Canada: Bennett Jones Fall 2018 Economic Outlook

Replay the November 27 Calgary seminar.
Replay the November 28 Toronto seminar.

SECTION I: GLOBAL GROWTH TO 2021

Recent Developments

The world economy has expanded at a solid rate in the first three quarters of 2018, although growth has been somewhat slower and less synchronized than during 2017. In the first half of the year, growth in OECD countries as a whole lost some of the strong above-trend momentum experienced throughout 2017. The slowing was most pronounced in the euro area where annualized growth fell from 2.7% during 2017 to 1.7% during the first half of 2018. Growth in other advanced economies was also weaker in the first quarter than in 2017, but did rebound strongly in the second quarter, notably in the United States and Japan. In 2018-Q3 growth continued to be brisk in the United States at 3.5% while growth in the euro area receded further to 0.7%. China and India continued to expand at a rapid pace in the first three quarters. In China, however, the manufacturing purchasing managers' index fell in October to a level that barely exceeded the threshold that separates expansion from contraction, signaling that slower manufacturing activity is to be expected in the fourth quarter. Stronger oil prices benefited oil-producing countries this year, notably Russia. In contrast, growth in Brazil has been very anemic during the year, hampered by strikes and political uncertainty, and in Argentina activity has plummeted.

Inflation in the year to August was about 1.0% (core CPI) in the euro area and 0.2% in Japan, both still far below target. In the United States, core consumer-expenditure (PCE) inflation, the measure preferred by the Federal Reserve, continued to increase in the first three quarters of 2018, reaching 2.0% year-on-year in both the third quarter as a whole and September. Core CPI inflation was 2.1% in October and 2.2% in August and September after rising from 1.8% in February to 2.4% in July. While the pace of hourly wage gains in the United States has picked up since last April, wage increases remain surprisingly moderate in light of unemployment rates that have reached their lowest levels since the end of 1969.

Monetary policy remains accommodative. The European Central Bank (ECB) and the Bank of Japan have held their policy interest rates at record low levels. Both continued quantitative easing although the ECB started cutting the volume of its monthly bond purchases in October. In contrast, the Federal Reserve has continued the process of interest rate normalization, lifting the target federal funds rate by another quarter percent in June and again in September, to 2.25% (upper limit), and it continued also the process of reducing the size of its balance sheet.

Commodity prices in U.S. dollars, as measured by Bank of Canada indexes, rose considerably in April and May 2018 to reach a 3 1/2–year peak before retreating to their lowest levels since mid-March 2017 by early November 2018. Weighing on commodity prices have been less certain growth prospects for China, increases in Chinese and Mexican tariffs against U.S. agricultural exports, and a significant appreciation of the U.S. dollar. International oil prices, on the other hand, were relatively firm all the way to late October, with WTI prices hovering around the level of US$70 level reached in May. This firmness was buttressed by current and anticipated very limited spare output capacity in the oil market, expected strong oil demand and uncertainty about future oil supply expansion after the production loss from Venezuela and the impact of sanctions on Iran.

In the first half of November, however, WTI prices sunk to the mid US$50s as concerns about oil supply abated due to stepped-up OPEC and U.S. shale production and increased Iranian supply due to temporary waivers to key consumers of Iranian oil. At the same time, an unusually sharp reduction in refinery runs temporarily reduced oil demand and increasing concerns about the strength of future global demand for refined products, due to growing signs of weakening global growth, added to the bearish sentiment about future oil prices. Meanwhile the Western Canada Select (WCS) heavy oil price discount to the WTI price widened to historic highs between May and October. This was attributed to a combination of rising oil sands production, full oil export pipelines, lack of storage capacity in Alberta, a slow uptake in crude-oil-by-rail shipments, and, for a while, reduced U.S. demand amid refinery maintenance. While some of those factors may abate, pressure on price discounts will remain high until significant new capacity is added to connect producers to markets.¹

The U.S. dollar exchange rate has appreciated between mid-April and early November 2018, by 9% on a tradeweighted basis (broad index) and against the euro, by 11% against the renminbi and by 4% against the Canadian dollar. This appreciation fundamentally reflects both the strength of the U.S. economy and rise of U.S. interest rates relative to the rest of the world as well as intensifying concerns about Brexit, Italian budget issues and weakening Chinese growth. In June and September both the United States and China announced and implemented increases in tariffs against each other over an increasing range of imports (see Section II on international trade).² These trade frictions have intensified concerns about Chinese growth and depressed both the renminbi and Chinese equity markets.

Equity prices have become volatile. The S&P 500 index of U.S. stock prices rose by 11% between early May and October 3 and then fell by 10% to October 29. Volatility continued in November. The S&P/TSX Composite index and several other stock exchanges experienced considerable decline during this fall. Some have considered that U.S. equities had become overvalued and hence were due for a downward price correction. The triggers for the recent volatility in stock markets include heightened worries that U.S. corporate earnings could weaken as the current cycle becomes long-in-the-tooth, apprehension of a coming economic slowdown in Asia, and fear of rapid interest rate increases.³

Global Economic Outlook

The relatively rapid global expansion of 2017 and 2018 is coming to an end. The world economy is expected to slow to its potential rate of growth in the next two years. This is a view that we held last spring as well. What has changed since then, however, is that the strong momentum observed during 2017 lost steam faster during 2018 than we expected. Moreover, a trade dispute between the United States and China took a surprisingly bad turn in June and September at the instigation of the United States. Projected growth rates for 2019 and 2020 are now somewhat lower than we envisioned last spring,⁴ primarily reflecting the expected global impact of increased trade tariffs by the United States against China and the consequential reaction of the Chinese authorities. While the rate of growth of the global GDP will decline significantly over the next two years, we do not think that the global economic and financial headwinds that we anticipate are sufficiently severe in and of themselves to cause a global recession.

Base-Case Projection

Annual global growth is projected to recede from the above-potential rate of 3.7% in the last two years to 3.5% in 2019, 3.4% in 2020 and 3.3% in 2021, its trend rate at that time (Table 1). Much of the projected slowdown originates in the advanced economies, which now operate at or near capacity and could not grow much faster than their potential rate beyond 2019 without risking an intensification of inflationary pressures. Going forward, potential growth in the advanced economies is expected to be held back by a continuation of the disappointing labour productivity growth experienced in the last several years and by the negative impact of population aging on labour force growth. Meanwhile, aggregate demand growth in the advanced economies will be driven down to its (lower) potential rate in the short term primarily due to the run-off of the effects of the 2018 U.S. fiscal stimulus and the normalization of U.S. monetary policy. U.S. and Chinese tariff increases will accentuate the policy-induced slowdown in advanced economies, as probably will ongoing political issues in Europe, at least for a while. China will also see its growth rate diminish over the short term as authorities are likely to offset through stimulative policies only part of the drag on growth stemming from further rebalancing of the economy and the trade war with the United States.

Our economic projection is based on the assumption that the WTI oil price will fluctuate around US$60-65 in the short term, much as in our Spring Outlook. We interpret the steep price fall in the first half of November as a temporary movement resulting from both a strong short-term supply increase in anticipation of the U.S. sanctions on Iranian oil and a downward adjustment in expectations of oil demand growth. While we expect global oil demand to grow at a slowing pace going forward in concert with gradually lower growth in global activity, we assume that global oil supply will adjust to that slower pace of demand and keep prices in the range of US$60-65 on average over time. We anticipate much volatility around that level in reaction to industry news, geopolitical developments, revised economic forecasts, and delayed adjustment of oil supply to changes in demand.

Table 1: Short-Term Prospects for Output Growth (%)*

*Figures in brackets are from the Bennett Jones Spring 2018 Economic Outlook.

1. Weighted average of Canada, United States, euro area and Japan.

2. Shares of world output are on a purchasing-power-parity basis.

U.S. growth is projected to decelerate from 2.9% in 2018 to 2.5% in 2019 and 1.8% in 2020 and 2021, a profile only slightly lower than in our Spring Outlook. The much-above-potential growth expected in 2018 and 2019 is buttressed by the 2018 fiscal stimulus, less restrictive regulation, high confidence levels and a buoyant labour market. All these underpin continued growth in consumption spending and business investment. Growth in aggregate demand nevertheless declines gradually towards its potential rate of 1.8% by the first half of 2020 as the economy adjusts to: (a) higher interest rates, (b) a stronger U.S. dollar, (c) a run-off of the effect of the existing fiscal stimulus,⁵ and (d) the negative impact of increased trade barriers. As a first approximation, escalating trade barriers between the United States and China would cut U.S. real GDP growth by 0.2 percentage points by the end of 2020.⁶

U.S. price and wage inflation has remained surprisingly tame this year in light of the fall in the unemployment rate to historical lows. While some analysts anticipate a stronger response of prices and wages to labour market developments in the future, as in our Spring Outlook, we judge that a sudden burst of inflation has a low probability of occurring in 2019. Thus, there is a low risk that the U.S. policy interest rate will rise by significantly more than the already anticipated 100 basis points by early 2020. Nevertheless, mounting trade frictions and the collateral threat to global supply chains create a small upside risk to cost and price inflation in the United States in the short term.

With the U.S. economy currently at capacity and core inflation at about the 2% target, we expect the Federal Reserve to increase its target federal funds rate to a "neutral level" of 3.0 to 3.5% by the end of 2019, with little chance of a further increase thereafter. This roughly 100 basis points increase from the current level would be enough to constrain core inflation to be close to the 2% target over the short term. There is limited potential for some further appreciation of the U.S. dollar on a trade-weighted basis in 2019, given the projected relative strength of the U.S. economy and widening policy interest rate differentials relative to some other currencies. Yields on 10-year U.S. Treasuries is likely to top out at 3.5% around the end of 2019.

Euro area growth is projected to be 1.9% in 2018 compared to 2.4% in 2017 and to converge toward a potential rate of about 1.5% by 2021. Much of the quarterly growth slowdown in the first three quarters of 2018, to about 1.4% from 2.7% during 2017, stems from weaker export growth which was probably caused in part by an earlier appreciation of the euro. There was also a slowdown in household consumption despite considerable cumulative improvement in the eurozone labour market. In both Germany and France, confidence levels have receded since early 2018 with little prospect for a rebound in the current uncertain European and global context. In Germany, a change in emissions regulation in the car industry, whose negative effect on growth is expected to be temporary, contributed to slightly negative growth in 2018-Q3 and depressed business surveys in October. In Italy, there was no growth at all in the third quarter amid political turmoil and financial volatility. Consequently, our projection assumes that quarterly real GDP growth in the euro area will remain subdued at the end of 2018 before rebounding to above-potential rates in the first half of 2019. It will then recede gradually to its potential rate over the next year as elevated political uncertainty in Europe, slowing global growth and trade, and a late withdrawal of monetary stimulus weigh on the eurozone expansion. As a result of this quarterly profile, annual growth rates come out at 1.9% in 2018, 1.6% in 2019, 1.7% in 2020 and 1.5% in 2021. Growth remains lower than in our spring projection throughout because of weaker global demand for EU exports and greater political uncertainty (Italy and Brexit). Policy interest rates are not expected to be lifted from their 0% level before the end of 2019, although the ECB announced it would terminate its monthly bond purchases at the end of 2018. If growth continues to be anemic for a while, the ECB may well continue or resume its bond purchase program in 2019.

Our projection for Japan is slightly weaker than in our Spring Outlook, with growth rates of 1.1% in 2018, 0.9% in 2019, 0.3% in 2020 and 0.5% in 2021. The effect of the global slowdown in 2020 will be accentuated by a planned hike in the value-added tax in October 2019. Growth in Japan is projected to be below its potential rate of 0.5% in 2020 before returning to it in 2021. The tax increase in 2020 would have permanent effects on the levels of consumer prices and real disposable income but not on the growth of real consumption and GDP, hence the rebound in growth projected for 2021.

Growth in China is projected to be 6.6% in 2018, but to fall to 6.2% in 2019, 6.0% in 2020 and 5.8% in 2021. Two main factors cause this slowdown. First, based on estimates produced by the Bank of Canada, Morgan Stanley, Moody's Investors Services and some Asian analysts, the tariff increases announced by the United States would directly reduce real GDP growth in China by about 0.5 percentage points by the end of 2020.⁷ This does not include potentially significant adjustment and reallocation costs that would reduce growth further. A weaker yuan should, nevertheless, provide some support to growth via net export gains.

Second, rebalancing of the economy to achieve more sustainable growth over the longer run is set to continue and should entail a slowdown in growth in the absence of counteracting policy measures. As advocated at the 19th Congress last year, Chinese authorities would take steps to emphasize "quality" rather than "quantity" of growth. This would involve a continued and perhaps accelerated shift from industrial production to services, from physical infrastructure investment to consumption, investment in high technologies and intellectual property products, including AI.

In the recent past, Chinese authorities have had the room and the willingness to do what it takes to achieve a target growth rate for the economy, currently at 6.5%. The question now is whether and to what extent they will be ready to adjust downward this growth target going forward in the face of the trade headwinds, the rebalancing objective, and high levels of debt and credit risk. Three years ago we expected that Chinese authorities would let growth recede to 5% within a few years in the interest of promoting a rebalancing of the economy and limiting a buildup of debt and credit risk. Our judgment was premature at the time. But we expect that Chinese authorities now will give more weight to these considerations going forward and let growth slip below the current official target to about 6% by 2020. A number of economic reasons would support such a move. First, potential growth in China is expected to decline over time because of adverse demographics and a shift to lower-productivity services production and should probably be well below 6.5% by 2020.⁸ Second, policies that stimulate growth by boosting credit expansion raise already high debt levels and increase credit risk. As well, stimulating physical infrastructure investment runs counter to the objective of rebalancing the economy without significantly improving potential growth, given that the marginal return to new infrastructure is decreasing and that so much investment has already taken place. In addition to these economic reasons for accepting lower growth, the trade war with the United States provides political cover to Chinese authorities vis-a-vis its public.⁹ This being said, the central government has the fiscal capacity to prop up the economy and should be expected to provide a cushion against the effects of the new tariffs. Indeed, policies have recently become more stimulative amid signs of slowing growth and in all likelihood will be loosened further going forward, but not to an extent that would prevent growth from falling significantly below its recent pace in the years ahead.

We expect tighter financial conditions, slowing growth in China and large advanced economies, and flat or declining real commodity prices to hold back growth in the rest of the world. Emerging and developing economies that have significant debts in U.S. dollars are expected to face a reduction in capital inflows that would otherwise support growth. This being said, India is set to continue to grow strongly at 7.5% over the next three years. Fast-growing East Asian emerging economies should expand at a somewhat slower rate going forward due primarily to weaker growth in China. While the economies of Brazil and Mexico are expected to gain some momentum after a disappointing performance in 2018, the rest of the advanced economies and emerging Europe are projected to lose momentum in concert with slowing growth in the large advanced economies and China. Growth in other emerging and developing economies is projected to slightly exceed its 2018 pace.

Risks to the Global Outlook

There are two key issues regarding which upside and downside risks to our projection are evenly balanced: first, U.S. inflation and interest rates, and second, the limited size of the additional fiscal boost to growth in 2019 flowing from last year's U.S. tax cuts and expenditure increases. We consider that the risk of a substantial burst of U.S. inflation in 2019 and 2020 is low and hence that the risk of an increase of substantially more than 100 basis points in the Federal Reserve's target interest rate is low. We also judge that the risk of additional fiscal measures in the United States being passed in 2019 and 2020 is relatively low especially in light of the Democrats' gain of a majority in the House, and that the stimulative demand impact of last year's fiscal measures will fade out by the end of 2019.

That said, we see two possible upside risks to our projection. First, growth in China could be stronger than we envisage if authorities show more readiness than we expect in keeping growth, at or close to, their current official target of 6.5% through fiscal and monetary stimuli, as they have done in the past. This would have positive short-term spillovers on global growth and commodity prices. Second, there is always a chance that productivity growth in the advanced economies might improve materially over the next three years, thereby raising potential growth. The persistence of modest productivity growth in the face of stronger investment in recent years points, however, to a limited upside risk to trend productivity growth in the short term. In the United States, labour productivity growth has narrowly fluctuated around 1.2% on a year-on-year basis since 2016-Q3, with no sustained pick-up even though business investment was growing at a robust pace.

While we acknowledge these two limited upside risks to growth, there are a number of specific downside risks to our short-term outlook besides geopolitical risks related to the Middle East, Russia, or Asia (the Korean Peninsula and South China Seas).

First, while our base case assumes that the recent tariff increases imposed by the United States and China stay in place through to 2021, in fact they may escalate further and have a larger negative net impact on growth than projected.

Second, the current plan for Brexit and EU negotiations with Italy over budget issues could end up in failure. This failure would have adverse effects on financial stability and growth in Europe, with spillover in the rest of the world.

Third, U.S. interest rate normalization, the expected fading of the U.S. fiscal stimulus impact on corporate earnings, and unfavorable geopolitical issues, including trade restrictions, could induce a re-pricing of asset prices, especially U.S. equities, a process which may have started in late October. A big correction and large collateral decline in financial wealth might temporarily bring slower growth than expected in the short term.

Fourth, increased U.S. interest rates and further strengthening of the U.S. dollar may slow growth more than currently anticipated in our base case in a number of emerging economies that have significant U.S. dollar debts.

All in all, we judge the balance of risks to our projection of global growth to be somewhat tilted to the downside, especially if a combination of increasing political uncertainty, escalating trade tensions, rising interest rates and ever higher debt levels were to trigger a significant loss of confidence and a retrenchment of both consumer spending and business investment.

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Footnotes

1. Enbridge's Line 3 pipeline expansion, which will add 380,000 barrels a day of capacity, is expected to enter service in the second half of 2019.

2. On June 15, the United States announced a 25% tariff on imports from China worth $50 billion; China announced retaliation on a similar scale. On September 17, the United States announced a 10% tariff—rising to 25% by year end—on an additional $200 in imports from China. In turn, China announced tariffs on a further $60 billion of U.S. imports.

3.In fact, the expected normalization of interest rates alone could have been sufficient to depress stock prices since it implies that expected future earnings would need to be discounted at higher interest rates.

4. Our 0.3% markdown in global growth for 2019 since last spring compares with a 0.2% markdown by the IMF.

5. We assume that no new tax cut or spending programs will be passed by Congress in 2019 or 2020.

6. This estimate is from the Bank of Canada. See Monetary Policy Report, October 2018.

7. See Bank of Canada Monetary Policy Report, October 2018, Gavyn Davies, "Can macro policy easing still rescue China?" in Financial Times, September 18, 2018, "Trade war: how will Donald's Trump tariffs on US$200 billion of goods affect China's GDP?" in South China Morning Post, September 18, 2018, and "China needs policy toolbox to fend off financial risks", in Global Times, September 13, 2018.

8. The Bank of Canada estimates the rate of potential growth at just above 6% in 2020. See Monetary Policy Report, October 2018.

9. According to a Chinese analyst "It would be acceptable to Chinese policymakers and most of the Chinese public if the world's secondlargest economy expands 6 percent annually, taking into account the unprecedented trade war against China by the Trump administration. See Wen Sheng, "China needs policy toolbox to fend off financial risks", in Global Times, September 13, 2018.

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