Canadian government actions to contain the spread of COVID-19 have been more stringent than those in the U.S., with Ottawa moving more slowly to relax restrictions and reopen its economy. The slower pace has benefited Canada’s public health, as the daily count of new cases has fallen dramatically, while cases in the U.S. have surged. This has raised questions about the medium-term resiliency of the U.S. recovery relative to Canada’s because additional U.S. policy actions to restrict mobility are likely needed. Indeed, six states in the U.S. have already reversed course on relaxing social distancing restrictions, while an additional 14 have halted their preexisting reopening plans.
Nonetheless, while some modest outperformance in the Canadian economy is possible over the next few quarters, we continue to believe that the overall impact of the novel coronavirus on the Canadian economy is likely to be larger, and the effects longer lasting, than in the U.S.
In March, we highlighted three structural factors that make Canada more susceptible to domestic and global growth shocks – a higher reliance on oil and other exports, and higher household debt. We continue to believe these factors are likely to weigh on the country’s recovery.
In addition, Canada’s somewhat weaker fiscal response thus far is another factor that could slow the Canadian recovery relative to the U.S. Similar to the U.S., Canada has implemented various measures to directly support jobs, incomes, and specific sectors through the temporary disruption in economic activity; however, U.S. government transfers to businesses and households have been larger (15% of GDP versus 9% in Canada) and a larger portion of the Canadian stimulus has come in the form of measures to benefit business and household liquidity, and ease credit conditions.
The Canadian focus on liquidity will ensure a continued flow of credit to the economy, and benefit the longer-term federal debt trajectory. However, these measures could also further increase household and business-sector liabilities and necessitate higher future private sector savings balances and slower growth.
Canadian government officials have the full support of the Bank of Canada (BOC) to expand and extend fiscal stimulus. And we expect the federal government to take advantage of this support by, at a minimum, further extending the Canadian Emergency Response Benefit, which will start to run out in September. However, more might be needed. Extending and expanding direct government support should help prevent longer-term economic damage that could depress the Canadian economy’s real neutral rate of interest (r*) and complicate the BOC’s ability to meet its inflation target.
Crisis response: Canada versus the U.S.
Relative to the U.S., Canada has focused a larger share of its government programs toward providing liquidity to households and businesses. Indeed, measures including temporary tax deferrals, loan guarantees and outright purchases of mortgages insured by the Canada Mortgage and Housing Corporation have been larger as a percentage of GDP than more traditional programs that provide direct support through grants, tax rebates and unemployment insurance benefits.
According to Canada’s latest Economic and Fiscal Snapshot, the programs that focus on maintaining business and household liquidity add up to roughly 14% of GDP in support (versus 6% in the U.S.), while outright government transfers have been smaller at 9% of GDP, compared with over 13% in the U.S. (with another 5%-of-GDP stimulus package expected to pass the U.S. Congress in July). These government-sponsored liquidity measures include income tax deferrals and deferred remittances of customs duties and sales taxes. In addition, the government has provided lending support through the Emergency Business Account Program, and through additional loans and loan guarantees to small- and mid-sized businesses. These measures, coupled with outright purchases through the Insured Mortgage Purchase Program, add up to roughly 14% of GDP (see Figure 1).
While these programs can provide a necessary funding bridge through a period of virus containment efforts and mandated business closures, they will also increase business and household liabilities when Canadian business and household debt to GDP is already around 200% – well above U.S. levels. Eventually these liabilities will need to be paid back. And research has shown that high private sector debt, and low private sector savings rates, can precede periods of economic weakness and deleveraging, and likely will slow the Canadian recovery.
Shifting consumer behaviors necessitate economic adjustment
Moreover, changes in domestic and global consumer spending patterns due to the pandemic could make Canada’s liquidity and credit support measures less impactful. As with the U.S., we think Canadian consumers will generally prefer to maintain higher levels of personal savings and more permanently shift their spending habits – a trend that could lead to a new mix of consumption and exports. Indeed, high frequency data suggest consumers are spending less on travel and leisure services, and more on substitutable home-use durable goods – including electronics and recreational equipment – and on internet services.
These emerging trends, if sustained, will require a shift in labor and economic resources away from some industries and toward others – a process that will take time and could necessitate more government support in the form of expanded social safety net programs, including emergency unemployment benefits, and less reliance on liquidity programs.
Income replacement reduces the risk of collapse
Finally, strengthening the argument for a further extension in emergency benefits, we think these programs have and are reducing the risk of a collapse in the financial and housing sectors. However, continuing to mitigate this risk until a vaccine or other therapeutic treatment can be mass produced will likely take a further extension in government support. Despite the headwinds, Canadian banks remain very well capitalized, and Equifax data suggests that households reduced their credit balances in the first quarter as a result of virus-related social distancing measures.
While we expect mortgage arrears to pick up, these government social safety net programs will likely keep levels quite low in absolute terms, and comparable to rates in the U.S. A recent BOC analysis of the pickup in mortgage arrears following natural disasters estimates that Canadian mortgage market arrears could increase to 1.3% of outstanding loans in the absence of government stimulus measures, but government emergency income replacement programs may limit the increase to about 0.5%.
Similarly, these programs are likely supporting housing prices and, with continued support in the form of a further extension of the Emergency Wage Subsidy, we suspect the dire Canada Mortgage and Housing Corporation’s forecasts for a 9% to 18% decline in home prices this year won’t come to fruition.
The Bank of Canada is standing by
The Canadian government deficit is expected to total roughly C$350 billion this fiscal year, and to remain high next year. However, the BOC is standing by to support government efforts to stimulate the economy.
By some measures, the BOC’s quantitative easing program has been one of the most powerful among developed economies, especially vis-à-vis the U.S. and Europe. Indeed, the BOC’s government bond purchases have been skewed toward longer- dated maturities, on a duration-adjusted basis. This has served to flatten the term structure of interest rates in Canada relative to other developed economies, and, in our view, will continue to be a force driving yields in the near future. We also believe it will create a portfolio rebalancing effect, serving to drive investors into provincial, mortgage and corporate debt, and other higher-yielding alternatives (which, in turn, will bring down funding costs for those borrowers).
With the BOC’s support, extending and expanding direct government checks to households and businesses could ultimately prevent longer-term economic damage, which could depress the Canadian economy’s real neutral rate of interest (r*) and complicate the BOC’s future ability to meet its inflation target.
The investment implications of our analysis of Canada’s economic recovery path are threefold.
One, the significant indebtedness that will emerge from the COVID-19 recession will necessitate low interest rates for an extended period of time to allow the economy to recover and grow out of debt. In our view, interest rates on higher-quality debt, including government bonds, are poised to remain depressed for the foreseeable future.
Two, an environment of low yields will increase demand for higher-yielding fixed income, as an aging population stretches its risk tolerances to build capital for retirement. Hence, we are constructive on high quality spread products, although we recognize there will be industry-specific winners and losers as consumer behaviors change on the long road to recovery. In general, we have a strong preference for sectors benefiting from implicit or explicit government and central bank support. These include provincial and corporate sectors where initial conditions of indebtedness are low and the extent of disruption from COVID-19 to business models are more modest.
Three, and most important, we believe Canadian fixed income investors will stand to benefit even more from diversification of their portfolios outside their home market. These represent a 50-fold opportunity set relative to Canada and include countries where economic and market impacts from the global recession will likely create additional investment opportunities that offer both higher yields and more attractive total return potential.
Sectors we view as particularly attractive in the current environment include U.S. securitized debt, including agency and non-agency mortgages, global financial credit, and select high quality emerging market sovereigns.
Please see PIMCO’s “Investing in Uncertain Markets” page for our latest insights into market volatility and the implications for the economy and investors.
For detailed insights into our views across asset classes, please read our July 2020 Asset Allocation Outlook, “Building Resiliency Amid Uncertainty.”