#MacroMemo - RBC Global Asset Management

#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.


December 10 - December 14, 2018

Webcast  |  Brexit  |  Canadian oil  |  Rate risk  |  Data run


Monthly webcast:

Another Brexit update:

  • Two recent developments have further jostled the Brexit pinball machine.
  • The first is that British Prime Minister Theresa May has cancelled plans for a Tuesday parliamentary vote on her negotiated transition deal with the EU, evidently based on the assessment that the vote would fail by a considerable margin.
  • The second is that the European Court of Justice has concluded that the U.K. can unilaterally cancel its Brexit plans without requiring approval from other European countries. This had been strongly hinted in recent weeks, but is now official.
  • The net effect of all this is unclear, as per the seeming modus operandi of the Brexit saga thus far.
  • Perhaps the most straightforward implication is that the risk of the U.K. crashing out of Europe in a spectacular, uncoordinated and highly problematic fashion has surely shrunk. Should no agreement prove possible, the U.K. could simply rescind its Article 50 invocation and stop the associated ticking clock, securing additional time for Brexit planning, negotiations or even outright abandonment.
  • However, the cancelled vote introduces a considerable complication to the main path ahead. To approve a Brexit deal, a parliamentary vote will still be required. For now, Prime Minister May will return to the EU over the remainder of this week and plead for a more favorable deal.
  • Surely, the EU negotiators will feel a bit more pressure to accede given their desire to resolve the Brexit matter. However, they appear disinclined to make major changes, and their fundamental negotiating advantage persists:
    • The potential economic damage is far smaller for the EU than for the U.K.
    • The EU must ensure a sufficiently unappealing deal such that other countries won’t follow the U.K. out the door.
    • The requirement of unanimous consent by the 27 remaining EU member states means that the deal must align to the fiery demands of the hardest-line countries.
  • As we have said for several months, the odds of a new Prime Minister, a new election and/or another referendum have also risen considerably. Each is entirely conceivable in the near term. Each would bring its own kaleidoscope of scenarios and implications.
  • Cutting through the enormous uncertainty and all of the complexities, we continue to believe that the most likely single scenario is something approximating the current proposed customs union deal between the EU and the U.K. However, a “No Brexit” scenario is entirely conceivable and had risen in probability in recent months – even more so given the escape hatch recently provided by the European Court of Justice.

Canadian oil:

  • Canada’s oil sector has grappled with cascading challenges, beginning with a gaping discount relative to the North American benchmark, followed by a collapse in global prices.
  • Western Canada Select (WCS) spent the spring with a fairly normal $15 to $20 discount relative to West Texas Intermediate (WTI) oil, before beginning a slow motion (and then a not-so-slow motion) descent. Ultimately it bottomed out at a walloping $50 per barrel discount to WTI on October 11th. The gap was the result of a mix of factors, but centred on transportation bottlenecks in bringing Alberta oil to market.
  • While the Canadian discount didn’t get any worse after October 11th, the absolute price of Canadian oil did, as global oil prices cratered. This sent Western Canada Select to an abysmal $13 per barrel on November 15th.
  • This created emergency conditions in Canada. While low oil prices are bad for the economy in discouraging capital expenditures on new projects, descending below $25 per barrel presented a further problem in that producers were also suddenly operating at an operating loss.
  • In theory, the economy would have lost something like 0.5% off of GDP if these conditions had persisted. If this seems light, the only reason the situation didn’t add up to an obvious recession was that oil sector capital expenditures were already so depressed from the 2015—2016 shock that there simply wasn’t much lower they could realistically go. Note, of course, that even a 0.5% hit,if delivered disproportionately in a single quarter, could add up to a 2% annualized ding to one quarter’s growth.
  • Of course, since then, the Alberta government stepped in with the unusual action of mandating a 9% reduction in oil production for 2019. In almost any other industry, lower production would equal lower revenues. But the demand for oil is sufficiently inelastic that the opposite happens in the oil sector. Indeed, revenues are already rising. Since the announcement, the spread between WCS and WTI has helpfully shrunk to just $13/barrel, sending the price of WCS oil up to $38/barrel. That’s almost triple where it stood in mid-November.
  • The new price is still low by the standards of 2018, though it is in line with the normal experience since mid-2016. In turn, the worst of the oil shock has been averted. Indeed, from a corporate profit perspective, the damage has been largely undone. However, from a GDP perspective, the fact that Alberta production will be cut by 9% suggests a lingering hit to the level of real GDP. After all, real GDP is nothing more than a sophisticated way of tallying the number of things an economy makes. And Alberta is clearly set to make less oil in 2019.
  • Taking a simplistic approach, one could argue for a hit of as large as about 0.4% of GDP. But the fact that more money will be sloshing around on the nominal side of the equation should trickle positively into real GDP in other ways (such as via improved government fiscal coffers, reduced layoffs, etc.), leaving perhaps a 0.2% drag.
  • While the worst-case scenario has been avoided, we still anticipate Canadian GDP weakness emanating from oil, competitiveness and housing, adding up to an underwhelming rate of economic growth in 2019.

The rate risk:

  • In October, we identified two main macro explanations for stock market distress: deteriorating economic growth and rising interest rates.
  • The first of these is still a threat, and remains a central worry for markets.
  • However, we are unsurprised that the interest rate risk has shrunk substantially, and we continue to believe it presents only a limited risk for the future.
  • There are several reasons why the rate risk is limited.
  • First, the bond market is inherently sympathetic to market concerns: almost by definition, an environment in which investors are skittish about the stock market is one in which they are glad to plow additional funds into government bonds. In so doing, stock market worries have helped to tame government bond yields, acting as something of a self-correcting mechanism. The U.S. 10-year yield peaked at 3.24% in early November, but has since retreated back to 2.85%.
  • Second, central bankers function in much the same fashion as the bond market, at least at the short end of the curve. While they are not quite as exclusively attuned to the machinations of equities, central bankers nevertheless recognize mounting risk aversion as a danger to economic growth, and so are inclined to become less hawkish. Simultaneously, the ongoing global economic deceleration has forced a downgrading of central bank expectations. To illustrate, whereas the debate was once whether the Fed would raise rates by two versus three times in 2019, the market now prices in no more than one rate hike in 2019 (note that it still prices a decent chance of a final 2018 hike in December).
  • Third, we think the neutral policy rate may be lower than central banks imagine. Virtually everyone agrees that the “new neutral” is significantly lower than in prior cycles. This is mainly due to higher debt loads that render each rate hike more consequential, and lower productivity growth that requires a lower hurdle rate to motivate a steady flow of business investment. The conventionally assumed range is 2.5% to 3.5% for the neutral policy rate, versus perhaps 4% to 5% in the prior cycle.
  • However, there is a further consideration that receives less acknowledgement in these discussions: after many years of ultra-low rates, economic actors are now habituated to, and perhaps even dependent on, low borrowing costs. Providing a simple illustration of this, for the great majority of the past four decades, the U.S. 10-year borrowing rate was cheaper than its prior five-year average. In contrast, the latest borrowing rate is now more expensive than that average. This suggests borrowers may already be unusually burdened by the limited rate increases that have come to date. Suffice it to say that, at least for this cycle, the neutral rate may be lower than 3% rather than higher.
  • Fourth, and with relevance to bond yields further out the curve, we are not convinced the term premium needs to expand by much from its current depressed state, meaning that term bond yields may also not have to rise by much. Current estimates put the term premium around 0bps, versus +100bps or even higher historically. Granted, quantitative tightening (QT) in the U.S. exerts an indisputable upward pressure on the term premium. However, Fed QT has been exceedingly well telegraphed, meaning forward-looking markets have likely already priced the great majority of it into current yields.
  • From a theoretical perspective, while the historical norm has been for longer-dated bonds to pay a higher coupon than a shorter-dated one, this is not necessarily a birthright. Yes, longer-dated yields traditionally suffer from higher volatility, but this is only in an absolute sense. For liability-matching pension funds, long-dated bonds experience no relevant volatility given that pension fund liabilities are gyrating in an identical manner. Such investors are thus theoretically willing to pay more rather than less for such an instrument. Similarly, in a world in which term bonds helpfully stabilize a portfolio by serving as a counterweight to stocks, this service provided by bonds is arguably worth paying a premium for, rather than demanding a discount. In short, a world without a significant term premium could simply be the new norm.

Data run:

  • It was a heavy week from a data development perspective. Here are some highlights.
  • Canadian employment: Canada managed one of its famous, inexplicably strong job prints in November. The report was quite something from start to finish, with a sparkling 94K net job gain driven by full-time and private-sector employment. The unemployment rate fell from 5.8% to 5.6%, the lowest level in modern history. Wage growth remained mysteriously weak, but the broader message was still quite a good one.
  • U.S. payrolls: U.S. employment was perfectly fine by almost any standard, with 155K net new jobs and an unemployment rate of just 3.7%. However, this job creation fell a little shy of the recent norm and revisions were slightly downward. We have similarly noticed that weekly jobless claims (while still quite low) have been edging higher over the past few months. It remains extremely premature to make any sort of claim as to whether the U.S. job market has peaked, but it seems worth watching given global economic distress and domestic financial market worries.
  • Twin ISM numbers: Making the counterpoint that the U.S. economy continues to rollick along, the ISM Manufacturing and Non-Manufacturing reports for November were also just released. These reports argued that U.S. growth continues to defy the global slowdown, managing big prints of 59.3 and 60.7 respectively, each up from the prior month and consistent with stellar economic growth.
  • OPEC update: The OPEC meeting in Vienna concluded with an agreement to cut 1.2M barrels per day of oil production. Saudi Arabia will absorb the bulk of the adjustment, slicing 800K barrels per day from its production. The other OPEC nations plus Russia will handle the remaining 400K. Three OPEC nations were exempted altogether: Iran, Venezuela and Libya. Nigeria, in contrast, lost the exemption it had enjoyed during the prior round of cuts. Qatar quit OPEC altogether. The size of the cuts were arguably at the low end of expectations, helping to explain why oil prices (and Brent, specifically) have lost a few dollars since the meeting, now residing in the high-50s. Of course, when the OPEC cuts are tallied alongside Alberta’s oil reduction, it totals a 1.5 million barrel cut. This was not far from initial hopes to keep the oil market in balance in 2019.



December 3 - December 7, 2018

U.S.-China trade  |  U.S. 2019 slowdown  |  Oil update  |  Central bank focus


November 12 - November 16, 2018

Global growth slows  |  Commodity retreat  |  Midterms review  |  Canadian competitiveness


November 5 - November 9, 2018

Webcast  |  Mid-terms preview  |  U.S. housing slowdown  |  Italy budget math


October 29 - November 2, 2018

Business cycle  |  Climate change  |  Cannabis in Canada


October 22 - October 26, 2018

Global order  |  Trade  |  China  |  BoC preview


October 15 - October 19, 2018

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


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


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