Dr. Avery Shenfeld
July 26, 2018 12:00 pm to 1:00 pm
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[DR. AVERY SHENFELD]
Out topic for today's webinar is the Economic Backdrop. To present this, we have Avery Shenfeld with us this afternoon. And we are excited and thrilled to have him here. Avery is a Managing Director and Chief Economist at CIBC and has been with this firm since 1993. He holds a PhD in economics from Harvard University and is ranked as the top economist in the survey of Canadian Institution Equity Investors. He has received multiple awards for forecast accuracy. With great pleasure, please join me in welcoming Avery.
Thanks very much. And it's a pleasure to be here. I'm not only a CIBC Chief Economist, but I'm also actually a client of our Investor's Edge service as well. So it's my pleasure to be here. I call this presentation, "This Means War... Or Maybe Not." "Should Investors Duck for Cover?" And obviously, what I'm referring to in the title is, are we on the precipice of an ever growing trade war with the United States?" And if so, and if not, what would that mean for your investment decisions and where the economy would go.
[Victim of Our Success: Diminishing Global Slack Poses a Ceiling on Growth]
Obviously, we're concerned that if a trade war erupts it will slow economic growth, but it's worth noting that economic growth was going to slow one way or another over the next couple of years. And to some extent, that's because of all the world economy and Canada's economy are a victim of their own success, so the unemployment rates that we now have in places like, Canada, the US, Germany, Japan are at historically low levels, multi-decade lows, and simply put we're running out of room for rapid economic growth because we're running out of the workforce to generate that.
The World Bank follows a measure called the output gap. It shows how far economic activity is above or below, where we would be at full employment. And then their judgment, in fact, the world economy as a whole is pretty much approaching, the output that you'd expect at full employment.
[Even Without a Trade War, Growth Was Set to Slow]
So the result of this was that when we did our forecasts, we were already looking for World GDP growth which was almost 4% last year to by 2019 slow to about 3% because that would be the pace where having attained full employment, that's about as fast as the world's economy could grow so we can see that we have the US accelerating this year to 2.9% growth helped by fiscal stimulus, big tax cuts, but slowing to about 2% growth next year.
And you can see the Canada is already projected to run it about 2% this year and a bit slower next year, so these are not as good numbers for Canada as we saw in 2017, but they're good enough to actually keep Canada close to full employment. And this would happen even if there wasn't a trade war.
[China is Less Export-Dependent Than a Decade Ago But is Still More Vulnerable to a Trade War Than the US]
However, there are some fears, of course, that global growth could slow more than that and we have to step back and try to figure out. Well, what is Donald Trump really trying to do? Does he want to end up in a world with big tariffs on everyone or does he understand or at least some people in this administration understand that that would be a lose-lose proposition?
Our view is that Trump knows that some of his trading partners have more to lose in a tariff war or with the US than America does and so he's not hoping to end up in a world with permanent tariffs, he's hoping to use the threat or the actuality of these tariffs to bring others to the negotiating table.
And if you take China for as a case in point, you can see that China is less dependent on exports than it was a decade ago, but still, almost a fifth of the Chinese economy is exports, which is well above the US. And for China, almost 20% of their exports go to the US while less than 10% of US exports go to China. So if each country puts tariffs on the other one's goods, China has more to lose and that's why the US thinks that it can get China to lighten up on some of the other barriers it has to US companies participating in that economy.
[Venezuelan Supply Declining Much Faster Than Expected (L); But Iran Sanctions Were Twice That Shock (R)]
Inspite of the slowing, we've seen a global growth which has actually seen a bit of a weakening in some resource prices so you may have noticed that, for example, uranium prices, copper prices have come down. Oil prices still are running near $70 a barrel even with this slowing in global growth. And that is obviously good news for the Canadian energy sector. And what it reflects is actually some problems at some of Canada's competitors in the world oil market.
So particularly in Venezuela where a political crisis has seen a collapse in their oil production by more than 600,000 barrels a day gone missing as well as the threat to Iranian economic oil output, now that they're under sanctions from the US. When Iran was last under sanctions from the US, its oil production was about a million barrels a day lower than it was during periods prior to or after the removal of those sanctions. So world oil prices are trading a little higher, probably just under $70 a barrel on average reflecting this loss and threatened loss to world oil supply, and that is a bit of a plus for Canadian oil producers.
[Transport Bottlenecks, A Headwind to Capital Spending in Canada's Oil Patch, For Now]
We're not getting the full economic lift from that. Higher, oil prices, which means higher gasoline prices are not a complete win for Canada because remember, Canadians do drive cars, even the people going to an oil sands protests probably get there by car or maybe by bus, but one way or the other they're also consuming fuel, and higher gasoline prices do take up some consumer spending power. The plus side for Canada is that when oil prices rise, we typically get a lift to capital spending and hiring in Canada's own oil industry and that usually more than offsets the hit to consumers.
The problem right now is that while we've expanded the shipments of oil by rail we're almost as high as we were in 2014, which means that we're close to peak capacity there and the oil industry is concerned about whether Canada will go forward with enough new pipeline capacity to take up additional barrels of oil three or four years down the road.
So so far, we're seeing a big uplift in US oil and gas capital spending which we show on the chart at right, not really that much happening on larger projects in Canada, I think awaiting some more certainty about progress on pipelines.
[US Yield Curve Slope - Nothing to Worry About Yet]
Some people are worried about the US economy. I'm not one of the worry warts just yet. You may have read stories that look at something called the slope of the yield curve. It's a very technical term. What it refers to is the gap between 10-year interest rates and 2-year interest rates. So typically, if you invest in a longer term bond you expect to get a higher rate interest rate than if you lock your money away for a shorter period of time.
And on average, typically that gap is as much as a full percentage point higher rate on 10-year bonds. But what economic analysts have observed is that as we get close to a recession, typically two years interest rates start to rise because the central bank is raising short term rates, but 10-year rates stop rising because the market anticipates maybe the economy is going to go into recession and the short term rates will come down again.
Right now there is only about a quarter of a percent or 25 basis points gap between 10-year interest rates and 2-year interest rates in the US, which is typically where we are two years before a recession. I think you have to discount some of that in terms of its use as a warning signal because what wasn't true in those past cycles is, in this cycle, the US Central Bank, the Federal Reserve, the European Central Bank, and the Bank of Japan collectively have bought trillions in government bonds in an effort to artificially lower long term interest rates. And 10-year interest rates in the US still reflect the legacy of those purchases. So they do look low, relative to normal times, but there is an explanation other than that we're headed for recession.
Instead, what I look at is just, where are short term interest rates? Have they risen enough in the US to really cause us to fear anything other than a slowdown rather than an outright recession? And I would say the answer to that is "No." What we look historically at is, where our short term interest rates relative to inflation so we call that the real rate of interest. The lowest real rate of interest that has sparked a recession in the last several decades is a rate of interest at roughly 2%, so that's inflation plus 2.
Today, if you look in the US, short term interest rates are still actually a bit below the running rate for core inflation. So the real rate of interest is there for still negative. So we haven't really seen the kind of rate hikes yet that caused me to worry about US growth. And instead, what we're seeing is a very robust year for the US economy.
[Trump's "Biggest Tax Cut Ever" ....Not Quite But Still a Bump in US 2018 GDP to 2.7%]
Fueled, of course, by what someone said we're the largest tax cuts in US history. Actually that was Donald Trump who said that. So it's not quite true. They want the largest tax cuts, but okay, they were actually the eighth largest tax cut as a share of the economy since 1945, but they're still worth roughly 0.5% on addition to economic growth. And in an addition to tax cut, we also had a big increase in government spending passed by both Democrats and Republicans and signed on by Donald Trump. That's going to last not only in 2018, but 2019 as well. So the economy has built up a head of steam.
The equity market, I think, you've seen has responded to that in the US. And this is all about the impact of those tax cuts and spending increases on US grow. That's a here and now story, it won't last forever. And the problem is by 2019, the US economy is going to be approaching full employment and simply put they won't have the supply of workers to continue to grow at something close to 3%.
[Battle of the Budget: Fiscal Policy Boosts 18/19 Growth While Fed Works to Slow it Down. Tightening Looms for 2020? ]
Even though the budget deficit will rise more next year than this year, which is a measure really of how much stimulus is going into the economy. We don't think the economy will be responding in growth, and that's because we'll also have the Federal Reserve raising interest rates roughly a quarter of a percent every quarter. We might skip a quarter in 2019, but short term interest rates are heading higher in the US. By the end of 2019, they will have reached something close to 3%. And that's going to put an offsetting drag on economic growth. By 2020, the fiscal stimulus actually turns the other way. The US budget right now is set up for a small reduction in the budget deficit as some of the spending bill expires, some of that spending is temporary.
[Fed Hikes US Short - Term Interest Rates to Nearly 3% as US Fiscal Stimulus Eliminates Output Gap (Economic Slack)]
And so maybe there's the prospect of actually interest rates coming down a little bit in 2020. But for now we're going to see interest rates on the rise in the US, and our estimate, as I said is that, short term interest rates will get up close to 3%. That's actually above what economists think the so-called neutral rate is, that's the rate where you would normally be if you're just at full employment, but the Federal Reserve actually has to lean a little bit harder against economic growth because it's facing stimulus from deficits spending and tax cuts in the US. So the US story certainly still encouraging in the sense that we have this year very strong growth, next year growth of 2% sounds a little lower but it's consistent with what you can get at full employment.
[American Losers and Winners in Trade War: Act I]
As far as the trade war is concerned, it's important to note that while Trump has been citing tariffs as a big win for the US, it hasn't been a win for all segments of the US economy. So sure, putting tariffs on imported steel have raised steel prices in the US to the benefit of Americans steel producers, but that has been a negative for car manufacturers, appliance manufacturers who use steel as an input in what they produce.
Moreover, other countries including Canada have responded by slapping tariffs on American goods. And so far, American farmers, for example, soybean farmers, they are seeing much weaker prices because of the fears that China or Mexico won't buy US agricultural products. This is actually to some sense a good news story for Canada. Because some US industries are starting to feel heat from this trade war. Their political representatives in Washington are starting to sound the alarm bells with the Trump administration. And we've been very encouraged by developments just in the last 24 hours that suggest that the US is willing to start negotiating with Europe and backing down from additional tariffs on US vehicles.
And also just today, we had encouraging words about reaching a NAFTA Agreement coming from the US Treasury Secretary and the US Trade Negotiator, all of this is very new, but it may signal that the criticism of Donald Trump from other Republicans is reaching the White House, and we may be getting the first signs of actually a very hopeful change in tone from the Trump administration on the traded front.
[Canada Has Little Industrial or Labour Market Slack]
For Canada's economy, our main issue is just that we have to slow the economy one way or another because we're running out of unemployed people to bring back into the workforce. It's not that the Canadian economy can't grow, but it can't grow much faster than 2% without bumping up against very tight capacity use in industry as well as a very high employment rate. So as of today roughly 82% of Canadians who are between 25 and 55 are employed, and that's well off from the trough in the recession, and it's actually about as high as it's ever been. So the growth is going to be constrained by what we can achieve now given population growth and immigration, and that's a slower number than we saw in previous years where the economy had an ocean of unemployed people to put back to work.
[Poloz: Juggling Two Balls at the Same Time]
And that is why the Governor of the Bank of Canada here... We show a picture of Stephen Poloz, started to raise interest rates in the middle of 2017. He was actually trying to lean a little bit toward slower economic growth to prevent an overheating of the economy and an outburst in inflation. And the problem he's had since he started to raise interest rates is that he's trying to juggle two balls at the same time. We have seen a bit of an upturn in inflation, overall inflation is running at 2.5, it is true that if you strip out gasoline it's a bit below 2, so it's not too alarming, but it has picked up. At the same time, there are some new risks to economic growth in Canada which are telling the Bank of Canada, well, you need to go slowly on these interest rate hikes because you don't want to overdo the slowdown, you're just trying to moderate economic growth not cause a recession.
[New Rules and Rates Tighten Mortgage Availability (L),] [Household Credit Growth at Slowest Since 2001 (R)]
One of those slowing factors is the one that the Bank of Canada and Canadian regulators intended, which is back when the economy was facing a much weaker global backdrop, it was necessary to in order to get enough growth offer Canadians really low interest rates, really cheap mortgages, hope the Canadians did the borrowing and spending to get the economy back to full employment.
Now that we are closer to full employment, the Bank of Canada's judgment and the regulator's judgment is, maybe we don't need to be so encouraging anymore, to Canadians to go further and further into debt. So in past year we've had two things happen. We had interest rates start to rise and we also had new rules brought in that limit mortgage availability, that reduced the size of the mortgage that some Canadians can qualify for.
We did a simulation looking at last year's data and said that suppose these higher interest rates and tighter mortgage rules have been in effect last year, well, our estimate is that instead of having mortgages grow by 6%, that's the total pool of mortgages outstanding, they would have grown at only half that rate.
And sure enough, that's what we're seeing this year. We are seeing the monthly growth rates or the six month average growth rate that we show in the chart at right, start to slow down. Canadians have reduced their appetite for debt and that is impacting the pace of housing turnover, house prices in some of the hottest cities, and consumer spending for that matter as well.
[Toronto vs Montreal Comparison Sheds Light on Housing Story]
So this is a slowing in that part of the economy that the Bank of Canada fully intended to see. I'm not too panicked about the drop that we saw earlier this year in some cities house prices that was particularly evident for those who live in Toronto. This is not the start of an economic calamity.
And you can just see that if you look at what happened to Toronto sales volumes in the housing market and Toronto house prices, and compare that to Canada's second largest city Montreal. The big drop we saw in Toronto house prices for a while, it was just the mirror image of a crazy period last year where house prices ballooned on the order of 30%. We really just gave that back. In Montreal, that hadn't had the big upswing last year. You can see that house price inflation is fairly moderate and fairly steady.
[Condo Price and Rent Growth]
So yes, we've had a cooling in Toronto, Vancouver, but nationally, it's a relatively stable housing story. There may still be one leg to drop. I know that you can't click on Investor's Edge and buy a condo, but many investors have seen buying real estate and renting it out as an alternative investment, then of course, it's been one that has performed very, very well in the past decade. But there are some warning signs ahead on that front, particularly if you look for example at the condo market in Toronto which we chart here.
As you can clearly see from the picture, condo prices have risen a lot faster than condo rents per square foot. And the issue there is if people buying these condos for investments aren't getting a high enough interest rate to cover their taxes, their mortgage interest payments, and the occasional broken fridge that needs to be replaced, perhaps they'll start to sell off some of the condos they bought, and that's going to challenge the market because we also have a lot of condos currently under construction that are going to come to completion in the next couple of years.
[Only a Tiny Fraction of Mortgages are Overdue on Payments (L),] [No Excess Inventories of Completed But Unsold Apartments (R)]
What we're not seeing, and this is good news is, we're not seeing Canadians in a crisis over meeting the mortgage payments that they've taken on. So you see a lot of scare articles. These articles go back, oh, good, five, six, seven years saying that Canadians are going to all the fault on their mortgages, we're going to have a financial crisis. There's no evidence of that. If you look at the chart at left, less than 0.3% of all mortgages are behind on their payments. And historically, that's actually a very low number. And have we also built too many condos? I did say that maybe there's a risk to prices, but in terms of the number we built, there is no overhang of vacant or completed, but unsold apartments in either Toronto and Vancouver, population growth has justified every single one that we've built.
[Government Investment Dollars Not Going Where the Economic Slack Is]
So that's good news. Now when you have the Central Bank trying to slow economic growth in areas like, housing and debt finance, consumer spending, they must be relying on something else to keep the economy moving. One of those things was government infrastructure spending that you heard a lot about in the federal budget two years ago.
Unfortunately, if you look at the distribution of that spending this year, the big increases seem to be coming in Ontario, BC, and Quebec, which are three provinces that are essentially at full employment, and we're actually seeing weaker government capital spending in the few provinces, Alberta, Newfoundland, and Labrador, in particular where there's still a little bit of a pocket of unemployment.
[Problems for Canada Long Before Trump:] [Stagnant Industrial Capacity Limiting Export Growth]
So it's not actually being that well-targeted right now. What we're hoping is we're really hoping that exports and business investment spending pick up to take some of the place of housing as a driver of growth. You can't have an economy that grows forever on. I build you a condo, you build me a condo, look how great things are.
We need a more balanced picture. And while a lot of attention has been played to whether trade wars will impede Canada's exports, we really haven't done that well on that part of the economy going all the way back to 2000. So annual growth in either, exports or industrial capacity, that's really how many factories or mines are we opening up that could export things. That's been growing at less than 1% a year since 2000, which is a far cry from what we had in the prior decades where exports and the capacity, the industrial capacity, to grow exports were both growing.
[New Millennium Has Seen Listless Trend in Canada Exports]
So for a number of reasons actually, companies have not been choosing Canada as a place to expand in recent decades. And if a country should be complaining about its trade performance, ironically, it should be Canada. If we measure the volume of our exports, so we strip out inflation in the prices of our exports. And just measure in effect, are we exporting more barrels of oil, cars, parts, and so on in volume terms. We barely had any growth at all since 2000, and have dramatically trailed not only global trade volumes, but actually we've been dramatically trailing the US in terms of export performance.
[Economic Uncertainty Soars as Tariffs Hit Lumber, Paper, Pipe, Metals.] [Are Autos or Uranium Next?]
So we've been running at a very slow pace for a long time long before Donald Trump threatened us with a trade war. However, the trade war adds another thing into the mix because if a business was thinking about expanding in Canada, they have to make sure that they believe that they will have good access to the US market because that's where so many of our manufactured goods and so many of our resource products are destined. There is a group of academics who created an index of economic policy uncertainty, I think they track media sources and so on.
They look for key code words that talk about uncertainty. And you can see that both around the time that Trump was elected and around the time that this tariff talk heated up, we've had a spike in uncertainty. Canadian businesses have seen Canadian lumber, paper, pipe, and metals, all hit with special tariffs from the US and have grown worried that some of the other things that the Americans are talking about doing like putting tariffs on our autos, or uranium, or just again the next chapter in a wave of trade barriers to Canada.
[Why Canada Can't "Win" a Trade War with the US: The Case of Autos]
If these things materially happen there would be a big problem for Canada because as was the case for China, even more so for Canada, we can't win a tit for tat trade war with the US. And let's just look at autos as an example of that. So in Canada, we have a bunch of auto plants, but they produce only a handful of different car models. So fewer than 25 car models are actually produced in Canada, but Canadians buy well over 200 different models of vehicles. So the way the industry works is we specialize in a few vehicles, we export 80% of those to the US, and Canadians buy barely more than 10% of the vehicles sold in Canada or made in Canada. That's not true for the US.
The US 80% of the vehicles sold in the US are made in the US. So if we better put a big tariff on American vehicles, we're just going to be penalizing Canadian consumers. They simply can't buy the cars they would want from Canadian factories, then reverse is not true, there is room over time for America to expand its production and meet more of their needs at all. So Canada is working hard to try to avoid an auto tariff. We estimated that if a 20 or 25% tariff were put on Canadian-made vehicles, their sales would plunge, unemployment rate would revise in Canada.
We might not have a national recession but we could easily have an Ontario recession. So this is something that we've been watching closely. And I think the good news is, and this is recent good news, is that the Americans willingness to pledge to Europe that they're not going to put a tariff on European vehicles right away that they're going to try to negotiate with the Europeans to open up trade in both directions is a positive signal for Canada. Because I really can't imagine, Trump putting a tariff on vehicles made by General Motors and Ford in Ontario, and not putting a tariff on vehicles made by Volkswagen and BMW in Germany. It just seems politically implausible.
[Half of Canadian Retaliatory Tariffs on US Products Aimed at Intermediate Goods]
So we may have won a reprieve from this in a way that will be important to Canadian economic wealth. The other problem for Canada is that when we put tariffs on US-made goods we hurt our own manufacturers because half of the things we've put tariffs on coming from the US are what economists call intermediate goods.
They are goods used by business to produce something else. Now if you're buying American steel and manufacturing something and exporting it you can actually get the tariff back, but if you are making products for Canada you're just out of luck. And so again, Canada has a strong incentive to get the negotiating table and our sub-position is even though it might be difficult to conclude a NAFTA deal this year, we're hoping to see one sign still in 2019.
[How are the NAFTA Talks Going? Read the Body Language]
So so far, the NAFTA talks have not been going well. You can add your own caption to this slide. To me, it looks like Trudeau was saying, "This is my good side." And Trump is saying, "Who is this guy here?" The talks have not gone well, but as I said they're now appears to be maybe a bit of a ray of sunshine on that front.
[NAFTA Scenarios Have Deteriorated] [Canada Lost Its Corporate Tax Advantage (L), While US Shifts to Lighter Regulatory Burden (R)]
And if so, some of the things I wrote in this slide maybe are changing just as we speak that there is maybe a deal coming in sight on some of these other items, and we'll just have to see whether this week's news in fact continues into the coming weeks. It is true, however, that even if we reach a trade deal, as I said, Canada's problems and attracting export industries go back long before the trade barriers came up and they relate to other competitive disadvantages that if anything have gotten worse in recent years.
So Canada used to have much lower taxes than the US, so new investment in the US used to pay a corporate tax effectively after deductions of 35%, now they're down under 20%, they're basically a bit lower than Canada. And on regulatory policy, Trump has passed the fewest new regulations in this first year in office any president back to 2000, and in fact, has been undoing a lot of previous regulations, particularly environmental regulations. So the reality is we may not agree with the merits of this, we may think that the Americans are trading off the economic growth for an environmental problems, but that's what they're doing and they are becoming friendlier, therefore, to their oil industry than perhaps our regulators have been to Canada's oil industry.
[Sign of What's to Come? Oil Providing Less of a Boost to Canada Dollar]
How does Canada then make itself attractive to get enough growth from exports to take some of the place of condo building and debt finance consumption? I think part of it is making sure that the Canadian dollar doesn't depreciate from where it has been, and maybe over the longer term will need a weaker Canadian dollar.
And to some extent, we're already seeing this. We haven't seen the Canadian dollar and move lower in recent months. It's been trading, you know, 76 cents or so for a little while. But in a world in which oil prices are rising historically that would've meant a stronger Canadian dollar. The yellow dot show combinations of oil prices and Canada's US dollar exchange rate in the past decade. And typically, when oil is around $70 a barrel, the Canadian dollar would be a good 10 cents higher than it is now.
And I think the market is picking up on the fact that Canada needs the competitive edge of a somewhat weaker Canadian dollar, that's why the Canadian dollar is not appreciated along with the price of oil. And part of keeping the Canadian dollar a bit softer is for the Bank of Canada to not match the US on every rate hike. By offering, by letting US rates rise above those in Canada which is where we see things going over the next year and a half. We will keep the Canadian dollar trading in its current range maybe even a little bit weaker in order to give exporters that a little bit of a push they might need.
[Pressure on Long Term Interest Rates is a Global Story]
So for the Bank of Canada, what this implies is that short term interest rates may only rise a 0.5% here over the next year and a half as opposed to the US where we will have them rising by 1.25%, so there are still some rate hikes coming. Longer term interest rates could move higher for another reason which is that longer term rates in Canada are very closely tied to what happens to longer term interest rates in the US, in Germany, in Japan, there's a very strong link. We don't necessarily have to be at the same level, but we move up and down with those global interest rates.
And I just showed a chart here it showed how 10-year interest rates in Canada responded to three different events from the Bank of Canada, two were interest rate hikes last year, one was a speech that warned of interest rate hikes, but you can see we had a bigger move when the head of the European Central Bank gave a speech last year where he warned that maybe the European Central Bank would stop buying as many bonds as it has been. So we do think that longer term interest rates will be pushed up higher in Europe, in Japan, in the US over the coming year.
[Central Banks Bought Trillions in Bonds Since 2010 Bond Yields Will Creep Higher as They Unwind That]
So we still have some room for 10-year interest rates and 30-year interest rates to rise in Canada, even a 5-year interest rates and 2-year rates actually don't move up very much. And the reason for these long term rates rising goes back to the chart I talked about when I talked about the slope of the yield curve. Central Banks around the world have bought trillions in government bonds, so we show that in the yellow bars on this chart how much that's grown since 2000. You can see that the total stock of bonds outstanding have grown from something like 4 trillion to 15 trillion, but a lot of those bonds were bought by the US Federal Reserve Bank, the European Central Bank, and the Bank of Japan. In other words, they didn't have to be sold on the market.
That's going to change over the next decade because the US Central Bank is actually now selling some of its bonds or rather letting them mature and we think the same will be true from the European Central Bank next year. And the result is that as government debts continue to grow, and the US is a big part of that, the running big budget deficits. They're going to have to sell more bonds to the private market.
That's those other colored bars. And typically, if you want investors to hold more 10-year bonds and 30-year bonds you have to offer them a bit of a higher interest rate to get the market to clear. So in terms of your portfolios what it means is that on our estimate, if you have for example, an ETF that is weighted to bonds of five years and under, that's going to be a fairly safe investment because we don't think yields will be going up a lot.
[US Earnings Consensus as of Early 2018] [But Get Tougher to Meet In 2019/20 as Growth Slows, Pay Rises ]
If you had an ETF, that's heavily weighted to longer term bonds you may see some price risk because if longer term interest rates do rise there will be a bit of price pressure on the longer term bonds.
[Was Too Conservative for 2018]
Has the stock market fairing in all this? Well, the US market has continued to outpace Canada. I think that reflects the benefit of corporate tax cuts in the US of government spending stimulus. In other words, it's just a faster US economy with a more favorable tax and regulatory environment than Canada now has. And if anything what looked like optimistic expectations for corporate profits in the US at the start of the year actually are proving to light.
So the target left shows what analysts together on average or forecasting for earnings per share on the S&P 500. And at the start of the year, analysts did recognize that maybe tax cuts would help those earnings accelerate 10% growth last year and they were estimating 14% growth this year. As the numbers have rolled in and we know what the first quarter numbers were and we have a portion of the second quarter numbers. It looks like US earnings are tracking more like 18% maybe even a bit higher.
So if anything there's been some pleasant surprises to corporate profits. Where there's a bit of a risk is that analyst are also thinking that next year we'll have a 10% growth in corporate profits. One risk to that is that interest rates will slow growth, interest rates will also be a cost for US business that's rising, and maybe employees will start to get a bigger share of the pie. So last year US employees earned 53 cents out of every dollar coming into American businesses.
The historic average in the last cycle was 55 cents. And typically, as the unemployment rate drops which it has workers on the better position to barter for higher pay and they start to get a bigger slice of the pie which does cut into corporate profit growth. So we're not expecting a barnburner equity market because markets are going to be starting at the end of the year to look ahead to not only slower growth, but maybe some wage pressures. But we still think that, you know, both the US S&P 500 and the TSX, maybe a bit less for Toronto will be creeping a bit higher to the end of the year.
[What it All Means: Friend With Fewer Benefits]
So for now, it all means that while we have a friendly economic backdrop in the US, you may have heard the phrase "Friends with Benefits." This is a friend with maybe a bit fewer benefits than we would normally have because we are countering them with interest rate hikes because we do still for now have these trade uncertainties, but the slowing in growth was one that we were going to see regardless it simply reflects reaching the success and reaching full employment.
We think that there will be more rate hikes in the US than Canada to keep the Canadian dollar contained, 10-year interest rates will still be creeping higher in both countries. Do you still favor the US stock market? There are still some trade risks as I said, but we're hoping for a resolution, maybe that's going to come sooner than 2019 after all. One sector that should do reasonably well with or without trade war is the energy sector. The Americans are not going to put a tariff on Canadian oil because they are an oil importing country. They need to buy it from somewhere. They'd only be hurting their own drivers if they put a tariff on imported oil. So well, that's a sector that is the least exposed to a traded threat if you're looking for that.
We do think the Canadian dollar will be roughly weight range bound, and it's possible that as we move past 2020 and we start to see the impact of higher mortgage rates more noticeably on housing activity in Canada that maybe we're going to need a cheaper Canadian dollar to get a little more growth out of exports. So that concludes my formal remarks. I'd be happy to consider some questions over things I haven't mentioned.
[WEBINAR, Question & Answer]
So we're just going to take a look now at questions that have come in while I've been speaking. I've stunned you all into silence or our technology is not picking them up. Thank you. That was an amazing presentation. So while Avery is reviewing some of the questions, I wanted our audience who joined in later to know, you can type in your questions in the Q&A panel located in the right-hand side of your screen. And if you wish to listen to this webinar again, a link will be email to anyone with registered.
Also, I would like to request the audience to ask questions more explicit to today's topic. And to avoid asking questions that are specific to a security or a company. So we have some questions coming in as I speak and Avery will be reviewing and answering those questions shortly. Just give us a moment please.
So I see we have a question on what's called DXY, which is really the US dollar on average against a basket of other currency. So where is the US dollar going to go in general, not just against the Canadian dollar but against the Euro, the Yen and so on. Of late, the US dollar has been, I think been up to a level that, you know, we've heard Donald Trump complain a little bit that the strong US dollar may be hurting American competitiveness.
And actually he's right on that score that the US dollar is reaching a level where American exports are a bit handicapped compared to exports from Japan or Europe. He needs to look a little bit in the mirror because one of the reasons that the dollar has risen is the threat by the US to impose tariffs on everybody else, so that's caused investors to worry about China, worry about Japan, worry about Europe, and its bid up the US dollar as investors have sort of sought the safe haven in the US.
The other factor driving it, of course, is that the US has been raising interest rates so there's a better yield in US dollars than there is in Europe or Japan, so that is the central bank's actions driving the exchange rate. Our view is that the dollars gotten a little overvalued and that we will see the Euro back above a $1.20 US, next year we'll see the Yen appreciate as well. And what's going to cause that is not only potentially a calming of these trade fears, but also Europe is getting closer to full employment. By 2019, we may be starting to get signals from both Europe and Japan that they're not as far from raising interest rates as markets now think.
And if so, we could see a rebound in the Euro and Yen. So we're sort of neutral on the Canadian dollar, but we do expect by next year to see some rebound in the Euro and the Japanese Yen against the US dollar. Next question here, will there be separate bilateral trade agreements? That means between Canada and the US and Mexico and the US. You know, it's not that really that Canada signing a separate deal with the US would be bad news for Canada, in fact, one could argue if Canada managed to get free trade status with the US and Mexico didn't have it that maybe Canada Would regain some of the automotive business that it lost to Mexico in the last decade.
The problem with that scenario is that if you went into bilateral talks you're starting from square zero. And I think the Canadian government is concerned that it would just simply take too long to negotiate in entirely brand new trade deal which is why for now at least their negotiating strategy is to insist that they want to amend NAFTA, not start from scratch. So still the most likely scenario is that we reach a trilateral deal including Mexico. I got a question on my outlook for the price of gold.
So we've been relatively neutral on gold. And the reason is when I look at the price of gold, there's really three variables that affect it. One is inflation, if you ever get big inflation it tends to be a positive for gold. And the problem is historically to really move gold you've got to start to see numbers like 6% inflation, 7% inflation, seems like central banks and around the world they're just not going to let that happen. So we can take inflation out of the picture really as a driver. Gold isn't really affected by whether inflation is 1.5 or 2.5.
The second thing that moves gold is the US dollar. So if the US dollar strengthens against other currencies, gold tends to weaken against the US dollar. So there is a bit of a plus. If I'm right that the US dollar weakens next year, maybe gold can get back to, you know, sort of, above $1,300 so we do think maybe a little bit of a recovery in 2019 from gold.
The reason the recovery could be small though is one thing gold doesn't like is rising interest rates because if I buy a gold bar and I put it in my safety deposit box, my yield is zero. That's not such a big cost when interest rates were near zero. But as interest rates move up, your alternative investments start to look a little better. So we think a small recovery in gold, but nothing beyond where we were in the last 12 months.
Another question here, what about the outcome of the Brexit negotiations? You know, that's obviously, I have to admit. British politics are sometimes as messy as American politics. We have a real problem in that. What the UK wants, it can't get. So they somehow want an open border between Ireland and Northern Ireland, at the same time they don't want to commit to having the same tariffs with the rest of the world as Europe does. Well, those two things don't go together.
It's hard to know where the Brexit process is going other than its stuck for now. But one thing is clear is that the US, the UK economy is actually not doing all that badly despite these negotiations and we may still get, for example, an interest rate hike in the UK before the end of the year. And therefore, a little bit of a rally, for example, then in the British pound as a result of that even with a stuck Brexit process.
What about US corporate debt? So generally speaking, corporate yields globally move together. And we have seen actually very low interest rates on corporate debt in part because we're coming out of a period where government debt in some parts of the world had a negative interest rate on it. And where so many are the government bonds were bought by central banks.
They kind of force pension funds and other investors to buy corporate bonds. I think as the governments over the next couple of years stopped buying those government bonds and actually start selling back to the market. We may see a little bit of a higher spread on corporate bonds just because the yield on government bonds will now be a little more attractive. But I don't see any huge default risks in the next year or so because we don't really have a global recession coming.
That's always the biggest risk for corporate bonds. We'll see some other questions here have come in. What's the biggest shock that could cause a recession like in 2008? Well, I think you have to take your eye off 2008 because that was an exceptional recession in the sense. It was the worst recession since the Great Depression. So one advantage I have of having done this job for 25 years and been an economist for more than 30 years is I've seen quite a few recessions.
So first of all, I wouldn't expect another one of that scale hopefully in my lifetime 'cause it's only a once in a lifetime event. But as far as a recession risk, the biggest recession risk right now is what happens in the US after 2019 when the impact of tax cuts and government spending increases start to fade. We might need the US Central Bank to actually start cutting interest rates to offset the slowing impact on US growth from not having all of that government spending in tax cuts stimulus.
There was a few items built into the US tax cut bill that actually imply that some people start to pay higher income taxes as we move from sort of 2020 to 2025. So we're going to need a slightly gentler hand on interest rates. My view is the Federal Reserve, we'll see this coming, but that right now is the biggest recession risk. The other part of that story is if the US facing a trillion dollar budget deficit in 2019 decides to rapidly cutback on government spending to address that deficit.
Of course, that can create a more worrisome slowdown. But we don't, you know, I have... I'm pretty humble as an economist. I hope to get the next year and a half, right? I certainly wouldn't publish a forecast for a recession in 2020 until we're lot closer to that year and I have more insights into what's happening. I think I did that question. We're looking at... We're just scanning through the questions here.
Okay, let's look at that. So why am I not expecting more of a shock despite the underlying factors seem to have a lot of extremes? This is true, there's a lot of winds buffeting the economy one way or the other that I've mentioned. The one thing that encourages me to think that overall growth could be relatively stable is that the central banks, particularly the Bank of Canada is well aware of all the things I talked about.
So they know that Canadians are holding a lot of debt, for example, and will face a bigger squeeze as interest rates rise than they did in the past. They are aware that businesses may be a bit reluctant to expand in Canada while there's this cloud of uncertainty over NAFTA. And so the result of all that is is to date they have been quite gentle by historic standards in terms of the pace of interest rate hikes.
And as long as inflation stays fairly low, and that's true if you strip out gasoline, inflation really hasn't moved much in the US or Canada, both the Federal Reserve and the Bank of Canada are going to keep a close eye on how the economy is doing before each individual interest rate hike. So the fact that inflation is still fairly tame, takes away one of the big risks which is that the central banks overdue these rate hikes and caused a recession by accident. When they've done that in the past, inflation has typically been a lot higher.
And therefore, they've been gambling a little bit on how much slowing they induce in the economy. Now let's take a... We did that one. What about... Someone asked a question about the Trans Mountain Pipeline and what does that do. I guess, one of the issues around that. It isn't that Canada desperately needs a pipeline today. We actually took a look at it and there's enough capacity now to handle what we're exporting.
And we also have some things that are coming further down the road that will alleviate some of the pressure. There is an intermediate period though where it'd be very helpful to have Trans Mountains or at least one of the other alternatives that have been contemplated at various points in time to just give an oil industry reassurance that the capacity is there. So it's more of a question.
It's not that today there's a crisis in the oil industry. It's that, if we want oil industry capital spending to stimulate economic growth, we probably need to provide a little more insurance to the energy sector. So with that, I think I've taken up a fair bit of your day. And I thanks for tuning in and for those of you listening after the fact.
And as always, we wish you much success in the coming year with your investments and your life in general. Thanks very much. Thanks again, Avery. That looks like that's all the time we have for today. I'm sure I speak on behalf of all the audience that we thoroughly enjoyed listening to your insight. Thank you so much for such a great presentation and your precious time. On behalf of CIBC Investor's Edge, I would like to thank the audience. We really appreciate you being here. Should you have any questions or comments, please visit the Investor's Edge website, or please feel free to get in touch...
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