An Outside-of-the-box Forecast
There is the opportunity for be two competing themes for the Canadian economy into 2018. The first, and perhaps favored is that a strong US economy will benefit a slightly lagging Canadian economy in the year ahead. Moderating economic growth in Canada follows a year of robust, G7 leading performance. Further, interest rate hikes south of the border will be witnessed in accordance with a robust domestic US economy benefiting from one of the largest corporate tax rate cuts since the Reagan administration.
Alternatively, the Canadian economy will advance on its own merits once again with the best job growth since 2002, and the lowest jobless rate since 1976, which will see the momentum ending 2017 carry forward into the new year. For the Canadian-US dollar exchange rate, it seems that the first half of this year could prompt a range bound tug of war for whichever economy is outperforming the other.
Since the 19th of December, the Canadian dollar has advanced over 3 per cent. Commodities quietly seem to be a significant part of the story. Since 2014 and a bear market in commodity prices led by a downturn in crude oil markets, the story has been one of abundances. Stockpiles of raw materials and surpluses of oil in storage buffered any demand shocks. As US oil inventories sit 20 per cent below their March high, one analyst commented this week following the protests and unrest in Iran that geopolitics haven’t impacted the oil markets in a sustained manner over the past three years, and that tide could begin to change.
Like Canada and other G7 nations including Europe and Japan, China and other emerging market economies saw a significant rebound in 2017. As a result, the MSCI Emerging Markets Currency Index is at its highest level since May of 2013 because of a strengthening backdrop in Asia. As the global economy is on track for its strongest year since 2011, the picture of a renewed manufacturing boom portrayed by positive economic surveys and increased demand for raw materials is another positive supportive for the loonie.
To revert to the consensus forecast, we will likely see the US economy as the leader in 2018. The question, however, is one of a transitory boost to economic growth versus the notion of sustainability. The corporate tax rate reduction to 21 per cent will be supportive for corporate earnings in the US and specifically more so for companies with greater exposure to the domestic economy. The sustainability question though is raised over whether congress will go into deficit control and the forthcoming debate over entitlement programs, which will likely shape the conversation around midterm elections in November.
Hence, we have a tug of war. Already forecasts for the Bank of Canada’s first interest rate hike is moving forward in 2018. The Fed is then due to up US rates in March. But the rationale for rate hikes could be the surprise in 2018. Instead of lifting rates with a strengthening global economy, and fitting with the commodity story are inflationary pressures, at which point interest rate hikes from central banks remain necessary, but risk becoming restrictive to economic growth.
As the New Year provides an opportunity to regroup and hypothesize themes for what’s ahead, certainty and complacency fit with a status quo risk-on investment environment. If something outside-of-the-box was to disrupt that, central bankers going on the offensive (increasing interest rates ahead of inflation) could be just that for 2018.