Selected Facts and the Fed

The new administration has only been in office for a little over a week but they have started with a bang.  There is no doubt that the rantings of an ex-reality TV host are going to become very real policies.  Disturbingly, many of the policy initiatives appear to be based, not on “alternative facts” as immortalized by a Trumpeter last weekend, but rather on “selected facts”.

It is fascinating how individual facts can distort reality and be used to create a pleasing narrative that conveniently justify actions.  With respect to the economy, there is factually no doubt that factories have closed, that 5 million manufacturing jobs have been lost since 2000 and that there has been human suffering in the rust belt.  I believe the word to describe this in the inauguration address was “carnage”.  But it is just as factual to note that the economy is growing, inflation is low and total unemployment in the US is well below 5%.  It is also factual that all citizens have benefited from globalization.  Every time an American, even one without a job, goes shopping for food, clothing, appliances and electronics they have been able to walk away from the store with more for their dollar due to globalization. But these facts do not resonate.  They do not align with the reality many people see around them as many have not seen any fruits of the gains in the aggregate.  Even those who have not been directly negatively affected, claim to see others who have been.  To explain their predicament of unemployment and/or a reduced standard of living, the only thing to do is turn to blaming immigration, free trade and the government.  

This group of voters has high expectations of “their man” and he is determined to fulfill his promises that they believe will address the impediments that have stymied America. His administration is responding by building walls, bullying companies, becoming more protectionist and promising tax reform and infrastructure spending.  The administration seems to have adopted a strategy where they will very forcefully take action for one select section of the economy, manufacturing.  A component of the economy that employs one in ten Americans and frankly has not been a significant driver of growth for the economy in years.  

The administration is putting a monkey wrench into creative destruction.  I know Trump has said he will be the greatest creator of work for the US since the invention of pick-up-sticks.  But so far, through his tweets, he seems entirely focused on bringing back the high-paying manufacturing jobs found in the auto industry that in the 1970’s brought us such unreliable disasters as the Ford Pinto and Chevy Vega (back when America was great, but I digress).  They seem to be concentrating on an American industry that is easily identifiable to their voters, but one that could unfortunately be on a longer term downward trajectory with respect to jobs given robotics, climate change and the growth of ride sharing.  

All this verbiage to set the scene for the Fed.  The Fed claims that the aggregate economy is nearing or is at full employment.  The leadership suggests that additional measures from the administration are not needed to stimulate growth at this point in the cycle.  The looming challenge is that the current government has vowed that more labor resources need to be allocated to manufacturing, no matter how inefficient this may be for the total economy.  So by Trump’s standards and given where he is focused, his economy is not at his definition of full employment.  The mandate of the Fed, as written, and the apparent mandate of the new administration are not aligned.  

This could get interesting very quickly, especially if the real economic and price data forces the Fed to accelerate their tightening program in order to achieve their inflation goal for the aggregate economy.  Neither higher rates nor a stronger US dollar are in the best interest of achieving Trump’s employment nirvana on the manufacturing side.  

Given this president’s style, open conflict between the White House and the Fed is a strong possibility in the near future. It will be interesting to see if Trump’s new appointees to the Fed will feel any obligation to the administration when the going gets tough.    

A Nervous Governor

This week the Bank of Canada announced that it was keeping its overnight rate unchanged and released its latest outlook for the Canadian economy.  The projected growth rates and their profile were very similar to those published in October but they came with a major caveat.  The Bank stressed the large amount of uncertainty surrounding their outlook emanating from possible US fiscal policy actions and their impact on Canada, specifically around measures that impact trade.  

Despite the published outlook that has the economy growing well above potential in 2017 and 2018, the Governor seemed to go out of his way at the press conference to emphasis the negatives.  The risk that the US economy may strengthen further was countered by his view that our exports may not benefit to the same extent as they did in the past.  Recent positive data (employment, trade and the Business Outlook Survey) was downplayed.  He underlined the narrowness and precariousness of the Bank’s projections for above potential growth.  He explained that the outlooks for consumption, investment and net exports were not sufficient to get total economic growth up to potential but needed the announced federal fiscal measures to be finally implemented to reach the projected levels.  To date this stimulus has not been seen in the data.  

The Governor also reminded his audience of the headwinds coming from the financial markets.  Since the US election, domestic yields had backed up significantly in sympathy with treasuries and our dollar had notably appreciated against other countries that compete with us to export to the US.  He reiterated that tightening financial conditions are not conducive to supporting an economy like Canada that has a high degree of economic slack.  

It should not be surprising then that the Governor was not going to encourage further tightening with his comments.  Hence his emphasis on the negatives. If that was too subtle, when asked if a rate cut was still a possibility, he suggested that if trade protectionism became a reality and the closing of the output gap in a timely manner was at risk, that he had the room to act.    

The market responded accordingly to the Governor’s comments with front end yields moving lower and the currency depreciating against its US counterpart.  Whether the market’s reaction was overdone, as some analysts claim, is dependent on how likely Canada finds itself the victim of a drive-by shooting caused by damaging US protection policies.  The hurdle to cut would be very high (and I believe the result of any cuts would be futile) but policies that are expected to have a significant detrimental impact on our exports would warrant the Bank taking action to achieve its inflation mandate.  How likely this is and its timing depends on our good friend and his advisors to the south.   To date, it is still too early to determine whose voices Trump will listen to (and if they are even on this planet) about economic policy.  Hearing him at his inauguration cry out the slogan “Buy American, Hire American” tells me the probability of the Bank’s next move being a cut is not zero.   

Politics trumps Policy

CNBC can’t wait for the Dow to crack 20K.  The index came very close at the end of last week but was unable to do it.   Many analysts believe that the post election rally of nearly 9% cannot be justified by any abrupt upswing in economic activity so it can only be explained by the renewed animal spirits of investors sparked by Trump and his team.  Proposed policy initiatives like tax cuts, cash repatriation, less regulation, renegotiation of trade deals and a sprinkling of infrastructure spending seems to have stirred the optimism in investors.  So Dow 20K…any day now.  Don’t touch that dial.

Now that we are days away from the inauguration and the contours of the Trump administration are beginning to unfold, it’s fair to ask if the US equity markets are properly priced or if they are ahead of themselves.  I would argue the markets have the positives from the proposed policies priced in but have not discounted the risks around implementation and, more importantly, have not priced the risk of good old politics.   

The equities market appears to ignore anything that does not fit into the positive narrative.  One of the better examples is the thought process around the border tax adjustment.  It would seem to be just bad macro policy.  Many market pundits are quick to emphasize this and point out that it would hurt the exact voters who elected Trump. The resulting higher import prices and a likely higher dollar would hurt everyone, so the market narrative seems to be that cooler heads within the administration will prevail and the issue will not get any traction.

But then there is the politics of a border adjustment tax.  We are talking about a president and his followers who do not seem to understand the concept of a deal where everyone can end up being better off.  His constituents claim they have never witnessed it.  Their choice of president is a transaction- or deal-oriented person who appears to believe the size of the economic pie cannot grow, so you have to take it from others.  When a deal is struck, you either get more and are a “winner”, or you get less and are a “loser”.  The fact is that this tax can show his voters that he is strong (a winner) and is not afraid of taking on trade partners who apparently have done America harm.  Importantly, this particular initiative can also be used as a bargaining chip for dealmaking when his people sit down with different trade partners to cut a better deal for America.  Politically, it seems like a no-brainer. 

The market does not seem to be giving the politics around this proposal enough respect.   

I would suggest that the markets have been spoiled over the last twenty years, when policy has ruled over politics.  This has sadly been the result of US government gridlock and many policies being enacted by unelected institutions, like the Fed.  Following this election, this no longer appears to be the case.  An investor must now consider politics more than in the past.   One must cast their mind back to the politically motivated micro managing of Presidents Johnson, Nixon and Ford, to name a few.  

President Johnson, for instance, believed he could battle inflation by bullying and manipulating companies.  As Sebastian Mallaby points out in his biography on Alan Greenspan, Johnson became personally involved in trying to lower the prices of aluminum, copper, household appliances, paper cartons, newsprint, men’s underwear, women’s hosiery and glass containers, and “when egg prices rose in 1966, he had the surgeon general issue a warning on the hazards of cholesterol in eggs.”  His micro-management made no sense in terms of economic policy but it was not stopped by cooler heads around him, those of whom knew that this would do more harm than good.

The US has a president-elect now who has started to bully and manipulate both foreign and domestic companies through social media on how they should allocate their labor resources globally.  Some in the media have suggested he has already had a few “wins” doing this.  Others have pointed out the similarities of actions taken by Mussolini in Italy.  These tweets are obviously not based on robust macro-economic theory and cannot be considered good policy at any time, let alone unnecessary when the US economy is already at full employment. President-Elect Trump’s actions are the result of how he operates and are done in recognition of what he believes his voters want to see.  If policy mattered more than politics, I would suggest the first thing on the administration’s plate would be tax cuts, not the repeal of Obamacare before any replacement has been contemplated.  

The market wants to believe the best outcome and I hope it is right and I am wrong.  However, until I see the brave souls who will act as the cooler heads and speak up or take actions to ensure that the good policies will be enacted, I will say that the US equity market is ahead of itself.  

Welcome back to the 1960’s and 1970’s where politics trumps good policy.  

Canadian Dollars: String Theory

The New Year is opening with a high degree of optimism around the US economy.   Proposed changes to the US tax code, deregulation and infrastructure investment certainly have the equity markets convinced that better days for growth are just ahead.  Unfortunately the optimism seems to stop at the border.  The latest GDP and inflation data out of Canada came in well under expectations, increasing the possibility, in the minds of some, that the next move we will see from the Bank of Canada is a cut.  Another January surprise, like we had last year?

I just saw in a piece in the Globe and Mail, that stated that out of 149 currencies, only 14 outperformed the Canadian dollar in 2016.  For a country competing to export to the world, the fact that we became more expensive certainly does not help the near term growth outlook.  We appreciated over 19% relative to the Mexican peso last year, making their goods much cheaper in the US than ours.  For many analysts, the solution is easy.  Canada needs a lower exchange rate versus the US dollar. 

There is no doubt that Canada is at a competitive disadvantage to many countries that export to the US.  The problem is that a weaker currency is only helping offset the disadvantages Canadian firms have to deal with relative to the rest of the world.  As the Bank themselves points out, energy cost differentials (hello Kathleen), rising non-tariff trade barriers, uncertainty around existing trade agreements and a slow and complex approval process around large projects, all play a part in making our exports more expensive.   In a recent article in the Financial Post, $129 billion of infrastructure projects have been stalled or stopped in the last couple of years from opposition of environmental, aboriginal or community groups.  Surprisingly, a number of the initiatives revolved around green-friendly projects, like wind turbines.  Apparently they were canceled to accommodate the migratory movements of birds.  I suspect there were no chicken sandwiches served at the community meetings when the topic was discussed.

Canada is blessed with natural resources.  It is our competitive advantage.  If we cannot find a way to responsibly utilize these resources for the betterment of our people, then we will find ourselves in a sub optimal growth position.  We will find ourselves competing globally, but we are not allowing ourselves to play our starting line-up.  

The people who demand a weaker currency have to ask themselves how great the depreciation  would need to be to offset these large disadvantages.  They should remember that Canada has taken this road before.  On a couple of occasions in the last decades, the Canadian dollar has had brushes in the low 60 cent level versus its US counterpart.  One could argue that these moves temporarily gave relief from shocks to our economy, either through commodity price swings or as a result of global stress, but the one thing it did not do was build a sustainable and robust export sector.  In fact, one could argue that it built a “false” export sector that relied too much on the where the currency was trading and these firms vanished very quickly when the exchange rate moved.    

There is a cost, or a tax imposed, on everyone when the Canadian dollar weakens.  For our country, this usually means more expensive essentials, like food and energy.  It means it costs more for companies to make capital investments to remain competitive in the world, as many of these capital goods are imported.   Finally, in these days of financial stability concerns, it pushes home prices in our larger cities ever higher as it makes it cheaper for foreigners to buy.   A weaker Canadian dollar is not a panacea.  

Will the Bank of Canada openly encourage a weaker currency?  It is an easy fix for them that will help them achieve their inflation target as it will push our below-target inflation temporarily upwards.  But, in the analogy of interest rates, are we pushing on a string?   Given the constraints that we are putting on our nation’s competitive advantage, does the increased value of exports that will respond to a weaker currency outweigh the medium to longer term costs to all Canadians?   I would argue that it does not.  At some point, we should stop masking the source of our competitive problems with an ever cheaper currency.

And finally to address the likelihood of a January surprise, I would put the odds as very low.  With the US expected to do better, oil prices moving higher, domestic infrastructure (if allowed by our eco friends) spending ahead, and with trade deals with the US uncertain, I don’t believe the Bank needs to “panic”.  Yet.