I want to say right at the outset that I don’t think anyone knows where exactly this global trade war is going to lead, but I wouldn’t advise that anyone raise their GDP forecasts.
In fact, the Bank of Canada, based on what has already happened and the general uncertainty about what is to come, said on Wednesday that it will cost Canada one-quarter of a percentage point from annualized economic growth. It was not dramatic enough to prevent the central bank from raising rates, but I think if you’re bullish on growth, seeing a subtraction is not what you would ordinarily like to see. But my general caution comes not just from this global trade war, but from an array of factors. I just see a heightened level of uncertainty, which is going to cause business spending to freeze up once the fiscal stimulus fades, and this was the key comment in the most recent set of minutes of the U.S. Federal Reserve’s Federal Open Market Committee. Yet, if the Bank of Canada isn’t going to relent in draining liquidity, then the Fed isn’t either, and therein lies the primary risk to the outlook.
So in a nutshell, here’s what I see. I see the Fed continuing to raise rates, albeit gradually, and to also continue on its quantitative tightening (QT) path. By the end of next year, the Fed’s balance sheet will shrink nearly US$900-billion as we play out quantitative easing (QE) in reverse. This is a really big deal for risk assets, and keep in mind that the same month the stock market peaked was the same month that QT really began to take effect.
Nobody talks about what this means for the market, as if central bank balance sheet movements only affect asset prices in one direction. When you tack on everything the Fed says it will do on rates, and on the balance sheet, coupled with what it has already done, that will come to a de facto 525 basis point tightening cycle. Never in the past has such a monetary policy tourniquet failed to generate an economic downturn.
I agree that the current economic backdrop looks firm, but why wouldn’t it given the fiscal sugar-high we find ourselves in? Strip out the tax stimulus, and the U.S. economy actually is doing no better now than it was in the first quarter when real GDP growth was running at a 2-per-cent pace. By year end, if not sooner, the U.S. tax cut effects fade but what doesn’t fade is the strength of the U.S. dollar, the weakness in emerging markets, higher interest expenses and the margin-squeeze from accelerating unit labour costs. But, the elephant in the room is and has always been the Federal Reserve, since it has a very large say on what liquidity conditions are going to look like.
Larry Kudlow, U.S. President Donald Trump’s key economic adviser, has always been fond of saying that “profits are the mother’s milk” for the stock market, which is probably true. But liquidity, your best buddy in a bull market and the biggest coward in a bear market, is the “oxygen tent” for investors. Even a child can live without mother’s milk, but nobody can breathe without oxygen. And so the big story for a year replete with stories is that we had first-quarter earnings-per-share growth of 25 per cent, and the consensus for the second quarter has been bumped up to more than 20 per cent. And yet even with that, the stock market is basically no higher today than it was seven months ago.
The market had paid up for the U.S. tax stimulus early on, as in December and January. We now have heightened volatility. That volatility comes down to increased uncertainty, especially on the global trade front, about how this trade war ends and the implications for global supply chains and cost structures. It also comes down to liquidity issues, previously reflected in the flattening yield curve, then the lagging performance of the financial stocks, and now the widening we have seen in credit spreads. All are leading indicators, by the way.
There is a cost to the U.S. fiscal stimulus at this stage of the cycle, which is that it makes the Fed’s job that much tougher. Instead of it being revenue neutral, a whole slate of bells and whistles made this a budget-busting boondoggle at a time when the last thing we needed was pro-cyclical stimulus – stimulus that is not being accommodated by the Fed. The Fed typically cuts rates 500 basis points in a recession, but there’s not a snowball’s chance in hell that Fed chairman Jerome Powell will have that luxury in the next down cycle.
Here is the reality: Every bull market, every bear market, every expansion and every recession had the Fed’s thumbprints all over them. Not fiscal policy. Not regulatory issues. History can’t be rewritten folks. The Fed is not on hold. It is tightening, and don’t be fooled by the funds rate alone. Since the end of the Second World War, there have been 13 Fed tightening cycles, and 10 landed the U.S. economy in recession, and the forecasting consensus missed all 10. I’m playing the odds based on history. Nothing I see on the macro side passes the smell test, and the markets themselves have sent me enough of a signal to shift into becoming much more defensive.
David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.