Federal Finance Minister Bill Morneau is tabling his third budget on Tuesday. The economic momentum is stronger now than it was for the previous two: robust real GDP global growth supports commodity prices and the unemployment rate sits near a four-decade low. This being said, there are still some issues in the Canadian economy that need to be addressed by the federal government.
A key issues is the erosion of competitiveness caused by U.S. deregulation, Trump’s tax reform (see chart below) and NAFTA uncertainty. Non-residential business investment in Canada increases, but it is weak versus the U.S. (see chart below). Foreign direct investment in Canada, mostly driven by American companies, has also been declining substantially from 12-18 months ago (see chart below). Inversely, Canadian direct investment abroad has been rising substantially. One thing to look for in the 2018 federal budget is if it will include a response to Washington’s policies. While a massive and generalized cut to the corporate income tax rate is very unlikely, the odds of a targeted measure such as the immediate expensing on capital investments are relatively higher. In addition, small business owners will find out the federal government’s final decision regarding the utilization of passive investment income above the $50K tax-free annual threshold announced last October.
As for individuals, this budget is likely to pursue on the inclusive growth agenda. After generous middle-income tax cuts in 2016 and funding for skills training in 2017, measures to promote gender equality is likely to be front and center in this year’s budget according to several media reports. With 800K more men than women in the pool of labour force aged 25-64, targeted measures to improve the female labour participation and employment rates would positively affect economic potential.
The financial market community will, as usual, take a close look at the six-year fiscal outlook. Projections in last fall’s update and the 2017 budget showed a fairly stable debt-to-nominal GDP ratio close to 30% (see chart below). Given the higher probability of a global economic downturn at this stage of the business cycle, it would be surprising if the federal government suddenly commits to a reduction of this ratio. Last fall’s fiscal update projected manageable deficits in the range of $17B-$19B for the next three years (less than 1% of nominal GDP), similar to the $18.6B deficit estimated for FY 2017-18. These deficits were based on the assumption of a favorable economic momentum increasing fiscal revenues at a moderate pace of 3.5% annually. This is unlikely to change in the 2018 federal budget. One game changer is the higher interest rates environment, which is likely to lead to an upward revision in debt servicing costs in this budget relative to last fall’s forecasts ($27B in debt charges projected in FY 2018-19 for instance). Finally, program spending was on track to increase by 6% in FY 2017-18 according to last fall’s fiscal update, before moderating to approximately 2.5% per year in the medium term. It will be important for bond investors to find out if the 2018 budget still proposes substantial reduction in the pace of growth in program spending. Otherwise, bond issuance could be revised up in the new Debt Management Strategy.
