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by  Eric Lascelles Apr 25, 2023

What's in this article:

Banking stress

Six weeks after the failure of two U.S. regional banks, there remains a degree of stress in the banking system. Deposits fled the system and have not yet significantly returned (see next chart).

U.S. bank deposits drop while borrowings soar

As of the week ending 04/12/2023. Source: Federal Reserve Board, Macrobond, RBC GAM

Demand for emergency loans from the U.S. Federal Reserve has mercifully begun to decline. Usage by financial institutions remains elevated, however (see next chart).

Emergency lending to banks by Fed soared amid latest bank failures

As of the week ending 04/20/2023. Source: Federal Reserve Bank, Macrobond, RBC GAM

As for the level of concern in financial markets about banks in general – as to whether they will be able to repay their debt, and so on – this has significantly eased. It was never anything like the level of concern expressed about banks during the global financial crisis of 2008-2009 (see next chart).

U.S. funding stress eases after initial surge amid banking turmoil

As of 04/19/2023. Spreads between forward rate agreements and overnight index swaps. Source: Bloomberg, RBC GAM

All the same, many banks nevertheless lost a significant sum of money on their bond holdings as interest rates rose. Combined with the outflow of deposits, they are less liquid and more capital-constrained than normal. Banks were already sharply tightening their lending standards before this episode of acute stress (see next chart), and the risk-aversion afterward will only increase it.

U.S. business lending standards are tightening for all firms

January 2023 Senior Loan Officer Opinion Survey on Bank Lending Practices. Source: Federal Reserve Board, Macrobond, RBC GAM

Accordingly, the level of U.S. commercial industrial loans has now transformed from a slightly decrease to a more significant drop (see next chart).

Early sign emerges of ebbing U.S. credit growth

As of the week ending 04/05/2023. Source: Federal Reserve, Macrobond, RBC GAM

This decline may not be over. A sharply rising fraction of U.S. small businesses now expect tighter credit ahead (see next chart).

Small businesses expect harder credit conditions

As of March 2023. Shaded area represents recession. Source: National Federation of Independent Business, Federal Reserve Bank of St. Louis, Macrobond, RBC GAM

The recently released U.S. Beige Book confirms that lending and loan demand declined for both businesses and consumers in recent months. While several regions of the country reported tighter lending standards due to greater uncertainty and liquidity concerns, the New York region reported that conditions “deteriorated sharply.”

It is primarily via this channel of more constrained bank credit that economic damage should be expected. Because borrowing conditions in the corporate bond market have remained more normal, the disproportionate economic damage should accrue to bank-reliant mid-sized and smaller businesses rather than larger firms. This reduces the implications for stock- and bond-market investors, though second-round effects should still impact larger entities.

From a timing perspective, it is not unreasonable to think that some of this new chill cast upon regional U.S. banks will persist for years:

  • Depositors are now fundamentally more skittish given a greater alertness to banking sector risk and a technologically driven decline in friction when moving money between banks.
  • The novel preference for the relative stability of larger financial institutions seems likely to last. The preponderance of small American banks was never completely logical, eschewing economies of scale and resulting in outsized exposure to small regions of the country and particular sectors.
  • The higher interest rate environment makes zero-interest chequing accounts – the cheapest source of bank funding – significantly less popular.
  • It is clear that smaller U.S. banks are about to be regulated more heavily to avoid future missteps. This will reduce their regulatory advantage, cut their profitability and pare their ability to lend.

A diminished ability to lend will further reduce the clout of smaller banks, with problematic implications for the commercial real estate sector and smaller business clients in general. A recession in the near term would further challenge such banks (and a wide range of other economic actors).

It remains to be seen how problematic this all proves to be. At the negative end of the spectrum there could be parallels to the U.S. savings and loan crisis that spanned a full decade, from 1986 to 1995. Nearly a third of such institutions failed in that period.

Economic developments

U.S. hangs on

The overall economic story remains familiar. Economic data is mostly hanging on despite a variety of recessionary headwinds blowing. But not all is perfect.

Some labour market indicators have been weakening, discussed shortly. The latest Beige Book revealed little change in overall U.S. economic activity, but a deceleration in consumer spending, manufacturing activity, transportation & freight volumes, and in non-residential real estate.

U.S. retail sales for March fell by a sharp 1%, only the latest in a string of choppy figures that leave the inflation-adjusted trend in retail sales and consumer spending advancing less forcefully than in the past (see next chart).

U.S. consumption is decelerating

Personal consumption as of February 2023, retail sales as of March 2023. Source: U.S. Bureau of Economic Analysis (BEA), U.S. Bureau of Labor Statistics (BLS), U.S. Census Bureau, Macrobond, RBC GAM

China’s recovery still on

China’s economy is recovering after three years of recurring lockdowns, but the precise rate of improvement is subject to debate. It feels like every month the narrative flips from a rapid acceleration to a slower one, and then back again. The latest data has skewed in the more optimistic direction.

As an example, China’s traffic congestion index has again surged, after a substantial drop over the prior month and a leap higher in the one before (see next chart).

Chinese traffic congestion index surges again

As of 04/19/2023. Congestion index measured as 7-day moving average of weighted average of daily peak congestion levels and number of vehicle registrations in 15 cities with highest number of vehicle registrations in China. Source: Baidu, BloombergNEF, RBC GAM

The country’s first-quarter Gross Domestic Product (GDP) print also arrived, with a 9.1% annualized rate of increase (see next chart). That reflects the sudden reopening of the economy, with slower quarters presumably ahead. Chinese exports also substantially exceeded expectations in the latest month. Exports have now returned to growth on a year-over-year basis after five consecutive months of decline.

Chinese economy revives after end of zero-COVID policy

As of Q1 2023. Source: China National Bureau of Statistics, Macrobond, RBC GAM

Our own take on the debate remains that a moderate recovery is most likely in store for China. The country was not actually comprehensively locked down for long, limiting the magnitude of the subsequent recovery. The sum of Chinese household savings accumulated during the pandemic is significant but not especially impressive relative to other countries. Still, some form of recovery is underway and should power China forward at a time when most countries are set to slow. China is therefore set to provide a welcome global counterbalance.

However, again, the scale of China’s contribution to global growth may not be what it once was. Whereas each additional percentage point of Chinese GDP growth normally spills over to the rest of the world in the form of an additional 0.3 percentage points of growth, the International Monetary Fund (IMF) speculates that the boost may only be a third as large this time due to the internal focus of the recovery.

Labour supply revival

The supply of available workers fell sharply during the pandemic, depressed by illness, fear of infection, inadequate childcare, generous government transfers and surging household wealth (as stock markets soared and home prices roared early in the pandemic).

Even as the pandemic itself receded and some of these motivations faded, the supply of labour revived reluctantly and only partially. Yes, hiring surged and unemployment rates tumbled, but the labour force participation rate – the fraction of the population either working or desirous of work – was still well short of the pre-pandemic rate.

Right when nearly everyone had given up hope that these missing workers would ever return to the labour force, they began to trickle back in 2022 and now 2023 (see next chart). The labour force participation rate for the U.S. is still short of the pre-pandemic level, but the gap has been massively reduced. The U.S. labour force participation rate was 63.4% before the pandemic, fell to just 60.1%, and is now back to 62.7%. The 0.7 percentage point shortfall that persists is actually just 0.5 percentage point when one adjusts the participation rate for demographic factors (the aging population organically reduces the “normal” participation rate over time).

U.S. participation rate continues to rise

As of March 2023. Demographically adjusted rate assumes the same population composition since January 2007. Source: Haver Analytics, RBC GAM

Incidentally, and again on a demographically adjusted basis, the U.S. labour force participation rate has also nearly returned to its pre-global financial crisis level. This is remarkable, as there was a lengthy period from 2009 to 2016 when this participation rate steadily declined. This occurred despite reasonable economic growth and in a way that suggested structural depressants were at work (refer again back to the prior chart).

The recent leap in the labour force participation rate is quite important in that it has prevented the job market from further overheating despite a year of robust hiring. Put more simply, the demand for labour rose quickly, but the supply of labour unexpectedly kept pace. People were presumably pulled back in by diminishing household savings, shrinking retirement account valuations, falling home prices, ebbing pandemic fears, strong wage growth (at least in nominal terms) and the plethora of jobs available.

In turn, the U.S. economy is not significantly tighter than a year ago. Among other things, this means that central banks are not as far behind the curve as one might first imagine if told that another 2.6 million workers had been added to payrolls over the past 12 months.

More strikes?

It would seem logical for there to be more strikes than normal right now. The labour market is tight, increasing the clout of workers, and inflation-adjusted wages have recently declined due to high inflation.

The U.K. has certainly had a large number of strikes recently, spanning rail workers, doctors and nurses, teachers, the civil servants of 124 government departments and so on.

A large fraction of Canada’s federal civil servants has also recently gone on strike.

Despite this, the number of work stoppages in North America remain fairly tame by the standards of prior decades (see next chart, though note that the data is somewhat stale for Canada and excludes the recent civil service strike). It could be that the amount of striking rises from here, but so far it is only moderate despite well over a year of labour market tightness.

Number of work stoppages remains low in U.S. and Canada (recent civil service strike not reflected yet)

Canada as of January 2023, U.S. as of March 2023. Canadian work stoppage data includes those with 10 or more person-days not worked. U.S work stoppage data includes work stoppages involving 1,000 or more workers. Source: StatsCan, U.S. BLS

A back-of-the-envelope effort to quantify the economic impact of Canada’s brand-new government strike starts with the observation that about 100,000 non-essential workers are striking, or about 0.5% of the Canadian workforce. Presuming an average level of productivity and a strike that lasts a month, this would subtract just 0.04% from the amount of annual economic output – a small sum. That understates various second-round effects arising from missing government services and the altered behaviour of poorer government workers. On the other hand, any decline should be fully recovered as soon as the strike ends. There may even be a catch-up effect as the government scrambles to work through any backlogs.

Softening job market

While hiring has been good, we continue to see signs of burgeoning weakness at the edges of the labour market. The temporary employment share of the workforce is falling, as is the quits rate and the level of job openings. Indeed, alternative measures of job openings to the standard JOLTS survey argue that job openings have fallen even more substantially than generally imagined over the past year. These sources include data published by Indeed, LinkUp and ZipRecruiter.

Meanwhile, U.S. jobless claims continue to inch higher, reaching 245,000 new claims in the latest week. That’s a 26% increase relative to early 2023 (see next chart).

U.S. jobless claims have been inching higher

As of the week ending 04/15/2023. Source: Department of Labor, Macrobond, RBC GAM

We now monitor two different measures of mass layoffs. One is rising more sharply than the other, but both are starting to increase. This is traditionally a precursor to economy-wide job losses and recession (see next chart).

U.S. mass layoff announcements and announced job cuts are rising

As of March 2023. Worker Adjustment and Retraining Notification (WARN) Notices for larger states: California, New York, Florida, Texas, Illinois, Pennsylvania, Ohio, Maryland, Washington and Virginia. Shaded area represents recession. Source: openICPSR, Challenger, Gray & Christmas, Federal Reserve Bank of St. Louis, Macrobond, RBC GAM

Emerging market debt distress

When interest rates rise substantially, various pockets of borrowers and investors feel distress (see the next table for areas of realized and potential vulnerability).

Higher interest rates affect many borrowers and investors

As of 04/21/2023. Source: RBC GAM

Emerging market (EM) borrowers are among this group of adversely affected parties. Not only have borrowing costs risen, but investors have become somewhat more risk averse.

China’s growing status as a lender to developing nations also complicates matters. Once upon a time, the world’s lenders would get together under guidance from the International Monetary Fund (IMF) and agree upon an appropriate haircut to a distressed country’s debt. But China wants the IMF and World Bank to write down their own portion of the lending, which has never happened before. More generally, China is reluctant to accept haircuts on its portion of the debt.

In turn, lenders from the rest of the world are disinclined to indirectly reward Chinese lenders by accepting larger haircuts on the share of the distressed debt that they hold. This has prevented the quick and reasonably tidy resolution of distressed EM debt that normally occurs.

Some of the recent headlines about EM debt woes have been hair-raising. The Economist magazine describes this as “the largest debt crisis since the 1980s” (as judged by the share of the world’s population affected). The IMF’s managing director notes that almost half of low-income countries are in danger of falling into a state of “debt distress,” with about 15% already there.

Notable affected countries include Pakistan, Ghana, Sri Lanka, Malawi, Mozambique, Zambia and Grenada. There are at least 21 countries in total, home to 718 million people. The collective debt stands at approximately US$1.3 trillion. Debt payments as a share of government revenue for the world’s poorest countries has reached the highest level since 1998 – an ominous year.

All of this is set to depress the near-term economic growth of the world’s poorest developing nations.

However, from an EM bond investor’s perspective, the implications appear to be less severe than one might first guess. The standard EM bond index is skewed toward the largest and richest countries, which are encountering less distress. The EM defaults that have already occurred represent just 1% of the market cap.

If one adds to this the 10 additional countries in the index that are in “distress” (a spread of greater than 1000 basis points), one still only reaches 2.7% of the market cap. Given that the recovery rate on any default is considerable, the theoretical losses are well under 2.7% of the portfolio. The EM bond credit spread more than compensates for this risk. Indeed, these issues are well understood and priced by the market.

Revisiting yield-curve recession models

The yield curve is a classic tool for predicting recession. When the curve has flattened so much that long-term yields are below shorter-term ones, that is a classic recession signal. Whether one cares to look at the 2-year—10-year curve, the 3-month—10-year curve or some other part of the curve, these are all inverted for the U.S. today. In turn, the New York Fed’s yield-curve based recession model now flags a high probability of a recession (see next chart).

Yield-curve based U.S. recession risk skyrockets

As of March 2023 for NY Fed model, RBC GAM estimates as of 04/19/2023. Probabilities of a recession 12 months ahead estimated using the difference between 10-year and 3-month Treasury yields. Shaded area represents recession. Source: Federal Reserve Bank of New York, Haver Analytics, RBC GAM

But the yield curve has lately begun to steepen back up somewhat (see next chart). Does that mean the risk of a recession is now starting to fall?

U.S. Treasury spreads narrowed on bank turmoil

As of 04/21/2023. Shaded area represents recession. Source: Federal Reserve Board, Macrobond, RBC GAM

Not necessarily. While a flattening yield curve is the classic predictor of recession, this is only true from a distance of several quarters. When a recession is truly close at hand, the yield curve then starts to steepen as the market prices imminent rate cuts at the short end.

So should the recent steepening of the curve be interpreted as a reduced recession risk or as the imminent arrival of a recession?

We are inclined to vote for the latter because it has manifested as a bull steepener rather than a bear steepener. A bull steepener refers to a steepening curve while yields are falling – consistent with rate cuts getting priced at the short end and risk aversion being priced more generally. A bear steepener involves rising yields, which would usually happen if the economic outlook were suddenly improving.

The main message is that a steepening yield curve doesn’t invalidate the recession call. To the contrary, it may actually strengthen the call, as bull steepening tends to immediately precede the recession itself. We continue to assign an 80% chance to a U.S. recession over the next year, with the second half of 2023 the most likely timeframe.

Inflation cooperating

We are feeling pretty good about our forecast that inflation falls slightly more quickly than assumed by the market.

Despite some wobbly periods, inflation has cooperated more often than not over the past eight months. For example:

  • U.S. headline Consumer Price index (CPI) fell from 9% year-over-year (YoY) to 5%.
  • Canadian inflation fell from 8% to 4%.
  • Eurozone inflation fell from 11% to 7%.

The U.K. has had a somewhat rockier road, but now appears to be declining as well. In the case of the U.S. and Canada, inflation is now more than half of the way back to normal.

Furthermore, based on what we believe are reasonable projections for each major sector over the next three months, we anticipate that both U.S. and Canadian inflation will be down to approximately 3% YoY in June. That isn’t yet normal – 2% is – but it is within shouting distance of normal. It represents a radically different inflation regime than when inflation was in the realm of 8-10%.

There is no guarantee around these figures, of course. Prominently, if the Ukraine does mount a counter-offensive imminently, then there are risks to the price of energy.

But we believe the underlying assumptions are reasonable. Shelter inflation should peak around the middle of this year based on historic lags. Food inflation is finally turning, and the sheer breadth of inflation has narrowed significantly lately (see next chart). Illustrating this, the fraction of products in the consumer basket rising at 10% per year or more has collapsed from 31% of the total in September to just 19% in March.

High inflation in the U.S. is quite broad, but finally narrowing

As of March 2023. Share of Consumer Price Index (CPI) components with year-over-year % change falling within the ranges specified. Source: Haver Analytics, RBC GAM

Tentative Canadian housing recovery

Canada’s housing market has recently staged a tentative rebound. After a long and severe decline, home prices have risen for a few months (see next chart). Resale activity is incrementally higher as well (see subsequent chart).

Canadian home prices are rebounding across markets

As of March 2023. Source: Canadian Real Estate Association, Macrobond, RBC GAM

Canadian home sales rise slightly

As of March 2023. Source: CREA, Macrobond, RBC GAM

The question is whether this is the beginning of a genuine recovery or merely a seasonal blip.

The arguments for a genuine recovery are that the rebound in prices was not a sudden development. Rather, it was the logical culmination of a gradual process in which home prices declined less and less quickly, then stabilized, and then started to rise.

This did not come out of thin air. Structurally, Canada suffers from a housing shortage. The population is growing rapidly due to high immigration, while builders are not coming close to keeping up with the resulting demand.

Conversely, the argument that this is a mere seasonal blip centers around three observations:

  • It is normal for housing markets to heat up in the spring, which is precisely what has happened.
  • The supply of homes for sale is still quite low, such that home prices may be rising artificially due to this temporary constraint.
  • Most fundamental of all, affordability is still quite poor and only getting worse. Something like 1.5% of Canadians with mortgages roll into a markedly higher rate each month.

It is a tough call, but we think the odds tilt more toward the latter set of arguments. We don’t forecast a return to the rapid price declines of last year. Instead, we look for an ongoing housing malaise for some time in which home prices are closer to flat on a nominal basis (and falling slightly in real terms). Housing market corrections normally take several years to play out, not a mere handful of quarters. It is hard to imagine the housing market completely shrugging off extremely poor affordability.

Fiscal burden

We tackle two intertwined fiscal matters here:

  1. The fiscal impulse for 2023.

We estimate this using a model that calculates the (weighted) lagged change in the structural fiscal balance over the prior three years. On this basis, most developed countries should continue to experience a moderate fiscal drag in 2023. In plain language, governments may still be spending enthusiastically, but most are doing so to a considerably lesser degree than over the prior few years – and that’s what matters for the economic impact.

There are exceptions. The Canadian fiscal drag for 2023 is quite large given a sharp reduction in the deficit in recent years (despite fairly eager spending in the latest budget). The U.K. is technically set to enjoy a moderate fiscal boost in 2023.

  1. The magnitude of the (mostly) deficits that remain.

The deficits remain even after that fiscal drag has been applied (see next chart). Most countries are still running deficits in the 5-7% of GDP range. This is quite large in an absolute sense, and all the more so given that economies are already operating at or above their full potential.

Significant structural fiscal deficits persist

International Monetary Fund (IMF) projections for year 2023. Source: IMF World Economic Outlook, April 2023, Macrobond, RBC GAM

These deficits mean that the public debt load is racing higher each year, and at a time when the cost of servicing each dollar of debt is already soaring due to elevated interest rates.

The current year is arguably somewhat special. Nominal GDP growth has been quite fast due to high inflation, such that debt-to-GDP ratios are not necessarily much worse than before. But this is a dangerous thing in which to take comfort. That extra inflationary buffer is unlikely to be there in future years, and so the deficits will have to come down.

Countries including Canada, South Korea, Switzerland, Sweden and Ireland are in a good position. But many others, including the U.S., Japan, France and the U.K. have work to do. The math gets trickier for places like Brazil, India and China which either have structurally higher inflation or structurally faster growth rates, both of which make their deficits somewhat more bearable.

-With contributions from Vivien Lee, Thao Le and Aaron Ma

Interested in more insights from Eric Lascelles and other RBC GAM thought leaders? Read more insights now.


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