Transcript: Out of the fire, into the frying pan (Eyes on 2020)
Dr. Avery Shenfeld
September 27, 2019, 12:00 pm to 1:00 pm ET
Duration: 55 minutes
[Out of the fire, into the frying pan (Eyes on 2020), with Dr. Avery Shenfeld]
Good afternoon, everyone. And thank you for joining us today. On behalf of CIBC Investor's Edge, I would like to welcome you to this webinar. My name is Peter Campbell, and I'll be your host for this event. Now, a few things before we get started.
CIBC Investor's Services, does not provide investment or tax advice or recommendations, so everything we share with you today, is for educative purposes only. We are recording today's session in a link that will be emailed to any who register online.
[Full screen control > Q & A Window]
To view this webinar in full screen, please click on the expander arrows, located on the top right-hand corner of your screen. And if you have any questions during the presentation, please kindly take a note, and you'll have the opportunity to submit your question after the presentation.
Our topic for today's webinar will be a review of the major economic drivers for the global, U.S. and Canadian economies in the coming year, and how these drivers may shape investor returns, in various asset classes. To present this today, we're very excited to have Avery Shenfeld, CIBC's Chief Economist, here to share his expertise in this subject matter. Avery is one of the country's most sought-after commentators, and was ranked as one of the top economists in a survey of Canadian institutional equity investors.
With great pleasure, please join me in welcoming Avery Shenfeld for today's presentation.
[Out of the fire into the frying pan (Eyes on 2020)]
Thanks very much, Peter, and thanks to our clients for tuning in today.
The economic backdrop, certainly, is a hot topic these days. Lots of talk about the "R" word, recession, particularly a couple of months ago. Certainly some signs of economic fragility have emerged. But, as our participants will note, we've seen equity markets, sort of holding in there, so some certainty. Bit of a vote of confidence that we'll avoid the worst.
And, in terms of our outlook, we've called this webinar "Out of the Fire, into the Frying Pan," a reversal of the usual expression. Because while we do think that Canada and the U.S. will avoid the fire of an outright recession, that will be only to fall into the frying pan of still somewhat disappointing economic growth.
So, there are two potential doors out there, one, not so good, one, much worse. And we think we'll avoid the worst outcome, but still face challenges as investors in dealing with a sluggish economy.
[Recession avoided, but no return to the good old days]
To put these into somewhat numerical perspective, if look at the average growth rate of the major industrialized economies. So, here we've weighted the U.S., Eurozone, Japan, Canada, UK, by their share of GDP globally. And you can see that in the years from 2014 until roughly through the first half of 2018, the average growth rate for that group of economies was a little over 2%. Not spectacular, but good enough in most cases to get these economies moving towards full employment.
In our forecast, however, by this time next year, or certainly into the summer of next year, when we look at year-over-year growth, it's going to slip for this group of countries in our forecast to something a bit below 1%. And even when we emerge from this soft patch with a rebound in 2021, we're still looking at growth coming in below the pace we enjoyed earlier in this business cycle. And, to some extent, that is a reflection of the fact that we've been so successful in many of these countries, getting to a state somewhere close to full employment. So, we look at countries like the U.S. and Canada at the lowest unemployment rates that those countries have enjoyed since going back to the 1970s, in many cases, there simply isn't the slack in the labor market to allow these economies to grow at the pace they were enjoying earlier in the cycle, when labor was much more available. So we still have immigration. We still have new people entering the workforce. But not at a pace that would be sufficient to let economic growth return to where it was on an average in 2014 to 2018.
[2020 marks a mid-cycle growth]
To get drilled down into how these individual areas are going to perform, if you look at world growth, those numbers all look hotter. And the reason is that they include countries like China and India, whose average growth rates have tended to be higher because they're still emerging from a much more poorer status.
And some of them have, in the case of emerging markets, a faster population growth. World GDP in this cycle had been averaging a little over 3.5%. By 2020, we're looking for a growth rate a shade under 3%. So, that's going to be the slowest year, really since the recession.
[But 2021 is still below 2014-18 trend]
And we do have it rebounding in 2021, but still, a bit disappointing. And for the U.S. and Canada, the Canadian growth rate next year, a little below 1.5%, so somewhat slower than 2019. Similar story in the U.S., and both countries are rebounding to a growth rate of roughly 2% in 2021. And that’s about as fast as we think they'll be able achieve, again, simply because of the limits of a nearly full-employed workforce. We get much slower numbers when we look at countries like, Europe, the UK, Japan. But some of those countries, again, have even worse demographics. So their long-term speed limits are lower. Both Europe and the UK are certainly in danger of recession—parts of Europe and the UK. We don't expect to see better numbers from those economies until 2021. So, generally, a pretty sluggish global environment.
[U.S. yield curve: the “Grim Reaper”?]
Some people are arguing that we, in North America, are doomed to recession. And if there's one chart that you could say is the "Grim Reaper"—that thing that people look at as the definitive signal that the U.S., for example, is falling into recession—it's this one that I've displayed here, which would look very similar for Canada.
What the chart shows is the difference between 2-year interest rates on government bonds and 3-month government bill yields. Now, normally, that difference is a positive number. You get a higher yield when you lock your money away for 2 years, than you get for 3 months. But as you can see in the chart, the latest readings are negative, which implies that 3-month rates are actually higher than 2-year rates. And when we've seen this in the past—I circled 3 previous cases where that number went negative, and you can see on the chart, there's a shaded area shortly after that. The shading marks recession periods for the U.S. economy.
So, some look at this chart and say that you don't need an economist, you just have to look at this slope of the yield curve, and factor this difference in interest rates at different terms, and it tells you everything you need to know.
I would point out, that economists, yes, they're sometimes wrong about the outlook. But so is the yield curve. And if you look at '95 and '98, for example, on this chart, you can see two previous occasions where that slope went negative—where 3-month rates were, in fact, higher than 2-year rates. But there's no shading right after that. There was no recession. Because what this actually tells you is—not that a recession is coming—it tell you that investors are expecting short-term interest rates to fall. Why else would you lock away money for 2 years at a lower interest rate than you can get for 3 months? You must be expecting that those 3-month rates are going to be coming down. So it tells you that investors are concerned enough about what they're seeing in the economic numbers. That they're betting that the Federal Reserve, and to some extent the Bank of Canada, are going to have to cut short-term interest rates.
The Federal Reserve did, in fact, end up cutting interest rates in both '95 and '98. But a small dose of rate cuts, in both cases, actually helped prevent a recession.
So, all we know at this point, is there's some softness in the data. The market is expecting to see some further interest rate reductions in the U.S. and Canada. But what we don't know, or what this can't tell you, is whether those rate reductions are actually going to be enough to fend off a recession the way they did, in fact, work in '95 and '98.
[Slower trend raises odds of random negative quarters]
One of the things that investors will have to get used to, however, is that with a slower average growth rate than in decades past, we're going to see randomly more quarters where the quarterly growth rate for the economy turns negative. And you'll see headlines about impending recession that may or may not be correct.
So if you look at the chart, for example, the bars for Canada, 20 years ago, because population growth was faster, and in particular, we weren't aging as quickly, so we didn't have as many people heading for retirement, the trend growth rate in the Canadian economy was a little over 2.5%. And, given the normal variability in quarterly growth, there was only a slightly better than a 10% chance, on random noise, that a quarter could have a negative growth rate. Today the average growth rate, given a slower growth rate in our working-age population, we estimate at 1.8%. Which means there's nearly a 20% chance that just randomly, even if we're going to average 1.8, you would see an individual quarter with a negative growth rate.
In Europe, it's even more dramatic. The Eurozone's average growth rate, because they have no growth in the working-age population, is below 1%, and we're going to quite frequently see a negative quarter here or there for some of the countries in the Eurozone. So get used to a little bit of an equity market volatility, associated with, what might be, false signals about impending recession.
[He said, Xi said]
The biggest concern in the real world these days is about trade, and in particular whether the frictions that we're seeing in trade, between the U.S. and China—the threat that that might spread to a trade war between the U..S and Europe or Japan—are what’s keeping trade muted, and keeping businesses on uncertain ground, in terms of their investment decisions. And uncertainty is an enemy of economic growth. When businesses aren't sure if they can produce something in China—as a component, for example, for a final product made in the U.S.—they might hold off on building a new plant in the U.S. or China, in order to wait and see where the dust settles on that trade war.
And, of course, we've had some uncertainty over in North American trade, in terms of the fate of NAFTA or its replacement deal. So we're watching quite closely some of the signals between the U.S. and China on whether we're going to get any resolution in this trade dispute, whether we're going to go from bad to worse with even higher tariffs, or whether we’ll see those tariffs role back. And so this is really a story of "He said, Xi said," with Xi being the leader of China. And, "He," of course being Donald Trump. And, if you look at the quotes, that I've included on this slide, you know, starting at the top, obviously, Trump has taken a very hard line with China to start these talks off. And he’s said some pretty tough things about China, including accusing China of raping our country. So it's hard to imagine more negatively-colored language than that. That said, there are also signals that Donald Trump understands that if this is going to pay off for him politically, he needs to achieve a deal before the election.
And he, every now and then, says he's hopeful about getting a deal, because, either, "China has respect for Donald Trump's large brain," as he said in the second quote, or because he keeps saying you know, every now and then, that a deal might be had, relatively soon. And our view is, that in fact, right now, Trump is listening heavily to his trade advisors. They are Lighthizer, who's his Trade Negotiator, Peter Navarro, who's his Trade Advisor. Those two people are very hawkish about trade with China and are encouraging the President to stand tough. And they have a very long list of almost unreasonable or unlikely demands on China.
That said, as we get into 2020, Trump is going to be meeting even more frequently with his campaign advisors. And our view is that, on days where he talks to his campaign advisors, they tell him, "Mr. President, the equity market is nervous. Business uncertainty is holding back growth. And to win reelection, you've got to dial down these trade tensions." And so our view is that, while we don't expect to see much progress in upcoming meetings in October, the U.S. will be pressing a little harder for a deal, perhaps dropping some of its demands or agreeing to a partial deal that rolls back some of the tariffs and eases these trade tensions as we move into 2020.
Now, it takes two to tango, so, what is the Chinese Leader saying? Well, he's also had some tough talk. You can see a reference to, "bored foreigners with full stomachs, who are pointing a finger at us for their problems." I don't know who the full stomach bored foreigner is, but you can take your guess. He also gave a speech where in somewhat enigmatic language, he talked about, "embarking on a new Long March." Those of you with a knowledge of Chinese history will know where that reference comes from. And saying that China has to start over again—which people interpreted as he was digging in for a long dispute, and basically arguing that they can reorient the Chinese economy away from trade with the U.S. And finally, there's a quote where he talks about, "Jade can be polished by stones from other hills." Actually, I have no idea what that quote means, but it's very poetic.
[Slowing global trade exposes (L) open economies to greatest deceleration (R)]
So, to judge what China's going to do, sometimes it's hard to read the nuances of the tea leaves, from some of these speeches, but we can look at what's happening to the Chinese economy. It's not particularly good, and we do think it's going to put pressure on them, as well, to reach a deal. But in the meantime, what we're feeling, in terms of growth in Canada, and to some extent in other countries, is a recession in the trade side of the global economy.
So global trade volumes have actually been declining for 3 successive quarters. Which is why the manufacturing sector, in many parts of the world, is in a recession, even if the overall economies are not. The countries feeling this the greatest are the countries where exports are the larger share of GDP. So the biggest slowdowns, in terms of what year-over-year growth looks like today, versus where it looked in 2017, have been seen in countries like Germany, Italy, Canada, South Korea—economies where trade and exports are particularly important. And it's a reason why the U.S. has actually seen less of a slowdown because—or really, no material slowdown—because their economy is still not that heavily oriented to trade.
[Chinese banquet over for rest of Asia, too(L); Beijing can’t keep up pace of fiscal rescue (R)]
China, as I said, in our view can't afford to hold off for too long, on this intransigent stance, in terms of reaching a deal with the U.S. So China has taken some steps to elevate growth, or at least provide a cushion on growth. But they're not working all that well.
If you look at Chinese economic data on the chart at left, you can see that the official data are showing that growth is slowing to something like 6% this year. And we believe below 6% next year. The truth might be even a bit worse than that. If you look at other countries that are in Asia, that trade with China, you can see that they also have been slowing quite heavily.
The slowdown we are observing in China is despite the fact that China's pulling out all stops to try to counterbalance the slowing in trade with the U.S., with growth elsewhere in the economy. They have cut interest rates and freed up banks to lend more money. They understand, however, that those loans are often going for capital projects that may be somewhat low return, or housing speculation that's not necessarily desirable. They have also undertaken a massive fiscal stimulus program. So the budget balance has gone from a deficit in the order of 1% of GDP, to balloon out to something more than 6% of GDP, and that's even a figure that's adjusted for the weakness in where they are in the business cycle. Those are big numbers.
So Canada's deficit is around 1% of GDP or less. This isn't something that China can do forever. So, again, that's a reason actually for optimism. The fact that China's feeling the pain—the fact that they're seeing that pain despite a maximal effort on fiscal stimulus—tells you that they're going to be willing negotiators as we move further into 2020. So that's one reason why we're retaining some optimism that North America will avoid a recession, because these trade tensions, if they lighten up, will also improve business sentiment.
[Interest rate cuts haven’t worked (L); Eurozone needs Germany to take the brake off debt (R)]
Europe does seem to be falling into recession, particularly in Germany, and they have been aggressively lowering interest rates. So the latest move by the European Central Bank was to cut interest rates on overnight loans from -0.4% to -0.5%. And it's hard to imagine that if -0.4% wasn't helping the economy that -0.5% is going to make a huge difference. And you're right to be skeptical. We would argue, in fact, that it might actually be doing more harm than good. Normally we think of low interest rates as a stimulus for both the business sector and the consumer sector. That businesses if they could borrow at low or even negative rates, will find more projects that make more sense to undertake. But also that consumers will decide that if I'm not getting rewarded for saving my money, I might as well spend more now, rather than put it aside for spending later.
Unfortunately, there is a counter-story to that argument. Which is that if you imagine a typical 50-year-old who's starting to worry that interest rates are going to be low forever, they might decide that they need to actually save more of their money and spend less of it, in order to have a larger pool of assets when they hit retirement age. Because if they're not going to earn any interest on those assets, they're going to need a bigger retirement slush fund. While Germany, of course, is an aging-population country, so you're getting more and more of the population in those late—or near—late-earning stage or early retirement stage, and that's exactly what we're seeing. That as interest rates on 10-year government bonds have fallen—as you can see in the chart on left, they've gone negative—that the Germans’ savings rate for the households, which is the percentage of income that is being saved rather than spent, has actually gone up. So, actually, you've been squeezing household spending, not boosting it, by having rates go lower and lower. So is there a cure for what ails Europe? Absolutely. The cure is fiscal stimulus. And it's a cure that governments in Europe have been unwilling to reach for. In part, because countries like Italy and Greece have so much debt that the rest of Europe has lectured them and said, "You can't run deficits." And also because Germany has still been running budget surpluses, even as their economy is falling into recession.
Now, we do think that the political tide is starting to change. We’ve been seeing more talk in Europe about reaching for fiscal stimulus. The problem right now is that the largest economy, Germany, has a debt brake law that actually prevents them from running significant deficits. And they would have to change that law between now and 2021 to actually deliver the kind of increase in stimulus that we think they'll need to get out of this negative interest rate climate. We think that's coming, so that's the good news, but in the near term, expect to see more stories about parts of Europe falling into recession, which is certainly one reason why markets are nervous. You know, could that contagion spread to North America?
I would remind my listeners that Europe had a recession in 2012. You know, they had the one in 2008. Then they had to repeat recession in 2012. And North America did not fall into recession. So, certainly, history suggests that a recession in Europe or Japan doesn't necessarily doom North America to recession, even if it is a negative and a drag on wealth.
[Only 4 of 16 indicators point to U.S. recession]
And when we look at the U.S. economy right now, you will see the occasional isolated indicator that creates headlines. So, for example, recently the ISM manufacturing index, which is a survey done of manufacturers in the U.S., fell below 50, and people take that as a signal of recession. The problem with just looking at one indicator like that, is it ignores the fact that we have dozens of economic indicators with which to decide how the U.S. economy is doing. So we looked at 16 indicators that have a various degree of ability to tell you whether the U.S. is in or falling into recession. And the bars on this chart show you how well, in some sense, each indicator does in determining on its own whether an economy is in recession or still growing.
So, hours worked by people in the economy that changes in employment or payrolls, are the strongest correlated indicators. And like housing starts and home sales or auto sales, still have some predictive power, but, not as much. And we have indicated in red, the four of these indicators that are currently flashing recession-type levels. But that still means, of course, that 12 of them are not. And I think that's giving you the right answer, which is that the U.S. economy has slowed somewhat. We see growth in the third quarter, likely to come in around 2%, which is the same as the second quarter. And 2 is not 3. It's not a great year. But it's certainly far from recession. So there are things that are keeping the U.S. economy moving.
[Feds hikes haven’t put households in a bind (L); Wage gains boosting the bottom quartile (L)]
And by and large, those things, have been the good old American consumer. So there was a slightly softer consumer spending number for August, but some pretty good income numbers that suggest that there's still a lot of fire power in the American household sector to continue to spend money and keep the economy moving along. And, in particular, we've seen pretty decent job growth, good income gains associated with those jobs. Americans have a pool of savings that have been building that they can draw on to continue to consume.
And what we're also seeing in the chart at right, is that not only are wages improving, but they are improving more for the people in the bottom 25% of income earners. So the Walmart greeters, the people whose jobs have as a requirement that you have to ask the customers whether they want fries with that order, those people have actually been getting bigger increases than the average worker. That's partly because labor is becoming scarce. So you have to pay up to get people to take those low wage jobs. And also because some states have been raising minimum wages over the past few years. The reason this is important, is because the people in the bottom 25%, they spend every dollar that comes in. And so this is a very important driver of consumer spending.
The other thing that we're looking at is the fact that, while we are very late in a business cycle, in terms of the number of years since the last recession, we aren't seeing the typical late cycle squeeze on households' ability to continue to spend. Normally, as the cycle gets longer and longer, consumers have been out there borrowing to buy cars, or they've taken mortgages to buy new houses or cottages, and, typically, interest rates have also been rising over the cycle. And when you put the two together, you start to find that more and more of a household's income is going to pay interest on the debt they've accumulated, leaving a smaller portion available to go spend some more. That hasn't happened in this cycle.
The chart at left covers the period where the Federal Reserve was raising interest rates—that's the red line on the chart. And the gray line shows the percentage of income that is going to make those monthly payments on interest. And this particular measure also includes rent, so that it's not biased if people sell their house and don't have a mortgage but start renting. Of course, they now have rent payments to make, rather than mortgage payments. So we include rent, as well as mortgage payments, credit card interest and so on. That financial obligation ratio tells you that as a share of household income, we are at very, very low levels, in terms of those monthly obligations.
So it's still lots of spending power in the U.S. economy. And we think that's enough to keep the economy out of recession. Particularly with the Federal Reserve having lent a helping hand, by having delivered two quarter point cuts in interest rates.
We do think the Federal Reserve has one more cut to come. Probably not in October, because the economic data are looking good enough that for now the Federal Reserve could take a wait-and-see stance, but by December or early next year, we expect the sluggishness in manufacturing to show up in a little more of a slowdown in employment growth. It might be enough for the Federal Reserve to cut rates one more time, just to be sure that we avoid a recession.
[Bond yields rise as mid-cycle ease is concluded well before Fed tightens]
But if that ends up being the last of the rate cuts, we can look at what the implications of that will be for the bond market. And we have, actually, a very good analogy to this case. It was those two instances I talked about. One in '95, and one in '98, where we had a small dose of interest rate cuts from the Federal Reserve, but those helped avoid a recession. So the Federal Reserve, actually, then stopped cutting rates in 1998 after reducing them by 3/4 of a percent. So, in fact, that will be exactly where we would be at the end of the year, if the Federal Reserve cuts rates one more quarter point. They will have cut rates by 3/4 quarters of a percent in total. And you can see how the bond market behave.
What tends to happen is that, once the Fed starts cutting interest rates, you know, the bond market starts to think of this as like, you've opened a bag of potato chips. You said you were only going to eat 2 or 3 chips! But, you know, you've opened the bag. You're going to eat the whole bag. But, that isn't actually the way it always works with interest rate cuts.
Sometimes what happens, and this was the case in '98, and we think it will be the case this year as well, is the bond market, initially thinks, "Oh, we've got lots of more rate cuts to come." So they drive down 5-year interest rates and 10-year interest rates, well down. And then they're surprised when the Federal Reserve actually goes on a pause and stops cutting rates.
We saw in 1998, which I illustrated here, is the Federal Reserve did a few rate cuts after August '98. 10-year interest rates were falling. But then when the market realized, "Oh. They're done. They're not continuing to cut rates," we saw long before the Federal Reserve returned to rate hikes, 10-year interest rates moved up.
We've seen a bit of that in the last month. We might get a little bit of a rally in the bond market from here to the end of the year, if the Federal Reserve actually goes ahead with another cut in December. But our view is, when we get to 2020, we're going to see 10-year interest rates in the U.S. about 1/2% higher than what they are right now. And that will spill over into a similar move in Canadian bond yields.
So, for investors, it means that if you had money, for example, in a bond fund or particularly an indexed bond fund that holds the whole bond market, you've got a very big price rally in that asset class, as bond yields have fallen. And what this suggests is that we may be getting close to the end of that, and, in fact, maybe a bit of giveback, not all of it, but some of that will be given back in terms of the pricing in those bond funds as interest rates move up a bit next year.
[Equity investors: be careful what you wish for. Fewer rate cuts are better than more]
How will stocks take this? Somewhat disappointing news that the Federal Reserve is not going to keep cutting interest rates all through next year.
Well, actually, day-to-day right now what we see is when someone from the Federal Reserve comes up and says, "Oh. We're not going to keep cutting," you have the stock market sell off. They sort of want the Fed to keep cutting. But if you look back, the two cases, is the last two times the Federal Reserve cut rates deeply, were in the 2001 recession and the 2007, '08 recession, and that was terrible news for stocks. Because, yes, rates went down, but earnings plunged. The best outcome for stocks were actually those two cases where we only got about 3/4% move in interest rates, but then we avoided a recession and earnings started to grow.
So, we're not that pessimistic about stocks, despite the fact that we don't see as many interest rate cuts as investors now believe.
[But cyclical profit share squeeze caps upside (and a small negative for corporate spread trend)]
That said, there is a bit of a ceiling on stocks next year. Because if we look in the U.S., corporate profits growth have slowed. And that's because, as a share of the economic pie, corporate profits are now giving up some share in favor of employee compensation growing a little faster. So at the stage of the business cycle where labor's getting a little more expensive, compensation's growing a bit faster, and that is putting a constraint on profit growth.
So, profits could still grow a bit next year, but probably on average, you know, sort of low single digits or, you know, 2 - 3% profit growth. It doesn't make for a banner year for stocks, even if stocks actually outperform bonds, they're not likely to offer tremendous returns.
Now, what about in Canada?
[Canada has kept inflation on target in past decade (L); still true today (R)]
We haven't seen the Bank of Canada start to cut interest rates. One reason is, Canadian inflation is sitting just under 2%. And that is the Bank of Canada's target. And, in fact, if we look since 2010, some other countries have seen inflation run well below their target, on average. Whereas the Bank of Canada has actually been within 0.1% of achieving its average inflation target of 2%.
The other factor is that the Bank of Canada didn't hike rates as much as the U.S. So, the overnight rate of interest in Canada, they stopped hiking at 1.75. The U.S. was the one that, maybe, made the mistake, of raising rates to 2.5 and is now reversing some of that. So for the time being, the Bank of Canada is pretty comfortable, saying, "Yes. We've seen a slowing in the global economy that's affecting Canadian exporters, but we already took a lot of that into account, because we stopped raising interest rates, earlier than the U.S."
[Slowing growth has dampened inflation expectations 10-year breakevens too low in Canada]
I am a bit concerned that the bond market, you know, is thinking that inflation is going to stay a lot lower than it's likely to be. This gets a bit technical, and I won't go into all the details. But there are inflation-adjusted bonds called real return bonds, and you can use those to tell you what the bond market is assuming about inflation. Bond market seems to be assuming that inflation in the next ten years is going to be less than 1.4%. That's well below Bank of Canada's 2% target. I think that's unlikely.
So, again, that's another reason to think that long-term rates in Canada may be too low to be sustainable. The market is expecting inflation to plunge. We think it's going to stay close to 2%.
[Long run with positive output gap needed to sustain core CPI above 2%]
That said, we don't see inflation surging. The Bank of Canada has a measure called the Output Gap. It measures slack in the economy. When the number is negative, there's slack in the economy, and inflation tends to be stable or ease off. You have to have that number be very well above 0 for inflation to heat up. We're not there right now. So we think inflation's going to stay near 2%.
[Canada’s Q2 growth is a head fake]
That said, the Bank of Canada, right now, is not interested in cutting. But I wouldn't rule out a Bank of Canada rate cut for December or January. The most recent economic numbers have looked a lot better. So second quarter growth was 3.7%. But about a 1/3 of that was just turning the taps back on, in terms of oil production in Alberta, having previously cut them. If you look back, growth in the 4th quarter and 1st quarter was near zero. So, yes, 2nd and 3rd quarter growth this year is looking a lot better, but it's because we're rebounding from a period where we almost dipped into recession.
The underlying trend for the Canadian economy, is only so-so, and if we saw a further slowing coming in the 4th quarter, which we think is coming as the slowing in global trades starts to impact hiring in Canada, we could get a rate cut from the Bank of Canada in December or January. But because they never hiked as much, I think we're only looking at a 1/4 point reduction in rates by the Bank of Canada, and that's about it.
[Wages not as strong as in the U.S. (L); Canadians have less room to spend more, save less (R)]
We do think that the Canadian economy will be still, though, relatively sluggish next year, only 1.5% growth. Our consumers don't have quite as much room to continue to spend as Americans. Wage growth hasn't been quite as brisk.
But, more dramatically, Canadians have not been shy in this business cycle about borrowing and taking advantage of low-interest rates. And, also, not shy about running down the percentage of income that they're saving, and devoting more and more of their income to spending. So if you compare the savings rate in Canada and the U.S., it's a lot lower in Canada. And we think that will induce a note of caution among consumers, that we're already sort of seeing in the data over the past year or so. That's going to make it hard to lever up consumer spending, without some support from job growth in the export sector.
[Export and capital spending have been serial disappointments]
And the challenge here is that, while the Bank of Canada is optimistic that exports are going to turn the corner, and that business investment spending is also going to pick up, the Bank of Canada has been consistently too optimistic on those two elements of its forecast. So going all the way back to 2012, if you look at Canadian GDP growth, what this chart shows is that while the elements of GDP driven by consumers or housing, sometimes the Bank of Canada's forecasts are too high or too low. The actual numbers on business capital spending and exports have almost always disappointed the Bank of Canada's forecasts.
[Canadian exports have fallen short vs. Foreign Demand Measure]
And that's because Canada's been losing market share in many of our exports. So the Bank of Canada has a measure called a Foreign Demand Measure, that looks at the countries we export to, and the parts of those countries that buy, in particular, Canadian goods. Those have been growing much faster than our exports. And that reflects the fact that in many industries, whether it's automotive assembly or auto parts or railway components or ketchup, we don't make as much of it, in terms of the North American demand, as we used to. And I think that drag on our exports is going to persist, unless we end up with a weakening of the Canadian dollar sufficient to make Canada more cost competitive.
[Capacity additions have run ahead of needs (L) pointing to disappointments in future capital spending (R)]
We've had a little bit of growth in business investment spending, and in addition to capacities—capacity in that industry. But as you look at the chart at left, production growth has trailed capacity growth. Which in our view means we're likely to see some disappointments, then, in business capital spending. They don't need to add capacity in Canada right now. And these are going to be the reasons why the Bank of Canada could end up cutting interest rates.
[Poloz opened the door…]
But even a token interest rate cut is, I think, going to be enough to avoid an outright recession? The Bank of Canada Governor, Poloz, back in March was only talking about uncertainty about when they would raise rates. By July, they talked about the fact that they're OK with interest rates where they are. But they might move if the headwinds worsen or dissipate. And by mentioning the risk that the headwinds from the global slowdown could get worse, he did open the door to providing an interest rate cut if the economy needs it.
[Government debts not a huge burden]
If we do end up falling into greater weakness, I don't think interest rate cuts are going to help much, because Canadians already borrowed so much in this cycle. But we do have room to ramp up deficits if we have to. I know many listeners will think that Canada's still running a big budget deficit, or that their province is running a big budget deficit. But if you measure the burden on the economy, in terms of how big are these government interest payments on all that debt as a share of GDP? Actually, at the Federal level, they've never been lower in our lifetimes. And at the provincial level, they have fallen from where they were in the '90s, and even deficits in Ontario and Alberta, which have been a little large lately, haven't tipped that into an upturn. So there is room, if we need it, and I don't think we need it yet, to deliver a big fiscal stimulus, should the economy weaken more dramatically.
[Don’t go west, young man]
We've tracked indicators at the provincial level, if you're interested in how your province is doing. This chart doesn't measure each province in absolute terms. It looks at nine indicators and says, "How is your province doing, relative to how it normally does?" So provinces with bars pointing upwards, are provinces where those indicators are growing a little faster than they normally do for that province. So it's not that New Brunswick is growing faster than Ontario. It's that New Brunswick might be having a slightly better than average year for New Brunswick. You know, it's a bit better than 1% growth. But, as you can see in the chart, we are seeing some disappoints, relative to the normal trend, and those are mostly in Western Canada, where, either the housing slowdown in BC or the oil production cuts in Alberta, are part of the story.
[Mostly small surprises vs. budget forecasts. And BC is still a very solid credit]
We don't think that this makes government bonds risky, though, if we actually translate this into how much is GDP growth—which is the revenue base for the province—falling short of what was assumed in the last budget forecasts. You know, it's a few decimal points here or there. And most of these budgets have already built in a cushion for what happens if the economy was a little slower than we expected. So we still think that, you know, for those of you holding government bonds, provincial government bonds, the credit quality still looks quite good.
[Canadian and U.S. corps are not awash in interest payments]
And even corporate bonds, you know, we see a lot of stories about corporations borrowing aggressively. Are they at risk? Well, again, measured the right way, they don’t appear to be.
If you measure interest paid as a share of GDP by Canadian business, yes, companies have borrowed more. But given that interest rates are so low, the percentage of GDP that's being paid out, as interest on corporate debt, is actually quite low. In Canada we have a much longer series on the right. For the U.S. these numbers aren't comparable, because in the U.S. numbers they exclude the financial sector. But you can see in the U.S. the numbers are also quite low. You have to go back to the early '70s to find a lower interest burden on the corporate sectors. So corporate bonds are still relatively well positioned to meet their interest obligations.
[Central banks play defense, but not a full easing cycle]
So let me sum up by saying that we don't have a super-bullish story year for either the U.S. or Canadian economies. We do think we're in the midst of a little bit of a slowing, coming in upcoming quarterly growth rates. But the central banks, with a modest rate cut in Canada, and a slight, further rate cut in the U.S., we think will be enough to avoid an outright recession. That will mean that long-term interest rates could move up a bit, because they're anticipating somewhat larger interest rate cuts, in terms of short-term rates. We do think that equity gains from here will be a bit limited by the sluggish profit growth, associated with a global slowdown. I didn't mention this, but, you know, the Bank of Canada, the market's not fully expecting a rate cut at the end of this year, or early next year, so could put a little bit of downward pressure on the Canadian dollar. And, we're not particularly concerned by budget deficits or corporate debt, as a risk factor right now for investors.
Thanks very much for listening to me, and, I think we do have some time for questions. So, we'll be—if you have a question, please. use the web to pass it on to us.
[Question & answer]
Thanks so much, Avery, for such a great presentation.
So, while Avery's reviewing some of the questions, I just wanted our audience to join in later, so Avery can view your questions in a Q&A panel, located on the righthand side of your screen. If you wish to review this webinar again, a link will be emailed to everyone who registered for this.
Also, I'd like to request the audience members who have questions, that they are explicit to today's topics, and to avoid asking questions that are specific to a security or company.
Well, we do have some great questions coming in. So, let me pass this to Avery now. And Avery's going to answer some of your questions for you.
So, one investor asks, "Is it the right time to move into Bond ETFs?"
I always caution that in order to answer a question like that, you have to know what you're already in. [LAUGHTER] So I always argue that no economic guru, including the great Avery Shenfeld, has a clear crystal ball about the future, and that a portfolio should always have a mix of asset classes. So if you had absolutely no fixed-income investments, and 100% of all your life savings were in equities, I would say, definitely, now is the time to be moving into Bond ETFs, because you should have done that a long time ago.
Now, if you were, of course, heavily weighted in Bond ETFs, with particularly a tilt towards longer-term bonds, it might be time to lighten up a bit on that exposure. I would say there's still a bit of room for that to run between here and the end of the year. So I don't think there's a rush. But certainly around the turn of the year might be a time to say, for example, move into a mix of Bond ETFs that are somewhat more mid and short-term bonds, and a little less weighted on the long end.
So I think you'll have to be adjusting your exposure, but it's never the time to eliminate some fixed-income exposure.
There's some other questions here. See, I have to— "What do I see the outlook for oil pricing?"
So it's interesting. We had an interesting test in the oil market lately, because we had an attack on Saudi Arabia. It was only, of course, viewed as a temporary disruption. But one would think that it would, at least, raise the question about, well, what is that—you know that hot war heats up? And we had more lasting damage, and you can see that despite that fear, which certainly should have been raised, oil prices are actually down a little bit from where they were, I think, the day before the attack. But they've certainly gone nowhere. Which tells you that we are in a market, characterized by two things. One is sluggish global growth, which in turn means, a bit more sluggish than normal growth in world oil demand. And also a view in the market that there is plenty of supply out there that could be tapped profitably at prices at $60 dollars a barrel or maybe even a shade under.
So, it's not just the question of what the supply is today, but in order to take oil prices a lot higher, you need to be pessimistic about how quickly additional supply could be brought on, or the price it would take to do that. And I think that's telling you something. It's telling you that oil prices are probably, the most likely outcome is range-bound from here. That is, you know, at the low end we can dip down towards $50 a barrel, but you get much lower than that, and it starts to create doubt about whether shale oil is really all that profitable, for example. But there's a bit of a ceiling on the high end because, you know, to get prices to $70 dollars a barrel, we need a damaging hot war that really does take out supply, or, you know, newfound pessimism on the ability of the industry to generate more supply. So I think, at this point, very range-bound for oil prices is the most likely outcome.
Someone asked, "Is the economy in a demographic squeeze?"
I would say, yes, although not as severe in Canada as in other countries.
So, we have upped our immigration numbers. You know, roughly speaking, we take about half as many immigrants as the U.S., and we’re a country a 10th the size. And, I think, the U.S. is actually making a big mistake, because there are two separate issues that are being conflated.
One is, whether the country should control its own borders and decide who comes in and who doesn't. And, certainly, there are all sorts of political views on that. And I don't know if an economist is the right person to comment. But there is a second question that I do feel free to comment on, which is, let's think about the number of immigrants that you're going to accept in total, and how should we think about that? My view is that the U.S. is accepting too few immigrants. They're at full employment now, and, in certain segments of the economy, they're being squeezed by labor shortages and would be doing better. And Canada's actually taking advantage of that. Because globally-active companies are finding it easier to bring in, you know, that computer guru from India, or that engineer from China—easier to get them into their Canadian office, than their U.S. office—and that's one reason why we're seeing the Googles and Amazons, and so on, open more office space in Canada, because they can get the people they need. Both Canadians who are well educated, but also new immigrants that they can bring into Canada that they can't get into the U.S.
But, in both cases, you know your trend rate of growth is more constrained than it was, if your memory goes back to the '60s or '70s, when Baby Boomers were entering the workforce on mass, joined by women, whose increased labor force participation was, at that point, a new story. We're now in a much more of an aging population, and we may have peaked out on the female-participation rate. So the trend growth rate is a bit slower.
Question here, "If bond and equity returns are expected to be low, where would you invest your retirement funds?"
I think that's, you know, that's the question of the day. Which is that, sometimes unfortunately, you're in a world where you're at the dessert table, and none of that looks that appetizing, but you're still hungry, so you'll go for the little piece of cake. And that's, sort of, where we are now. That, in fact, if you look across asset classes, it's hard to find something with a generous return. And, I would say, I would even include, some of the alternatives that people have been turning to. You know, hard assets, like real estate and so on. Because the price of those get bid up by the fact that bond yields are so low. So we've reached the point now where, you know, across the range of asset classes, it's hard to find a huge winner, and so you've got to settle for something that's going to be, just, okay.
Now, where are those "okay" returns? Well, I think there are still some dividend-paying stocks, for example, that even if the stock price doesn't move, as long as the dividend payout is maintained, you're going to beat returns on cash which are close to 0.
So, there's certainly some assets out there that are going to yield an "okay" return. But I think it's fair to say some Canadians are going to have to rethink how much money they are going to need for retirement? Because if low-interest rates are a more persistent story, and, therefore, returns on safe assets are going to be persistently lower than we might have thought 15 years ago, it unfortunately means you have to have a larger pool of retirement funds to meet your retirement objectives. So that is an unfortunate fact of life. The dessert table doesn't have as many large portions as it might once have.
Lots of questions, by the way, asking me about, "What happens if Donald Trump gets impeached?"
[CHUCKLE] "Or, doesn't get elected?"
Certainly, that's, you know, a question we're asking ourselves. I think the problem right now, and you haven't seen the equity markets react much to this, is that the range of possible stories is simply too wide. So you could look at the case, if Trump is out, and a more left-wing Democrat gets elected, does that mean that we're going to have a less pro-business environment in the U.S. that could be negative for equities? Is it, maybe? Or does it mean that the Republicans end up running someone else for President? There's still time for that to happen. And is that someone else better placed to beat an Elizabeth Warren? For example, I think that—I think at this point, it’s just too early to really have any clarity what this political story actually means for financial markets.
I think we've run through some of the questions out there—a lot of them. It's actually people have similar things on their minds. So... that's interesting. We do have this presentation, I guess, on playback, that you'll be able to look at.
And, with that, I'm going to turn it back over to Peter, for some final words and instruction on that.
Avery, thanks so much. That was really insightful.
Looks like that's all the time we do have for today—I'm sorry.
To speak on behalf of the entire audience that thoroughly enjoyed listening to your insights, thank you for such a wonderful presentation.
On behalf of CIBC Investor's Edge, I'd like to thank you and the audience for attending today. So, if you have any questions or comments, please visit the Investor's Edge website. Or please feel free to get in touch with us—by phone, you can contact us by live chat and email.
Thank you for joining us today. And we're looking forward to our next session.