#MacroMemo: July 31 – Aug 4, 2017

Greenback weakness in perspective:

• The US dollar is down roughly 10% since the start of the year. This is the biggest drawdown since the U.S. dollar bull cycle began in 2011, reversing around a quarter of the cycle’s upward progress.
• The U.S. dollar weakness is a function of several things. Some of it relates to extreme technical positioning in the FX market that was bound to eventually unwind. Some is a function of U.S. political failings – delayed tax cuts, failed health care reform and a simmering political scandal. Some relates to the fact that non-U.S. economies have pleasantly surprised. And some is the result of a new hawkish tilt among non-U.S. central banks, including the Bank of Canada.
• Normal U.S. dollar cycles last 5-10 years and run from a very weak USD valuation to a very expensive one. This cycle is now six years old and has gone from a very cheap value to a somewhat expensive value. One can thus debate whether this latest move represents a mere pause or the end of the rally.
• Our conviction is diminished relative to a few years ago, but we are still inclined to think that U.S. dollar strength can reassert itself and manage some further gains, especially with the Fed continuing to lead the monetary policy pack.
• A weaker dollar most obviously imbues the U.S. economy with improved competitiveness and its multinationals with more muscular overseas earnings. The opposite can be said for U.S. trading partners like Canada and Mexico.
• However, this isn’t the end of the story on the subject. From an economic perspective, currency movements have a substantially lagged effect on growth. It is a currency’s movement over the past two years that matters most to immediate growth prospects, not the machinations over two quarters. From this perspective, the U.S. dollar is still higher than two years ago and so casting a bit of shade on U.S. economic growth (though less than before).
• This is not to say that the recent softness is inconsequential – it can show up in currency-adjusted corporate earnings right away. But the length and depth of the move so far is not enough to drastically change the economic outlook of the U.S. or its trading partners.

Japanese political dangers:

• Japanese Prime Minister Abe has been an important figure for the Japanese economy across his 4.5 year tenure. His signature initiative “Abenomics” has helped to prod the Japanese economy forward with aggressive monetary and fiscal stimulus, despite some disappointment on the structural reforms front. Although Japanese wage growth and inflation is still lower than desired, the labour market has made enormous progress, to the point that the economy is now at its tightest point in more than 25 years.
• Lately, however, his popularity has fallen sharply – to just 33% to 36% in recent polls. Other signs of his recent tumble include local Tokyo elections that rejected his Liberal Democratic Party in favour of an upstart party headed by one of his former cabinet ministers. This rhymes with the recent French election. Adding insult to injury, the LDP’s longstanding coalition partner opted to pair with the upstart party rather than the LDP in that election.
• Abe’s newfound unpopularity can be traced to a variety of causes. Most acute are allegations of corruption surrounding a land deal and the licensing of a veterinary school. Other considerations include his failure so far to achieve the constitutional reform he had campaigned on (to eliminate the pacifist elements of Japan’s constitution), his incomplete economic reforms, and perhaps even the fatigue of a country unaccustomed to keeping prime ministers for more than a year at a time.
• Japan must hold its next election by the end of 2018. Given Abe’s low popularity, there is a very real chance he does not win. This is a higher risk than just a few months ago, and must surely be viewed as a negative for the Japanese economy. However, let us not get ahead of ourselves. It is not so much the LDP that is unpopular – its polling still easily bests any other single party, none of which even manage double-digit levels of support – but rather that Abe himself is personally unpopular. He could yet have to fall on his sword. Whether a replacement LDP leader/candidate would continue on the current economic course is less clear. Fortunately, there is more than a year until serious decisions will need to be made. In the meantime, Bank of Japan head Kuroda should be safely reappointed before the political situation grows too blurry.

Canadian signals versus noise:

• The Canadian economy is doing quite nicely right now, though burdened by medium-term concerns about competitiveness (adverse shifts in the currency, tax rates, environmental laws and labour laws) and the country’s hottest housing markets.
• In this precarious environment, it is important to be able to distinguish economic signals from economic noise.
• An example of economic noise was a recent much-publicized claim that Canadian job creation over the first part of 2017 had been the worst since the 2009 recession:
• This claim is only technically true when examined through the lens of the (second fiddle) Canadian payrolls survey and when comparing the recent January to May period exclusively with other January to May periods.
• Broadened to a more traditional 6-month period, the payrolls survey reveals above-average job creation. Broadened even more to include the past year, the payrolls survey looks positively strong and aligned quite nicely with the more popular Labour Force Survey.
• Even sticking arbitrarily with a 5-month wingspan, there were at least seven other times since the financial crisis when job creation was weaker (just not between January and May).
• In short, Canadian job creation looks just fine despite claims to the contrary.
• Another distraction is the much-ballyhooed fact that the IMF now expects the Canadian economy to be the fastest growing G7 nation in 2017. This is undeniably true, but a bit less momentous than it first seems:
• Canada is not exactly leading the world in growth:
• The G7 is an extremely narrow and slightly arbitrary subset of countries. Naturally, Canada continues to lag emerging-market growth by a wide margin. But it is also forecast to underperform many other developed countries that don’t happen to land within the G7, including Australia, New Zealand, Ireland and Spain.
• Much is already baked into Canada’s economic cake for 2017:
• The year 2017 is already more than half over. The IMF’s cheery assessment is less a forecast and more a statement of fact that the Canadian economy did very nicely over the first half of this year.
• Some rough calculations suggest that the IMF is actually budgeting for fairly meagre growth over the second half of the year for Canada, presumably as it gives back some of the outsized ebullience of the first two quarters.
• Again, the bottom line on Canada is that it has done very nicely over the past year as the oil shock has faded. Reports of labour market troubles are patently untrue. At the same time, suggestions that future growth will be remarkable are a bit less than they seem. And don’t forget about those medium-term storm clouds on the horizon.

Data run:

•  Fed recap: The latest U.S. Federal Reserve decision warranted a slightly dovish interpretation given the (perfectly reasonable) removal of the word “somewhat” from its characterization of inflation as being “below 2 percent.” Similarly, while the market is now rightly aligned with a September start to balance sheet reduction, this isn’t quite as ironclad as some had expected given the statement that this would happen “relatively soon” rather than just “soon.” Fed speeches and the Jackson Hole summit would need to deviate significantly from the current interpretation to remove expectations for further near-term action.
• U.S. Q2 GDP review: Q2 GDP landed at +2.6% annualized, a solid outcome and approximately in line with a consensus that had fallen somewhat in the month leading up to the report. Inventories and residential construction represented temporary drags for the quarter, whereas consumption and business investment – crucial factors – were strong. Net exports provided a modest addition. The prior quarter was revised down slightly, but more importantly the previous few years managed slight upgrades that were ultimately more important in our books.
• Canadian May GDP review: Canadian GDP in May recorded a huge 0.6% gain. This is all the more remarkable as it comes after a decent April print and a strong March figure. Some of the latest strength was artificial as an oil facility came back online, but this means that earlier activity was unnaturally weak, rather than that a second shoe remains to drop. Housing exerted a drag as governments sought to cool the sector. Not only was Q1 GDP strong in Canada (+3.7% annualized) but Q2 GDP is now on track for nearly 4% growth. It is hard to imagine that the economy won’t have to give back some of this strength over the second half of 2017.
• U.S. ISM manufacturing preview: Our models suggest that the surprise leap higher managed by the ISM manufacturing index in June should probably be unwound in July. We forecast a drop from 57.8 to a below-consensus 55.5. This is still consistent with good growth.
• U.S. payrolls preview: Our models point to an above-consensus gain of 200K or better in July. This aligns well with the quick job creation in June and other measures of labour market health that abound in the U.S. However, we are aware that there is a slight undercurrent of decelerating job creation over the past few years that will probably extend on a trend basis into the future – a natural function of an aging cycle.
• Canadian employment preview: We stick with the most successful job forecasting strategy in years: consistently picking an above-consensus outcome. As such, we point to the prospect of a 15K+ outcome for Canadian hiring in July. It is tempting to ignore this and pursue a mean-reverting strategy with the implication of a weak outcome on the heels of the big gain in June, but econometric testing argues against mean-reverting approaches.

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Published July 31, 2017