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Inside the Market ‘A very unprecedented situation’: CIBC’s Benjamin Tal on where the trade war, interest rates, home prices, and markets are heading next

Economic health is the foundation for earnings growth for many industries and companies. The economy is the engine that can fuel corporate profitability and strong stock market returns.

Given the relatively flat return in the S&P/TSX Composite Index year-to-date, The Globe and Mail recently spoke with Benjamin Tal, deputy chief economist from CIBC World Markets, to get his view on the state of the economy.

Earlier this month, the Bank of Canada raised the overnight rate. Looking forward, what are your interest rate expectations?

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I think the dilemma that the Bank of Canada is facing is the following. The way I put it is, ‘Fight inflation like there is no Trump or fight Trump like there is no inflation.' If you just fight inflation like there is no Trump, you continue to raise interest rates and if you fight Trump like there is no inflation, you are not raising interest rates.

I don’t think that the Bank will move again this year. I think the headwinds from the U.S. will be significant enough to show that GDP is being negatively impacted by the uncertainty regarding the tax cuts, NAFTA, and even a trade war between China and the U.S. In the short term, I think the Bank of Canada will focus on the negative headwinds and even if inflation is a bit above target, they will allow it to happen before raising interest rates. In addition, the housing market is slowing down so that's another factor.

How many rate hikes are you expecting for 2019?

We are expecting two at this point.

How much of a negative impact may trade actions have on economic growth, can you quantify it?

It's basically a binary outcome, zero or one. Zero would be everything is fine, we will find some sort of resolution to NAFTA, there will not be a trade war with China, and that's very bullish for markets and economic growth. One is the other possibility, where we have a full-scale trade war, NAFTA is destroyed and we have a much more negative impact on stock markets and economic growth.

We are in a very unprecedented situation where things can go one way or another because policy is so unpredictable. Quite frankly, I can pretend to know where we are going but nobody knows because let's face it, what we are doing now is trying to normalize the abnormal. What is happening south of the border is abnormal in terms of how unpredictable U.S. President Trump is and everybody is trying to make decisions based on this uncertainty and that is very difficult to do. I do believe that at one point common sense will prevail.

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What are your real GDP growth expectations for Canada ?

In 2017, which was a fantastic year, real GDP growth was 3 per cent. In 2018, we forecast 2 per cent and in 2019, 1.6 per cent.

Turning to the U.S., 2018 and 2019 are going to benefit from significant fiscal stimulus. That is why we see GDP growth at 2.9 per cent in 2018 and 1.9 per cent in 2019. However, this fiscal stimulus is like a sugar high, it’s a temporary story. I think that by late 2019, early 2020, the fiscal situation, which is a very significant positive boost, will come to an end, which means you are going from something positive to nothing, which is actually a negative. In addition, the Fed is moving so interest rates will be relatively high by 2020.

I would not be surprised if by late 2019, early 2020, people will be tweeting about the possibility of a recession in the U.S. That's a possibility that will clearly impact our market but that's two years from now. In between, the U.S. will outperform given the fiscal situation.

So in between investors are better off investing in U.S. equities versus Canada?

We have calling for the U.S. to outperform. The tax cut itself is a significant boost to earnings. Valuations are already reflecting all the good news coming so at this point it will be more difficult for the U.S. market to really be fantastic. That is why we go to the binary story. If tomorrow, you tell me that the situation with China will improve, that will be a significant boost for the U.S. stock market.

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My sense is that the trade war with China will end up being a trade dispute as opposed to a war. China is very limited in its ability to retaliate. I think at the end of the day, there will be some sort of compromise, which I think can be, at the margin, bullish for both markets. I think that China will be willing to compromise more than the market is willing to admit at this point but they will not do it in a quiet way, there will be a lot of noise in between, and that's why I see volatility in the market.

I think the end result will not be a full-scale trade war, which I think will benefit the markets, same with NAFTA. I think we will start getting some better news over the course of the summer on NAFTA but nothing big, but if I have to guess, I think we will get something done that is reasonable.

So in the near-term, the S&P/TSX could continue to gain strength?

Again, you have the zero or one scenario. There may be some positive noise during the summer, which might actually have a positive impact on the market or at least prevent it from going down in both Canada and the U.S.

So how do you see NAFTA negotiations playing out?

Our assumption is that we will have a zombie NAFTA, basically a situation where NAFTA is not going anywhere. There won't be a decision but there will ongoing negotiations that will continue to go on for the next year and that will continue to impact, in a negative way, the psyche of CEOs. Even Trump told us that he doesn't want to make NAFTA a major focus until after the mid-term elections, so that's November.

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Are there sectors in the S&P/TSX Composite Index that are compelling areas to invest in?

We think that energy is undervalued. Also, companies that have a significant portion of their earnings from the U.S., we are overweight them. We are not extremely bullish on the TSX.

Given your expectation that the Bank of Canada may remain on hold for the balance of the year, should investors be concerned about financials – the largest sector in the S&P/TSX?

Financials have been underperforming recently and one of the reasons is the slow trajectory of interest rate hikes. Another reason is the negative impact on the housing market from B-20 [federal guidelines on residential mortgage underwriting], a significant force that is slowing down activity, which is very important for banks. I don’t see banks going down but I see limited upside potential. In this environment, the dividends are extremely attractive so this a good enough reason to own banks, but in terms of valuations, I don’t see significant upside in the near-term.

Turning to the Canadian dollar, strong oil prices and Bank of Canada rate hikes do not appear to be providing much support for the loonie.

Exactly. Despite the increase in oil prices, the dollar is not doing so great because of expectations about interest rates. The expectation is that the Bank of Canada will go much more slowly than the Fed so the spread between the U.S. and Canada will widen. I think the U.S. dollar will grow stronger - globally. I think the tax cuts in the U.S. are clearly helping. Its GDP growth will outperform many other countries.

I do believe that in the near-term the Canadian dollar will stabilize where it is. If there is a bias, the bias in my opinion would be towards a lower dollar as opposed to a higher dollar but it will be by one or two cents. I think most of the damage is there. I don't see it going to 70 cents unless we have negative news on NAFTA.

What is your outlook for the Canadian housing market?

What we are seeing now in the housing market is extremely healthy. We see a soft landing driven by policy. The main force is not interest rates, it’s B-20, namely the changes to the qualification rate by OSFI [Office of the Superintendent of Financial Institutions]. To me, at this point, that’s more significant than higher interest rates.

I think we are 80 per cent through the correction in the low-rise, single-family market. However, I think that the next leg, especially in places like Vancouver and Toronto, might be the condo space where I see the risk of investors slowing down activity, and about 50 per cent of that market is [composed of] investors. That market will probably slow down moderately because the economics of investing are not as good as they used to be.

Nevertheless, one negative is that alternative lenders are getting a lot of business and they are less regulated. Some people are moving from banks because they cannot qualify to alternative lenders, MICs –mortgage investment corporations – so we are transferring risk from the regulated market to the unregulated segment of the market.

Outside of the U.S., are there other markets that are attractive to you?

Japan can be interesting. They probably will have some sort of deal with the U.S. to keep their exemption status. They were able to increase their labour force participation and the Bank of Japan is not moving any time soon.

Now, I have a few questions from our subscribers for you. First, where will interest rates be in five years?

I don’t think they will be very different from where they are now. I think they will go up and then they will go down because there will be a recession at one point.

Lastly, what is your outlook for stocks in the global infrastructure and gold sectors?

I am neutral on gold, I don't think gold is going to shine any time soon. I don't see inflation rising strong enough to justify gold.

Infrastructure is a good story but you have to be very selective. It is a very good way of collecting dividends and stable returns without too much risk.

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