Stats Canada showed that the Canadian economy bounced back in May with a growth rate of 4.5%. In the U.S., GDP growth data was released last week, showing the sharpest quarterly downturn on record, driven by shutdown policies aimed at combatting the spread of the coronavirus. The negative GDP growth, however, was better than expected, with stocks finishing the week slightly higher on positive earnings news. Big tech held the earnings spotlight, with three big tech names (Facebook, Amazon, and Apple) reporting significantly better than expected results. U.S. Congressional negotiations over a fifth coronavirus relief bill were stalled as Democrats and Republicans struggle to reach terms. Looking overseas, China showed stronger-than-expected manufacturing growth, with a Purchasing Managers' Index (PMI) reading of 51.1 in July.

Canadian and U.S. stocks escaped a busy week of earnings, economic data reports, and the Federal Reserve's (Fed) policy meeting unscathed, finishing modestly higher and adding to the biggest four-month gain in both the TSX and the S&P 500 since 2009. At the same time, nervousness about the negotiations over the next round of U.S. fiscal relief, along with concerns about the sustainability of the rebound, pushed the 10-year and five-year Government of Canada yields to a new record low¹. Here are three key takeaways from last week's developments and our view of what lies ahead:

1. U.S. economy posts worst drop on record, as expected - It's no secret that the pandemic has caused widespread economic pain, and last week provided some clarity on the depth of the economic hole. The government-mandated shutdown in April and parts of May resulted in a 9.5% decline in U.S. GDP in the second quarter (equivalent to a 32% annualized decline), the largest quarterly drop in GDP dating back to 1947. Unlike past recessions, the shrinking of the economy was driven by a sharp decline in consumer spending, specifically in services, as consumers were unable to spend because they were under stay-at-home orders. Investment, exports, inventories and state spending all contracted, and only federal-government spending added to growth.

Statistics Canada released last week included the GDP growth number for the month of May, which expanded 4.5%. The agency also provided an estimate for June, calling for another 5% increase. Even with the May and June increases, the second quarter, like the U.S. will probably go into the books as the worst quarter since the Great Depression, with GDP estimated to have declined 12% from the first three months of the year.    

• What lies ahead:  The good news is that this historic decline (more than twice the magnitude of the 2008-2009 contraction) is now in the rearview mirror. Economic data in May and June have improved at a fast pace, which reflects the transition from recession to reopening. Following a two-month rebound, Canadian and U.S. retail sales are almost back to their pre-virus levels, largely helped by the direct support and fiscal transfers from the government to consumers. Also, housing in the U.S. appears to be on solid footing. June pending home sales released last week were higher over a year ago, driven by a jump in the U.S. homeownership rate and record low interest rates. Canadian building permits have also rebounded nicely, but are still lower compared to last year's level.
  
  However, the recovery seems to be losing some momentum in July, as coronavirus cases are rising in different parts of the U.S. and reopening measures are rolled back. Timely, high-frequency indicators like credit card spending, restaurant reservations and trips taken show that the resurgence of the virus is having an impact on consumer confidence and spending. Also, improvement in the labor market, a critical element for a sustained recovery, appears to be stalling. The number of U.S. workers applying for jobless benefits increased for the second week in a row. This comes at a time when enhanced unemployment benefits expired on July 31 and lawmakers have made little progress on agreeing to another stimulus package that is necessary to support incomes. We believe that a compromise will be achieved, and that U.S. and Canadian third-quarter GDP will show a snapback in activity boosted by pent-up demand. After that, we believe the economy will gradually recover heading into 2021, moving in a “two steps forward, one step back” fashion as uncertainty around the path of the virus lingers.

2) Earnings clear a low bar, and leaders keep on leading – With about half of the S&P 500 companies having reported quarterly results, 84% of the companies have exceeded analyst estimates. While the better-than-expected results are welcome, they're more a reflection of low expectations heading into the earnings season, with earnings forecast to have declined 41% in the second quarter and 22% for the year. In Canada, the earnings season is now ramping up. The consensus forecast calls for a 33% decline in earnings this year for the TSX¹.

Positively, almost half of the S&P 500 earnings are derived from sectors that are less impacted or even in some cases benefit from the pandemic. For example, technology and health care are the only two sectors that are expected to grow earnings this year. On the other hand, energy, industrials and consumer discretionary are expected to experience 50% plus earnings declines¹. This wide divergence in trends and the relative earnings resiliency of a few concentrated sectors and stocks have played a key role in the recovery of stocks prices. While this dynamic has benefited market-capitalization-weighted indexes like the S&P 500, it has created a polarized environment, which is evident in the decomposition of market returns. The largest five stocks in the S&P 500 (Microsoft, Apple, Amazon, Facebook and Google) now account for about 23% of the index and are up 30% on average this year, versus the average of the remaining 495 stocks in the index, which is down 9%².

• What lies ahead:  We expect a gradual improvement in corporate profitability and a return to earnings growth next year based on 1) a sustained but bumpy economic recovery, 2) low interest rates, and 3) corporate cost-cutting efforts. As the market breadth remains narrow, with few stocks driving the index, some have drawn parallels to the 2000 tech boom and eventual bust. In our view, a key difference this time around is that performance is more closely tied to fundamentals rather than sentiment. The handful of mega-cap technology stocks that are in the driver's seat have low debt levels, high returns and resilient earnings growth supported by consistent trends that are unaffected by market cycles (called "secular" trends). We believe that maintaining appropriate exposure to sectors with secular growth and sectors that are more defensive, as well as cyclical sectors, can better position portfolios for the wide range of outcomes that are likely. Cyclical sectors that are hit hard by the pandemic stand to benefit more from potentially faster-than-expected progress on vaccine development and an economic recovery, or a larger-than-expected new round of stimulus, while defensive and secular-growth sectors will stay in favor if the recovery proves slow with virus-induced setbacks along the way.

3. The Fed vows to do "whatever it takes" - If there was any doubt about the Fed's commitment to support the economic recovery, last week's statement provided yet another clear signal that the committee is going to do everything in its power to help fill the economic hole left by the pandemic. Officials acknowledged that the path of the virus is the most central driver of the economy, noting that while the economy has picked up in recent months, the outlook remains uncertain and activity is well below pre-pandemic levels. Aside from holding interest rates near zero for an extended time, the Fed plans to maintain its bond purchases at least at the current pace and use all of its tools to support the recovery.

• What lies ahead:  We expect monetary policy to remain a key pillar of support for equity and credit markets in both U.S. and Canada. Using Chairman Powell's words in June and reiterated again last week, the Fed is "not even thinking about thinking about raising rates," which strongly suggests that rates and credit costs will stay low for longer, reducing some of the market downside risk that would have been more pronounced without the Fed's backstop. We believe that long-term rates will only start to move modestly higher if there is a clear path for a full economic recovery, which will likely require an effective vaccine development and distribution. If the recovery stumbles and reverses course, the Bank of Canada and the Fed will become more supportive and likely increase the pace of its bond purchases.

Nevertheless, a fresh look at the three underpinnings of long-term investment returns – the economy, earnings, and monetary policy – reveals that the fundamental backdrop, while fragile, is trending in the right direction, in our view. A rebound in economic activity and corporate earnings, along with ongoing monetary-policy stimulus, should provide broad support, but virus concerns and political uncertainties are likely to spark bouts of volatility along the way.

Angelo Kourkafas, CFA
Analyst

^{Sources: 1. Bloomberg, 2. FactSet}

Important data being released next week include employment breakdowns and the unemployment rate.