#MacroMemo: August 28 – September 1, 2017

Hurricane Harvey first look:

• Hurricane Harvey hit Houston over the weekend, unleashing truly biblical quantities of rain. The resultant flooding of the fourth largest U.S. city appears to be quite significant and if anything getting worse. Beyond the human tragedy that this constitutes, it will take some time before a more precise sense of the economic implications can be distilled.
• While it is unlikely that Houston will suffer the permanent population drawdown that befell New Orleans after Hurricane Katrina, the need to rebuild and repair could substantially slow the city’s previously rapid rate of organic growth.
• Houston is arguably the oil and gas capital of the U.S., and significant outages of oil production and refinery activity have been reported. Whether these will merely persist until the water dries up or instead reveal significant damages in need of repair is not yet known. We are inclined to think the former.
• It is not clear that the price of oil needs to go any higher as a result of the storm since the greater constraint appears to be in refining capacity rather than oil production. Retail gas prices are slightly higher in recent days.
• Past U.S. weather disasters – Hurricanes Katrina and Sandy in particular – usually have a palpable effect on economic growth for the quarter in which they occur, but then tend to fully unwind that weakness in subsequent quarters as the normal course of economic activity resumes and a degree of reconstruction occurs. It is unlikely to substantially alter the course of U.S. monetary or fiscal policy.
• More on this in the coming weeks depending on how the storm and its repercussions play out.

U.S. business cycle assessment:

• In recent months we have worked feverishly on a project to more formally identify the stages of the business cycle, and to better distinguish this assessment from more pedestrian fluctuations in the economy. In a nutshell, a slowing economy does not always signal a recession.
• The project currently considers 17 different signals originating from the U.S. economy and financial markets. When tallied according to the signal emanating from each, the conclusion is the expected one: the U.S. economy is most likely in its “late cycle” phase.
• Factors supporting this include the length of the cycle, highly optimistic sentiment, the dwindling quantity of economic slack, narrow credit spreads and slightly diminishing profit margins, among others.
• The main surprise in the research, though, is that there is a half credible argument to be made that the business cycle might instead only be at a “mid cycle” moment. To be clear, this is less likely than the late cycle diagnosis, but only slightly. Arguments in favour of a mid cycle interpretation include significant room left to run in the housing market, still rising consumer durables spending, the level of bond yields and the modest rate of inflation.
• It is still prudent for investors to incrementally reduce their risk-taking as this cycle matures, but there is a chance that next recession is a bit more distant than previously imagined.

U.S. protectionism update:

U.S.-centric trade developments continue to alight.

• Softwood lumber negotiations between the U.S. and Canada are continuing, with a ruling expected from the U.S. Department of Commerce on permanent tariffs by September 7th. Hopes for a quota agreement on Canadian exports are said to be diminishing as NAFTA negotiations capture the limelight. In the meantime, European lumber exports have surged into the U.S.
• U.S. steel and aluminum tariff plans are behind schedule, with the Department of Commerce having missed a self-imposed deadline to publish its recommendations over the summer. The Defense Logistics Agency is expected to publish a report in early September on steel production as it relates to military security. Canada is substantially at risk in all of this despite theoretical NAFTA protections given the parade of tariff threats and the fact that Canada is the number one source of U.S. steel and aluminum imports by a considerable margin.
• Chinese intellectual property: The U.S. is now looking hard at Chinese practices that give Chinese firms a considerable domestic advantage, to the point of effectively harvesting intellectual property from their American partners. Compared to Chinese access to U.S. markets, it is an asymmetric situation. Reflecting President Trump’s general animosity toward Chinese economic policy, he has apparently complained to his staff about the lack of action on the file so far, saying “I want a tariff. And I want someone to bring me some tariffs.”
• Of course, the main subject at hand is NAFTA. The second round of negotiations are scheduled for Mexico City later this week. It will be crucial to watch for any progress, as the three parties seemed to largely talk past each other at the first such engagement. They fundamentally disagree with one another on most issues, and aren’t even interesting in discussing the same subjects.
• President Trump recently threatened to kill NAFTA, going so far as to indicate that his default assumption is that negotiations will fail. Of course, he may be bluffing, though as pundits have pointed out, it is a strangely early point in the negotiations to make this existential threat. Normally one would wait until the last moment to extract key concessions. Then again, he has one other bazooka in his pocket that can be saved for later: actually initiating the six-month NAFTA exit sequence. The trick is that there is no obligation to actually leave once the six months are up.
• We see four broad scenarios that might play out in NAFTA negotiations, with loose probabilities assigned to each:
• 1) NAFTA is killed. We assign a 15% chance to this scenario. It can’t be ruled out given the conflicting goals of the parties and Trump’s repeated threats and campaign promises. On the other hand, it is hardly assured given expected defensive efforts by business interests, Congress and the President’s increasingly centrist contingent of advisors. This outcome would be quite economically negative, though it is worth recalling that the U.S. and Canada have a second less comprehensive free-trade agreement lurking beneath the surface and that the fallback WTO default tariffs are not especially high on most products. Battles over the legality of the President unilaterally killing NAFTA could stretch on interminably. The anti-trade outcome paired with a plume of uncertainty is akin to a Brexit-lite scenario.
• 2) Substantial NAFTA changes. We assign a 20% chance to this scenario. This is the case in which the U.S. achieves many of its aims, such as eliminating Chapter 19 tribunals and securing the right to safeguard exclusions. These are problematic as they would seriously defang NAFTA, raising questions about the functionality of the entire agreement if the U.S. were able to resolve disputes in its own courts and to levy tariffs on any foreign sector deemed to be doing harm to U.S. interests. Call this a moderate economic negative.
• 3) Modest NAFTA changes. We assign a 35% chance to modest NAFTA changes. These would mostly involve benign or even beneficial changes to modernize the trade deal, better incorporating intellectual property and the service sector. The U.S. would likely get a few of its less economically constructive aims as well, but generate no more than a modest economic drag.
• 4) Unchanged NAFTA. Finally, we assign around a 30% chance that NAFTA will remain utterly unchanged. Given the extent of disagreement, it is quite conceivable that nothing gets done. Moreover, unrealistic aspirations to conclude a deal in record time despite a long history of trade deals taking years to negotiate further imperil the prospect of change. The question is whether the White House would respond to this by killing the agreement or simply dropping it. We see a higher chance of it being dropped than killed.
• On a weighted expectations basis, then, we must budget for some sort of drag from NAFTA negotiations. However, the reality is that there is only a 35% (15% + 20%) chance of significant economic damage, versus a 65% chance of a mildly pleasant surprise if the more negative scenarios were avoided.

Toronto condo vacancies:

• Having tackled several key aspects of Canada’s housing market in last week’s thematic bullets, we circle around to some acute concerns about Toronto’s condo market in this edition.
• At first glance, the number of new condominiums in Toronto’s downtown core is nothing short of shocking. Given anecdotes about speculators, foreign buyers and the fraction of condos perpetually dark even as day turns to dusk, one worries about this segment of the market in the event of a serious correction.
• Fortunately, the actual statistics bely this fear.
• Among condos made available for rent in Toronto, just 1.0% are vacant according to the latest data. It goes without saying that this is extremely low.
• Wait a moment. What about the “shadow inventory” – all the condos held off the market but nevertheless empty? Using data from 2015, CMHC has calculated that among condos that are not primary residences, fully 48% are rented out, a big 42% are used in some fashion by the owner or family members, and just 4.1% are vacant. Thus, the most pessimistic interpretation is that the true vacancy rate is 4.1%. This is considerably higher than 1.0%, but literally an order of magnitude smaller than feared.
• Toronto’s condo market is not without its risks and does possess the capacity for a middling supply shock in the event of a sharp housing downturn. But the risk is significantly overstated. The fact that condo prices have held up better than detached homes during the city’s recent swoon hints at this resilience.

Odds and sods:

• Canadian second-quarter GDP is set to manage another remarkably strong gain. Our models point an above-consensus monthly outcome for July, permitting as much as a 4.0% annualized GDP increase for the entire second quarter. Lest there be any question about the sustainability of this performance, particularly coming on the heels of a similarly stupendous 3.7% gain in the first quarter, the Bank of Canada assumes that Canada’s steady-state potential growth rate is just 1.4%. What a hot streak.
• U.S. government shutdown and debt ceiling risks continue to inch higher. Fireworks are possible toward the end of September, though we budget for a successful avoidance of disaster. President Trump’s demand for a Mexican wall is an x-factor.
• The Jackson Hole confab of central bankers last week revealed little of immediate application on the monetary policy side. Fed Chair Yellen engaged in a spirited defense of financial market regulations introduced since the financial crisis, likely not endearing herself to President Trump at a time when the Fed Chair role is up for renewal in early 2018. ECB head Draghi also shared little new, though failed to complain about the strong euro, in the process giving it permission to rise a little further.

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Published August 21, 2017