economy to contract by 4.9% this year and rebound to 5.4% in 2021. However, this forecast assumes the following: 1. if there is a second wave, lockdowns will not be as drastic as the first half of 2020 2. better protocols are in place and medical personnel better prepared 3. A vaccine will likely be developed and mass produced in early 2021.
In Canada, GDP dropped by 8.2% (annualized) in the first quarter with domestic demand collapsing due to declines in business investment, residential investment and consumption. The second quarter is expected to contract by 32% (annualized) resulting in the worst back-to-back economic contraction. While a rebound is likely in the second half of 2020 with more of the economy reopening and firms rebuilding inventories, it won’t make up for the first half collapse in economic activity. Canadian GDP is forecast to contract approximately 6.8% in 2020 and rebound by 5.5% in 2021. Furthermore, Canadian unemployment hit 13.7% in May. The Government of Canada has been swift and unwavering in their fiscal aid packages to help support household incomes and keep Canadian businesses afloat through the lockdown period. The Canadian Emergency Response Benefit and the Canadian Emergency Wage Subsidy are the main federal support programs. The next federal government challenge will be a shift towards incenting growth, job market participation and business creation in order to help push the economy back to capacity.
There has been mounting concern over the Federal Government’s budget deficit which currently sits at $343 billion. This has caused a major credit rating agency i.e. Fitch to downgrade Canada’s credit rating from AAA to AA high. 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. These constraints include persistent labour market slack (recent job losses becoming permanent, unemployment rates remaining noticeably above their pre-pandemic levels), larger private-sector debt burdens and restrained business and consumer confidence in the absence of a vaccine.
As mentioned in the last quarterly economic comment, the Bank of Canada (BoC) has been working hard behind the scenes providing a supporting role to the Government of Canada’s fiscal aid packages. Even with a new BoC Governor, Tiff Macklem, its goal remains the same - to maintain a well functioning financial system that will help support economic recovery.
A few of the market supporting actions include:
Government of Canada Bond Purchase Program – which began in April – minimum of $5 billion a week. As mentioned, there was tremendous strain put on government bonds in March and this program has helped provide stability and liquidity to the government bond market which serves as the foundation of the credit market.
Provincial Bond Market Purchase Program - initiated May 7th - $50 billion scalable based on market conditions.
Corporate Bond Purchase Program- commenced May 26th - $10 billion scalable based on market conditions.
Since the announcement and start of these programs, liquidity in the bond market has improved significantly. As shown in the chart, both US and Canadian Investment Grade Corporate bond spreads peaked at the end of March. Since Central Bank intervention, we have seen Corporate spreads narrow through the second quarter. Going forward, we expect both central banks to keep policy rates unchanged for at least the next 12-18 month.
The bond market had solid returns during the second quarter. Government of Canada bonds returned 2.27% while provincial and corporate bonds returned 7.68% and 8.36% respectively. The difference in performance has been primarily driven by liquidity injected into both Provincial and Corporate sectors through Quantitative Easing programs and both liquidity premiums and credit spreads continuing to narrow. Our strategy for the balance of the year is to hold the duration slightly above benchmark and continue with the yield tilt portfolio. We expect both Provincial and Corporate sectors will significantly outperform Federal bonds in the second half of 2020.