Canadian Highlights
- A slow start to 2018 has given way to healthy growth that should carry through the rest of the year on the back of solid labour markets and other economic fundamentals. Real GDP should expand by 2.2% this year and next.
- Some of this upward revision is not due to a change in our view on domestic economic drivers. The legalization of cannabis will result in a one-time lift to the accounting of GDP, boosting the growth figure for 2019. Absent this influence, underlying momentum will likely be closer to the 2% mark. This reflects a slight upgrade from June, as residential investment momentum comes back to the forefront. With the economy operating near capacity, more interest rate increases are in store. October remains the most likely timing of the next hike by the Bank of Canada.
Note: As we went to press, the U.S. announced tariffs on an additional $200 billion on imported Chinese products, impacting 5,745 items. Effective September 24th, the tariff will be levied at 10%, and could be raised to 25% on January 1, 2019. Shortly thereafter, China announced retaliatory tariffs of 5 to 10% on $60 billion of U.S. imports.
The forecasts contained within do not incorporate this recent development and we will re-state the forecasts should it become inevitable that the U.S. will follow through on the more material tariff of 25% in 2019. Past tariffs have resulted in limited economic impacts so far, but the upcoming broader reach of tariffs has the potential to be a game changer.
Based on the current announcements, we estimate U.S. real GDP growth would be weighed down by roughly 0.4 percentage points over a 4-6 quarter period. This may not resonate as a large impact, but it’s important to bear in mind that economic momentum in the U.S. is already slated to slow towards a 2% pace by the end of 2019 due to waning fiscal impulse and tighter financial conditions.
In the event of full escalation of the U.S.-China trade war that includes a further $267 billion of U.S. tariffs on Chinese goods, we estimate that the U.S. real GDP forecast could be marked down as much as 0.8 pp relative to the baseline enclosed here. Inflation would be marked up by 0.6 pp. The Federal Reserve would look past one-time tariff impacts on inflation, and the slower economic growth profile could likewise temper the pace of rate increases. The Federal Reserve will be gauging inflation expectations by market participants as a key determining factor to the policy path.
Please see Chart 4 for reference on the potential economic impacts under varying scenarios.
As a final comment, the economic drag will not be isolated to China and the U.S. from this trade spat, due to economic and financial linkages to other countries, including Canada.
The Canadian economy shifted into a higher gear in the second quarter (+2.9% annualized), in part reflecting resolution of production disruptions that constrained activity at the open of the year. Early indicators suggest solid momentum will carry into the second half of the year, albeit at a more sustainable pace. GDP growth should sit around the 2.2% mark both this year and next. Despite increased volatility in the most recent labour market data, the trend remains our friend with income gains sufficient to absorb the impact of rising borrowing costs. This is reinforced in the housing data that depict a market well on the healing path in the wake of macroprudential policy changes.
As always, headline growth masks many moving parts. Complicating matters this time around will be the upcoming legalization of cannabis, which will artificially boost growth at the end of the year. Canadians should look through this one-time boost, as the Bank of Canada certainly will. Instead, there are plenty of domestic demand drivers to keep the central bank’s bias towards raising interest rates, as evidenced by measures of inflation that are already at or above their target.
External backdrop solid as clouds part
Perhaps the most closely watched component of the Canadian economy, international trade, has so far managed to hold up well despite the storm clouds that formed south of the border. Export of goods surged in the second quarter after shipments at the start of the year were held back by temporary disruptions in the auto and energy sectors (Chart 8). Encouragingly, trade activity appears resilient despite evidence that tariffs have scarred some sectors, like steel and aluminum. As evidence of business investment confidence holding firm amidst an uncertain climate, imports of machinery and electronic/electrical equipment continued to trend higher.
Recent developments on NAFTA negotiations offer some optimism that a deal is within reach for Canada. The U.S. and Mexico have worked out their major disagreements, particularly for the automotive sector that was a major stumbling block in moving the negotiations forward. Canada is unlikely to have any issue with those terms, although other sticking points remain to be sorted out (see commentary). Even in the absence of fully fleshed out trade and technical details, a ‘handshake’ agreement would suffice in lifting the cloud of uncertainty that hangs over Canadian businesses. In addition, strong underlying U.S. economic growth offers fertile ground for Canadian exporters. This combination leaves us wedded to the view that net trade will continue to contribute modestly to economic growth through 2019.
Decent domestic fundamentals
Although trade headlines capture a lot of our attention, it is the domestic economy that should be the near-term focus. Tariff and NAFTA threats have left many economists fretting that business investment would be severely undermined. There has been no evidence of this, as yet. The pace of business investment slowed in Q2, but we believe this to be only a temporary breather after impressive growth in the prior five quarters. In addition, the economic backdrop argues for ongoing investment growth, both in terms of capital and the expansion of physical space. Capacity utilization rates are elevated across almost every sector, while permit data for industrial construction remains solid. Looking beyond the private sector, the federal government should also lend a hand via its spending plans, as projects continue to move through the pipeline.
The steward of the Canadian economy, the consumer, regained vigor in Q2, and is expected to remain an important driver of the growth profile going forward. However, there’s one caveat. That strength in consumer spending will be hard-pressed to recapture the momentum seen in prior years. Rising income gains will now be counterbalanced with higher borrowing costs. Nevertheless, the fundamentals that underpin consumers are intact. This is nowhere more evident than within the housing market, which has begun to spring back to life (see report). Sales activity has turned positive within most major markets, as buyers shake off the impact of mortgage rule changes implemented at the start of the year. Likewise, a recovering housing market will support spending on related goods, such as furnishings, furniture, building materials, and other items.
Cannabis takes growth higher (but it’s an accounting illusion)
We have upgraded our economic growth forecast for 2019 to 2.2%, but we would caution against reading too much enthusiasm into this. Some of the lift to next year’s growth outlook can be put down to an artificial boost from the government’s legalization of cannabis. On October 17th, the consumption of cannabis will become legal, and shortly thereafter, Statistics Canada will include both licenced and unlicensed cannabis activity in the official economic statistics. This is expected to boost real GDP by about $7bn to $8bn. While not a massive sector in a nearly $2 trillion economy, the inclusion as a “level lift” in 2018Q4 and 2019Q1 will impact measured growth rates.
Thus, growth for Q4 would have been around 2% absent this measurement change, and now becomes 2.9%, followed by a smaller lift in Q1. Because the technical change comes at the end of the year, this lift flatters the annual growth figures via the higher hand-off it imparts to 2019 (Chart 9). It is all a bit of an illusion, however. A portion of this activity already existed in the Canadian economy, but wasn’t formally captured within most measures of economic output. In fact, with time, these growth rates will be revised back towards their ‘true’ value as Statistics Canada incorporates historic estimates of cannabis-related activity. This amplified high in the growth outlook should thus be discounted when taking the pulse of the economy.
Beneath the haze, cause for more hikes
Looking beyond the noise in the data, the underlying picture is still of an economy operating at or above capacity. Core inflation is sitting on the Bank’s 2% target and economic slack is effectively non-existent (Chart 10). Conditions remain ripe for further rate increases. The Bank’s communications point to another near-term hike, most likely with their October 24th decision.
After October, the outlook is less clear, with much depending on NAFTA and the pace of wage gains. The Bank of Canada has reduced the level of GDP in their prior projections by roughly half a point through the end of 2020 based on trade uncertainty. A failure to achieve resolution will keep this uncertainty in play and likely moderate the pace of rate hikes in 2019 and beyond. Conversely, a move towards resolution would be growth-positive, and could accelerate the pace of rate increases. Wage growth remains an important consideration for the Bank, and recent gains have been described as softer than they would have expected. This has been the Bank’s characterization for some time, even as they raised their policy interest rate four times in roughly a year. Thus, this factor is most likely to serve only as a moderator for the pace of rate hikes. Balanced against still solid economic fundamentals, we expect the net result will be continued hikes, but at a somewhat slower pace of roughly one 25bp increase every six months.
On September 26th, the Federal Reserve will raise the federal funds rate, marking the eighth straight quarter in which it has announced monetary tightening. We don’t think they are done, and expect four more rate hikes over the coming year, placing the fed funds target at a peak level of 3.25% in 2019. This policy rate path has created substantial divergence between the Federal Reserve and other major central banks. Divergence is occurring even as central bank peers have moved increasingly hawkish – we believe the Bank of Canada will raise rates for the fifth time in October and the ECB will end QE in December. Against this backdrop, the broad trade-weighted U.S. dollar has appreciated roughly 6% year-to-date, further boosted by trade risks and emerging market weakness (Chart 11).
Greenback reflects diverging economic risks
While the Federal Reserve is facing some of the clearest skies yet on the domestic landscape, other central banks are being slowed by idiosyncratic risks. Think how Brexit muddies the path for the Bank of England, trade risks for the Bank of Canada (BoC), and Italian bank risks for the European Central Bank. Central bankers are slower to raise rates on improving economic data because they are cognizant of the near and present dangers that could produce negative shocks. Take the example of Canada. If there was resolution of trade risk, markets would likely price a faster pace of rate hikes by the Bank of Canada. In this scenario, we would expect the current negative 60 bps differential in Canada-U.S. 2-year government yields to narrow approximately 30-40 bps. The reduction in trade risk and improved pricing for the BoC would boost the Canadian dollar versus the greenback to the tune of about 3-5%. But, as long as these risks remain, major currencies will trade at discounts against the U.S. dollar.
Emerging risks in developing markets
In spite of the discounts to developed market currencies, nowhere has economic risk had more of an impact on U.S. dollar crosses than with emerging markets. The U.S. dollar has appreciated 3.5% against the trade-weighted basket of major currencies, but a whopping 8.4% against the emerging market basket (see Chart 11). The Turkish lira, the Argentinian peso, and Venezuelan bolivar garner a lot of attention given their dramatic declines this year. But, outside of contagion risk, these currency moves don’t materially impact America or its trade-weighted currency index. Instead, the biggest contributor to the broad trade-weighted dollar’s move has been the Chinese renminbi. This currency contributed to approximately 26% of the rise in the dollar index in the last six months. This is unsurprising given China is front and center for the U.S. administration’s policy of reducing bilateral trade imbalances. With tariffs already imposed and the risk of further action, currency depreciation is justified.
Bottom line
The Fed will continue to chart its own path and push policy rates higher, but they will be approaching the end game pretty soon – we believe in 2019. This leaves other countries in “catch-up” mode with their policy path, suggesting the strength of the greenback is on borrowed time. Likewise, any dissipation in trade risks will also serve to shift momentum from the safety of the greenback. In all, the U.S. dollar is flirting with a period of outperformance that will be difficult to sustain in the absence of another global shift downwards in economic momentum.
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