Our latest monthly economic webcast is now available, entitled “Anxiety about tighter monetary policy”.
This week’s note covers the latest COVID-19 trends and considers long-term scenarios for the pandemic. It then evaluates the economic damage – or lack thereof – from the Omicron wave. We then briefly review the latest developments from supply chain, inflation and geopolitical perspectives, before assessing the business cycle and central bank developments.
Broadly, there have been more positives than negatives over the past few weeks. Positives include:
- COVID-19 cases continue to fall across the developed world. They are also now declining among emerging markets.
- The U.S. economy performed surprisingly well during the Omicron wave in January.
- There are anecdotal reports of improving supply chain conditions.
- Inflation seems likely to peak over the next few months.
- The risk of a Ukrainian invasion has fallen somewhat.
Conversely, negatives include:
- The business cycle continues to march forward.
- Central banks have maintained a hawkish footing.
- The Canadian economy suffered during the Omicron wave.
Happily, COVID-19 infections are now moving lower not just in the developed world but also among emerging markets (see next chart).
COVID-19 emerging markets vs. developed markets
As of 02/04/2022. Calculated as the 7-day moving average of daily infections. Source: WHO, Macrobond, RBC GAM
Accordingly, the fraction of countries reporting rising cases has plummeted from nearly 90% at the start of the year to just a third today (see next chart).
Countries reporting rising daily new COVID-19 cases
As of 02/04/2022. Change in cases measured as the 7-day change of 7-day moving average of daily new infections. Source: WHO, Macrobond, RBC GAM
Among individual nations, both U.S. and Canadian infections have fallen palpably. In the U.S., for the first time since the onset of the pandemic, every single state is recording a declining infection rate (see next chart).
Number of U.S. states with transmission rate above key threshold of one
As of 02/06/2022. Transmission rate calculated as 7-day change of underlying 5-day moving average of new daily cases, smoothed with 7-day moving average. Transmission rate above one suggests increasing new daily cases. Includes Washington, D.C. Source: Haver Analytics, Macrobond, RBC GAM
However, some countries are bucking the improving trend. Among emerging economies, Iran, Russia, South Korea, Poland and Brazil have all experienced a significant further deterioration.
In the developed world, Germany, Australia and Austria are all still recording increases. Japan’s deterioration is particularly extreme – the country is now reporting nearly four times more cases per day than its prior record. For the most part, these countries are simply encountering the Omicron variant later than elsewhere.
The U.K. is in a curious situation at the moment. Its infection rate has declined substantially from its peak, but is now stuck at a still-high level (see next chart). It isn’t entirely clear why – possibly this reflects the arrival of the BA.2 sub-variant. To the extent the U.K. remains a bellwether for other nations, this could mean that the current wave does not resolve quite as neatly as commonly imagined. Recall that South Africa – which has enjoyed a sharp decline in infections after its initial encounter with Omicron – has been helped by the fact that it is summer there.
COVID-19 cases and deaths in the U.K.
As of 02/04/2022. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM
Alternate measures of the pandemic confirm the improvement across a range of countries. The test positivity rate for the U.S. is finally in serious decline (see next chart).
COVID-19 cases and positivity rates in the U.S.
As of 02/04/2022. 7-day moving average of daily new cases and test positivity rates. Source: Our World in Data, WHO, Macrobond, RBC GAM
Hospitalizations are now improving in several countries, including in the U.S., U.K., Canada and Israel (see next chart). Finally, measures of COVID-19 concentration in wastewater are mostly improving as well.
COVID-19 hospitalizations in developed countries
Based on latest data available as of 02/06/2022. Source: Our World in Data, Macrobond, RBC GAM
The next variant
We continue to monitor the BA.2 sub-variant, which has 27 mutations not found in its Omicron ancestor. It seems likely that the sub-variant will eventually receive a Greek name of its own, with “Pi” the next available letter in the alphabet.
BA.2 has now been detected in 57 countries, up from the 40 countries reported two weeks ago. The sub-variant is somewhat harder to identify than Omicron, meaning the true count may be considerable higher. It is now the dominant variant in Denmark, India and South Africa.
Whereas initial research had suggested BA.2 could be twice as infectious as Omicron, more recent research has downgraded that to 34% more infectious than Omicron. Still, this argues the sub-variant should become the dominant variant globally over time.
It is unclear whether BA.2 can evade immunity better than Omicron. Some studies argue yes. Others indicate it behaves similarly to Omicron (which, it should be noted, is highly capable at evading pre-existing antibodies).
A promising piece of news is that in each of Denmark (see next chart), India and South Africa, the infection rate is now flat or declining. As such, BA.2 is apparently not guaranteed to spur a further large wave in every country. A rising level of immunity via vaccination and antibodies developed from Omicron infections may help to explain this. The hospitalization rate has not moved significantly in the most affected countries. But the day is still young for this variant.
COVID-19 cases and deaths in Denmark
As of 02/04/2022. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM
On the subject of vaccinations, the world recently delivered its 10 billionth inoculation. This is a momentous achievement in not much more than a year -- if not one capable of delivering herd immunity. Alas, the pace of vaccinations has slowed sharply recently after having surged in December and January in response to Omicron fears (see next chart).
Coronavirus vaccine daily doses administered
As of 02/06/2022. 7-day moving average number of new daily coronavirus vaccine doses administered per million. Source: Our World in Data, Macrobond, RBC GAM
Long-term pandemic outlook
The long-term pandemic outlook is unavoidably murky. One need only reflect back on the woeful predictions made in prior years.
Two years ago – in the first quarter of 2020 – the widespread expectation was that countries would lock down for around six weeks and in so doing eradicate the virus much as China had. But it turned out that the rest of the world had far more porous mobility controls and so this goal proved elusive.
A year ago – in the first quarter of 2021 – the widespread expectation was that then-new vaccines would rapidly lift the world (or the developed world, at any rate) to herd immunity. This would eradicate COVID-19 and allow a complete return to normality by the second half of that year. This was entirely realistic at the time, requiring only around 65% of a country’s population to be inoculated.
But then the mutations began, ultimately creating variants so much more contagious that a 100% vaccination rate would not deliver herd immunity (given that each vaccination is less than 100% effective).
Today, it seems reasonable to imagine that the combination of vaccine boosters plus a high level of Omicron-induced natural immunity should significantly limit future waves, diminishing the effect of the pandemic on lives going forward. But this prediction could prove as incorrect as those of the prior two years, depending on the circumstances.
In optimistic scenarios, the virus could mutate in a milder direction, ultimately becoming irrelevant. Or there could be limited, sporadic flare-ups that quickly fizzle due to a high level of population immunity.
In more moderate scenarios, COVID-19 could generate an annual wave as acquired immunity decays over time and seasonal fluctuations alter the transmissibility of the virus, not dissimilar to the flu. Or, given its highly infectious nature and capacity for rapid mutation, there could be multiple seasonal waves each year – an unfortunate development, but not one requiring a permanent alteration of human life.
In the most pessimistic scenarios, the rapid rate of COVID-19 mutation could undermine the immunity achieved so far, regularly sending the world back to square one and forcing scrambles for new vaccines and periods of significant caution; and/or the virus could mutate in a more deadly direction, requiring enduring precautions.
These worst-case scenarios could, in turn, be dampened by some combination of antiviral drugs (such as the recently announced Pfizer offering, which targets a part of the virus that doesn’t seem to mutate) and pan-coronavirus vaccines. These vaccines could protect against any number of future variants, of the sort undergoing testing in the U.S. already.
In short, while it seems reasonable to expect COVID-19 to have incrementally less effect on day-to-day life over the coming year(s), the actual situation could prove slightly better or significantly worse than this.
Several of the countries setting new infection records, such as South Korea and Russia, are imposing additional restrictions on their populations. However, the trend is mostly in the opposite direction – consistent with declining infections (see next chart).
Severity of lockdown varies by country
Based on latest data available as of 02/04/2022. Deviation from baseline, normalised to U.S. and smoothed with a 7-day moving average. Source: Google, University of Oxford, Macrobond, RBC GAM
Key economic themes
U.S. economic health during Omicron
Recent U.S. economic data for January finds that the Omicron damage was surprisingly slight.
A remarkable 467,000 net new workers were hired in January, better than the most optimistic forecast. Somehow, employment even increased in pandemic-affected sectors including retail, accommodations, and food services and drinking places. Hourly earnings accelerated from 4.9% year-over-year (YoY) to 5.7% YoY.
While not strictly reflective of the Omicron wave, the prior two months were also revised aggressively higher, with an incredible 709,000 additional new jobs uncovered upon closer examination.
Financial markets have not been as enthusiastic as one would normally expect to this development. This is in large part because such strong economic data means that rate hiking is almost certainly imminent.
The country’s twin-Institute for Supply Management (ISM) numbers admitted some softening, but remain healthy. The ISM Manufacturing Index fell by 1.2 points to 57.6 in January, a solid reading. Meanwhile, the ISM Service Index fell by 2.4 points to 59.9, also a robust reading (if not the heights of a few months ago).
Our primary real-time economic indicator conceded some softness in December and early January, but indicates that the recovery is well underway (see next chart).
Economic recovery emerging from Omicron tsunami
As of 01/22/2022. Economic Activity Index is the average of nine high-frequency economic data series measuring the percentage change versus the same period in 2019. Source: Bank of America, Goldman Sachs, OpenTable, Macrobond, RBC GAM
Despite this relative health, U.S. first-quarter gross domestic product (GDP) growth is merely tracking a 0% performance according to the Atlanta Fed’s GDP tracker. This seeming disparity with employment can be reconciled. Even though hiring was quite positive in January, many people were temporarily sick during the month, resulting in a slight drop in aggregate hours worked. Furthermore, a spike in inventory accumulation artificially boosted Q4 2021 GDP to +6.9% annualized, with some give-back likely in Q1 2022 that won’t represent genuine weakness in the quarter.
Canadian economic weakness during Omicron
In contrast, the Canadian economy was hit considerably harder than the U.S by the Omicron wave. Statistics Canada’s real-time local business conditions index fell sharply over the past few months (see next chart).
Business conditions in Canada deteriorated during Omicron wave
As of 01/17/2022. Equal-weighted average of Business Conditions Index of Calgary, Edmonton, Montreal, Ottawa-Gatineau, Toronto, Vancouver and Winnipeg. Source: Statistics Canada, RBC GAM
Simultaneously, Canada’s January employment dropped a massive 200,000 jobs, or 1% of all workers. The decline in total hours worked was considerably worse, down 2.2% due presumably to sick workers. High touch sectors suffered the most, with the decline in accommodation and food services, information, culture and recreation, and retail accounting for nearly the entirety of the job losses. In contrast, goods employment actually rose 23,000 positions in January.
A quarter ago, we felt some trepidation upon learning that the International Monetary Fund (IMF) had a 2022 growth forecast for the U.S. that was nearly 2 percentage points stronger than our own (+5.2% versus +3.5%). What did their staff of 2,400 know that our team of 2.5 didn’t? That answer appears to have been “not much” – the IMF has just slashed its forecast to +4.0%. We’ll admit this still leaves us below consensus and we are even in the midst of shaving another tenth or two off our own forecast. But the gap is no longer quite so glaring. And, it must be emphasized, 3-4% growth still represents an economic recovery.
The IMF also cut its growth forecasts elsewhere. It pared its Chinese 2022 GDP forecast by nearly a percentage point to match our own +4.8% call. It also chopped 0.4 percentage points from its Eurozone forecast.
As a reminder, the following graphic summarizes the key tailwinds and headwinds we consider in generating our own growth forecasts (see next graphic).
Key economic forces for 2022
As at 01/31/2022. Source: RBC GAM
We wrote in the last #MacroMemo that the U.S. household savings rate was no longer elevated. The implication was that the big, free spending boost associated with the conversion of that saving into spending had therefore already come and gone. Despite this, the consumer outlook remains fairly good: hiring is strong, wage growth is accelerating and households have accumulated significant savings.
A further source of strength comes from the financial health of the average household. We have revived an old chart that speaks to this (see next chart). The U.S. delinquency rate on mortgages, auto loans and credit cards are all nicely declining and fairly low on an absolute basis. It will be important to watch these measures as interest rates begin to rise, but for the moment they are good.
U.S. consumer loan delinquency rates fell after initial spike
As of Q3 2021. Percent of balance of 90+ days delinquent loans normalized. Shaded area represents recession. Source: Federal Reserve Bank of New York Consumer Credit Panel/Equifax, Macrobond, RBC GAM
Perhaps the other key theme for households is the anticipated transition from spending on goods back to services (see next chart). Consumer spending on goods continues to run around 10% higher than normal, with services demand proportionately lower.
U.S. consumer spending on goods to return to pre-pandemic levels eventually
As of Dec 2021. Source: Macrobond, RBC GAM
We are a little bashful about trying to predict this shift with any precision as we had thought a significant transition would occur across 2021, whereas the move was incomplete at best. Nevertheless, it would make sense as restrictions ease and lives return to normal that goods demand be replaced by services demand.
This may have several important implications:
- Supply chain problems should ease significantly as these are primarily a function of an elevated demand for goods.
- Purveyors of goods stand to suffer.
- Purveyors of services stand to benefit.
- This could be quite bad news for the Chinese economy, which has reveled in elevated demand for consumer goods.
A key question is whether the demand for goods falls back to normal or instead undershoots since people have already bought all of the TVs and computers they are likely to need for the foreseeable future. We are inclined to think it does not significantly undershoot as some goods – such as motor vehicles – still enjoy pent-up demand.
Our quarterly U.S. business cycle update has reached the same broad conclusion as a quarter ago: “mid-cycle” (see next chart).
U.S. business cycle scorecard
As at 02/04/2022. Darkness of shading indicates the weight given to each input for each phase of the business cycle. Source: RBC GAM
However, this statement neglects several important developments. Critically, it is clear that the cycle continues to move forward with unusual haste (see next chart). The “early cycle” claim continues to weaken. The “mid-cycle” claim strengthened and is now the clear top choice. The “late cycle” argument also rose.
U.S. business cycle score
As of 02/04/2022. Calculated via scorecard technique by RBC GAM. Source: RBC GAM
As a quick refresher, “mid-cycle” is a benign place to be, associated with solid economic growth and several further years of growth likely. However, the rate of cycle advancement is so fast that this could ultimately be a mere 5-year cycle rather than the 10-year cycles that preceded it. Additionally, risk assets are generally happiest the closer they are to the beginning of a cycle, so this ongoing progression argues for more moderate equity gains in the future.
One of the beauties of our business cycle scorecard system is that it allows for different interpretations from different variables. For instance, temporary employment recently rebounded – normally a signal of an early to mid-point in the cycle (see next chart).
U.S. temporary employment share rebounds
As of Jan 2022. Shaded area represents recession. Source: Bureau of Labor Statistics, Macrobond, RBC GAM
On the other hand, high inflation, central banks that are on the cusp of tightening, and a nearly closed output gap (see next chart) are consistent with a more advanced point in the cycle.
U.S. output gap just about closed
As of Q4 2021. Shaded area represents recession. Source: Congressional Budget Office, Macrobond, RBC GAM
As part of the business cycle update, we also revisit a collection of recession models. Those models indicate that the U.S. is definitely not in a recession right now, with the risk of a recession over the coming year rising but remaining below 10% (see one such model in the next chart). With considerably less rigour (and no hard numbers to support this assertion), we have tended to think the recession risk is a bit higher than this given the uncertainties of a new round of monetary tightening, high inflation, a complicated Chinese outlook and the unresolved pandemic.
The probability of U.S. recession within a year
As of Jan 2022. Based on RBC GAM model which includes financial and macro factors. Shaded area represents recession. Source: Haver Analytics, RBC GAM
Inflation remains very high. We think it can begin to settle down over the next few months. What follows are three supporting arguments.
- Although supply chains remain quite tight, as evidenced by high shipping fees and significant port backlogs, some easing is likely. From a theoretical standpoint, the two periods of peak demand have just passed – Christmas and Lunar New Year – and the first quarter usually experiences significantly less demand than other quarters. All of this gives a chance for supply chains to unsnarl. Simultaneously, anecdotes are building that supply chains are actually improving. Several corporate executives have recently indicated that problems are easing, with further improvements forecast (even in the chips space). Supply chain problems have been a big driver of inflation, and any resolution should not just cease to exert an upward pressure but have a deflationary influence.
- The real-time inflation metrics we track have ceased to rise and are actually edging slightly lower. Further, for the U.S., these indicate that inflation should actually be closer to 4% than the current 7% reading. Admittedly, Japan is the reverse – reported inflation is lower there than the real-time metric uncovers.
- While there are some similarities between the 1970s inflationary backdrop and today, there are significantly more differences (see next graphic):
- The population was very young in the 1970s versus fairly old today.
- Inflation pressures came from a very different source in the 1970s (a negative and corrosive supply shock rather than the positive demand shock of today).
- The gold standard had just been abandoned in the 1970s, whereas there has been no equivalent pivot today. In short, high inflation is less likely to become structural this time.
Inflation: 1970s versus today
As at 01/28/2022. Source: RBC GAM
Quick geopolitical update
Without rehashing the main narrative (refer back to the prior #MacroMemo), the risk of a Russian invasion of Ukraine has arguably slipped a little. Reflecting this, the Good Judgement betting market has reduced the likelihood of a Russian attack from 75% to 65%. We are inclined to continue taking the “under” on this bet, though the risk is admittedly very real.
There are a few matters worth elaborating on.
- The assessment of the likelihood of war by pundits in Russia is apparently lower than it is from the rest of the world. Similarly, the Ukrainian President has indicated he believes the Russian mobilization represents psychological warfare rather than the real thing. Those closest to the conflict are not convinced that war is imminent.
- The Russian stock market has rallied by 7% since January 24, suggesting markets have lowered the likelihood of sanctions being applied after an attack. However, it should be noted that Russian markets remain sharply lower than last fall, and emerging market equities are generally more volatile than their developed market brethren.
- In our last report we expressed the thought that Russian actions may be an effort to restore Russian President Putin’s personal popularity, and that the threat of military action may accomplish this without requiring an actual attack. A recent Russian poll finds that the president’s popularity has now risen from 61% in August to 69% in January. The 61% reading had been the lowest – barring the initial wave of the pandemic – since 2013 (the last time Russia engaged with Ukraine). The 69% reading is a much more comfortable level, toward the higher end of the normal range over the past several years.
U.S. political outlook
It is still a bit early for this, but we nevertheless highlight the approaching U.S. midterm elections scheduled for November of this year.
President Biden’s popularity has fallen quite far (see next chart), in line with diminishing prospects for the Democrats more generally. A mid-January Gallup poll found that there has been a net 14 percentage point shift away from the Democrats and toward the Republicans over the span of 2021 – a massive swing, and one reflected in the outcomes of recent elections in New Jersey and Virginia.
Biden’s approval rating has dropped since being elected
As of 01/28/2022. Source: FiveThirtyEight, Macrobond, RBC GAM
Biden’s low popularity is not unprecedented – Trump was even lower at the same point of his presidency and it is normal for the incumbent party to lose support in the midterm elections. Nevertheless, this makes for what could be a “change election” in November. Indeed, betting markets assign an 80% chance of the House of Representatives turning Republican and a 70% chance of the Senate becoming Republican.
In turn, the subsequent two years of Biden’s term will be seriously constrained from a legislative perspective, though not from a regulatory or foreign policy perspective.
Equally, the midterm election will tell us something about the 2024 election, when the next president will be chosen. American political polarization continues to increase, to an extent simply not seen before (even greater than during the Civil War according to one measure – see next chart). Fears of large-scale political violence or even secession are now regularly articulated in the press.
U.S. Congress partisan polarization intensified
As of 1/27/2022. Measured as the difference between median scores for the Democratic and Republican members in the House of Representatives and Senate. Source: Voteview.com, RBC GAM
A key and largely unanswered question for economists and businesses is the extent to which such discord will impact the economy and financial markets. This is truly hard to say: the U.S. political environment has been messy for at least the past six years and yet markets have regularly reached new highs and economic growth has broadly been good. We have sliced a few tenths of a percentage point per year from our U.S. growth forecasts in response to these chronic issues (on the presumption that some amount of damage is being done to the U.S. social fabric), but this is entirely guesswork.
Hawkish central banks
Developed-world central banks are clearly on a tightening path:
- The Bank of England has already delivered two rate hikes.
- The European Central Bank is no longer promising to keep its own policy rate unchanged over the coming year. The new expectation is that the Eurozone could unwind its negative policy rate over the coming year.
- Recent meetings from the U.S. Federal Reserve and the Bank of Canada didn’t yield rate increases, but these appear quite close.
U.S. Federal Reserve
In the U.S., the Federal Reserve and financial markets appear to have settled upon a March rate increase (see next chart). Supporting this view, the Fed indicated that inflation is “well above” its target, and that “labour market conditions are consistent with maximum employment.” Further, Fed Chair Powell indicated the economy is much stronger than it was at the start of the last tightening cycle in 2015, and that “there’s quite a bit of room to raise interest rates without threatening the labour market.”
Market expectations of Fed hikes over time
As of 01/28/2022. Source: Bloomberg, RBC GAM
Consequently, the Fed hinted that the pace of tightening could be somewhat steeper than prior cycles, with the implication that rate increases won’t necessarily be spaced at every second meeting. Indeed, financial markets now price in just over five 25-basis point (bps) rate increases by the end of 2022. Some have even gone so far as to argue that the Fed could raise rates by 50bps in a single leap, with markets pricing 35bps of tightening for the March 16 decision – more than a single 25bps increase.
At this point, a 50bps increase feels needlessly bold when two 25bps rate increases in fairly short succession could accomplish the same thing without the shock to markets and the economy. Nevertheless, the Fed does seem to be in somewhat of a hurry.
As we discussed in the prior #MacroMemo, there is reason to think this round of Fed tightening (and indeed, tightening by the world’s central banks more generally) carries some risk with it given how long rates have now been at zero, the aggressiveness of the planned tightening, the fact that the tightening is in response to high inflation more than strong growth, and the fact that central banks probably should have been responding to high inflation over the second half of 2021.
Bank of Canada delayed
The Bank of Canada was certainly hawkish in the sense that it lined itself up for an imminent rate increase on March 2. However, it defied expectations in the sense that the market had priced in a 75% chance of a rate increase for the January meeting and yet the Bank did not deliver. One could have easily justified a rate increase then given widespread market acceptance, high inflation and the Bank of Canada’s view that the country’s economic slack is now gone.
Nevertheless, the Bank delayed its rate increase for slightly longer. Motivations for this could include:
- A desire to avoid tightening while Omicron was still inflicting damage.
- Seeking to better synchronize with the U.S. tightening cycle, thus avoiding needless Canadian currency and financial market volatility.
- Trying to scale back market expectations for 2022 monetary tightening in Canada (though expectations have only accelerated since then – now pricing in a whopping seven 25bps rate hikes across 2022).
The Bank of Canada currently gives the impression that it may tighten at consecutive meetings rather than at every second meeting, and indeed that would be necessary to get anywhere near seven rate hikes over the remaining seven meetings of 2022. We continue to believe the central bank will ultimately tighten by less than this, though it is evident that considerable tightening is on its way.
One thing to be aware of – and of relevance to nearly every central bank – is that the precise trajectory of tightening ahead is hardly clear. Central banks are unusually data dependent right now, so markets will not enjoy the hand-holding they received across prior cycles.
Miscellaneous market thoughts
We conclude with a few brief thoughts on the financial market implications of this tightening.
- While rate hikes usually beget higher bond yields, one shouldn’t expect too large a selloff given how much has already been priced in.
- Temporarily, bonds and stocks may not provide as helpful of a hedge against one another as usual. A central threat to stocks comes from central bank tightening. That very same tightening may send bond yields higher (and thus bond prices lower).
- The spread between the U.S. 2-year and 10-year bond yields is now just 62bps. This is fairly low.
Further, on average, one would expect additional flattening as short-term rates rise with central bank tightening. The yield curve could be quite flat or even inverted in a year’s time, getting tongues wagging about recession risks.
-With contributions from Vivien Lee and Aaron Ma