Hello and welcome to our latest video #MacroMemo. And as usual there’s quite a bit to cover.
We’ll talk about emerging market debt and the extent to which we see some challenges in that space. We’ll talk, of course, about inflation, which is still very high but now seemingly turning, which is something we’ve been flagging for a while.
Recession discussions continue and we will stay true to that. Soft landing possible outcomes also worth mentioning. And so as much as a recession is more likely, arguably the recession risk has shrunk a little bit if anything recently. Still the overwhelmingly most likely outcome though.
We’ll spend a moment on U.S. politics in the context of midterm elections that are approaching with some slightly altered expectations relative to what was the default prediction as of just a month ago.
And then lastly we’ll just dig into demographics and some really fascinating things came out of the most recent United Nations population forecast update. And so I’ll share some of those with you.
Let’s start with emerging markets and emerging market debt. And so, of course, emerging market economies have been struggling as well over the last few years. They were hit by the pandemic. They are now being hit by the usual set of issues that the developed world is facing, including rising interest rates, and high food prices, and energy prices, and so on.
Arguably emerging market countries though, particularly in a debt context, have additional challenges or at least more intense challenges. And so, for instance, the increase in food prices that has struck the world is particularly relevant for emerging market countries. Just a bigger fraction of their spending basket is on food, and food has gone up quite a bit.
Emerging market countries have also been more affected by rising interest rates. You can think of it as the U.S. borrowing costs have gone up, emerging market borrowing costs are anchored to U.S. costs plus a borrowing credit spread. And that credit spread has widened as people have grown concerned about global economic growth. And so that’s hit them harder as well.
The U.S. dollar’s been strong. That’s also a problem for many emerging market countries because a fraction of their borrowing is in dollars. Effectively, they now owe more money than before because the borrowing currency has become more valuable. And so all of these are fairly significant challenges. And as a result, 20 of the 70 or so main countries in the Emerging Markets Bond Index are in some form of distress right now. And so that’s why emerging market bond spreads have widened quite a bit more than you’ve seen for investment grade debt or high yield debt.
The number of countries running into trouble fairly similar compared to the number that ran into trouble in 2020, in the early phase of the pandemic, fairly similar to the number that ran into trouble in 2008, at the beginning of the global financial crisis. So not unprecedented, but nevertheless a significant sum. It’s a silver lining, or it’s some consolation at least, that most countries this time are smaller frontier markets. And so at least not as damaging from an investment perspective. These are smaller markets. Nevertheless, not good.
Let’s be clear, that not all the countries that are in distress are going to default. In fact I would say a significant number won’t. But the point here is just that emerging market economies are suffering too. It’s easy to overlook them at a time that there are so many global forces of such great relevance to the developed world. But emerging market countries getting hit and getting hit worst, at least through a debt lens.
Okay. Let’s pivot from there. Let’s talk about inflation. And so that’s been front and centre for quite some time. And really the news here is that since we last talked we now have July inflation prints out. I’m recording this in August but the July numbers came out not long ago, and they were good. They were weaker than expected.
And so in a U.S. context, monthly consumer prices were flat from June into July. And that’s a good thing. They’ve been rising at 0.6%, 0.7%, 0.8%, 1%, 1.2%, 1.3% in recent months. And so a flat print is quite a departure, and that allowed the annual number everyone tracks to go from a 9.1% down to 8.5%.
Now clearly 8.5% is still far too high. The work isn’t done. Clearly one month of data isn’t saying a whole lot. And in fact we know why inflation was weaker. It was primarily gas prices went down. So energy costs fell 4.6%. That was the big source of weakness. Airfares were also somewhat cheaper.
Other things still stayed fairly strong. And so shelter costs were still rising fairly robustly. Food prices still rose. We can’t say that all of the inflation pressures have suddenly vanished. Nevertheless, the turn in energy was a very helpful thing and at least gave us one good month. Other countries also saw that one good month. And so the Canadian numbers also softened in July, again on gas prices.
At this point in time, we need to be looking ahead or at least looking to where we are right now, which is into the August figures. And we’re mostly through August as I record this, though we don’t have all of the answers in terms of what different components have done. We do know that commodity prices broadly have been flat to a little bit lower. And so that should be helpful again in August.
And we’re seeing quite credible forecasts suggesting maybe not flat inflation, but suggesting inflation rates that are fairly normal looking compared to the elevated readings for most of the last year, excluding natural gas, which has still been a big pressure point and is creating big problems in the UK and in Europe in particular.
We have some real-time data that we look at that does suggest, again, that inflation trends are becoming a little bit softer. And I guess in the end you would say in theory, the four big drivers of inflation that have collectively been responsible for three-quarters of the inflation, at least in the U.S., in theory all of them should be starting to turn.
So the first is gas, which is clearly down and has fallen a little further, and it arguably makes sense as the global economy weakens.
You then get to other transportation costs, like car prices and this sort of thing, and we’re starting to see some flattening, if not a turndown in those prices after a pretty incredible run-up—I think an unsustainable run-up—earlier in the pandemic.
Shelter costs. Well, it’s a tricky one. There’s a lag here. And so some rent rates are still rising quite aggressively, and some people are, of course, many people paying more for their mortgage. But in terms of home prices themselves, of course, we’ve seen a flattening, if not an outright decline, depending on the country. There’s a lag here, but we can say the housing pressures should be starting to abate over time.
And then you turn to food. And so food prices at the commodity level have fallen. Wheat, and corn, and other commodities like that are lower. It does take months though for that to map its way into consumer prices, but in theory we should see some softening.
And so the four big drivers are in theory going to come down somewhat over time. We have said for a while we think peak inflation probably was in the realm of June. And so we’re hoping to continue to get slightly softer readings.
We’re not holding our breath though in terms of thinking that inflation snaps back to completely normal overnight. It’s still quite a journey, and central banks are likely not done the heavy lifting in terms of the rate hikes they’re delivering to help to tame inflation.
Okay. Onto recession risks. And so this is something we’ve talked about for quite some time. We do believe recession risks are still high. They’re worse in the UK and Europe. They’re a little bit less bad in North America, at least in terms of the intensity of a prospective recession.
And in terms of recession depth, we’ve talked before about perhaps economies—U.S. as our benchmark—declining by maybe 2.5 percentage points relative to the prior level of output. Recently we’ve thought maybe the hit could be a little bit less than that. That would be in line with the historical average. We’ve been saying maybe it’ll be a 2 percentage point hit or a bit less, recently.
So softening that expectation a little bit, which is a good thing. And that’s because some things are getting a little bit less bad. And so, as an example, oil prices have now clearly dropped. People are filling up their tanks and it’s costing less money than it did a few months ago. And it’s a somewhat similar story in the interest rate side. Borrowing costs have come down a little bit, though I wouldn’t want to overstate that.
But it does create, or at least highlight, the possibility of a milder recession or a soft landing. Again, I still think a recession is more likely than not, but soft landings are not entirely impossible. You look at some of the key metrics here and inflation’s becoming less intense. That’s one precondition for a soft landing.
Financial conditions are easing. Central banks maybe raise rates a bit less. The stock market’s not quite as low right now. These sorts of things. Supply chains are definitely getting better. And the China slowdown, maybe there’s some room for stabilization there. The government is certainly making efforts in terms of rate cuts, and guaranteeing loans to builders, and so on.
And so I would say we’re getting a bit of a helping hand from each of those key items. I don’t think it’s anywhere near enough to achieve a soft landing yet, but if those trends were to continue, then you could start to talk a bit more credibly about a soft landing.
I think as it stands right now, I’ve gone from thinking of recession risk in a U.S. context maybe it was an 80% chance over the next 18 months or so, and maybe now it’s a 70% chance. So still more likely than not, but less of a certainty maybe than it was as we’ve had some lucky breaks recently.
I will say—and this is circling back to the fact that the recession risk probably is fairly high—there is some value in a recession at this juncture. And so some of it is simply that it would likely help to tame inflation, and that’s the crucial thing here to get inflation under control and to allow prosperity to rise going forward for the next generations. It’s hard to do when inflation is approaching double-digit levels.
But you could also argue a recession could be helpful in a few other ways. Maybe not to our pocketbooks in the short run, but it is necessary to prevent this economy from overheating. We cannot have this level of tightness in the labour market, for example, for very long without creating problems that induce their own deeper economic problems later.
Arguably, fixing housing excesses is a worthy cause and any recession would go some distance towards reducing the extent to which affordability is poor, and some of these things that are preventing the next generations from getting into the housing market.
And arguably it’s a good thing just to get out of an ultra-low interest rate environment. Strange decisions get made, distortions occur when interest rates are extremely low. And so arguably not a good place to be, and it seems as though we might manage to escape from in particular negative rates in, say, a European context. And so I think that’s a good thing too. So not celebrating recession, but saying there could be several helpful things that happen if there were to be one.
Let’s talk U.S. politics just briefly. And so midterm elections are coming up in early November. That’s just a few months away at this juncture. President Biden, a Democrat of course, is unpopular right now and that’s not helpful for his party.
Up until recently, up until late July, markets had expected a sweep for the Republicans. They thought the Republicans were going to win the Senate and the House of Representatives. That’s changed a little bit. The markets still say that Republicans are likely to win the House of Representatives. There’s a 79% chance assigned by one particular pundit.
But in terms of the Senate, now the thinking is the Democrats are a little bit more likely. They’ve got a 60% chance. Now both of those numbers could yet change many times over the next few months. So this is not ironclad whatsoever. But nevertheless it might actually be a split outcome, which is interesting.
And in the end I suppose it looks as though a divided Congress is likely. Even if the Republicans won the Senate as well, you’d have, of course, division in the sense that the White House would still be Democrat. And so little legislation is likely over the next few years. That’s still a constant. I should financial markets don’t mind a divided Congress. In general, markets are fearful of big policy changes that could upset their business plans and that’s less likely in this context.
And let me finish with some demographic thoughts. And so United Nations have come out with their latest long-term population projections and there are some interesting things in there. To begin with, they continue to expect population growth to slow going forward as fertility rates continue to fall. So nothing really new there.
They acknowledge that 2020 and 2021 were particularly bad for population growth. So partially that was pandemic-related deaths, both directly and indirectly. Partially that was lower fertility rates over those few years, also perhaps in part due to the pandemic.
But the bigger story is one in which they’ve significantly revised downward their long-term population projection. They now expect around half a billion fewer people by the end of the century. They are now seeing a peak of just over 10 billion people around that time frame and previously it was well above that. So that’s a significant change.
Most interestingly, their prior forecast just three years ago was for the population to continue growing beyond 2100, beyond their forecast horizon. They now have the population peaking in 2080. So there is a population peak in sight. We happen to think they’re still overestimating the numbers and chances are they will have to revise that down again, so maybe we never quite get to 10 billion. Maybe the peak happens a little bit before 2080. But nevertheless, the basic idea here is one in which credibly the world’s population could well be peaking. And so, of course, that’s a good thing from an environmental perspective. Maybe from a food supply perspective. Perhaps from a quality of life perspective. Maybe not quite as good from an economic growth or stock market return perspective, since more people have to buy more things. So there’s good and bad to that as well.
And then just digging into the composition for a moment, I can say that the big trend is one in which, well, to begin with, developed countries have never been all that large a fraction of the total but they become a smaller fraction, including in North America and in Europe.
Asia right now with 60% of the world’s population, it shrinks to 45% because fertility rates are extremely low there. People think of Japan as being the low fertility rate country. It’s actually one of the higher ones in at least the wealthy Asian markets. South Korea is much, much lower. China’s in the same vicinity. Taiwan is lower. Singapore is lower. Fertility rates are extremely low to the point that in places like Korea each generation should have half the population of the prior generation, which is hard to fathom. So Asia loses influence but remains quite big.
Africa’s the real story though. And so Africa goes from being 17% of the world’s population today to 38% by the end of the century. So more than a doubling. Not quite catching Asia, but you can extrapolate out and say they probably catch Asia not far into the 22nd century. And so quite a change. The next century certainly is the African century, it would appear.
And I’ll stop there. Hopefully you found this useful and interesting. And thanks for sticking with me. Please consider tuning in again next time.