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Economic Insights March 3, 2016 Take a Chill Pill Economics Avery Shenfeld (416) 594-7356 [email protected] Benjamin Tal (416) 956-3698 [email protected] Andrew Grantham (416) 956-3219 [email protected] Royce Mendes (416) 594-7354 [email protected] Nick Exarhos (416) 956-6527 [email protected] “text text text” by Avery Shenfeld We’ve been steadily downgrading our Canadian and global growth outlook since the second half of 2014. But we now find that market chatter has left us feeling like rosy-glassed optimists. The wall of worry isn’t that high in consensus economic forecasts. Instead, it’s been heard in the talk on the trading floors of Wall Street and Bay Street, and whatever street the Shanghai market sits on, among the newly cautious FOMC voters, and in the resulting flight to safety rally in US Treasuries. Prospects aren’t as bleak as some now fear, and rates aren’t going negative everywhere. Emerging market recessions, or in China’s case, growth disappointments, have been front and centre in the global economic slowdown of the past year. And make no mistake, these are challenging times for the likes of China, Russia, Brazil and their regional trading partners. But as investors, we need to be scanning for signs that the news ahead might be better rather than worse, and there are indeed some forces that might pave the way for at least lessbad news in the EM space (see pages 6-9). Stateside, only weeks after the Fed hiked in December, we were being asked to assess the odds that America’s central bank will eventually be pushed into negative rates. Increasingly, the analogy is being drawn to Japan, which had its own real estate and financial market shock way back in the early 1990s, from which it ended up being stuck in a zero rate policy, and now negative policy rates, for what seems like forever. We long ago projected that US rates will track much lower than in past cycles (See Economic Insights, April 2014). But America isn’t turning Japanese, not by a long shot (see pages 3-5). Nor is it sitting with a massive output gap like the one still festering in Europe, wounded by the Eurozone’s failure to use fiscal stimulus during the Great Recession. The analogies that the bond market was relying on to price away almost all rate hikes in the next two years, and take 10-year rates below 2%, simply ignore too many of the facts on the ground. In recent days, we’re seeing what could be the early signs of a reversal of that trend. The market’s assessment of Canada is rightly one of concern for near-term growth prospects. Just as fiscal policy differentiated the Eurozone’s post-recession fate from that of the US, it will hold the cards for getting the Canadian economy back in gear. Monetary policy is a spent force here, given an indebted household sector and an aging housing boom. Look for the federal budget to deliver a larger fiscal boost than was talked about during the campaign (see pages 10-11) as a way to avoid Canada having to turn Japanese in monetary policy ahead. Take a chill pill, as things aren’t as bad as you’re hearing on the street. http://research. cibcwm.com/res/Eco/ EcoResearch.html CIBC World Markets Inc. • PO Box 500, 161 Bay Street, Brookfield Place, Toronto, Canada M5J 2S8 • Bloomberg @ CIBC • (416) 594-7000 C I B C W o r l d M a r k e t s C o r p • 3 0 0 M a d i s o n A v e n u e , N e w Yo r k , N Y 1 0 0 1 7 • ( 2 1 2 ) 8 5 6 - 4 0 0 0 , ( 8 0 0 ) 9 9 9 - 6 7 2 6 CIBC World Markets Inc. Economic Insights - March 3, 2016 MARKET CALL • A larger fiscal stimulus package is likely to be seen as a sufficient boost to keep Canadian policy rates on hold. But the Bank of Canada’s serious consideration of a cut in January reflected its distaste for having Canadian yields get pulled up too soon when the Fed is seen as tightening. We see it using forward guidance to remind markets that BoC rate hikes are much further off, and we’ve slightly trimmed our path for two-year Canadas as a result. • So far, Treasuries haven’t reacted much to what we see are nascent signals of a return to a 2%+ inflation world, and are not yet priced for even two hikes by the Fed this year. That seems misguided, and overly influenced by developments in countries overseas with much larger output gaps. We’re retaining our call for a June hike, and upward pressure on Treasury yields. • The C$ has staged a decent rebound off its weakest levels, helped by dovish Fed talk and a modest firming in crude oil. The latter could continue, but we expect the Fed to return to the rate hike table in June, giving the US$ one final day in the sun against other majors. Longer term, while oil might be supportive, recoveries in the loonie will be limited as the BoC lags sufficiently behind the Fed in rate normalization in order to retain the lift to exports. INTEREST & FOREIGN EXCHANGE RATES 2016 2017 2-Mar Jun Sep Dec Mar Jun Sep Dec CDA Overnight target rate 98-Day Treasury Bills 2-Year Gov't Bond 10-Year Gov't Bond 30-Year Gov't Bond 0.50 0.45 0.54 1.25 2.04 0.50 0.45 0.50 1.35 2.25 0.50 0.45 0.55 1.50 2.30 0.50 0.45 0.70 1.60 2.50 0.50 0.45 0.90 1.95 2.80 0.50 0.45 1.10 2.20 2.85 0.50 0.55 1.10 2.35 2.95 0.75 0.70 1.20 2.35 3.00 U.S. Federal Funds Rate 91-Day Treasury Bills 2-Year Gov't Note 10-Year Gov't Note 30-Year Gov't Bond 0.375 0.33 0.86 1.86 2.70 0.625 0.55 0.95 2.25 2.85 0.625 0.60 1.00 2.50 2.95 0.875 0.75 1.30 2.60 3.05 0.875 0.75 1.30 2.75 3.10 1.125 1.00 1.40 3.00 3.15 1.375 1.30 1.60 3.10 3.20 1.625 1.50 1.85 3.10 3.30 Canada - US T-Bill Spread Canada - US 10-Year Bond Spread 0.12 -0.60 -0.10 -0.90 -0.15 -1.00 -0.30 -1.00 -0.30 -0.80 -0.55 -0.80 -0.75 -0.75 -0.80 -0.75 Canada Yield Curve (30-Year — 2-Year) US Yield Curve (30-Year — 2-Year) 1.51 1.84 1.75 1.90 1.75 1.95 1.80 1.75 1.90 1.80 1.75 1.75 1.85 1.60 1.80 1.45 EXCHANGE RATES 0.74 1.35 114 1.08 1.40 0.72 1.00 3.92 17.91 0.70 1.42 115 1.10 1.43 0.69 1.00 3.95 17.22 0.73 1.37 118 1.12 1.47 0.71 0.98 3.91 16.71 0.74 1.36 120 1.14 1.54 0.74 0.98 3.97 16.46 0.75 1.34 118 1.16 1.55 0.77 0.97 3.48 16.21 0.75 1.33 116 1.18 1.55 0.78 0.97 3.48 15.97 0.76 1.32 122 1.15 1.53 0.77 1.03 3.55 15.73 0.75 1.33 123 1.16 1.57 0.78 1.03 3.45 16.06 END OF PERIOD: CADUSD USDCAD USDJPY EURUSD GBPUSD AUDUSD USDCHF USDBRL USDMXN 2 CIBC World Markets Inc. Economic Insights - March 3, 2016 Turning Japanese? We Really Think Not Avery Shenfeld and Andrew Grantham Demographic Destiny and Real Neutral Rates Japan is the poster child for what could go wrong after a real estate and financial crisis. Turning Japanese was not only an unfortunate 1980 pop song, but is now a shorthand for being stuck with employment, growth and inflation all below target, bond yields at nearly zero, and of late, overnight rates in negative territory. What all developed economies share today is that, due to slower growth in the working age population, their trend growth at full employment is likely to trail historic norms. That’s relevant to monetary policy because it implies less pressure for businesses to expand capacity to keep pace with demand. A lighter track for capital spending at any given real rate of interest in turn means that central banks can’t set rates as high once full employment is reached. Interest rates ultimately have to be low enough to turn the savings of the household sector back into the economy in the form if investment spending. Only weeks after the Federal Reserve took a baby step towards higher rates, Treasury yields were looking a lot like those seen earlier in Japan’s story (Chart 1). Prospects for additional rate hikes were nearly priced out of futures, and some were even asking if American rates could go negative. Canada, beset with the drag from low energy prices, was also being seen at risk of a Japan-style outcome. Japan’s story, however, is one of extremes that won’t be seen in North America for decades to come, if ever. Fertility rates are low across the developed world, but Japan added to that with an aversion to immigration (Chart 2). Europe had shared that, but a wave of refugees from war and weak economies in the Middle East and Africa has, at least for now, significantly increased net immigration. But Japan’s story is not likely to be universal even if, as we long ago argued, US and Canadian interest rates follow a much gentler path in this cycle than we have seen in the past. Structural factors and poor policy decisions in Tokyo doomed Japan to its present fate, and these simply aren’t replicated in the US, or Canada for that matter. The result is that markets are getting too pessimistic on equities, and too bulled up on safe-haven government bonds. Chart 1 Chart 2 North American Bond Yields Following Those of Japan 4 6 Japan 10Y Bond Yield (%) Low Immigration A Factor Behind Japan’s Demographic Malaise 10Y Bond Yield (%) 8 Net Immigration Rate (per 1000 of Population, Avg of 5 Years to 2013) 5 3 6 4 2 3 4 1 2 US 1 Feb-16 Sep-14 Apr-13 Nov-11 Jun-10 Mar-06 0 Aug-07 Jan-16 Nov-11 Sep-07 Jul-03 May-99 Mar-95 -1 2 Canada Jan-09 0 Adj. For 2015 Surge 0 Japan Source: Bloomberg, CIBC Euro Area UK US Canada Source: World Bank, CIBC 3 CIBC World Markets Inc. Economic Insights - March 3, 2016 Chart 3 Working Age Populations Rising Slower in US, Cda; But No Japan-Style Plunge 1.2 Chart 4 Large Fiscal Drag in Japan, Not in US Avg Annual % Change in 25-64 Population 0.4 Drag/Stimulus From Fiscal Policy (%-pts) US 0.8 0.0 0.4 -0.4 0 -0.8 2005-2015 -0.4 Japan Fiscal Drag -1.2 2015-2025 F -1.6 -0.8 US Canada W.Europe 2015 Japan 2016 Source: UN, CIBC 2017 2018 Source: IMF, CIBC North America has a longer history of welcoming newcomers, albeit one that is under question in this year’s US election season. But current projections have both the US and Canada still avoiding the worst of Japan’s demographic time bomb (Chart 3). That should see trend GDP growth dip a bit below 2% in the coming decade, but nothing akin to what happened in Japan. nearly forced to try its hand at negative policy rates, even knowing that their efficacy would be limited. The Eurozone has been similarly ham-handed fiscally, refusing to ease even as the economy has struggled to close a massive output gap, pushing the ECB into negative rates of its own. In contrast, the US eased policy sharply after the recession, and while it was in a tightening mode in 2015, now has fiscal policy settings on track to be neutral this year, and stimulative come 2018, barring a post-election rethinking. Canada, of course, is about to unveil a federal fiscal stimulus effort that the Bank of Canada specifically cited in its decision to eschew the next step towards lower rates in January. Policy Steps and Missteps Of course, it’s not just that Japan has a tumbling potential growth rate, it’s that for most of the past couple of decades, its fallen short of that potential. Unemployment rates look low, but full employment in the past has been well below where the jobless rate now sits. That was true for most of the post-1990 period, and the resulting slack allowed deflationary forces to take hold. Inoculated Against Deflation The errors of the 1990s included a failure to clean up a banking system calcified by bad debt, a sharp contrast to what the US did with the TARP program. It took the BoJ a half-decade to ease its policy rate to 1% after that shock, and another half decade to undertake QE. By acting more aggressively to defend against a persistent, massive overdose of economic slack, both the US and Canada are much less likely to fall into the deflation trap that has fed into negative policy rates and ultra-low bond yields. It’s just that to some extent, the bond market has not recognized that difference. More recently, Japan’s missteps have been associated with a premature turn to fiscal tightening, in this case in the form of hiking the sales tax, with another due in 2017. The result is that fiscal policy shifts are taking a roughly 1.2% of GDP bite out of growth, as measured by the change in the cyclically adjusted budget balance (Chart 4). Little wonder then that the Bank of Japan felt Japan’s near-zero nominal 10-year yields assumes that inflation isn’t coming back in the next decade. That’s visible in the market for inflation linked bonds, with a breakeven implied 10-year inflation rate of only 0.2%. Monetary policy could ultimately get aggressive enough to make that the wrong call, but its easy to see why investors could form their current opinion. After all, the 4 CIBC World Markets Inc. Economic Insights - March 3, 2016 Chart 5 Chart 6 Inflation Expectations Out of Line With History, Current Core CPI Japanese Wages Never Recovered (L), US Pick-up Already Starting (R) Japan Avg Earnings (% Yr/Yr) 6 Avg CPI Past 10Y 10Y Breakeven 5.0 4 4.0 Current Core CPI F'cst 2 1.6 US Avg Hourly Earnings (% Yr/Yr) 3.0 0 2.0 -2 0.8 1.0 -4 -6 Sep-17 Jan-16 May-14 Jan-11 Jul-15 Jun-10 May-05 US Apr-00 Canada Mar-95 Germany Feb-90 Japan 0.0 Jan-85 0.0 Sep-12 0.4 Sep-07 1.2 May-09 2.0 % Jan-06 2.4 Source: National Statistics Agencies, Bloomberg, CIBC Source: SBJ, BLS, CIBC past decade has already seen a similar near-zero inflation rate, and current core price hikes remain moribund (Chart 5). territory, although it could cool given the tumble in employment in the high-paid energy sector. But that’s not the trend stateside (Chart 6). US wage gains are off their lows, and are projected to head higher as the prime-age employment rate continues to recover. In contrast, inflation expectations for the US and Canada are below their past-decade’s average, even though that historical period included the much greater economic slack of the great recession. Moreover, current core CPI inflation readings are still sitting near 2% in both countries. Add it all up, and investors are simply overstating the odds that the Fed will stay on hold, that inflation in the US will dive, and that bond yields are thereby reasonable at sub-2% 10-year rates. Even in Canada, fiscal stimulus could avoid the worst of what beset Tokyo markets. Japan’s recent past may still be a guide for what lies ahead for Japan, and even a risk for Europe, but North America isn’t turning Japanese any time soon. The low inflation assumed in the JGB market is also in line with Japan’s near zero wage inflation, a consequence of imbedded low inflation expectations and ample labour market slack. Canadian wage growth is still in the 2% 5 CIBC World Markets Inc. Economic Insights - March 3, 2016 Emerging Markets' Rebalancing Act Benjamin Tal and Nick Exarhos With Asiaphobia taking over from Asiaphoria, the impact of slowing emerging markets on the rest of the world is currently of crucial importance. As China tries to rebalance its economy and find the optimal path between an aggressive reform agenda and an acceptable rate of GDP growth, there’s a non-trivial risk of an accident. But to date, the market’s reaction to slowing EMs has probably been too severe as investors overestimate the linkage between emerging markets’ weakness and pass through to developed economies. When the fog clears, EM differentiation will continue to be a theme, with policy stimulus and the pull from developed market growth paying dividends in 2017. Chart 2 Emerging Market Slowdown: Not Just China 8 % Slowdown in Emerging Markets Was Broadly-Based 6 Acg 2012-2015 4 2 0 -2 -4 0 EMs Slowing is Old News 2 4 6 8 % 12 Avg 2000-2011 Source: World Bank, CIBC After being the darlings earlier in the cycle, markets are now waking up to the realization that emerging markets can actually slowdown. But the reality is that growth in emerging markets has been decelerating for almost half a decade (Chart 1). EMs Slide, and The Spillover Abroad With the growing role of emerging markets in the global economy, asset prices in developed markets have become particularly sensitive to what happens in EMs. Although it’s tempting to attribute all of this deceleration to China’s well-publicized slowdown, essentially all emerging markets have seen slower growth in the past 4 years relative to the growth they registered in the previous decade (Chart 2). During that broad-based slowdown, currencies have softened relative to the greenback and firms have seen both margins and topline growth come down. But what is the impact that of a slowing in emerging markets on developed economies? The answer lies primarily in the interplay between two factors. The first is the income effect, as slower external growth reduces effective demand in domestic markets. The second is Chart 1 Chart 3 EMs Have Been Slowing for a Half-Decade Sizing Up EM Dent To DM Growth 0.0 -0.1 -0.2 -0.3 -0.4 -0.5 6 UK -0.6 Japan 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Developed Emerging economies Markets to to Emerging Developed economies markets Eurozone 0.0 -0.1 -0.1 -0.2 -0.2 -0.3 -0.3 -0.4 -0.4 -0.5 Impact of 1%-point slowing in Emerging markets Impact of 1%-point slowing in GDP US 10 9 8 7 6 5 4 3 2 1 0 Source: IMF, CIBC 10 Source: IMF, CIBC CIBC World Markets Inc. Economic Insights - March 3, 2016 Further complicating the matter, there isn’t a uniform impact amongst developed market corporates. Corporate Germany derives close to 10% of sales in emerging markets, compared to an estimated 2% seen in the US. Also note that those sales are largely aimed at emerging markets’ consumers, who are—on the whole—still seeing an acceleration. That serves to limit the negative impact on multinationals. Chart 4 EM Slowdown Lowers DM Growth Track – A Bit Growth in Advanced Economies 2.5 % 2.0 1.5 1.0 As for financial markets, bank linkages and cross boarder holding of securities have grown rapidly over the past decade, but relatively speaking they’re still small. Bank claims on EM borrowers range from 4% of assets in the UK, just over 1% in the US and even lower in Japan and Germany. The EM slowdown matters to the rest of the world, but the impact appears to have been exaggerated. 0.5 0.0 2011 2012 Actual 2013 2014 2015 Ex impact of slowing EMs Source: IMF, CIBC Calculations The Blow To and From Commodities the substitution effect, driven by weakening foreign currencies rotating exports away from developed markets. If the link between emerging market and developed economies growth is not as strong as perceived by many, that’s not the case in the commodity space. As illustrated in Chart 5, commodity exporting countries like Russia and Venezuela felt a harsher blow recently. Based on elasticities calculated by the IMF, a 1%-pt slowing in emerging markets growth will lead to just over 0.2%-pt softening in developed economies, with most of the impact seen in the Eurozone and Japan (Chart 3). The impact of slowing EMs on growth was noticeable but hardly a game changer (Chart 4). In fact, a softening in developed economies has a greater impact on EM growth. Granted, slowing emerging markets can impact developed economies via other channels such as the effect on their corporate sector. Large multinational companies derive sales and profits from goods manufactured and sold in China and services provided there as well. The latter’s economic and financial impact is not well captured by exports. However, overall oil exporting economies account for only 13% of EMs’ GDP. In fact, the impact of EMs’ growth on the commodity space was more important, and can be measured by using specific IMF elasticities. Estimates suggest that the deceleration in aggregate EM growth accounted for almost half the decline in commodity prices since 2011 (Chart 6). Chart 5 Chart 6 Oil Exporters Hit Harder (L); But Still Small Slices of EM Pie (R) Slowing EMs Accounted for Half the Decline in Commodity Prices Deceleration in Activity: Oil Export vs. Non-Oil Export 0 Contributions to Commodity Price Weakness (%) -5 13% 0.0 -10 -0.5 -15 -1.0 -20 -1.5 87% -25 -2.0 -30 -2.5 Oil exporters Oil importers Source: IMF, CIBC Calculations Oil Exporting EMs -35 Rest EM Slowdown 7 Other Factors Including Supply CRB Drop Since 2011 Source: IMF, CIBC Calculations CIBC World Markets Inc. Economic Insights - March 3, 2016 The Middle Kingdom vs Rest of EM Universe Chart 8 China’s Worth-less Investment China’s economy is destined to slow as it matures. In fact, recent output from the economy has been somewhat firmer than what the statistics alone would have suggested GDP growth should be running at. Investment Efficiency (Inversed Icor) Index 2004=100 120 100 But the recent soft patch in Chinese economic indicators has been cyclical as well as structural. Some of it has even been policy-induced. The most notable examples of the former have been failures in reducing financial market volatility, but there have been other missteps that have affected the real economy. For example, a reform aimed at mitigating risks from the shadow banking sector led to a decline in public investment. 80 60 40 20 0 04 05 06 07 08 09 10 11 Furthermore for EMs as a whole, cheaper resource prices driven in part by a slowing in the Chinese appetite for raw materials could see a broader pick up in investment in other countries. Taking another look at Chart 7 suggests that most EMs are committing roughly the same amount of their national output to investment as the developed market average. Despite renewed efforts that should see a stabilization in growth, investment’s share of GDP is still destined to come down over the medium term. Will that be the death knell for Chinese growth? We think not. The overall quality of investment has been on a precipitous decline (Chart 8), meaning that additional capital flowing to these projects is having a diminishing impact on overall growth. Capital committed to these large projects could actually be crowding out spending that would otherwise serve as a catalyst for other sectors. A more balanced Chinese economy will be growing at a slower pace than seen previously, but will see more sustainable underlying dynamics. Given their smaller capital base, and the greater returns that capital would have in those nations than in more developed ones, there’s room for most other EMs to ramp up investment spending, something that planned fiscal easing in most Asian EMs will target in the year ahead. Capital expenditures in these other emerging markets will be funded by FDI that has been crowded out by China over the last two decades (Chart 9). Furthermore, central government debt burdens are still modest in Asia leaving ample room for investment initiatives. Chart 7 Chart 9 Investment in GDP: China Miles Above Other EMs EM FDI Inflows Soaked Up By China FDI Flows (US$ bn, 2014) Investment Share of GDP (%, 2014) 250 DM Avg 200 60 150 50 China Share of Emerging Asia FDI (%) 40 100 30 50 20 10 China (incl Rest of HK) Emerging Asia 8 80 70 0 Source: IMF, CIBC 13 Source: IMF, CIBC Unlike other EMs, growth in China depends heavily on capital expenditures (Chart 7). Indeed the typical response function from Chinese policymakers to cyclical slowdowns is well-known: stimulate borrowing to target investment in large infrastructure projects. The most pronounced example was heavy fiscal stimulus program of 2008-9. 50 45 40 35 30 25 20 15 10 5 0 12 0 90 94 98 02 06 10 14 Source: UNCTAD, CIBC CIBC World Markets Inc. Economic Insights - March 3, 2016 EM Winners: Separating the Wheat from The Chaff Chart 11 Some EMs Not Reliant on China Part of the answer of who will receive these flows, and which countries are likely to lead emerging market growth over the medium-term lies with underlying institutional strength. Averaging the six governance scores that the Work Bank compiles (Chart 10), reveals that there is a great disparity amongst emerging markets in terms of institutional development. Share of Value Added in Exports Absorbed by China (%) 30 25 20 15 Nations like Poland and Hungary are near the top of chart, and should also be well positioned to take advantage of what will be firming Eurozone growth in the coming year. Others who rank lower aren’t likely to be the first to attract capital, and are also tied to less constructive areas of the global economy. 10 5 0 Commodity Focused China Linked Other EMs Source: IMF, CIBC commodity producers—no surprise for those of us based in Canada—will be for another anemic year, if a bit less negative than 2015 proved to be, as firmer demand puts a bottom in source prices. Indeed, we can think of separating emerging market economies between those linked directly to China, others whose economies are tied to the production of commodities, and the rest who are tied to other areas of the global economy, particularly to developed market growth. For the last group of countries, the IMF’s TIVA data suggests that less than 10% of the value added in their exports is destined for the Middle Kingdom (Chart 11). Emerging markets tied to developed economies, including Mexico and eastern European nations, are likely to fare slightly better. Although the budgetary outlook for emerging markets in Europe points to the government sector being a drag, they are in a better starting fiscal position than Latin American EMs and those in the Middle East and Africa. 2016: The Transition Year for EMs China will continue pursuing simulative policies, and by the end of the year there will be greater signs of a firming in activity. Asian emerging markets as a whole are poised to see fiscal stimulus play a role in supporting growth in the year ahead, while low resource prices have given room on the inflation front that has already seen several central banks in the region ease rates. The outlook for Putting it all together, this year should see somewhat of a repeat of 2015, although the divergence in growth amongst emerging markets should narrow somewhat. A more even flow of capital, easier monetary policy, a modest rebound in resource prices, and momentum in developed markets should bear fruit in 2017 (Chart 12). Chart 10 Chart 12 Wide Range of Institutional Strength Policy Eases in Asia (L), EM Growth Pickup in ‘17 (R) 2.0 Change in Policy Rate from Year-Ago (%) Average Governance Score 1.5 0.0 1.0 -0.2 0.5 0.0 -0.4 -0.5 -0.6 -1.0 -1.5 -0.8 Venezuela Egypt Russia China Argentina India Thailand Colombia Saudi Arabia Mexico Indonesia Turkey Brazil South Africa Malaysia Hungary Poland Chile USA Germany -2.0 Source: World Bank, CIBC -1.0 Emerging Market Growth (%) 6.0 5.0 4.0 3.0 2.0 1.0 0.0 9 Source: Bloomberg, IMF, CIBC CIBC World Markets Inc. Economic Insights - March 3, 2016 Federal Budget: Turning Prudence On its Head Royce Mendes and Avery Shenfeld When setting a federal budget against a backdrop of anemic growth, low interest rates, and a modest debt burden, what’s typically seen as prudent is anything but. A failure to provide adequate stimulus risks seeing a period of subpar growth leave lasting scars on the domestic economy. Fortunately, judging by the majority government’s recent communications, Canada’s March 22nd federal budget won’t make that mistake. A Deterioration in the Outlook Chart 1 Canada Has Low Federal Government Debt Federal Government Debt-to-GDP Ratios (%) 250 200 150 100 Last week Canadians received a sneak peek at the Liberal government’s economic assumptions for the next few years. As expected, the outlook presented was anything but pretty. In line with the street’s forecasts, growth and inflation projections were slashed. 50 0 Canada Germany UK US Japan Source: StatCan, Eurostat, FRED, Japan MIAC, Bloomberg The revised starting point for the 2016-17 budget deficit is now $18.4 bn. Of that, only $2.3 bn reflects measures taken since the Liberals took office, including the tax cuts for the middle class and the $250 mn stabilization payment to Alberta. revenue on the additional GDP growth generated more than covers the interest payments accruing on the initial ramp up in debt. The key variable left to forecast the final deficit is the size of the stimulus program. The Liberals had campaigned on $10 bn of stimulus which would roughly translate into a $30 bn deficit, but we’re betting on something larger as the outlook for the economy has dimmed since then. Infrastructure is an appropriate place to spend the lion’s share of stimulus funds given that it will put people back to work and, if the projects are chosen wisely, increase the economy’s productive capacity. Infrastructure Spending Recent estimates suggest that Canada’s infrastructure deficit stands at over $120 bn. Moreover, the share of infrastructure spending by the federal government Fiscal Flexibility The federal government has ample fiscal room to stimulate. Relative to central governments in other major economies, Canada’s debt-to-GDP ratio of 30% ranks among the lowest (Chart 1). But even those countries with considerably more debt have not come up against any material borrowing constraints. Chart 2 Interest as a Percentage of Revenue Falling 45 Interest as a Percentage of Federal Government Revenue 40 35 Moreover, public debt charges as a percentage of federal revenue have continued to fall (Chart 2). With longterm interest rates at historically low levels, that ratio should shrink in the years ahead as maturing debt gets rolled over at lower rates. Indeed, a widely cited paper by leading economists Larry Summers and Brad DeLong demonstrated that, under plausible assumptions and low interest rates, the burden on future generations is actually reduced by expansionary fiscal policies. The tax 10 30 25 20 15 Forecast 10 5 0 Q1 1981 Q3 1985 Q1 1990 Q3 1994 Q1 1999 Q3 2003 Q1 2008 Q3 2012 Q1 2017 Source: StatCan, CIBC CIBC World Markets Inc. Economic Insights - March 3, 2016 relative to that of provincial and local governments has been falling since the mid-1990s. With provincial debt already elevated by historical standards (Chart 3), and their bond spreads widening recently, having Ottawa pick up more of the tab will both protect credit ratings and lower the overall cost of borrowing. of the small business tax rate, thereby providing a little more cover for the middle income tax cut. Separately, the government could target tax relief at private capital investment, an area that is struggling in the wake of the oil price collapse. Balance Not Necessary to Improve Fiscal Position The Liberal’s election platform called for $5 bn in additional infrastructure spending and roughly $5 bn in other stimulus during the first two years of the mandate. However, with the economy underperforming even the modest outlook that most market participants were forecasting last fall, we question whether that’s enough to get the economic engine firing on all cylinders again. Federal stimulus under that scenario would be barely more than 0.5% of GDP, arguably too little to do the job, particularly with some provinces applying fiscal brakes. Given the weaker outlook, a balanced budget during the Liberal mandate is no longer in the cards. But that doesn’t mean Canada’s fiscal position, properly measured, is set to deteriorate over time. In fact, as growth rebounds, aided in part by government stimulus, the debt-to-GDP ratio is expected to fall in spite of the forecasted deficits. Assuming a $35 bn deficit in 2016-17, a $30 bn deficit in 2017-18 and $20 bn deficits during the subsequent eight years, the debt-to-GDP ratio would fall from roughly 30% today to 28% by 2025 if nominal growth averages four percent. Indeed, it would take 15 years of $100 bn deficits to see the federal government’s debt-to-GDP ratio even approach the levels seen during the mid-1990s (Chart 4). $20? $30? or Do I Hear $40 bn? We see a $20 bn stimulus program with a $40 bn deficit as being more appropriate, but given the political sensitivities, the government might show something closer to $35 bn for 2016-17, while perhaps taking on some further stimulus charged to the outgoing year. A key lesson learned in the aftermath of the financial crisis was that overly restrictive budgets can do more harm than good, if their effects on GDP are great enough. That’s been the case in the Eurozone, where the dent to GDP due to tight government purse strings has stymied progress on debt-to-GDP ratios. Larger deficits will no doubt attract some harsh words from those who recall the stresses of the early 1990s. But in today’s context, they represent the prudent approach to getting Canada back in gear, and are clearly a superior alternative to the negative interest rates seen in Europe and Japan. Beyond infrastructure, funding will likely be aimed at aboriginal people, veterans and families. An extended period for EI eligibility and support for low income households could also be on the table, with the government studying a “guaranteed annual income” approach. Support for environmentally friendly technologies could show up on budget day, as well. On the tax side, the government might restrict the ability of incorporated professionals to take advantage Chart 3 Chart 4 Provinces and Territories Have High Debt Loads Current Source: Haver Analytics, StatCan, CIBC Prior Peak 2007 Current 11 2028F 2007 2025F Prior Peak 0 2022F 0 2019F 0 10 2016F 10 2013 5 Forecast Assuming Deficits of $35 bn in 2016, $30 bn in 2017 and $20 bn Thereafter 20 2010 20 2007 10 30 2004 30 2001 15 40 1998 40 1995 20 50 1992 50 1989 25 Forecast Assuming Deficits of $100 bn each year 60 1986 30 60 Federal Government Accumulated Deficit to GDP 70 1983 70 Federal Government Debtto-GDP Ratio 1980 35 Province and Territory Debt-to-GDP Ratio Debt-to-GDP to Fall Even With Expected Deficits Source: StatCan, CIBC CIBC World Markets Inc. Economic Insights - March 3, 2016 ECONOMIC UPDATE 2015A 2016F 2017F 15Q4A 16Q1F 16Q2F 16Q3F 16Q4F 17Q1F Real GDP Growth (AR) 0.8 1.6 1.2 1.9 2.4 2.7 1.2 1.4 2.3 Real Final Domestic Demand (AR) -0.6 -0.1 0.8 1.3 1.8 1.7 0.5 0.3 1.5 Household Consumption (AR) 1.0 1.1 1.6 1.3 1.3 1.4 1.9 1.4 1.4 All Items CPI Inflation (Y/Y) 1.3 1.7 1.6 1.5 2.1 2.5 1.1 1.7 2.5 Core CPI Ex Indirect Taxes (Y/Y) 2.0 2.0 1.9 1.8 1.8 1.9 2.2 1.9 2.0 Unemployment Rate (%) 7.1 7.3 7.5 7.4 7.3 7.3 6.9 7.4 7.2 CA NA DA U.S. 2015A 2016F 2017F 15Q4A 16Q1F 16Q2F 16Q3F 16Q4F 17Q1F Real GDP Growth (AR) 1.0 2.5 2.6 2.2 2.2 1.7 2.4 2.2 2.1 Real Final Sales (AR) 1.1 2.8 3.0 2.4 2.3 1.8 2.2 2.5 2.2 All Items CPI Inflation (Y/Y) 0.5 1.2 0.8 1.3 2.5 3.0 0.1 1.5 2.9 Core CPI Inflation (Y/Y) 2.0 2.2 2.2 2.3 2.3 2.2 1.8 2.2 2.3 Unemployment Rate (%) 5.0 4.9 4.7 4.6 4.5 4.5 5.3 4.7 4.4 CANADA The fourth quarter of 2015 was hardly a scorcher, but the 0.8% growth rate was better than the expected flat outcome. That, combined with a brighter Q1 outlook, is good enough to lift the overall track of GDP growth for 2016 by one-tick, to 1.4%. Softer oil prices should dampen headline CPI’s annual average this year, while providing easier base-year comparisons for 2017. Our outlook for the labour market continues to highlight an even higher unemployment rate ahead. UNITED STATES Amidst the financial market turmoil earlier this year, talk of a US recession grew louder and caused traders to pull back bets on further Fed rate hikes. It’s true that the economic data has seen soft patches, but that overly sour sentiment underestimates the underlying momentum in the domestic economy. Employers’ demand for labour remains robust leaving consumers with more spending power, while both wages and the Fed’s preferred measure of inflation have been trending higher recently. Looking ahead, that strength should allow the domestic economy to grow by more than 2% in 2016. 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