Twas The Night Before...

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The S&P 500 shook off its early January malaise the past few weeks driven mainly by a cooler-than-expected CPI report and strong bank earnings as the index reversed the 4.3% slide that had been in place since early December after hitting a new record high on 1/23, and currently is up ~3 YTD. However, Monday’s tech stock rout was a reminder that there remains a decent amount of headline risk, especially considering that the expectation bar is much higher this year compared to the previous two years (and specifically for AI-driven investment themes). In addition, while we were certainly relieved by the US CPI inflation data, we would remind investors that one month of data (good or bad) does not make a trend – a sentiment we have conveyed frequently in previous reports.

Source: US Strategy Comment

So, while we remain optimistic for 2025, we will be taking our cues from upcoming data and still expect headline risk to persist, particularly as it relates to Fed expectations, and this is likely to create a bumpy ride for US stocks along the way, in our view.

Source: US Strategy Comment

Meanwhile, on Wednesday the Bank of Canada trimmed its overnight rate 25 bps to 3.0%, the sixth consecutive cut for a cumulative reduction of 200 bps. The move was as expected and cements the Bank's title of most aggressive cutter in the world. In addition, in a bit of a surprise, the Bank also abruptly ended quantitative tightening, and will begin term repos in early March.

Source: BoC — Bracing for Impact

Looking ahead, the entire discussion was, appropriately, dominated by the threat of U.S. tariffs. The Bank's economic forecast did not take tariffs into account (which has been our convention as well), citing the profound uncertainty around the timing, scope and duration of any tariffs. However, it did lay out a detailed scenario of how broad 25% tariffs would affect the economy; the key points there are an expected 2.5% hit to real GDP in the first year, but also some net upside on inflation (reflecting full retaliation and a much weaker Canadian dollar). The key takeaway is that the Bank will intensely monitor the impact of tariffs (if and when they come), and we shouldn't necessarily expect an immediate policy reaction to the start of a trade war.

Source: BoC — Bracing for Impact

The Bank had some other key messages beyond the tariff threat, as it also highlighted that inflation is expected to stay close to target, and that domestic demand is indeed turning the corner. The modest downward revision in GDP growth for both this year and next is put down to the much slower population growth projection now in train. The Bank also pointed out that the labour market, while soft, has seen some improvement too. Wage growth is showing signs of slowing. Business investment continues to be a soft spot (and could be truly rattled by a trade war).

Source: BoC — Bracing for Impact

A few key points from the commentary:

• "While we expect some volatility in CPI inflation due to temporary tax measures, our forecast is that inflation will remain close to the 2% target over the next two years."

• "There are signs economic activity is gaining momentum as past interest rate cuts work their way through the economy. Lower borrowing costs are boosting activity in the housing market as well as consumer spending on big-ticket items like automobiles. The pickup in household spending is starting to broaden to other consumer items and is projected to strengthen further." If not for the tariff threat, we would be talking about the Bank moving to the sidelines today.

• "The Canadian dollar has depreciated materially against the US dollar, largely reflecting trade uncertainty and broader strength in the US currency." This was really the first indication that the Bank is noting the downswing in the currency, and Macklem indicated during the press conference that a deeper drop would (finally) need to be taken into account in setting policy.

Source: BoC — Bracing for Impact

Bottom Line: Wednesday’s steps by the Bank of Canada can be viewed as battening down the hatches ahead of a possible trade war. As noted, the 200 bps of cumulative rate cuts are setting a much more positive backdrop for the Canadian economy. Next steps clearly are dependent on what unfolds on the trade front; we suspect while the Bank may initially respond cautiously to a trade war, eventually it would be compelled to cut much more than the market currently expects.

Source: BoC — Bracing for Impact

And of course we will end on tarffis. BMO Senior Economist Robert Kavcic published a report this morning on the ongoing tariff dispute and what it could look like for Canadians in a variety of forms. We will include a section of it here, but please feel free to reach out if you want the full 18-page report.

If such tariffs do occur, the next discussion (after retaliation and any border-related measures) will be on the monetary and fiscal policy responses. The Bank of Canada’s Monetary Policy Report laid out some baseline expectations of how the economy could evolve in the event of a permanent 25% tariff on all U.S. trading partners, with full retaliation. They estimate a 2.4 ppt hit to Canadian growth in year one and a 1.5 ppt hit in year two. Full retaliation also spurs a 1 ppt increase in Canadian inflation by year three. BMO Economics’ own estimates arrived at a more moderate impact, though they assume a more targeted retaliation. BMO estimates that growth would be cut nearly 2 ppts at the point of maximum impact, which would leave calendar-year growth down by roughly 1 ppt.

Source: Canada’s All-Important Tariff Policy Response

Key elements include the tariff level; the coverage; how long it lasts; the scope of retaliation; and how much gets absorbed through the U.S. inflation and currency channels. BMO also assumes that there would be both monetary and fiscal policy responses in Canada that will cushion the impact: The BoC was coy on what its response would be, since it will be balancing downside risks to growth with upside risks to inflation. In BMO’s view, the former will outweigh the latter, and they suspect the BoC would ease more aggressively vs. the baseline.

Source: Canada’s All-Important Tariff Policy Response

For fiscal policy, the choices are wide open given that Canada and most provinces come into this period with relatively sound finances, but the slope is slippery. Early chatter has some policymakers eying a pandemic-like response, but BMO would argue that the size and style of that response won’t be appropriate. Even in the Bank of Canada’s tough scenario, the estimated impact would pull annual average growth slightly into negative territory. That’s consistent with a modest recession, but far shy of the massive 5% calendar-year decline during the pandemic; and the much deeper 2.9% decline during the global financial crisis. The challenge is real, but the fear mongering is a bit much—especially if it’s used for political gain and cover for big new spending. As for fiscal policy itself, targeted relief in certain highly-impacted sectors could be warranted, but the kind of wide-ranging measures implemented during the pandemic would seriously miss the mark—this would not be a mandated shutdown, and the impact might not be temporary.

Source: Canada’s All-Important Tariff Policy Response

Rather, measures to drive growth, investment and productivity, while facilitating the economy’s adjustment would be more appropriate; and what better reason for a full-scale pro-growth policy push than an external threat to economic growth? Some examples: permanent corporate and/or personal income tax relief that improves Canada’s position as a place to invest and work; immediate expensing of capital investment; accelerated infrastructure build-out that expands our ability to move goods, resources and people; and a destruction of interprovincial trade barriers that weigh on productivity. First we wait for any tariff action, and then we’ll be watching the policy response. Closely.

Source: Canada’s All-Important Tariff Policy Response

 

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