Global investment outlook:

• Our Spring 2019 quarterly outlook is now available: “Central banks to the rescue”.

Dovish Fed:

• The U.S. Federal Reserve (Fed) left its policy rate unchanged and scaled back its economic assessment last week, delivering on a widely anticipated tilt toward a more dovish setting. The central bank’s growth outlook was chopped by 0.2 ppt for each of 2019 and 2020, the unemployment rate forecast increased by 0.2 ppt and the inflation forecast fell by 0.1 ppt.
• However, the full extent of the Fed’s dovish pivot was more substantial than expected, contributing to materially lower bond yields. Two changes in particular were noteworthy.
• First, the Fed’s “dot plots” – the individual anonymous forecasts from all 17 FOMC participants for the year-end Fed funds rate – retreated more substantially than expected. Whereas the market and we had expected the median forecast to decline from a prior prediction of two hikes in 2019 to just one hike, the median forecast actually fell all the way to an unchanged policy rate for 2019.
• This doesn’t mean that the Fed is definitely done tightening monetary policy. While 11 voters favoured no change, six continue to predict further tightening, whereas none actively forecast a rate cut. Thus, the distribution surrounding “no hike” is skewed in an upward direction. Furthermore, the median forecast for 2020 is a single rate hike (though seven out of 17 voted for no increase in 2020 either).
• Of course, with the exception of the past few years, the Fed has erred on the side of predicting more monetary tightening than it actually manages to deliver. With this in mind, when the Fed suddenly brought its forecast down to the “no change” setting long embraced by the bond market, the market, in turn, felt compelled to retreat even further, now pricing in 73% of a 25 basis point (bps) rate cut by the end of 2019. An unchanged Fed funds rate is our best guess, with rate cuts and rate hikes both entirely conceivable, depending on how the economy and business cycle unfold.
• The second dovish development concerned the central bank’s balance sheet. The Fed decided to announce the contours of its plan to bring the era of quantitative tightening to a close. After years of quantitative easing that boosted growth and expanded the Fed’s balance sheet by a factor of nearly six, the Fed has, in more recent years, been working to shrink the balance sheet back to more tolerable proportions. The home stretch is now in sight: the Fed will scale back its net sale of Treasuries from US$30B per month today to US$15B in May, and will conclude the sales altogether by the end of September. This is slightly sooner than previously imagined.
• All of this constitutes more support for monetary policy than previously expected; it helps to ease U.S. financial conditions, and provides modestly more support for economic growth.
• However, a portion of the effort has arguably backfired as the Fed now finds itself painted into a corner. Not only is the Fed becoming more cautious about the future, but it no longer has any space left to boost morale further without reverting to rate cuts. That would be a dangerous game, as it would signal something profoundly wrong with the economy, possibly scaring investors and economic actors more than it would encourage borrowing.
• With this in mind, we had been of the opinion that the Fed would have been better off delaying the announcement of its pivot away from quantitative tightening, saving that last silver bullet for a future meeting when markets are in more need of a boost.

Inverted yield curve:

• The U.S. three-month bill to 10-year bond curve just inverted, meaning that the government three-month yield is now slightly higher than the government 10-year yield. The two-year to 10-year curve remains positively sloped for the moment, but only barely.
• This is an important development, as an inverted yield curve has served as a reliable predictor of U.S. recessions for several decades. The logic behind this is that bond yields can be thought of as a proxy for growth expectations over the relevant period. So if the market is looking for less growth down the road (10-year bond) relative to the current growth outlook (three-month bill), that signals a decelerating economic trajectory that frequently culminates in recession.
• What has prompted the curve’s inversion? From an economic perspective, it makes sense that the curve has been flattening over the past several years as the Fed raised rates at the short end (the primary driver of the three-month yield) and as an aging cycle started to dim longer-term growth and inflation prospects (reflected in the 10-year yield). We flagged 2019 as the likely year for an inversion some time ago.
• Furthermore, the most recent Fed decision arguably provided the final push past the inversion finish line. On the surface, this would seem illogical, as the Fed furnished a dovish rather than a hawkish decision. The three-month yield did indeed fall slightly on diminished rate hiking expectations, but this was outweighed by an even larger drop at the long end of the curve, pulling the 10-year yield down sharply from 2.61% on March 19 to 2.39% on March 25, on the basis of nervousness about the Fed’s dimming growth forecast and suspicions of the business cycle drawing to a close.
• Making matters (slightly) worse, the flattening in recent months has been of the “bull flattener” variety, meaning that the gap between long-dated and short-dated yields was shrinking on the basis of falling long-term yields rather than rising short-term yields. This signals growing pessimism about the long run, rather than rising optimism about the short-term outlook.
• Several silver linings provide a partial offset:
  • First, most econometric models of the yield curve require that the curve be inverted for a full quarter before properly triggering a recession signal. That has not yet happened, and for that matter the yield curve could well flip back into positive territory before that happens.
  • Second, and as we have noted in the past, the fact that the bond market currently lacks a term premium means that – in theory – the yield curve should have to invert by more than usual to provide a proper recession signal. However, let us not become too enamoured with this notion. Other measures of the yield curve, such as the Fed’s preferred one-quarter-to-six-quarter three-month T-bill forward spread, aren’t distorted by the wonky term premium and yet also just inverted.
  • Third, on average, a recession occurs roughly a year after the yield curve inverts. Thus, this signal doesn’t predict a recession tomorrow, but instead prophecies a recession next year. That leaves a bit of breathing room.
• In conclusion, the inverted yield curve is undeniably bad news, but is not exactly a shock given its slow motion arrival, and the likelihood that a recession remains down the road some distance. This aligns with our business cycle scorecard, which continues to provide a “late cycle” reading while acknowledging a growing number of “end of cycle” claims.
• We have argued for some time that the probability of a U.S. recession is in the realm of 35% for 2019 and 40% for 2020. With the recent inversion of the yield curve, formal recession models are starting to agree with that assessment.
• From a market perspective, we continue to advise only limited investment risk-taking given the lateness of the cycle, but not an outright retreat given the prospect of further near-term economic growth and relative stock-bond valuations.
  -With contribution from Vivien Lee

Mueller report:

• The full Mueller report itself is not yet public, but the main revelation so far is that the alleged conspiracy between Russia and the Trump 2016 presidential campaign was not proven.
• This comes as somewhat of a surprise given the Mueller probe’s 2,800 subpoenas, 500 witnesses and 34 indictments.
• Furthermore, Mueller opted not to rule on obstruction of justice claims. This leaves the matter in the hands of the Department of Justice, which has opted not to prosecute along this line.
• Of course, others in President Trump’s gravitational pull, including his campaign chair and his personal lawyer, have been found guilty of various offenses.
• To be clear, none of this nullifies roughly a dozen other investigations at the state and Congressional level that could yet surface new information or reach a different conclusion with the same information.
• Despite the many investigations that continue, the Mueller probe was undeniably the biggest and probably the most thorough of the bunch. As such, the odds of President Trump being impeached by the Democratic House of Representatives has surely declined, the possibility of his early departure before 2020 has accordingly fallen, and his re-election prospects for 2020 have arguably increased (though are still challenging).

Canadian budget:

• Here are four quick observations on last week’s Canadian federal budget:
• First, there isn’t much for investors or business – taxes were largely unchanged and no major improvements were made to the competitive environment. The taxation of stock options became somewhat less attractive for all but startups. On the other hand, small businesses may find it easier to access R&D incentives.
• Second, to the extent it is a spending-oriented budget, the entirety of that enthusiasm was enabled by faster-than-expected revenue growth in 2018-2019 and the assumption that this larger revenue base will persist into the future, rather than particularly fast spending growth penciled in for the next several years. In fact, projected nominal spending growth over the next five years is just 3% per annum. Of course, future budgets may yet depart from that plan.
• Third, as usual, there are many new spending programs. Particularly notable ones include:
  • Housing: the government will take an equity stake of up to 10% in newly purchased homes, reducing the effective carrying cost to interested buyers. Alas, this seems likely to increase home prices rather than the intended goal of making the housing market more tolerable for millennials. It also exposes the government even more to housing market downside. However, the program is arguably inconsequential, with just $416M budgeted, and the program’s rules are such that homebuyers in the most unaffordable cities won’t be able to access much of it. Of greater relevance and assistance, if capturing fewer headlines, $9B of additional funding that has been provided to finance the construction of new rental properties.
  • Training: the government created a new program for worker skill development, though the large number of training programs that already exist and the complexity of the new one argue it may not change the human capital equation by much.
  • The seed of a commendable pharmacare program continues to germinate, with more details due this summer.
  • Other changes include programs to encourage seniors to continue working, construct additional infrastructure, support Canadian journalism, and provide internet access to rural areas. Farmers will receive $3.9B in compensation for adverse changes to USMCA rules.
• Fourth, the federal fiscal position remains fairly good, with a deficit of less than 1% of GDP and a public debt-to-GDP ratio that is low and gradually declining. All the same, the government long ago abandoned its promise of a balanced budget by this year (current deficit: $15B) and although a steady-state forecast argues for ever-improving fiscal finances, a more realistic assessment that acknowledges the realities of the business cycle would concede that any future recession could blow the public debt substantially off course.

Canadian election early preview:

• The Canadian election is now fewer than seven months away, motivating these introductory thoughts.
• The incumbent Liberals have lately stumbled in the polls for a variety of reasons, including the recent SNC Lavalin scandal, unpopular carbon taxes, unsuccessful infrastructure efforts, a gaffe-filled state visit to India and a failed effort to negotiate a trade deal with China. A slowing economy could also begin to weigh.
• As a result, Prime Minister Justin Trudeau has lost a considerable amount of popularity, falling from 45% support to just 31.4%. At the same time, the largely unknown Conservative leader Andrew Scheer has grown in popularity, and is now tied with Trudeau.
• To the extent the current incarnation of the Liberal Party is built disproportionately on the back of Trudeau’s name recognition and popularity, this could spell trouble for the upcoming election.
• Recent provincial elections in Ontario and Quebec reflect an apparent public appetite for more rightward-leaning governments.
• The Canada Poll Tracker now assigns a 58% probability to a Conservative victory, versus a 42% chance of a Liberal victory. This represents quite a reversal relative to last year, when the debate revolved almost exclusively around a Liberal majority versus a Liberal minority.
• On the subject of majority/minority, the Conservatives are assigned a 31% chance of forming a majority government, while the Liberals are given just a 22% chance. The Conservatives have a 28% chance of a minority government, versus a 21% chance for the Liberals. Figures do not add to 100% due to rounding.
• Of course, much may yet change. Many months remain, the SNC Lavalin matter is not the juiciest of political scandals and so may fade from memory, and the new right-leaning People’s Party could siphon votes from the Conservatives.
• Platforms have not yet been written, but one can easily imagine markedly different stances on such matters as taxation, regulation and the environment. More to come.
  -With contribution from Nicola Deery

Brexit update:

• As we wrote last week, the half-life of any Brexit analysis is exceedingly short. This seems to be getting worse, not better.
• For the moment, the EU has agreed to extend the Brexit deadline to April 12. This provides a bit of breathing room, but a deal still needs to be struck.
• Parliament has seemingly snatched control of Brexit away from the government, with a recent vote now requiring a series of indicative votes to determine which of the many permutations politicians most support. This ranges from no Brexit all the way to an uncoordinated hard exit. This seems a logical approach, as no one option is likely to receive more than 50% support, making the traditional binary approach to parliamentary decision-making unsuitable.
• It remains notable that public attitudes have shifted against Brexit, and that parliamentarians – if allowed to vote according to conscience and across party lines – would likely support a softer Brexit rather than a harder one. As party discipline breaks down, this could prove decisive.