Recorded May 28, 2018 - Our in-depth conversation with David Rosenberg, Chief Economist, at Gluskin Sheff on Canada, the U.S., and the Global Economy, and what to do with assets given the current economic and market environment we are entering.
AA: Hello and thank you for listening to the Insight is Capital podcast™. This is Pierre Daillie, Managing Editor of the AdvisorAnalyst.com and today we are very pleased to welcome David Rosenberg, Chief Economist with Gluskin Sheff + Associates and author of the daily economic newsletter "Breakfast with Dave."
David will be giving the opening keynote address at the Inside ETFs Conference June 21st and 22nd in Montreal. The subject of his keynote will be "Where to invest for tomorrow, today." David, thank you very much for joining us today! In your most recent notes you've become critical of the growth outlook for Canada and the U.S. First, let's talk about Canada. What are the factors you see are interfering with the Canadian story?
David Rosenberg: Right, well the Canadian story I think is a probably a more obvious one than the U.S. but I think in Canada it's a case of excessive regulation, the fact that we're having trouble obviously attracting foreign direct investment into the country, because of what's happening on the domestic pipeline side, which has artificially depressed our oil price, and that's been a critical constraint, obviously, for for the energy patch, and all the ancillary industries, attached to it.
I think at the same time you know we have diverging tax policies between Canada and the rest of the world, and especially the United States. So for the first time in over two decades our net effective tax rate in the corporate sector it's above what it is in the United States and when you take a look at the whole gamut of tax reforms that are taking place in the US and the lack of a response by the federal government, um you know, everything from the lack of a response here, to the tax rate decline in the United States, and also the reality that you have full-year depreciation allowance write-off in the United States, which we don't have here at home.
The reality is that if you're a North American business you are completely incentivized today to book all your revenues in the United States which means that investment and job creation is going to be deflected from Canada into the United States. So, that's I think one of the critical factors – diverging fiscal policies.
When you tack on hydro costs in Ontario, higher minimum wages, the tax situation, we are become much more uncompetitive relative to our chief trading partner and competitor, and you layer that on top of a incoherent energy policy and housing markets that are correcting hard in 35 percent of the country called Toronto and Vancouver, and excessively indebted Canadian households, you really if you're bullish on the Canadian outlook, you've sort of boxed yourself into a corner, to figure out you know what is going to happen in the next several quarters or years that are going to cause an acceleration of economic growth.
I think it's going to be hitched to a weaker Canadian dollar artificially stimulating exports into the US and that's basically going to be ... so long as you don't get hit with the wave of protectionist policies and the eradication of NAFTA, that's really all we can point our fingers at, is the cheap Canadian dollar, buying our market share, way into the US market that's the bullish story for Canada for the next while.
AA: You've said that the Bank of Canada is 'caught in a box' ...
David Rosenberg: Well I mean "caught in a box" in the sense that you know the Fed is under the new chairman Jay Powell is clearly raising rates albeit gradually and normally you'd expect to pay in Canada, although we do have our own independent monetary policy, ninety percent of the time in the past we follow what the US does. That's just a fact.
But we're going to find going forward that the Fed will continue to nudge the funds rate up. The Bank of Canada is going to be forced to the sidelines because of these range of domestic constraints and economic growth. The bank has already said that they're going to be willing to tolerate any extended period of inflation above target.
Their bet, their view is that any inflation in Canada will be transitory. They're going to look right through it – the Fed has you know more to do primarily as well when you consider that the feds got this bloated four trillion dollar balance sheet which it is shrinking also gradually when you look at the 'shadow' Fed Funds rate in the United States.
You take a look at the policy rate in the U.S. it is actually still negative when you account for the pregnant Fed balance sheet. So the Fed's got more room to go to take out the accommodation. The Bank of Canada is going to stand pat, and these interest rate spreads which are negative fifty sixty basis points right now across the Canadian yield curve compared to the U.S., those negative interest rate spreads over time become more negative and irrespective of what commodity prices do that is going to be one of the albatrosses around the necks of the Canadian dollar.
AA: It's been said that the policy response from the Bank of Canada has been very reactive rather than proactive ...
David Rosenberg: Well, only in one specific sense, which is that the Bank of Canada it seems to me, was pushed into that rate hike in January, which I think ever since then based on all the dovish rhetoric seems to me a classic case of of buyer's remorse or maybe in this case seller's remorse. You know we had an unexpected boom and jobs in November/December, which frankly when I was looking at the data and analyzing it did not pass the sniff test.
But there was no, at that point, you know, December and January, there was no communication from the Bank of Canada. The market classically shot first, ask questions later, rapidly priced in from almost nothing; rapidly priced in a Bank of Canada tightening, and the bank felt compelled to follow the market, instead of leading the market.
I think since then the bank has been leading the market towards a view that they are on hold. You know, the market continues to believe the next move will be a hike but whenever it is I think it's way down the road if it happens at all. So I think, look there's always a symbiotic relationship between the market and the central bank, and central bank and the markets. [we recorded this conversation on Monday May 28, 2018 - no rate hike yesterday]
My sense right now is that is that the bank has the markets where they like it, which is thinking that the next move could be a hike but not really knowing when that could possibly be.
AA: Are you saying that they're leaving the door open on that there isn't a a schedule in mind, that they're going to watch and see?
David Rosenberg: I think it's, uh yeah, look I think it's not just data dependent, its also forecast dependent that the Bank [of Canada], in it's nuanced way, has managed to tell the markets that it's going to be very patient because, for example, the most recent revelation was this undiscovered amount of economic slack in the labor market which the bank said they didn't identify before.
This, therefore, is telling the Bank of Canada that we're not going to get a sort of wage inflation we may have in the past with the unemployment rate as low as it is, and, of course, you know, telling the markets that, you know, they're not going to overreact any length of time where inflation is at or above target. So they're finding different ways to signal to the market that they're going to be a unduly patient.
No, they're not giving any signal that they're going to cut interest rates, and it would take really, just, a either a monumental freeze up in the capital markets, or there would have to be something global, or a complete shift in their forecast towards a recession for them to cut interest rates, especially at a time when the Fed is nudging the funds rate higher. But my sense is that for the time being you know the Bank of Canada will be as usually very situational.
But we have, just, this range of of clouds or constraints. You know, we mentioned the energy side. We didn't share nearly as much in this big run-up we had up until recently in Brent or WTI. You know we have the NAFTA overhang, and on top of the NAFTA overhang, the general increase in the protection sentiment in the U.S. Look we have now, some political uncertainty related to Ontario and we have the tax and fiscal divergence that's playing a role as well.
You know the reality is that when you're taking a look at the Canadian national balance sheet, look at all levels of government, all households, all businesses, our total debt to GDP ratio is it two hundred ninety percent of GDP. It's never been that high. We've never been as a nation, this indebted relative to the size of the economy.
In fact were at a point now where you know we're making Italy start to blush at our current level of indebtedness and look at what's happening over there right now, and that's a pervasive constraint on how far can the Bank of Canada raise interest rates especially when their own data show that almost half of residential mortgages in Canada are going to be refinanced in the coming year, which is an incredible statistic, when you consider how conservative Canadians used to be.
Everybody should take out a five-year mortgage, but because interest rates were left so low for so long and everybody believed the Bank of Canada would never raise interest rates.
And, actually what we're seeing is that the bank doesn't have to raise interest rates. U.S. bond yields are going up we're importing that interest rate pressure into our mortgage market so even though the Bank of Canada is not doing anything because 90 percent of our bond market correlated to the U.S. we're seeing mortgage rates back up and half of the outstanding mortgages are being refinanced in the coming year, at higher interest rates, which in turn is gonna end up crimping consumer spending which is 60 percent of GDP.
So, in that environment what's the Bank of Canada really supposed to do. Really, their hands are tied you know I say that they're 'caught in a box' is no different than saying that they are severely constrained in terms of raising interest rates anytime in the forecasting horizon, as far as I'm concerned,
AA: So, doing so would be an error?
David Rosenberg: I think it's pretty clear; the Bank Canada raised interest rates in January ... for what reason? And they didn't follow through with anything else ever since, except just consistently dovish policy rhetoric, so, you know time will tell whether January was a mistake.
I think the Bank of Canada, like most other economists, had a slightly different GDP forecast for the first quarter than what we're getting, which is you know barely one-and-a-half percent which for all intents and purposes, is what you call stall-speed economy.
So I think that's Bank of Canada has some regrets they won't say it openly. Why would they? I wouldn't.
But, I think there's probably some regret for having raised rates in January, based on spurious employment data in November / December that showed no extension into the opening months of this year, and so, you know, I think only a fool makes the same mistake twice. And I think the Bank of Canada is not going to make that same mistake.
AA: Let's talk about the U.S., David. You foresee that Trumponomics will cause the next recession. What could possibly go wrong there?
David Rosenberg: Well, firstly, to be stimulating fiscal policy to the extent that the U.S. is doing in this stage of the cycle, is the height of irresponsibility, very myopic view towards how you run an economy, and so here we are heading into the tenth year of the expansion an unemployment rate of sub four-percent.
It's a time period where you want to basically, you know, almost pull a Joseph out of the Old Testament – you know and save for the rainy day; this is not the time to be running structurally high fiscal deficits at the peak of the business cycle. So what's happening is that we're getting a bit of a sugar high, you know, in some of the economic numbers, not all of them, because of the fiscal boost, but it's going to come out of the economi numbers we get next year, when we're going to be left with a huge fiscal hangover.
Now on top of that you've got to consider that last year, for example, the U.S. was running close to say a six-hundred-billion-dollar fiscal deficit. That's now going up to a trillion in the next few years, probably on its way to two-trillion, because it wasn't just tax reform that we had in the United States, you know, tax reform the way that Canada did it in the past, Australia, United Kingdom, you cut the rate, you broaden the base. Well there's no broadening of the base.
There were just more bells and whistles. Then they cut taxes on the personal side, so that we can make the corporate tax cuts more palatable to the electorate, and then of course gargantuan spending on defense and social programs on top of that, at the peak of the cycle, so, we're going from 600 billion dollar deficits to a trillion, to then two-trillion, and we have to remember that you know because the net national savings rate in the United States is barely more than 1%; the U.S. loves to spend.
They don't like to save very much. The question is who's going to step up the Treasury auctions to buy all these bonds that will be issued in record sizes. You know, go back last year, half of the fiscal deficit was financed by the good graces of the foreign investor, the same foreign investor who resides in the country, now, where Donald Trump in this protectionist team are threatening you with higher tariffs.
It'll be very interesting to see how this all plays out. How the United States can attack its trading partners in this blame game, and at the same time expect that they're going to show up to the auctions to fund your deficits which you're going to record highs, tells me that no matter what the Fed does, the laws of supply and demand are going to dictate that interest rates are going to be backing up, and higher interest rates have been behind every single recession in the United States in the post-world War two era.
We've had ten recessions in the US – all of them were led by higher interest rates and so this is the the fallout from running irresponsible fiscal deficits, as if we don't know about what these do in Canada, in our experience, in the 1980s, early 1990s. So it seems like every benevolent and pro-growth fiscal stance is actually a critical policy error, to be carrying out pro-cyclical fiscal stimulus at the peak of the business cycle is going to sow the seeds for inflation, cost-push inflation, at a time of higher tariffs which is the other part of Trumponomics, which is trade protectionism, with the U.S. running out of workers – it all just is frightening [sic].
It's pretty obvious everybody thinks that this business cycle is going to last indefinitely and if there's a recession until 2020 or 2021. I think it's going to be a lot sooner than that. I don't see how the Fed just sits idly by and ratifies a fiscal stimulus package of this size as a time of full employment.
Keeping a mind that the Fed Funds rate right now is still negative in real terms ... at a time of full employment, which has never happened before.
So look I'm not a rampant inflationist, and I don't think we're going into the 1970s, and going to listen to disco music, and put on bell-bottoms again, but I do think that we have sown the seeds for much higher interest rates, over the course of the next year and that is what is going to undo this expansion, because higher interest rates at a time of record high leverage across the business sector in particular, and flaws of the household sector.
I'm talking specifically about auto loans and talking about about credit cards, those are going to be some of the some of the points of interest in terms of what rolls this thing over, on top of the fact that you know we went into the cycle with a third of outstanding corporate debt in the United States and the investment-grade sector rated triple B.
Today that's almost half. We've never had a junkier corporate bond market. And, we have a mountain in the next couple of years of corporate debt re-financings across leveraged loans, investment grade, and high yield, that they're going to be refinanced at higher interest rates, and those debt service payments are going to come at the expense of spending in the real economy.
So it's not difficult to look at this situation understand where we are in the cycle, which is the ninth inning, and connecting the dots you know that uh that with a lag, these rising rates are going to pinch the economy. It's not obvious today anymore than it was a year before the last recession.
I don't remember anybody in January of 2006 talking about or in January - you know 2007 talking about a recession in January 2008. I don't remember anybody talking in in 2000 about a recession 2001; you see it's never obvious to anybody until it staring in the face. But I think that an economic downturn United States is probably no more than a year away right now.
AA: As for the global economy you say the synchronized growth story is fading. David what is happening there?
David Rosenberg: Well, you know we we were, past tense, in a synchronized growth story last year, much like we were in a synchronized growth story back in 2007. You know it's like the you know story of the optimist and the pessimist go for a cup of coffee, and the optimist says "things can't possibly get any better" and the pessimist says to him "well I think you're probably right on that one," so it's exactly right. Things can't possibly get any better.
I, you know, the, the, it's one thing to have a dramatically easy global monetary policy and then that begins to fade. So much of the cycle was premised on the generosity of global central banks. So the Fed is raising rates, they're shrinking the balance sheet.
The ECB is no longer cutting interest rates, I mean, they're already negative in Europe, but they are, they are starting to taper their balance sheet; Japan is stuck with these um you know ongoing demographic challenges; China is tightening credit to rein in their debt binge, and Europe of course got hit with the lag, from the fact that the Euro appreciated by 10% in the past year, and that's of course come home this year with a lag to negatively affect their manufacturing sector when ex-forex and you're seeing that really in what was once the engine Germany is now become a bit of a caboose.
Tack on some of the recent political uh uh politically tenuous situation in both Italy and Spain coming home to roost. You have the UK where the Brexit uncertainties are pervasive overhang over their economy. So yeah, you've seen it in the data this year. You know the U.S. is not accelerating. Japan actually contracted in the first quarter.
Looking at the at the aggregate data in Europe It looks as though they are basically running barely above a one percent annual rate. China is not imploding but China certainly is slowing down. So this synchronized growth story I'm going to say is going into a full-scale reversal, but it's certainly gone into a much different slower year than it was this time last year.
AA: So David, given this downbeat growth scenario, where do we go from here?
David Rosenberg: Well I think that's where you go from here if you're an investor, is the most important thing is to have an understanding of where we are in the business cycle. You know so the economists really should be Topographers right now – lay out a map, show people where exactly are we in the cycle.
I think that we are late cycle, and I'm talking in baseball parlance. I think that we are probably the bottom of the eighth inning, heading into the ninth inning. In fact I've done a whole bunch of analysis showing that where we are 90% of the way through this cycle. So you want to invest with a life cycle mentality in mind. and that means that you want to be hedged against rising interest rates, especially in the United States, and the spillover that will have into Canada.
You want to be hedged against late cycle inflationary pressures, which will be exacerbated by this US trade protectionist policy. So you want a hedge against inflation, and edge against rising rates, because there's so much leverage in the system you want to be more focused than ever on the balance sheet.
Equity investors of course are attentive when it comes to the income statement, but it's going to be even more important to focus on the quality of the balance sheet, especially to consider what debt service payments going to look like over the course the next several quarters and years.
So balance sheet quality; and it means that you step up the quality of your bond portfolio, reduce the duration, but also a very clear understanding of what they're refinancing risks are for any particular company that you own irrespective of whether it has earnings visibility or not.
What might be the debt refinancing schedule will look like? So it's really about, you know, I think you want to have more cash on hand than you normally do, to use for optionality purposes, and and I think that you want to have a bit of a more defensive Non-physical bias in the portfolio, and I think that you'll do just fine if you follow those protocols.
AA: And, do you have any thoughts on the equity markets?
David Rosenberg: Yeah I say that you know, you know, look, Canada is always an interesting commentary, because it's not really a market, it's more like a barbell between resources and financials, with special situations in between. You know financials actually are a pretty good hedge from rising rates, and and I think that's actually energy tends to be a very good late cycle performer.
If you're going to ask me who do I prefer more, and I see this understanding the political risk in Canada, don't forget that so many of these Canadian companies are multinationals that do so much of their business outside of Canada so when you're buying Canadian companies you're not really buying Canadian GDP. Actually you know a lot of the Canadian companies In the TSX are more correlated to the Chinese GDP, or U.S. GDP, than the Canadian GDP.
We don't dictate really where the price of global energy prices are going, but energy stocks, commodities stocks, they tend to be good classic late- cycle performers, and good hedges against inflation, and the financials and not just the banks but also also the LifeCos tend to be natural hedges against rising interest rates.
In the United States again it's going to be a case of being a very selective. it's not so much sector- specific in the US as much as being very cognizant of the degree of economic sensitivity you have in your equity portfolio. And there are different ways as well you can hedge against inflation and rising rates; very similar to what you would be doing in the Canadian space.
I think in Canada the one thing that's obvious to me is that Canadian dollar's direction is going to be weaker, and the cuts both ways creates winners and losers, but the winners in the stock market in Canada will be those companies that have large-scale US dollar denominated revenues that will be accretive to their earnings. So it'll be some parts of the industrials that will be very well in that environment. And you know if you can ever remove the NAFTA cloud, so much the better.
So notwithstanding the fact that I have a more downbeat economic outlook in Canada, notwithstanding the fact that the politics, well the politics in the United States are going to look dicey too, when you consider what could possibly happen with the midterm elections. So it's not as if Canada's alone in this realm of political uncertainty.
We're going to have the Ontario election, then followed by the Quebec election. Then we'll be, before you know it, in the middle of a federal campaign here as well. But the point I'm making in the Canadian context, as a as a plug for Canada, is a lot of bad news has already priced in.
I mean when your interest rates are this far below the United States, when the Canadian dollar's trading this far below its equilibrium value, based on what commodity prices would tell you it should be, you know, when you have the Canadian stock market trading at a two-multiple discount to the US stock market on a p/e basis, there's a lot of bad news priced in Canada at the same time.
The one thing I'll say about Canada is if you're looking for a traditional late cycle out-performer, and you're looking for something that has value in a part of the cycle where value does outperform growth, keeping in mind the S&P 500, is a growth, is a growth universe, Canada's really a value.
I'm probably at the margin more bullish on the Canadian stock market right now over the the U.S., despite everything else I've talked about.
AA: David thank you so much for your time and we'll see you at the Inside ETFs Conference.
David Rosenberg: Excellent! I'm very excited about it.
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