Happy tax holiday eve.

 

Friday the 13^th is often seen as a superstitious day, but in Canada we are celebrating as we wait for our early Christmas gift from Ottawa and most provinces. Yes, the 2-month GST/HST break starts tomorrow, just in time for the last 10 days of Christmas shopping. Whether this creates a phenomenon in Canada akin to Black Friday is unclear. Whether it was needed appears an easier question to answer, both in economic and political terms. 

 

The economy has weakened in absolute terms and relative to the robust picture south of the border, even though interest rates had already been lowered 125 basis points before the federal government announced the holiday on November 21^st. And then there is the fact that Canadians will be going to the polls before next year is out. Still, there is an element of this fiscal initiative that can be construed as insurance against the unknown. For that matter, we can lump this week’s decision by the Bank of Canada to cut rates a further half a percentage point in that same category.

 

The whole concept of insurance is one of risk management. Whether it’s trip cancellation insurance, health and dental insurance, critical illness insurance or term life insurance, we buy it in case something happens, not because we expect something to happen. As I tell people, you don’t buy life insurance and wake up the next morning upset you are still alive. Fiscal and monetary policy can be conducted in such a way as to insure against bad outcomes, but it is much trickier when developments in the next two years are going to be unknown with a capital “U”.

 

 

It’s not that economists weren’t expecting a 50bp cut in the Bank of Canada’s overnight rate this week to 3.25%. Inflation had fallen below 2% and the unemployment rate jumped 3-tenths of a point to 6.8%, which is the highest since 2017 when you exclude the pandemic period. It is true that the anticipated ebb in immigration flows into the workforce could put a lid on how high the unemployment rate goes, all things being equal. The problem is that 2025 doesn’t look like a lot of things will be equal or status quo. In the Q&A session, Tiff Macklem faced the inevitable questions on whether Trump’s tariff threats had influenced the Bank’s decision to execute a second large cut in rates in as many meetings. In his responses and the actual policy statement, we can say the influence was there and there is indeed an element of insurance in the action the Bank took.

 

In the statement, the Bank states “the possibility the incoming US administration will impose new tariffs on Canadian exports to the United States has increased uncertainty and clouded the economic outlook”, though the Governor said that “the reality is we don’t know if these tariffs will be implemented, we don’t know what exemptions there may be, we don’t know if Canada will retaliate.” It was somewhat coincidental that a day after the Bank’s decision, the Ontario premier announced that Canada could cut electricity supplies to the US. The list of possible payback measures includes banning US alcohol shipments into the US, as well as certain minerals.  Tariffs on Canadian exports, in isolation, are one thing. A trade war is a different animal and magnifies not only uncertainty but the magnitude of the hit that Canada’s economy would take.

 

 

Therefore, a more rapid approach to getting the Bank of Canada’s overnight rate down closer to “normal” or equilibrium might make sense from an insurance perspective. This is the interest rate which is neither restrictive nor stimulative to the economy. The Bank’s own estimates put the range for “normal” at 2.25% to 3.25%. Again, this is just an estimate, and it does move around, but it suggests that the Bank may have cut the rate into normal territory this week. That said, the Governor did mention that they are in favour of additional easing, even if at a more gradual pace. If uncertainty is truly keeping them up at night, then we might conclude that they see another full percent off the overnight target before the middle of the year. That takes us to 2.25%, however, if worst case economic scenarios play out, that doesn’t leave a lot of ammunition for the Bank to ward off or escape from a serious recession.

 

Then there is the insurance policy taken out by the federal government last month. If the GST/HST holiday was intended to give low to middle class Canadians a break from higher prices on food, children’s products and alcohol, then there is some cogency to that. If the temporary relief is aimed at shoring up a weak economy, it doesn’t make as much sense mainly because the consumer accounts for almost 70% of total demand and this segment hasn’t looked all that bad recently.

 

 

In September, retail sales came close to $67 billion on a seasonally adjusted basis – not far off the pace set in December of last year, as the above chart shows. In other words, despite one of the most aggressive monetary tightening cycles on record and an abundance of domestic and geo-political uncertainty, Canadian consumers have held in remarkably well. In terms of the near-term outlook, it’s safe to say that we are probably going to see a decent December and January for sales, which will not only spruce up the fourth quarter consumption number (and hence GDP) but give us a strong base effect for the first quarter.

 

The risk is that we end up front-loading a lot of spending from subsequent quarters, so the GDP pattern in the first half could be a little wonky. Then again, if the tax holiday is extended beyond the slated February expiry, either because we have found ourselves in a tariff/trade war or because the Liberals and NDP want need votes going into next year’s election, we could see continued buoyancy in spending. If that is the case, I would argue that the Bank of Canada is going to be placed in a not so comfortable position.

 

If the consumer has a fiscal tail wind, then additional rate cuts could cause inflation to creep higher above the 2% target. And, if an extension to the tax relief takes place without the tariff bogeyman showing up, the inflation risk would be higher. Depending on where the Loonie is trading, which might prompt the Bank to pause or even stop cutting early in the year. To the extent that this puts a higher floor in place for borrowing costs than what businesses and households envisioned, the looming wave of mortgage renewals over the coming three years could represent more of a risk to growth.

 

Which brings me to the final point as we prepare to celebrate. The last time a federal government cut the sales tax was back in 2006, when the GST was lowered by two percent. In today’s climate, the roughly $14 billion that the measure cost federal coffers looks small, but it effectively reduced the government’s ability to respond to any future economic challenge (which it had to a couple of years later). A balanced budget these days has become a figment of our collective imagination. Today, the federal government issued its Fall Economic Statement (I remember when we didn’t have to wait until the holiday season to get this report) and to no one’s surprise, the deficit for the current fiscal year is still expected to be north of $40 billion. This new tax holiday may not be permanent, but it could still push the deficit even higher, especially if economic risks next year become reality.

 

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.   

Andrew Pyle

 

 

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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.

 

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