ECONOMIC & FIXED INCOME COMMENT: "So Far, So Good - Part 2"
Canada’s GDP was up 2.9% in the second quarter, a little lower than what was expected but a good pick up from the first quarter of 1.7%. Strength was found in the export sector; this reflects the robust 4.2% GDP growth in the U.S. economy during the second quarter. Canada’s economy was held back by business concerns over the NAFTA negotiations. Our unemployment rate has declined to 5.8%. This is the lowest unemployment rate in over 40 years. There is some concern that the low unemployment rate is the result of educational summer employment which could be reversed in future months. Inflation for August was reported at 2.8% but core inflation, as measured by the Bank of Canada was 2.1%, up 0.1% from July. The Canadian economy is in good shape at this time.
The elephant in the room has been NAFTA. The negotiations did appear to have stalled prior to this writing as politics were getting in the way of any agreement being reached between both countries. In Canada, Quebec was having a provincial election on October 1st. With half of the country’s dairy farmers in Quebec and the fact that the U.S. wanted access to the Canadian dairy market, no announcement on NAFTA was expected until after the election. In the U.S., the Trump administration wanted to get a signed deal to the current Congress as quickly as possible as it is dominated by the Republican Party. The U.S. Mid-Term election is on November 16th. The Democrats are expected to win the majority in the House of Representatives and maybe a few Senate seats. If (when) this happens, the Trump administration would have had a more difficult time getting NAFTA approved by Congress.
Our forecast for the Canadian economy assumed a favourable trade deal would be reached with the U.S. This came to fruition on Sunday September 30th, when Canada and the United States settled upon a “new, modernized trade agreement for the 21st century; the United States-Mexico-Canada agreement.” The new bilateral deal will last for 16 years, with a mandatory review after 6 years at which point the three countries can agree to continue for another decade, or if they are unhappy, begin formal negotiations to be completed within 10 years.
Here are the highlights of the new USMCA agreement:
Canada will keep Chapter 19 - the dispute settlement mechanism.
Chapter 20 (state-to-state dispute resolution) will remain intact however; Chapter 11 (investor-state dispute) will be phased out between U.S and Canada.
Canada will give U.S. farmers access to 3.5% of the Canadian Dairy market (greater than the 3.2% granted to 10 other countries under the Trans-Pacific-Partnership).
U.S. steel and aluminum tariffs will remain in place for the time being.
The De Minimis threshold value on imported online goods has been raised from CAD$20 to CAD$150.
Canada has agreed to increase protections for pharmaceutical patents to 10 years; previously it was 8 years.
In the auto sector, Canada agreed to:
Higher “North American” automotive content (75% up from 62.5%)
40-45% of content must be made by workers earning at least US$16 per hour
An automotive quota on passenger vehicles per annum.
What does this mean? This agreement has removed a massive cloud of uncertainty for policymakers and businesses. Furthermore, it will likely be growth positive for the Canadian economy. Finally, the signed deal could open the door for the Bank of Canada to increase rates at a faster pace. If a deal was not completed, economists predicted Canadian GDP would be reduced by 0.2% in 2019 and 2020. Additionally, core inflation would be higher due to a lower Canadian dollar (import inflation). The Bank of Canada would likely hold off increasing the Bank Rate to support the economy.
Turning to interest rates, the Bank of Canada embedded a trade risk discount into their growth forecast. However, with the new USMCA agreement in place Governor Poloz is expected to increase the Bank Rate from 1.5% to 1.75% on October 24th. Going forward, the Bank of Canada is expected to raise rates three more times to 2.5% over the next 12 months.
The U.S. Federal Reserve increased its Fed Funds rate from 2.0% to 2.25% on September 26th. This move was widely expected and fully priced into the markets given recent economic strength. We anticipate the Fed Funds rate will reach 3.0% over the next 12 months. Please note that the increase in short term interest rates by the Bank of Canada and the Fed are not an indication that the economy is running too fast and inflation is rising. This is not a restrictive monetary policy move. All they are doing is reversing the very loose monetary policy after the 2008 financial meltdown. If the cost of borrowing is too low for too long, history has shown asset bubbles, such as the current high real estate prices in Toronto and Vancouver, tend to develop.
The Government of Canada 10 year bond yield has remained in a narrow range so far this year, 2.03% to 2.52%. With the positive result from NAFTA and the increase in the Bank Rate from 1.5% to 2.5% we expect the 10 year yield to move above 3.0% over the next 12 months.
The Globe and Mail; Canada, U.S reach tentative NAFTA deal; Trump approves pact. September 30th, 2018