I suspect I’m not the only one who has accumulated literally tens of thousands of digital family photos and videos over the past decade. No longer having to pay by the picture makes it all too easy to run up the count. What bothers me, though, is that in contrast to the photo albums of old, that would get taken off the shelf from time to time, we never seem to dig into our digital archives in the same way.

A few months ago, I decided to remedy that. For many of the subsequent evenings and weekends, I have been hunched over a glowing PC, renaming files, simplifying a byzantine folder structure, eliminating duplicates and flagging the best images. Dealing with videos proved even harder than with pictures – you have to watch the whole darn thing. In our particular case, there must be over a thousand videos filmed through chain-link fences of children playing baseball. Which one features that inside-the-park homerun? There’s only one way to know!

My bleary eyes are happy to report that I finally finished the project last weekend. And to my delight and relief, we then sat around laughing and reminiscing at the newly exhumed pictures and videos for a good long time.

COVID-19:

The COVID-19 virus has again put fear into the heart of financial markets as the focus shifts from what appear to be diminishing risks within China to rapidly rising risks outside of the country.

In China (see first chart), the daily growth rate of COVID-19 cases has shrunk to just 520 on February 24 – almost six times less than the February 5 peak. The daily growth rate in percentage terms has declined to just 0.7%, the lowest yet recorded. The peak was a gargantuan 85% in late January.

In fact, on a net basis, there are now more Chinese each day being declared newly free of the disease than are acquiring it. Fully 24 Chinese provinces – including the capital and Shanghai – reported no new cases in the latest data. President Xi has now called for a resumption of economic activity. Of course, it is possible that this tentative reset could drive the infection rate back up.

The spread of COVID-19 

Note: As of 2/24/2020. Spike on 2/17/2020 (grey color) due to change in reporting methodology. Source: WHO, RBC GAM

Outside of China

In contrast, the growth rate outside of China is still far from tamed (see next chart). The number of new cases in the rest of the world has set a new record each day, with 2,069 reported on February 24 alone. While the percentage growth rate has declined from its initial highs, it has seemingly become stuck at around +15%/day.

Granted, the disease made its way outside of China with a lag, so it makes sense that it is taking longest to resolve there. Furthermore, China is still host to the great majority of the overall cases. But China’s caseload growth was already beginning to slow after two weeks, whereas there is no sign yet of a peak in the rest of the world.

Increasing COVID-19 global cases (ex-China)

Note: As of 2/24/2020. Source: WHO, RBC GAM

Two issues immediately present themselves as the rest of the world now grapples with COVID-19:

1. While rich countries may enjoy a health care advantage over China, they may lack the ability to mobilize (or in this case, immobilize) their population to the extent that China did.
2. The world’s poorest countries would appear to be very vulnerable on both fronts, to the extent they lack quality health care and also do not possess the tools necessary to quarantine entire populations of people.

Outside of China, several countries are capturing particular attention:

• South Korea has suddenly exploded to 763 cases, with 7 fatalities. The bulk of the cases have now been acquired domestically, rather than via direct travel to China. The country now has 7,000 troops in quarantine after a handful tested positive for the disease. We now assume significant economic damage.
• Until recently, Japan had the highest caseload outside of China, though much of this was from a quarantined foreign cruise ship (695 cases). Nevertheless, even without that group Japan maintains 144 cases and is especially vulnerable – not merely by virtue of its proximity to China, but also due to its large elderly population (the disease disproportionately targets the old and infirm). We assume modest economic damage.
• Iran has been a source of concern since late last week when a Canadian was reported to have contracted the disease in Iran rather than China. The country has since admitted to 43 cases (though the 8 official deaths suggest a considerably larger overall pool of sick people). Iran is now reported to have closed its schools.
• Lastly, and further hinting at the highly contagious nature of the disease and its ability to seemingly pop up nearly anywhere, Italy has suddenly leapt from three cases on February 21 to 124 cases on February 24, with five deaths now reported. These are clustered within a region of 10 towns not far from Milan. Italy is attempting to impose a strict quarantine.

Disease parameters

COVID-19 continues to operate according to our initial expectations. The fatality rate remains in the range of 3% (2,595 deaths out of 77,262 confirmed cases in China). And, it has proven highly contagious, as evidenced by the aforementioned cross-section of affected nations.

Perhaps the only twist is the extent to which the fatality rate has thus far proven highly variable. Outside of China’s Hubei province, the fatality rate appears to be considerably less than within it. Furthermore, the virus appears to discriminate aggressively based on age. The fatality rate so far is 0% for young children, just 0.2% for those aged 10-39, and then incrementally rises to a large 14.8% for those aged 80-plus. For those below middle age, it is arguably no more dangerous than the ordinary flu. For the elderly, it is deadly.

Revisiting economic assumptions

Even as the caseload growth in China has slowed, businesses have remained shuttered to an even greater extent than we had initially envisioned. Surveys suggest businesses continue to operate well below their normal capacity a full four weeks since the virus began to significantly impede economic activity. Even though we assume an incremental return to business over the coming weeks, it is hard to see Chinese 2020 GDP growth operating much above 5.0%. This is down from our prior forecast of 5.6%. Absent the virus, we would have forecast 5.9% growth for the year.

At a more detailed level, it seems nearly certain to us that Chinese Q1 GDP growth on a quarterly basis will be substantially negative. There is also a good chance that year-over-year GDP growth will be temporarily negative for the quarter before rebounding in later quarters. The monthly data in January and February will likely be truly terrible, with property sales down by more than 90% already. The Chinese government has already leaped into action with monetary stimulus and improved credit growth, but there is not much that can be done in the near term so long as workers are told to stay home. One reason for our forecast uncertainty is that the Chinese government may not reveal the true depth of the economic weakness.

For the rest of the world, as China slows and as the virus spreads internationally, we have now taken a cumulative 0.4ppt off our global growth forecast – 0.2ppt more than the prior estimate. This leaves global growth expanding at a meek 2.9% in 2020.

A worst-case scenario would have COVID-19 ping-ponging around the world, forcing companies to shutter on a nearly worldwide basis. It is unlikely to be quite that extensive, but the next week will reveal much and containment is no easy task.

Inflation surge:

Inflation has suddenly accelerated in both the developed and emerging world. We will leave the emerging-market story for another week. In the developed world, U.S. year-over-year inflation has now increased to 2.5% in January, and core CPI (Consumer Price Index) has risen to 2.3%. This is a notably increase relative to early 2019 when inflation was running in the range of 1.5%. Canadian headline inflation has now moved up to 2.4% and the country’s three core measures are all at or above the 2% target as well.

To the extent that low unemployment rates prevail nearly everywhere, it could be that this extra inflation represents the long-awaited arrival of inflation pressures.

However, we are doubtful that the situation has truly changed so abruptly. Tight economic conditions remain a less influential force than in past cycles, in part due to a flatter Phillips curve and in part due to the deflationary effect of a slowing and aging population.

There are four further reasons to think that the inflation environment will likely remain benign:

1. Commodity prices have been falling as the COVID-19 virus spreads and begins to impact economic growth.
2. There is a curious pattern of base effects underlying the latest inflation print. The January 2020 jump in U.S. CPI had more to do with a weak month (January 2019) falling out of the annual equation than any new strength in the latest month. Furthermore, our calculations suggest that the natural inclination for U.S. year over year (YoY) CPI will be to settle back down in the coming months, as unusually large increases in February through April 2019 fall sequentially out of the equation (see next chart).

U.S. inflation likely to ease in the short run

Note: As of 2/24/2020. Source: BLS, Haver Analytics, RBC GAM

3. Other measures of consumer prices remain fairly tame. The PCE (Personal Consumption Expenditures) headline and core deflators are both barely above 1.5%, and the U.S. central bank actually pays closer attention to these than to CPI.
4. When we investigate the underlying sources of the inflation, we reach an interesting discovery: it is government-administered prices rather than market-set prices that have risen most aggressively in both the U.S. and Canada (see left side of next chart). This doesn’t make the inflation any less real, but it argues that it isn’t the result of a tight economy and so may prove less enduring.

Inflation scenarios

What scenario would be more problematic for inflation – high or low? Neither is especially desirable. A number in the vicinity of 2% is arguably best from a mix of economic and financial stability perspectives.

Stubbornly low inflation would suggest the undesired advance of Japanification, would provide less room for central banks to deliver economic stimulus, and would risk a deflationary loop.

Conversely, stubbornly high inflation erodes the rate of economic growth, imposes an artificially high real tax rate on investments and can punish stocks and bonds simultaneously.

In our view, the risk of a major inflation surprise extends more toward low rather than high inflation. Market inflation expectations hint that this view is not ours alone.

That said, our base-case forecast is for slightly above-consensus, though entirely benign, inflation. This is based on the view that while the Phillips curve (the relationship between economic tightness and inflation) may be diminished, it is not completely gone. Furthermore, it may hook upwards when economies are extremely tight.

Inflation methodology:

Many people feel that inflation runs hotter than what is officially reported by statistical agencies. Certainly, some people do actually experience higher inflation than others – seniors in particular have suffered from this phenomenon. But for most, it comes down to two main debates around how to measure inflation.

Quality

The first issue is hedonic pricing. When the price of a mobile phone rises, this frequently fails to register as inflation because the quality of the phone has also gone up. Where possible, price indices try to control for how products change over time. With technological items, the quality is often rising at such a rapid rate that quality-adjusted prices are in nearly perpetual decline, whether the item actually costs less money or not.

Housing

The second debate is with regard to how housing is factored into price indices. For most people, their house is both an investment and also something they consume. They hope to someday sell it for a profit, but they also live in it, and this use causes the house to gradually depreciate over time. A consumer price index is only meant to capture things that households consume.

In Canada, a homeowner’s mortgage payment is only partially included in the CPI. The principal payment is excluded because it represents an investment that will be harvested by the homeowner when they later sell. Instead, the CPI includes mortgage interest payments and whatever sliver of the home’s value is deemed to have been “consumed” due to its use that month. Only this last part directly reflects the rising value of the home, and it receives only a 5.1% share in the CPI.

In the U.S., home prices are included via “owner’s equivalent rent”. Homeowners are asked to guess how much they could rent out their home for. Beyond being imprecise, the cost of renting tends to rise less quickly than the price of a home, such that the U.S. measure understates the true costs faced by American households.

European measures of CPI tend to have an even smaller connection to the housing market, to the extent that the new head of the European Central Bank has mused that European inflation may not be quite as low as it looks for this reason.

A third smaller and temporary reason for the mismatch between inflation perception and reality is that items purchased frequently by households are currently experiencing a higher rate of inflation in the U.S. and Canada than are items purchased less frequently (see right side of next chart). Naturally, these high-frequency purchases are more prominent in the minds of households.

Inflation pressures already at or above 2% in some categories

Note: As of Jan 2020. Inflation components of the U.S. (US) and Canada (CA) categorized by RBC GAM. Source: Haver Analytics, RBC GAM.

Remarkably, formal investigations that have looked into the measurement of inflation have concluded that actual inflation is probably running moderately below the official CPI rate as opposed to above it! One reason for this is that the CPI operates with a fixed basket of goods. This is only modified occasionally. To the extent that hot new technologies arrive and then experience rapid deflation as they achieve economies of scale, this downward pressure is missed by the price basket. The U.S. PCE deflator does a better job of integrating new products, and is accordingly running cooler than the CPI.

So who’s right and who’s wrong? In our view, statistical agencies are right that it is important to control for the rising quality of things like cars and electronics, meaning inflation is lower than people think in such areas. However, households have a point that their housing costs are substantially underestimated by CPI. Granted, to fully include home prices would be to distort the meaning of the CPI away from that of a “consumption” price index. But in so doing, the measure would do a better job of capturing the true cost of living encountered by individuals.

Sanders, Sanders, Sanders:

The third U.S. Democratic Primary in Nevada yielded another victory for far-left candidate Bernie Sanders. He has now captured the most delegates in two of the three states. While he failed to capture the most delegates in the third state, he did win the popular vote there, too.

With 47 states left, only a trivial fraction of the delegates have been awarded, such that the race could yet pivot. However, the historical precedent is that the first few states normally correctly divine (and also influence) the views of the broader electorate, such that Sanders now has a very good chance of capturing the Democratic nomination (see next chart). Betting markets have assigned a large 62% probability of a Sanders victory, nearly five times higher than for any other candidate. Trailing in second is centrist Mike Bloomberg, despite the wounds he suffered in his first debate. He is followed by centrist Joe Biden who has badly underperformed at every opportunity so far, but isn’t quite done yet.

Who will win the Democratic presidential nomination?

Note: As of 2/23/2020. Based on prediction markets data and RBC GAM calculations. Source: PredictIt, RBC GAM.

The next primary will be held on February 29 in South Carolina. It should further reveal the extent to which each candidate can expect support from a more diverse electorate. Following closely on its heels will be the aptly named “Super Tuesday” on March 3, which will be make-or-break for most candidates.

Notably, financial markets have expressed trepidation about Sanders given his promise to raise taxes and more tightly regulate large businesses. However, this fear has thus far been contained by the fact that as Sanders has risen in the polls, the prospect of the Democratic nominee gaining the White House has fallen. This is a roundabout way of saying that markets now believe President Trump enjoys a 12ppt probability advantage over the Democratic nominee in the race for the White House (see next chart). While markets have mixed feelings about Trump, they remain grateful for the tax cuts delivered in his first term.

Status quo after 2020 election?

Note: As of 2/23/2020. Source: PredictIt, RBC GAM

Also notable in the latest figures is that betting markets are no longer convinced that the Democrats will retain the House of Representatives. It remains more likely than not, but is a substantially closer race than before. As such, our longstanding claim that Congress should remain divided is now in some doubt. There is a scenario in which Republicans sweep all three offices.

Canadian rail blockade:

Protests related to the recent approval of a natural gas project blockaded a main Canadian rail line for more than two weeks. The police are now intervening, potentially bringing the episode to an end.

The temporary halting of passenger and freight transportation may have a small negative effect on the Canadian economy in the first quarter. Given the duration of the outage, Canada’s Q1 annualized GDP could lose between 0.2% and 0.3%. Layered on top of an already timid quarter, this could leave overall Q1 annualized growth at little more than 1.0%. That said, mild winter weather may help to mitigate the damage.

Business-level disruptions have included temporary layoffs by rail companies and limited reports of shortages of some products such as propane.

Any damage from the blockade should unwind fairly quickly, to the extent that delayed shipments are restarted and depleted inventories rebuilt. It is unlikely that there will be a visible effect on overall 2020 Canadian growth.

From a medium-term perspective, Canada’s bigger issue is its poor economic competitiveness. In addition to notably higher tax rates than the U.S., the regulatory environment appears to greatly limit Canada’s ability to get infrastructure and resource projects off the ground. In what is perhaps a sign of the times, Teck Resources has just cancelled a long-awaited oil sands project.

- With contributions from Vivien Lee and Graeme Saunders