Global economic concerns are at the forefront of investors’ minds, with corporate earnings, for now, taking a back seat. Economic issues are driving the stock market moves. Most recently, trade war concerns have created market volatility.
Last week, Gluskin Sheff + Associates Inc. hosted a well-timed economic forum at the Four Seasons hotel, which featured viewpoints from Canada’s leading economists. David Rosenberg, Gluskin Sheff’s chief economist and strategist, moderated a panel discussion with outlooks provided by: Douglas Porter from BMO Financial Group, Benjamin Tal from CIBC World Markets, Craig Wright from RBC, Frances Donald from Manulife Asset Management, and David Doyle from Macquarie Securities.
Below are highlights from the evening’s exchange of perspectives on several key issues.
NAFTA –Deal or no deal?
Douglas Porter: “We’re not assuming that NAFTA will be terminated. I think even in the worst case, even if Mr. Trump did decide to try to terminate it, I don’t believe Congress would fully play along and we’d probably be in a world of zombie NAFTA, and we’ve seen this before on certain contentious issues, where basically Trump throws it back to Congress and then nothing really happens, and I can see that in a worst-case scenario on NAFTA.
I think what’s more likely is that the political, incredibly tight timetable means that we’re probably not going to get anything done by midyear and then it gets dragged out, and in many ways this is exactly what President Trump wants. He wants jobs and investment back in the U.S. and not in Canada or Mexico.
In terms of who would be hurt if NAFTA were to be eliminated, we think there’s really no debate about it: Ontario would be hardest hit, and then our next two neighbours would be the most affected after Ontario — Manitoba and Quebec.
I think probably the most likely scenario is this middle-of-the-road, zombie NAFTA where really nothing happens. I think the chances of some kind of a deal have increased. It might be almost a stop-gap measure where we have a NAFTA-light deal that basically tides us over through political uncertainties of the next nine months and then we have a more serious effort after the midterm elections. I would give it about a 50-per-cent chance of a zombie NAFTA, about a 20 to 30 per cent of a deal, and 20 to 30 per cent chance of some kind of abrogation.
Benjamin Tal: “You need clarity and you don’t have anything and this will continue into 2019. So, to me, this means that the Canadian market will underperform the U.S. market in a big way simply because of the fact that this uncertainty is not going anywhere.
So how do you trade this? Well, first of all, you short the Canadian dollar. Second, you definitely short the Mexican peso.”
David Doyle: I assign a relatively low probability to an agreement. I don’t think that the Trudeau government can move far enough towards what the Trump administration is demanding on this deal and still achieve a deal that’s domestically saleable here.”
Housing market in the Greater Toronto Area – Where are home prices headed?
Benjamin Tal: “The market is adjusting and what we are doing now in the GTA, we are simply undoing [the gains from] 2016 and the first half of 2017. Can single family go another 5 to 7 per cent down? Absolutely it can over the next year but I think that the vast majority of the decline is already there.
When you have an affordability crisis, you have a situation which people go to where they can afford and that’s the condo market. I believe we will see some softening also in high rise over the next year, year and a half, but this is just the short-term story.
The long-term story is that this city is becoming more and more expensive. This is just a slowdown. In the GTA, it’s all about policies; we simply don’t have enough supply. We don’t have land because of policies. The lack of supply is definitely there and policies today are making the situation even worse. I’m talking about changes in the Ontario municipal board. I’m talking about rent control; this will make the situation even worse. From a short-term perspective, the next year or two, am I going to invest in real estate? Maybe not, but from a long-term perspective, if you believe that this city is unaffordable now – you wait!
Craig Wright: “It’s a supply challenge. We need municipalities to get more “builder friendly” if you will; release more supply. I suspect unless we see more supply, Toronto prices will firm this year.
David Rosenberg: I think the big risk is going to be demand erosion…When I was talking about this, when I was at Merrill, in the last cycle, I just reverted to Bob Farrell’s rule No. 1 which is that markets and ratios revert to the mean over time. Home price-to-rent ratios and I’ve looked at housing valuation-to-income ratios, those charts don’t look like they’ve really mean reverted just yet.”
Monetary policy – Rate hike forecasts
David Rosenberg posed the question, “Why is it that the futures market in Canada is still priced for two Bank of Canada rate hikes this year despite everything that Stephen Poloz has said?”
Frances Donald: “I officially have one in the forecast for July with the risk that another one happens later this year. Let me give you a framework for thinking about the Bank of Canada. They have to balance a very strong economy with an incredibly uncertain future. What is making this outlook very cloudy? There’s really four buckets in my mind. One is NAFTA, two is the housing outlook, three is what happens to rising minimum wages and how that affects investment, and then the fourth one is maybe the hardest of them all which is what impact does the three prior rate hikes have on the total economy.
What is the Bank of Canada actually watching? I think they’re watching two things. They’re watching potential GDP and they’re watching the output gap, how much excess demand do we have in the economy and they’re watching the neutral rate of interest, which is what they believe is the interest rate that is neither tightening or loosening in the economy. When Governor Poloz says he wants to remain accommodative, I really believe he’s looking for something below the neutral rate of interest, which they believe is between 2 1/2 to 3 per cent.”
David Rosenberg: “I don’t think the Bank’s raising rates again this year.”
Douglas Porter: “We’ve been saying two more rate hikes both in the second half of the year after we have a lot more information about NAFTA, but after that speech [by Poloz] and some of the new numbers we’ve seen recently, I think the odds are definitely tilted to them doing less not more.”
Canadian dollar outlook – Bullish or bearish?
The debate continues with economists voicing differing expectations.
David Doyle: “At the end of this year, it’s $1.32 or 75 cents. We get much more bearish as you get out in 2019. We see it weakening all the way through to the end of 2019. At that point, we’ve got it at $1.36 or 73 cents versus the U.S. dollar. Relative to the euro, we actually see even greater downside, we think the Canadian dollar will go to all-time lows versus the euro by the end of 2019.
I think what we’re in for over the next 18 to 30 months is that Canada is going to be paying the price for what I call the “hyper-leveraging” cycle that we went through from 2001 through 2016/2017. Now, it’s time to pay the piper and why is now the time to pay the piper? It’s because interest rates are going to go up and they’ve been going up; we’ve already had three hikes. We still don’t have an appreciation for what the slowing effect of those hikes will be. We’ll gain some appreciation of that later this year and into 2019.
My research suggests that the three hikes we’ve had so far is already the most severe hiking cycle in over 20 years and it relates to a couple of things: the indebtedness that the consumer has at the moment, but also the astonishing rise we’ve seen in the Government of Canada five-year yield. Why does that matter so much? Well, the Government of Canada five-year yield tells us what five-year fixed mortgage rates are going to be about.
People who were fortunate enough to buy their houses five years ago are now renewing at higher rates. That’s a negative shock for the consumer but this problem only becomes more intense as the years go on, particularly as we get into the back half of 2019 and into 2020. At that point, people could be renewing their mortgages at 100 to 150 basis points above what they first got them at and the reason for that is that’s when we lap Mr. Poloz’s rate cuts from 2015.
Our economy has never been more reliant on housing investment; it’s close to 8 per cent of GDP. Interest rate hikes are going to hit housing.
So the market is discounting two hikes by the Bank of Canada through the end of this year. I actually don’t have an objection with that. I think they will deliver two more hikes. I think they might realize that their window for getting those hikes under their belt is closing and it’s closing fast because by the time we get to 2019, and we have a more fulsome picture as to what’s going on with the consumer and with housing and the effect of the rate hikes, they’ll be forced to back away.
Craig Wright: “$1.22 (81.9 US cents) at the end of the year.”
Benjamin Tal: “I think it can go down a few more cents.”
Mr. Rosenberg closed out the discussion with this open-ended question to the panel, “Tell us your most controversial, out-of-the-box, unique forecast for the coming year or two?”
Douglas Porter: “We think we’re going to see negative interest rates in Canada in the next cycle. I think Canada has a very weak competitive position. I think we’re going to get crushed in the next recession and it’s going to lead to negative rates but that’s not a call for the next year or two.”
Benjamin Tal: “S&P 500 earnings, I think 2019 is too optimistic. The market is discounting about a 10-per-cent increase in earnings. I just don’t see how we’re going to get it.”
Craig Wright: “Canadian growth, we’re on the low side of consensus.”
Frances Donald: “I think we’re closer to the end of the U.S. cycle than many are pricing in. Huge fiscal push creates overheating, the Fed goes too fast, and the odds of a U.S. recession go much higher by 2021.”
David Doyle: “I have the U.S. 10-year Treasury yield going to 3.75 per cent by the end of 2019 but the Canadian 10-year about 125 basis points below that. The reason is that I think we’re up for a prolonged period when Canada’s growth and economy will underperform the United States.”
Jennifer Dowty, CFA, Globe Investor’s in-house equities analyst, writes exclusively for our subscribers at Inside the Market.