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by  Eric Lascelles Nov 4, 2019

What's in this article:

  • Webcast
  • Financial conditions improve
  • ISM & payrolls
  • Central banks
  • Brexit

As with much of North America, it was an extremely wet Halloween for us last week. My usual (losing) position on rubber boots is that they are expensive, take up precious closet space, limit movement and are rarely necessary. Nevertheless, even I will admit that they found their purpose this October 31. That might well have been what kept my kids out trick-or-treating long after most bedraggled children had retreated indoors. The good news is that our candy haul was accordingly enormous. The bad news is also that our candy haul was accordingly enormous.

Economic webcast:

Financial conditions improve:

  • Financial conditions indices (FCIs) attempt to combine the movements of interest rates, credit spreads, the stock market and exchange rates into a single variable that can be used to gauge the extent to which financial markets are set to help or hurt economic growth.
  • Over the past year, FCIs have mostly improved thanks to central bank easing, narrow credit spreads and a rising stock market.
  • Prominent examples of the improvement in financial conditions over the past year include the global index (see chart), plus the U.S., China and the Eurozone.
  • The main effect of a changing FCI is not pumped into the economy all at once. Instead, it accrues over the span of a year, with some small residual effects continuing to interact with growth for another year after that.
  • To illustrate how this lag is relevant, the significant tightening of financial conditions in 2018 acted as a moderate drag on growth in 2019.
  • Conversely, the easing of financial conditions in 2019 is set to boost growth in late 2019 and early 2020. The following chart converts the FCI into its growth implications. The improvement could well add as much as 0.7ppt annualized to global quarterly GDP growth. This is the largest positive impulse since the initial recovery from the global financial crisis.
  • Why, then, do few forecasters anticipate a substantial acceleration in global growth in 2020? There are a few reasons:
    1. There are other shocks interacting with the economy in 2020, including drags from protectionism, policy uncertainty and a negative fiscal shock (though we have highlighted the possibility that fiscal policy could prove less of a drag than generally imagined).
    2. Downside risks (i.e. the lateness of the business cycle) outweigh upside risks such that it is more likely that additional headwinds eventually have to be factored in rather than new tailwinds.
    3. Much depends on how financial conditions themselves evolve over the coming months. Our impulse model assumes that financial conditions remain unchanged from here. They might, but the recent trend has actually been toward rising interest rates as the Fed backs away from easing, and that will likely subtract a bit of pop from the positive growth impulse.
  • Let us also highlight that not every country is set to benefit from easier financial conditions. The FCI growth impulse for the U.K. and Japan is roughly neutral. The impulse for Canada looks set to be slightly negative thanks to a strong currency and an absence of central bank rate cuts.
  • Despite all of these gloomy provisos, the main point remains that global financial conditions have been improving and this stands a chance of stabilizing global growth after two years of deceleration.
  • Furthermore and relatedly, the RBC Global Asset Management Investment Policy Committee recently opted to increase its allocation to stocks, raising the equity allocation by a percentage point to 58%, leaving fixed income unchanged at 40%, and cutting cash to 2%. The logic underpinning this relates to the diminishing downside risks detailed in last week’s #MacroMemo, the potential stabilization of growth prospects discussed in this note, plus the possible troughing of earnings, several technical considerations, and the fact that the long-term risk premium favours stocks over bonds to a greater-than-usual extent.

U.S. payrolls perform nicely:

  • The U.S. job numbers in October delivered several pleasant surprises. The total job creation of 128K is meager on the surface, but after removing temporary Census unwind (-17K) and GM strike (-42K) distortions, the pace would have been more like +187K – a strong outcome.
  • Net revisions to earlier months netted +95K previously unrecognized new jobs – a further boost.
  • Unemployment was the one exception to the good-news story, though it merely ticked a tenth higher to 3.6%. The labour market is extremely tight.
  • Still, the U.S. job market continues to merit careful watching:
    • Business confidence remains deeply depressed, and any contagion from business to households is most likely to come via reduced hiring. It is already the case that the monthly rate of hiring has slowed from an average of 223K/month in 2018 to 168K/month year-to-date in 2019. This lower rate is still more than enough to absorb a growing population, but a dip into double-digits would start to challenge that thesis.
    • Other labour market metrics show some tentative slippage. Jobless claims have ceased to fall; the unemployment rate is no longer declining with the regularity of years past; and the job openings-to-unemployment ratio has recently peaked (see chart).

ISM Manufacturing stabilizes:

  • The U.S. ISM Manufacturing Index – alongside payrolls, arguably the most closely watched monthly U.S. economic metric – was a mixed bag.
  • Strictly speaking, it arrived below consensus and yet again below the critical 50 threshold, signaling a continuation of the manufacturing sector recession. Indeed, the latest durable goods orders broadly confirm that diagnosis.
  • That said, the metric did manage a slight rebound in October, from 47.8 to 48.3. Furthermore, the crucial employment and new orders inputs both recorded increases of their own.
  • For the better part of two years, we have been looking for a floor in purchasing manager indices. This could well represent that bottom, particularly given that downside risks have shrunk and financial conditions have become more helpful. Then again, there have been several false readings before. Watch the ISM Non-Manufacturing Index, set for release on Tuesday November 5.

U.S. Federal Reserve’s hawkish cut:

  • The Fed cut its policy rate by another 25bps to 1.625% on October 30, the third such move of the year.
  • But, true to the Fed’s avowed belief that its actions merely represent a mid-cycle adjustment rather than the beginning of a slippery slope down to another near-zero policy rate, it hinted that no further easing was likely in the near term. This was a hawkish (though not unexpected) development. The clearest signal of this came from the Fed’s statement that any further stimulus would require a “material reassessment” of the outlook.
  • Several further considerations underpin the Fed’s plan to leave the fed funds rate unchanged from here:
    • Interest-rate sensitive sectors like housing have staged a tentative rebound in response to easier borrowing conditions.
    • The Fed views its recent rate cuts as “insurance” again downside risks. And several macroeconomic downside risks, ranging from Brexit to the proximity of a recession to U.S. protectionism, have diminished recently.
    • The Fed rightly notes that prior easing will continue to actively support the economy in the future: the full transmission of monetary policy takes 6-8 quarters, such that the most recent cut will still be (modestly) boosting growth in early 2021.
    • The Fed also notes that its policy rate is now in stimulative territory, meaning that the level of economic output should remain higher than otherwise so long as this stance is maintained. Whereas a neutral policy rate was likely between 4% and 5% prior to the financial crisis, the consensus view post-crisis has been that it is around 3%. If anything, recent developments have argued that neutral might even be closer to 2%. Regardless of the exact definition of neutral, the current 1.625% stance is below it.
  • Although most historical rate-cutting episodes are linked to the arrival of a recession, there are exceptions and it is entirely conceivable that the Fed manages to avoid further easing, particularly if financial conditions remain friendly and economic growth persists.
  • Consistent with this, financial markets have backed away from further Fed easing. The market has deferred its expectation for a fourth rate cut until the April 29, 2020 decision, and fails to fully price in a fifth cut at any point in 2020.
  • While the market’s view is entirely reasonable as a base-case scenario, we continue to dwell on the bear-case. There is a roughly 35% chance of recession over the next year, a scenario that would likely demand six further rate cuts (leaving the policy rate just above 0%). Combining that with a base-case scenario of no further easing leaves the impression that markets may be a bit light on how much rate cutting they price in.

The Bank of Canada’s dovish pause:

  • The Bank of Canada did the exact opposite to the Fed: it opted to leave the overnight rate unchanged at 1.75% while delivering a notably dovish message.
  • Dovish elements included:
    • Downgrading the global and Canadian growth forecast.
    • Upgrading its estimates of the economic damage from protectionism and the uncertainty surrounding trade.
    • Highlighting the strength of the Canadian dollar (and, implicitly, the economic headwinds that result from this).
    • Acknowledging that many other central banks have been lowering rates.
    • The statement in the communiqué that “the resilience of Canada’s economy will be increasingly tested as trade conflicts and uncertainty persist.”
    • The revelation in the opening remarks of the press conference that “Governing Council considered whether the downside risks to the Canadian economy were sufficient at this time to warrant a more accommodative monetary policy”, paired with the later comment that this was not something the BoC had debated at the prior meeting.
  • Ultimately, these factors failed to motivate the Bank of Canada to cut rates. Its justification for this stubbornly stable stance, despite easing by global peers, revolves around several positive developments in Canada:
    • Inflation remains slightly above target.
    • Hiring has been very good.
    • Housing has regained its feet.
    • The service sector continues to perform well.
    • Government spending may prove supportive, particularly after the recent election of a minority-led parliament.
    • Canada’s policy rate was – up until last week – lower than the U.S. equivalent, meaning that for all of its action, the U.S. had simply managed to match the pre-existing Canadian policy stance. This argument is strengthened when one considers that Canada’s 10-year bond yield remains outright lower than the U.S.
    • It went unstated, but we continue to believe the Bank of Canada is placing greater weight on its base-case scenario than are other central bank’s like the Fed, which has dwelled a great deal on downside risks in conducting monetary policy.
  • However, in our view, Canada is not getting as much of a free ride as would first appear. While borrowing costs in Canada have come down in line with the rates in more monetarily active countries, Canada’s exchange rate has paid the price, appreciating slightly versus the U.S. dollar and notably versus most other currencies. Indeed, the financial conditions index for Canada shows a deterioration for Canada despite improvement in most other markets.
  • In response to the Bank of Canada’s signaling pivot, markets now price in 22% of a rate cut at the next meeting (December 4). The market prices in a greater than 50% chance of a rate cut starting with the June 3, 2020 meeting.
  • As with the U.S., we flag the risk of more easing, not so much because it is a slam dunk, but because a proper accounting of downside (recession) risks argues that there are non-trivial scenarios in which central banks have to ease by far more than presently imagined.

Bank of Japan, briefly:

  • The Bank of Japan is already locked into a highly stimulative position, with a negative policy rate and ongoing bond purchases.
  • Not to be left out (and in recognition of slowing global growth) the Bank of Japan indicated that is open to further monetary easing involving tools other than its policy rate.

The briefest of Brexit updates:

  • The British election is now officially set for December 12.
  • Conservatives continue to surge in the polls, with a majority increasingly within reach as the party cannibalizes support from the single-topic Brexit Party.
  • Should a majority result, Prime Minister Boris Johnson will presumably be free to pursue his tentative Brexit deal recently agreed upon by the EU.
  • But we flag the risk that the Conservatives slip back somewhat, consistent with the 2017 election when an expected Conservative majority imploded over the course of the campaign.
  • Were a minority government to be the result, complexity would naturally increase in several regards, but most crucially on the subject of Brexit. The Scottish National Party prefers a milder form of Brexit (or best, none at all), and the Liberal Democrats are avowedly pro-EU. Labour, meanwhile, officially favours a milder Brexit, but many of its constituents prefer to remain in the EU.
  • On the other hand, any partnership with the Brexit Party could still push the Conservatives toward a “harder” outcome. Other smaller parties, such as the DUP that has supported the Conservatives over the past two years, could also permit such an outcome.
  • Suffice it to say that the Brexit outlook depends heavily on how the election turns (see next chart).
  • Fortunately, there is now more time to nail down a Brexit deal as the deadline was bumped from October 31, 2019 to January 31, 2020. Furthermore, we continue to believe that the risk of a Hard Brexit is much smaller than it was in early September.

Disclosure

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