What corporate outlook, inflation say about economy

This year’s positive Canadian economic data has indicated a steady, albeit slow, improvement in the economy, says equities expert Colum McKinley.

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Speaking during a mid-May interview, before recent inflation and retail data, McKinley said, “We actually have seen signs over the last several quarters that suggest economic growth is, at minimum, continuing [and] some signs that it is actually improving.”

The pace of economic growth in Canada slowed in the first quarter of this year to 1.3%, its lowest rate in nearly two years, as housing investment pulled back amid new mortgage stress test rules and a cooling housing market. That compared with an annual pace of 1.7% in the fourth quarter of 2017. For 2017 as a whole, the economy grew 3%.

There are other positive signs for the economy, though. Canada’s unemployment rate for May came in at 5.8%, the lowest since 1974.

“The health of the overall economy is getting better,” McKinkey said.

Read: Why economy lost 7,500 jobs in May

More people working means they’re going out and spending money, says McKinley, vice-president of Canadian equities at CIBC Asset Management, and a manager of the Renaissance Canadian Core Value Fund.

Corporate earnings

Positive corporate earnings are another indication of how well the economy is doing, McKinley says. For example, all of Canada’s Big Five banks reported Q2 earnings this year that exceeded expectations.

Read: Promise and opportunity in energy and banks

Overall, he says, “companies have done a very good job of controlling costs and they’re now marrying that lower cost with stronger revenues.”

McKinley sees the optimistic tone of corporate leaders as a boon. He’s heard companies talk about their business growth plans, which include increased hiring, as well as about deploying capital, introducing new products and building new facilities.

These types of remarks support stock valuations, he says.

Still, recent surveys suggest corporate directors have a cautious, near-term outlook on the economy. A survey commissioned by the Institute of Corporate Directors (ICD) between March and April found only 34% of survey respondents believe the Canadian economy will improve over the next two to five years, down from 52% in a fall 2017 survey.

Meanwhile, a 2018 EY survey says executives are equally concerned about trade issues and recent changes to Canadian tax, regulatory and fiscal policies. A majority (59%) cited the potentially negative impact of those issues on Canadian companies.

Read: Corporations cautious on Canadian economy: surveys

Inflationary pressure

McKinley’s keeping a close eye on inflation, which Statistics Canada reported was 2.2% for the second month in a row in May, despite expectations of a steep rise. The Bank of Canada’s target rate is 2%.

“We are a generation of investors that haven’t dealt with inflation for most of our investment lives,” McKinley said in May. “As the economy starts to improve, watching signs for inflation starting to rear its head is incredibly important.”

Read: Inflation rises for second straight month, but data disappoint

Inflation is far from out of control, but some companies are seeing pricing pressure, he says. “Where they’re seeing it is if you have businesses that have base materials that are priced off energy or oil. [There], you’re seeing input costs increase and transportation costs have increased quite dramatically as well,” McKinley says.

“We’re seeing a fairly dramatic increase in trucking pricing across North America. As companies see these costs increase across their businesses, [one option…] is they pass that through consumers; that’s inflation,” he says. “That is cost plus inflation that would start to come into the economy.”

Alternatively, “if companies don’t pass through pricing increases, then their margins come under pressure. So we would see a scenario where companies have better growth and volume, but less profitable businesses,” he explains.

As a result, he’s monitoring closely “to see if margin compression or inflation starts to raise its head, and whether or not that needs to be priced into our expectations.”

Portfolio picks

As of mid-May, McKinley favoured companies that had the power to pass on pricing increases. Some examples in the Canadian market were railway companies such as CN Rail and CP Rail. Both, he said, have had strong pricing power in the last 10 years as well as a history of managing costs.

“They have an ability to look within their network and identify opportunities to control costs,” McKinley explains. “A combination of these two [things] will allow them to maintain and sustain their profitability as we start to see changes and acceleration in the economy.”

Overall, McKinley looks for exposure to what he calls “good businesses,” or companies that have the ability to price their products accordingly and manage costs.

Also read:

Advisors concerned about volatility, rising rates: survey

Why financial sector will be strong this year

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