One of the annual traditions that go with federal budget day — along with the custom of new shoes for the Finance Minister — is the post-lockup question, “What’s Doug Porter saying?” Here is the edited version of Porter’s post-budget analysis for BMO.

 

Douglas Porter and Robert Kavcic

 

Overview—Don’t Stop Us Now

The fourth budget of the current federal government has been overshadowed by events, but is quite important in its own right as it will serve double-duty as the pre-election economic document. Stronger-than-expected revenues over the past year provided some fiscal leeway to fund yet another spending boost. Ottawa is again projecting a string of double-digit budget deficits as far as the eye can see, widening to $19.8 billion in the coming fiscal year, while the key debt-to-GDP ratio continues to gradually drift lower—it’s pegged at 30.7 per cent in FY19/20. This outlook comes as little surprise, as a fading debt ratio has become the de facto anchor for fiscal policy. The major new measures in the budget document also did not come as a shock, and include moves to address housing affordability, skills training, support for seniors and a wide spattering of spending programs on other priorities.

A firmer-than-expected revenue backdrop provided a big tailwind for finances, although that favourable trend has likely just about run its course with economic growth cooling markedly late last year and into early 2019. While the FY18/19 deficit is tracking $3.2 billion better than what was expected in the 2018 Fall Statement (effectively the now-removed risk adjustment), the upcoming two fiscal years will run with slightly deeper shortfalls. There remains no plan to balance the books, with a $9.8 billion deficit persisting by FY23/24. Beneath the surface, a stronger-than-expected revenue base in FY18/19 has helped lift underlying finances by roughly $5 billion per year through the forecast horizon, but that gain has been almost precisely offset by increased spending across a wide range of initiatives. In other words, Ottawa has chosen to let it flow rather than improving the bottom line, clearly revealing the fiscal priority. This is notable, given that the economic outlook has quickly deteriorated. For example, we now expect this year’s real GDP growth to come in 0.5 ppts below the budget assumption, and nominal growth a full percentage point lower.

A contingency of $3 billion per year remains in place through the forecast horizon, but we judge that the current downside risk from the economy carves into the entire FY19/20 reserve. And, we’d just reiterate that we are observing some tell-tale late-cycle conditions in North America, often a period that governments should build fiscal capacity.

Major Policy Measures: Moving from Pot to Pharma

The net fiscal impact of new measures proposed in this year’s budget is $4.0 billion (or 0.2 per cent of GDP) for FY19/20, rising to $5.7 billion in the following year—not big by any stretch, but not immaterial either. Here’s a recap of some of the many new initiatives:

• Housing affordability: The headline measure is the CMHC First-Time Home Buyer Incentive, expected by September 2019. Effectively, CMHC will contribute 5 per cent of the purchase price of an existing home (10 per cent on a new build), to be repaid later on sale of the property (not yet clear is whether CMHC will share in home value changes—both on the way up and down). The program will only apply to those with household income below $120,000, and with a maximum mortgage and incentive amount of 4-times income. As such, the impact will be contained to the lower end of the market below roughly $500,000 and, arguably, that’s the level where affordability challenges only really begin. For example, the most acute affordability problems surround larger units or single-detached homes in the GTA and GVA; yet, most of these are beyond the price range covered by this program. The impact, of course, would be broader in other regions, but affordability in many of those cities is historically quite normal. The biggest impact will be in low-priced new builds. More fundamentally, this measure runs counter to the many other recent policy measures to cool housing demand.Ottawa will also modify the Home Buyers’ Plan, which allows tax-free withdrawal from an RRSP (repaid over time). The withdrawal limit will rise from $25,000 to $35,000.

• Pharmacare: Ottawa will continue to progress toward a national pharmacare program. While the advisory process is still underway, this budget takes three steps: 1) Create a Canadian Drug Agency to negotiate prescription drug prices on behalf of all drug plans, targeting $3 billion per year in long-term savings; 2) Develop a national list of prescribed drugs; and, 3) National strategy for high-cost drugs for rare diseases.

• Program spending will rise 1.8 per cent in FY19/20 after a 4.9 per cent jump in FY18/19. A big chunk of the new announcements in this budget ($4.2 billion) will be rolled out before FY18/19 ends. One of the key features is just how wide a range of areas the spending increases have been spread across.

• Infrastructure spending: One of the chunkier dollar amounts is an immediate $2.2 billion transfer to municipalities to top up their infrastructure funding (through the Gas Tax Fund), and $1 billion for energy efficiency. These costs were loaded into the fiscal year that ends in March 2019, effectively using up a large portion of the extra revenues for the year. Municipalities will have 12 months to use the money.

• Support for supply-managed farmers totalling $3.9 billion in the wake of CETA and CPTPP ratification.

• Skills training: The Canada Training Benefit will provide a means-tested tax credit for skills training that accumulates at $250 per year, up to $5,000 over a lifetime. Income support will also be offered through the EI program.

• Lower interest rate on student loans, to prime from prime plus 2.5 percentage points (on the much more popular variable rates) and to prime plus 2.0 ppts from prime plus 5.0 ppts (for fixed). This meaningful reduction will cost Ottawa $345 million by FY20/21.

• GIS full earnings exemption increase for seniors, from $3,500 to $5,000 and a 50 per cent partial exemption is introduced up to $10,000.

• Electric Vehicle subsidies: Will provide $5,000 on cars with a purchase price of less than $45,000.

• Stock option taxation: Will limit the future benefit of the employee stock option deduction for high-income individuals at mature (i.e., not start-up) firms by applying a $200,000 annual cap—further details pending, as was the case for many measures.

Debt Management Strategy: Red Book    

With a string of deficits still looming, government borrowing requirements will remain elevated. Gross marketable bond issuance will total $119 billion in FY19/20, up from $100 billion in FY18/19. After accounting for maturities, buybacks and other adjustments, the net increase in bonds will be $8 billion in FY19/20, versus a $2 billion decline this fiscal year. The stock of Treasury bills is projected to drift up from $131 billion to $151 billion, while the average term to maturity of domestic market debt is expected to remain stable around 5.5-to-6.5 years. Ottawa continues to focus more of its issuance in the 2-, 3- and 5-year sectors than the longer end.

Economic Assumptions

Ottawa’s economic assumptions were brought together prior to the sour news on Q4 GDP and, thus, already appear overly optimistic—a rare case when the consensus forecast has shifted significantly just ahead of budget day. In the budget assumptions, Canadian real GDP growth is a moderate 1.8 per cent this year, but the latest consensus has since dropped to just 1.4 per cent growth (and we’re at 1.3 per cent). Even last year’s initial estimate has been shaved to 1.9 per cent. The assumption for 2020 growth of 1.6 per cent is closer to the current mark (we’re actually a tad higher at 1.7 per cent). A key message here is that growth will be modest at best over the next couple of years, limiting any potential upside surprises to the bottom line like we saw in the past year.

Importantly for revenues, the assumption for nominal GDP growth also looks high for 2019—the budget is based on 3.4 per cent this year and 3.5 per cent next (our calls are 2.5 per cent and 3.7 per cent, respectively). This comes alongside expected further gains in oil prices—we see WTI averaging $60 in 2019/20. Some offset for finances will be provided by an even more benign interest rate environment than anticipated just a few short months ago. The budget assumed that three-month interest rates would average 1.9 per cent this year and 2.2 per cent next year; but, we now look for 1.7 per cent in 2019 and just under 2 per cent in 2020. The assumption on 10-year GoC yields of 2.4 per cent this year and 2.7 per cent in 2020 look wildly high, at least at this point, and we are looking for them to average less than 2 per cent over the next two years. It’s noteworthy that, aside from a brief period through 2013, much of this cycle has been characterized by lower-than-expected interest rates, leading governments to revise down their debt-service cost estimates in-year. That looks very likely to be the case yet again this year. Even so, the much softer growth backdrop suggests that the risks from an economic perspective look like they will readily consume the contingency reserve in the coming year.

 

Douglas Porter is Chief Economist and Robert Kavcic is Senior Economist with BMO Capital Markets.