Quarterly Market Update
A great deal of news has occurred in the past quarter, with a new trade deal leading the way. NAFTA has been replaced by the “USMCA” – or US, Mexico & Canada Agreement – to be ratified end of November, 2018. This new deal will exist for 16 years with an option to review in 6. Key elements for Canada include the retention of the Chapter 19 dispute resolution mechanism; an opening of 3.5% of the Canadian diary market to U.S. producers (this will match recent opening of that market to European producers); an increase in the cross border duty-free purchase amount from C$20 to C$150; and the extension of patent protection for pharmaceuticals from 8 years to 10. Of perhaps greater importance is the establishment of quotas on Canadian auto production that far exceed current output, thereby eliminating the risk of tariffs on cars built in Canada.
This was a relief to those employed in the Auto sector and Ontario in general, where auto manufacturing is a significant industry. Further, the “Proportionality” clause in energy production and sales has been removed – meaning Canada may now sell more energy products internationally. You have likely heard about the recent opening of a new $40 billion LNG plant in Kitimat, B.C. This is a direct result of this deal being made. Two aspects of the deal are less positive – Canada must allow the US and Mexico to review any free-trade deals with “non-market” countries (China), and the Steel and Aluminum tariffs remain in place. Overall however, the deal is viewed through a positive lens in that the uncertainty of no deal has been removed.
Momentum from such new trade deals is needed to ensure the global economy can maintain its upward growth trend. Confidence in Canada as a stable place to invest capital had been shrinking, and the lack of a trade deal has been a factor. Simply stated, businesses will locate where they can achieve the best net margin of profitability. In Canada, Foreign Direct Investment went negative, with a net outflow of $70 billion last year. In addition, we remain behind the U.S. in domestic Capital spending at 11.6% of GDP (vs. 13.6% for the U.S.). To compound matters, tax cuts south of the border have been another competitive factor to contend with. This is not to say the U.S. is drawing in all the foreign capital. Flows have reduced from $146.5 billion in the first quarter of 2016 to $51.3billion first quarter of 2018 – hardly a shining endorsement of the tough talk that appears to be in fashion these days. There are other factors at play.
Let’s take a look at the US Treasury Bond market, and interest rates in general. U.S. Federal Debt totals approximately $21.4 trillion at this time. Of this, approximately $7 trillion is owned by foreign interests – the largest amount held by China at $1.2 trillion. There is some speculation about what would happen should the Chinese government decide to dump these bonds and refuse to buy any more, as retribution for the trade battle initiated by Mr. Trump. If these bonds were to hit the market all at once, we would expect U.S interest rates to rise by about 60 basis points (0.60%). A bit of a shock yes, but rates are already expected to rise by 1.0% by the end of next year, so not a long term shock by any stretch. In addition, the U.S. Treasury Dept. is more than capable of absorbing any and all these bonds on a moment’s notice. Why? The U.S. dollar remains the world’s reserve currency. They can simply print enough cash to cover the purchase without affecting rates more than the expected 0.60% bump that would occur.
But how long will this last? There is a distinct possibility that sequential deficits of this magnitude (approaching $1 trillion/year) will cause a point of inflection where the risk of holding U.S. bonds is recalibrated. At present, we forecast interest rates to rise in both Canada and the U.S. – a full 1% to the end of 2019, respectively, to 2.50% for the BofC rate; and the Fed rate to 3.13%). But it is not simply the high debt and deficits that are causing rates to rise; another major factor is the strength in the economy. With employment at near historic levels, wage inflation is beginning to add pressure to the central banks to act. Our economy has benefited from a very long period of low rates – and that has come to an end. Mr. Trump is no fan for he crafted a tax-cut just as the economic cycle was ending, causing the economy and stock markets to bound higher in anticipation of a new round of higher business profits. This has been referred to as a “sugar high” – the markets are reacting to this short term factor.
Is growth sustainable under these conditions? A few things to consider: interest rates will surely rise, but at a modest pace, allowing investors to understand and accommodate the increase in their forecasts. No shocks are expected – we all understand what is coming and can adjust our holdings over time. The knock-on effect is the total cost of interest cost is also rising. Interest expense to the U.S. government on the federal debt now sits at 8% of the total federal budget. With increasing debt and rising rates, this will reach 13% of the annual budget by 2025 (at which point interest expense will be higher than military expense). The concern is this will crowd out other federal program spending (Medicare, Medicaid, social security), and simply lead to an eventual increase in taxes, unless the conservative’s hypothesis proves true – that a tax cut does lead to higher tax revenue (I remain sceptical).
On a global basis, GDP Growth is pegged at 3.4% (China the largest factor, with GDP growth forecast of 6.2%) for 2019 (Canada at 2.1% with the U.S. at 2.5%). It is profit, pure and simple, that drives share valuation, and profit outlook has never been better. The true problem in my estimation is with how these profits have been spread in the economy. I believe the Velocity of Money and M2 money supply prove instructive. Velocity of Money indicates the number of times one dollar is used to buy goods and services in an economy. When this number is in decline, it means people and businesses are holding on to their money rather than spending it. At present, this figure is less than 1.5 times – near an all-time low (peak was 2.2 in 1997 – of interest when wages were at their highest point and began a two decade stagnation). M2 (money stock) on the other hand has hit an all-time high (largely due to the print-out that occurred with Quantitative Easing as a means to supporting the economy during the Great Recession). The money is out there, but in too few hands - up to this point. Employment is improving by the day with more job openings than applicants and wages are starting to rise for the first time in 20 years. Consumer spending is increasing as a result, and this begets more employment, which further improves the economic outlook.
The investment environment is quite robust with no indication that the current growth in the economy is nearing its end. There are concerns that rising interest rates will increase the cost of capital, and this could slow the growth cycle. However the pace of the rate increase is measured and well-forecasted and therefore easy to incorporate into the business plans of any corporation. It must also be understood this is a way for the Treasury to re-absorb some of that excess M2 – to help avoid a period of high inflation. In accordance, on a global basis, GDP Growth is pegged at 3.4% (China the largest factor) for 2019 (Canada at 2.1% with the U.S. at 2.5%) – roughly in-line with and slightly improved over 2018.
The growing deficits and debt will have to be addressed at some point – when that occurs is anyone’s guess (though I feel comfortable in saying sooner (years) than later (decades). In the meantime the market is set up for continued growth in certain sectors. Sectors on which I am focused include: technology (for the very high margins); defense (large commitment in federal budget to defense spending); banking (fair capital growth and growth of dividends); and clean water is becoming more important.
“Feature – NAFTA 2.0” - Doug Porter, October 5, 2018 – BMO Capital Markets
“Feature – Canada Competitive?” – Doug Porter, Sept. 21, 2018 – BMO Capital Markets
“How Trump is Repelling Foreign Investment” – Adam Posen, July 23, 2018 – Foreign Affairs
“Commentary – China’s US Treasury Holdings” – Adam McGeever, Sept 18, 2018 - Reuters
“As Debt Rises…” - Nelson Schwatrz, Sept 25, 2018 – The New York Times
Economic Forecast – October 5, 2018 – BMO Capital Markets
Interest Rate Scenario – October 3, 2018 – BMO Capital Markets
Velocity of Money and M2 indicators – St Louis Fed – August 21, 2018
“Should we be concerned with the fall in the Velocity of Money?” – Mises Institute – August 15, 2016
Rod Major BA, PFP, FMA, CIM
Associate Portfolio Manager