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Q&A: RBC chief economist Eric Lascelles reveals his latest market outlook

For this week's live chat at Inside the Market, we will be joined by Eric Lascelles, chief economist for RBC Global Asset Management, for a broad-ranging discussion on markets and the economy. He'll provide his latest outlook on North American stock markets, currencies, housing and macroeconomic developments.

  • Welcome to today's live discussion with Eric Lascelles.
  • Eric, thanks for joining us today.
  • There is a lot to talk about on the Canadian front, so let’s start there.
  • Should Canadians take comfort in the economic growth figures released today for the fourth quarter, or have the ill effects of the oil selloff yet to squeeze domestic GDP?
  • I'm glad the Q4 GDP number was fairly good (+2.4% annualized), but in truth the details didn't particularly impress. Business investment was down, exports were down, consumer spending grew at a pretty ho-hum rate. The secret to the success of the Q4 number was a big inventory build, which means demand didn't keep pace with supply. There is definitely some additional economic pain coming over the next few quarters.
  • How bad could 2015 get from a growth perspective in Canada?
  • I don't think we're talking anything resembling a recession for Canada, particularly given the helping hand that comes from the weaker loonie and a robust U.S. economy (and, I suppose, the Bank of Canada rate cut in January). However, leading indicators -- be they the Ivey PMI, RBC Markit PMI or CFIB business barometer all show a significant swoon in January/February, so I would assume that the first quarter of 2015 will see some pretty anemic numbers, likely south of 2% growth, conceivably below 1%....
  • ...However, for the year as a whole, real GDP growth shouldn't be all that bad. We figure a 2.0% gain for 2015, versus 2.5% in 2014. If that sounds optimistic, keep in mind that many of the benefits of a weaker currency accrue with a lag, so should start to appear more visibly later in the year. And also note that the energy sector is only 12% of Canadian GDP, even including indirect effects...
  • ...That said, nominal GDP should be quite a lot weaker, and could conceivably be down on the year (it was basically flat in Q4 2014, for instance). That's why government budgets are being hurt so badly... And gross domestic income -- an underused measure that is probably the closest approximation of how an economy feels to the average person -- will probably also flirt with a decline...
  • ...Finally, the implications vary enormously by region. Alberta, Saskatchewan and Newfoundland suffer, while others benefit (or at least suffer less). Alberta and Saskatchewan leading indicators are already flirting with 2009 type levels. Similarly, their existing home sales have fallen out of bed (though home prices and housing starts are proving more resilient, as they did in the 2008-09 oil price correction).
  • Canada's pain is rooted in the energy market, so perhaps you could give us your take on oil. Should the oil patch get used to $50-per-barrel crude oil?
  • Allow me to inject a dose of optimism into the subject of oil prices. There can be little doubt that oil prices have substantially overshot (or is that undershot) fair value. To illustrate, fully half of global oil production is not viable at current prices. If you think half of the world's oil supply needs to go away, then $50 is the price for you. If, instead, you recognize that the global oil supply is only running about 2% ahead of global demand, then a fair price would be significantly higher than that...
  • ...Our modelling argues that low oil prices paired with OK global economic growth should add 2 million barrels per day of oil demand over the next year -- enough to wipe out the supply-demand mismatch all by itself. Meanwhile, on the supply side, we are already seeing evidence of an adjustment...
  • ...Normally, OPEC would simply cut production and resolve any supply-demand mismatch fairly quickly. Of course, they opted not to do that, in part to punish shale oil, in part for internal coordination problems. I'd give a 1 in 3 chance that OPEC cuts production by June given some of the fiscal pressures building among their weaker members, but that isn't my base case. Rather, market forces are going to have to resolve this one...
  • ...You might think that the excess supply should naturally come from the most expensive sources of oil (like Canadian oil sands). But that isn't necessarily the case. In actual fact, what matters is how quickly oil production tails off when investment ceases. You see, oil investment is being ratcheted back around the world. But this will have very little effect on Canadian oil production given that the existing projects have multi-decade lifespans. Instead, U.S. shale oil is the most viable candidate to substantially cut production. Fully 50-70% of a well's production is over within a year, and so a decline in investment should have the greatest production effect there...
  • ...we are seeing some tentative evidence of this now. The oil rig count in the U.S. is down by more than a third over the past few months. That hasn't translated into lower oil production just yet, but it should over the next few quarters. In turn, my sense is that oil prices should rise substantially over the next several quarters, with $80 being my medium-term fair value price...
  • ...Finally, you can also slice this a different way by observing that oil prices collapsed in 2008-09 from almost $150 per barrel to just $31 per barrel. What tends to get neglected is that oil prices rebounded from that low to exceed $70 within six months. Again, it should be a multi-quarter period, not a multi-year period of low prices. To be sure, this isn't 2008-09 in the sense that OPEC isn't cutting today. On the other hand, global demand was collapsing in 2009 whereas global demand is fairly resilient right now.
  • Do you expect to see a rash of energy company bankruptcies or can they mostly hold off until U.S. shale production declines and global growth can reduce the supply-demand imbalance?
  • The risk of energy company bankruptcies is fairly high in the U.S. and much lower in Canada. The two industries are really quite different. In Canada, they are mostly large international companies with strong sources of internal funding, and with a multi-decade investment trajectory. They should be fine. Of course, there are small support firms that surround them, some of which could struggle. But it is unlikely to be a systemic crisis, and keep in mind that in Canada oil production probably will not fall. It is the investment side that is declining by about 30% this year. Most companies would be aligned with the former, not the latter...
  • ...For the U.S. shale oil sector, it is a somewhat different story. The companies tend to be smaller and more entrepreneurial. They tend to fund themselves in the high-yield bond market, which has turned on them to some extent. The production of their existing wells fades fairly rapidly, meaning they run into revenue problems fairly quickly. And they have usually plowed all past profits into future projects, such that they don't have a big buffer. As a result, the risk is definitely bigger in the U.S.
  • You mentioned recent manufacturing indicators, which have pointed to a slump in domestic activity. Would you have expected those numbers to register a recovery as a result of the low Canadian dollar?
  • Context is everything with regard to Canadian manufacturers. The back story is that Canadian manufacturers were crushed in the 2000s given the combination of a rising Canadian dollar and some "catch up" from an unsustainably good 1990s. In the 1990s, practically every developed country in the world lost manufacturing jobs to emerging economies, except Canada (thanks, loonie!). That unwound with a vengeance across the 2000s...
  • ...Looking forward, Canadian manufacturers are indeed regaining competitiveness as the Canadian dollar has fallen and they are benefiting from a robust U.S. economy. However, the globalization story persists, and -- at least from the perspective of manufacturing workers -- an automation story is also becoming increasingly relevant. Moreover, the benefits of the currency accrue with quite a lag. A factory can shut down the day it becomes unviable due to a strong exchange rate, but it is highly unlikely to be restarted the instant the currency is competitive again. Moreover, once burned twice shy -- many manufacturers won't want to re-enter the Canadian market having remembered how the currency moved over the past few decades...
  • ...So my bottom line is that Canadian manufacturers are absolutely in a better position than they were a few years ago, but I am not looking for a huge renaissance, and my expectations are especially muted for manufacturing workers themselves, particularly of the unionized reasonably high paying variety, who have been undermined by a whole host of things (globalization, automation, declining unionization, the American south, and others).
  • With the energy sector guiding only 12 per cent of Canadian GDP, do you think the Bank of Canada is overstating the risks of the oil price shock to the domestic economy?
  • I'm torn on the Bank of Canada rate cut. I happen to like the fact that they are providing less forward guidance about future decisions (a subject for another day, perhaps), as much as I'm frustrated not to have anticipated the surprise cut in January. On whether it was the right decision or not, we have had a below-consensus growth forecast for Canada for several years, and we recognize that lower oil prices impose a net drag on the Canadian economy. So it was a defensible decision...
  • ...I suppose the only quibbles I have are a) does it particularly help the struggling oil companies (not much); b) does it take away a bit of wiggle room in the event of a bigger crisis down the line (yes, alas); and c) does it create inflation risks later given how little slack remains in the Canadian economy? (I think this is a slight risk, though I'll acknowledge not many share that view). In the end, a 25-basis-point rate cut adds maybe 0.1 to 0.2 percentage points to GDP growth, so these sorts of things really only tweak the outlook slightly.
  • Maybe we could touch on Bank of Canada's guidance, since Stephen Poloz is getting a little flak for being ambiguous about his policy intentions. Is the Bank confusing the market?
  • I see two aspects to that question. First, was the Bank of Canada inconsistent in its statements and action (a rate cut)? Many of us heard the Tim Lane speech before the rate cut, and while detecting an acknowledgement that lower oil prices were bad, didn't quite get the sense that the Bank felt compelled to cut rates. Then, the text accompanying the rate cut seemed to suggest additional easing to come, which now seems unlikely (at least for tomorrow). So perhaps the guidance has been a touch wobbily, though maybe the private sector "experts" just haven't adjusted to the Poloz governing style yet...
  • ...The second aspect of your question is whether less guidance is bad. I don't think it is bad. It absolutely makes predicting rate cuts and hikes more difficult, but there are several reasons for it. One is that the more transparent a central bank becomes, the less credible it (eventually) becomes as we see its flawed forecasts laid bare. Credibility is important for central banks, so providing less forward guidance helps to bolster this over time. Another reason is that the extremely clear forward guidance during the financial crisis was necessary during a period of unusual uncertainty, but arguably less so now that the world is stabilizing. It is also healthy to have different market participants with different assumptions about what a central bank will do next. Some will think a big cut, some will think a small cut, some will think on hold. There will rarely be a scenario when the entire market is caught flat-footed, which is arguably desirable. So kudos to Governor Poloz for backing a bit away from extreme transparency, and it seems that in some ways the Fed's Yellen and a few others are heading down a similar road. Phew, that was a mouthful.
  • You mentioned that a further rate cut is unlikely tomorrow. Do today’s growth figures change anything related to that decision?
  • The latest Poloz speech seemed to indicate that the Bank of Canada believes it has done enough rate cutting for now. This threw some of us, since it is rare for a central bank to reverse course and the merely cut a single time. Nevertheless, the signalling seems to be that no more cutting happens for now. I'd say the odds of a rate cut in the next three meetings have declined from perhaps a 60% chance to a 40% chance...
  • ...The GDP number today was ultimately in line with their forecast (2.4% actual vs 2.5% forecast), even if the composition was a bit weak. Keep in mind what has happened since the January Bank of Canada rate cut, though. Canadian inflation fell by less than people thought it would, the Canadian dollar is many cents softer (and thus more stimulative) than the Bank of Canada had assumed in in its last forecast. And oil prices have rebounded slightly. Of course there are always two sides to an argument: leading indicators have since been weak, Alberta and Saskatchewan housing is softening, you get the picture. In the end, what the Bank of Canada says is the most important thing, and they seem to be saying "no cut for now."
  • If the Bank of Canada's rate cut only tweaks the economic outlook, would you expect farther-reaching effects from a U.S. Federal Reserve rate hike -- the first since 2006?
  • To me, a U.S. Fed rate hike would be more consequential than a Bank of Canada rate cut. Part of the reason is simply that the U.S. is a much larger economy. But the reasons go well beyond that. The U.S. is also the world's bellwether economy (and, sometimes, central bank), rate hikes are such novelties in a world of rate cuts (as you note, the Fed hasn't initiated a new tightening cycle in a mind-boggling nine years), and U.S. rate hikes also tend to have outsized consequences on emerging markets given that much of their debt is U.S. dollar-denominated...
  • As to whether the Fed will hike or not, I think it will. I assume we get a first hike from them in the summer or fall. My personal sympathy is toward the summer, especially as wage growth seems on the cusp of picking up after the creation of an amazing one million new jobs in just three months. If anything is going to pull global bond yields higher, you'd think this will...
  • ...Of course, the Fed isn't going to want to tighten aggressively for several reasons. Part of the rationale is wanting to avoid repeating the double-dip recession error of 1937. Another is that they are much more worried about deflation than inflation at present. A further reason is that U.S. dollar strength must surely be exacting a toll on the U.S. economy, even though it is less vulnerable to this sort of thing than most economies.
  • Turning to markets, how much of the S&P 500's bull run do you attribute to Fed monetary easing? And what might a rate hike mean for U.S. stock values?
  • I struggle to answer that question, in the sense that we might still be in a global depression if it wasn't for the aggressive monetary and fiscal easing undertaken by the world's major economies in 2007 through to recently. So stocks are much higher than they would have been...
  • ...But there is also a more pernicious interpretation of your question, in other words -- has the Fed just blown a stock market bubble? My answer to that is "no", it hasn't blown a bubble. What it has done is dragged the stock market up from incredibly cheap valuations to more normal valuations, and it has helped to nurture economic growth to bring earnings higher as well. But, by our math, U.S. equities are approximately fairly valued right now, meaning there isn't much of an obvious bubble...
  • ...By the way, just for fun, I know there tends to be a lot of focus on the fact that the U.S. Fed has printed about $4 trillion work of money, with the thinking being that this has gone directly into elevating stocks. In reality, though, the vast majority of that money got gummed up in the banking system because banks just couldn't find $4 trillion worth of borrowers to lend the money to. So they gave the money back to the Fed as excessive reserves. Only a couple of hundred billion dollars made its way into the actual economy. That still sounds like a lot, but note that U.S. private sector wealth is something like $150 trillion. The money is barely a drop in the bucket.
  • ...ah, and you also asked about what a rate hike would do for stock values...
  • ...Our analysis shows that the stock market is usually able to rise in the year leading up to the start of a tightening cycle (correct so far), and usually continues to rise over the subsequent two years. So it doesn't have to be a killer blow. Now, some additional context is important. There have been times when stocks have fallen almost 40% over the two years following a first hike, and there have been times when stocks were up almost 60%. Possibly the right answer is that stocks can do a whole lot of things in the aftermath of a rate cut, but it isn't guaranteed doom...
  • ...I tend to take a careful interpretation to what central bank actions mean for stocks. There are two classic (and contrary) intepretations. The first is that a rate hike is taking away the proverbial punch bowl, and so bad news for stocks. The second is that a rate hike is a signal of confidence in a strengthening economy, and so good news for stocks (or at least not an impediment). I think the real story is actually as follows: a rate hike (or cut) is good if it keeps an economy on its optimal growth path. That is to say, if an economy is weak, a rate cut is good. If an economy is at risk of overheating, a rate hike is good (because it avoids inflation and recession and lots of trouble afterwards). The flip side is that rate cuts and hikes can be bad if they are mistimed. My personal judgment is that a rate hike is appropriate for the U.S. in 2015, so I think they will be fine...
  • ...It may be a bit tricky for emerging markets since they have a history of not liking a strong U.S. dollar, but even there I think they are starting to bottom out, and I see important structural reforms occurring in those countries. For that matter, their stock markets also look cheap to us. How's that for a digression!
  • Considering the influences on the stock market beyond the Fed, do you have a view on the S&P 500 over the rest of the year and beyond?
  • I believe the S&P 500 can continue to rise, but I don't have particularly lofty expectations, with a target of around 2,200 (versus 2,104 today). The rationale is as follows. U.S. equity valuations are no longer cheap, so I don't look for any significant valuations contribution. U.S. profit margins are very high, but based on in-depth research we have performed over the past year, they aren't all that vulnerable. Perhaps the slightest of drags from this. Last is earnings. A solid economy should theoretically generate good earnings growth, but these might underwhelm a bit this year given drags from a strong U.S. dollar (bad for multinationals) and lower oil (which is good for the U.S. economy as a whole, but arguably bad for large cap stocks since a disproportionate share are in the energy business).
  • What about the Canadian market? The S&P/TSX composite index has proven resilient to the energy rout and the downward revisions to GDP. Can Canadian stocks continue to overcome an unimpressive economic outlook?
  • Canadian stocks should be OK -- they are starting to get interesting given my view on oil prices rebounding and given that they have substantially underperformed the U.S. market over the past few years. That said, we're not quite ready to overweight the Canadian market given some lingering housing issues (with relevance for the banks) and given the substantial uncertainty surrounding oil. On the other hand, we find European equities increasingly appealing.
  • That brings us to the end of our hour. We've certainly made you type enough. Thanks for doing this, Eric. Any parting thoughts for Canadian investors?
  • Thanks to my Grade 9 keyboarding teacher -- I knew that class would eventually come in handy!
  • As for parting thoughts, I really shouldn't be saying this as an economist, but for investors what matters far more than catching the right economic or market trend is a) being fully invested -- not sitting on the sidelines for years waiting for crises that rarely erupt; and b) being properly diversified. For instance, as global growth has looked wobbily over the past year and oil prices have fallen, foreign investments -- in Canadian dollar terms -- have soared. There is real value in having a diversified portfolio both with regard to asset class (stocks, bonds -- who would have expected yet another year of outsized returns from them) and also geographically (we think European equities -- currency hedged, perhaps -- are looking quite attractive given a recovering Europe).
  • That'll do it. Thanks for following along, everybody.
  • Thank you and have a great day.
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