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Jun 21, 2023

Opinion: Bank of Canada shows growing interest in corporate earnings, stock market

Bank of Canada building in Ottawa on May 23, 2017.Chris Wattie/Reuters In search of some telling signals about how interest-rate increases will work their way through the economy, Bank of Canada

Bank of Canada building in Ottawa on May 23, 2017.Chris Wattie/Reuters

In search of some telling signals about how interest-rate increases will work their way through the economy, Bank of Canada researchers have lately been taking a closer look at a not-so-reliable source: the stock market.

More specifically, the central bank’s research staff has been looking more closely at corporate earnings information and expectations in the market. In two recent papers, they argue that trends in this area provide valuable information about how the bank’s steep interest-rate increases over the past year and a half are playing out, and how we might expect them to weigh on different segments of the economy in the months ahead.

In one paper, economists Greg Adams and Jean-Sébastien Fontaine looked at forward price-to-earnings valuations in the stock market – prices for stocks relative to forecast profits over the next year – as a proxy for economic-growth expectations. They found that P/E ratios have been “as good as or better than” a variety of more standard economic indicators over the past two decades at predicting one-year GDP growth.

“This degree of accuracy confirms that the cross-section of valuation ratios summarizes the information contained across several leading indicators of the Canadian economy, even though publicly traded firms produce only a fraction of Canadian GDP,” the report said.

Their analysis indicated that market valuations this year imply a substantial slowing of expectations for real GDP growth in the next year, from 5.6 per cent in early 2022 to 2.1 per cent as of this past May. This decline has been driven by valuations for stocks in industries that are historically the most sensitive to interest rates, such as banks, consumer durable goods and capital goods.

The researchers also noted that this valuation-implied GDP forecast held relatively steady from February through May – the period in which the Bank of Canada took a pause in its rate hikes. It suggests that tracking the P/E ratios by industry can provide valuable signals about how different segments of the economy are affected by rising interest rates.

“The effect of higher rates is expected to vary in timing and size across sectors, which means that studying how interest-rate-sensitive sectors respond to higher interest rates shows how interest rate increases are working to balance supply and demand, and moderate inflation,” the report said.

Another recent paper examined earnings conference calls that publicly traded companies hold each quarter with stock analysts and investors. Using natural language processing – a type of AI – economists Marc-André Gosselin and Temel Taskin tracked references to supply and demand in transcripts of earnings calls, and gauged the sentiment expressed in those discussions.

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The researchers found that, during the COVID-19 pandemic, this information outperformed traditional indicators in predicting changes in the output gap – the discrepancy between demand in the economy and available supplies. Measuring the output gap is critical to the Bank of Canada’s assessment of underlying inflationary pressures, and is, thus, a vital guide to interest-rate policy.

“Central banks could benefit from incorporating our text-based measures into their forecasting models,” the authors wrote in the report. “Using textual information in forecasts is promising not only because of the strong correlation between the output gap and inflation … but also because the information in the earnings calls is timely. The data needed to estimate the output gap are usually available with substantial lags, unlike the information in earnings calls, which is immediately available.”

The Bank of Canada is always careful to point out that the views of its researchers do not amount to official policy positions for the bank. Nevertheless, the focus of its research at any given time can provide a window into what the bank’s decision makers have on their minds. And lately, the output from the research department has indicated a great deal of interest in corporate information – and more specifically, what it might say about inflation and the transmission of rate policy.

If you’ve been listening to what senior bank officials have been saying in recent months, that shouldn’t be a surprise. Governor Tiff Macklem has spoken repeatedly about the importance of such issues as corporate pricing behaviour, hiring and wage growth in assessing the persistence of inflationary pressures.

The bank has for years leaned on information that it gleans from its quarterly Business Outlook Survey, as well as private consultations with business leaders, to understand corporate sentiment and expectations – and to incorporate that information into its forecasts and its monetary-policy position.

You might recall that during the oil market collapse of 2014-2015, it was conversations with corporate leaders in the sector that convinced then-governor Stephen Poloz that business investment was about to tumble much faster and deeper than traditional data had yet signalled. That prompted his surprise rate cut in early 2015.

Now, with the sentiments and actions of the business community again forming a crucial part of the monetary-policy discussion, it appears that the Bank of Canada is exploring more timely and data-intensive ways of making those sorts of assessments.

That’s encouraging to see. Given how important the evolution of corporate behaviour will be to interest-rate decisions in the coming months, the more sophisticated the bank can get in this area, the better.