#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.


October 15 - October 19, 2018

Market turmoil  |  Financial conditions  |  IMF outlook  |  USMCA loose ends


Market turmoil:

  • Stock markets have suffered through their sharpest decline since early February, with as much as a 7% drop in the S&P 500 and a 5% drop in the TSX. Refer to the chart below.
  • After a period of unusually happy and smooth equity gains from April to September, the volatility that tattooed February and March of this year is seemingly back. This makes sense – volatility should be higher than normal at a late stage in the cycle and with many moving parts such as tightening central banks, a shifting inflation regime and the winds of protectionism.
  • For the record, we continue to believe stocks are more likely to rise than fall from here, though not with the enthusiasm or grace of prior years.
  •  Market sell-off again in 2018 chart
  • Why did stocks drop so suddenly and so abruptly?
    • There are many interwoven theories as to why the stock market fell.
    • Probably the best guess is that interest rates had risen abruptly in the weeks beforehand, a subject discussed in more detail in the next chapter of this week’s note.
    • Another solid hypothesis is that the IMF had recently downgraded its growth outlook, signaling less macro enthusiasm on the horizon. We discuss this in a later chapter as well.
    • U.S.-China trade tensions have been intensifying – a serious macro risk.
    • Equity markets outside of North American have been weak for some time, suggesting this development is not quite as new as it seems to North American investors.
    • A surprisingly powerful hurricane in the U.S. might have spooked markets.
    • The month of October is notorious for its sharp stock market swings, and for that matter there is a tentative pattern of equities being soft in the lead-up to the U.S. mid-term elections, followed by strength thereafter. Though, on this last subject, it is less clear why markets would celebrate the likely ascension of Democrats to the House of Representatives after Republicans blessed risk assets with tax cuts in the present Congressional term.
  • However, let us recognize the folly of trying to precisely map macro onto markets:
    • For all of this analysis, however, let us recognize that hindsight cannot truly claim to be 20-20 when financial markets are involved. While all of the aforementioned reasons are perfectly reasonable guesses for why the stock market suddenly turned sour, let us equally recognize that we can’t pull out a calculator and tally up the precise effect of each one.
    • Moreover, many of these developments had been apparent for weeks or longer before the stock market got a hold of them.
    • Thus, there is still an element of mystery as to why the stock market picked one particular week to recoil so powerfully.
    • The reality is that financial markets occasionally stumble into virtuous or vicious circles, rising or falling beyond reasonable expectation as changes in sentiment build upon themselves.
    • Illustrating the folly of trying to identify the precise rationale for market turns, one could imagine that instead stocks had continued to rise happily over the past week. How might pundits justify that? Probably via the observations that the U.S. economy is red hot, the global economy is solid and the successful USMCA trade deal is still casting a warm glow. The reality is that there are always a mix of good and bad things happening in the global economy at any time, and rarely does one side obviously overwhelm the other.
  • Why this probably isn’t the beginning of the end:
    • While one can never speak with absolute confidence about the market outlook, this stock market slide probably isn’t the beginning of the end, for several reasons.
    • U.S. growth remains stellar, and this feeds into earnings.
    • Global growth is decent.
    • Stock valuations were not unreasonable given the broader context.
    • Crucially, credit markets are holding together fairly well, and they are often a bellwether for other asset classes.
    • We believe the developed world is at a fairly late stage of the cycle, but not yet at the outright end of the cycle.
  • Investment philosophy for times of trouble:
    • Episodes of stock market distress are never pleasant, but panic is rarely appropriate.
    • Drawdowns such as this one are usually short lived, whereas investing is ideally a long-term pursuit.
    • Stocks go up far more often than they go down.
    • Rarely does a company’s future stream of earnings genuinely shrink by 5% or 7% in a handful of days. It is perhaps a more complicated matter to determine whether expectations were too optimistic beforehand or too pessimistic afterward, but the future likely hasn’t been altered that drastically so quickly.
    • With admitted exceptions, it rarely pays to sell after a sharp decline. It is usually better to hold tight (stocks go up over time) or even to buy more (since stocks are cheaper than they were).
    • The biggest mistake long-term investors can make is to be out of the market altogether. While the right asset mix depends on the person and the point in the cycle, rarely is a large hunk of cash a good investment bet. To that end, our Investment Strategy Committee has recently recommended that we reduce our already slim cash holdings further by deploying them into the bond market now that yields are more attractive. Our recommended asset mix for global, balanced investors remains modestly overweight equities.

Tighter financial conditions:

  • Financial conditions have tightened abruptly in recent weeks, contributing in significant part to recent stock market distress (see next chart).
    • While there are several underlying contributors to this tightening, the big one is that interest rates have increased.
    • A further contribution – at least from a U.S. financial conditions perspective – is that the dollar has strengthened by a substantial 8% on a trade-weighted basis since April.
    • Third, and confusingly, a weaker stock market is now also contributing to tighter financial conditions, though clearly that aspect can’t be used as a reason for why equities have fallen, lest we descend into a circular argument.
    • Higher oil prices do not explicitly factor into most financial conditions indices, but it is noteworthy that oil prices are more than 40% higher than a year ago. The economic implications of this range from positive to negative depending on the country, but it is a negative on the global scale.
  • Global financial conditions have tightened chart
  • The increase in interest rates merits the closest examination because the move there has been particularly abrupt, and because it constitutes the most likely explanation for recent stock market weakness.
    • The U.S. 10-year yield has literally doubled in just over two years, and has moved aggressively higher since late August. Naturally, savers relish the opportunity to clip juicier coupons, but borrowers only grudgingly pay the higher servicing costs on their debt. It is not a coincidence that U.S. home buying aspirations have recently fallen.
    • The relationship between the stock market and bond yields is an inconsistent one. Often, when economic prospects are improving, the two can rise hand in hand as the bond market prices in extra central bank rate hikes and the stock market salivates at the prospect of superior corporate earnings.
    • However, rising bond yields can sometimes have a negative effect on the stock market, as has been the case recently. After all, higher borrowing costs means that a) corporate borrowing is becoming more costly, b) a subtle brake is being applied at the economy-wide level, c) the value of a company’s future stream of earnings has just diminished due to the application of a higher discount rate, and d) bonds are becoming relatively more attractive as a substitute for equities.
    • Disentangling the recent increase in bond yields (see next chart), the main part of the action over the past month is not the result of more hawkish central bank expectations (though there has been a bit of that – see grey line) or stronger inflation expectations (brown), but rather due to a leap in the term premium (gold).
    • Disaggregating bond market movements chart
    • The term premium is the mysterious residual of the bond equation, observed only indirectly and influenced by the vagaries of supply and demand more than by macroeconomic logic. Whereas more hawkish central bank expectations are usually paired with better growth prospects and rising inflation has so far been fairly benign, a bigger term premium is simply a drag on growth, plain and simple. Thus, the latest increase in yields has been for “bad” rather than “benign” or “good” reasons.
    • Moreover, because the term premium remains unusually narrow by historical standards even after its recent leap, one cannot automatically assume the latest move will necessary unwind, especially at a time that the Fed is actively selling bonds.
  • Turning back to financial conditions more broadly, the main implication of the ongoing tightening is that a headwind to economic growth is forming. This development, alongside U.S.-China protectionism and a diminishing U.S. tax cut tailwind, largely explains our forecast for decelerating (and mostly below-consensus) GDP growth in 2019.

IMF semi-annual outlook:

  • Growth downgrade:
    • The IMF has released its latest economic outlook, with its first reduction of the global growth forecast since July of 2016. The 2018 and 2019 GDP growth outlooks have both been sliced from 3.9% to 3.7%, bringing them into line with the realized growth rate of 2017. As such, it is not that growth is expected to swoon from here, but instead that it is no longer expected to accelerate.
    • Several emerging-market countries including China and India were revised lower, as were forecasts for the Eurozone, the U.K. and the U.S.
    • U.S. 2019 growth is now pegged at 2.5%, down from 2.7%. For the record, we also have a 2.5% forecast for the U.S.
    • The Canadian growth outlook was left unchanged at 2.1% and 2.0% for 2018 and 2019. For reference, our forecast is for 2.0% and 1.5%.
    • The IMF articulated several reasons for its reduced growth forecast. Weaker economic data was one. Another was tighter financial conditions, a subject we discussed in the prior section. Policy uncertainty was a third factor, with trade uncertainty and monetary policy the two largest elements.
    • The IMF further acknowledged that risks to this base-case outlook are tilted asymmetrically lower rather than balanced.
    • Why do we care? Not because the IMF is especially nimble at updating its forecasts. To the contrary, it is actually fairly lumbering. But its analysis and modelling is of a very high quality, and it serves as something of the global forecaster of record. Thus, markets do still move when the IMF adjusts its forecast, even if private-sector economists had long ago revised their own outlooks.
  • Thematic stuff:
    • The economy a decade after: The IMF continues to see long-lasting output losses that have resulted from the financial crisis. Economies are not back to where they would have been without the crisis. To be clear, economic slack is gone, but some productivity growth was squandered along the way. They note that the experience has been worst for countries that went into the crisis with weak fiscal positions and those with fixed exchange rates.
    • The financial system a decade after: The IMF concludes that the global financial system is in better shape than it was before crisis, with shadow banking reduced and supervision increased. But near-term risks to financial stability have lately increased somewhat, reflecting EM pressures and trade tensions. Medium-term risks relate to non-financial sector leverage in the developed world, and external borrowing among emerging economies.
  • Mood at the IMF meetings: The mood at the IMF meetings in Indonesia is somber among officials concerned about protectionism and financial stability. However, investors have remained fairly cheery. Who will be proven correct remains to be seen, though the recent stock market dip argues that investors are the ones adjusting their thinking?

USMCA loose ends:

  • We wrote two weeks ago about the main contours of the new USMCA trade pact between the U.S., Canada and Mexico. Our view, in a nutshell, is that the deal is probably a bit worse for trade than the prior one, but nevertheless better than expected. The auto sector finds itself somewhat more impeded than before, but the overall text has been modernized, and a few small trade barriers (such as Canada’s supply management) have been nibbled away at. More generally, uncertainty has been happily reduced.
  • We take this opportunity to wrap up four loose ends about the trade agreement.
  • Currency manipulation:
    • Rumours abounded after the deal that the Canadian and Mexican governments had effectively given up control of their exchange rates and potentially even of their monetary policy due to the inclusion of a chapter on macroeconomic policies and exchange rate matters that included a promise to “refrain from competitive devaluation.”
    • To the extent this term was never truly defined, an expansive reading could argue that a central bank cuttings its interest rates is engaging in competitive devaluation since a country’s currency usually declines alongside such a move. If this is illegal, have the three countries just locked themselves into something approximating a monetary union?
    • Hardly, for several reasons.
    • First, these rules apply symmetrically to all three nations. There is no way the U.S. just signed onto an agreement that lets Mexico or Canada interfere in U.S. monetary policy or the value of the dollar.
    • Second, the chapter has no teeth. Yes, there is a committee and a dispute settlement system. But literally the only thing a country is allowed to complain about is whether the other countries are publishing various statistics, not what they are doing to their exchange rate.
    • Third, the chapter explicitly excludes central banks from its jurisdiction. To the extent central banks are the ones that set monetary policy and occasionally interface with the currency market, the rules don’t apply to the very parties that might otherwise run afoul of the rules.
    • Fourth, the relevant chapter leans heavily on a similar agreement among IMF members to avoid manipulating exchange rates. All three countries had already promised not to manipulate their exchange rates to the IMF.
    • Fifth, while the chapter advises countries to “refrain from… …intervention in the foreign exchange market” this restriction only applies if the country is pursuing a competitive devaluation. Normally, such activities are instead conducted to stabilize an exchange rate that is actively plummeting or soaring, and strictly speaking this would appear to remain legal (albeit rare).
  • No trade deal allowed with China:
    • A new clause in USMCA requires that a country notify its partners if it intends to pen a trade deal with a “non-market economy” such as China. In an extreme scenario, the other countries can kick this country out of USMCA altogether.
    • Clearly the requirement is targeted at China, as that country represents by far the largest non-market economy in the world, and the U.S. is currently at odds with China.
    • This undeniably represents a step backward for free trade. However, in practice, let us recognize that it doesn’t change the outlook too drastically.
    • First, keep in mind that USMCA already allows any country to leave the deal for any reason with just six months’ notice. True, the particular clause we are discussing would have a country kicked out rather than voluntarily leaving. But the point is that the USMCA isn’t much of a deal without the U.S. Thus, even without the clause, the U.S. could blow up USMCA in a very similar fashion by itself quitting if it doesn’t approve of a partner’s trade dance partner.
    • Second, using Canada as the specific example, in the last year China rejected Canada’s effort to open trade negotiations. Negotiations between Australia and China took the better part of a decade. Thus, a deal between Canada and the U.S. was hardly a slam dunk even absent the new restriction.
    • Third, the world has begun to look more closely at Chinese competitiveness, disentangling what part of it is honestly earned versus what part is the result of unequal rules around joint ventures, intellectual property and the conduct of state-owned enterprises. It isn’t clear that a country should want a vanilla free trade deal with China without China first levelling the playing field somewhat. It is highly unlikely that Canada would be able to exert such pressures, but conceivably the U.S. can.
    • Fourth, the rule does not so much ban a trade deal with China, as prevent a trade deal with a non-market economy. China may be lumped into this category for now, but presuming progress on the aforementioned list of international grievances, China could well be eligible for a trade deal in future decades.
    • Fifth, if China managed to strike a trade deal with one USMCA nation, its products could then enter the rest of the market tariff-free via the backdoor. Ideally, trade with China would open up simultaneously for all three countries.
  • Sunset clause:
    • A sunset clause is a step backwards for USMCA, but also not as bad as it first sounds.
    • The first reason is that the sunset is fairly lengthy. USMCA cannot die via the review mechanism for at least 16 years from today. Barring serious opposition, there should always be a 10 to 16 year window of life left in the pact, as the deal can be renewed every sixth year for a further 16 years.
    • The second reason is that regular reviews provide the opportunity to modernize, and even to deepen the trade relationship, especially given that the first review will occur in the post-Trump era.
    • The third reason is that, as mentioned earlier, USMCA can be killed by anyone at any time with six months’ notice. Thus, while a 16 year sunset is a nice idea, it is hardly guaranteed to be binding. The more worrying clause is the six months’ notice, and let the record show that is a holdover from the original NAFTA.
  • Financial services sector opened?
    • Immediately after the USMCA deal was tentatively struck, there were claims that Canada had just opened itself up to additional foreign competition in the financial sector.
    • All three governments have promised via the agreement to treat foreign investors in the financial space and foreign financial institutions themselves in the same way that they treat their own investors and financial institutions.
    • However, the change is less material than it looks, with the large banks concluding that the competitive environment has not notably changed.
    • Keep in mind there has not been an explicit country-level restriction on bank ownership in Canada for years. Instead, the main restriction is the “widely held” rule, which prevents any one investor – be they a wealthy individual or a foreign bank – from acquiring anything close to a majority stake in Canada’s big banks.
    • Furthermore, the Canadian market has not generally proven attractive to foreign entrants due to its saturation with domestic players.
  • A final observation. It is interesting that a few of the special factors discussed in this report give the appearance of something slightly more than a mere free-trade agreement. For instance, customs unions are notable for requiring that all countries negotiate new trade deals with third parties in unison. There is a bit of this in the China clause. And the currency manipulation clause, superficially at least, binds countries slightly more closely together in much the way that a currency union does (the first step is to lock the currencies into an ever-diminishing range of movement before ultimately merging them into one). Again, this is not to say that a currency union is on the way, but in some ways this is a next-generation trade deal.

And more!

  • Far-right candidate Bolsonaro won the first round of Brazil’s presidential election, and seems very likely be the ultimate victor. On the surface, the promise of an anti-corruption drive and tax cuts have whetted the market’s appetite. However, a certain resemblance to other strongmen leaders also presents a risk to Brazil.
  • U.S. hurricane season is well underway, with hurricanes Florence and Michael inflicting significant damage on the country. For now, the economic damage is likely to be fairly limited in the third- and fourth-quarter GDP reports, but more data and analysis is needed.
  • U.S. inflation has cooled somewhat in recent months, in line with our expectation. The original spike in oil prices has now been mostly absorbed into the annual CPI figures. What is left is an inflation trend in the 2.0-2.5% range, which makes sense to us given the tightness of the U.S. economy. We highlight an inclination for inflation to drift a bit higher from here, in part as the unemployment rate plumbs ever deeper depths, and in part as oil prices have recently perked up again.



October 1 - October 5, 2018

NAFTA = USMCA  |  Data run


September 24 - September 28, 2018

Canadian counterfactual  |  Brexit update  |  Fed preview


September 17 - September 21, 2018

Global Investment Outlook  |  Mid-term elections  |  U.S. energy clout


September 10 - September 14, 2018

Webcast  |  Dairy / Wages  |  Trade  |  and more


September 4 - September 7, 2018

NAFTA  |  US-China  |  more


August 27 - August 31, 2018

Trade breakthrough  |  Jackson Hole  |  Distorted recession signal


August 20 - August 24, 2018

Productivity revival  |  EM crises  |  and more


August 13 - August 17, 2018

Business cycle  |  Consumer outlook  |  Cdn competitiveness  |  Tariffs  |  and more


July 30 - August 3, 2018

Webcast  |  China stimulus  |  Tariffs  |  Savings rate  |  and more


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