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by  Eric Lascelles Nov 22, 2022

What's in this article:

Inflation eases

Surely the most important and positive macro development of the past few weeks was the long-awaited arrival of a well- below consensus U.S. Consumer Price Index (CPI) print. The inflation numbers for October were a substantial 0.2ppt below consensus both for headline CPI (+0.4% month-over-month) and core CPI (+0.3% month-over-month). Those were also each around a quarter of a percentage point softer than the average of the past year.

This isn’t the first month of softer inflation. July logged a sharp decline in both headline and core CPI. But a second month is welcome after two intervening months of worryingly large increases.

Annual CPI has now decelerated for four consecutive months since peaking in June.

More than half of the monthly inflation came from housing (see next chart). Housing operates with a significant lag versus actual home prices and rental costs given that it takes time for leases to expire and then reset higher. People will continue to face rising rental costs for some time due to this resetting process. However, one can argue that central banks don’t need to do anything more about it since they know the housing market is already turning and that this will eventually show up in CPI. Excluding shelter, headline CPI roses by just 0.19% – a historically normal pace.

Many sources of U.S. monthly inflation have softened

Many sources of U.S. monthly inflation have softened

October 2022. Source: U.S. Bureau of Labor Statistics (BLS), Macrobond, RBC GAM

Central banks had previously been unimpressed by the incremental declines in annual CPI. These declines had come disproportionately from a small number of volatile sources such as gasoline prices.

The good news is that this month of relative inflation softness happened despite rising gas prices in October. A wide range of core inflation measures have all turned down recently (see next chart). Granted, many core measures also declined in July, but two months of softness is surely more convincing than one rogue month.

A wide range of U.S. core inflation measures have eased

Many sources of U.S. monthly inflation have softened

Personal Consumption Expenditures (PCE) deflator as of September 2022. CPI measures as of October 2022. Source: Macrobond, RBC GAM

Arguably the best measure of inflation breadth is the chart that follows. It concedes that inflation remains quite broad, but evinces a tentative decline in breadth. Inflation breadth had been the one thing really not cooperating in the inflation data.

Inflation in the U.S. remains broad but may have started to shift

Inflation in the U.S. remains broad but may have started to shift

October 2022. Share of CPI components with year-over-year % change falling within the ranges specified. Source: Haver Analytics, RBC GAM

We remain firm in the following views:

  • The original drivers of high inflation have all turned (commodity shock, supply chain problems, monetary stimulus, fiscal stimulus).
  • There is evidence of changing corporate pricing behavior (see next chart).
  • Inflation can therefore continue to fall from here, albeit in choppy fashion, and not necessarily immediately back to 2.0%.

Fraction of U.S. businesses planning to raise prices is falling precipitously

Fraction of U.S. businesses planning to raise prices is falling precipitously

October 2022. Shaded area represents recession. Source: National Federation of Independent Businesses (NFIB) Small Business Economic Survey, Macrobond, RBC GAM

Accordingly, our 2023 inflation forecasts are mostly below consensus. The major rally in both stocks and bonds in response to this latest CPI release hints that stocks and bonds could remain correlated as inflation falls – this time in a happy direction. That said, there is the alternative scenario in which stocks shift their attention from inflation to recession and are held back for longer even as bonds rally.

Looking forward, the upcoming November CPI print remains subject to debate. The Cleveland Fed’s CPI nowcast anticipates a more heated reading than in October (+0.57% month-over-month). However, the model’s construction is such that it essentially tacks real-time oil price movements onto the trend rate of inflation. Because the trend rate of inflation remains high, the model is incapable of forecasting substantially softer inflation unless oil prices are collapsing.

It is promising that oil prices have recently descended to their lowest level since January as China has locked down and rumours swirl about additional OPEC production. It is also helpful that the U.S. producer price index for October arrived well below expectations and was outright weak. This hints that future CPI releases could follow suit as those products trickle down the supply chain toward consumers.

We do not tend to put much weight in the money supply as a predictor of inflation. However, it is nevertheless heartening that the recent sharp deceleration in the U.S. money supply is theoretically consistent with a sharp CPI decline over the next 16 months (see next chart).

U.S. money supply has collapsed, is inflation to follow?

U.S. money supply has collapsed, is inflation to follow?

September 2022. M2 year-over-year % change leads by 16 months. Shaded areas represent U.S. recessions. Source: Macrobond, RBC GAM

More stubborn CPI elsewhere

Outside of the U.S., inflation has been less ready to decline. As an example, Canadian CPI continued to rise by 0.7% month-over-month in October – nearly double the U.S. rate for that month.  British CPI in October recorded the fastest annual rate of inflation in more than four decades.

Each country, of course, has its own idiosyncrasies. U.K and European inflation, for instance, continue to be driven higher by the lagged effect of earlier natural gas price increases that are only now bleeding into regulated consumer-facing prices.

It is important to consider how much the U.S. may be benefiting from the strength of its currency. It is a deflationary force and a factor actively working against most other country’s price levels. But the roughly 10% appreciation of the U.S. dollar since the beginning of the year should theoretically soften U.S. CPI by a percentage point and add less than a percentage point to the inflation of other countries. The significant relationship between the currency and import prices can be seen in the following chart.

Strong dollar to bring down import prices

Strong dollar to bring down import prices

October 2022. Source: BLS, J.P. Morgan, Macrobond, RBC GAM

At the monthly level, one might thus imagine that U.S. CPI should be 0.1 or at most 0.2ppt weaker per month than other countries for purely currency-related reasons. The actual gap was significantly larger than that in October, so weaker U.S. CPI is not purely a currency story. Interestingly, the difference in import prices between the U.S. and Canada isn’t even all that large, though the U.S. does enjoy the advantage (see next chart).

Import prices are falling faster in the U.S.

Import prices are falling faster in the U.S.

Canada as of September 2022, U.S. as of October 2022. Source: BLS, Statistics Canada, Macrobond, RBC GAM

Supply chain update

The supply chain story remains favourable toward declining inflation. For example: 

  • Container shipping costs are plummeting and increasingly normal (see next chart).
  • Dry bulk shipping costs are lower (see subsequent chart).
  • The number of ships waiting at southern Californian ports has fully normalized (see third chart).
  • The demand for trucks relative to the supply has largely normalized (see fourth chart).

Container shipping costs are falling further

Container shipping costs are falling further

As of the week ending 11/10/2022. Source: Drewry Supply Chain Advisors, RBC GAM

Dry bulk shipping costs retreat from latest peak

Dry bulk shipping costs retreat from latest peak

As of 11/15/2022. Shaded area represents recession. Source: Baltic Exchange, Macrobond, RBC GAM

Container ships at anchor or loitering have normalized around Port of Los Angeles & Long Beach

Container ships at anchor or loitering have normalized around Port of Los Angeles & Long Beach

As of 11/10/2022. Source: American Shipper, Marine Exchange of Southern California, RBC GAM

U.S. freight demand has dropped sharply

U.S. freight demand has dropped sharply

As of 11/10/2022. Source: American Shipper, Marine Exchange of Southern California, RBC GAM

U.S. midterm elections wrap up

Two weeks after the U.S. midterm elections, the precise results remain elusive. However, enough is now known that we can draw important conclusions.

After polls had whiplashed back and forth in the final days before the election, the Democrats managed to hang onto the Senate after all, with at least 50 out of the 100 seats (plus a Democratic Vice-President to serve as tie-breaker). Meanwhile, the Republicans did pick up enough seats to take over the House of Representatives, but the gain was the feeblest for the opposition party at a midterm election in decades.

Relevant takeaways include:

  • Congress is now divided, greatly limiting legislative action over the next two years.
  • The Republicans gained, but fared surprisingly poorly despite Biden’s low popularity and the pain of high inflation and rising borrowing costs.
  • Former President Trump-supported Republican candidates performed particularly poorly, suggesting his magic touch may be waning even as he formally announces his candidacy for the 2024 presidential election.
  • Law and order appears to be a reviving issue after a recent crime surge, to the advantage of Republicans in some normally Democrat districts.

As expectations ebbed and flowed, markets appeared to signal a preference for a Republican outcome. However, history shows that divided Congresses – the new configuration – are generally appreciated as well.

So, what might get accomplished with a divided Congress over the next two years?

The Democrats can still take the lead in key appointments, including those to the Supreme Court and those made in forming committees.

The White House can still issue executive orders that clarify (or, more realistically, adjust) how existing legislation is implemented. However, there are limitations to this strategy, as revealed by the recent court challenge to President Biden’s student loan relief initiative.

Where might Democrats and Republicans find common legislative ground? Presumably they will muster the will to avert debt ceilings and fiscal cliffs, and to pass care-taker budgets. Both parties are certainly unified in their anti-China views and anti-big tech sentiment – so there is the possibility of further action on these files. Should the U.S. economy descend into recession, one might imagine a concerted effort to revive the economy. However, government action on the usual scale is not likely given mounting evidence that prior stimulus efforts were too generous and given lofty inflation.

COVID spikes in China

The global pandemic trickles along. In many countries, the BQ.1 and BQ.1.1 sub-variants are taking over. They have now risen to 49.7% of all new U.S. cases as of November 19, at the expense of the BA.5 sub-variant. BA.5 had represented three-quarters of new cases a month ago, versus just one-quarter today. The BQ family is not obviously more severe than prior variants, though some research now argues that the new generation of bivalent vaccines are less effective at neutralizing them than hoped.

Despite the new variant wave, overall global infections and fatalities remain quite subdued by pandemic standards (see next chart). It is fair to concede that infections are no longer as well monitored as earlier in the pandemic, but the fatality figures shouldn’t lie. Hospitalization rates also remain tame relative to prior spikes (see subsequent chart).

Global COVID-19 cases and deaths remain subdued

Global COVID-19 cases and deaths remain subdued

As of 11/20/2022. Source: Our World in Data, Macrobond, RBC GAM

COVID-19 hospitalizations in developed countries also remain lower

COVID-19 hospitalizations in developed countries also remain lower

Based on data available as of 11/20/2022. Source: Our World in Data, Macrobond, RBC GAM

As the northern hemisphere cools, other respiratory viruses circulate and the risk of another COVID-19 wave theoretically mounts. Some jurisdictions – including Ontario – are now recommending masking while indoors. Compliance is spotty at best. But virtually all lawmakers are stopping well short of mask mandates, let alone locking down entire sectors of the economy. It would be an enormous surprise if such practices returned.

The exception, of course, is in China. China maintains its zero-tolerance policy, even if it slightly shortened the length of mandatory quarantines from 10 days to 8 days. Despite this (or, arguably, because the country has refused to source more effective vaccines from the rest of the world, has failed to comprehensively inoculate its vulnerable seniors and never allowed herd immunity to naturally build over time), China is now experiencing its biggest COVID-19 wave since last spring (see next chart). This will presumably continue to inflict economic damage.

China is now experiencing new COVID-19 wave

China is now experiencing new COVID-19 wave

As of 11/20/2022. Source: Johns Hopkins University, Macrobond, RBC GAM

China appears to be on track to ease its restrictions next spring, not only as the weather turns but after it has had a chance to implement its new plan of significantly increasing hospital capacity.

Economic signals remain mixed

The economy continues to emit rather mixed signals, especially in the U.S.

At the positive end of the spectrum, the broad U.S. economy apparently remains fine despite obvious headwinds, with fourth-quarter real GDP tracking a robust 4.2% annualized gain according to the Atlanta Fed. October retail sales rose by a strong 1.3% in October alone, albeit on the heels of a flat month.

Walmart recently upgraded its sales outlook for the year ahead, and indicated that demand remains good.

However, not all retailers agree. Target observed a “dramatic” downturn in consumer spending over the latter part of October and into early November. Amazon observed a slowdown in October spending. Even Walmart conceded that discretionary spending had weakened, even if spending on essentials was offsetting this.

The secret to teasing out these seeming contradictions may lie in the details.

  1. There is evidence that Americans are borrowing more to sustain their spending – arguably an unsustainable proposition at a time of rising borrowing costs.
  1. The Walmart-Target divide may best be understood in that, while both are theoretically discount retailers, Walmart is the more down-market of the two. Thus, as people trade down, this may come at the expense of Target and to the advantage of Walmart.
  1. More than half of Walmart’s business is selling groceries – a historically stable sector given that most foods are necessities rather than discretionary purchases. Conversely, Target’s food share is only around one-fifth.

The bottom line is that consumer spending may indeed be starting to weaken and is at a minimum vulnerable to softening.

Tech as leading indicator?

The tech sector has seemingly fared much worse than other sectors of the economy recently. Many companies are engaged in large-scale layoffs that simply aren’t happening in other sectors.

What is going on?

Anticipated economic weakness is part of the story. The tech sector may be more nimble and far-sighted than other industries, meaning recent actions could simply represent tech companies downsizing before everyone else.

Additionally, advertising spending – which funds Google, social networks and many other tech enterprises – is an easy expense line item for brick-and-mortar businesses to cut as they become worried about the future. Digital advertising is especially simple to pare as it has the least turnaround time between purchase and ad delivery. So tech weakness may be a leading indicator of more cost cuts later.

However, there are other reasons unrelated to the economic cycle that help to explain the tech retreat. Many tech firms badly over-expanded over the past few years on the expectation that the pandemic-driven boom in online activity would continue unabated. In reality, much of the surge has unwound as restrictions have faded. Companies were thus left with large workforces that required thinning.

Second, online advertising revenue has plummeted for non-economic reasons as stricter privacy rules have been implemented. This limits the ability for tech companies to track internet users, reducing their value to online advertisers.

In short, tech sector weakness may be saying something about the broader economy, but there are also some idiosyncratic factors at play.

New sentiment trends lower

The San Francisco Fed’s daily news sentiment index has sawed back and forth over the past 18 months (see next chart). But, through the volatility, a downward trend remains intact that suggests the high water mark for good news was the spring of 2021, with things getting progressively worse since then.

Daily news sentiment trends lower

Daily news sentiment trends lower

As of 11/13/2022. Source: Federal Reserve Bank of San Francisco. Macrobond, RBC GAM

Recession outlook

We continue to anticipate a recession for much of the developed world in 2023. The consensus outlook for 2023 developed-world growth continued to decline in November according to Consensus Economics, though not quite to the point of matching our own forecasts.

Our scorecard of simple recession signals recently witnessed the migration of two indicators from “no” to “yes” (see next graphic). The 3m-10yr curve recently inverted, as did the Fed’s short-term curve. Those developments have historically presaged a recession. Now, only one of 12 indicators continues to say “no” (though with the caveat that a “yes” may not be far away based on our expectations for the variable).

Recession signals point mostly to “yes”

Recession signals point mostly to “yes”

As of 11/15/2022. Analyst for U.S. economy. Source: RBC GAM

Currencies shift

Dollar reversal

U.S. dollar strength has been a constant for most of 2022. As the world grew more concerned about inflation and central bank rate hikes, the dollar won versus other currencies due to its safe-haven status and the more hawkish stance of the U.S. Federal Reserve.

But this trend has lately begun to reverse (see next chart). The dollar has actually lost ground against the yen, pound, euro and other currencies. Whereas the yen initially depreciated by 28% versus the dollar across the pandemic, it has since reclaimed 7% of its value. The pound lost as much as 16% and has since reclaimed 11% versus the dollar. For the euro, a decline of 12% has been followed by a rally of nearly 8%.

U.S. dollar has strengthened against currencies of most developed countries

U.S. dollar has strengthened against currencies of most developed countries

As of 11/18/2022. Source: Macrobond, RBC GAM

In essence, the world is becoming less worried about inflation. This growing confidence removes the appetite for safe haven assets and simultaneously reduces pressure on the U.S. Federal Reserve to act aggressively.

To the extent that inflation continues to fall – as per our forecast – this is certainly good for bonds. It is arguably good for equities (though whether the market will instead obsess about recession risks is an open question). However, it is arguably bad for the U.S. dollar. From a long-term perspective, the dollar is expensive by almost any measure. All of this suggests the potential for non-U.S. markets to outperform the U.S. as financial markets rebound.

Crypto disaster

Cryptocurrencies resemble the Wild West: a largely lawless sector in which fortunes are made or lost.

Most of the losses of the past year are due to declining cryptocurrency valuations. The asset class has badly underperformed despite the perfect alignment of high inflation and elevated risk aversion that should theoretically have pushed crypto assets higher.

More recently, the story has been one of corporate misdeeds. On the heels of the bankruptcy of the Celsius cryptocurrency platform in July, FTX – one of the world’s largest cryptocurrency exchanges – has collapsed, with billions of dollars of customer funds potentially lost. It is in some ways reminiscent of the failure of Canada’s largest cryptocurrency exchange, QuadrigaCX, in 2019 -- albeit in the case of FTX on a larger scale and without the mysterious death of the company’s founder.

In turn, confidence in cryptocurrencies has been further shaken even though the blockchains themselves did not fail.

It seems that the FTX was claiming to be a boring custodian of client assets but was really acting as an unregulated (and irresponsible) bank-like entity, using client money to invest in other things. As it happens, those other things were highly speculative cryptocurrency assets. Those assets have since collapsed in value to nearly zero. The company therefore appears not to have enough money to refund depositors.

This experience will presumably get regulators heavily involved in cryptocurrencies. Whether that straightens out the industry and allows it to thrive or instead kills the appeal of unregulated cryptocurrencies is as yet uncertain.

We continue to believe the most likely path toward widespread cryptocurrency acceptance will involve central banks issuing their own cryptocurrencies. China is now doing exactly that. It will be fascinating to watch uptake, to see how it changes financial payments and transactions, the extent to which China can tempt other countries to use its new digital currency, the extent to which this removes power from the U.S. and its SWIFT banking network, and the extent to which other countries quickly follow on its heels with their own functioning digital currencies.

In other crypto developments, the world’s second most popular cryptocurrency – Etherium – managed to enact a “merge” that allows it to effectively reduce the energy consumption of the underlying blockchain by an impressive 99.95%. It may be possible for other cryptocurrencies to do the same. Recall that cryptocurrencies are normally extraordinarily energy-intensive, and so this reduces the weight of that criticism.

Ukraine gains continue

The Ukraine military has continued to make gains in eastern and southern Ukraine, pushing Russian forces out of the provincial capital of Kherson.

Despite the narrowing of the war to eastern and southern Ukraine, Ukrainian refugees have not significantly returned to the country. In fact, the outflow continues as Russia occasionally bombs cities far from the front lines and undermines Ukraine’s electrical grid with targeted attacks. Nearly 16 million people out of the country’s 44 million population have now departed, mostly to Poland (see next chart).

Poland has accepted the greatest portion of Ukrainian refugees

Poland has accepted the greatest portion of Ukrainian refugees

As of 11/15/2022. Source: United Nations High Commissioner for Refugees, Macrobond, RBC GAM

One might expect a significant fraction to return once the war is over. Alternatively some members of the military may join their families outside of Ukraine once the war is over. Furthermore, most refugees have ended up in countries that are wealthier than Ukraine and the resultant financial opportunities may dampen later outflows, especially given the diminished condition of the country.

In short, Ukraine will have a big hole in its population and in its economy once the war is over. This is even before accounting for the massive infrastructure investment that will be needed when the war is over. This is estimated to be in the many hundreds of billions of dollars.

Grain and gas

Two other items related to the Ukraine war are worth highlighting.

  1. After Russia temporarily dropped out of the deal that was allowing Ukraine to export its grain, it has since agreed to re-enter it. This should reduce the amount of global hunger felt as a result of the war.
  1. Europe has managed to stockpile quite an impressive amount of natural gas for this winter – more than usual, despite more limited access to gas supplies than normal over the past nine months (see next chart).

Europe natural gas inventory levels remain high

Europe Natural Gas Inventory Levels remain high

As of 11/15/2022. Source: Gas Infrastructure Europe (GIE), Macrobond, RBC GAM

The combination of energy conservation, greater reliance on coal plants, the extension of nuclear plants and the importing of liquid natural gas from the rest of the world has been a successful strategy so far.

Presuming it is not an overly cold winter, Europe should have enough natural gas to get through the winter months. The price of natural gas, while still high, has fallen significantly (see next chart). The 2023 economic outlook for Europe, in turn, is a bit less grim than otherwise (though still likely recessionary).

Germany NCGI Natural Gas Index shows natural gas prices have fallen significantly

Germany NCGI Natural Gas Index shows natural gas prices have fallen significantly

As of 11/16/2022. Source: Intercontinental Exchange (ICE), RBC GAM, Macrobond

The complication is that Europe will likely have very low inventory levels next spring.  The region may struggle to build its inventories enough to avoid similar hardships in the winter of 2023—2024. This is especially true if Russia were to cut its European natural gas flows from the current 20% of capacity to zero. Alternately, if Chinese demand for liquid natural gas picks up as that economy revives, this would be another stressor for Europe. European economic growth in 2024 could thus be weaker than otherwise assumed.

In the background and of a long-term significance, many businesses are looking at expanding into the U.S. rather than Europe. This is largely due to the prospect of geopolitical instability and a multi-year period of high electricity costs in Europe, contrasted by highly tempting new green subsidies and “Buy American” rules in the U.S.

Fiscal affairs evolve

British budget

The new British budget proposal was the mirror opposite of the expansive one first envisioned a few months ago. In the intervening months, the bond market threw a fit, the Chancellor of the Exchequer was dismissed, the Prime Minister quit and new politicians replaced them.

The latest plan was somewhat better received. The proposal is to narrow the British fiscal gap via 55 billion pounds of higher taxes and spending cuts. The tax hikes are a mix of lowering the threshold at which various personal income tax rates hit and increasing the energy windfall tax already announced last July.

Certain spending cuts happen later, while health and education – two sectors that have struggled during the pandemic years – will enjoy additional funds.

COP27 climate summit

The COP27 climate summit in Egypt has concluded. It was widely regarded as a disappointment in that a proposal to phase out all fossil fuels (not just coal, a commitment made at the prior year’s summit) failed. Major emitters, including Saudi Arabia and Russia, blocked the proposal.

A smaller victory against climate change came in the form of an agreement to create a loss and damage fund. This fund will compensate the countries hardest hit by climate change for their suffering. The precise amounts, recipients and funders will all be determined at a later date. Since industrialization, rich countries are cumulatively responsible for 59% of history’s carbon dioxide emissions and yet some of the world’s poorest nations have been most adversely affected by climate change. The U.S. alone is responsible for 25% of the world’s historical carbon emissions.

Wealthy nations also committed $20 billion to helping Indonesia reduce its reliance on coal. If that sounds like a strange thing to promise to a single nation, it should be noted that a) a similar promise was made to South Africa last year for $8.5 billion to reduce coal emissions; and b) Indonesia is the world’s fourth most populated country with an incredible 276 million people. As it becomes wealthier, it threatens to emit massive quantities of carbon dioxide.

As an aside, one of the trickiest aspects about plans to reduce carbon emissions is how the decarbonization burden should be shared among nations. Emissions are rising quickly in emerging market countries whereas they are already falling in the developed world. This leads to the argument that emerging market nations must now pivot with the greatest haste. But developed nations have already far exceeded their fair share of emissions over the past two centuries and their emissions per capita today remain far higher (15 tonnes of carbon dioxide per capita in the U.S. per year, versus 7 in China and just 1.7 in India).

The logical conclusion is that it would be most fair for developed countries to aggressively cut their emissions and for poorer countries to be given more leeway. But it is far harder to cut emissions than it is to stop emissions from rising, and it seems unwise for some of the world’s most populated nations to continue ramping up their emissions as this would swamp the conservation efforts elsewhere. There is no easy answer other than a serious effort by all parties.

-With contributions from Vivien Lee, Vanessa Adams and Aaron Ma

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


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