One of my favorite definitions of risk and uncertainty comes from a book by Nate Silver entitled, “The Signal and the Noise.” He defines risk as the grease that facilitates economic activity, whereas uncertainty grinds things to a halt. According to a popular index developed by Professors Baker, Bloom and Davis, Canada’s economic policy uncertainty has moved to new highs in 2018 after rising for the past several years (see the chart below). No wonder the Bank of Canada (BoC) has been sounding so cautious even though Canadian economic data remains firm.
The most pernicious of these uncertainties has been the escalation of trade tensions in the wake of the 2016 U.S. presidential election. The heated NAFTA renegotiations and threats of a unilateral U.S. withdrawal were uncertain enough. Now, Canada finds itself ensnared in a larger ideological trade battle between the U.S. and China over the Trump administration’s broad imposition of tariffs that includes imported Canadian steel and aluminum and that has prompted Ottawa to retaliate. The potential for more tariffs, this time on automotive imports into the U.S., and the Trump administration’s tendency to respond to trade retaliations can keep tensions high from here. Of course, there’s already a good reason for the BoC to go slow to avoid rattling a highly rate-sensitive economy, but even more so given the unpredictable path of trade negotiations and the impact protectionism could have on highly integrated global supply chains.
In that spirit, Governor Poloz seems to be abiding by the Hippocratic Oath: at first do no harm. One could easily make the argument that there’s nothing wrong when looking at the S&P/TSX composite index posting new highs, but this would be ignoring the signals coming from the Canadian dollar, which is probing new cycle lows. Two things stand out: in Canadian dollar terms, the Canadian stock market is one of the worst performers in the developed world in 2018 (see the chart below). And compared to other currencies, the loonie is one of the only major currencies following short-term interest rate differentials (see the chart below). For now, high oil prices don’t matter to the loonie – these days it’s not behaving like a petro currency.
We think the Bank of Canada would like to raise rates one more time this year and that the July meeting is as good a time as any to do so. That said, the uncertainty overhang from trade tensions could dominate at the July meeting. And let’s face it, inflation pressures aren’t so acute as to suggest the bank may be about to fall behind the curve if it passes.
We think Poloz is right to highlight uncertainty at this stage. The economic outlook has become more uncertain, financial conditions have tightened and, consequently, we think investors should build more resiliency into portfolios. As a result, we recommend taking shorter duration postures in fixed income with an up-in-quality bias in credit. As well, we have focused on taking exposure in equity markets with the greatest earnings growth like U.S. equities and the technology sector. And we have recently begun to stress the importance of companies with solid balance sheets and ample cash flow generation (i.e., quality).