ECONOMIC COMMENT- The New Uncertainty
In our second quarter Economic Comment, we were concerned with the market volatility around the UK referendum to leave the EU and the US Presidential election in November. The surprise outcome by the British people to leave the EU was not expected. Capital markets and the British pound were rallying up until June 23rd. The negative reaction on the value of common shares and the currency is understandable. The value of Government bonds in the US, Japan, Germany and Canada rose as investors were looking for a safe haven to protect their capital- again understandable.
Since the decision, we have been monitoring the commentary of key stakeholders and a few things are becoming clearer;
The “Leave” side do not have any strategy of what to do now that they have won. Two key leaders of the Leave side, Johnson and Farage, have taken themselves out of leadership positions of their political movements. We have had a lot of politics with little serious analysis of the consequences of leaving the EU.
As a result, Britain is going to drag its feet before it exercises article 50 of the Lisbon agreement which sets in motion a formal two year period where the EU and the UK will untangle the relationship.
The EU has stated that they are not going to be easy on the UK. They want to set an example to the other 27 members of the EU that, “Breaking up is hard to do!”.
At this point, no one knows exactly what is going to happen in the negotiations and this uncertainty will hang over the marketplace for the next 2-3 years.
The UK economy will begin to slow as businesses hold off making investment decisions and consumers delay making major purchases due to greater uncertainty. UK economic growth over the next five years will be much slower than what was projected prior to June 23rd.
There will be a negative growth impact on the EU but not to the same extent as the UK. The economic impact on Canada and the US will be minimal.
The Bank of England will likely lower their overnight lending rate and increase liquidity to support the economy. The US Federal Reserve is unlikely to raise the Fed Funds rate until 2017. The Bank of Canada is on hold until the second quarter of 2017 and maybe longer.
US and Canadian bond yields are expected to trade at lower levels by year end 2016. The Canadian 10 year bond is expected to trade in a range 0.90-1.30%.
Dividend yields on stocks look even more attractive than before June 23rd.
While all the above is relatively straight forward the big question is: how did the British people get to this decision? Since the 2008 financial meltdown, technological advancements and the economics of globalization have been hard on factory workers and the middle class. Trade with China and the rest of the EU has contributed to the loss of manufacturing jobs and low salaries. Without retraining, many of the unemployed are unable to obtain new positions or suffer from wage cuts. The free movement of labour within the EU has exacerbated this situation; because of the UK’s better than average economic growth, it has attracted workers desperate for jobs. Therefore, we have a toxic stew of low salaries and foreign labour migration. Lack of trust in the political elite and resentment of the growing wage gap between the rich and the poor has caused the conditions for change. The surprise on June 23rd was the size of the population who felt so disenfranchised in their own country.
There are parallels between the Brexit outcome and the surprising success of Donald Trump. He has tapped into the disenfranchised US workers who have suffered from globalization and changing technology. It is as if the middle class was served up as sacrifice on the altar of corporate profits. The perception exists that members of the House of Representatives and the Senate have been bought by corporate self-interests and this feeds into the building resentment and desire for change. The question remains: is the size of this pool of the disenfranchised large enough to elect Donald Trump as president?
After a slow start to the year (GDP in Q1 was 1.1%) in the US, economic activity has increased in the second quarter. The US consumer, which accounts for about 70% of GDP, is in good shape as employment, house prices, the stock market and wages have all increased. Capital spending remains depressed; corporations are experiencing only modest sales gains and confidence is shaky. Further strength in the US dollar caused by a flight to safety from international investors could reduce export activity. We are expecting GDP growth for the year to be 2%.
Canada’s GDP grew at 2.4% in the first quarter however; all the strength was in January with negative growth in February and March. Since then, activity has picked up with growth in the month of April. The unemployment rate declined from 7.1% to 6.9% in May. For the year, GDP growth of 1.2% is forecast. We have seen a sharp increase in the oil price since the lows of February and it is now trading in a range of $48-$51 US. This is good news for the industry and the Western Canadian economy. The fire around Fort McMurray has caused a temporary shutdown of oil sands production which is now back up to its previous levels; the fire will have a negative impact on second quarter GDP. We anticipate that the price of oil will slowly increase to the $60 level by year end 2017 as balance is achieved in supply and demand. At that level, oil sands and conventional oil producers will be making a decent profit but it will be low enough to restrict high cost fracking production.
Bottom line: The uncertainty caused by Brexit will result in slightly lower growth for the global economy over the next year or two. In turn, this will mean interest rates stay depressed for a longer period of time. Modest growth and low rates will continue to provide support for stocks.