U.K. stabilizes

U.K. political turmoil has hopefully come to a close with the resignation of short-lived Prime Minister Liz Truss and the tidy arrival of her successor Rishi Sunak. Sunak had placed second to Truss in the summer leadership campaign. To the relief of markets, he was selected quickly after a few prospective opponents bowed out. He had been the country’s finance minister from 2020 until earlier in 2022, and will become the third Prime Minister in seven weeks.

Recall that Truss and her original finance minister had proposed a series of tax cuts upon their arrival in September. These had prompted indigestion in bond and currency markets, both on the basis of concern about rising debt at a time of high borrowing costs and the imperative to slow rather than spur the economy during a period of high inflation.

While those plans had already been fully unwound under replacement Finance Minister Jeremy Hunt, the British bond market nevertheless celebrated the development with a significant decline in the 10-year yield (by a third of a percentage point, returning to a sub-4% yield). It was a timely development given that the Bank of England’s emergency bond-buying support operations expired not long ago. Yet it remains a difficult time for the U.K., for several reasons:

• Inflation is much too high.
• The pound has weakened greatly.
• High natural gas bills are proving damaging.
• Brexit repercussions continue to undermine the economy.

Clearly the Bank of England’s work is not done. The British current account deficit was significant even before the pandemic and Brexit, but has grown larger and remains enormous (see next chart). In a nutshell, this means that the U.K. is consuming more than it is producing – usually not something that can be sustained indefinitely, particularly at this scale. Further belt-tightening and economic restructuring appears necessary over time.

U.K. current account deficit yawns wider

As of Q2 2022. Source: Office for National Statistics (ONS), Macrobond, RBC GAM

Chinese meetings end

China’s National Congress has concluded, with President Xi seemingly certain to be reappointed next March to an unprecedented third five-year term, as had been widely anticipated. Xi used the opportunity to further consolidate his power, bringing close associates into the Politburo Standing Committee and excluding anyone who might be a threat to replace him in the future.

The lack of rivals or contrary views creates an echo chamber from which it is difficult for good public policy to emerge.

President Xi’s keynote speech revealed a focus on national security and upgrading the military. He reiterated his commitment to unifying China and Taiwan, preferably peacefully, but by force if necessary (more on that in the next section).

There was no mention of abandoning the country’s economically damaging zero-tolerance approach to COVID-19. The best guess remains that this will happen next spring, after any winter wave is complete and bivalent vaccines have been administered.

There was also no mention of a change to China’s housing policy. The housing market was long a source of strength, but is now consolidating.

Chinese growth was not as bad as feared in the third quarter, with real-time activity holding up and industrial production rising solidly. However, the country is still tracking an anemic rate of growth for 2022 as a whole. Retail sales and housing remain feeble.

More generally, we are increasingly concerned about China’s medium-term growth prospects. Whereas the country once grew at 6%, 8% and even 10% per year, we are increasingly leaning toward an assumption of sub-4% growth on a steady-state basis going forward. It is perhaps not a coincidence that as the figures become less impressive, China is becoming ever-more cryptic with its data releases. It has pared the number it publishes by half over the past decade.

The country’s three long-standing priorities under President Xi are not conducive to fast economic growth:

1. Tightening controls over the domestic population.
2. Pursuing a more assertive foreign policy.
3. Reclaiming state control over the economy.

In particular, the last priority seems antithetical to the kind of innovation that drives economies forward. Instead, it represents a reversal of the progress China had made over the past several decades. The National Congress had 50% fewer private-sector representatives than before President Xi came to power.

Several other concerns have emerged in the data:

• Housing was long a driver of economic growth and will now be a headwind for quite some time, if necessarily.
• Debt levels have increased significantly.
• Capital expenditures have become less efficient at driving growth and productivity growth has slowed sharply. Growth of total-factor productivity, a measure of productive efficiency, is negative.
• Education levels are still well short of the levels needed to progress from being a middle-income country to a high-income country.
• Access to high-tech chips is being shuttered by tightening U.S. regulations.
• The country’s demographics are famously poor.

This slower growth threatens China’s ability to achieve its societal objectives. It could make its leadership more willing to take risks in a geopolitical context to achieve “wins” on other playing fields (such as with regard to Taiwan). It also means China may provide less of a tailwind to global growth than in the past (see next chart).

China makes up one-third of global growth

Five-year average real GDP growth and 5-year average weights used in calculations. Source: IMF World Economic Outlook, April 2022, Macrobond, RBC GAM

Taiwan risk rises

China is asserting itself more forcefully on the Pacific and global stages in general – including a spat with Japan in the East China Sea, island-building efforts in the South China Sea and its One Belt-One Road global infrastructure initiative. However, Taiwan sparkles as the country’s biggest objective.

Taiwan was once a Chinese province, though it has also been an independent nation, a colony of the Dutch, Portuguese and Japanese, and has twice been ruled by exiled Chinese leaders. It is presently a democracy and functionally an independent country, though not recognized as such by most nations due to Chinese political pressure.

Polls indicate that most Taiwanese citizens do not wish to join China and the U.S. has become more explicit in its promise to defend Taiwan from Chinese attack.

On the other side, Chinese President Xi’s recent speech pledged to “reunify” the two countries, with a peaceful process preferred but force not ruled out. His repeated promises make it hard for China to delay indefinitely, and he would surely like to reclaim Taiwan during his presidency, and perhaps even within his next five-year term. Consistent with this, a leaked Chinese military document showed President Xi asking for a military option occurring no later than 2027.

Previously, the conventional wisdom was that China aspired to grow ever closer to Taiwan over time, eventually achieving a mutually agreed-upon unification. The year 2049 was often referenced, when China pledged to achieve “national rejuvenation.”

Betting markets assign an 8% chance of a lethal China-Taiwan confrontation by the end of 2022, though that could include the loss of a few lives via provocation as opposed to outright war.

There are a number of ways China might seek to initiate its pursuit of Taiwan:

• One would be to capture some of the small islands lying between China and Taiwan, as a means of testing the response of the other actors.
• Another would be to start by blockading or significantly limiting Taiwanese exports and imports. This would weaken Taiwan and allow China to control the country’s borders – a first step toward absorption.
• Scenarios involving full-scale military attacks are possible, but the geography of the island apparently makes this difficult.

Given the undesirable consequences of a conflict pitting China against the U.S., the odds of a major assault on Taiwan are still well below 50% in our eyes for the next few years. But the risks have nevertheless grown in recent months.

The matter is highly consequential for the global economy and investors. Were the world to respond to a Chinese invasion in the same manner as it has treated Russia, the economic damage would be enormous. The Chinese economy is, conservatively, six to eleven times larger than the Russian economy (see next chart). Sanctions might thus be an order of magnitude more damaging.

China’s economy is several times larger than Russia’s

Annual 2021 data. Source: CEIC, MSCI, Statista, Goldman Sachs Global Investment Research

Severing China from the developed world would be enormously costly. Global supply chains pass through China far more than any other country. In addition, China owns nearly US$1 trillion in U.S. Treasury bonds. However, the U.S. could easily freeze Chinese assets, so a sudden sale of Treasuries is unlikely.

Taiwan is also a highly significant country. Though small in population, it produces 70% of the world’s microchips – of relevance to the production of phones, computers, cars and more. Even if China were to capture Taiwan without physically damaging the chip fabrication plants, production would grind to a halt given that most of the chips rely on western designs and inputs.

Again, the risk has increased but is not strictly high. The problem is that the consequences would be so great. This will hopefully be enough to deter the main actors from engaging. In the meantime, western companies have begun to diversify some of their production from Chinese manufacturing facilities, to the advantage of India, Southeast Asia, Mexico and other aspiring manufacturing hubs.

Ukraine escalation continues

Ukraine continues to make incremental gains on the battlefield, with Russia responding via escalation and a change of tactics:

• Russia has now sabotaged its own (dormant) natural gas pipelines connecting to Europe.
• The country is using Iranian drones to target Ukrainian electricity infrastructure.
• Russia recently conscripted several hundred thousand additional soldiers into its military and declared sovereignty over the parts of Ukraine it currently occupies.

It is possible the war may slow for weather-related reasons as a muddy season begins. However, it seems likely to remain quite vigorous given Ukrainian designs on regaining significantly more territory. Betting markets give a low likelihood of a near-term cease-fire, and now assign a (distressing) 11% chance of a tactical nuclear weapon being used by March 2023.

The theory of war can help us understand why this conflict first arose and why it continues. The concept of informational asymmetry helps to explain Russia’s decision to start the war. Russia thought it had the stronger military, but in practice this has not proven to be the case. The country over-estimated its own prowess and underestimated Ukraine (and how much military support Ukraine would receive from the west).

Matters of trust and politics can help to explain why the war now lingers. Given an extreme lack of trust between the two parties and a lack of realistic enforcement mechanisms, neither party trusts the other to comply with any ceasefire or peace treaty. This makes it hard to agree to terms even if they would otherwise be mutually acceptable.

The Russian political environment also complicates any effort to end the war. In democracies, Ill-advised wars can end when the leader is pressured by the public to end an unpopular war or is removed from office if they fail to comply. In absolute dictatorships, the dictator can end an ill-advised war with no personal threat to themselves given their absolute power. It is partial dictatorships – the political space Russia arguably occupies – that are least likely to abandon an ill-advised war because the leader may be in personal jeopardy if they admit it was a mistake. So the war continues.

Economic developments

We continue to anticipate a recession across much of the developed world and have upgraded the likelihood by the end of 2023 from 75% to 80% for North America. The likelihood is more like 90% in the Eurozone and U.K.

We continue to anticipate a middling recession depth. There are persuasive arguments for a milder recession than this, largely based on the observation that the labour market may fair better than usual through any coming downturn. But there are also good arguments for a deeper recession, such as the fact that central banks aren’t cutting interest rates to cushion the blow. In our view, the two sets of arguments cancel one another out, justifying the historically middling decline of 1.5% to 2.0% that we anticipate.

We are in the process of adjusting our growth forecasts lower to fully reflect these views. We had already incorporated a recession place-holder in our prior projections, but the new figures will better incorporate the full magnitude of the anticipated decline. This will again place us below the consensus for 2023 growth after a quarter in which the consensus forecast plummeted from well above our predictions to smack dab on top of them.

Subtle labour market weakness

While North American job numbers were positive in September, subtle weakness is becoming apparent beneath the surface. For instance, the number of U.S. job openings and the number of people quitting their jobs have both clearly begun to turn lower. This pattern usually presages later job losses (see next chart).

Both job openings and quits have dropped in U.S.

As of August 2022. Estimates for all private nonfarm establishments. Shaded area represents recession. Source: Bureau of Labor Statistics, Macrobond, RBC GAM

Job cuts are still fairly limited, but are clearly starting to rise (see next chart).

U.S. job cuts announced have started to rise

As of September 2022. Source: Challenger, Gray & Christmas, Inc., Macrobond, RBC GAM

Supply chain improvements

Supply chains have already improved enormously, if not completely (see next chart).

Global supply chain pressure has eased, but still elevated

As of September 2022. Shaded area represents U.S. recession. Source: Gianluca Benigno, Julian di Giovanni, Jan J.J. Groen, and Adam I. Noble, “A New Barometer of Global Supply Chain Pressures,” Federal Reserve Bank of New York Liberty Street Economics; Macrobond, RBC GAM

We remain confident supply chains will continue to improve as businesses adjust and economic activity slows. A series of more obscure supply chain proxies also support that view. U.S. warehousing utilization and warehousing prices began to turn over the summer (see next chart).

Warehousing usage and price growth moderates

As of August 2022. A reading above 50 indicates expansion; a reading below 50 indicates contraction. Source: Logistics Managers’ Index reports, RBC GAM

The cost of computer chips has also declined from its worst point. This is a good signal that demand and supply are returning to alignment (see next chart). In fact, many analysts are predicting a multi-year chip glut given what now appears to have been over-investment in the industry.

Chip shortage eases

As of August 2022. Mainstream density DDR4 chip used is the DDR4 8GB 1Gx8 2400/2666 MHz chip. Source: InSpectrum Tech, Bloomberg

Ocean logistics reports see a 20% drop in ocean freight orders in September and October. Meanwhile, the ratio of the demand for trucking in the U.S. versus the supply of trucks available for transport has fallen by a stark 70% from its high.

Inflation breadth & lags

North American inflation has eased slightly over the past three months. The problem is that core inflation has not yet slowed (see the yellow line in the next chart). One can measure core inflation in a variety of ways and the results are nearly all the same: there has not yet been a clean turn downward in most metrics (see subsequent chart; core goods is the one exception).

U.S. Consumer Price Index (CPI) monthly trend eases slightly

As of September 2022. Source: Bureau of Labor Statistics, Macrobond, RBC GAM

U.S. core inflation metrics have not yet turned

U.S. Bureau of Labor Statistics (BLS), Federal Reserve Bank of Cleveland, U.S. Bureau of Economic Analysis (BEA), Macrobond, RBC GAM

Fortunately, economic theory argues core inflation should eventually turn. All four of the key original drivers of high inflation have reversed:

1. Central banks have gone from rate cuts to rate hikes, to the extent that monetary policy is now outright restrictive.
2. Fiscal policy has become less generous than before.
3. Supply chains have already improved quite a lot, as discussed earlier.
4. The commodity shock has at least partially eased, as evidenced by lower oil, base metal, lumber and raw food prices.

The problem is that as central banks wait for this to trickle through with various lags into a wider range of consumer products, they feel compelled to continue raising interest rates.

The Bank of Canada is likely to raise rates by 50 or 75 basis points at the end of October, with the Fed likely to hike by 75 basis points in early November. While the pace of tightening may slow from there, central banks will struggle to stop until they have seen a few months of softer core inflation and a narrowing inflation scope. But that now won’t be crystal clear until early 2023 at best.

A key unanswered question is the extent to which central banks are willing to gamble on historical lags repeating themselves. For instance, we estimate that food commodity prices turn approximately three to six months before food CPI turns. As such, we should reasonably expect food inflation to ease within the next few months given that wheat and soybean prices have already declined from their peaks. But it hasn’t yet.

It is an even more vexing situation with dwelling costs. In the U.S., home prices and rent tend to turn about 18 months before their CPI equivalents. In a recent study, the Dallas Fed estimates that the shelter component of U.S. CPI will continue to get worse until the middle of 2023, at which point it will finally begin to improve. So do central banks have to keep tightening until then?

If central banks are willing to accept that actual home prices started to fall a few months ago and that actual rents are at least decelerating (see next chart, and note that some other rent metrics argue rent prices are already outright falling), then they could breathe a sigh of relief sooner rather than later.

Surge in U.S. rents abates

As of September 2022. Source: Zillow, Macrobond, RBC GAM

An interesting aside is that monetary policy is also thought to operate with an 18-month lag. In other words, the effect of already-delivered rate hikes will continue to mount over the coming 18 months. Thus, central banks could theoretically stop tightening even as some inflation components remain hot, but with the twofold confidence that their earlier monetary tightening will continue to have a mounting effect and that the inflation components should also cool on their own.

U.S. political musings

The U.S. midterm elections are set for November 8: just two weeks away when this is written. To recap the story so far, the White House is not up for grabs, the House of Representatives likely pivots toward the Republican Party, and the Senate likely stays with the Democrats. However, this last assertion is the least certain of the bunch. Fivethirtyeight assigns a mere 62% chance of a Democratic Senate win, which is barely greater than a coin flip, and the odds has been converging recently (see next chart).

Who will control the Senate after the 2022 midterm elections?

As of 10/19/2022. Source: FiveThirtyEight, RBC GAM

Either way, legislation will be impeded by a Democratic White House and a (partially or completely) Republican Congress. Markets don’t usually mind gridlock, though that attitude could change depending on what burning policy issues arise over the coming two years.

In addition to an annual budget deadline that will have to be tackled by December 16, there are a few fiscal cliffs of sorts that arise early in 2023.

Americans with federal student loans have not had to pay interest on those loans for the better part of three years. That ends in January, regardless of whether President Biden’s executive order to moderately reduce student debt loads survives a legal challenge. With nearly US$2 trillion in student loans, Americans will have to start paying in the realm of an additional US$100 billion per year – a significant diversion of financial resources.

Nearly simultaneously – on January 11 – the Biden Administration is expected to allow the pandemic-motivated public health emergency declaration to expire. This will have a significant effect on some households, as approximately 15 million people will lose their Medicare eligibility and 7 million will lose Medicaid. The Supplemental Nutrition Assistance Program will also shrink.

All of this is to say that there will be a material blow to American household finances early next year.

Human development and demographics

Our in-house measure of global human development – heavily inspired by a similar but ultimately flawed United Nations metric – suffered two consecutive years of decline in 2020 and 2021 (see next chart). That was the first time the measure – which factors in life expectancy, educational attainment and gross national income per capita – has fallen in its three decade history. The story had always been that the economy ebbs and flows, but the fundamental quality of human life has always managed to rise despite those fluctuations.

GDP vs human development

As of September 16, 2022. Human Development Score computed by RBC GAM based on life expectancy, education and Gross National Income (GNI) per capita. Source: The World Bank, United Nations Development Programme, RBC GAM

But the pandemic did real damage, along all three axes. Longevity fell, educational attainment (and the quality of education) was hurt, and the economy shrank.

When the 2022 data is released it will presumably reveal some improvement in all three metrics, though probably not enough to fully unwind the damage done in the prior two years, along with the threat of another looming recession.

It is instructive to spend a moment on the U.S.-specific longevity data, which was particularly poor. U.S. longevity fell by 0.9 years in 2021, a year after descending by a massive 1.8 years in 2020. Combined, that is the biggest drop since the 1920s. It takes life expectancy at birth down to just 76.1 years. This is the lowest level since 1996 and leaves the U.S. no better than 46^th in the world despite having the most expensive health care system.

COVID-19-related deaths explain over half of the recent decline in life expectancy, with mounting drug overdoses representing another significant chunk.

While we wrote critically about China’s economy earlier in this report, that country can at least now claim superior longevity to the U.S.

Generational angst

In our August 23 #MacroMemo we wrote about a number of interesting demographic trends. Among them was the observation that although there are now more Millennials than Baby Boomers, this doesn’t mean that Millennials will have the same outsized effect on society as the Baby Boomers did.

Having conducted additional research on the subject, we are in a position to elaborate on that claim.

As a starting point, the influence of Baby Boomers versus other generations is slightly exaggerated because the generation is usually defined as encompassing nearly 20 years, whereas most other generations are only assigned 14—16 years of births. To correct for this, we set aside the different names and convoluted date ranges affixed to each generation, and instead lumped the U.S. population into 15-year segments dating back to the year 1900 (see next chart).

U.S. population is dominated by generations of prime working age

Estimates were made for age groups over 100. Source: U.S. Census Bureau, RBC GAM

By doing this, we can see that no single generation every really dominates, so much as it occupies a bigger share of the total than normal. The 1945—1959 cohort was so famous in part because it was unusually large, but also because the prior “Silent Generation” was unusually small and the overall U.S. population was less than half its current size when Baby Boomers were born, giving them a greater influence relative to similarly-sized generations today.

As a share of the population, the 1900-1914 generation was actually even more consequential than the Baby Boomers, but presumably in large part because longevity was so much less at the time that each generation represented a larger share of the total population (see next chart). Had the analysis extended back into the 19^th century, one imagines there would be generations with an even bigger peak population share.

Baby boomers born before 1960 share of U.S. population peaked at 30%

Estimates were made for age groups over 100. Source: U.S. Census Bureau, RBC GAM

Millennials awkwardly straddle the 1975-1989 and the 1990-2004 cohorts in our analysis. The final chart makes clear that they are nowhere near as important as a share of the population as their parents – the Baby Boomers – were at their peak. And let us not forget that a big part of why Millennials have recently surpassed Boomers is that Baby Boomers are beginning to pass away in significant numbers. It is no longer an entirely fair comparison.

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