HIGHLIGHTS OF THE WEEK
- Despite heightened political uncertainty it was another good week in equity markets, with the three U.S. benchmarks reaching peaks mid-week before retracing somewhat ahead of the weekend.
- U.S. data came in well above expectations with survey indicators from the NFIB, as well as the New York and Philly Federal Reserve Banks rising to multi-year highs. The optimism was also prevalent across harder data, with retail sales as well as consumer and producer inflation metrics surprising to the upside.
- Together with the stronger data, Chair Yellen’s testimony where she indicated it "unwise" to wait too long to remove accommodation, boosted the odds of a March hike. Nevertheless, we continue to anticipate the Fed will wait until mid-year to raise rates next.
- It was a busy week for the jet-setting Canadian Prime Minister with stops in Washington D.C. and Europe. In both cases, trade was on the agenda. Canada received some reassurance from the U.S. President on the strength of the relationship between the two countries, but he also noted that NAFTA would be "tweaked."
- With the approval of the free-trade deal between Canada and the European Union by the European Parliament, the agreement has passed another important hurdle. The deal will eliminate tariffs on 99% of trade between the jurisdictions and should help to diversify Canada’s trade.
- Canada’s housing market is showing some signs of slowing down, especially in terms of home sales. Nonetheless, tight supply in Canada’s hottest markets have kept upward pressure on prices, which are up over 20% year-on-year.
UNITED STATES – ANIMAL SPIRITS CONTINUE TO TRUMP ANXIETY
Investors continued to be enamored by the potential for growth-inducing policies of President Trump this Valentine’s Day week despite relatively few details. While politics continued to drive headlines, financial markets were more focused on healthy earnings and robust economic data. The three main U.S. equity indices hit record highs on Wednesday, before paring back some gains through this morning. The sell-off in the bond market, which saw the U.S. 10-year Treasury rise near 2.5% by mid-week as Janet Yellen testified to Congress, also reversed course recently, with the benchmark falling to 2.4% by this morning. Oil remained largely range bound, as the support from realized cuts by OPEC were offset by rapidly rising inventories in the U.S. where production has been recovering in recent months.
News across the Atlantic was largely lackluster this week. The economy of the Eurozone area grew by 1.6% in the final quarter of last year, missing expectations for a 2.0% pace of growth. The U.K. economy also exhibited signs of weakness, with retail sales declining in January. The result missed expectations for a rebound from December’s large decline, and suggests that Brexit anxiety and rising prices related to the falling pound are beginning to affect U.K. consumers who previously appeared unfazed by the vote results. Greece is also beginning to make headlines as a rift between European officials and the IMF looks to delay the next disbursement of much needed funds, while anxiety about upcoming elections in France is having investors rethinking holding French bonds.
Political uncertainty remained on the back-burner in the U.S. as investors focused on healthy earnings growth with U.S. corporate profits looking to grow by over 6% after three quarters of declines. Moreover, the animal spirits that have been driving stock markets since the election appear to also be showing up in the economic data.
Much of the positive sentiment can be found in survey data. This week, the NFIB’s Small Business Optimism index surprised to the upside, rising to the highest level since December 2004, while both the Empire and Philly indices – the earliest indicators of February activity – rallied strongly (Chart 1), with the latter at a more than three-decade high. The positive news was not limited to survey data, however, with retail sales also surprising to the upside in January, rising by 0.4% on the month from an upwardly revised 1.0% gain in January. This performance suggests that the consumer is becoming increasingly confident to spend and should remain a key support for the U.S. economy this year as job gains eat up slack and push wages higher.
The reduction in slack also appears to be manifesting in higher prices. Both the core CPI and PPI measures surpassed expectations, rising by 0.3% and 0.4% in January, respectively, with the headline consumer inflation measure accelerating to 2.5% (see Chart 2). The hotter-than-expected data is adding pressure on the Fed to not fall behind the curve. In her testimony to Congress this week Chair Yellen highlighted that waiting too long to remove accommodation would be "unwise," suggesting that the Fed could raise rates in the near-future. While a March or May hike is not off the table should the data continue to come in above expectations, we remain of the view that the Fed will wait until June to raise rates.
CANADA – MR TRUDEAU GOES TO WASHINGTON (AND EUROPE Too)
It was a busy week for the Canadian Prime Minister. On Monday, Justin Trudeau was in Washington for meetings with the Trump administration and members of Congress. He was there to promote Canada’s close economic relationship with the United States and to get some reassurance that the bond will remain strong. President Trump for his part, lent some credence to this view, praising the close relationship with Canada. But, on a direct question about NAFTA, he still noted that the agreement will be tweaked, adding that it would be in ways that would benefit both countries.
Even if there are only minor tweaks made to NAFTA as far as Canada is concerned, other policy changes, particularly to U.S. taxes could still prove disruptive. Of particular concern are proposed changes to corporate income taxes that would include a border adjustment tax that would effectively raise prices of all U.S. imports by as much as 20%. Exchange rates would likely adjust with the Canadian dollar falling against its U.S. counterpart to make up for the change in relative prices. But, despite the exchange rate rebalancing, the measure could still present quite a shock. A recent report by the C.D. Howe argues that the disruption to supply chains could cut Canadian real GDP by as much as 1.0%.
There have been few moves on the tax front in Washington over the last few weeks, with the exception of a statement from the President that he would be announcing details for a "phenomenal" package within the next few weeks. Within Congress, tax reform appears to have taken a back seat to changes to healthcare legislation. In the meantime, there appears to be a growing opposition to the border adjustment tax within the political and business community in the United States that may yet prevent it from moving forward. Still, given the potential size of the shock to Canada and other trading partners, it will remain an important area to watch.
Not long after his trip to the U.S., Trudeau was off once again, this time to Europe to celebrate the approval by the European Parliament of Canada’s free trade deal with the European Union. The deal eliminates 99% of the tariffs on goods traded between the two jurisdictions. It also opens up government procurement and reduces non-trade barriers in services by standardizing rules across major sectors. While the trade deal will not reduce the importance of NAFTA, it should help diversify Canada’s trade and bring benefits to consumers through lower prices.
On the home front, data on existing home sales showed a continued slowdown in activity, and considerable divergence in price growth across the country. The hottest markets in the country are those around the Greater Toronto Area, where prices are up over 20% over the last year. There is little doubt that the sharp rise in prices has cut into affordability and is unlikely to be sustained. However, one point of caution on an expectation for a major turnaround in prices is that the supply of listings remains very tight. Across the country, new listings fell even more than sales in January, bringing the months’ supply of existing homes for sale to its lowest level in years. While downside risks are building, the limited supply suggests that a deceleration in home price growth is more likely than a sharp reversal.