What Trump 2.0 Means for Canada - Views from the North

Ben Reitzes:

Welcome to Views from the North, a Canadian rates and macro podcast. This week I'm joined by Doug Porter, the chief economist of BMO Financial Group. This week's episode is titled What Trump 2.0 Means for Canada.

I'm Ben Reitzes and you're listening to Views from the North. Each episode I will be joined by members of BMO's FICC sales and trading team to bring you perspectives on the Canadian rates market and the macroeconomy. We strive to keep the show as interactive as possible by responding directly to questions submitted by our listeners and clients. We value your feedback, so please don't hesitate to reach out with any topics you'd like to hear about. I can be found on Bloomberg or via email at benjamin.reitzes@bmo.com. That's benjamin.reitzes@bmo.com. Your input is valued and greatly appreciated.

Doug, welcome back to the show. Only the second time I've had you on, but I wait for big topics to bring you on and I appreciate you taking the time.

Doug Porter:

Oh, thanks for inviting me.

Ben Reitzes:

So last week we had the US election of course and the Fed, but the election was really the big event of the week. And I think the big question for Canada is what do we take away from this? Where does it leave Canada? What do we need to be worried about? What are the potential repercussions? There is plenty of uncertainty here. I think that's really probably going to be the word for the next little while, given that we don't really know what policies are going to come in under Trump. We have domestic uncertainties as well. There's political, some political uncertainty here. We're not sure how far the bank's going to go. There's uncertainty right across the board.

But the potential for a sharp change in policies out of the Trump administration could have a very large impact on Canada. And first and foremost on the trade front, I think that's probably the best place to start for now. They don't get to reopen USMCA until June 2026 I believe. So it's still a long ways away before they can renegotiate that pack. But Trump can still go ahead with tariffs as he has threatened most of the world that could get blanket 10% across the board. Canada was mentioned in one of his many rants. Does this worry you for Canada when trade is, exports at least are about 30% of GDP?

Doug Porter:

The short answer is it does concern me. I definitely think for Canada this is the biggest potential driver of all the election results. I have to say, just stepping back for a moment, to your point that it increases the uncertainty. I think a simple way to sum it up is the range of possible outcomes is much, much wider given the election outcomes, but it's notable that we didn't really adjust our forecast for Canada just yet. We do want to get a little bit more clarity in terms of exactly what the president plans to do, especially on the trade front.

And just stepping back a little bit further for a moment, the one thing I always like to point to is in the first three years of Trump's first mandate, so before COVID hit, the Canadian economy managed to do just fine. Even amid all the uncertainty around the NAFTA negotiations at that time, the Canadian economy managed to grow about 2.5%, which is better than average. Now, admittedly, it was at a time when the US economy was growing a wee bit stronger than that, but it shows that the most important element in the Canadian outlook from the US perspective is how is the US economy itself doing? And as long as the US economy stays on the rails, that really is the most important factor in what drives Canada.

But no doubt the trade uncertainty is going to be a cloud over the outlook. And I would say that, yes, USMCA doesn't officially come up for a review until 2026, but that does not mean we're going to escape a lot of trade uncertainty in the meantime.

I think in terms of what we're actually going to see on the trade front, I think a good quote is maybe you shouldn't take Trump literally, but you should take him seriously. And that is that I think he does mean business this time. Basically, the policymakers he's putting around him, they seem very aligned. I do believe that when he talks about serious tariffs on China and perhaps to a lesser extent Mexico and the rest of the world, I think he's dead serious.

And so I think it's going to be a real struggle for Canada to basically avoid those tariffs. And even if we do somehow manage to negotiate a carve-out, we are then ourselves probably going to have to put tariffs on pretty much all our imports from the rest of the world just to stay on site. And that's going to anger a lot of our trading partners if that's the route we choose to go down. And by the way, I'm not at all convinced that we are going to escape US tariffs. In fact, I'm more or less assuming that we are going to face some kind of blanket tariff outside of on energy products from the US.

Ben Reitzes:

And how growth negative would that be and how potentially inflation positive would it be if we retaliate with targeted tariffs? I mean, and I feel like we're all just guessing here, but I'm kind of working under the assumption they're going to target what they targeted last time. So it'll be give up some ground on dairy, give up some ground on maybe lumber. I'm not sure on that one. Just some of the more protected industries in Canada and spend more on defense and we won't crush you too badly perhaps. His scorn will be more targeted on Mexico and on China I think much more than on Canada. And I think if we give in a little bit then he'll kind of take us out of the crosshairs.

But if they were to go ahead with, let's say they put a 10% tariff on everything that comes from Canada and then we retaliate with also 10% across the board, ballpark what kind of cut to GDP growth and how would that impact inflation?

Doug Porter:

So first off, just from a strategic point of view, I personally think the rest of the world should not retaliate, not severely anyways. I think they should really use targeted retaliation. To some extent, the financial markets might offset a lot of the tariff increases by themselves. In other words, you could, if everyone just let everything be alone, the US dollar actually might appreciate quite a bit in the event of a 10% tariff, which would largely negate the impact of the tariffs. And by the way, we've had a number of years where the Canadian dollar has risen by 20% in a single year. Think back to 2003. And it's actually not as disruptive for the economy as one might think. I'm not saying it's easy to deal with, but we've had a number of big exchange rate moves in the course of a year before that haven't skewered the economy, haven't sent inflation rocketing.

There's all kinds of different offsets whether it's through the financial markets or through margins, trade divergence, there's different ways for firms to try to handle it. It might not be quite as punishing as many expect. And personally I am of the view that tariffs might not be so inflationary. I actually do think that a lot of foreign firms will end up eating a lot of the US tariff if they were to impose it on everyone. It might not actually not drive up US inflation as much as many economists are making out. It definitely would lift consumer prices to some extent. But the experience of 2017, '18, '19 was it barely showed up in US inflation when the US went at it pretty hard with China. It almost didn't make a mark on US inflation at the time.

So I actually think the best strategy for the rest of us is to pick a few items to target to hurt the president politically, but not... In a way it's almost shooting yourself in the foot by retaliating. It might feel good, but it doesn't make your economy perform any better and ultimately it can hurt your own consumers. So I'd almost let the financial markets do the work and let the US dollar rise to largely offset the impact of a tariff.

But let's say, let's take your scenario into account and everyone retaliates by 10%. Well, to some extent it would be stagflationary. It would raise costs for everyone. It would crimp global trade. There would be some trade diversion outside of the US, but it would tend to crimp global growth and probably lift inflation a little bit. But I don't want to overstate it because the growth dampening effects will somewhat dampen inflation as well. Best guess off the top of my head would be about a tenth to two-tenths on global inflation if tariffs were to rise 10% across the board versus the US both ways. And it would probably shape growth by a couple tenths as well.

Ben Reitzes:

You mentioned financial markets a number of times there. I've been staring at the Canadian dollar for most of today. It's Wednesday, November 13th in the afternoon and we've been trading just shy of 1.40, .39999 consistently has traded. I'm not sure if we've gotten through that since we started here, but 1.40 has had yet to trade when I pushed record. The dollar is one area for Canada where I am and have been particularly concerned about the outlook.

You mentioned that if the US puts tariffs on the world including but not limited to Canada, greenback takes off, that would mean the Canadian dollar goes the other way, same as everybody else. We've already weakened off somewhat already. Are we at risk of a much weaker backdrop for the Canadian dollar, not just on the tariff side, but you can argue on the rate side as well? If the tariffs that the US puts on Canada maybe are a little more damaging than expected and maybe we don't benefit from the US economic strength the way that we have in the past, does that create an outlook where Canadian interest rates need to be much lower than the US? And the market is kind of telling us that at this point. I'm not sure if it's real personally, but you're seeing Canada-US spreads right across the curve. Canada's more than a hundred basis points through the US. And in the long end it's 130 basis points. There's technical reasons there. I'm more than aware of that. I think we'll probably reverse some of that after December's flows.

But this worries me personally as a Canadian who likes to travel. It definitely concerns me. And it worries me on the inflation front because we import a lot of food from the US and especially in the winter months because it's cold here. I'm pretty sure we don't grow a lot of lettuce and tomatoes and such. Is there some inflation risk from that perspective? And maybe that's where we should be most concerned or maybe that's where the Bank of Canada should be most concerned. I guess that was a lot for me. What are your thoughts on the dollar, how the Bank of Canada should be thinking about it, and I guess what the risks are to the currency from the US?

Doug Porter:

So one reason why I've been a little bit more hawkish than the markets and the Bank of Canada in recent weeks and maybe months is on concern about the Canadian dollar. It is fair that in the last 10 or 20 years there's not a lot of evidence that you see immediate pass-through from a weakness in the currency to a big run-up in Canadian inflation. But at the margin, clearly, as you said, it does bleed into food prices. It definitely bleeds into energy prices, gasoline prices, for instance, when the currency weakens. And I think there is a risk that the Canadian dollar could weaken a lot at this point. You can just add up the factors.

First of all, we've already got this divergence between the bank and the Fed, which could widen in the year ahead. We do have the possible competitiveness issue getting worse, especially if the US actually does cut corporate taxes even further. We've already got pretty steady foreign direct investment outflows on this front. And frankly, just on top of that, we've got energy prices as well. Now oil prices drooping below $70 a barrel. It's not as if oil has been a direct driver of the Canadian dollar, but it's not helpful to have oil on its back foot as well.

So it's pretty tough to find reasons to be positive on the Canadian dollar at this point. About the only thing I would point to is the fact that the currency is probably a bit below fair value at these levels. We don't have the really dire fiscal situation that the US is facing in the years ahead. But those are long-term considerations and I would say most of the near-term factors do stack up against the currency. And of course we know that currency markets can overshoot once they get going in one direction. And I personally think the Bank of Canada is playing with fire here a little bit by being so dovish at a time when the currency is already under a lot of stress.

Ben Reitzes:

Keeps trading at 1.3999, it's kind of, I can't help it, it's mesmerizing for me. So I guess where does that leave the bank? We have an economy that has been growing consistently below potential and inflation that's slowed down pretty notably. Core inflation is coming closer to target. The next inflation print's probably going to be on the hotter side just due to base effects, very unfavorable base effects. So a small pickup in core and headline is expected, both sides. Maybe a little more on headline than on core, but still some acceleration on both fronts.

But the economy has been consistently weak. The unemployment rate's high, the labor market's soft. The last jobs report wasn't terrible, but the underlying details were not pretty. You continue to have a decline in the participation rate and the employment rate, even as the unemployment rate is trending higher. These are not signs of a healthy labor market, not signs of a healthy economy. And we're sporting an out output gap, which I think it's the size of the output gap is very debatable and we can definitely touch on that.

But where should the bank go? I mean, I guess how concerned should they be about the currency? How much of a role should that play in their policymaking. So far Macklem has said it is not playing a role, which is somewhat shocking to me, but that's what they've said. How much of a role should it play? Should it keep them from easing or just keep them from easing aggressively going forward?

Doug Porter:

Yeah, I would say more of the latter. I think all the factors that you listed there are good reasons for the Bank of Canada to keep easing. And this is where my bias is going to show through. I do think as a result of events of the last week or two, they should turn a little bit more cautious until they get a bit more clarity in terms of exactly what we're going to see from this administration. I believe they should step back to quarter-point cuts just because the range of possible who comes here is so large and there's certainly a possibility that we're actually looking at some upward pressure on inflation in Canada in the year ahead as a result of what's just happened. Yes, some of it is from the currency. So I personally think they should turn more cautious at this point.

A couple other things I would point to and reasons behind that is first of all, we have seen clear evidence that wages are still pretty sticky. Look, we've had a lot of labor unrest. I know the Bank of Canada tends to downplay the LFS wage measure, but if you look at the payroll survey, it also really popped in the latest month on its wage measure. Actually, the highest reading we've seen in more than 30 years of data in the latest month in the payroll report. The fixed wage increase went up 5.6%, the strongest in more than 30 years.

Another concern I've got is it does look like the housing market is actually starting to stir. Now whether that can be sustained or not is debatable, but after a lull through the summer and early fall, it looks like housing is really starting to get going here.

And finally, the third thing I would point to is financial conditions have eased a lot in Canada weather through the currency, the decline in yields over the past year, admittedly not in recent weeks, but over the past year, and the equity market, which just has recently hit an all-time high in Canada even, at close to 25,000. So overall financial conditions are pretty easy.

I don't really think the Bank of Canada has to push that much harder on the accelerator at this point. So I personally think it makes sense to dial it back to quarter-point cuts.

Ben Reitzes:

I'm with you. 25 in December definitely. And last week under-the-radar release because the Fed and the election took up pretty much all the oxygen in the room, the StatCan put out the provincial and territory GDP numbers for 2023. That kind of gives you a sneak peek into where the revisions are going to come at the national level. And we got big upward revisions for 2023, 2022, and 2021. In total GDP in 2023 is about 1.3% higher than it previously was. So that will get incorporated into the GDP numbers we get at the end of this month. So expect big upward revisions.

So if the economy's 1.3% bigger, potential growth might also be higher, so that would mitigate some of that increase. But I think it would be naive to say that you should just ignore that increase in the size of the economy, especially given that the bank puts a lot of weight on GDP. I think that is very much undervalued by the street in general and by all the talking heads. GDP is probably, especially the quarterly numbers are the most important number for the bank outside of inflation perhaps. And when you get a huge upward revision like this, it should put some doubt into their minds as to where the output gap is. And there's already tons of uncertainty on that front just because it's impossible to tell at any point in time what potential growth is or where the output gap is. And that tells you... You can tell that by the fact that there's a one percentage point range in the output.

But maybe it's on the narrower side of the range rather than being on the wider side of the range as maybe previously thought. And so there maybe is a little bit less downside risk to inflation than they thought there was. Plus you have all the uncertainties that Doug mentioned going forward, and so 25s make a lot of sense to me here. December is still priced about 50/50 for a 50 basis point rate cut at the moment. I think that's wrong. Unless we get really bad inflation numbers, and by bad I mean low for inflation next week and a pretty weak job number at the start of the month, I just don't think the smart move or the right move is going 50 basis points again, especially with the dollar teetering the way that it is at the moment.

Doug Porter:

Yeah, I think there were some mixed messages from that upward revision. I mean, in some sense it's somewhat good news because it shows that the real GDP per capita, which we thought was absolutely getting annihilated in recent years, actually wasn't so bad after all. It's still pretty weak, but...

Ben Reitzes:

Still bad.

Doug Porter:

Yeah. What it shows is the level of GDP per person in 2023 was the same as in 2019 after the revision. So not horrendous. And I think the way the Bank of Canada will look at it is they'll expect productivity to be revised up somewhat in years gone by. So they'll still look at what's happened in the unemployment rate in the last year or so, and we'll still believe there's a fairly sizeable output gap. But as you say, maybe not as wide as they previously thought. I mean, to me, at the margin, what that does is it sort of dampens the need to cut aggressively.

Ben Reitzes:

Okay, so we're in agreement with that. You talked about productivity, and this is something I wanted to ask about. And you can kind of address this from all of the stuff that we've talked about so far, all of the topics, because tariffs will impact things as well and the ability of Canada to attract business here, to attract business investment, to attract firms to come and build plants and other things, and to operate in Canada and to just really grow from scratch in Canada.

Clearly, the GDP revisions tell us it's not quite as bad as it was, but it's still much weaker than the US. The backdrop is very challenging. We discussed this last time I spoke with you. We agreed that the tax code probably needs some massive changes, which will be helpful. The tariffs will not help on this front, will they? That will make Canada even more challenged on the investment front outside of massive changes on the domestic front, be it tax changes or regulatory changes or otherwise. Is there any other way forward? Is there any other way to improve our productivity, to improve the investment profile in Canada?

Doug Porter:

It's pretty tough for a firm to be aggressively investing or expanding when we've got so much uncertainty on the trade front and the policy front. And I talked earlier about how growth in Canada was actually pretty good in the first Trump mandate up until COVID, but business investment was not particularly strong. And that's even though there were a number of supportive elements in policy to try to boost capital spending at that time. It still was pretty soggy. And I would blame a lot of it on the trade uncertainty. And yeah, I'm actually concerned that this combination is bad for Canadian productivity, whether it is even a partial trade war with the US or just the uncertainty on the trade front, which will blunt domestic investment. I think that's a challenging backdrop.

I guess the one thing, and we haven't talked about it too much, is the change in immigration policies recently. I think that alone, it actually will just arithmetically will actually help productivity in the next couple years. Not to put too fine a point on it, but essentially we've been bringing in a lot of low-wage workers, which I think at the margin have actually tended to dampen productivity. And we're going to go through a two-year hiatus here on that front, which I think, as I said, the arithmetic alone will probably lead to somewhat better GDP per capita and better productivity for a few years, but that's just a short-term bump.

Ben Reitzes:

Yeah. That immigration change will definitely have an impact on that front. There's long-term and short-term implications of that. Today's probably not the day for that. But I can't help but to think that... I look at Canada, I look at the US, we're a small economy, they're a very large economy, 10 times our size, more or less nine-plus times our size. And this is kind of off-topic from what we've been discussing for most of the day, but we are going to have an election here at some point in Canada.

Would it be wise for political authorities here to really, again, I'm going to mention the tax code again, to take a much closer look at really just scrapping the whole thing and starting from scratch? Because if I'm a business, even if I'm a Canadian business, once you get to a certain threshold, one, there's not a lot of incentives to continue to grow unless you think you're going to become really large. And even then why wouldn't you look at the US? It's a much larger market, it's friendlier market, nine-plus times our size. Isn't that where you'd look to expand? Why would you set your sights on Canada? And isn't that where the productivity problem comes from for Canada? Why would you want to operate here when you can operate in the US?

And maybe there's some reasons to stay in Canada. I mean, I still live here, so clearly there are some reasons. We all have our reasons. But as a business, I think it's really challenging to attract the top businesses to stay here and invest in Canada without some kind of big change. We need a drastic change. Am I wrong in that thinking? We have to be better than the US. We can't just try to compete with them from one perspective. We have to be better from every perspective.

Doug Porter:

Yeah. And regardless of what the US does in the next few years, I actually think it does make sense for Canada to take a long hard look at its tax system again. We haven't had a serious rethink of Canada's tax arguably in about 50 years or 60 years actually, going all the way back to the mid-60s.

There was of course a bit of a reform in the late 80s, early 90s, but I actually do think it makes a lot of sense to take a long hard look. If we have a new government in Ottawa in a year or so, I actually do think a prime order of business would be to do an extensive review of the tax code. And again, that doesn't matter what happens in the US. I think just for our own competitiveness sake, I think it's worth, at the very least, reviewing it.

For years, we actually were very competitive on corporate taxes. And then Mr. Trump basically pulled an end run around us and took the US more competitive. And we haven't really fixed that since then. But I think it goes beyond corporate taxes. I do believe our personal rates are an issue. When you think of it, businesses are just run by individuals. They have to attract talent, they have to attract individuals. And if the top personal marginal tax rate kicks in at basically high middle-income levels, that's tough. That's a challenge to really attract talent and investment to this country. And I personally think that's the biggest competitiveness issue is the relatively low level of income that a 50% tax rate kicks in in Canada.

Ben Reitzes:

Doug, I think we're going to leave it there. 30 minutes in, the Canadian dollar continues to trade just below 1.40. I can't stop but watch it and keep refreshing my phone here. Thank you very much for coming on the show this week. And when the next big topic comes on, you'll be the first on my list.

Doug Porter:

It was my pleasure. And I did see 1.40 for a minute there.

Ben Reitzes:

Oh, all right. Uh-oh.

Thanks for listening to Views from the North, a Canadian rates and macro podcast. I hope you'll join me again for another episode.

Speaker 3:

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