Sari about Fiscal Policy

Freshly back from his foray on the runways during fashion week in India, our PM returned and had his pal Finnegan table his government’s budget. (Can’t wait to see what JT, Sophie and the kids will be wearing when they visit the San people in South Africa).  Not surprisingly, it turned out to be more of a political document rather than an economic blue print needed to address the challenges that confront Canada.    

Over the last half of year, headwinds to economic growth in this country have stiffened.  Growth has dropped from well over 3% in the first half of 2017 to bump along around 2% at best.  There is little that the government can do about the damage to investment being caused by an erratic Trump and what he may or may not do with Nafta but there are many things that have negatively impacted the competitiveness of our economy that have been self inflicted that could have been acknowledged.  Apart from the seismic shift in international competitiveness resulting from American tax reform, recent domestic policy changes have excessively burdened our industries.  As one person noted to me, there is no sense that Canadian politicians have the “back” of business.  There is no thought of where the money comes from that these toads like to spread around in their party’s name.  From dramatically raising minimum wage to consistently throwing more regulation and environmental studies at projects, there is a sense of fatigue. 

This budget reminded me that the notion recently brought forward by the Bank that they could work in a coordinated and ex-ante way with the government to address consistent inflationary or deflationary forces is fantasy.   The government would have the Bank’s back only if it was viewed by the government in power as politically expedient.  Right now gender issues are more important than showing leadership to end interprovincial spats that keep Canadian produced oil prices depressed;  more important than keeping our overall business taxes competitive; more important than facilitating critical infrastructure in a timely manner; and more important than readying the overall fiscal situation to be prepared for the next downturn.

So all this leaves monetary policy as the only game in town to offset these challenges.  Rates will be lower longer and the currency weaker than would be the case if Mr. Dressup and his government had a different agenda.  With C+I+(X-M) sagging and no change in G (no Justin that does not mean Gucci) look for the Bank to do what it does best for a while….absolutely nothing.   

Bring in the Clowns?

At the end of the last week, one of the Bank’s Deputy Governor spoke in Winnipeg on the benefits of well anchored inflation expectations and how inflation targeting has been a major contributor to anchoring these expectations.  

He explained the issues and challenges ahead for the central bank as they start the process of renewing the inflation target agreement between the Bank and the Department of Finance for 2021.  Very candidly, he spoke of the declining trend growth of developed economies and the dampening of cyclical recoveries that could be expected.  While greater stimulus will be needed to offset these structural changes in the next downturn, he admitted that the amount of firepower that central banks have at their disposal is declining.  Less space in G7 countries for borrowing to stimulate demand due to the overhang of debt resulting from the 2008 “fix” and a declining neutral rate will constrain the effectiveness of monetary policy in the next downturn.  As a result, optimal macro policy would now demand more coordination of fiscal and monetary policy.   Studies have shown that when interest rates are pinned to the bottom, countercyclical fiscal policy arising from the automatic stabilizers kicking in and discretionary spending, like infrastructure outlays are highly effective at supporting output.  As a result, one of the things that the Bank wants to explore ahead of the renewal is looking into ex-ante mechanisms to co-ordinate fiscal and monetary policies to deliver better outcomes.  Unlike what we see south of the border, fiscal and monetary policy should be pushing in the same direction.   

With monetary policy potentially less powerful, as a citizen and asset holder, it would be reassuring to know that Parliament Hill and Wellington Street had a framework in place to ensure they would be leaning in the same direction post the next crisis in a timely manner.  Unfortunately, the philosophical and practical hurdles, and their associated risks, attached to some sort of actionable agreement between the Bank and the government are extremely high.

From a historical perspective, if managing inflation is your goal, mixing politics with monetary policy has not worked well.  Canada is a poster child in this area with the resignation of the Governor in 1961 when he set tight monetary policy to counter expansionary fiscal policy.  For a long time, central banks, including the Bank of Canada (after the “Coyne Affair”), worked to get at arm’s length from their political masters to ensure rates were set by economic fundamentals, not set by the electoral calendar.  There would seem to be some risk associated with tampering with this arm’s length arrangement.  

It is probably also fair to ask if the commitment would be binding across governments.  Politicians tend to do what is politically expedient.  The commitment to the inflation target by the current government and the Bank cited in the speech as providing the genesis for an agreement to complementary monetary and fiscal policy in a crisis is only on a piece of paper that could be terminated by the stroke of a pen by the next government (may I introduce Jagmeet when he is confronted by “excessively” high rates that are necessary to quell inflation).  Moreover, this commitment has the Bank accountable to parliament to achieve the inflation target regardless of fiscal policy dictated ultimately by the electorate.  I doubt our elected representatives would want to be seen backing fiscal actions that are contrary to what their voters want; that were triggered by what many constituents view as an arbitrary target.

On the practical side, only in a text book could you come up with ex-ante mechanisms to coordinate policies.  It is difficult enough for unelected officials to enact policy based on their outlook of what will happen.  This is almost impossible for an elected official to risk his career on what may happen.  Political momentum to enact fiscal stimulus beyond the stabilizers almost always happens after the sh** hits the fan (or they feel they are overtaxed, their military is still too small and they don’t have enough debt outstanding).  Even if the triggers (whatever they may be) were correct in anticipating a time when coordinating policies was needed, the political process could easily derail the timing. Fiscal policy, apart from the automatic stabilizers, is not quick and nimble by design.  

Given that monetary policy will not have the same amount of ammo going into the next downturn, it makes sense that the Bank pursues avenues to enhance overall macro policy.  I am just not sure that relying on politicians to act in an appropriately sized and timely manner is the type of assurance the market would want to bet on.  The best bet would be to structure your portfolio knowing the next time things go sour, the safety net below you is now much lower.

The "New" Fed in the "New" Environment

If you own stocks, the last few weeks have been turbulent.  Everyone seems to have a story about why it happened and what it means for the market going forward.  I listen to some of the talking heads and hear how great it is to see volatility back in markets.  The recent dive has acted as a release valve and now we are back to a healthier market.  The captain is about to take the seat belt sign off so the rally can recommence.  The fundamentals, we are told, remain favourable for equities to reach new highs.  Party on, Garth!  

Then there seems to be the deeper thinkers who suggest that there has been a seismic shift under the markets.  Investors had been operating in an environment of slow and steady growth, low interest rates, dormant inflation and accommodative central bank policies which led to a period of extremely low volatility and a relentless bid in all markets, including  equities.  Now, this view has been rattled.  While expectations for economic growth do not seem to have been altered much even with additional US fiscal stimulus, the market seems to have suddenly become aware that we are now in an environment where central banks are reigning in liquidity, yields have jumped higher and there is growing evidence that inflation is not dead.  This “new” environment requires that portfolios need to reposition for higher inflation and need to lower their risk profiles given the expectations of increased volatility.  

Adding to all this is the question as to how the new leadership at the Fed will respond to this “new” environment. The market was well served by Yellen over her term.  Rates were kept low and any increases were well telegraphed and tempered.  Her decision to start unwinding QE was virtually ignored.  Her market-friendly actions and resulting dovish moniker were the result of her setting appropriate policy.  With inflation stubbornly low, she could err on the side of ease.  Now, with Jerome in charge, the market has to consider whether he will be more hawkish than Janet.  For him, his starting point includes firming inflation, with core measures already close to their assumed inflation target.  He also has the economy growing above potential and in an excess demand situation.  Unlike Yellen, who could afford to act slowly, it is doubtful Mr. Powell has the same latitude.  Hence, he will likely be seen as less market-friendly and viewed as more hawkish over his entire term than his predecessor.  

The market already has a number of hikes built in for the next year.  Asset market valuations will depend on whether Fed actions match this profile.  To answer whether they do or not, we are right back to our “old” environment conundrum.  You know the one where inflation remains surprisingly suppressed relative to a given output gap by technology, globalization and other factors.  Unless there is more proof that inflation is really gaining traction and accelerating, I doubt we will see a huge personality change towards more aggressive behaviour coming out of the Fed.  It may take some time before we see the “hawk” in Mr. Powell.   Party on, Wayne!

Groundhog Day

Friday’s plunge in the Dow seems to have finally rattled the complacency that has persisted in the equity markets for the past year.  Whether this is just a pause for the markets to catch their breath or the beginning of something more sinister, no one has a clue.  

What I found intriguing is that the “jarring” 2.5% decline (remember when a 20% drop in one day was considered life changing?) occurred on Groundhog day.  This seemed appropriate both in context of Punxsutawney Phil’s call on the beginning of spring and in context of the movie bearing its name.  

Up until this week, the last year has reminded me of the movie Groundhog Day, the one with Bill Murray where he is trapped living the same day over and over again.  In the market’s version, every day the equity investor goes to work and starts buying stocks in response to hearing that in addition to a global economy that is strengthening, the US tax cuts will immediately boost earnings, incite massive repatriation that will spur buy-backs, dividend increases and all sorts of manna from heaven.  Over the course of the day, this buying pushes the indices higher and the investor goes home.  The next day, it is tableau rasa, groundhog day all over again.  The investor goes into work the next day, with the indices at a higher level and hears for the first time that US tax cuts will be great for earnings and repatriation of foreign profits by US companies will rain cash down on the market and that the global economy is gathering steam.  Investors have to get on board, so they start to buy equities, regardless of valuations, pushing the averages higher again.  The investor then goes home, and then gets up and goes to work the next day and he hears for the first time exciting news about the impact of tax cuts and the global economy…You get the picture.

I know the market is suppose to be a forward-looking discounting machine, but is it possible the degree of good news being priced into global equities was overdone while participants seemingly were locked into an infinite loop with the same factors getting rediscounted again and again?

It is now possible that from these elevated equity valuations, there has been a subtle shift away from the sweet spot.  The good news of global economic growth mixed with ample materials for financial engineering that for the last year have signalled all systems ‘go’ may now be interpreted as increasing the risk of higher yields and hence lower expected discounted future earnings. All of a sudden, good news maybe not that good after all.  

Last Friday, up on Gobbler’s Knob, Punxsutawney Phil came out of his hole to be greeted by a perfect cold morning.  With no clouds to protect him from the rising sun, he was startled by seeing his shadow and scurried back into his abode, the omen being we are in for a long winter.

On the same day, at 8:30 am, the market poked its head out to see the US employment release.  The news was good and the resulting possibility of higher-than-expected yields startled the market and sent it reeling back under its desk.  Now we just have to figure out if this means a long winter ahead for the market as well.  Happy Groundhog day.  

    

Party On

I really don’t have a life, so for the last few days I have been reading and listening to what government elites and industry titans have been saying at the World Economic Forum in Davos.  You can’t help but feel that most of these participants are almost giddy about the current state of the world.  Global growth is healthy and synchronized and probably most important to these attendees, the markets are soaring around the world.  And with the implementation of US tax changes expected to spur business investment over the near future, many pundits see stocks only going higher regardless of their starting point.

Through headlines, we were reminded by Mr. Dalio of Bridgewater and Mr. Fink of Blackrock that despite the tripling of the S&P since the depths of the great recession, there continues to be ridiculous amounts of liquidity on the sidelines that could potentially be deployed into markets.  Fink told Bloomberg News that in some countries in Europe, around 70% of people’s savings was still held in their banking accounts.  Imagine, he said, if that moved into his business sphere (stocks and bonds) and imagine what that would do to help reduce inequality as these people benefited from rising markets.  (I will give you a moment to gag).  Mr. Dalio suggested that there was a risk we could see a “melt-up” in markets as cash moved in from the sidelines.  He feared that institutions and people left holding cash would feel stupid.  

The only real risks mentioned that could derail these extremely bullish forecasts seemed to be an unanticipated acceleration of inflation or a mistake made by central banks as they try to re-calibrate monetary policy to stronger real growth in highly levered economies.  If rates rise too quickly, all bets are off.

Would one dare suggest that the policy makers may have already made their mistakes?  That the reason for the near euphoria around markets evident at this gathering is because of the sugar rush provided by policy makers when they earlier added three sugar cubes instead of the one that was needed?  A global economy at or near full employment with American fiscal policy soon to kick in does not seem like appropriate, well-timed policy.  A world awash in cash that might yet be put to work in already overvalued equity markets does not seem to be well calibrated global monetary policy.  But these “mistakes” have resulted in an overabundance of “positives”.  What’s there not to like?

It’s the next mistakes that will now have to hurt even more.    

January MPR: No Change, Still Dovish

The Bank raised its benchmark interest rate this week, as many in the market expected.  More surprisingly, the tone from the documents and the press release seemed aligned with market expectations. In the press conference, the Governor seemed pretty pleased with how things evolved, saying the market digested the firmer data as it was released and repriced itself on an ongoing basis, allowing the Bank to ratify the analysis with its increase in the target rate.  That is how it is suppose to happen, he said, when the Bank is data dependent.  

There was nothing that truly stood out from the MPR document.  NAFTA continues to be the fly in the ointment.  The uncertainty surrounding the outcome of the negotiations is already putting a damper on trade and business investment, subduing aggregate demand from where it could be and potentially having a longer-term negative impact on the economy’s capacity to produce.  If the US decides to pull itself out of the negotiations, then all bets are off with respect to the outlook.    

All said, the Bank’s forecast was relatively optimistic, with growth remaining firm and then gradually slowing down to around potential by 2019.  Although the contributors of growth do shift, the overall economy appears to have momentum and be on a firm basis.  The risk to the positive outlook is an exogenous shock. Something like the US pulling out of NAFTA.  

The Governor tried to get ahead of the market, fearing that it may start trading off of Nafta headlines, creating unnecessary volatility by indicating that the Bank would not view this as a binary event. He is right that the decision is not binary.  It will not have a significant immediate impact on the real economy.  Just because one of the participants decides to opt out, the trading world will not cease to exist.  It will potentially take years before the trade framework that replaces NAFTA will be settled on.  But in the meantime, the market will of course remain vulnerable to NAFTA headlines and, being forward looking, will rightfully react on any news as any post-NAFTA trade regime will be sub-optimal to the current one and need some degree of additional monetary stimulus. 

In addition to the NAFTA headlines which will keep risks to front end rates to the downside, there was other evidence that the Bank remains dovish.  They continue to seek reasons to justify not being as aggressive as a pure read of the output gap and the data would suggest.  Governing Council continues to want to believe that we are now in a sweet spot where stronger demand leads to greater supply with increased investment, more business creation and new hires.  They seem to want to let this run as far as they can.  They have come up with a new and improved measure of wage growth, wage-common, that just happens to show that wage growth is slower than normally reported and that the best determinant of this new measure is labour slack.  The fact that this measure is running just above the rate of inflation suggests to them that slack continues to exist. And finally, to stress that point, the Governor again at the press conference defied the analysis of many and said he was still preoccupied with Karim holed-up in his parents’ basement unable to get that job in management.

When you add all of this to their concern about the sensitivity of the leveraged household sector to higher rates, you have a central bank that seems willing to be extremely patient.  It will take some sharp upward surprises for both wages and their core measures before anything close to a hawkish bent makes its way into the building.       

The End of Judgement Days?

Here we go again with the set up for more confusion between the market and the Bank of Canada.  It should be simple.  With core measures of inflation firming at 1.7%, an incredibly strong monthly jobs report diminishing already little remaining excess capacity in the labour market and an economy already at full capacity, it should be a lay-up to expect an inflation targeting central bank that says they are data dependent to nudge rates higher at their next meeting. I know they said they would be cautious when raising rates but surely this is enough, even for this Governor.  

The market has learned over the last few months that Bank action is not strictly data dependent but instead heavily judgement dependent.  The heavy reliance on judgement, we are told, is to allow Governing Council to fill in the blanks caused by the many “uncertainties” that their models just can’t capture.  And so here we are with increasing risks to inflation from a labour market blasting away and about to feel the effects of higher minimum wage legislations, with oil above $60 and with the US economy about to get a fiscal boost, but at the same time with Governing Council having to deal with the same “uncertainties” and structural issues they consistently point to that may dramatically temper any future inflationary impulses.  Nafta could still get pulled, accumulated household debt could adversely impact consumption, OSFI’s new mortgage rules could still flatten the housing market, and, probably coming soon, the legalization of pot could potentially lower productivity (but no one will care).  But besides all these “what ifs”,  this Governor could keep the Bank on the sidelines for the simple reason that youth unemployment did not fall last month….Karim is still in his parents’ basement! 

At some point, however, you would think that the Bank’s own credibility as a forward looking, data dependent inflation targeting central bank will become more at risk.  How far can they push their reliance on their “go-to” list of uncertainties that allow them to justify a level of monetary accommodation that looks more and more targeted to only a few select slices of the economy.  I believe the Governor, in his noble zeal to be the hero of main street is risking giving many people the impression that he is either targeting the currency or unemployment rather than what he is mandated to do.

The Bank, for its own credibility, needs to move rates higher in January.  Responding in a timely and consistent manner to the data will reassure the market that the Bank remains committed to its inflation targeting mandate.  This acknowledgement that risks to inflation have increased and are being addressed will ultimately give the Bank the needed trust from the market to implement appropriate policy that will achieve their 2% inflation target and ultimately get Karim into a management position.