Economic & Investment Outlook
Global economic growth remains stable, but at a pace that is slower than recorded last year. There continues to be a divergence between the performance of manufacturing and service sectors. Manufacturing activity remains negatively affected by escalating tariffs, while most service industries in developed countries continue to exhibit growth.
The Canadian economy has been rebuilding momentum following a winter slow-down. Spending by households and businesses rebounded in the first quarter, while the housing sector is no longer acting as a drag on growth.
In April, Canadian wholesale trade jumped by 1.7% and economic growth rose 0.3%. The Oil & Gas sector was the main contributor to the increase due to the partial reversal of Alberta's oil production curtailments.
The Canadian labour market produced 106,000 new jobs in April. This is the largest monthly employment gain since the government started collecting data in 1976. Further job gains in May decreased the unemployment level to a record 4.5%, which is a 45-year low.
The labour market has been strong since mid-2016 and has remained a bright spot for our economy. The Canadian economy has added 426,400 jobs over the last 12 months.
Unlike many other developed economies, the inflation rate in Canada continues to increase. The monthly increase in May was 2.4%, led by higher prices for food. This increase should support the view that the Bank of Canada will hold off from cutting interest rates in the near term.
The backdrop for some major export sectors is becoming more challenging as a result of Canada being drawn into the US-China trade dispute. This began when the US requested the arrest and extradition by Canada of the chief financial officer of Huawei, the premier Chinese telecommunications and consumer electronics manufacturer.
After the arrest, Chinese authorities warned of further actions if she was not released, and then acted on the threat by stopping imports of Canadian canola and suspending import permits for three pork producers.
This diplomatic conflict intensified at the end of June, when China suspended all Canadian meat exports to their country. This action is a significant escalation as China represents 22% of pork exports and is also the fifth-largest beef and veal export market, according to Statistics Canada.
Even if alternative export markets can eventually be found, these restrictions will have a significant initial negative effect on a large portion of Canada’s agricultural sector.
US economic growth outperformed expectations to start this year, advancing at a 3.1% pace in the first quarter. However, some temporary factors added to this advance and will act as a drag on second quarter growth as they abate.
Personal spending rose 0.4% in May following a 0.6% gain in April as domestic consumption continued to increase. However, this trend may be set to reverse, as the June Conference Board Consumer Confidence index recorded the largest decline in eight years.
The US administration raised its tariff rate from 10% to 25% on the second tranche of Chinese imports in May. Although the direct economic impact of this move is relatively small in an economy as large as that of the US, the escalating trade conflict is having an outsized impact on business sentiment and manufacturing activity. Factory output declined in the first four months of the year and durable goods orders fell in May for the third time in four months. The pace of orders has now declined by the most since mid-2016.
First quarter economic growth in the Eurozone was stronger than expected, as consumer spending supported activity. However, factory output fell to near a six-year low in May, with declining orders showing no change from the current downward trend.
The final date for the UK to leave the European Union was extended to October 31st in an effort to continue negotiations on an agreement. This process has now gone on for three years, and the uncertainty of the outcome will continue to weigh on the UK economy until a resolution is found.
Most equity markets continued to advance in the second quarter and the majority of markets have recouped the losses recorded from the sharp decline at the end of 2018. Although recent economic data has indicated decelerating growth, support from lower bond yields continues to underpin the rise in equity prices.
Returns in local currency and Canadian dollar terms were:
Since the financial crisis of 2008, policymakers have increasingly used non-traditional monetary measures in an effort to transition the global economy to a period of self-sustaining growth. However, despite a 10-year economic recovery, global monetary policy is still far from returning to normal.
Most advanced economies now have more total debt and larger fiscal deficits than they had in 2008 and central bank policy rates are also much lower. As a result, there is much less fiscal and monetary policy flexibility to manage slowing economic growth or unanticipated geopolitical events.
Global bond yields have declined back to levels last seen in 2017. The amount of negative yielding government debt has now risen to more than US $12 trillion and represents nearly 40% of outstanding global government bonds. The European Central bank has indicated that quantitative easing measures (the purchase of securities by central banks to increase the money supply) could potentially be introduced once again.
Most developed economies are now experiencing low inflation, modest economic growth and financial markets that are being sustained by ongoing monetary easing. In this environment, equity markets continue to have a contradictory view that bad economic news is good, since it increases the likelihood of more central bank easing.
Even though the actions by central banks have become increasing less effective at stimulating economic growth, equity markets have become increasingly dependent on central banks continuing to keep interest rates at these historically low levels to support valuations.
We view this central bank/equity market relationship as increasingly unsustainable as many historical relationships that existed between interest rate levels and volatility in financial markets have become increasingly distorted. At some point, this divergence between the slowing global economy and artificially supported asset prices will have to be reconciled.
Tariffs - One Step Forward, One Step Backward
The US continues to raise global economic tension through tariffs and other trade threats. As each new tariff is followed by subsequent retaliation by trading partners, the continuing escalation is significantly hampering trade and investment that adds risk to global economic growth.
As a condition for Canada and Mexico to officially start the legislative process for the ratification of the agreement to replace the NAFTA trade agreement (USMCA), both countries demanded that the US remove tariffs on steel and aluminum that were implemented last year for “national security” reasons. On May 17th, the US agreed to remove these tariffs, but then announced 13 days later that the country would be introducing a 5% tariff on all US imports from Mexico to address immigration issues. These tariffs would go in effect on June 10th, with subsequent increases if Mexico did not dramatically reduce the number of illegal migrants crossing into the US. After negotiations between the two countries, these tariffs were suspended prior to implementation due to a border security agreement.
Trade negotiations between the US, the European Union and Japan are now underway. The US has threatened to impose tariffs on an additional $11bn in European imports and continues to mull levying auto tariffs after announcing a 180 day negotiation period. Should negative trade actions take place with Europe or Japan, this will add another headwind to the global economy.
Hope for a quick resolution to the trade dispute between China and the US was dashed in May, when President Trump increased the 10% tariff on $200 billion of imports from China to 25% and also threatened the same tariffs on an additional $325 billion of imports. The announcement came as US-China trade negotiations were occurring. China immediately responded by increasing tariffs covering $60 billion of imports from the US.
The US and China agreed to resume trade talks in late June with the US temporarily suspending the implementation of additional tariffs pending the outcome of negotiations. If a further 25% tariff is actually implemented, it will essentially cover all goods imported from China. It will also have a much more direct impact on American consumers than the previous rounds of tariffs, as it would now include many popular electronic items such as smartphones, tablets and computers.
Despite President Trump’s claim that China is paying billions to the US Treasury, an International Monetary Fund study concludes that costs of tariffs are being borne almost entirely by American importers. Tariffs raise prices for imported products and therefore have the same economic consequences as a tax increase.
With the daily value of trade between US and China near $2 Billion US, the negative effects of tariffs on consumer and business spending are mounting.
The trade policy actions of the US continue to have destabilizing effects for the global economy. As a result, financial markets are now dealing with the reality that this may continue for an indefinite period.
On May 15th, the US Commerce Department placed Huawei and 70 of its affiliates on an “entity list”, which prohibited American companies from selling certain technologies to Huawei without government approval. The US administration views Huawei as a national security threat given its close ties to the Chinese government.
This moved prohibited exports of technology from companies like Google and Intel to Huawei. It was a significant blow to the Chinese company, as it relies on American suppliers for nearly 20% of all its components.
Huawei is the largest global manufacturer of telecom equipment and ranks second in global smartphone sales. It also holds many crucial patents on emerging 5G mobile technology and is aiming to be a leader in this field.
The US administration has been lobbying allies around the world not to buy Huawei equipment, which the US says could be used for Chinese espionage. The company has denied the allegations.
At the end of June, President Trump suddenly eased most of the restrictions on Huawei that were imposed only six weeks earlier as part on the resumption of trade negotiations between the US and China. This action clearly illustrates that Huawei was being used as a bargaining chip in the ongoing trade dispute rather than it being a real nation security risk.
These US trade negotiation tactics have produced an unintended outcome in how the future supply chains of many technology companies will be structured. Just as Huawei saw that it was vulnerable to having some of its components cut off for political purposes, US based technology companies that have part of their supply chain in China now have the same exposure.
In the near term, a decoupling of the US and Chinese economies is now underway. Over a longer horizon, it is likely that global supply chains will now move toward becoming smaller and serve regional markets. This will change the existing system where specific countries tended to specialize in manufacturing only one particular type of component rather than all types. This will have the benefit of eliminating supply disruptions, but may ultimately increase costs for companies and consumers.