#MACROMEMO

On our economic radar this week

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Produced by RBC Global Asset Management's Chief Economist Eric Lascelles, the #MacroMemo covers what's on our economic radar for the week.


November 13 - November 17, 2017

Substantial Saudi risks  |  Chinese financial reforms  |  Inflation ahead


Substantial Saudi risks:

  • We have tended to describe geopolitical risks as primarily revolving around North Korea in the short run and then having to do with the growing clout of China over the long run.
  • Saudi Arabia arguably deserves to be added to the list of short-term risks. It and the Middle East are relevant to investors not so much due to their domestic economic heft – this is still fairly limited – but rather because of their outsized capacity for influencing the global price of oil via supply shocks, and secondarily because the region possesses a second-to-none capacity for sucking major Western powers into its frequent conflagrations.
  • A large part of the risk reflects acrimony between Saudi Arabia and Iran. Although each has long been the flagbearer for a different form of Islam – Sunni and Shia, respectively – the two countries had been quite civil for several decades. However, their relationship has deteriorated badly. This may partially reflect greater discord between the two religious factions in a more general sense. But it also arguably reflects waffling U.S. support for Iran, Iran’s expanded role in Syria and Iraq (battling ISIS, but also gaining influence), and the shifting sands of Saudi politics.
  • President Obama had welcomed Iran in from the cold by removing sanctions in exchange for an anti-nuclear weapons deal. However, President Trump now seems tempted to unwind some of those actions, weakening Iran’s perceived strength. Saudi Arabia may be taking advantage.
  • At the same time, Saudi Arabia is now effectively under the new leadership of Crown Prince Mohammed Bin Salman. He has made many changes, several economically positive that reflect the country’s “Vision 2030” plan: removing some restrictions on women, reducing the power of the religious police, seeking to diversify the economy, increasing domestic energy prices, planning to sell off a stake in oil powerhouse Saudi Aramco, and engaging in an anti-corruption drive (though it looks to have also been motivated at least in part by a bid to consolidate power). However, he is also ramping up Saudi Arabia’s foreign policy (likely emboldened in part by the apparent support of President Trump), prosecuting the longstanding Yemen proxy war with additional ferocity (with Iran pulling the marionette strings on the other side), embargoing Qatar, and now interfering in Lebanese politics (with Iran the other frequent meddler).
  • It is difficult to get a sense for whether all of these moving pieces are likely to mesh together into a stable outcome or instead come crumbling down. Saudi Arabia’s economic reforms seem more good than bad. But the foreign policy changes would appear to carry an elevated chance of stirring up even greater conflict between Saudi Arabia and Iran. With a large swath of the crude-rich Middle East as their potential canvas, a major oil supply shock constitutes an outside risk, with a scenario of higher oil prices leading to elevated inflation and weaker global growth. Another risk is that Mohammed Bin Salman could himself succumb to internal disgruntlement from Saudi clerics and/or other royals, resulting in a sudden change of leadership and thus an abrupt change of course for the country. These are all just risks, but significantly greater than a few months ago.

Chinese financial reforms:

  • Providing a clear rebuke against the human inclination to fit macro developments into neat narrative boxes, China has just announced plans to more fully open its financial institutions to foreign ownership. This comes in considerable contrast to the theme of reduced market forces that was so central to the five-year plan laid out in the country’s quinquennial Congress last month.
  • In fairness, China was always expected to continue liberalizing its currency and financial markets, despite reduced enthusiasm for privatizations in a more general sense.
  • China’s decision likely reflects three things. First, the country’s banking sector had been shielded for long enough to allow large, muscular domestic players to emerge. Incredibly, China now possesses the world’s four largest banks. The sector is unlikely to be subsumed by foreign acquirers, whereas that was not inconceivable a decade ago.
  • Second, given the country’s sordid history of rapid credit growth over the past decade, there may be a desire to inject fresh capital into China’s banking system while simultaneously spreading the risk around somewhat. In their haste to deepen their ties with the world’s second-largest economy, Western financial institutions might just be willing to make this trade.
  • Third, coinciding as the announcement did with President Trump’s visit to China, it may represent a concession designed to keep Trump’s protectionist inclinations focused on other shores.
  • Practically speaking, foreign banks have long been allowed to operate inside China. The changes now underway are to allow foreign players to acquire majority stakes in China’s financial institutions. The permitted foreign ownership share of Chinese banks will shortly rise from 25% to 51%, and then to 100% after three years. For securities, fund management and insurance companies, the limit rises from 49% to 51%, and will also vanish completely after three years.
  • Realistically, any entry by foreign players should be gradual.

Inflation ahead:

  • Myriad research reports have volleyed back and forth over the past year as to whether traditional wage and inflation dynamics still largely apply (IMF, Bank of Canada) or instead whether their connection to economies have weakened (BIS, Olivier Blanchard).
  • We land somewhere in the middle, acknowledging a series of structural constraints on the level of wage growth and inflation, but also that the basic premise of insufficient labour translating into wage demands must surely still hold at some level. Indeed, we are starting to see a bit more wage pressure. Our preferred measure of the Phillips Curve (depicted below) argues that a clear relationship between the unemployment rate and wage growth continues to exist, but leaves unanswered whether the relationship is simply weaker than before (which nevertheless argues for higher wages and inflation) or instead about to snap back as it passes a key inflection point.
  • Additional insight into the subject will shortly be available as U.S. and Canadian CPI for October will soon be released. No great surprises are likely. After a surge higher in September, U.S. headline inflation should take a breather in October before later mounting another charge on the back of surging oil prices in November. Annual CPI should sit bang on 2.0%, while core inflation continues to track a few ticks below that, though with a solid underlying trend. Canadian inflation is in a similar position - slightly low readings and not much action likely for headline CPI in October, but core CPI may be starting to perk up as economic conditions winch tighter.

 




November 6 - November 10, 2017

Monthly economic webcast  |  A new Fed chair  |  U.S. tax reform update  |  European fracture   |  Macro data


October 30 - November 3, 2017

U.S. corruption investigations  |  Fed preview  |  Bank of Canada review  |  Data run 


October 23 - October 27, 2017

Next Fed Chair  |  China Party Congress  |  Upcoming BoC decision  |  Canadian mortgage rule change  |  A few others


October 16 - October 20, 2017

More NAFTA thoughts  |  Election updates  |  Policy in the week ahead  |  Canadian economy slips


October 2 - October 6, 2017

Monthly economic webcast  |  Catalonian referendum  |  U.S. capital stock concerns  |  Three U.S. fiscal items  |  Other interesting items


September 25 - September 29, 2017

U.S. dollar weakness  |  Hawkish Fed recap  |  U.S. tax reforms  |  Canadian GDP preview  |  Seeking Bank of Canada clarity  |  Election roundup


September 18 - September 22, 2017

Monthly economic webcast  |  Reviving inflation  |  Hawkish central banks  |  U.S. politics  |  German election preview  |  Hurricane recap  |  Appetizers


September 11 - September 15, 2017

Monthly economic webcast  |  Bank of Canada raises rates  |  Understanding Canada's stock-GDP disconnect  |  Bitcoin as currency  |  Hurricane(s) update  |  Miscellaneous medley  |  Week ahead





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