ECONOMIC COMMENT - " It's All About NAFTA"
The global economy has expanded faster than what forecasters envisioned earlier in 2017 and provides a strong handoff to 2018. Emerging economies have produced some high growth rates with Asian countries in particular (India and China) at 6.5%. This level is expected to continue in both 2018 and 2019. Advanced economies have grown more slowly (2.2%) and were a drag on global growth however, the rate accelerated from 2016.
Turning to the U.S. economy, the largest in the world, it is expected to grow 2.2% in 2017 and increase to 2.5% in 2018. Both consumer and business sentiment are quite strong and have been reflected in new highs in U.S. stock markets. Consumer spending on goods and business spending on equipment are areas of strength. With a stronger economy, it generates more imports than exports which is a negative for GDP growth. The newly passed tax plan where corporate taxes are reduced from 35% to21% should give further support to the U.S. economy over the next two years.
Inflation in the U.S. is expected to increase in 2018 and in 2019 to 2.1% for core CPI from 1.8% in 2017. The Federal Reserve Board (Fed) has been addressing this by reversing Quantitative Easing (QE) in the Fall of 2017. Rather than purchasing bonds in the market, they are now selling. While we are early in this unwinding process, it will bear watching later in 2018 as it could cause bond yields to rise more quickly than expected. Also, the Fed increased its Fed Funds Rate to 1.5% on December 13th. Given the strength in the U.S. economy, we see more tightening of Monetary Policy in 2018 and 2019 (see fixed income comments).
There are a number of risks to this economic forecast. North Korea, trade with China, Brexit and mid-term U.S. elections in November, 2018 could have negative effects on confidence which would hold back growth.
Another risk which is important to the U.S. but much more so to Canada is NAFTA. There is anticipation that our trading relationship with the U.S. will change to Canada’s detriment. While Canada is expected to have GDP growth close to 3.0% in 2017, the growth rate is expected to decline to 2.2% and 1.9% in 2018 and 2019, respectively. Leading the growth in the economy in 2017 was consumer spending on goods, government spending and business spending. These areas of strength are expected to continue in 2018 and 2019 but at a slower pace.
Core CPI inflation in Canada is expected to increase from 1.6% in 2017 to 1.9% - 2.0% in the 2018/19 period. All things being equal, the Bank of Canada (B of C) would like to increase our Bank Rate early in 2018 to keep inflation under control. Unfortunately, all things are not equal with our trade with the U.S. NAFTA is the key policy pivot point for the B of C. If the settlement is negative, the economy will need support. Therefore, the B of C will be on hold. This could put some downward pressure on our dollar as the interest rate spread between Canadian and U.S. Treasury bonds will widen in favour of the U.S. If oil prices remain in the current range of $55-$60 U.S. our dollar will receive some support. Clearly, there are a lot of moving parts to this puzzle at this time and it is logical that the B of C will be slow to move the Bank Rate higher until NAFTA is decided.
In summary, “it’s all about NAFTA”.