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by  Eric Lascelles Nov 8, 2022

What's in this article:


This week’s note checks in on the pandemic, contrasts strong labour market data with evidence of economic softness elsewhere and revisits assumptions about the depth and timing of a possible recession.

On the inflation front, we highlight more persistent inflation problems in Europe and the UK, but celebrate important inputs that are turning lower elsewhere.

Central banks continue to send interest rates higher, but there is a growing divergence with regard to their plans for the future, and the extent to which markets have sufficiently priced in those plans.

Financial markets merit our attention: it is useful to consider two different scenarios for stocks versus bonds in the future. Bonds perform well in both of these scenarios, whereas the stock market performs well in only one.

Lastly, we look at political items including the U.S. mid-term election and the latest global climate summit.

November economic webcast

Our monthly economic webcast for November is now available, entitled Waiting for recession.

Pandemic check-in

Let us check in on the COVID-19 pandemic in two capacities: first, with regard to the spread of new variants; and second, whether China might imminently ease its pandemic restrictions as some rumours have claimed.

New variants

The Omicron sub-variant BA.5 has been the dominant COVID-19 strain since last summer. More than 300 sub-variants are now swirling around the world. Several have significantly expanded their reach and two are most likely to break out as the new dominant strain. In the U.S., the BQ.1.1 sub-variant is well on its way to supplanting BA.5, which fell below a 50% share of new infections in early November. In Asia, the XBB variant is spreading quickly. It can now be found in 26 countries.

By definition, these new more successful variants must either be more contagious or better at evading vaccines and accumulated immunity. Several, including BQ.1.1, are believed to be adept at resisting antibody drugs.

Fortunately, none are thought to inflict more severe illnesses than prior strains.

Combined with colder weather in the Northern Hemisphere, it seems reasonable to anticipate another wave of infections over the coming months, albeit with fewer adverse health or economic consequences than prior waves.

For all of the bad news, it is arguably promising that, despite the great proliferation of sub-variants, the spike proteins are mostly mutating in a way that makes them more similar to one another, as opposed to more disparate. This suggests that the virus is nearing its most optimized form, after which there could be significantly fewer new variants of consequence.

Chinese re-opening rumours

Chinese equity markets surged last week on rumours that the country might be on the cusp of significantly easing its zero-tolerance policy toward COVID-19 infections. There does appear to be some credibility to the view that the country’s quarantine requirements for inbound travelers will be incrementally loosened.

However, a major change in COVID-19 policy seems less likely in the near term, for several reasons:

  1. China’s National Health Commission announced over the weekend that China will “unswervingly” adhere to its current virus controls.
  1. China is presently suffering a significant increase in infections – an inopportune moment to ease restrictions. China’s daily case count has suddenly surged to 5,436 cases on November 6 – the most since early May when Shanghai was locked down. A large portion of the new infections originate from Guangzhou, a city of 19 million people near Hong Kong.
  1. The statement by former chief epidemiologist Zeng Guang of China’s Centre for Disease Control and Prevention that the conditions for China to open up are “accumulating” – the original impetus for the market’s enthusiasm – was a) subsequently undermined by the aforementioned comments from the National Health Commission and by the increase in infections; and b) is less striking than it first seemed as Zeng spoke of a five to six month timeframe for opening up – not imminently.

Some incremental reopening is ultimately likely over the coming months. However, it is logical for the largest changes to come next spring – perhaps in March – when winter weather is easing, the travel-oriented Chinese New Year is complete and the country’s new bivalent vaccines have been administered to a significant part of the population.

Economic trends

Economic trends remain quite mixed. In short, North American jobs data was hot, while other metrics were lukewarm, and measures of economic intentions were outright cold.

U.S. payrolls added a robust 261,000 new positions in October, handily exceeding expectations. The jobs were mostly in the private sector and there was an upward revision to the job creation previously reported over the prior two months.

The one twist was that the unemployment rate rose from 3.5% to 3.7%. This wasn’t simply because more people on the sidelines decided to start looking for work. Instead, it was because the unemployment rate is estimated by the household survey rather than the establishment survey. Business establishments have no idea how many people don’t have jobs, after all.

The household survey makes its own estimate of job creation. While the number is usually choppier than the widely cited number that emerges from the payroll survey, it does possess some informational value of its own. In October, the household survey estimated the loss of a whopping 328,000 U.S. jobs. This is a disagreement of 589,000 jobs versus the payroll survey in a single month!

It is further notable that the household survey has reported job losses in three of the past seven months – unlike the payroll survey. Also, the household survey has been the weaker of the two in six of the past seven months (see next chart).

U.S. employment may be weaker than it looks

As of Q1 2022. Source: U.S. Bureau of Labor Statistics (BLS), Macrobond, RBC GAM

To be clear, the payroll survey is still generally the more reliable of the two surveys. But there is a chance it is overestimating U.S. job market strength, particularly when we pair the household survey readings with the fact that major tech companies have clearly pivoted to layoff mode, job openings are falling and quits rates are falling.

It must be conceded that Canada’s jobs report was also very strong in October, with a huge 108,000 new workers reported. In one fell swoop, this fully recouped all of the jobs lost in three consecutive months of layoffs over the summer. All of the new job creation was full-time in nature.

It makes some sense that the labour market is proving more resilient than normal in the face of economic adversity. Companies have struggled to hire workers and so will be reluctant to shed them. However, the pace of hiring is arguably inconsistent with what the economy is currently saying, and certainly with where interest rates have gone.

What is the economy saying? The U.S. Institute for Supply Management (ISM) Manufacturing Index continues to fall, and is now on the cusp of a contracting manufacturing sector (see next chart). The ISM Service Index also fell somewhat, though it remains in the territory of moderate growth.

U.S. manufacturing activities are deteriorating

As of October 2022. Shaded area represents recession. Source: ISM, Haver Analytics, RBC GAM

In the Eurozone, our aggregate index of economic activity has fallen sharply. It is now consistent with a recession, though not a deep recession (see next chart).

Eurozone composite activity index has fallen sharply

As of October 2022. Chart reflects first principal component from principal component analysis (PCA) analysis on select indicators of Eurozone economic activity. Shaded area reflects recession. Source: CEPR, ZEW, Deutsche Bundesbank, HIS Markit, Macrobond, RBC GAM

In China, the country’s exports were just announced to have fallen by 0.3% over the past year – significantly worse than the expectation for a 4.3% gain. This reflects weaker global demand, the world’s pivot back from goods toward services and China’s own zero-tolerance COVID policy. A major Chinese Apple manufacturer recently had to shut down its complex in response to an outbreak.

Souring consumers

As interest rates have soared around the world, the demand for consumer loans is weakening. The demand for mortgage loans specifically is in free fall (see next chart).

U.S. consumer demand for loans has dropped substantially

October 2022 Senior Loan Office Opinion Survey on Bank Lending Practices. Shaded area represents recession. Source: Federal Reserve Board, Macrobond, RBC GAM

In Canada, RBC’s own real-time consumer card index detects the beginning of weaker spending relative to the summer. Further, an October survey of Canadian consumers found diminished appetite for spending on non-essentials including luxury items, travel, electronics and restaurants.

Recession views

Business cycle update

Our refreshed U.S. business cycle scorecard makes the same claim as a quarter ago: that the economy is at an “end of cycle” moment. Furthermore, the cycle continues to march forward in subtle ways. Counterclaims for “early cycle” and “mid cycle” have palpably weakened relative to last quarter, while “recession” counterclaims have strengthened (see next chart).

U.S. business cycle score points to end of cycle

As at 10/28/2022. Calculated via scorecard technique by RBC GAM. Source: RBC GAM

One would normally expect a recession within the next several quarters given this reading. We maintain the view that a recession is substantially more likely than not over the next year.

Consensus now prices a recession

The consensus economic forecast has now fallen to the point that a mild recession is priced in for 2023 (see next chart). Although the consensus for the year as a whole is still for a marginally positive number – +0.2% U.S. GDP growth – that is weak enough to contain a few quarters of declining output.

U.S. consensus growth forecast continues to decline

As of October 2022. Source: Consensus Economics, IMF, RBC GAM

For comparison, we have been calling for a somewhat deeper recession, albeit still only of a middling depth relative to the historical average. This would involve a steeper 0.6% decline in U.S. 2023 GDP.

Recession timing revisited

Earlier this year, we foretold a recession that would commence sometime between the final quarter of 2022 and the middle of 2023.

As the labour market and economy have proven more resilient than initially expected, it is worth asking whether the recession might happen later than previously imagined. It is already evident that, at least for North America, the recession has not begun in the final quarter of 2022. A recession does appear to be happening in the Eurozone and UK along this timeframe.

The first half of 2023 is still a good guess for the beginning of a North American recession. But there is now the increased possibility that it happens later, such as in the second half of 2023.

What would support a delayed recession? In addition to the sheer economic resilience on display so far despite a range of headwinds, one might point to the classically lagged impact of rising interest rates. The full transmission of monetary policy theoretically takes around 18 months to play out. Illustrating this, despite the giant leap in borrowing costs in 2022, U.S. consumer delinquency rates have actually continued to decline (see next chart). Any deterioration happens with a lag.

U.S. delinquency rates for auto and credit card loans are trending down

As of Q2 2022. Percent of balance of 90+ days delinquent loans normalized. Shaded area represents recession. Source: FRBNY Consumer Credit Panel/Equifax, Macrobond, RBC GAM

Given that the Fed’s first rate hike was in March 2022, the full effect of that action won’t be incorporated into the economy until September 2023. The bulk of the Fed’s tightening – which occurred over the second half of 2022 – won’t be fully absorbed until the first half of 2024.

Another reason for a delayed recession is that households and businesses have been able to rely on the higher than normal savings they accumulated over the past three years to get them through the initial phase of weakness.

Why, then, do we cling to the notion that a recession is most likely in the first half of 2023? To summarize:

  1. An 18-month monetary transmission horizon does not mean that rate hikes have no effect for the first 17 months. Instead, there is an immediate effect and even an anticipatory effect given that rate hikes are usually anticipated by the bond market. It is only the last vestiges of drag that arrive 18 months later.
  1. This has been perhaps the most anticipated recession in history. That could pull forward the recession as trepidation prompts economic actors to behave in a recession-inducing way.
  1. Recall also that there are more economic headwinds in place than just rate hikes: high inflation, high gas prices, Russian sanctions, a stumbling Chinese economy, tight financial conditions and so on. Those don’t have to wait 18 months to impact the economy.
  1. As discussed, our business cycle work argues a recession is near.

Inflation developments

Inflation data for October is beginning to arrive. Alas, it doesn’t appear set to reveal a sudden swoop lower. Eurozone inflation hit a record high of +10.7% year-over-year (YoY) in October, and the U.S. Consumer Price Index (CPI) is tracking only a mild decline from +8.2% to +8.0% YoY. Real-time inflation metrics show that Eurozone inflation pressures are not yet receding and they continue to actively intensify in the UK.

The inflation experience in Europe is worse given the inflationary consequences of extremely high natural gas prices, depreciating currencies and also a delayed start in the Eurozone to monetary tightening.

What inflation drivers have turned

We expect inflation to soon begin the choppy process of softening. The four original thematic drivers of high inflation have all turned:

  1. Monetary stimulus has become restraint.
  2. Fiscal stimulus has become a fiscal drag.
  3. Supply chain problems are resolving.
  4. The commodity shock has de-intensified (if not disappeared).

Despite the stubborn persistence of core inflation and the remarkable breadth of high inflation – the two things in the orbit of inflation that are refusing to cooperate – there are actually quite a few important inflation signals that are turning. What follows is a compendium of price signals that are starting to go right:

The New York Fed’s Underlying Inflation Gauge has been clearly turning lower (see next chart). This metric combines market variables with statistical techniques that focus on persistent sources of inflation rather than idiosyncratic ones. Historically, it “provides a more timely and accurate signal of turning points in inflation.”

Underlying trend and headline Consumer Price Index have peaked

As of September 2022. The New York Fed Staff Underlying Inflation Gauge (UIG) “full data set” and “prices-only” measures are estimates of trend inflation derived from a large number of price series in the Consumer Price Index (CPI), plus macroeconomic and financial variables in the cases of the full-data set series. Source: Federal Reserve Bank of New York, Macrobond, RBC GAM

Manufacturers’ concerns about inflation have receded so profoundly that they have fully reverted to normal (see next chart). If input prices have ceased rising for manufacturers, lower inflation should begin to work its way through the supply chain. This will provide further relief to manufacturers.

Price increases and supplier deliveries have normalized

As of September 2022. Shaded area represents recession. Source: ISM, Macrobond, RBC GAM

Small businesses are less convinced that inflation is improving, but their level of concern is at least starting to abate (see next chart).

The biggest small business problem is inflation

As of September 2022. Source: National Federation of Independent Business. Macrobond, RBC GAM

Businesses are responding to their diminishing inflation concerns – and, likely, a diminished willingness on the part of customers to pay more – by sharply reducing their plans to raise prices in the future (see next chart). It is fair to concede that these intentions are still higher than normal, but the improvement appears consistent with inflation receding from 9% to perhaps 4%.

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

As of September 2022. Shaded area represents recession. Source NFIB Small Business Economic Survey, Macrobond, RBC GAM

Inflation continues to surprise forecasters with higher than expected readings, but to a significantly diminishing degree in recent months (see next chart).

Global inflation surprises are starting to turn

As of September 2022. Source: Citigroup, Bloomberg, RBC GAM

Real-time inflation readings extracted from internet retailers and other websites continue to show a deceleration in North American inflation.

Inflation expectations are tentatively falling, regardless if one surveys financial markets, businesses or consumers (see next chart).

U.S. inflation expectations have started to fall

Market-based expectations as of 10/21/2022, survey-based consumer and business expectations as of October 2022. Source: Federal Reserve Bank of Atlanta, Federal Reserve Board, University of Michigan Surveys of Consumers, Haver Analytics, RBC GAM

Finally, commodity prices are clearly declining, whether one looks to agricultural products, base metals, lumber or even energy. Oil prices are significantly lower than in the early months of 2022. Even natural gas prices in Europe have retreated somewhat in recent months – while remaining exceedingly high (see next chart).

Germany NCGI Natural Gas Index has retreated slightly

As of 11/01/2022. Source: Intercontinental Exchange (ICE), RBC GAM, Macrobond

In short, there is a strong argument that inflation should ease from here. Theory and reality simply need to start aligning.

Central bank divergence

Central bank actions remain unified: significant monetary tightening continues. In the last few weeks, the U.S. Federal Reserve and Bank of England tightened monetary policy by another 75 basis points. The Bank of Canada raised its overnight rate by 50 basis points.

But the messaging around this monetary tightening is beginning to diverge. At one extreme, the U.S. Fed continued to browbeat markets, informing them that even more rate hikes were likely coming than the market had priced in. Accordingly, the market’s pricing of the peak U.S. policy rate has now increased to approximately 5.25% (see next chart).

Expected peak federal funds rate has increased sharply

As of 11/07/2022. Source: Bloomberg, RBC GAM

At the opposite extreme, the Bank of England informed the market that it priced in too much UK monetary tightening ahead. That is a first during this monetary tightening cycle. Time will tell whether the central bank is actually correct, but even the notion that the market has gone too far is a novel concept.

The Bank of Canada landed somewhere in the middle. It seemed content with market pricing and has signaled that the central bank will continue to slow the rate at which it raises rates.

It is also worth recognizing that, even for the hawkish Fed, the distance travelled substantially exceeds the distance left to travel. The fed funds rate is now 4.00%, having begun at a mere 0.25% just eight months ago. Even if the fed funds rate reaches 5.25%, that means the tightening sequence is already three-quarters complete. And the bond market has already priced all of it in.

Market scenarios

This has been an extraordinarily challenging time for financial markets. The classic counterbalancing partnership of bonds and stocks in an investment portfolio breaks down during periods of problematically rising inflation – precisely the situation the world has been in for the past year. Both asset classes devalue in this environment.

Setting aside the nearly impossible challenge of precisely timing the market bottom, it is worth contemplating what a market turn might even look like.

There are two obvious scenarios, both hinging on inflation starting to decline in earnest.

Scenario 1: Markets recognize that inflation was the greatest threat to long-term prosperity, and thus that declining inflation is the most important achievement, regardless of a temporarily weak economy in 2023. Stocks and bonds would remain positively correlated but reverse course, offering superior returns to investors across both asset classes.

Scenario 2: Inflation also declines, but this pleases only the bond market. The stock market remains depressed as its attention turns from high inflation and high discount rates to weak economic activity and declining corporate earnings. There would presumably be an equity rebound later as the recession comes to an end, but before that there would be a period of rallying bonds and weakening stocks. This scenario argues for an overweight of bonds.

An interesting takeaway is that bonds perform well in both scenarios, but equities in only the first scenario. The first scenario is arguably the more likely one, and equities will possibly recover to a greater extent in this scenario than bonds. However, the yield available from bonds now easily outpaces the dividend available from equities, suggesting a superior return from bonds if the stock market remains depressed.

The same idea can be conveyed from a valuation perspective: while the earnings yield available in the stock market has increased significantly in 2022 and now promises unusually strong equity returns over the long run, this pales in comparison to the jump in bond yields and the long-run returns now available there (see next chart). The 2-3 percentage point risk premium that one can usually expect to earn in the stock market over bonds is, temporarily, non-existent. This is the first time that has happened since the global financial crisis of 2008-2009.

U.S. equity risk premium turns negative

As of 10/31/2022. Source: ICE Data Services, Bloomberg, Haver Analytics, RBC GAM

U.S. mid-term elections

A quick note that U.S. mid-term elections are on November 8. Republicans are highly likely to capture the House of Representatives and now – for the first time in months as polls gyrate – deemed likely to capture the Senate as well. Legislation will be hard to come by over the next two years given a Democrat in the White House.

Climate change

The latest global climate summit – COP27 – is now taking place in Egypt. A smattering of additional commitments to reduce carbon dioxide emissions have been made by the world’s governments since last year’s meeting in Scotland, with the U.S. Inflation Reduction Act importantly nudging the large U.S. economy in that direction.

But it is clear that limiting the world’s temperature increase to 1.5 degrees Celsius – the stretch goal – is no longer viable, absent an enormous negative economic shock or technological breakthrough. In fact, this target has been extremely unlikely for several years. The math is straightforward: the global temperature will rise by more than 1.5 degrees if the world emits over 2,890 billion cumulative tonnes of carbon dioxide. But the world has already emitted around 2,510 billion tonnes over the past two centuries. This leaves just 380 billion tonnes of space left, or less than 10 years at the current pace of emissions.

The true stretch goal is limiting the temperature increase to 2.0 degrees, and we have tended to think that a 2.5 degree increase may be the most likely outcome. Yes, government commitments are beginning to outpace that outcome with the implication that it is strictly possible to achieve a lower peak temperature increase. But some slippage in implementation is very likely.

In descending order of importance, climate change is enormously consequential for the planet, a significant problem for humans and a fair-sized challenge for the economy and financial markets.

Our job is to focus on the last of these implications. Broadly speaking, climate change and efforts to combat it are set to incrementally slow global economic growth – by between 0.01 and 0.3% per year (the academic estimates vary to a startling degree). Inflation should be somewhat higher than otherwise due to a mix of carbon taxes and costly adaptation efforts.

But the real economic story begins at the sectoral level, with fossil fuel producers enormously challenged and massive opportunities at the opposite end of the spectrum for green companies. A great deal of adjustment will be necessary as well in sectors such as utilities, agriculture, car-making and energy-intensive manufacturing.

-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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