The Canadian economy has entered a period of stagflation that will impact market returns in the years ahead, says Stephen Johnston, director of Asset Management in Calgary. Regardless of whether U.S. President Donald Trump makes good on his threats to impose tariffs on Canadian imports, portfolio managers will have to adapt to a new period of slow economic growth and stubborn inflation.
Make no mistake though. A trade war will make matters worse. “I don’t think you can continue on as you’ve done historically,” Johnston said.
We’re not the only economy facing down a slow-growth, high-inflation future. Any country that depends significantly on U.S. consumers for its goods is at risk, as Washington seeks to rebuild America’s domestic manufacturing base. “Canada is the poster child for that,” Johnston said. “We’re the most reliant, as a percentage of our GDP, on the U.S. as a counterparty.”
Johnston said that Canada’s predicament is its own doing. “We’ve really painted ourselves into a corner,” he said. Other developed economies invest greater sums than we do in productive capital — machinery and intellectual property, for example — that contributes to economic growth. According to Statistics Canada, residences make up about 54% of total fixed capital stock in Canada.
“We invest in residential real estate at all-time-high valuations,” he said, driven by two decades of historically low interest rates. “It’s all inflationary.”
That lack of productive investment has contributed to Canada’s current account deficit. “We buy from other countries and we fund that consumption with debt,” Johnston said. “We’ve done it for decades.”
Add to that the inflationary effects of deficit spending at all levels of government, no matter the party in leadership.
Hedge your bets
It hasn’t always been a smooth ride, but Canadian investors have done well with a buy-and-hold strategy in recent decades. Some version of the traditional 60/40 portfolio fared well as a result of low borrowing rates and middle-income purchasing power.
The ramp-up in retail investor interest in alternatives is a clear sign that the game has changed.
“We like farmland,” said Johnston. “It lasts forever and produces commodities. … People don’t stop eating, so it tends to hedge stagflation really well.”
Asset Management has also taken private equity positions in automobile maintenance and environmental sciences, for example. The former is expected to see an upswing in business as Canadians find ways to squeeze more kilometres out of the family car. The latter continues to deliver growth as a result of the introduction of new regulations.
“As regulations are drafted, you have to comply with them, regardless of economic conditions,” Johnston said. “So you see very low correlation between the growth in environmental services and GDP.”
Johnston also likes lower-mid-market companies, which he said can be had at six times cash flow. Compare that to a stock on the S&P/TSX composite index — the average price-to-earnings ratio on Canada’s main equity index is close to 19.
Things get a bit more complicated when you look at other inflation hedges.
Commercial and multi-tenant real estate are “trading at record-high valuations,” Johnston said, largely as a result of outsized consumer and business debt levels.
Similarly, infrastructure valuations have been driven up by institutional investors desperate for yield. Cryptocurrencies, which some have begun touting as an inflation hedge, are too volatile, he said.
“It’s one thing to get all the macro drivers right,” Johnston said. “But if you buy an asset at an inflated valuation, you’re typically going to lose money.”