As we enter the 3rd quarter of 2019, the U.S. economy is continuing its longest uninterrupted expansion since the start of records (effectively about 150 years). When things are going well, we can’t help ourselves from asking when they will start getting worse. History and common sense tell us that sooner or later growth will stop and there will be a recession. When, why, for how long, and how severe it will be, are unknown and we are not arrogant or silly enough to forecast any of these things. However, it is worthwhile to look at some things we worry about. Here are two causes for economic concern. Whether either of them, or both in combination, will be enough to tip the economy from growth to recession only time will tell.
Not surprisingly, the first and most obvious of the dangers facing the North American economy is Donald Trump. His administration has weaponized trade tariffs as an all-purpose bargaining tool. This has had a detrimental impact on world trade and world economic growth and has hurt Canadians and Americans as well as Mexicans, Chinese, Iranians and perhaps soon, Europeans. Tariffs often raise costs for those who can afford it least. For example, lower income American families who buy toys and household items made in China have few substitution options and they are the ultimate payers of the tariffs imposed by Trump in an attempt to alter the terms of trade between the U.S. and China. In addition, retaliation can be devastating. The U.S. government has had to give its soybean farmers $16 billion so far to compensate for lower Chinese purchases, which were recently announced as being down 24% year over year.
The pain here is just beginning. Canadian trade with China is a collateral damage casualty of the U.S./China trade war. Two Canadians in jail in China could pay with their lives. Canola farmers, pork producers and grain exporters are suffering severe losses as a prime export market closes. China has a very long view, very deep pockets and an undervalued currency. Its leaders have absolute power and do not have to worry about elections. If the price of soybeans goes up, Chinese consumers will suffer in silence, or if not, in jail. This is a trade war that a democracy cannot win.
For much of 2018 and 2019, Canadian steel and aluminum converters and primary producers were subject to punitive tariffs to help the U.S. primary metals industry. This hurt Canadian output and exports and raised the cost of multiple goods in the U.S. General Motors estimates the tariffs cost it $1 billion per quarter, which it of course passed on to buyers of cars and trucks. Happily, it appears that these tariffs will now disappear as part of the new Canada/Mexico/U.S. trade agreement that will, if passed by the U.S. Congress, replace NAFTA.
The Trump trade wars at the current level probably will not cause a recession in the U.S. but analysts at Morgan Stanley, one of the world’s largest banks, recently warned that a prolonged or intensified stand-off could put the U.S. economy into recession by 2021.
The second big problem for the economy is what I will call the debt overload crisis. During the course of the current financial expansion, debt has grown enormously at all levels and in all sectors: sovereign debt (federal governments of U.S. and Canada) sub-sovereign debt (provinces and states) and borrowings by corporations and households are all at record levels.
To a great extent, the gravity of the problem has been masked by low interest rates. Interest costs on $1 million of debt at 6% are of course the same as on $2 million at 3%. As long as rates don’t rise and maturing debt can be rolled over into new loans with later maturity dates the problem is kicked down the road; but what happens in a recession? Corporate debt may be hard to roll over, or lenders may demand much higher interest rates. Companies may face a huge amount of maturing debt just when they can least afford to pay it. Banks may freeze lending and call in loans. It is important to realize that for many companies much of the recent debt has been incurred to finance buyback of shares, not for investment in productive assets.
The problems for consumers are different in Canada and the U.S. Canada has not seen wide-spread defaults on residential mortgages, even in very weak markets like Alberta that have seen falling home prices. In Canada, mortgages are full recourse, unlike the U.S., and this makes personal bankruptcy the natural outcome of mortgage default, an outcome homeowners will do almost anything to avoid. Canadian banks have doubled down on the housing boom and have been increasingly using home equity lines of credit (HELOC) as the preferred lending tool. This has resulted in rising collateral mortgage principal amounts. Again, low interest rates have shielded both borrowers and lenders, but in a falling housing market, these rising debt amounts will be secured by declining equity value in homes, meaning banks may be unwilling to roll these loans over. Where will consumers find resources for repayment?
Many news reports have noted that Canadian consumers have a record debt to income ratio and a record household debt to GDP ratio. Over-indebted households put a brake on purchases of new homes, durable goods and consumer goods and consequently, hamper further economic growth. The U.S. has the added problem of huge student debt, a problem which is much worse than in Canada. U.S. student debt is delaying new household formation as graduated students continue to live with their parents to save money. This in turn delays marriage and family formation, which worsens the demographic issues of an aging population.
Government debt has grown tremendously in the U.S. and now totals over $22 trillion or about $65,000 for every living American. The recent U.S. corporate tax cuts have increased the current federal budget deficit which will likely be over $1 trillion or about 4.5% of GDP for the foreseeable future, even absent a recession. The theory that lowered tax rates will result in higher total tax collections has conclusively been proven to be a fantasy. Happily, the situation is better in Canada, where the federal government deficit will likely not exceed 1% of GDP. Provinces, which have had runaway spending and huge deficits, such as Ontario and Alberta, are now getting their financial affairs more in order, although of course there is much dissension in regard to the ways in which this is happening.
In the U.S., the Social Security system is a pay as you go system; unlike the Canada Pension Plan which has real assets backing up its obligations. The U.S. system will either fail or need to be rescued when the number of new entrants into the labour force falls below the number of new retirees. This will likely happen within ten years. Already, many U.S. states and cities cannot meet their pension obligations. So far, eight substantial U.S. cities including Detroit and Bakersfield, CA., have become bankrupt. The state of Illinois has pension debt of $250 billion which is 6 times its entire annual revenue. Its debt has been downgraded 23 times and is now junk status.
Debt markets are based on confidence in the ability and willingness of borrowers to repay. In the event of a recession, both ability and willingness come into question. Some commentators have floated a new theory of monetary policy based on the notion that government debt does not matter because “we owe it to ourselves”. This is an attractive idea since it enables governments to lower taxes and increase spending. History would seem to demonstrate that debt does matter. Usually we need an economic stress test to find out.
One of the oldest clichés in our business is that markets climb a wall of worry. Being worried keeps investors careful and wary, and this acts as a natural brake on over-enthusiasm and what former Federal Reserve Bank Chairman Alan Greenspan called “irrational exuberance”. Are we too worried? We don’t know. Only time will tell. The risk of being too cautious is to miss out on great markets such as we have had in the first half of the year. We didn’t fall into this trap, and our clients have had the full benefit of a great start to 2019. The risk of being too aggressive is to be overexposed if things get bad quickly. We believe that it is likely better to err on the side of caution, but that the most important thing is to be paying attention all the time. If that means we lose some sleep, that’s part of the business too.
