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Market Update

 
     Canadian Consumer Prices continue to rise, producing an annual inflation rate of 2.2%, in-line with the expectations
of most analysts.  A few factors are pushing this rate higher going forward; including an uptick in the price of oil (and
therefore gasoline prices), mortgage interest costs, food and entertainment costs (minimum wage adjusted higher) and
cigarettes (up 9% year over year through legislative changes in most recent budget).  However the lack of a trade deal on
NAFTA  runs contrary to these inflationary factors, and has suppressed any move to increase the overnight rate of interest by the Bank of Canada.  The markets anticipate some form of bi-lateral trade deal being announced with America in the next month or two, and for the Bank of Canada to increase the bank rate by July.  We then expect a return to the upward moving trend for rates to at least the end of 2019.

     Unemployment continues to shrink in Canada – sitting at 6% at present.  We anticipate the rate to reach 5.5% by year end 2019.  The experience for our friends south of the border has been far more robust.  Unemployment has just dipped below 4% and is expected to drop further to 3.5% by year end 2019. Perhaps the main driver has been the corporate tax cut
(decrease in general corporate tax rate by 40%).  This has lifted business confidence and driven corporate capital investment upward, with a few short-term bonuses given to employees along the way.  It should be noted however these tax cuts have not “trickled down” to the mass of workers – (rather they have helped boost the savings of most corporations).  The next agenda point for the Trump administration is trade; or more directly, the trade imbalance he views as a hindrance to the growth of the U.S. economy.  This trade deficit totalled approximately $570 billion in 2017 (2.9% of GDP).  It is instructive to note that since 1976, the average annual trade imbalance has been 2.5%, not too far off the current figure.  Further, the U.S. runs a services surplus of $240 billion; whereas goods have been the deficit problem – running at $800 billion annually.  This last bit is what sticks in Mr. Trump’s craw.  Certainly one area of trade that is adjusting to a positive surplus is oil production – the U.S. is now producing more oil and gas than it can use.  Add to this the recent legislative changes that allow the country to export oil and gas and we can expect this good to help reduce the trade imbalance.

    In terms of the trade imbalance, Canada accounts for 2% of this total – with Mexico accounting for 8.9%.  Roughly speaking we are an even trading partner with the U.S. – however we are part of an agreement with a third party that is causing 4 times the trade deficit as are we.  Further, by far and away the country causing the largest trade imbalance is China at 47% (add the Eurozone and Japan and you get to 75%).  Yet we are being viewed it seems the same as any country running a surplus with America.  It is no wonder negotiations have been slow and full of sticking points. 
   An area of additional concern for the U.S. is its poor savings rate.  The average saving rate for the American family is just
shy of 5%.  Compare this to China, where the general  savings rate is closer to 30%, and you can start to see a challenge
facing the People’s Republic in changing Chinese society to a consumer-based economy from an industrial-manufacturing
one.  Yet this is just the plan the ruling party has adopted.  Why is the savings rate so high?  First, the one child policy meant there were fewer children available to care for parents in old age.  Second, healthcare reforms meant individuals were responsible for more of their own medical costs.  Also, state-owned enterprise reforms in the late 90’s ended guaranteed employment for life.  While this unleashed a torrent of economic activity and expansion over the last 30 years, it came with an economy and people that have been incredibly focused on building businesses, making money and tucking it away. 

   Beijing has a plan in place to become a high-income economy by 2030.  A significant component of this plan revolves around
urbanization, with a target of 70% of the population to live in city-centres to be met (currently at 59%) by that time.  In
addition, China wishes to move manufacturing up the chain to become value- added (i.e. – make smart, high value products
with supplies from in-country) in order to improve the capital to labour ratio.  “Made in China 2025” is a comprehensive plan in place to accomplish this goal; targeting a reduction in Industry/GDP ratio from 40% now to 34%; a reduction in
employment in Agriculture from 28% to 12% and in increase in Services/GDP for 50% now to 61% by 2025. 

   This will further improve income and help move citizens toward a more consumption-based society.  Our outlook is for consumption to GDP to increase from the current 60% to 66% by 2030.  Of course Mr. Trump would like this to happen now. A reasonable person might expect a psychological shift of this magnitude to take a bit more time.

     Quantitative Easing programs are near the end in Europe and Japan, and they have are being unwound in the U.S. as we speak.  Globally we should expect interest rates to continue increasing as a means to absorb all the liquidity QE has created – albeit at a modest pace so as not to hamper economic growth.  We have so far seen rate increases only after improvements in employment and economic expansion.  This bodes well for modest growth in market valuations – so long as interest rates do not rise faster than growth (we expect to see 2.30% overnight rate in Canada; 2.75% Fed Fund rate by end of 2019), we expect stock prices to provide growth in the range of 5 to 7% over the next year (over and above dividend).  Financials, infrastructure and select real estate continue to be favorites – with an expanded list of U.S. and multi-national stocks for added growth in the mix.  I currently am over-weight U.S. holdings.
 
 

Sources:

econoFACTS; Doug Porter, May 18, 2018 – BMO Capital Markets
The Goods; May 2018 – BMO Capital Markets
Focus; Mar 29, 2018 – Michael Gregory (Deputy Chief Economist, BMO)
Focus; Mar 23, 2018 – Art Woo (Senior Economist, BMO)
The Madness of (Investing Crowds); May 17, 2018 – Doug Kass, Seabreeze Partners