Jason Daw:
Hello and welcome to Macro Minutes. During each episode, we'll be joined by RBC Capital Markets experts to provide high conviction insights on the latest developments in financial markets and the global economy. Please listen to the end of this recording for important disclosures.
Hello, everyone, and welcome to this edition of Macro Minutes called Butterfly Effect, that we're recording at 9:00 AM Eastern Time on March the 26th. I'm Jason Daw, your co-host for today's call and being joined by Peter Schaefer on Europe and Su-Lin Ong on Australia. Today we're going to discuss the butterfly effect and how US trade policies are having intended and unintended consequences for various countries ranging from fiscal spending, politics, and monetary policy. Let's jump right into it to unpack some of these topics. And Peter, let's start with Europe. It does appear that one of the intended or unintended consequences of Trump's policies is that we've had a very large fiscal stimulus package agreed out of Germany. Can you give us the background and put the numbers in perspective and especially how big is it?
Peter:
Thank you, Jason. Indeed, we can debate endlessly whether that's an intended or an unintended consequence, but the fact remains, it is large and it is meaningful for markets. So let's look at it a bit more in detail. So what has been introduced is two things really. One is a special $500 billion infrastructure fund that's supposed to run for the next 10 to 12 years. So that's worth about one to one and quarter percent of GDP, so that's quite meaningful. The second thing though that has changed is the German constitution contains something that was colloquially called the debt brake, where the German government was limited in how much deficit it could run, to 0.35% of GDP. Now, what has been introduced now is a carve out for defense spending, and in fact, the defense spending definition is quite broad because it not only entails tanks and guns, but it also entails things like money for intelligence agencies, cyber defense, and things like that.
And anything north of 1% of GDP is now not covered under this so-called debt brake. Now, what that implies is that for all intents and purposes, defense spending is de facto unlimited, and we don't know exactly where the German government will set it, but we reckon from around about 2% of GDP at the moment to somewhere between three and three and a half over the coming years. And that is obviously a fairly large boost of fiscal spend as well. And on top of that, what we'll get is probably some smaller but still noticeable increases in defense spending from other countries as well. And precisely because of the double threat of, on the one hand, the Russian invasion in Ukraine and what this might mean for the future, but also because the US has threatened to not be there if push comes to shove for Europe and Europe feels they have to defend themselves. So yes, indeed a very, very meaningful change that will leave its imprint on markets I'm absolutely certain.
Jason Daw:
Okay, great. Peter. And as a follow-up, I hear from some clients that the actual spending might be smaller than expected, and specifically the track record in defense spending is not that great in Germany and Europe at large. So I guess the question is is this not all a bit of smoke and mirrors?
Peter:
Yeah, that's a very good question and it's obviously one that everyone over here in Europe wrestles with. And where this comes from is when you think about over the last two years, Germany had already another $100 billion package in place and there was supposed to be spent on military equipment. And out of those $100 billion, only about $25 billion have been spent over two year window. Furthermore, in the Draghi report, it was said that over the last two years about 74% of all the military spending went abroad, out of which 68% went into the US. So you can clearly see that people are a little bit worried.
Now, having said that, what also seems to be clear however, is that the Europeans want to make a conscious effort to spend more money at home. You can see that in many other debates that are around, such as for instance, whether some orders that have already been made, say for F-35 fighter jets, for instance, shall be canceled and how to increase the capacity for military equipment production in Europe itself. So I can see where the market is coming from. I don't think that we will spend all of it in Europe also because some of the things are simply not available or the production capacity is not available, but the Europeans will make a very big effort of spending particularly the military side as home as much as they can.
Su-Lin:
Now, Peter, what does this all mean for ECB policy? Will they keep cutting and how low will the ECB go?
Peter:
Yeah, thank you, Su-Lin. That's obviously a great question. We have been for quite some time, and as I said on many of previous recordings, less optimistic as far as the ECB cutting cycle is concerned than other people in the market, which stems, of course, from the fact that we have been a bit more optimistic on the economy. So our terminal rate forecast is 2.25, which I think now looks better than ever. The market has briefly priced in about 2.10, is now back at about two. And when you look at the next two meetings, we are pricing about a little bit more than 50% chance of a cut in either. So in my mind there is a very, very clear chance in the market that the ECB will pause at one of the next two meetings.
And frankly, we think that once they start figuring in these fiscal expansions we've just been talking about into their forecasts, we think it would be much, much more difficult for them to keep cutting. So 2.25 looks still like a very good forecast to me, and I'm wondering if the market will come around to that, say, over the next two to three months.
Su-Lin:
Peter, you also have a fiscal event in the UK this week with the spring statement, and your last budget in October caused quite a lot of turmoil in markets. It looks like the UK is unwilling or unable to follow Germany and announce big spending plans. What's your read of the situation?
Peter:
Yeah, that's a very, very good question. Thanks, Su-Lin. In fact, you might hear a little bit commotion in the background whilst we're recording. UK budget announcement is actually underway. The one thing that's very clear, and it's not only true for the UK but certainly also for the UK, is that not the same fiscal headroom exists, as for instance, in the case of Germany. Germany has a very low debt-to-GDP level. The UK debt-to-GDP level is much, much higher and also the UK specifically is still mentally scarred by the events around the Lis Truss time.
So what we're seeing in the budget here is that whilst the government is trying to increase military spending on the one hand as well, they're also trying to rein in spending and other measures, particularly on the Social Security side of things. And that's clearly the outcome of this budget as well. And I think this will be a theme for the UK going forward as well, how to preserve the fiscal headroom, how to preserve the fiscal credibility that they have whilst at the same time changing the spending mix that they have to make in the light of the Trump events. So it's much more of a reshuffling, whereas in Germany, it is an actual expansion.
Su-Lin:
And Jason, you are also heading to an election soon on April 28th, and it seems that the governing Liberals have been gaining some momentum. What are the polls saying for possible majority or minority government scenarios?
Jason Daw:
Thanks, Su-Lin. The Liberal bounce that we've seen in the polls post Trudeau's resignation, that's really morphed into further upside momentum and in recent weeks the Liberals are gaining more momentum by taking voting intentions from basically all the parties, from the Conservatives, the NDP, and the Bloc. And they're also improving across various provinces. Now based on the current state of affairs, what the polls are showing, there seems to be three scenarios that are all about equally likely. The first one, possibly a Liberal blowout with a large majority. The second one, a small Liberal majority or the third one, a Liberal minority. Now when you look at the vote split across parties, the election map is not that favorable for the Conservatives at the moment, but obviously things can change during the campaign cycle, during the debates over the coming five weeks before we get to the election on April the 28th, and we'll be closely watching the polling data, which is going to intensify with a daily frequency in the coming days and weeks.
Peter:
Jason, let me also come in here. Has anything concrete been enacted in Canada for fiscal stimulus related to tariffs? And how would future spending be oriented under different governments?
Jason Daw:
Good question, Peter. So there's been some bits and bobs so far from the Liberal party that does not require parliamentary approval such as expanding dental care, liquidity support for businesses, and some timing aspects related to employment insurance benefits. The only hard proposed measures that we've seen from the Liberals so far is a one percentage point tax cut to the lowest bracket and that would cost around $6 billion a year. And the Conservatives have doubled down on that essentially with a pledge to cut the lowest bracket by two and a quarter percentage points. I am a bit surprised with the Quebec budget yesterday that there wasn't more measures to shore up the economy against US trade threats.
We have the Ontario budget in April. That's another fiscal marker to watch after Ford's proposals during the recent campaign did suggest a decent fiscal impulse. And then when you look at the federal level, there is a need for Canada to protect itself, enact firewalls, and to diversify away from the US market. So there should be spending initiatives related to military, investment in infrastructure, productivity enhancing type of programs along with contingent direct tariff support for businesses and households. So I wouldn't be surprised to see the fiscal deficit expand in upwards of about $50 billion. And even if the actual numbers undershoot that figure, it does seem like the trajectory for government finances are clear.
Peter:
As a follow-up, Jason, so what does this interplay between tariffs and fiscal policy that you just highlighted, what does it mean for the Bank of Canada outlook?
Jason Daw:
So we thought for a long time the Bank of Canada would cut their policy rate down to two and a quarter percent. This was a bold call last year, but it's where the markets priced now. So it's not a bold call for two more cuts at the moment, but the risks are slanting to less rather than more. And we see a very narrow path to the Bank of Canada cutting below our target and where the market's pricing a terminal at the moment. It would essentially require a tariff induced growth hit and a lack of fiscal stimulus. And that seems like an unrealistic matrix of possibilities going forward.
Now the outlook for the Bank of Canada, this also has important implications for the bond market because yields across the curve have been highly correlated to market pricing for terminal. So we think the risk-reward has shifted to selling on rallies instead of buying on dips as the upside to yields is probably a little bit higher at the moment than the downside. And it's also likely that Canada starts to underperform the US market over a medium-term horizon when you consider the confluence of factors from monetary policy, fiscal, and also what we're seeing on the client flow side. So we've had some detailed information from Peter on the UK and Europe, from myself on the Canadian side. Now we're going to pivot over to Australia and Su-Lin, Australia is one of the few countries that the US has a trade surplus with. Could it avoid the worst of the Trump tariffs?
Su-Lin:
That's right, Jason. We are one of the few countries that the US has a trade surplus with and has had for many decades. But given the determination of this US administration on the tariff front, I'm not really sure that will be enough. So an early example is a 25% tariffs on aluminum and steel. We got a carve out under Trump Mark 1, but not so this time. I mean overall, our exports to the US are pretty modest in the scheme of things. They're worth about 1% of GDP annually, and while further measures including reciprocal tariffs will disproportionately hit certain industries like agriculture, beef, pharmaceuticals, it's probably manageable. What we're much more worried about is the second and third order impact of tariffs, retaliation and rising global protectionism. That's a much bigger threat to Australia, which is a medium sized open economy. So exports here are 20% of GDP.
Those exports are dominated, as you know, by cyclical commodities like iron ore and coal. And China is our largest export market, taking a third of total exports and Asia in total is almost 80%. So the impact of rising tariffs on growth in the region is far more important and poses greater downside to Australia. What could temper this though is what looks to be an increased determination from China to lend support to its economy, especially via fiscal policy with a focus on households and consumption. But we'll have to wait and see if there is further support.
Peter:
Su-Lin, politics is also in focus in Australia with the federal election due in May. After delivering a federal budget this week and with a number of cost of living measures, the Prime Minister could call an election as early as this weekend. What did you make of the budget?
Su-Lin:
I always say budgets are political documents and in no uncertain terms, this early federal budget that we got this week was a launchpad for a May election. We think there's a pretty good chance the Prime Minister calls the election this weekend. The budget dangled many pre-election goodies to help with the cost of living. And while a lot of these have already been announced, including further electricity rebates for households, lower prescription prices, greater rates of bulk billing, and more help for first home owners, the big surprise was really these further income tax cuts for lower income earners that were announced in the budget. They are pretty costly at AUD 17 billion, and when we look at the maths in the budget and the fiscal position, it's pretty simple. All the uplifting revenue and reduced outlays over the next four years is almost entirely spent on all of these measures.
And so not surprisingly, the budget returns to deficit to the tune of about one to 1.5% of GDP over the forward estimates, and more importantly, it stays in structural deficit. Beyond that, Australia's net debt to GDP is pretty low by G 20 standards even when you include state debt. But it is rising and has risen quite quickly in recent years, and we really think there's no room for complacency. We have multiple structural pressures on expenditure, including a still large and growing national disability insurance scheme. There's obviously the demographic challenges, rising defense demands, now and obviously the cost of energy transition as well.
Peter:
Su-Lin, the fiscal impulse continues to turn positive. Are there any implications for the RBA ahead of its board meeting next week now that it has finally joined the global easing cycle?
Su-Lin:
Peter, the budget does stimulatory both this fiscal year and next. It's adding to the growth in public demand and the RBA has had to constantly revise up its forecasts for public demand. We've argued it's part of the reason why the RBA held steady throughout all of last year, while many other central banks were cutting rates and the continued strength of public expenditure, which is spilling over to a strong labor market, is also likely to temper the size of the easing cycle in '25. So the RBA kicked off with a 25 point cut in February. We're sticking with just two more cuts this year, probably in May and August. And so it is a fairly modest cycle of 75 basis points putting, terminal at 360, around about neutral by our calculations.
I think that ahead of the meeting next week, the RBA is unlikely to move. It will need some time to incorporate the budget spending measures into their forecasts. And the next full update from them on the macro forecast front is in May. And I think they also want to wait for confirmation that underlying inflation is firmly back within their two to 3% target range, and we have the full quarterly CPI print due at the end of April. I think more broadly though, rising global protectionism and the potential negative impact on global trade and growth does skew the risk to our RBA profile to the downside.
Jason Daw:
Well, thank you to all our listeners for joining this edition of Macro Minutes. The concept of the butterfly effect and the intended and unintended consequences of Trump trade policies is going to be important for fiscal, monetary, and bond markets over the coming weeks and months. So if you have any further questions, please reach out to your sales representative or us directly.
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