Priced to perfection?

Risk assets have been on quite a run, with the S&P 500 Index recently achieving a new high. There is much to justify the recent rally from a macroeconomic perspective. These include the prospect of rate cuts by the U.S. Federal Reserve (Fed), the downward trajectory of inflation and the increasingly plausible hope for an economic soft landing.

However, it must also be noted that achieving this set of outcomes represents a nearly perfect outcome. In our view, it is at least as likely that a hard landing occurs for the economy (indeed, we assign a probability of 60% for a hard landing, versus a 40% chance of a soft landing). We concur that inflation can probably fall further but it might not, especially given new supply chain complications or if a recession fails to arrive. Similarly, without a recession, it isn’t clear that the Fed can actually deliver the rate cuts that so excite the market.

Thus, markets could well be correct in their optimistic assessment, but if they are wrong the risks tilt notably more to the negative side of the ledger.

Two consumer tailwinds

In assessing the outlook for the U.S. consumer that has so far refused to quit, two additional forces have become more friendly toward consumer spending in recent months: the cost of gasoline has fallen substantially and the 30-year mortgage rate has also declined (see next chart).

Mortgage rates and gas prices in U.S. have dropped markedly

Note: Mortgage rates as of the week ending 1/18/2024, gasoline prices as of the week ending 01/15/2024. Source: Freddie Mac, Energy Information Administration (EIA), Macrobond, RBC GAM

These two developments are not exactly of equal relevance. Nearly every household benefits immediately from lower gas prices, whereas the decline in mortgage rates only helps the small subset of families buying a new home (though each of those households benefits enormously).

A further distinction is that the price of gas had already been trending lower for nearly two years, whereas the mortgage rate reversal has just begun to unwind a significant earlier increase.

Despite their differences, both developments are good for the consumer at a time when other spending supports are beginning to erode, including diminished pandemic savings, the resumption of student loan payments in October 2023 and the prospect of less fiscal support in 2024. Higher rates are also beginning to hurt, as detailed in the next section. Of course, the most important variable for consumer spending is employment, which remains robust for the moment – albeit with some hints of weakness beneath the surface.

Higher rates start to hurt

Notwithstanding recent developments that could incrementally support consumers, the fact remains that interest rates have increased a great deal over the past two years and the resulting pain is starting to show up in the form of consumer loan delinquencies (see next chart). The overall U.S. consumer loan delinquency rate is now rising, if still low by pre-pandemic standards.

U.S. consumer loan delinquency

Note: As of 2023 Q3. Source: Federal Reserve Bank of New York, Macrobond, RBC GAM

At a more granular level, credit card delinquencies are rising sharply and are now at their highest level since the global financial crisis. It makes sense that these delinquencies are rising the quickest as credit card borrowing rates are highly responsive to the prevailing interest rate. Auto loan delinquencies are now also rising significantly and are also at their highest point in over a decade. The mortgage delinquency rate is also going up, though it is still low by pre-pandemic standards.

If history is any guide, these delinquency rates will continue to rise for several quarters even after the fed funds rate starts to decline.

Survey versus hard data

A disconnect has opened again between economic surveys and the hard data in the United States. The surveys remain mostly pessimistic, highlighted by an ISM Manufacturing Index that has now signaled contraction for 15 consecutive months, an ISM Services Index that sits perched between expansion and contraction at just 50.6, a National Association of Homebuilders Index that also signals contraction with a reading of just 44, and a below-normal reading from the NFIB Small Business Optimism Index.

Conversely, the recent hard data – referring to indicators that represent actual quantifiable actions like spending or hiring, rather than mere sentiment – has held together quite nicely. Third-quarter GDP came in at a screaming +4.9% annualized, the latest retail sales report rose by a nice 0.6% MoM, and the most recent weekly initial jobless claims report plumbed the depths with just 187,000 newly unemployed Americans for the week of January 13. Despite pessimistic home builders, U.S. home prices have actually been rising again (see next chart).

U.S. home prices continue to rise

Note: S&P/Case-Shiller HPI as of October 2023, Zillow Home Value Index as of December 2023. Source: S&P Global, Zillow, Macrobond, RBC GAM

Hard data ultimately trumps survey data, as it represents what is actually happening, rather than what is perceived to be happening, or what is expected to happen. The problem is that the survey data is usually released first and is also theoretically a leading indicator for the hard data, so it can’t be ignored. We still believe the risk of recession is elevated, and the weak survey data is one of several reasons why. But the longer the hard data and the survey data are disconnected from one another, the less credible that view becomes.

Geopolitical risks

There are an unusually large number of geopolitical issues and risks in the world today (see next graphic). It is far from automatic that these various frictions deteriorate from here, but there is the clear chance that several will, with potentially large consequences.

Geopolitical risks abound

Source: RBC GAM as at 01-16-2024

The war in Ukraine grinds on, with U.S. support for Ukraine wavering due to budget wrangling, and with a theoretical Trump presidency set to further reduce American funding. Ukraine ceased to steadily gain territory from Russia many months ago and has lost some ground in recent months. There is the distinct risk of further Russian gains as the West’s focus shifts toward other matters. Economically, this matters both in the context of oil prices and also in assessing whether Russia might eventually seek to absorb additional territory elsewhere.

Frictions between China and the U.S. largely persist despite a constructive summit late last year. President Biden is disinclined to ease restrictions on China. A Trump presidency would be even less friendly, meaning additional tariffs and restrictions would probably result. Consequently, friendshoring and (to a much lesser extent) onshoring trends continue. The recent Taiwanese election returned the incumbent pro-West government to power, further aggravating China. A Trump presidency would likely result in less American support for Taiwanese independence.

The Middle East remains a tinderbox given the ongoing conflict between Israel and Hamas; lower-grade skirmishes between Israel and Lebanon’s Hezbollah; a recent Israeli air strike in Syria; recent Iranian attacks in Syria, Iraq and Pakistan (targeting variously the U.S, ISIS bases, alleged Israeli facilities and foreign rebels); Pakistan’s response in the form of missiles directed at rebels located in Iran; and the use of rockets by Houthi rebels in Yemen to deter shipping traffic through the Red Sea. In response to this last development, the U.S. and U.K. now have naval vessels in the area and are no longer simply intercepting rockets but are also now targeting their points of origin in Yemen.

Not all of these events are connected, but the overall temperature in the Middle East has certainly increased. From an economic standpoint, the risk is primarily that such events continue to broaden in a way that materially and enduringly affects the world’s supply of oil and the ability for ships to transit the Suez Canal. Both would increase inflation and hurt economic growth. Already, the price of shipping a container has more than doubled, albeit to levels that remain far below 2021 and 2022 peaks (see next chart). If this persists, this could add as much as half a percentage point to inflation in Europe over the coming months.

Shipping costs rise on tensions in Red Sea

Note: As of the week ending 01/11/2024. Source: Drewry Shipping Consultants Ltd., Macrobond, RBC GAM

Despite all of this bad news, it must be remembered that the Middle East was actually on quite a constructive path before the events of the past several months. Israel had normalized relations with Egypt and the United Arab Emirates. The country was also close to normalizing relations with regional power Saudi Arabia. Last spring, Saudi Arabia and Iran – long foes – agreed to normalize their relations (brokered, interestingly, by China).  At the time, countries were seemingly awakening to the idea that peace in the region could be a boon, economically and otherwise, for everyone. The unanswered question is how much of this goodwill has been permanently lost, and how much of the loss is only temporary.

Beyond this, the U.S. presidential election looms – discussed shortly – as part of a record year for elections around the world.

Shutdown averted, again

As we predicted, the U.S. managed to avoid yet another government shutdown on January 20 – the third such avoidance in just four months. Hilariously, some of the motivation to resolve the latest impasse was found when a snowstorm threatened Washington, D.C., as politicians wanted to be able to flee the city before the weekend. The votes in the Senate and House were bipartisan affairs, though with some notable Republican dissent. President Biden then signed the continuing resolution into law.

Alas, this will only keep the national government funded through March 1 (March 8 for some branches of government), meaning that politicians will have to do it all over again in just over a month. We are already four months into the fiscal year and there still isn’t a 2023-2024 budget.

The good news is that politicians have shown their true colours and a future shutdown isn’t particularly likely in 2024 given that the last three have been successfully dodged. It’s also unlikely given the overwhelming support in both chambers to extend funding this time (77% support in the House and 81% in the Senate), and the diminishing likelihood of political gamesmanship as the November elections draws ever nearer.

Republican race underway

The first U.S. Republican primary took place on January 15, netting former President Donald Trump an even larger landslide victory than expected, with more than 50% of the vote. The second-place finisher – Ron DeSantis – has since withdrawn from the race along with other challengers, leaving just Nikki Haley to battle Trump in the imminent (at the time of writing) New Hampshire primary. Trump is heavily favoured in the state, but the gap has shrunk in recent weeks to a (still hefty) 14.2 percentage point lead according to fivethirtyeight.com. If Haley loses New Hampshire, Trump has likely cemented the nomination. This was always the most likely outcome. Technically, legal issues could yet theoretically get in the way of his coronation. In that unlikely scenario, Republican Party brass would be in a position to select another candidate themselves, without the rigamarole of state-by-state primaries.

Compared to his earlier campaigns, Trump’s campaign team has been upgraded in a way that theoretically improves his prospects in the general election.

President Joe Biden remains the presumptive nominee for the Democratic Party, making the election a likely reprise of 2020 with Biden against Trump. Right now, Trump leads by a small margin in a range of betting markets and polls (see next chart). This is mildly surprising, given that Biden bested Trump in 2020 and due to the advantage that incumbent candidates usually enjoy. But Trump is no ordinary candidate. Of course, all of this could yet change significantly over the coming months. A hard landing for the economy would theoretically hurt Biden, while a soft landing should help him. In addition to the state of the economy, immigration and crime are also major electoral issues this cycle.

2024 U.S. presidential election: Biden vs. Trump

Note: As of 01/19/2024 for RCP, 01/22/2024 for Predictit and oddschecker. RCP poll averages for Biden versus Trump matchups only. Others acknowledge possibility of other candidates contesting the election. Predictit probability of winning derived from prediction markets data. Oddschecker probability of winning derivd from median daily betting odds. Source: oddschecker, Predictit, RealClearPolitics (RCP), Macrobond, RBC GAM

U.S. election platforms

The candidates are still in the process of laying out their policy platforms, so further clarity should be gleaned over time. Let us also not forget that many campaign promises fail to be actualized, either because they were merely bait for voters, because Congress does not support the president’s policies, or because circumstances and/or political priorities change over time.

Still, we can say a few things about the tentative platforms of Biden and Trump (see next table).

U.S. election platform preview

Note: As of 01/22/2024. Source: RBC GAM

Biden is the incumbent and so a second consecutive term would involve less change. From a domestic economy standpoint, he proposes higher corporate and individual tax rates, tougher anti-trust laws and additional regulation in a variety of realms.

Trump, in contrast, talks of cutting the corporate tax rate, reducing bank regulations, and reducing government spending. Markets would probably prefer the Trump platform in the short run given that corporations would directly benefit from a number of his proposals, though there are several complicating factors discussed next.

Whether the economy would be any further ahead over the medium run is an open question as Trump’s stronger anti-China stance and plan for broadly based tariffs could sap U.S. growth (while simultaneously creating opportunities for some American businesses).

Immigration is a flashpoint for this election.  While both candidates plan to better control illegal immigration, Trump is more against immigration in general. To the extent this reduces population growth, it could be adverse for GDP growth. On the other hand, such actions could also have the effect of increasing the wages for low skilled Americans, along with a range of non-economic impacts.

Trump proposes to repeal Biden’s signature Inflation Reduction Act. In addition to the negative impact on the environment this would have, it would remove a significant amount of built-in fiscal stimulus (which would be good for fiscal sustainability but bad for economic growth), and potentially prove quite damaging to various nascent green industries in the U.S.

Deficits will likely remain in place as far as the eye can see. Neither candidate met a deficit they didn’t love, and so aggressive fiscal austerity seems unlikely unless the bond market forces the issue.

The two candidates’ geopolitical differences were discussed earlier in this report, amounting to Trump potentially being less supportive of Ukraine and Taiwan.

Like the first Trump presidential term, a second term would probably bring a considerable element of unpredictability – a negative for investors and economic actors who crave stability, regardless of what specifically transpires.

A Trump presidency is probably negative for the rest of the world. Additional tariffs, less international engagement and more adversarial dealings threaten to modestly subtract from ex-U.S. growth.

But we reiterate that presidents do not usually get to do entirely as they please, instead finding themselves frequently hemmed in by Congress. The Senate is likely to flip from the Democrats to the Republicans, leaving open the possibility of a Republican sweep if the House of Representatives remains in Republican hands.

However, there is a decent chance the House pivots in the opposite direction, leaving a divided Congress, albeit with the opposite configuration of today. That would limit major policy changes by either presidential candidate.

Admittedly, it is far more conceivable that a Republican sweep occurs than a Democrat sweep, so one must entertain a scenario in which President Trump is backed by a fully Republican Congress. However, even here, action is limited as there are inevitably factions within the House and Senate Republicans, each with different priorities. And do not forget that decisive legislative action usually requires rather more than the bare minimum of 50% plus one votes in the Senate.

Canadian housing financial stress

Canadian home prices have fallen materially over the past two years as mortgage rates soared. We expect a further malaise over the next few years as atrocious affordability and a possible recession outmuscle rapid population growth.

But despite housing market weakness, there has been surprisingly little outright financial distress in the Canadian housing market. By that we mainly mean that the mortgage delinquency rate remains quite low (see next chart). Yes, there has been a tiny increase, but the current 0.15% share of mortgages in delinquency is barely above the 0.14% all-time low set in 2022.

Financial stress for Canadians has started to rise

Note: As of Q3-2023. Share of the number of accounts 90 days or more past due over the previous three months. Source: Equifax, CMHC, RBC GAM

Amazingly, a “normal” delinquency rate five years ago was nearly twice as high as today’s reading, at 0.28%. As recently as the late 1990s, a “normal” delinquency rate was more like 0.40% to 0.50%. Today’s delinquency rate could double or triple without being unfamiliar and therefore presumably problematic for Canadian financial institutions (all the more so given additional loss reserves built up by banks in recent years, plus the trend toward higher overall levels of capital).

What explains the remarkable durability of Canadian mortgage-holders? We posit several things:

• Unemployment remains fairly low. Losing one’s job is the biggest stressor for creditors and there haven’t been many job losses so far.

• The great majority of Canadian homeowners have considerable equity in their home, thanks not just to their original downpayments but the subsequent stratospheric appreciation of home valuations (even after the decline over the past two years). As such, any cash flow problems experienced by the majority of people with mortgages can be resolved by selling the house at a profit, rather than defaulting on the mortgage.

• Loosely, the only people with negative equity in their homes are those who bought them within the last few years with a small downpayment. During this timeframe, the majority opted for fixed-term mortgages that enjoy a low locked-in rate for several more years. This means that while there are many households that are no doubt disappointed with the performance of their asset, their cash flow situation has not yet changed for the worse.

• It is mainly the subset of those who bought a home recently, with a small downpayment, and at a variable rate that should be suffering financially. But several major financial institutions have opted to allow those with variable rate mortgages to continue making a fixed payment per month even if that payment is temporarily less than the interest on their mortgage. This is not a long-term fix but provides the buffer of additional time to get finances in better order, and falling interest rates could eventually fix the problem independent of any action by the borrower. Also do not forget that those with small downpayments would have had to have passed a stress test at the time of purchase ensuring that they can survive with a mortgage rate 2 percentage points higher than their starting rate.

• Most of those whose five-year mortgage terms that have reset over the past 18 months have faced an increase in mortgage rates of approximately 1.0 to 1.5 percentage points. That’s significant, but not a killer blow. For those with small downpayments, it is less than the stress test they would have faced five years earlier. Most parties in this situation have managed to significantly increase their home equity over the intervening five years due to recurring principal payments and home appreciation, providing the capacity to sell at a profit, if necessary. 

• Anecdotally, Canadian banks have been quite accommodating of struggling borrowers, reworking loans to ensure that the borrower can continue to service them.

All of this helps to explain why the mortgage delinquency rate has only increased slightly. Of course, while many of these favourable conditions are set to continue, we do budget for higher unemployment and lower home prices in the future, which will adversely factor into the equation. Additionally, people with renewing mortgages are starting to face mortgage rate increases of well beyond 1.5 percentage points, and this should only get worse over the next few years. The Venn diagram intersection of those who have become unemployed, those with negative home equity and those experiencing a sharp increase in mortgage rates is the pain point to watch and will expand with time.

But the point here is that the financial distress aspect of Canada’s housing market downturn is proving manageable, and smaller than one might have guessed going into the event. Housing market issues should be viewed primarily through an economic lens rather than a financial crisis lens.

-With contributions from Vivien Lee, Vanita Maharaj and Aaron Ma