Andrew Pyle
November 04, 2022
Stowing the nuts away for a colder winter
Last year, Pam and I put up several new bird houses among the trees in our yard. Some were your typical old fashioned ones, while others were a little more chic. To our surprise, a lone chipmunk chewed a larger opening in one of the fancier ones and proceeded to make it their dwelling for the winter. By the time the really chilly temperatures had arrived, this chippy had covered the opening with all sorts of garden material and lived there until the spring, likely with a good stash of food items. The Canadian government appeared to take a leaf out of the chipmunk’s book when it released its autumn economic statement yesterday.
The deficit estimate for this fiscal year was chopped to $36 billion, which is about $17 billion below what the government had forecast in its April budget. Up until recently, the economic story for Canada and its provinces has been a positive one. Personal incomes have grown, with wages and salaries up more than 15% from before the pandemic, as of July. Commodity prices were also on a tear during the first half of the year and in just two months after the federal government tabled its April budget, crude oil futures had advanced another 27% to break above $120/barrel.
If you think back to the darkest days of the pandemic, economists believed that we would be dealing with massive deficits as far as the eyes could see, based on the assumption that the economy would remain anemic, people wouldn’t get back to work and deflation would exacerbate the government’s fiscal woes. Last year turned that view on its head and then Ottawa received a bonus – higher inflation. Some wonder why high inflation is good for a government, but basically anything that inflates things like incomes or goods and services – creates fatter tax revenues.
Even if fiscal expenditures were kept to budget, the higher revenues will bring in the size of the deficit. In fact, program expenses in the first three months of this fiscal year were down 28% from the same period in 2021, while revenues were up by 22%. No wonder then that the government recorded an actual surplus during those three months ($10 billion compared to a deficit of over $36 billion in Q1 2021).
The problem is that things aren’t looking that robust anymore. When we had the last budget, the Bank of Canada had just raised its key overnight rate by a quarter of a percent to 0.5%. Today, that rate stands at 3.75% and we are starting to see the lagged impact of the policy moves over the last several months. Employment in Canada has fallen in three of the last four months, for an average monthly decline of 23,000.
The housing sector has felt the immediate brunt of rapidly rising rates, with prices down more than 17% over the past seven months as of September and sales declines in all seven of them. Building permits also fell by 17.5% in September, which was the worst decline since 2007. Again, what we are seeing in the data is a glimpse through the rearview mirror at interest rate movements through the summer and doesn’t reflect the additional 1.25% in hikes since August.
In the government’s statement, it now predicts essentially zero growth in real GDP over the next several quarters, though it is also forecasting average annual growth of 2% from now through to fiscal year 2028. Please, don’t get me started on the validity of forecasts over five years. Just this week, the Bank of England stated that it sees a recession in the UK lasting two years, yet still hiked rates by 0.75% to protect the pound and stem inflation. Note also that a 2% pace of growth would be about half a percent above the 15-year moving average.
So, did the Trudeau government really steal a page from the chipmunk’s playbook? Yes and no. There was definitely a major revenue windfall this year versus what it predicted, but the spending and tax initiatives announced in the statement amount to about $13.4 billion this year – roughly half of the windfall. Over the remainder of the forecast period, it is going to add about $44 billion, which it claims is just over half of the estimated $81 billion revenue windfall compared to its earlier projection. One could make the claim that the government has at least put some nuts aside in case of a longer winter.
The issue here is that the revenue windfall that shows up this year and throughout the forecast period is frontend loaded at the start of this fiscal year. Extrapolating this positive surprise into the future simply makes it more fictitious. The initiatives, however, are not fiction. Not that the measures announced are all bad. Initiatives for clean technology and a consultation process to look at credit card fees for small businesses are welcome.
The proposed 2% tax on corporation share buybacks, however, is a questionable plan to boost Canadian investment. Companies could deploy more cash to dividends instead, although the feds wouldn’t mind this either as it would simply raise personal tax revenues. The reality is that if everyone around you is saying that a recession is coming, you are less likely to boost capital expenditures. You may simply park more of your retained earnings in higher-yielding low-risk fixed income. That said, companies aren’t stupid. If a tax is coming on something you want to do in 2024, then you simply execute beforehand. It is no different than announcing a hike in the GST next year. People will front-load their purchases now.
The social measures announced in the statement, from eliminating interest on federal share of student loans to doubling the GST tax credit were aimed at making sure that the NDP would vote in favour of the package, which the party leader has said it will. The student loan measure alone will cost an estimated $2.7 billion over five years and more than half a billion dollars a year after FY2028. The visibility of this initiative is clear. Borrowing costs have soared this year, so making student loans interest-free is appealing. It is also costly in terms of the government purse. Based on the government’s projections, public debt charges (what it pays annually on the outstanding debt) is going to rise from $24.5 billion last year to $44.8 billion in five years. And this is assuming the zero growth / economic recovery outlook that the government used in its budget forecast pans out.
In what the government calls its “downside scenario”, the economy experiences a mild recession and output drops 1.6% from peak to trough. It compares this favourably with the 4.4% contraction of the financial crisis. In this scenario, the unemployment rate moves up to 6.9% in the second half of next year. Usually, when we put out “downside” scenarios they are meant to be a stress test. Given that almost every economist I know believes a recession is almost inescapable and that a policy overshoot could cause a protracted one, I’m not sure this “downside scenario” is really so down. Sort of like the chipmunk experiencing a couple of weeks of sub-zero temperatures as opposed to a couple of months.
Let’s be clear. This economic statement was not going to be a market mover in Canada. The Canadian dollar literally snoozed through and bonds were being driven more by moves in the US market. This, after all, wasn’t the inexcusable fiscal blowout that the previous UK prime minister experimented with in September. No need to bail out the Canadian pension market. But it wasn’t a prudent mini budget either, especially with economic temperatures beginning to fall.
From an investment perspective, this is not going to make the inflation situation worse nor will it really enhance growth. With the Federal Reserve throwing cold water on both equity and bond markets this week, our markets are going to take their cue from south of the border and not from Ottawa. A tax on buybacks? Marginal impact at best. Our view holds that the preferred strategy is to tilt much more towards companies with solid balance sheets and the ability to maintain dividends in a weak economic environment. With yields approaching a peak, the fixed income strategy is to piece more into a barbell government bond strategy combined with investment grade discount bonds. In my opinion, those will turn out to be the best nuts to keep around in that chipmunk house this winter.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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