Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.
Recently, my YouTube feed displayed a new video of economists Art Laffer and Steve Hanke discussing the current state of the world economy and its outlook. It reminded me why the Canadian economy may be struggling so much versus the U.S., and by extension, our equity market.
Mr. Laffer is famous, or infamous, for developing the Laffer Curve, which became a hot topic in the early days of the Ronald Reagan administration in the 1980s. Professor Hanke is one of the pre-eminent monetarist economists in the world. Both men served as advisers to the U.S. government during the Reagan administration. Mr. Laffer has been making more public appearances of late, after a long period of dropping out of the public eye.
One might disagree with the Laffer Curve’s conclusion that higher taxes eventually result in lower overall government revenues, but there is little question that the increasing burden put upon the taxpayer is not yielding the revenues governments expect or desire. Importantly, there appears to be a negative correlation between government taxation and long-term economic growth.
Long-term economic growth does correlate, however, with corporate earnings. An analysis by Schoder Wealth Management found a correlation of more than 80 per cent between growth in gross domestic product (GDP) and corporate earnings growth over the last decade.
Prof. Hanke is a proponent of the Quantity Theory of Money, which asserts a relationship between monetary growth and inflation. He correctly predicted that after the rampant money printing that occurred during the lockdowns, inflation would soar to between 7 and 10 per cent before declining. In the realm of economic predictions, hitting a home run is rare. The good professor hit a second-deck grand slam. He is now predicting a period of economic weakness as the U.S. money supply is not growing as is the historic norm. Prof. Hanke does acknowledge that he had expected a recession by now and had to rejig his forecast.
In the YouTube video, the two economists reminisced about the Reagan years and the period of stability and prosperity from 1982 and the Great Financial Crisis of 2008. They pointed out the forgotten five principles of Reagan’s economic policy and credited them with the success of the post-1982 period. The five principles were:
- Lower taxes.
- Less regulation.
- Less government spending, or at least a decrease in the rate of growth in government spending.
- Free trade.
- Sound money.
Mr. Reagan, who held office for eight years starting in 1981, succeeded in his goals to various degrees. But, after a generation of inflationary booms and busts, the economy did enter a period of sustained growth with lower inflation and lower unemployment. Prior to the post-1982 period, the U.S. economy had endured four recessions in 12 years.
It may take some by surprise that between the mid-1960s and the beginning of the 1982 secular bull market, the S&P 500 Index fell by about 50 per cent, adjusted for inflation. The period that followed, as the Reagan era took hold, provided much more consistently strong returns for the U.S. benchmark.
While the S&P 500 and S&P/TSX Composite Index have traded positions as the better performer over the past four-plus decades, lately the difference in their returns has been stark. The S&P 500 has returned 10.82 per cent annualized over the last 10 years, versus 3.86 per cent for the TSX.
If the efficacy for Reagan administration’s principles is valid, it would explain the struggles of the Canadian economy and at least some of the underperformance of the Canadian equity market relative to the U.S.
Canada has high government spending relative to 50 years ago per capita and adjusted for inflation. This is even true if adjusted for GDP growth. A society with increasing wealth should see spending for each person go down due to people needing less assistance and infrastructure economies of scale. According to the Fraser Institute, the federal government spends just over $11,000 a person now compared to $6,000 adjusted for inflation 50 years ago, when Prime Minister Justin Trudeau’s father was in office.
Canadians pay high taxes. Tax revenue to GDP is about 33 per cent compared to the U.S. at 27 per cent. In fairness, Canadians do not pay more than some European nations, but their economies have not done well for a generation and people in those nations seem to feel they get more benefits for their money.
The Canadian economy hasn’t grown per capita since 2017, whereas the U.S. is up 11 per cent.
Although difficult to quantify across borders, the Canadian economy is being hamstrung by regulations and government red tape. We can see this in housing, mining and other areas.
That’s holding back our stock market. Government policy has hindered our resource sector, which is heavily weighted in our main equities index. We don’t have many great companies in Canada, and when we do have one, such as Loblaws, they can frequently become a target of criticism from politicians and the public. We’re so heavily weighted in banks because there aren’t many great companies in other sectors.
Investors should be cautious. The Reagan principles are not partisan politically, in the real world. So-called socialist nations in Europe have shown impressive discipline. The Liberals’ Paul Martin displayed a degree of responsibility that would put the present finance minister to shame despite being in the same party. In France, capital markets are concerned about the rise of Marine Le Pen’s far-right party because she is advocating increased spending. French government 10-year bonds trade at a lower yield than U.S. Treasuries, but this spread has narrowed in the two weeks since President Emmanuel Macron called snap parliamentary elections. (The first round of voting will take place Sunday.) The French stock market index is nearly 10 per cent off its mid-May high.
Long-term investors need to look at economic policies going forward. When assessing different nations’ investment outlook, concentrate on what governments do, and not rhetoric.
Also from Tom Czitron: Nationalist movements are on the rise. Here’s how to invest to prepare for the new era of politics
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