When a black swan runs into an oil spill

There are many moving parts to this market that are causing a lot of confusion and complications. As my grandfather used to say, “Too many parts, too many defects.” We will address our views on the US and Global economies in later notes. However, following the weekend’s events and yesterday’s pummeling of the oil markets, I wanted to express the Capital Markets Strategy team’s views on Canada and the risks to the Canadian economy, equity market, Bank of Canada policy, and the loonie.

Saudi Arabia’s decision to cut prices and pump oil like there’s no tomorrow carries specific downside risks for the Canadian economy. While Alberta will bear the brunt of the economic downside, we believe the combination of the oil price shock and the global economic impact of the coronavirus will negatively impact Canadian GDP. In short, we now believe that the Canadian economy faces significant risk of recession in 2020.

We would argue there is a high probability that the Canadian economy is in negative growth, as measured on a quarter-over-quarter basis for Q1 following the rail blockades in February and now the compounding issue of a materially weaker oil sector. The economic weakness is likely to continue through at least the second quarter of 2020 or longer. Already we are hearing from oil companies with respect to capex cuts and efforts to shore up their balance sheets and protect their covenants. Historically, crude price drops of this magnitude have led to very weak economic periods. On average, when the price per barrel of Western Canada Select oil is down more than 20% year-over-year, Canada’s economy averages 0.18% (QOQ SAAR). This is on top of the potential supply-and-demand stress from the worldwide COVID-19 epidemic on Canada and what was an already weak economy, as evidenced by the fourth quarter GDP growth rate of 0.3% on a SAAR QOQ rate.

The chart shows the year over year change in the oil price per barrel as measured by Western Canada Select vs the quarter over quarter Canada GDP, seasonally adjusted and annualized, from 2009 to current. The chart is arranged from right to left in descending order of the change in oil price. There is a strong relationship between the change in oil price and GDP. As the year over year change in oil price declines so does the growth rate for the Canadian economy.

Last week, the Bank of Canada (BoC) announced a 50-bps cut to its overnight rate. In its statement, the BoC commented:

COVID-19 represents a significant health threat to people in a growing number of countries. In consequence, business activity in some regions has fallen sharply and supply chains have been disrupted. This has pulled down commodity prices and the Canadian dollar has depreciated. Global markets are reacting to the spread of the virus by repricing risk across a broad set of assets, making financial conditions less accommodative. It is likely that as the virus spreads, business and consumer confidence will deteriorate, further depressing activity.

Ok, that was last week, before the oil price shock. What are you going to do for me today?

We do not believe current Canadian interest rates reflect the economic risk, nor reflect further potential BoC action. We do believe the BoC will at least follow the US Federal Reserve (the Fed) with additional cuts, if not exceed the number and magnitude of the cuts. We would suggest the economic impact from the global containment efforts of the coronavirus, combined with the oil price shock, will have a greater impact on the Canadian economy than on the US economy. Following last week’s announcement, the Bank of Canada will have to play a significant encore to support the economy, given the new headwinds. And while the market is pricing in an additional 50-bps cut for April’s meeting, we believe the BoC will have to be more aggressive. A 75-bps cut that is taking the overnight rate to 50 bps is a probable scenario, with the potential for even further cuts into the summer.

The combination of lower oil prices and rate cuts has taken the Canadian dollar down approximately 4% over the last couple of days to approximately US$0.7272 (at time of writing). We believe there is further downside potential to US$0.70 (or C$1.428) on realized rate cuts that may be deeper in Canada than the United States. What is interesting is that our fair-value model suggests that the correlation between the Canadian dollar and the interest rate differential between Canada and the United States has completely broken down. The loonie is trading back on its petro-dollar status. To that end, assuming the oil price war persists over the next two quarters and with respect to our view that the BoC may need to be more aggressive with rate cuts than the Fed, we believe there is further risk to the downside to a range of US$0.695 (C$1.439) and an upper bound of US$0.755 (C$1.324).

The chart shows the three month correlation of the CADUSD exchange rate compared to oil price as measured by West Texas Intermediate and spread between the US 2 year yield and the Canadian 2 year yield from 2016 to current. The magnitude of correlation of either oil or 2 year spread to the exchange rate varies over time. Recently, the it has been oil prices that have had the largest effect on the CADUSD exchange rate, at near 90%, while the interest rate differential as dropped from a correlation of 40% down to less than 10%.
The chart shows the year over year change in oil prices as measured by West Texas Intermediate compared to the year over year change in earnings per share for the S&P/TSX index, lagged 3 months, from 1995 to current. There is a string relationship between the change in oil prices and the direction of earnings growth. As oil prices fall, earnings growth tends to fall with a lag of three months. The chart assumes that if oil were to average $40 for the next nine months, that earnings growth on the S&P/TSX would fall by approximately 30%.

At the start of the year, we held the Canadian equity market in favour to the US equity market on better earnings growth and better valuation. That held through the early downside and was supported by the S&P/TSX Composite Index outperforming the S&P 500 Index with less downside through the correction to Friday. However, following the drop in oil prices, our view has changed. Historically a drop in the price of oil as we have seen over the past couple of days has had a negative impact on S&P/TSX Composite earnings (see the chart above). Given the likely sustained low price for oil, earnings are going to suffer a significant downward revision. As such, Canadian equities are unlikely to provide downside support, relative to their US and international peers. that we believed existed prior to this past weekend. From an asset allocation perspective, we believe the upside/downside potential between international, US, and Canadian equities to be roughly equal over the next 12 months and as such do not favour one over the other at this time.

What happens when a black swan runs into an oil spill? We are watching it right now.

Philip Petursson, CIM
Chief Investment Strategist

A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.

Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.

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Kevin Headland

Kevin Headland, 

Senior Investment Strategist

Manulife Investment Management

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Macan Nia

Macan Nia, 

Senior Investment Strategist

Manulife Investment Management

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Philip Petursson

Philip Petursson, 

Chief Investment Strategist and Head of Capital Markets Research

Manulife Investment Management

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