Global Investment Outlook
Our latest quarterly Global Investment Outlook is now available here. The Economic Outlook article, entitled “Economic stress mounts”, can be found on page 15. Or you may want to catch up by viewing this companion Economic Outlook video (13 minutes).
Chaos erupts in Russia
Certainly the most startling event of the last few weeks was what appeared to be an attempted coup in Russia. The Russian mercenary outfit Wagner Group turned away from its assault on Ukraine, captured a chunk of Russia including a city of one million people, and then traveled most of the distance to Moscow. Its apparent goal was to seek revenge over an alleged attack by the Russian military against Wagner forces.
Wagner Group head Prigozhin has long had a frosty relationship with the Russian military. He has criticized its decision-making and complaining of being allocated insufficient resources. But a ceasefire was brokered by Belarus President Lukashenko at the last moment, and the Wagner forces – claimed to be up to 25,000 soldiers strong – quickly relinquished the territory.
Prigozhin is expected to be exiled to Belarus and the Wagner troops are expected to return to civilian life or join the regular Russian military.
It is hard to understand how it plays out from here. Having threatened Russian President Putin and attempted something resembling a coup, one would think that Prigozhin’s life is now in danger, regardless of the deal struck. It is surprising that Prigozhin issued the order to turn around when he was encountering so little military resistance in his initial advances. Russian civilians reportedly cheered his group’s arrival. The troops who participated in the attempted coup also have reason to fear for their prospects in Russia, and to be angry with Prigozhin.
One might imagine a highly volatile oil price were there to be a regime change in Russia. It’s unclear whether oil prices would rise (given the potential for production outages or even destroyed production facilities during any power struggle) or fall (if a subsequent Russian government exited Ukraine and relations gradually normalized with the West).
In the context of the war in Ukraine, Russia has now lost its most effective force. Some of those soldiers will be absorbed into the regular army, but it is hard to fathom that this will be seamless. Furthermore, Russia may feel compelled to keep a larger fraction of its military on domestic soil in the future to prevent additional coup attempts, incrementally weakening its effectiveness in Ukraine. Ukraine had already begun its latest offensive against Russia, and this improves the odds of significant gains. Nevertheless, a long grinding war remains the most likely outcome.
From a Russian political perspective, President Putin appears to be on less stable ground than previously supposed. The risk is now higher than normal that other political opponents could take advantage of this weakness and attempt to oust him. That said, the base-case scenario is still that Putin remains.
Additionally, one must be careful about hoping for another leader. The most likely victor in a power struggle would be someone cut from the same cloth as Putin – not a West-leaning liberal. Had Prigozhin taken over, the war in Ukraine might have ended based on his reported views about the conflict. However, the world’s largest nuclear weapons stockpile would then be in the hands of a battle-hardened ex-convict with a history of extreme violence.
From an economic standpoint, the price of oil is ultimately little changed. However, one might imagine a highly volatile oil price were there to be a regime change in Russia. It’s unclear whether oil prices would rise (given the potential for production outages or even destroyed production facilities during any power struggle) or fall (if a subsequent Russian government exited Ukraine and relations gradually normalized with the West).
Inflation is mostly cooperating
The latest U.S. inflation numbers were fairly cooperative. May’s Consumer Price Index (CPI) fell from 4.9% year-over-year (YoY) to 4.0% YoY. Promisingly, base effects argue that the June print will be similarly cooperative, with a further decline from 4.0% YoY to the realm of 3.0—3.4% YoY. Real-time economic data also argues that inflation will look significantly better in June, possibly toward the lower end of that range (see next chart).
U.S. Daily PriceStats Inflation Index continues to decline
PriceStats Inflation Index as of 06/11/2023, Consumer Price Index (CPI) as of May 2023. Sources: State Street Global Markets Research, RBC GAM
It is certainly constructive that inflation data is no longer surprising persistently to the upside (see next chart).
Global inflation surprises have been falling
As of May 2023. Sources: Citigroup, Bloomberg, RBC GAM
To be fair, core inflation has remained stickier. It is still charting an undesirably fast monthly clip of +0.4% month-over-month (MoM - see next chart), but the annual figure of +5.3% YoY nevertheless represents an improvement. Relatedly, service sector inflation is also declining with far less enthusiasm.
U.S. CPI monthly trend shows inflation improving but remains sticky
As of May 2023. Sources: BLS, Macrobond, RBC GAM
Fortunately, the Fed’s closely watched measure of labour-intensive services rose by just 0.24% in May. That’s a nearly normal rate of increase after a long period of excessive gains.
Perhaps the most positive development is that the breadth of U.S. inflation continues to sharply narrow (see next chart). The weighted fraction of items in the price basket rising by more than 10% per year has plummeted from fully 33% to just 11% in the span of eight months. This is a huge and necessary first step toward normalizing inflation.
Breadth of high U.S. inflation is narrowing
As of May 2023. Share of Consumer Price Index (CPI) components with year-over-year % change falling within the ranges specified. Sources: Haver Analytics, RBC GAM
The U.S. producer price index for the same month was also below consensus. It showed an annual price decline that bodes well for consumer prices down the road (see next chart).
U.S. inflation has declined
As of May 2023. Shaded area represents recession. Sources: U.S. Bureau of Labor Statistics, Macrobond, RBC GAM
With regard to specific components of inflation, it is helpful that oil prices are now below $70. That represents a significant retreat from a year ago (see next chart).
West Texas Intermediate (WTI) crude oil price has dropped significantly
As of 06/22/2023. Sources: Macrobond, RBC GAM
Food inflation is now decelerating, though food prices are not falling outright (see next chart).
U.S. food inflation has declined
As of May 2023. Shaded area represents recession. Source: U.S. Bureau of Labor Statistics, Macrobond RBC GAM
Dwelling cost inflation is also finally turning – a key inflation component that is famously lagged and so had remained persistently high even after housing markets rolled over last year (see next chart).
U.S. dwelling costs in Consumer Price Index (CPI) are turning
As of May 2023. Source: U.S. Bureau of Labor Statistics, Macrobond, RBC GAM
But for all of this improvement, we mustn’t assume that inflation will neatly descend to 2.0% from here. The St. Louis Fed maintains a model that argues that the odds of inflation remaining above 2.5% over the next 12 months remain above 70% -- though this probability is steadily falling (see next chart).
U.S. Price Pressures Measure shows inflation may remain high
As of May 2023. The Price Pressures Measure indicates the probability that expected (year-over-year) inflation rate over the next 12 months will exceed 2.5 percent. Shaded area represents recession. Sources: Federal Reserve Bank of St. Louis, Macrobond, RBC GAM
In the Eurozone, inflation is also decelerating. Germany’s Consumer Price Index (CPI) has fallen to 6.3% YoY. Spain’s CPI has already fallen to just 2.9% YoY. Emerging market inflation is also declining nicely.
Central banks return to tightening
Central banks have come an awfully long way over the past 18 months as they combat inflation (see next chart).
Central banks hike policy rates to fight inflation
As of 06/22/2023. Sources: Haver Analytics, RBC GAM
After a lull, several have turned over a newly hawkish leaf in recent weeks, recommitting to incrementally more tightening to be sure of properly taming inflation.
Of particular note, the Bank of England accelerated from its prior course of 25 basis point hikes per meeting, shifting to a 50 basis point increase in June. That yields a 5.00% policy rate. The market prices in another 100 basis points of increases in the months ahead. This reflects the particularly acute inflation problems in the U.K., and the worrying acceleration of British wages into what threatens to become a wage-price spiral (see next chart).
U.K. average weekly pay continues to rise
As of April 2023. Sources: U.K. Office of National Statistics (ONS), Macrobond, RBC GAM
Recall that the Bank of Canada raised its own policy rate by 25 basis points not long ago to 4.75%. The market prices a further hike to 5.00%. The Reserve Bank of Australia similarly surprised with a rate hike recently.
The Federal Reserve stayed put in June, but clearly signaled plans for further tightening. Its dot plots flag another 50 basis points of tightening, to a peak of 5.75%. The market remains skeptical, pricing in a 5.50% peak for the fed funds rate. Fed Chair Powell indicated that the July meeting is entirely “live.”
We continue to think that it will be hard to tame service sector inflation without softening the labour market, and there is little precedent for a weaker labour market without a recession.
In instituting this additional mini-tightening cycle, central banks are acknowledging that inflation is not yet where they would like it to be. Economies are proving surprisingly resilient so far and in some cases housing markets are reviving in a way that is unhelpful to inflation.
They likely hope that they will not have to tighten monetary policy quite as far as they now project. However, dampening inflation expectations via signaling is part of the game, and there should be no doubt that they will travel the full distance – and then some – if inflation doesn’t continue to decelerate.
For our part, we continue to think that it will be hard to tame service sector inflation without softening the labour market, and there is little precedent for a weaker labour market without a recession. It is not so much that central banks are targeting a recession as they may be forced to induce one to achieve their inflation goals.
Stock markets rebound
Despite a decline in the stock market over the past week (see next chart), equities are significantly higher than they were last fall.
S&P 500 index rebounds from autumn 2022
As of 06/23/2023. Sources: S&P Global, Macrobond, RBC GAM
The best explanation is simply that the economy has continued to expand, in contrast to expectations of weakness or even recession by now. Declining inflation has also been helpful.
However, we remain on the cautious side of the spectrum, expecting some further stock market weakness ahead. Market sentiment has now pivoted from pessimistic to optimistic – creating space for a later decline. Critically, at least from the perspective of this economist, we still believe a recession is substantially more likely than not.
If a recession occurs as inflation is declining and as central banks pivot from hiking to cutting, some of the normal market concern may be soothed by the constructive developments happening alongside the recession.
Central banks have resumed tightening monetary policy – a drag on the economy and a warning against excessive risk-appetite. That said, and as we have written in the past, any stock market decline in response to an upcoming recession could be smaller than the historical norm. The fact that this has been a highly anticipated recession arguably reduces the expected magnitude of any stock market decline. Indeed, one can argue that a fair chunk of the decline in 2022 reflected the partial pricing in of a recession.
Second, with inflation likely to remain somewhat higher than normal in the immediate future, nominal earnings may not retreat by as much as normal. Third, if a recession occurs as inflation is declining and as central banks pivot from hiking to cutting, some of the normal market concern may be soothed by the constructive developments happening alongside the recession.
China’s economy underwhelms
China’s economic recovery remains underwhelming. The country’s economic surprises are deeply negative as post-lockdown growth has failed to meet expectations. Exports are back to shrinking (see next chart). Service-sector demand has generally outperformed goods-sector demand, but even tourism spending began to soften in June.
China exports are shrinking
As of May 2023. Sources: China Customs Statistics Information Center (CCS), Macrobond, RBC GAM
But the biggest issue is that Chinese housing remains soft. Homes sales and home prices are both down over the past year and have been falling for some time (see next chart).
Home sales and home prices are both down in China
As of May 2023. Sources: SouFun-CREIS (China Real Estate Index System), China National Bureau of Statistics (NBS), Macrobond, RBC GAM
Housing happens to be a very big deal in China. It is a huge portion of the economy that is now stumbling as previous bubble-like conditions have faded. Builders remain troubled by excessive leverage.
Real estate is also the main investment for Chinese households, to a degree that greatly exceeds other nations. Weaker housing thus casts a chill over Chinese consumption as households worry about their investments and ramp up their savings to ensure they remain on track. Even non-real estate businesses are affected because it is common to use property as collateral for business loans.
Attempts to draw comparisons to Japan’s epic housing bubble and subsequent bust are probably overdone, but there are some parallels including a similarly souring demographic picture.
The Chinese government has begun to recognize this weakness and is turning to stimulus, as we had predicted. The country has now cut three policy rates in an effort to stimulate the economy.
More generally, Chinese households may also be having a crisis of confidence about their country. Aggressive lockdowns followed by the abrupt reversal have left some of the upper and middle class questioning the competence of their government. This uncertainty can lead to worries about the future and a reluctance to spend. Reflecting economic concerns and also perpetuating them, just 6.83 million couples in China were married in 2022. This is the lowest number since records started to be kept in 1986.
The Chinese government has begun to recognize this weakness and is turning to stimulus, as we had predicted. The country has now cut three policy rates in an effort to stimulate the economy. However, the magnitude of the move – down merely 0.1 percentage points – is hardly an overwhelming show of force. There are reports that the central bank is now considering US$140 billion of new infrastructure spending supported by bond issuance. Housing rules could be further eased as well (though this seems dangerous after a long boom).
Consumer-targeted stimulus could even be used. This is standard practice across much of the world but has not been part of China’s playbook in the past. There is the ever-present fear that savings-happy Chinese households will just sock the money away, resulting in more public debt but no economic boost.
China’s youth unemployment soars
China’s youth unemployment rate continues to soar, now hitting a whopping 21% (see next chart). That’s nearly double the pre-pandemic level and more than quadruple the overall unemployment rate. The youth unemployment rate was never this high during COVID-19 lockdowns and continues to rise even as the country’s economy staged a modest economic recovery over the first half of 2023.
China’s youth unemployment rate continues to soar
As of May 2023. Sources: China National Bureau of Statistics (NBS), Macrobond, RBC GAM
How problematic is this? Let’s begin with the observation that it is normal for youth unemployment rates to be fairly high. In Spain, the youth unemployment rate is a massive 28%. In Italy it is 20%. In the U.S. it is much lower, at 7.4%, but still more than double the overall unemployment rate. It is a similar story in Canada, with the youth unemployment rate of 10.7% more than double the 5.2% economy-wide rate.
Therefore, part of the Chinese youth unemployment rate problem is natural, reflecting the challenges inherent in getting that first job, building a resume, and gaining experience. But the youth unemployment rate is four times the overall rate in China, not merely double it. So one might argue that a third of China’s youth unemployment story is normal, but not all of it.
What about the remaining two-thirds? It is certainly strange that the youth unemployment rate is rising at the same time the nationwide unemployment rate is falling. Job postings data confirms that the numbers of openings designated for fresh graduates has fallen more sharply than for other types of jobs.
What is clear is that China is missing an economic opportunity and also risks political discontent if its youngest and most educated people are failing to find their place in society.
The number of Chinese college graduates coming on the market has surged over the past two years, rising by 29% from 2021 to 2023. Some of this is just the normal increase in educational attainment for a prospering developing nation. But the leap higher over the past two years far exceeds the earlier rate of growth. It seems likely that a lot of Chinese youth responded to the pandemic and its diminished economic opportunities by pursuing more education, resulting in a double-cohort of sorts all entering the labour market at the same time. It will take time to clear this excess.
It is possible that the pivot toward a college education has simply happened more quickly than the economy strictly needs, and that there are just too many well-educated people relative to the demand. But we are inclined to downplay this idea as more educated people can usually be put to good use somewhere, whether they are strictly achieving their full potential in the role or not.
We are dubious that China has a two-tier labour market like in some Mediterranean nations, advantaging incumbent workers and disadvantaging new entrants. That hasn’t been the case historically, in any event.
A stronger explanation is that graduates are focusing on the wrong sectors, or alternately, that they have had the bad luck to be trained in sectors that were recently damaged by Chinese policy decisions. The education and information technology sectors are both popular ones among new graduates and young workers, and both have borne the brunt of the government’s crackdown on for-profit enterprises that began a few years ago. The lucrative private tutoring industry, in particular, has all but vanished.
In conclusion, the surge in Chinese youth unemployment can be partly attributed to three main causes:
- an artificial increase in Chinese college graduates
- a sector mismatch
- too many skilled workers relative to demand.
Perhaps there are other forces that have not yet made themselves clear, as this answer is not entirely satisfactory.
What is clear is that China is missing an economic opportunity and also risks political discontent if its youngest and most educated people are failing to find their place in society.
China’s local government debt rises
Chinese local governments struggle under the weight of a structural mismatch between their revenues and expenses. They are expected to provide a wide range of services to their citizens but lack sufficient revenue tools to afford such expenses. The national government is reluctant to transfer the revenue tools needed to put the local governments on an independent footing because it could undermine the central authority’s control over the regions.
Local governments have long bridged the gap through a mix of land sales and by accumulating debt. But as the housing market has weakened, the land sales channel has also weakened, with a 23% decline in revenue from this source last year. This may be overstated given allegations of local governments selling land to their own financing vehicles. If true, it could leave debt as an even more important conduit than normal. Yet the cost of servicing debt has also increased, further eroding fiscal capacity.
Chinese local governments have now accumulated an enormous quantity of debt. It is hard to be precise given a range of funding strategies, some less transparent than others. At the high end, there could be as much as US$10 trillion to US$15 trillion of such debt. That’s a lot.
The most likely scenario is a mix of government money and losses to the financial sector and investors, mostly in the form of the aforementioned delayed payments, delayed maturity dates and lower interest rates.
Key lenders include Chinese banks and insurers, and also retail investors. A fraction has been marketed internationally. Financial institutions could thus be destabilized by any large-scale defaults, with broad economic ramifications. Meanwhile retail investors do not generally appreciate the amount of risk they have taken on.
Two-thirds of Chinese local governments are now at risk of breaching the unofficial debt threshold of 120% of income set by the national government.
According to a recent survey, one-third of local governments are now struggling to make interest payments on their debt. Some local governments have been forced to cut back on their program spending, with anecdotes of unpaid workers, curtailed bus services, cancelled health care subsidies and unpaid COVID-19 bills. Some local governments are engaging in asset sales to reduce the fiscal gap.
While the sums are huge, outright disaster is unlikely. This is not China’s first encounter with debt excesses, and it has historically handled prior episodes via the creation of bad banks, deferring payments, extending maturity dates and lowering interest rates. The city of Zunhi recently reached an agreement with its creditors along these lines. More are likely.
There are some concerns that early bailouts are happening disproportionately at the expense of banks rather than the government. If this continues, it could limit the ability of such banks to lend in more productive directions, hindering economic growth.
In fairness, in China, the delineation point between government and financial institution can be quite blurred. One of China’s largest government-owned asset managers is evaluating the needs of the Guizhou region at present.
There is also scope for the central Chinese government to directly transfer more money to the local governments. It already fills part of the local government fiscal gap in this way, with more than US$4.2 trillion sent between 2020 and 2022 alone. The annual sum is set to increase again in 2023, though not nearly as much as it did in 2022. Beijing still has the financial space to provide further assistance, but arguably not to bail every party out.
The most likely scenario is thus a mix of government money and losses to the financial sector and investors, mostly in the form of the aforementioned delayed payments, delayed maturity dates and lower interest rates. That counts as a technical default, though officially the principal eventually gets paid back. Again, this is likely to marginally reduce the availability of credit in more productive directions for a period of years.
Canada enjoys growth advantage
Canada suffers from the same aging population and declining fertility rates as other developed countries. Yet its overall demographic profile is markedly superior thanks to enormous immigration numbers. In fact, due primarily to immigration, Canada’s population increased by a record 1.05 million people in the year to March 2023 (see next chart) – albeit with a post-pandemic rebound effect temporarily juicing the numbers. That blows away the old record, though given a larger population today, it is the fastest population growth on a percent basis since 1957.
Canada’s record population growth is fueled by immigration
As of Q1 2023. Sources: Statistics Canada, Macrobond, RBC GAM
Coincidentally, this growth has allowed Canada to achieve a big new milestone: 40 million people. The threshold was officially achieved on June 16. Canada hit 30 million people back in 1997.
It should be conceded that very little of the population growth is domestically generated (see next chart). When we subtract immigration and emigration from the population figures, Canada’s domestic population growth shows that births are barely exceeding deaths. Were it not for immigration, the country appears to be perhaps half a decade away from a contracting population.
Excluding immigration, Canada’s population growth is slowing
As of 2021. From July 1 to June 30 each year. Sources: Statistics Canada, Macrobond, RBC GAM
Overall, the United Nations (UN) forecasts that Canada’s population will grow another 19% by 2050. This is not an overly heroic rate, but it’s faster than any other country. It’s faster than slowly growing Japan, Russia and China, or peers such as the U.K. and U.S. It’s even faster than countries long recognized for growth, including Brazil, Mexico and even India (see next chart)!
We suspect Canada’s actual population growth will be somewhat faster than this, as the UN forecasts predate the federal government’s latest upgraded immigration target.
Canada’s population growth set to outpace other countries
Sources: United Nations World Population Prospects 2022, Macrobond, RBC GAM
-With contributions from Vivien Lee, Thao Le and Aaron Ma