#MACROMEMO

On our economic radar this week

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Produced by RBC Global Asset Management's Chief Economist Eric Lascelles, the #MacroMemo covers what's on our economic radar for the week.


April 16 - April 20, 2018

Remembering fiscal  risks  |  A geopolitical update  |  Bank of Canada preview


Remembering fiscal risks:

  • High debt levels were a universal concern in the immediate aftermath of the global financial crisis. Private sector debt had played a central role in igniting the crisis, while public sector debt increased massively to mop up the mess. The U.S. federal debt rating was downgraded by S&P. Europe slogged through a ferocious sovereign debt crisis.
  • More recently, however, the frictions and risks associated with high debt have faded from the public conversation, with only a handful of exceptions (such as Chinese debt). Providing a sense for the level of complacency:
    • The U.S. fiscal deficit and public debt barely came up in the most recent Presidential campaign, in sharp contrast to prior elections.
    • The Greek 2-year yield recently traded at a lower yield than the U.S. 2-year yield – not something anyone could have fathomed just a few years ago.
    • In all of the talk about the recent U.S. tax cut package, very little of the discussion referenced the implication of significantly more public debt.
  • Beneath the surface, global leverage continues to rise in each of the government, corporate and household sectors (see first chart).
  • To be clear, a sense of calm is not entirely inappropriate. Low interest rates have made even large debt burdens surprisingly affordable. For example, whereas the U.S. public debt load is at a modern era high, the share of GDP necessary to service it has only recently risen slightly above the modern era low. Although the circumstances are not identical, it is also notable that Japan has survived with a much higher public debt load with nary a market complaint.
  • Global interest rates have now started to edge higher thanks to unwinding quantitative easing and a handful of other rate drivers. How will the public debt burden play out over time?
    • Near term (1—2 years): Public debt remains largely affordable even as interest rates edge higher given the considerable lag with which rising rates map onto borrowing costs via maturing debt.
    • Medium term(3—10 years): Public debt becomes palpably more expensive, less because debt loads shoot higher or even because of rising interest rates, and more because the recent increase in rates infects a rising fraction of the outstanding debt as it matures over time. However, solvency is not a serious concern in most cases.
    • Long term (10-50 years): This is where the situation becomes more problematic. Given the uncertainties over such a long period of time, projections are unavoidably imprecise. The IMF figures public debt-to-GDP ratios could roughly double in many jurisdictions. This is for a mix of reasons, but revolves centrally around the starting point of structural deficits exacerbated by deteriorating demographics. What are the implications if this comes to pass for the U.S.?
      1. As with Japan, markets might ignore the high debt altogether, allowing continued low yields but declining budget room.
      2. Markets could suddenly awake to an undesirable public debt trajectory, resulting in an abrupt increase in U.S.
      3. borrowing costs and the need for a sudden belt-tightening with adverse economic implications.
      4. Lastly, markets could become gradually more concerned, prompting politicians to do something about the issue with enough runway to actually fix the problem without plunging the U.S. into recession.
    • Which long-run scenario is most likely? All are conceivable, but the first – U.S. debt continuing to pile up with nothing done about it – seems the most likely. That sounds like a happy scenario, but it really isn’t given the budget handcuffs that gradually tighten over time.
  • As an aside, whereas we have lately trumpeted the virtues of the U.S. economy and bemoaned the competitiveness and housing challenges of the Canadian economy, let us reflect for a moment on the longer term story. The U.S. is dipping substantially into its rainy day fund to support recent economic health (a budget deficit of 4.8% of GDP), whereas Canada has been less profligate in this regard (a deficit of 2.2% of GDP). When considering the longer-run economic outlook, it is arguably Canada with the upper hand.

A geopolitical update:

  • Geopolitical risks have hop-scotched from one region to another over the past six months.
  • Not long ago, concerns were focused on a newly aggressive U.S. approach to the always belligerent North Korea. But a war of words ultimately came to nothing, the Winter Olympics in South Korea provided a welcome détente and North Korea is now engaging in diplomatic negotiations with the key players including China and the U.S. Nuclear disarmament is theoretically on the table, though inconceivable in reality. But the point is that – as we argued from the start – the North Korean situation has changed very little over the past few decades, meaning minimal economic and financial market implications for the world.
  • Fairly recently, we had a bee in our bonnet about the risk of a war between Saudi Arabia and Iran. This could have been calamitous from an oil shock / Middle East stability perspective. The two countries are still at serious odds with one another, with an ongoing proxy war in Yemen and a battle for influence across the Middle East. But the risk of a direct confrontation has seemingly ebbed.
  • Syria is back in the mix due to a recent joint U.S.-France-U.K. strike against alleged chemical weapons factories in the country. On the other side of this particular skirmish (within a multifaceted conflict) is the Syrian government and Russia. Undeniably the risks have increased, but the strikes were limited and no retaliation has occurred so far. The fundamental dynamic has not altered.
  • Investigations by a Special Counsel continue into the Trump campaign and related parties. With recent raids on President Trump’s lawyer and explosive claims by former FBI Director James Comey, one must continue to entertain the possibility of an early departure by Trump. On the one hand, the investigation seems to grow ever more serious. On the other hand, the natural end of his term grows nearer by the day. As such, we stick with our prior guess of a 30% chance that President Trump leaves the White House before his first term is up. Whether this would be a market positive is another question altogether – the initial chaos would be negative, legislative progress would be halted for some time (ambiguous), but a President Pence would have broadly pro-business economic policy minus some of the intrigue.
  • In all of this, a lesson worth remembering is that geopolitical risks rarely manifest, and even when they do, they rarely have an enduring impact on the economy or financial markets. As a result, it is usually a bad idea to invest primarily on the basis of geopolitical expectations.
  • If any geopolitical risks are worth heeding, it is a much slower moving one with long-term implications: China’s ascent on the global stage, pitted against a retreating U.S. China’s rising clout was long evident from an economic perspective, but is now increasingly visible in a foreign policy sense as well. Not surprisingly, this is creating friction with the U.S., potentially spilling over into macro conditions.

Bank of Canada preview:

  • The Bank of Canada rate decision this Wednesday appears to be a “live” one in the sense that markets assign a non-trivial 20% chance of a rate hike. For its part, the Bank of Canada has thumbed its nose at markets in the past, suggesting a rate hike is entirely possible. We assign an above consensus 30% chance, but ultimately agree that a pause is more likely.
  • Hawkish arguments include the following:
    • Several measures of Canadian inflation now (slightly) exceed the 2.0% target.
    • Canada’s labour market is in excellent health. The unemployment rate is below 6% and recent job gains have dispelled trepidation about a weak January print.
    • Current monetary policy is quite stimulative, putting the onus on the doves to argue why rate hikes should not occur.
  • However, the dovish arguments look set to win the day:
    • Protectionism is a significant and acknowledged risk to the Canadian economy.
    • Crucially, we may know quite a lot more about trade policy when the subsequent Bank of Canada decision is made in May given expectations that a NAFTA deal may be struck by then. As such, it is reasonable to delay any desired hike until greater clarity is achieved.
    • Financial conditions have tightened somewhat, including a stronger Canadian dollar. Thus, other financial variables are already doing the work of Bank of Canada rate hikes.
    • Macro signals are ebbing slightly at both the global and Canadian levels. Nothing looks bad, but it would be useful to see whether an inflection point has just occurred, or whether it is merely a case of normal economic volatility.
    • Canada’s housing market is now palpably cooling. To the extent that was one of the more urgent items on the Bank of Canada’s agenda, it reduces the need for rate hikes.

Basically, the current economic signals are sufficiently robust to warrant for a rate hike, but a number of risks and headwinds are coming down the pipe that suggest caution. As an alternative, a May rate hike is entirely possible. We budget for two rate hikes over the next 12 months – a little less than the consensus.




April 9 - April 13, 2018

Economic webcast  |  Protectionism in a nutshell  |  Big NAFTA progress  |  Another round of China tariffs?  |  Softer Chinese consumers  |  Chinese housing also cools  |  US housing  |  Recent data


April 2 - April 6, 2018

Market swoon  |  Protectionism update  |  Canada slows  |  Data preview


March 26 - March 30, 2018

The protectionism backdrop  |  Steel & aluminum update  |  Chinese tariffs  |  NAFTA update  |  Data run


March 12 - March 16, 2018

A protectionism update  |  Canadian financial system vulnerabilities  |  Data review  |  Anti-trust and the tech sector


March 5 - March 9, 2018

Monthly economic webcast  |  Steel & aluminum tariffs  |  Italian election result  |  China National People’s Congress  |  Other items


February 26 - March 2, 2018

U.S. fiscal boost  |  Tighter financial conditions  |  Canadian budget preview  |  Protectionism update  |  Italian election  |  Data run


February 12 - February 16, 2018

Another market update  |  A mercifully asymmetric QE unwind  |  Canadian employment carnage  |  Smaller items


February 5 - February 9, 2018

Monthly webcast  |  Unhappy markets  |  Ten years on from the financial crisis  |  Smaller items


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