2 Key Risks to the Economic Outlook

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Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Michael Sager, managing director and head of multi-asset and currency management, CIBC Asset Management.  

I think it’s definitely a constructive growth outlook.  

Growth in the U.S. particularly has continued to remain robust for the third and fourth quarters. Data suggests that the U.S. economy continued to grow stronger than its long-term trend growth rate.  

That trend is a little bit below 2% in real terms. The economy is actually probably growing closer to 3%. The drivers of that strong growth in the U.S. remain the same. Consumer spending, particularly, has remained resilient. And as we look forward, we have a central bank that is now cutting interest rates, so easing policy; fiscal policy, that’s becoming more growth friendly. So, both of those are becoming supportive.  

And then if we broaden out the outlook from the U.S. to the global economy, we see the same trends. Generally supportive monetary and fiscal policy, but also global investment spending — for instance, related to infrastructure renewal — becoming a tailwind to growth.  

So that’s a pretty good outlook.  

In addition, in China, we’re beginning to see signs that the government recognizes the need to stimulate growth, which, again, at the margin, is a positive for the global economic recovery.  

In Canada, it’s a little bit less rosy. The consumer has been a bit weaker. The labour market has softened up a little bit more than in the U.S. But even for Canada, the latest data, whether it was in terms of consumer spending or business confidence, were relatively resilient.  

In terms of headwinds, it’s predominantly twofold. From economics, it’s whether we start to see issues around inflation. So, inflation has softened quite substantially over recent quarters, particularly in Canada. We’re getting very close now to the Bank of Canada’s inflation target, and so that’s a positive.  

But there’s just one or two signs in the context of a robust growth outlook that we need to just watch to make sure that we continue to have progress on inflation, which allows central banks to continue to ease policy consistent with market expectations.  

If inflation was to become a little bit more sticky around current levels, that would inhibit policy easing, which in turn would keep interest rates higher than the market expects and would inhibit the growth outlook.  

The second risk that we need to think about in the context of our constructive growth outlook is political risk. Let’s focus on the U.S. election. At the moment, it remains very uncertain who’s going to win the presidential election, and whether we’re going to have a divided government or a unified government. So, will the Republicans sweep, will the Democrats sweep Senate, Congress and president? Or will there be a divide between those three arms of government? Very difficult to have a clear view, particularly at the presidential election right now. It’s important, because a Republican sweep would have very different implications for policy versus a Democratic sweep.  

Think about, for instance, potential trade policy. Around tariffs, a Republican sweep would probably lead to a more aggressive broadening and increasing of tariffs, particularly in regards to China, but perhaps in regard to a broader set of countries. Whereas Democrats share a similar view regarding the need to de-emphasize U.S. economic reliance on China, as do Republicans, but Democrats don’t share the same view on the aggressive use of tariffs. So, that would be an important difference that would have implications for interest rate policy, inflation and growth, at least at the margin.  

Deregulation versus re-regulation. Republican sweep would be much more focused on deregulation, which would be important for particular sectors, relative sector equity performance. Think about finance and energy being particular winners under a Republican sweep that leads to aggressive deregulation, for instance. 

We think that the Canadian dollar is cheap relative to its intrinsic value, it’s long-term fair value. And there are good reasons for that. The Canadian dollar has had a poor productivity performance over several years now. Very weak productivity, whereas the U.S. has had strong productivity.  

Productivity growth is a key driver of exchange rates and currencies. Countries with strong productivity have higher expected returns to capital, and so they attract inward investment, and that inward investment leads to an appreciation in the value of their currency. So, U.S. productivity has been strong, Canadian productivity has been weak, and no surprise, therefore, the U.S. dollar has broadly been strong and also specifically been strong against the Canadian dollar.  

Commodity prices have been quite weak too. If you think about over the last several months, the price of oil has weakened off. That’s another key component of the drivers of the Canadian dollar. Oil is a key export and commodity for Canada. So, those are a couple of reasons why the Canadian dollar has been weak.  

For the euro, the short-term direction, a lot will be determined by political risk. For example, if we have a Republican sweep in the U.S. election, it’s likely to lead to fears of more aggressive tariff policy focused primarily on China, but perhaps upon other countries that are competitors in terms of, for example, autos. The euro comes to mind, in both those regards. It has a high dependency upon China. So, anything that adversely affects the Chinese economy will also affect the euro. And of course, the euro area itself is a big auto producer.  

So, net net, our bias is that the outlook over the next three or six months for the euro is weak versus the U.S. dollar, and sideways against the Canadian dollar.  

And then finally, Japanese yen. That’s a little bit more nuanced. The Japanese yen is cheap. The Bank of Japan is bucking the global central bank trend, because it’s tightening policy, whereas the Fed, the Bank of Canada and other major central banks are loosening policy. That will tend to support the yen. And the yen tends to be a safe haven. So, if our political risk factor becomes more relevant, the yen, along with the U.S. dollar, will likely be a beneficiary in the short term. 

So why will investors in fixed income and equity continue to do well over the next 12 months?  

It comes back to our constructive outlook for growth and inflation. Putting fixed income and equity together into a balanced portfolio is a very attractive opportunity. Yields on fixed income have risen back to interesting levels from very low levels a few years ago. The diversification benefit that fixed income offers now relative to equity is also very attractive. We call it useful diversification: Fixed income outperforming when equity has periods of underperformance. So, putting those two together very constructive. 

And then the growth outlook that we see as very constructive will be positive for corporate earnings, which in turn is very constructive for equities, broadly defined.  

So, whether you’re a fixed-income investor, an equity investor or a global balanced investor, we think our constructive fundamental outlook will hold you in good stead as long as you look through short-term volatility and focus on that long-term fundamental outlook.