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.<\/p>\n
AA<\/strong>: Hello and thank you for listening to the Insight is Capital podcast\u2122. 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 \u201cBreakfast with Dave.\u201d<\/p>\n David will be giving the opening keynote address at the Inside ETFs Conference June 21st and 22nd in Montreal<\/strong><\/a>. The subject of his keynote will be \u201cWhere to invest for tomorrow, today.\u201d David, thank you very much for joining us today! In your most recent notes you\u2019ve become critical of the growth outlook for Canada and the U.S. First, let\u2019s talk about Canada. What are the factors you see are interfering with the Canadian story?<\/p>\n David Rosenberg<\/strong>: Right, well the Canadian story I think is a probably a more obvious one than the U.S. but I think in Canada it\u2019s a case of excessive regulation, the fact that we\u2019re having trouble obviously attracting foreign direct investment into the country, because of what\u2019s happening on the domestic pipeline side, which has artificially depressed our oil price, and that\u2019s been a critical constraint, obviously, for for the energy patch, and all the ancillary industries, attached to it.<\/p>\n 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\u2019s 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\u2019t have here at home.<\/p>\n The reality is that if you\u2019re 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\u2019s I think one of the critical factors \u2013 diverging fiscal policies.<\/p>\n 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\u2019re bullish on the Canadian outlook, you\u2019ve 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.<\/p>\n I think it\u2019s going to be hitched to a weaker Canadian dollar artificially stimulating exports into the US and that\u2019s basically going to be \u2026 so long as you don\u2019t get hit with the wave of protectionist policies and the eradication of NAFTA, that\u2019s really all we can point our fingers at, is the cheap Canadian dollar, buying our market share, way into the US market that\u2019s the bullish story for Canada for the next while.<\/p>\n AA<\/strong>: You\u2019ve said that the Bank of Canada is \u2018caught in a box\u2019 \u2026<\/p>\n David Rosenberg<\/strong>: Well I mean \u201ccaught in a box\u201d in the sense that you know the Fed is under the new chairman Jay Powell is clearly raising rates albeit gradually and normally you\u2019d 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\u2019s just a fact.<\/p>\n But we\u2019re 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\u2019re going to be willing to tolerate any extended period of inflation above target.<\/p>\n Their bet, their view is that any inflation in Canada will be transitory. They\u2019re going to look right through it \u2013 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 \u2018shadow\u2019 Fed Funds rate in the United States.<\/p>\n 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\u2019s 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.<\/p>\n AA<\/strong>: It\u2019s been said that the policy response from the Bank of Canada has been very reactive rather than proactive \u2026<\/p>\n David Rosenberg<\/strong>: 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\u2019s remorse or maybe in this case seller\u2019s 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.<\/p>\n 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.<\/p>\n 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\u2019s way down the road if it happens at all. So I think, look there\u2019s 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 \u2013 no rate hike yesterday<\/span>]\n 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.<\/p>\n AA<\/strong>: Are you saying that they\u2019re leaving the door open on that there isn\u2019t a a schedule in mind, that they\u2019re going to watch and see?<\/p>\n David Rosenberg<\/strong>: I think it\u2019s, uh yeah, look I think it\u2019s not just data dependent, its also forecast dependent that the Bank [of Canada], in it\u2019s nuanced way, has managed to tell the markets that it\u2019s 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\u2019t identify before.<\/p>\n This, therefore, is telling the Bank of Canada that we\u2019re 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\u2019re not going to overreact any length of time where inflation is at or above target. So they\u2019re finding different ways to signal to the market that they\u2019re going to be a unduly patient.<\/p>\n No, they\u2019re not giving any signal that they\u2019re 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.<\/p>\n But we have, just, this range of of clouds or constraints. You know, we mentioned the energy side. We didn\u2019t 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\u2019s playing a role as well.<\/p>\n You know the reality is that when you\u2019re 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\u2019s never been that high. We\u2019ve never been as a nation, this indebted relative to the size of the economy.<\/p>\n In fact were at a point now where you know we\u2019re making Italy start to blush at our current level of indebtedness and look at what\u2019s happening over there right now, and that\u2019s 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.<\/p>\n 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.<\/p>\n And, actually what we\u2019re seeing is that the bank doesn\u2019t have to raise interest rates. U.S. bond yields are going up we\u2019re 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\u2019re 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.<\/p>\n So, in that environment what\u2019s the Bank of Canada really supposed to do. Really, their hands are tied you know I say that they\u2019re \u2018caught in a box\u2019 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\u2019m concerned,<\/p>\n AA<\/strong>: So, doing so would be an error?<\/p>\n David Rosenberg<\/strong>: I think it\u2019s pretty clear; the Bank Canada raised interest rates in January \u2026 for what reason? And they didn\u2019t follow through with anything else ever since, except just consistently dovish policy rhetoric, so, you know time will tell whether January was a mistake.<\/p>\n I think the Bank of Canada, like most other economists, had a slightly different GDP forecast for the first quarter than what we\u2019re getting, which is you know barely one-and-a-half percent which for all intents and purposes, is what you call stall-speed economy.<\/p>\n So I think that\u2019s Bank of Canada has some regrets they won\u2019t say it openly. Why would they? I wouldn\u2019t.<\/p>\n But, I think there\u2019s 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.<\/p>\n AA<\/strong>: Let\u2019s talk about the U.S., David. You foresee that Trumponomics will cause the next recession. What could possibly go wrong there?<\/p>\n David Rosenberg<\/strong>: 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.<\/p>\n It\u2019s a time period where you want to basically, you know, almost pull a Joseph out of the Old Testament \u2013 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\u2019s happening is that we\u2019re 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\u2019s going to come out of the economi numbers we get next year, when we\u2019re going to be left with a huge fiscal hangover.<\/p>\n Now on top of that you\u2019ve got to consider that last year, for example, the U.S. was running close to say a six-hundred-billion-dollar fiscal deficit. That\u2019s now going up to a trillion in the next few years, probably on its way to two-trillion, because it wasn\u2019t 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\u2019s no broadening of the base.<\/p>\n 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\u2019re 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.<\/p>\n They don\u2019t like to save very much. The question is who\u2019s 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.<\/p>\n It\u2019ll 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\u2019re going to show up to the auctions to fund your deficits which you\u2019re 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.<\/p>\n We\u2019ve had ten recessions in the US \u2013 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\u2019t 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 \u2013 it all just is frightening [sic].<\/p>\n It\u2019s pretty obvious everybody thinks that this business cycle is going to last indefinitely and if there\u2019s a recession until 2020 or 2021. I think it\u2019s going to be a lot sooner than that. I don\u2019t see how the Fed just sits idly by and ratifies a fiscal stimulus package of this size as a time of full employment.<\/p>\n Keeping a mind that the Fed Funds rate right now is still negative in real terms \u2026 at a time of full employment, which has never happened before.<\/p>\n So look I\u2019m not a rampant inflationist, and I don\u2019t think we\u2019re 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.<\/p>\n I\u2019m 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.<\/p>\n Today that\u2019s almost half. We\u2019ve 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\u2019re 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.<\/p>\n So it\u2019s 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\u2019s not obvious today anymore than it was a year before the last recession.<\/p>\n I don\u2019t remember anybody in January of 2006 talking about or in January \u2013 you know 2007 talking about a recession in January 2008. I don\u2019t remember anybody talking in in 2000 about a recession 2001; you see it\u2019s 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.<\/p>\n AA<\/strong>: As for the global economy you say the synchronized growth story is fading. David what is happening there?<\/p>\n David Rosenberg<\/strong>: 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\u2019s like the you know story of the optimist and the pessimist go for a cup of coffee, and the optimist says \u201cthings can\u2019t possibly get any better\u201d and the pessimist says to him \u201cwell I think you\u2019re probably right on that one,\u201d so it\u2019s exactly right. Things can\u2019t possibly get any better.<\/p>\n I, you know, the, the, it\u2019s 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\u2019re shrinking the balance sheet.<\/p>\n The ECB is no longer cutting interest rates, I mean, they\u2019re 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\u2019s of course come home this year with a lag to negatively affect their manufacturing sector when ex-forex and you\u2019re seeing that really in what was once the engine Germany is now become a bit of a caboose.<\/p>\n 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\u2019ve seen it in the data this year. You know the U.S. is not accelerating. Japan actually contracted in the first quarter.<\/p>\n 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\u2019m going to say is going into a full-scale reversal, but it\u2019s certainly gone into a much different slower year than it was this time last year.<\/p>\n AA<\/strong>: So David, given this downbeat growth scenario, where do we go from here?<\/p>\n David Rosenberg<\/strong>: Well I think that\u2019s where you go from here if you\u2019re 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 \u2013 lay out a map, show people where exactly are we in the cycle.<\/p>\n I think that we are late cycle, and I\u2019m talking in baseball parlance. I think that we are probably the bottom of the eighth inning, heading into the ninth inning. In fact I\u2019ve 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.<\/p>\n 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\u2019s so much leverage in the system you want to be more focused than ever on the balance sheet.<\/p>\n Equity investors of course are attentive when it comes to the income statement, but it\u2019s 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.<\/p>\n