There is the opportunity for be two competing themes for the Canadian economy into 2018. The first, and perhaps favored is that a strong US economy will benefit a slightly lagging Canadian economy in the year ahead. Moderating economic growth in Canada follows a year of robust, G7 leading performance. Further, interest rate hikes south of the border will be witnessed in accordance with a robust domestic US economy benefiting from one of the largest corporate tax rate cuts since the Reagan administration.

 

Alternatively, the Canadian economy will advance on its own merits once again with the best job growth since 2002, and the lowest jobless rate since 1976, which will see the momentum ending 2017 carry forward into the new year. For the Canadian-US dollar exchange rate, it seems that the first half of this year could prompt a range bound tug of war for whichever economy is outperforming the other.

 

Since the 19^th of December, the Canadian dollar has advanced over 3 per cent. Commodities quietly seem to be a significant part of the story. Since 2014 and a bear market in commodity prices led by a downturn in crude oil markets, the story has been one of abundances. Stockpiles of raw materials and surpluses of oil in storage buffered any demand shocks. As US oil inventories sit 20 per cent below their March high, one analyst commented this week following the protests and unrest in Iran that geopolitics haven’t impacted the oil markets in a sustained manner over the past three years, and that tide could begin to change.

 

Like Canada and other G7 nations including Europe and Japan, China and other emerging market economies saw a significant rebound in 2017. As a result, the MSCI Emerging Markets Currency Index is at its highest level since May of 2013 because of a strengthening backdrop in Asia. As the global economy is on track for its strongest year since 2011, the picture of a renewed manufacturing boom portrayed by positive economic surveys and increased demand for raw materials is another positive supportive for the loonie.

 

To revert to the consensus forecast, we will likely see the US economy as the leader in 2018. The question, however, is one of a transitory boost to economic growth versus the notion of sustainability. The corporate tax rate reduction to 21 per cent will be supportive for corporate earnings in the US and specifically more so for companies with greater exposure to the domestic economy. The sustainability question though is raised over whether congress will go into deficit control and the forthcoming debate over entitlement programs, which will likely shape the conversation around midterm elections in November.

 

Hence, we have a tug of war. Already forecasts for the Bank of Canada’s first interest rate hike is moving forward in 2018. The Fed is then due to up US rates in March. But the rationale for rate hikes could be the surprise in 2018. Instead of lifting rates with a strengthening global economy, and fitting with the commodity story are inflationary pressures, at which point interest rate hikes from central banks remain necessary, but risk becoming restrictive to economic growth.

 

As the New Year provides an opportunity to regroup and hypothesize themes for what’s ahead, certainty and complacency fit with a status quo risk-on investment environment. If something outside-of-the-box was to disrupt that, central bankers going on the offensive (increasing interest rates ahead of inflation) could be just that for 2018.

There’s no shortage of reasons why the Bank of Canada should start to think about higher interest rates. For example, in the last two years two Canadian provinces have implemented regulations to attempt to cool their overheated housing markets. However, to date prices are tracking higher. For first time in four years, Moody’s Investor Service, which is a debt rating agency, issued a warning and a collective downgrade on all six of Canada’s biggest banks. To add one more into the mix, the past six weeks saw the closest thing to a bank run in modern Canadian history. Depositors withdrew savings en masse from troubled alternative mortgage lender, Home Capital, because of their relation to higher risk mortgage holders. As we wait to measure the efficacy of fiscal or government policy, the Bank of Canada may have a hand to play.

 

The dovish nature of Bank of Canada Governor, Stephen Poloz has been witnessed on numerous occasions, and he still might hold one trump card. Canadian inflation through April is advancing at a pace of just 1.6%. This is far from levels of its G7 peers like the United Kingdom at 2.7% and the U.S. at 2.2%, and even the Euro Area seeing collective inflation at 1.9%. Into the summer months, with limited risk of higher energy prices, it seems likely Governor Poloz may lean on the muted level of inflation to keep him from raising interest rates while acknowledging the risks of consumer debt and inflated housing prices.

 

This past week, CIBC World Markets put out a report suggesting that because of how housing and associated costs were measured between the US and Canada, inflation between the two countries might not differ as much as economic statistics suggest. To save the technicalities, Canadian statistics may under gauge the increase in housing costs because inflation is tied to mortgage rates, and the US could be overshooting as they look at rental pricing. Regardless of which is more accurate, suggesting that the Bank of Canada is failing to capture the run up in home prices could eventually contribute to a convergence in interest rate policies. The differing policies over the past two years were casting a weight on the loonie when the US Federal Reserve began tightening. 

 

The Bank of Canada’s time on the sidelines may be limited. Ultimately, Canada’s major trading relationship with the US may see us import their inflation. The interconnectedness of our economy with theirs suggests this, and for this reason, interest rate policy in this nation can only lag that of the US for so long. The second part of the equation relates back to the status of the Canadian financial sector. Canadian banks are still acknowledged internationally as some of the globes safest, although the increased credit risk of their average Canadian borrower is what keeps everyone from short sellers to debt rating agencies to the IMF excited.

 

Canadian economists have not been anticipating a hike in interest rates until 2018. But higher interest rates could likely come sooner. The change in sentiment is the upside risk for the Canadian dollar.

 

 

There was a sentiment shift in the markets this week. Following a speech from Federal Reserve Chair Janet Yellen in Chicago on Friday, and other Fed governors and speakers leading up to her, it now seems with more certainty there will be an interest rate hike announced at their meeting on March the 15^th. Investors are pricing in a near 80 per cent probability that they will do so, (and it can be tracked here). In the short period between January 25^th 2017, and the 1^st of March, the Dow traded from 20,000 all the way to 21,000. With nothing standing its way, except the old adage that bull markets climb a wall of worry, the first obstacle for the exuberance of these US equity markets has presented itself. Within two weeks, we’ll see what, if any, challenges the Fed decision presents.

    

The US Federal Reserve cannot risk being behind the curve when it comes to raising interest rates. The rationale for this is simple. If they don’t raise rates when they are able, it’s unknown what extraneous event will prevent them from doing so in the future in this risk prone world. And in fact, some of the harsher critics of the US Fed in years past have been the ones that take issue with when they failed to raise interest rates. One example was not raising rates in September 2015, when heightened market and economic uncertainty throughout the remainder of that year nearly kept them on the sidelines despite an improving US economy.

     

Outside of the domestic US economy, last year’s focus seemed to be as much on international events such as Brexit. To date, the impact of Brexit on the North American economy has been minimal; moreover, it did hinder the Fed from raising rates last summer and unsettling what were already vulnerable markets. In hindsight, the sentiment around the lead up to Brexit fits even more with ‘the wall of worry’ scenario impacting the equity markets.  However, what other reaction would one expect from herd mentality, or even rational investors, who are experiencing an unknown event for the first time that deviates from what might be considered the status quo.

       

It is simply for the reason of being able to raise rates that we could see the Fed act as soon as March, and investors can and will take that as the much criticized and analyzed institution not wanting to fall behind the curve. For the markets, this may be a positive. While many had questioned their ability to “remove the punchbowl” from the party, meaning eventually raising rates, these minor rate hikes have been so gradual they do not yet look to stand in the way of the advancing equity markets.

Amidst all this ongoing political ‘noise’ Stateside, American and Canadian stock markets are continuing to record highs. By referring to the headlines and happenings of the new administration as ‘noise,’ it’s not my intent to make light of the day by day revelations, but illustrate how it has become a distraction from the markets and the economy. For a break, I will leave the otherwise unavoidable political debate to the pundits.

 

US Stock markets have been led ever-higher by financials. Over the last 3 months the S&P500 has gained over 7 per cent. Dow component financials such as JPMorgan Chase and Goldman Sachs are up 16 and 19 per cent respectively over the same 3-month period. Even over the last month, Trump’s first 30 days in office have seen the best performance of the Dow Jones Industrial Average by any president (first or second term) since FDR in 1945, (and these are not alternative facts).

 

Many seem to make the case that the markets are rallying because there finally is a sitting president that is good for the economy, and thus expect this trend to continue. Although, those select analysts or commentators may be right about the equity markets continuing to rally, I’d suggest they are right for the wrong reasons. I am yet to be convinced of a reviving US economy.

 

Financials are the first piece of proof. The present scenario is one where financial stocks are outperforming the market because anticipation of a wave of deregulation. This will require action by Congress, led by Trump’s Director of the National Economic Council, former Goldman Sachs President Gary Cohn. Details, however, are sparse at this point. Additionally, another reason for bank stocks rallying is the anticipated economic policy that is nothing but inflationary. Higher inflation raises the US Fed’s tightening path, and thus wider margins for banks. Ultimately though, the market seems convinced that the period of zero interest rates and squeezed margins for banks is coming to an end.

 

A more competitive tax regime in the US may be another reason for markets continuing to advance. This may attract investment and capital back to the US, but the unknown has to be whether that will contribute to increased capital spending and hiring by businesses. That story on its own is of course positive for stocks, but it can be positive also because companies are simply looking to increase dividends to shareholders or buy-back stock.

 

I do see some of these aforementioned investment themes very probable for 2017. It seems likely the US will move forward with a simpler and more attractive tax structure. Furthermore, simplifying Dodd-Frank will be welcomed by Wall Street and conveniently, former bankers hold the top seats as Treasury Secretary and the Economic Council. What this spells out for precious metals though, is a challenge.

 

Gold has traditionally been uncorrelated with financial markets. Typically, it’s a safe-haven and trades higher when investors are moving out of risk assets, and given the opposite at the moment, these themes could be negative for gold demand. There is a market saying though that “the stock market predicted 9 of the last 5 recessions.” Analysts use to look to markets as a forward indicator of the economy. This is becoming less and less prevalent as the two (stock markets and the economy) dislocate from one another. This could eventually be the positive story for gold.

It’s worthwhile to take a measured second look at what has been an absolutely wild week for the markets. Between the lows of Tuesday night in the overnight futures market, and the closing trade on Wednesday, we witnessed the Dow Jones Industrial Average in a range of 1000 points. What started was an initial selloff with Dow futures downs about 800 points to then rally and finish the day within double digit points of its all-time high. With that kind of market volatility, one would expect that catalyst to have been a definitive act from the US Federal Reserve indicating or making a change in interest rate policy, or federal stimulus unveiled by the US Federal government, but instead just an acceptance speech from the President-Elect, Donald Trump with hints to infrastructure spending and the more positive campaign promises that has investors reacting quickly and with their wallets to his pronouncements.

 

This will be the guessing game between now and the inauguration, and no doubt will contribute to more market volatility, but a modicum of rationality might be needed away from all this excitement to question how much change we may actually see, and what implications it has for the markets.

 

The Republican Party will have control of all three levels of government in the US, but how quickly they will act and give President-Elect Trump a mandate is at this point up in the air. Certainly the idea of corporate tax reform, a tax holiday for repatriating overseas earnings, and a dose of infrastructure spending are all positive to economic growth. On the other hand, it’s hard to quickly forget the uncertainty created by the protectionist rhetoric discussed over the course of the campaign, whether it was NAFTA and trade with Mexico, or slapping tariffs on Chinese goods in attempt to deflate the United States trade deficit with China. As Nouriel Roubini highlights in a recent post, tough talk on China carries the populist appeal, but is quickly realized once in office that it’s a zero sum game.

 

Similarly, with NAFTA, it does not seem like Trump would enter into scenario where he may cut off his nose to spite his face. As was a great pain for enlightened watchers throughout the campaign, the way in which the North America Free Trade Agreement was discussed illustrated how little understanding there was of the pact. As we’ve learnt, the threat of Trump pulling out of NAFTA could very much be possible by providing 6-month notification to Congress, but the ramifications of that makes it far less probable. An article in this Thursday’s Wall Street Journal debunks the “made in America,” idea of US automobiles and how the assembly is as much a story of parts travelling back and forth cross-border in the process. This is the essence in his team trying shift the conversation from being against free trade to promoting fairer trade.

 

Finally, we have to question whether it seems rational for the markets to be as overzealous as they are. A lot of the rally last week is certainly attributable to financials and anticipation that interest rates will be moving higher in December, and potentially soon after even more so with the inflationary policies proposed by Trump. Furthermore, it was further buoyed by the idea that the lax regulatory wing of the Republican Party would look to repeal Dodd-Frank and other measures that have tightened the grip on Wall Street. Our take is that if this were a government that were to accomplish anything, it will be in accordance with the slow moving pace of Washington, and very much in accordance with the marginally right of center but a divisive congress, and a filibuster prone senate.

 

As has been our view leading up to the election, the rhetoric created an opportunity for a lot of ‘noise,’ but whoever was to be elected does not change the dynamics of the global economy. As so many try to explain the phenomenon of Trump, former Pimco CEO Mohammed El-Erian explains it most prophetically by stating that low growth economic environments create civil unrest and prompt political change. The surprise outcome of the US shock should not surprise us any more than elections in Greece, Egypt, and Britain, including Brexit, and the list goes on. Trump will be a distraction, and justifiably an upsetting one for a number of people, but the current environment of a struggling debt burdened global economy has not changed, and for certain the alternative to President-elect Trump; albeit more tolerable to some, obviously wasn’t the answer.