Hedging the Canadian Economic Recovery

On February 24, 2015, Stephan Poloz, Governor of the Bank of Canada made the following statement:

“The negative effects of lower oil prices hit the economy right away, and the various positives—more exports because of a stronger U.S. economy and a lower dollar, and more consumption spending as households spend less on fuel—will arrive only gradually, and are of uncertain size.” (Monetary Policy Report April 2015)

The TSX Composite Index has risen close to 1700 points since the December lows led by short term recoveries in the Canadian energy and banking stocks. At the same time, we have seen a first quarter bottom in the Canadian dollar at $0.78 with now a $0.05 recovery to the current levels. The recovery has been in part due to the more optimistic comments from Governor Poloz during the last Bank of Canada press conference.

While I won’t dispute that the Canadian economy has yet to demonstrate recessionary characteristics, there are some reasons why I am not sold on the recent turn back higher. So what do I worry about?

Irrespective of the recent bounce in oil prices, there has become a fundamental shift in the energy space. A recent Financial Post article suggested that the drop in oil prices has forced over US $114 billion in spending cuts. New projects have been canceled or put on hold. This does not change just because West Texas Crude trades to $60.00. These projects were a major source of jobs and investment banking revenues. These are not coming back overnight.

As stated at the start, Stephan Poloz suggests that this can be offset by a stronger U.S. economy, more exports and more consumption by households that are spending less on fuel. To me, these offsets are turning out to be duds. While our weaker dollar makes our exports more attractive, there isn’t much of a global recovery occurring around the world, so increases in gross exports are likely to be a monetary adjustment and not real growth. At the same time, the U.S. GDP numbers released today are showing almost no growth in the U.S. economy. Is that what we are counting on for a boost north of the boarder? The lower gas prices may not have the spending effect the BoC is hoping for. Heavily indebted Canadian consumers may use the lower gas prices as an opportunity to get their heads above water on what continues to be a very stressed household budget.

While I am not trying to be overly bearish, I simply do not see the current conditions as being ripe for a new economic growth cycle. At the same time, Canadian equities are vulnerable to a negative turn in European and American stock markets going into the 3rd quarter of the year.

I am not opposed to owning Canadian equities, but I am using the recent run higher in Canadian stocks as an opportunity lock in the advance with at-the-money protective puts, particularly on energy and bank stocks. Why? To me, unless you are really bullish on a Canadian recovery, the question is how can you justify not hedging the risks?