BoC Insurance As Canadian Equity Bottoms Out

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Includes: EWC, FCAN, QCAN
by: FX Analyst

Summary

Canada has shown better labor market and retail is expected to grow in the months ahead.

This is constrained by low energy price which reduces Canadian income by 3% at the time of record high debt to income ratio of 162.6%.

BoC responded by rates cut as an insurance against the economic uncertainty. Together with the recovering energy prices, Canadian equity market has bottomed out with limited upside.

Canada is situated at the north of the United States and it is the second largest country in the world by total land space after Russia. It would be an understatement to say that its economy is vital to the recovery of the global economy. This article will look at the stage of the recovery in Canada.

Improving Labor and Retail Market

Labor conditions in Canada had improved recently when Canada added 35,000 positions in January 2015 over market expectations of 4,700 jobs. This stands in contrast with the loss of 4,300 jobs in December 2014. This is the result of more people working part time so it is not a full good news for the economy. However it managed to keep the headline unemployment figure at 6.6%.

As the labor market continues to be robust, we are seeing signs of renewed optimism in the consumption which makes up for a significant 77% of the Canadian economy. We have seen favorable wholesale sales growth of 2.5% in December 2014 over expectations of 0.4% growth and -0.3% in November 2014. This is good news as improvement in wholesale normally precedes improvement at the retail sales level. This is a leading indicator of consumer spending as retailers normally order more goods from wholesalers when they expect more sales.

BOC Loosening on Low Energy Price

This is seen in the latest yearly retail sales figure from Canada which saw a 4% growth in January 2015 after no growth in the prior month.

The Bank of Canada (BoC) is not taking any chances. It loosened its monetary policy on 21 January 2015 by cutting its target overnight rate by 25 basis points to 0.75% in a move which surprised the market. The BoC cited low energy prices for the reason behind the rate cuts and sees it as a net negative for Canada. This is a different view from the Fed which sees it as a net positive for the economy and is expected to tighten in mid 2015.

The BoC sees strong growth in the non-oil exporting sector but sees too much uncertainty over this period of low energy price. Hence it has decided to cut its target rate as an insurance move as seen in the quote below:

"The oil price shock increases both downside risks to the inflation profile and financial stability risks. The Bank's policy action is intended to provide insurance against these risks, support the sectoral adjustment needed to strengthen investment and growth, and bring the Canadian economy back to full capacity and inflation to target within the projection horizon."

The BoC has a base price of $60 for oil prices and assuming that they are referring to West Texas Intermediate (NYSE:WTI) Crude oil which is the main oil benchmark in North America, there is still some price recovery for oil to go as seen in the spot price of WTI below.

In a speech last week, BoC Governor Stephen Poloz explained that the January 2015 rate cut was to buy time for them to assess the economic impact. Poloz reiterated that the BoC sees the lower energy price as net negative for Canada as it will increase the debt to income ratio of Canadian households which grew to a record high of 162.6% in the third quarter of 2014. This is at a time where low energy prices are expected to cut 3% of income for Canada according to Poloz. This would increase the possibility that the BoC will cut rates again in its March or April 2015 meeting.

Bottoming Canadian Equity Market

This cautious approach by the BoC is likely to be bullish on the Canadian economy. The fact that the labor market has stabilized somewhat combined by a recovering retail environment should provide a bottom for the Canadian equity market.

We can observe from the iShares MSCI Canada ETF (NYSEARCA:EWC) above that it has bottomed out at the $26-$28 after plunging from the peak of $33 in September 2014. This seems to suggest that the market has priced in the weakness of the Canadian economy from the low energy price from its commodities based economy.

The anticipated rates cut by the BoC should provide some limited upside for the EWC but this is constrained by the weak balance sheet of the average Canadian household. So while there is some good news anchoring the recovery of the Canadian equity market, it is also unlikely to surge in the next 2 months.

The EWC is comprised of the leading companies in Canada such as Royal Bank of Canada (NYSE:RY), Suncor Energy (NYSE:SU) and Transcanada Corp. (NYSE:TRP). This ETF is highly diversified across sectors such as basic materials, financial services, energy, industrial, etc. It is also liquid with market capitalization of $2.53 billion and daily transaction volume of 1.09 million. For those who wants to diversify their investment portfolio into the Canadian economy, EWC would be a good addition to ride the ongoing recovery of Canada.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.