Produced by RBC Global Asset Management's Chief Economist Eric Lascelles, the #MacroMemo covers what's on our economic radar for the week.
U.S. dollar weakness:
- After several years of strength, the U.S. dollar has been profoundly weak for much of this year as the market priced out Fed rate hikes and White House tax cuts.
- This, in turn, has had a knock-on effect on many things, from helping emerging-market assets, to contributing to local-currency U.S. stock market gains, to improving American competitiveness.
- Although one cannot have as much conviction on the subject today as at the beginning of the long dollar rally in 2011 or 2012, we still believe there is further room for the greenback to appreciate.
- It is not a function of valuation – valuations are at worst fair for the U.S. dollar, and might even be expensive by some definitions.
- Instead, there are several important supports for a stronger dollar:
o Historical dollar cycles have gone from a very cheap valuation to a very expensive one – this one has yet to achieve that final destination.
o From a technical perspective, a further leg higher seems fairly likely.
o We believe the Fed may manage to raise rates by more than the market currently envisions. In contrast, some others, such as the Bank of Canada, may be in the opposite position.
o From an economic standpoint, the U.S. is moving along nicely and could benefit from tax cuts that are more likely than the market currently envisions for 2018. If a repatriation holiday is included for overseas corporate profits, the resulting inflows could further boost the dollar.
o While the risk of protectionism might seem a non-trivial fiscal offset to the aforementioned tax cuts – and it is, from a purely GDP perspective – the more important consideration for the dollar is that countries imposing tariffs on their trading partners usually experience a rising exchange rate. This phenomenon represents the FX market recalibrating post-tariff competitiveness levels across nations.
- There is no denying that the dollar appreciation story is closer to the end of its journey than to the beginning, but there likely remains another chapter to be written.
- Turning full circle, if the dollar reasserts itself, it is worth reflecting on the possibility that some of the recent dollar-linked high flyers could prove less lucrative going forward (and the reverse is also true).
Hawkish Fed recap:
- As per our expectations, the U.S. Federal Reserve alighted upon a hawkish message in its latest decision. Nothing in the statement or its surrounding paraphernalia was sharply different than in the prior (July) major meeting, but this was a surprise from a market perspective given expectations for more dovish comments. In the end, 12/16 of Fed participants are intent on a further rate hike by the end of the year, suggesting the tightening path is hardly over.
- Indisputably the biggest development – though also a widely anticipated one – was that the Fed has confirmed it will begin selling its stockpile of bonds in October, initially at a clip of $10 billion per month.
- This continued monetary tightening makes sense to us given the recent softness of the U.S. dollar, general economic health and the fact that hurricane-induced drags are only temporary.
U.S. tax reforms:
- No less scintillating than the “Who shot Mr. Burns?” debate from the 1995 season of the Simpsons is the 2017 “Will they cut taxes?” debate swirling around the U.S. Congress and the White House.
- Expectations have waned significantly over much of 2017 as a wide range of ideas have been vetted and rejected (does anyone remember the BAT tax?), to the point that the market is currently pricing in a fairly low probability of significant action.
- While nothing is certain, we are happy to take the above-consensus side of the debate. Tax cuts are not certain, but arguably sit at a greater than 50% probability of getting done some time in 2018. Our economic forecast assumes a moderate boost from said cuts.
- From an alignment perspective, both the White House and Republicans in Congress are desirous of a tax cut in general, and even more so in the run up to the mid-term elections of 2018.
- A sticking point has been whether to make this self-funding (in which case the deficit would not rise but equally economic growth would not palpably accelerate), or instead to finance it with deficit spending. It seems that some key players have tentatively agreed to allow the deficit to rise, with a mid-sized $1.0 to $1.5 trillion tax cut envisioned to last a decade.
- Based on this size and presuming the stimulus is delivered mainly in the form of a corporate tax cut and overseas cash repatriation with a bit of loophole-closing on the side, this argues for about a 0.5% boost to 2018 GDP.
- Of course, it is another matter altogether whether the timing is right for such fiscal stimulus. While it is generally good for U.S. corporate rates to come down toward the global norm and for some deductions to be eliminated along the way, it is not at all clear that the U.S. economy needs active help right now given an unemployment rate barely above 4%. This extra fiscal stimulus could contribute to higher inflation and a need for additional monetary tightening.
Canadian GDP preview:
- Coming on the heels of a remarkable 4.5% annualized gain for second quarter Canadian GDP, July’s monthly GDP print will offer a first hint as to whether that torrid pace will continue into the second half of the year.
- Although we fully expect some Canadian economic deceleration into year end, our models argue for another robust monthly print of +0.2% or +0.3%. True, trade was weak in the sense that real exports fell, but real imports fell by even more, providing a mathematical addition to GDP. Manufacturing was weak but housing and several other areas likely held their own. Leading indicators continue to point to good growth.
- Put another way, our gut instinct about Canada is that the risk of a downside miss is higher than usual, but the base case is yet again for more galloping growth.
Seeking Bank of Canada clarity:
- The coming week will also bring a speech by Bank of Canada Governor Stephen Poloz on Wednesday.
- After a fairly barren late summer followed by a semi-surprising September rate hike, this opportunity for clarification of the Bank’s intentions is welcome.
- In particular, the question will be whether the Bank of Canada is still full steam ahead on rate hikes, to the extent that an October 25th increase should be more fully priced in. At present, the market sits on a knife’s edge with 51% against and 49% in favour.
- Despite our earlier claim that July GDP could be fairly good, we think a rate hike in October is less likely than the market imagines. This is partially because the strong Canadian dollar is now being cited as a potential hindrance by the BoC itself (with a new trade-weighted currency index supporting this assertion); partially because the Bank has already come a fairly long way in a short period of time; and partly based on our concerns about Canadian competitiveness, declining policy support and a manic housing market.
- Of course, there is always uncertainty around these sorts of predictions, in part because of the sometimes fickle nature of economic trends, in part because the Bank of Canada has shown itself not to prioritize directly communicating its intended policy path, and in part because Governor Poloz will likely have preliminary Business Outlook Survey results in hand that the market won’t be privy to until several days later.
- Lastly, the Spanish region of Catalonia has scheduled an independence referendum for October 1st. The referendum is illegal according to the Spanish constitution and police recently raided Catalan government offices, arresting officials. “Yes” appears to be running slightly ahead of “no” in the latest polls, though Spain is almost certain not to recognize the results. Catalonia held a similar referendum in 2014 that yielded a low turnout but an 81% vote in favour of separation – it was ignored, though admittedly that was acknowledged as non-binding by the Catalonian government itself, whereas it is a different story this time.