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by  Eric Lascelles Nov 23, 2021

What's in this article:

The latest #MacroMemo tackles a wide range of topics, beginning with rising COVID-19 cases and increased government restrictions. We then tackle new issues including flooding in British Columbia, the re-appointment of Fed Chair Powell and a recap of the COP26 climate change summit. Next we review recent economic and inflation trends, and check in with supply chains and the oil market. Finally, we debate the long-term outlook for inflation and identify a shifting balance of power between workers and companies.

Recent developments are fairly mixed, perhaps skewing slightly in a negative direction.

Positives include:

  • The U.S. economy continues to accelerate after a lull.
  • Supply chain problems have become a bit less bad.
  • The Fed Chair will remain unchanged for another four years.
  • We are skeptical that inflation will remain high over the long run.

Negatives include:

  • COVID-19 infections are rising across the developed world.
  • Non-U.S. developed nations appear to be suffering an economic deceleration.
  • Inflation remains extremely high.
  • Canada has suffered serious flooding on its west coast, with economic consequences.

COVID-19 rising

Continuing a trend that has been in place for the better part of two months, COVID-19 infections have continued to rise in the developed world (see next chart). Interestingly, emerging markets have largely dodged this wave.

COVID-19 emerging markets vs. developed markets infections

COVID-19 emerging markets vs. developed markets infections

As of 11/21/2021. Calculated as the 7-day moving average of daily infections. Source: WHO, Macrobond, RBC GAM

Europe remains the epicenter for these problems, with Germany particularly affected. Germany is now suffering roughly twice as many new cases per day as at any other point in the pandemic (see next chart). The country is not alone. Cases are also rising sharply in Austria, the Netherlands, Switzerland and beyond. U.K. cases remain roughly flat, but elevated. It is a significant consolation that fatalities have not jumped to the same extent, presumably due to vaccines.

COVID-19 cases and deaths in Germany

COVID-19 cases and deaths in Germany

As of 11/21/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

U.S. infections continue to edge higher (see next chart), but this arguably understates the breadth of the deterioration. More than 40 out of 50 states now report rising caseloads (see subsequent chart). The U.S. remains peculiar in that its fatality rate per case hasn’t significantly declined over the past several waves. The pandemic is still highly deadly there.

COVID-19 cases and deaths in the U.S.

COVID-19 cases and deaths in the U.S.

As of 11/21/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

Number of U.S. states with transmission rate above key threshold of one

Number of U.S. states with transmission rate above key threshold of one

As of 11/21/2021. 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

Canadian infections are also rising slightly (see next chart), though with considerable variation depending on the region. Ontario and Quebec are now deteriorating, whereas British Columbia, Alberta and Saskatchewan have been improving.

COVID-19 cases and deaths in Canada

COVID-19 cases and deaths in Canada

As of 11/21/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

Why are the numbers getting worse in so many developed countries? It is likely some combination of:

  • People behaving less cautiously.
  • Fading vaccine immunity – the half-life for vaccine effectiveness may be as little as 7 months.
  • Colder weather making the air drier (a known driver) and pushing people to congregate inside.
  • Schools reopening and hosting a concentration of unvaccinated people.

Vaccine boosters should help address #2; colder weather (#3) is not forever, though spring remains many months away; many children will shortly be vaccinated (#4); but we are dubious that people will behave much more cautiously (#1). There is unquestionably a path toward declining cases within this jumble, via several permutations.

Countries tighten rules

Some governments are incrementally tightening their COVID-19 restrictions again. Our global stringency index recently edged slightly tighter for the first time in several months (see next chart).

Global Stringency Index update

Global Stringency Index update

As of 11/21/2021. Global Stringency Index measuring the strictness of lockdown policies that restrict mobility, calculated as stringency index of 50 largest economies. Sources: University of Oxford, International Monetary Fund, Macrobond, RBC GAM

A number of European countries have either introduced or reintroduced vaccine passports in response to rising infections, including Greece. Meanwhile, Austria announced a full lockdown, becoming the first country in Western Europe to re-impose a lockdown since vaccines were rolled out.

All of this causes some economic damage – indeed, we discuss evidence of an economic deceleration later. However, we continue to believe the damage should be fairly slight given that most restrictions are more targeted than during the first few waves of the pandemic.

British Columbia flooding

Southern British Columbia is suffering once-in-a-century flooding, with more rain anticipated in the coming days. It may prove to be the costliest natural disaster in Canadian history.

The bulk of the province’s road and rail transportation corridors have been disconnected from the rest of the country due to flooding and mudslides. From an economic standpoint, this is obviously a problem for the affected region. It is also highly consequential for Canada as a whole given that the Vancouver Port is in the affected area -- a facility responsible for 15-20% of all Canadian trade in goods. This is unfortunate as Canada’s ports were previously handling supply chain issues somewhat better than in the U.S.

One estimate puts the normal flow of goods between British Columbia and the rest of Canada via road and rail at around $325 million per day. To be fair, not all of this has been lost and the value-added amount would be considerably smaller. But the sums involved are nevertheless quite large.

Heroic efforts are underway to restore service. For the moment, some trucks can transit around the area via the U.S. and some trains are diverting up the coast to Prince Rupert. It is expected to take up to a week to get the rail lines working again, and some roads should be capable of handling limited traffic within a few days, though a full restoration of highway service could be months off.

From an economic standpoint, consumers are not getting the goods they want from Asia or British Columbia, and Canadian producers are unable to ship their products to Asia or British Columbia. People in the affected area have been advised to remain at home, reducing economic output and demand further. Fuel shortages may also crimp activity for a period of time. Tourism is naturally diminished, in part by the acute issues, in part by the fact that the torrential rain washed away much of the snow on ski slopes. Lastly, the cost to the insurance industry should sum well into the billions of dollars.

Preliminary economic estimates are that Canadian GDP should decline outright in November. The fourth quarter could lose several percentage points of growth (though the quarter is still likely to manage some growth). Overall 2021 growth may be trimmed by around a quarter of a percentage point. This adds to the thesis of decelerating Canadian economic growth.

Of course, as with almost all natural disasters, when the constraint goes away, activity usually rebounds nearly fully. Furthermore, extra economic activity will be generated by the need to rebuild infrastructure and private property. As such, economic growth should be somewhat faster than normal in the final month of 2021, in the first quarter of 2022, and likely beyond.

Fed Chair renewal

A key source of uncertainty this fall was whether U.S. Federal Reserve Chair Jerome Powell would be nominated for a second term, or instead replaced by the more left-leaning Lael Brainard. That uncertainty has now been resolved. President Biden has opted to revert to the long-standing tradition (broken four years ago by President Trump) of nominating the Fed Chair for a second four-year term.

Betting markets had grown increasingly nervous about the outcome. The assigned probability that Brainard would instead be nominated rose from less than 20% in September to nearly 40% just before the decision. Anecdotally, White House staff had been recommending that Powell be selected as a show of stability and bipartisanship and due to his handling of the pandemic so far. However, Biden was thought to be tempted by Brainard given the desire for a Democrat, for a greater focus on climate change, for possibly more dovish monetary policy and given her desire for stricter banking regulations.

The decision yields the slightly more hawkish policy path of the two scenarios, though it is hardly hawkish in an absolute sense and was already the presumptive path forward. Nevertheless, at the margin, the decision would appear to be dollar positive, yield positive and possibly stock market negative (though the stock market may care more about stability and ending high inflation than it fears incrementally tighter monetary policy). Given how high inflation is and the extent to which the U.S. economy has recovered, it is arguably for the best that the Fed not pursue a more dovish path.

All of this said, Lael Brainard will still be involved in the monetary policy process. She has been nominated as Vice Chair, and is expected to supervise the banking sector in that role.

These nominations need to be approved by the Senate, but both are likely to succeed – Powell on a bipartisan basis, and Brainard along partisan lines.

COP26 climate review

The latest edition of the annual global climate change summit – COP26 – ground to a close just over a week ago. Notably, 151 countries announced incrementally more aggressive climate plans to reduce emissions by 2030. Furthermore, specific agreements were reached to:

  • Reduce methane emissions.
  • Stop and reverse forest loss.
  • Align the financial sector with net zero goals by 2050.
  • Phase out internal combustion engines.
  • Reduce the use of coal more quickly.
  • Provide more support for poor countries pursuing their own climate mandates.

Despite this progress, commitments fell short of levels needed to restrict climate change to a 1.5 degree cumulative increase. That target now seems unlikely to be met given that global emissions would have to be cut by more than half by the end of the decade for it to be achieved. Current commitments are consistent with around a 2.5 degree cumulative temperature change.

Future meetings are likely to yield additional promises. Laggards such as China, Saudi Arabia and Australia may participate more enthusiastically in the future. But, equally, many countries will probably fail to reach their targets. In turn, we assume the actual temperature change ends up being close to 2.5 degrees – a sufficiently large increase that non-linear consequences cannot be ruled out.

There are a variety of economic consequences that emerge from this amount of climate change (and from policies designed to limit further warming). These are fairly small at the aggregate level. However, there is a great deal of uncertainty around them and there are massive implications for certain sectors – subjects to be discussed in detail in a later report.

Economic trends

The U.S. economic trend remains favourable: the mini-acceleration we discussed in the last report is still seemingly underway. U.S. retail sales for October was up by a strong 1.7% and industrial production rose by 1.6% over the same month.

Conversely, most other developed countries are now underperforming. Canadian retail sales fell by 0.6% in September, and the recent flooding will prove unhelpful in later months.

U.K. GDP rose by 1.3% (un-annualized) in the third quarter. This was a tepid showing relative to the prior quarter. It was seemingly impeded by a high level of COVID-19 infections in the U.K., a “pingdemic” that forced many people to isolate at home when a government app indicated they had been in close contact with an infected person. In addition, global supply chain problems have proven particularly acute for the U.K.

Japanese third-quarter GDP similarly underperformed, down 3.0% annualized in response to the country’s worst bout of COVID-19 infections. Fortunately, cases have since receded sharply in Japan and so the fourth quarter should be considerably better.

Inflation update

The latest inflation readings remain extremely high.

The U.S. Consumer Price Index (CPI) in October rose 6.2% on a year-over-year (YoY) basis, the highest reading since 1990. Prices roses by a big 0.9% over the past month alone. Core inflation is not quite so extreme, but has nevertheless now reached +4.6% YoY, with mounting evidence that inflation pressures have broadened out from their original drivers. As we had predicted in an earlier note, shelter costs are now imposing additional upward pressures that are not obviously going to reverse later.

Canadian CPI has also jumped once again, from +4.4% to +4.7% YoY in October. Of the country’s three core CPI measures, Common CPI remains sub-2% (+1.8%), but the other two are now significantly higher. Mean CPI is +2.9% and Trim CPI is +3.3%. U.K. CPI is now at +4.2% YoY and eurozone CPI is +4.1% YoY. Japan is the only major developed nation bucking the high inflation trend (just +0.1% YoY CPI).

To the extent that the developed world buys many consumer goods from China, it is concerning that China’s Producer Price Index (PPI) rose at its fastest rate in 26 years in October: +13.5% YoY.

A review of real-time inflation indicators finds that, whereas these metrics were high but steady over most of the summer and early fall, they are now actively ascending again. Suffice it to say that we remain comfortable with our above-consensus near-term inflation forecasts.

Inflation and markets

How does high inflation interact with financial markets? There is only a significant effect if the high inflation is expected to be persistent, which isn’t currently the case. But, if markets were to change their mind, bond yields tend to rise for two reasons, imposing short-term capital losses on fixed income investors:

  1. The first driver is that central banks tighten rates more, increasing short-term real rates.
  2. The second is that higher inflation expectations are priced into bonds, increasing the nominal yield. Higher yields, of course, mean lower bond prices. While subsequent coupons are then larger, the extra return is illusory to the extent it comes disproportionately from extra inflation rather than higher real rates.

For stock market investors, corporate earnings tend to be relatively well insulated by the fact that companies can increase their product prices when costs go up. However, equity valuations should still be lower in a chronically high inflation world:

  • The discount rate rises such that future earnings become less valuable to investors.
  • Higher bond yields necessitate a lower price-to-earnings (P/E) ratio if the risk premium is to remain constant.
  • Investors must be aware that the real effective tax rate goes up on financial market income when inflation rises.

Governments tax on the basis of nominal rather than real returns. If the real return is 2% and inflation is 0%, the real effective tax rate is the same as the nominal tax rate. But if the real return is 2% and inflation is 4%, the real effective tax rate is three times higher (and potentially completely eats the real return!).

Supply chain improvement

Supply chain problems remain intense (and have recently gotten worse in Canada due to flooding). However, some patchy improvements are visible elsewhere.

The number of container ships waiting to dock and unload their goods in Southern California has fallen nicely recently (see next chart). We hesitate to celebrate too much as there have already been two false dawns over the past few months. But an improvement is an improvement until it is unwound.

Container ships at anchor or holding areas in Los Angeles and Long Beach

Container ships at anchor or holding areas in Los Angeles and Long Beach

As of 11/19/2021. Source: Marine Exchange of Southern California, RBC GAM

The cost of shipping goods around the world has also declined – incrementally for containers and quite sharply for dry bulk goods (see next two charts). The actual cost of shipping products isn’t usually a large part of a product’s price – and so isn’t a big inflation factor. However, insufficient shipping throughput has been a major problem for many industries and so lower costs should correlate well with easing supply chain problems.

Shipping costs falling but still elevated

Shipping costs falling but still elevated

As of the week ended 11/18/2021. Source: Drewry Supply Chain Advisors, RBC GAM

Shipping costs continue to normalize

Shipping costs continue to normalize

As of 11/22/2021. Shaded area represents recession. Source: Baltic Exchange, Macrobond, RBC GAM

Southern California ports are getting serious about eliminating the backlog of unloaded containers waiting at their ports via the introduction of a new system of fines. However, to the extent there is a severe shortage of truck drivers and also rail constraints, it isn’t clear whether this will significantly resolve the problem.

Happily, several large retailers announced in their recent earnings reports that they have plenty of stock for Black Friday and beyond. It is hard to say the extent to which this represents genuine improvement, companies putting a positive spin on the situation, or perhaps even larger retailers outmuscling smaller ones for limited access to shipping.

Oil outlook

Oil prices have fallen from $83 to $76, but are still high even by the standards of the pre-pandemic period. High oil prices were not initially expected to be a feature of the pandemic recovery, as demand for oil remains lower than it was before the pandemic for obvious reasons: fewer people are commuting to office jobs and plane travel remains below prior peaks. But suppliers have proven very slow to increase their production, resulting in a shortfall.

We continue to expect oil prices will fall somewhat further over the coming six months, for several reasons.

First, the International Energy Agency forecasts that oil supply will rise by 1.5 million barrels per day over the remainder of 2021 – a significant sum. The Agency further expects that global oil supply will then moderately exceed demand for much of 2022 (see next chart).

Global oil deficit to alleviate in 2022

Global oil deficit to alleviate in 2022

EIA Short-Term Energy Outlook, November 2021. Source: RBC GAM

Additionally, in keeping with the historical experience after episodes of high energy prices, OPEC now predicts that recent elevated oil prices will hurt energy demand in emerging market countries such as China and India.

Financial markets certainly anticipate a further decline in oil prices, as per oil futures that are in an extreme state of backwardation (see next chart). Backwardation refers to a situation in which the futures market anticipates a lower price in the future relative to the present.

Backwardation is widening

Backwardation is widening

Price difference between Brent 6-month and 1-month contract. Source: Bloomberg, RBC GAM

With a focus on the U.S., oil production remains well below pre-pandemic levels (see next chart). This implies significant latent capacity to increase output. Further, there is some evidence that this is now beginning to happen, albeit gingerly, given a rising rig count (see subsequent chart).

U.S. oil production remains far below pre-pandemic levels

U.S. oil production remains far below pre-pandemic levels

As of 11/05/2021. Source: EIA, Haver Analytics, RBC GAM

U.S. rig count has been rising steadily

U.S. rig count has been rising steadily

As of the week of 11/12/2021. Source: Baker Hughes, Bloomberg, RBC GAM

To be clear, none of this is a prediction of outright low oil prices. It is more likely that oil prices simply become a bit less high. And we must be particularly cautious in assuming that the supply response will be as eager as in the past given new headwinds. These include a more difficult fundraising environment for oil producers and fears of accumulating reserves that could later be stranded due to climate change mitigation efforts.

More or less inflation over the long run?

I recently had the honour of debating Manoj Pradhan of Talking Heads Macroeconomics on the subject of whether inflation will be high or low over the long run. He took the high argument – consistent with the research presented in his book entitled “The Great Demographic Reversal.” In a nutshell, a rising number of seniors means a shortage of workers and a large fraction of the population will be dissaving as they live off of their retirement savings. Both of these forces could be inflationary.

As coherent as those arguments appear to be, I gladly took the opposite side of the debate: I expect inflation over the long run to be normal, if not a little low. Here is why:

  1. High inflation today is a cyclical rather than a structural phenomenon – it is the result of the abrupt restart of the economy, with demand snapping back more quickly than supply. This has little bearing on the long-term inflation outlook.
  2. The classic argument is that Japan has the world’s oldest population and also has the lowest inflation. Yes, the country also had a housing bust in the 1990s and made some policy errors along the way that could help to explain its low inflation. But it stretches the imagination to think that policy mistakes made 30 years ago – since largely corrected – could continue to explain low inflation. Furthermore, when one looks more granularly within Japan – and thus controls for national level policy distortions – the prefectures with the oldest populations have the lowest inflation while those with the youngest have the highest inflation.
  1. There are theoretical justifications for these findings. Countries that grow slowly – a common experience among nations with poor demographics – tend to experience lower inflation. Countries with slow to non-existent population growth also tend to experience falling capital costs and falling home prices – another deflationary force. As seniors gradually spend their savings, they repatriate investments from overseas, increasing their country’s exchange rate and thus reducing the price of imported products. Finally, seniors don’t like high inflation: most live on a fixed income and vote their preferences for low inflation.
  2. Globalization has undeniably slowed and is therefore exerting less of a deflationary force than before. However, the big transition on this front arguably happened a decade ago and yet inflation did not subsequently spike. Fed research calculates that China exerted a deflationary influence of perhaps -0.2 to -0.3% annually. The loss of this is significant, but not enough to take inflation from low to outright high readings.
  3. From the perspective of central banks, low inflation is a tricky problem but high inflation is not. It can be difficult to escape from a period of depressed inflation since there is a limit to how low central bank rates can go. But there is no limit to how much central banks can increase rates if they want to halt high inflation. In turn, it is fairly hard to get stuck in a period of structurally high inflation.
  4. There are a number of other deflationary forces that appear set to persist or even extend their influence. Automation appears to be picking up, and this handily replaces the workers lost to mass retirement. We believe productivity growth may be faster in the future – theoretically, a deflationary force. High indebtedness is also associated with periods of low inflation since such debt cannot be managed were inflation to be significantly higher.

To be fair, we do believe that climate change will be inflationary due to a range of factors including a higher price on carbon due to carbon taxes and higher food prices due to more challenging growing conditions. Further, as we will argue in the next section, workers may be starting to gain the upper hand relative to their employers, potentially creating additional inflation via higher wages. But these forces are unlikely to be powerful enough to fully offset the depressant effect from demographics.

Workers > Capital?

Over the past several decades, capital – that is to say, businesses and investors – have broadly thrived while workers have fared less well. There are many reasons for this:

  • Corporate tax rates have tended to fall.
  • Firm concentration has increased, creating large, extremely successful corporations.
  • The supply of labour has been abundant thanks to the entry of China into the global economy, the falling of the Iron Curtain and baby boomers’ peak years in the workforce.
  • Unionization has been in decline, reducing the clout of workers.
  • Globalization was on the ascent, reducing costs and increasing access to foreign markets.
  • Automation has increased, reducing costs further.

These factors have supported rising profit margins for businesses and restrained wages for workers.

Looking forward, the environment may be somewhat more challenging for businesses, and somewhat friendlier for workers:

  • The pandemic has arguably spurred a shift in focus from finances to people, culminating in what could be a permanently larger social safety net after fairly radical experimentation during the pandemic.
  • Labour shortages now exist due to people taking early retirement or dropping out of the workforce in response to the pandemic, and due to less immigration over the period. In the years ahead, large numbers of baby boomers will retire and the supply of labour will become more constrained.
  • Elections appear to be tilting leftward, to the disadvantage of businesses.
  • A global minimum corporate tax rate of 15% is being introduced.
  • The U.S. corporate tax rate may shortly increase.
  • Anti-trust efforts aimed at tech giants have expanded significantly in China and Europe, and are brewing in the U.S. and elsewhere.
  • Minimum wages have been trending significantly higher, with the most recent Nobel Prize in Economics awarded for research endorsing higher wages for low-income workers.
  • Globalization is no longer advancing as it once did.
  • (All of this said, it must be conceded that automation is still rising, and unionization remains diminished).

We stop short of predicting outright lower corporate profit margins, but these changes could bring about an era in which profit margins cease to rise, and in which wages increase somewhat more quickly. For investors, this would remove one of the three main drivers of stock market gains over the past decade (rising earnings, rising valuations and rising margins).

-With contributions from Vivien Lee and Aaron Ma

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

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