#MacroMemo: Mar 20 - 24, 2017

Wondering what to expect from the 2017 federal budget? This week’s #MacroMemo covers that topic, as well as the fierce debate over U.S. GDP, peaking global inflation, Toronto’s hot housing market and a second rate increase in short order by the Fed. In addition, I briefly discuss the Dutch election and Trump’s new proposed federal budget. Enjoy.

Canadian budget preview:

• Canada’s 2017 budget will arrive this Wednesday March 22nd. As the second Liberal budget, it is unlikely to create as many waves as the first one did, but it still offers the potential for a number of consequential developments.
• The budget arrives later than usual, seemingly based on the desire to achieve greater clarity around the Canadian implications of the new U.S. administration.
• Measures designed to encourage greater innovation are expected to constitute the key theme and the main new policies.
• Infrastructure spending should also receive some attention, both by pushing previously announced money out the door a little more quickly/efficiently and nudging forward a Canadian infrastructure bank.
• Free trade may also be celebrated, in the form of an already-announced trade deal among provinces that could be fleshed out in greater detail, and the activation of the CETA trade agreement this spring. Of course, the elephant in the room remains the (unknown) extent to which U.S. protectionism damages Canada.
• For a second straight year, Bay Street is abuzz with debate over whether the budget will announce an increase in the capital gains inclusion rate from the current 50% of an investor’s marginal income tax rate to 66% or even 75%.

       An increase is certainly possible given:

1. The government has an agenda of reducing inequality and the bulk of the capital gains tax is paid by the well-to-do
2. The personal income tax rate went up last year, signaling two things: a willingness to raise taxes and also that other levers will have to be chosen if future action is desired
3. The capital gains inclusion rate has been as high as 100% in relatively recent memory (though also as low as 0% if a longer swath of history is considered)

On the other hand, a capital gains tax increase is hardly a certainty and we ultimately put it below a 50% chance:

1. There was similar (incorrect) speculation about a capital gains tax increase before the 2016 budget
2. Canada’s capital gains tax rate is already in line with its global peers
3. Canada’s capital gains tax is already roughly “fair” in the sense that taxation at the corporate level plus the capital gains tax rate combine for an overall tax burden that is reasonably close to that paid on personal income
4. Canada is already on course to open a disadvantageous tax wedge with the U.S. even if no action is taken domestically

• Deficits should remain as far as the eye can see, at roughly $25 billion per year over the next few years before ebbing to a $15 billion level in later years. Despite this, the government debt-to-GDP ratio should manage to remain roughly steady given the prospect of a growing economy.

A dovish hike:

• As expected, the Fed raised rates to 0.875% last week. With a second rate increase in just three months, this represents an accelerating pace of tightening.
• The Fed continues to target a total of three rate increases in 2017, meaning it expects to deliver two more increases this year. There is still no precision on when the Fed’s balance sheet will begin to shrink, but market expectations are for around the end of 2017 / start of 2018.
• Projections for the future path of the fed funds rate, the neutral policy rate and its growth outlook were mostly unchanged in the accompanying appendix.
• On the qualitative side, the Fed was more hawkish in its assessment that business investment had “firmed”, but more dovish in its removal of any reference to strong sentiment. The latter action was a response to uncertainty about whether higher confidence will translate into actual economic activity. We discussed that issue two weeks ago.
• All in all, the FOMC decision was interpreted by markets as a “dovish” rate hike. This might sound odd given that the Fed has now delivered its third rate increase in more than a decade, but keep in mind that the tightening was already fully priced and a string of hawkish speeches in recent weeks had markets expecting an even stronger statement and upgraded forecasts.
•  We view the Fed’s determined but gradual pace of monetary tightening as economically appropriate and more likely to do good than harm.

The U.S. GDP debate:

• There is currently a fierce debate over how the U.S. first quarter GDP will fare (to be published in late April).
• As a backdrop to this issue, the U.S. economy’s “soft” (mostly confidence) indicators have strengthened beautifully, while the “hard” indicators (actual activity metrics, like GDP) have yet to fully confirm that strength. This GDP print takes on an outsized importance in confirming or repudiating any strengthening trend.
• The key thrust of the debate is that the Atlanta Fed’s GDP tracker argues for growth of just 0.9% annualized in the first quarter, while the New York Fed’s tracker predicts a strong 2.8% gain.
• Inconveniently, these numbers are aggressively different and happen to run the full gamut from very weak to very strong.
• Which to believe?

1. The New York Fed has the newer measure, meaning it is less tested. But, in theory, it is constructed in a superior way.
2.  Meanwhile, the Atlanta Fed has a much longer track record of success, and various third party estimates also tend to be soft this quarter. However, the Atlanta measure seems to be behaving oddly, falling as strong data has been incorporated into the model.

Global inflation peaking:

• For a number of years we have talked about rising inflation. Over the past year, this has finally begun to happen:

1. U.S. CPI has increased from just 0.8% YoY in July to a big 2.7% YoY today.
2. Eurozone CPI has now increased to 2.0% YoY after flirting with deflation for several years, with German CPI even higher at 2.25% YoY.
3. Canadian, U.K. and Japanese inflation have also increased.

• To be clear, we continue to anticipate a generally firming trend for core inflation over the next several years as economic slack continues to fade and as populism proves to be slightly inflationary.
• However, the initial surge in inflation is arguably coming to an end:

1. The most powerful component was the end of the commodity shock and a subsequent partial rebound in commodity prices. This has now happened and has been absorbed fully by the annual CPI figures.
2. Our tracking suggests that for most countries the annual inflation rate should now remain roughly stable over the next six months or so.

• As such, some of the enthusiasm around the “rising inflation” / “central banks are behind the curve” narratives will likely fade. This could limit the extent of any further bond yield increases over the coming few quarters.

Toronto’s hot housing:

• Toronto housing has now become white hot, with prices rising by around 25% over the past year.
• The underlying cause of high and rising home prices over the past decade can be traced back to many drivers:

1. Low interest rates
2. A reasonably healthy local economy
3. Supply constraints, both natural (a Great Lake) and artificial (green belt, zoning  rules, land hoarding by developers)
4. Strong organic demand growth (immigration, internal migration)
5. Artificial demand (foreign speculators, domestic speculators, and first-time homebuyers pushed into the market ahead of schedule by a fear of missing out should prices continue to rise)

• The Toronto market is now very strongly a “seller’s market”, meaning that homes are selling more quickly than new properties are being put on the market. But this is not a supply issue: supply is normal. It is demand that is unusually strong.
• “Artificial demand” is arguably the most relevant reason for the latest home price spurt. Immigration has not suddenly spiked nor has supply fallen.
• Affordability is now at least 30% offside in Toronto – a significant margin. The mismatch would be even larger if not for very low mortgage rates. This qualifies as a “bubble” in our books, though bubbles don’t always end with a collapse.
• Peripheral markets far afield of the city have enjoyed the fastest gains recently, and are vulnerable to the sharpest declines should the housing market weaken.
• How might this play out?

1. Vancouver’s experience is illustrative: once home prices are rising by 25% to 35% per year, the writing is on the wall as such heroics cannot persist for long (home prices would have to double every 2.25-3.5 years, which is absurd). Indeed, Vancouver has since cooled and was already doing so before regulators got involved.
2. Local regulators are beginning to take an interest. Although foreigners only represent around 5% of buying in the Toronto market, this is still significant. A foreign tax seems increasingly likely, much as Vancouver implemented. This notion enjoys widespread support among Torontonians.
3. National policymakers have also been tightening in myriad ways, and higher mortgage rates could start to bite.
4. The goal of policymakers is to get home prices going sideways, allowing rising incomes and inflation to eventually eat into a significant affordability problem.
5. While there is the possibility of a sharp fall, more likely is that a mix of natural dynamics, regulatory interventions and higher mortgage rates prompt Toronto’s housing market to level off at some point over the next six months to two years.

Other tidbits:

• Dutch election: The Dutch electorate soundly rejected the forces of populism last week, with a centrist coalition the most likely outcome. The populist loss was not especially surprising, but the strength of the rejection was. When paired with the Austrian presidential election result from late last year, it can no longer be said that populist parties always enjoy greater support than markets or pollsters expect. This is some consolation going into the April/May French election.
• Trump budget: The new U.S. Administration proposed a federal budget that would cut several programs to the bone while increasing military spending by 10%. However, it is not nearly as important as commonly imagined. First, it only represents a partial effort: tax and entitlement program proposals will apparently come later in the spring. That is where the real action lies. Second, the White House does not get to set the U.S. budget. Congress does. This is more of a symbolic action to signal where priorities lie, with the threat of veto should Congress’ budget not rhyme.

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