Our monthly economic webcast is now available: Delta down, economy fine, but new complications.
This week’s note spans an unusually wide range of topics. The list includes recent financial market adversity, COVID-19 trends, the abandonment of zero-COVID policies, the avoidance of a U.S. government shutdown, a critique of whether we are in a stagflationary environment, and more on China’s Evergrande. We also take a look at U.K. shortages, a series of Canadian vignettes – including a discussion about the Bank of Canada’s imminent mandate renewal – and revisit Modern Monetary Theory.
Recent developments have been more good than bad. Positives include:
- COVID-19 infections continue to decline even as the weather grows colder in the northern hemisphere.
- The economic recovery persists, albeit at a slower clip.
- The present situation does not look much like stagflation, despite superficial similarities.
- The U.S. managed to fund its government for another two months, avoiding a shutdown.
- China’s Evergrande is seemingly succeeding in raising funds by spinning off units.
Conversely, on the negative side:
- Evergrande is far from fully resolved.
- K. product outages remain quite concerning.
- Global supply chain issues are still problematic.
- Financial markets have recently been jittery, with higher bond yields and lower stock prices.
Financial markets have struggled recently. The U.S. 10-year bond yield pushed higher from 1.18% in early August to 1.49% in early October. This reflects worries about persistently high inflation and a more hawkish Federal Reserve. In turn, the U.S. S&P 500 index has tumbled by 4% from early September.
From a portfolio construction perspective, it is admittedly unwelcome that the correlation between stocks and bonds has temporarily reversed, meaning that both asset classes are selling off at the same time.
But all of this needs to be put into context.
- The new level of bond yields is hardly foreign: yields were higher all spring and through much of the summer.
- There is nothing inherently unsustainable at current yield levels. We had expected yields to rise – an entirely reasonable outcome during an economic recovery. In fact, we believe yields can rise somewhat further over the next year -- to 1.75% -- without creating significant problems. Reflecting this view, we reduced our allocation to bonds over the past few months in the hope of re-entering the market later at a more attractive yield.
- High inflation is not about to vanish. Supply chain drivers in particular appear set to persist over the coming year – as we wrote last week. Yet neither do we believe this is a new, structurally higher inflation era that requires a rethink of what constitutes a neutral interest rate or, by extension, a fair price-earnings ratio.
- The Federal Reserve is now on a slightly more hawkish path than previously envisioned. A rate hike is conceivable over the second half of next year. Yet it is hard to argue that this pivot constitutes a policy mistake. Central banks are still set to tighten much later than any traditional policy response function would recommend, and the U.S. economy is on track to reach and potentially exceed its full potential well before any tightening begins. As such, it is hard to argue that central banks are killing off growth. If anything, they continue to risk allowing too much inflation into the equation.
- Despite its recent retreat, the stock market has still managed impressive gains over the past year. Drawdowns like the one recently experienced are regular occurrences across an expansion.
- Recent market worries – about a possible U.S. government shutdown, a debt ceiling problem and Chinese property developer Evergrande – appear to be resolving more benignly than feared.
Delta variant continues to ease
Happily, the number of COVID-19 infections around the world continues to decline (see next chart).
Global COVID-19 cases and deaths
As of 10/03/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM
The improvement is even more impressive when viewed through the lens of the fraction of countries that are reporting rising infection numbers (see next chart).
Countries reporting rising daily new COVID-19 cases
As of 10/03/2021. Change in cases measured as the 7-day change of 7-day moving average of daily new infections. Source: WHO, Macrobond, RBC GAM
The U.S. is very much among the set of improving countries (see next chart).
COVID-19 cases and deaths in the U.S.
As of 10/03/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM
Canadian cases are beginning to decline at the national level, though it is concerning and surprising that fatalities are nearing the prior wave’s peak despite fewer infections per day (see next chart). Perhaps it is simply that the Delta variant is more dangerous than earlier variants for those who do become infected.
COVID-19 cases and deaths in Canada
As of 10/03/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM
We argued over the summer that the countries that had pursued zero-tolerance strategies with regard to COVID-19 infections might come to regret that stance in light of the difficult-to-eradicate Delta variant. Indeed, that prophecy has been fulfilled.
- Both Australian and New Zealand gross domestic product (GDP) are expected to shrink in the third quarter, reflecting the damage done by recent lockdowns.
- Australia abandoned its zero-tolerance strategy in late August. Now, New Zealand has announced that it is shifting from policies designed to eradicate the virus to those intended to control it.
That leaves China nearly alone in maintaining its zero-tolerance strategy. It has also suffered economic damage from the decision. A smattering of ports and factories were temporarily idled recently as the virus swept through them. However, unlike the other countries, China shows little sign of reducing its vigilance. This is in part because it is better able to target outbreaks due to more granular controls over its population (such as locking down individual apartment blocks rather than entire cities). This limits the economic damage. Second, its citizens are not in a position to significantly push back or defy government restrictions.
Turning to the rest of the world, it remains telling that there have been few lockdowns despite the spread of the Delta variant. The need to restore economic activity is taking precedence, and pandemic fatigue on the part of politicians and the public is very real. In fairness, few countries are actively lifting restrictions and a recent survey found that two-thirds of companies had delayed their fall return-to-office plans. Vaccine mandates and vaccine passports remain the most popular way to limit infections going forward.
Political problems avoided in U.S.
The most pressing U.S. political issue – the imminent shutdown of the U.S. government at the start of October due to inadequate funding – was avoided at the last moment. A bipartisan bill has extended government funding through December 3.
This action prevented widespread temporary layoffs of government employees and the curtailment of non-essential services. Unfortunately, the problem was only kicked two months down the road rather than delayed for a year as per the usual solution.
Debt ceiling limitations were not lifted as part of the initiative. In fact, haggling over the debt ceiling was precisely why it took so long to reach a stopgap agreement over government funding. This means that the U.S. government is still on track to run out of borrowing capacity as early as October 18, when the extraordinary measures already in effect are exhausted.
On a different note, negotiations continue over a multi-trillion dollar U.S. infrastructure bill. Centrist Democrats object to the $3.5 trillion price tag, instead preferring a figure in the $1.5-2.0 trillion range. Some of the time pressure around this was recently removed by the extension of highway funding for another 30 days. We assign good odds that a large infrastructure package is ultimately delivered, though it might take another month or two to complete. Further, while the sums of money are mind-boggling, the legislation won’t be as stimulative as one might imagine. Some will be offset by higher taxes and the spending will be diluted across many years.
The word “stagflation” has received renewed attention in recent weeks. It refers to an undesirable environment in which economic growth is slow, but inflation is high. It is the worst of both worlds. Normally, slow growth is paired with low inflation, and high inflation is matched with fast growth. On the rare occasion when growth is slow but inflation is high, the purchasing power of money erodes more quickly than usual. Yet central banks are not in a position to rejuvenate growth with low interest rates since they are simultaneously battling inflation.
Our own forecasts for 2022 have been described by some as stagflationary given that the growth outlook is modestly below the consensus and the inflation forecast is modestly above the consensus.
However, we don’t actually view this situation as stagflation. Yes, inflation is set to remain high over the coming year. However, even though growth is actively decelerating and conceivably set to land below the consensus, it is hard to argue that nearly 4% real growth is a stagnating economy. In fact, it represents extremely fast growth by any standard other than that of the past year.
Additionally, inflation should ease somewhat over the next year, and should head toward more familiar levels over the next few years. The damage from high inflation should thus be fairly limited.
From a theoretical standpoint, it is worth thinking about where the extra inflation is coming from. Stagflation classically originates from a negative supply shock. For example, in the 1970s the oil embargo of the Organization of Petroleum Exporting Countries (OPEC) simultaneously hurt economic activity and increased prices. There is undeniably a middling supply shock occurring right now given the difficulty in producing and shipping enough goods. But it is far more a positive demand shock – demand for consumer goods is significantly higher than normal. In fact, most of what superficially appears to be a supply shock is instead supply rising but failing to fully keep pace with surging demand. A demand shock is consistent with the high growth and high inflation being experienced today. That isn’t stagflation.
More on China’s Evergrande
We wrote in our last note about the woes of Evergrande – a major property developer in China that is struggling under its heavy debt load.
The company is now thought to have missed a second bond payment to offshore investors, confirming its liquidity problems. A 30-day grace period on these payments expires in late October.
As it scrambles to secure liquid assets, the company has been selling off divisions. It first shed its stake in a bank. It is now reported to be in talks to sell Evergrande Property Services Group – a division that manages properties rather than building new ones. Trading has halted as the transaction is finalized. This would apparently net several billion dollars – a significant sum, though a trifle relative to the company’s estimated USD 300+ billion in debt.
If further such sales occur, the company may be able to continue operating. It is a promising sign that Evergrande has restarted construction on nearly 20 developments.
However, there remains the serious risk that the company is also insolvent, in which case it may have to be converted into a form of state-owned enterprise: to be wound down or further dismantled over time. This would allow a better outcome than insolvency for the company’s Wealth Management Product retail investors, for homebuyers awaiting the completion of their homes, and for suppliers to the company with unpaid invoices.
Last week we also wrote about China’s regulatory crackdown. Part of this has been housing oriented. For example, China has:
- limited the leverage of developers
- capped the capital that banks may allocate to property loans versus other sectors
- tentatively imposed a maximum home price to be eligible for a mortgage in one market.
But the regulatory crackdown has been disproportionately focused on tech companies, and oriented toward preventing the formation of tech monopolies. One such initiative that did not attract comment in our original missive is China’s recent blanket ban on cryptocurrencies. This is not the first such effort, as China previously shut down many cryptocurrency exchanges. It now says that all cryptocurrency transactions and mining are illegal in the country. China is a major crypto market and world’s largest site of bitcoin mining, so this deals a heavy blow to cryptocurrencies.
We are not surprised at China’s adverse stance to cryptocurrencies. Not only do they represent the very opposite of China’s centralized government model; they allow citizens to evade capital controls and transfer their wealth out of the country.
While the headwinds are less severe for cryptocurrencies in other markets, the same basic issue exists: cryptocurrencies take power and tax revenue from the very governments that have the ability to snuff them out.
Supply chain issues are proving vexing nearly everywhere in the world. But nowhere have shortages been more intense than in the U.K. The challenges of the pandemic and global supply chain issues are magnified by the disproportionate reliance of the U.K. on products transported by ship, and seemingly most of all, by Brexit. Brexit has not only created an additional source of chaos for British supply chains, but has excluded many foreign workers from working in the U.K.
This, in turn, has created an acute shortage of truck drivers. There are 100,000 too few truck drivers in the country, limiting the ability for products to reach market (though it should be noted that the entire problem cannot be attributed to Brexit, since Brexit is thought to have banished just 15,000-20,000 European drivers).
The driver shortage has been particularly vexing for the transportation of gasoline, which requires a special license due to its hazardous nature. In turn, most British gas stations have been devoid of gasoline for the past few weeks. There are also reports that the combination of a butcher shortage plus the driver shortage is greatly limiting the supply of meat. Grocery store customers also report sporadic outages of supermarket essentials.
The problem is undeniably exacerbated by panic buying. This has prompted households to fill their cars and stock their larders to a greater extent than they normally would – much as toilet paper was temporarily in short supply at the beginning of the pandemic despite no actual uptick in usage.
While the panic could abate fairly quickly, it will take time to fix the underlying labour shortage. The British government has sprung into action, permitting additional foreign workers for the next few months. But it is unclear whether many will bother to take the government up on their offer when they must again vacate the country before the year draws to a close.
In theory, the U.K. economy has the most upside of major developed countries because it suffered more than most did earlier in the pandemic (and so has plenty of runway remaining for fast growth). However, these new issues begin to challenge that narrative.
Discombobulated labour market
The challenges of matching surging demand and sluggishly rising supply are as apparent in the labour market data as they are in metrics tracking supply chain problems. It is nothing short of astonishing that the U.S. economy can simultaneously claim a record number of job openings and a still-elevated level of unemployment at the same time (see next chart).
Unemployment in U.S. remains high even though there are more jobs than unemployed
Unemployment as of Aug 2021, job openings as of July 2021. Source: U.S. Bureau of Labor Statistics, RBC GAM
Specifically, there are currently 10.9 million job openings, pitted against a smaller 8.4 million unemployed people. This inversion is not unprecedented – there was a smaller mismatch favoring prospective workers in the years before the pandemic. But it is unusual, and argues that workers are very much in the driver’s seat.
Clearly it takes time to match job seekers with jobs. But it is nevertheless surprising that seven months after job openings began to seriously rise, the ascent has not yet been halted, let alone reversed, even as special jobless benefits expired, schools reopened and the risk of infection has fallen. Some people are attempting career transitions and others are restrained by geographic mismatches, but this can hardly explain much of the gap.
Perhaps the main takeaway is that resolving supply-demand mismatches in the labour market now appears to be a multi-year undertaking rather than the multi-quarter mission that was originally envisioned.
Private-sector finances excelled during pandemic
The pandemic induced a massive financial transfer from the public sector to the private sector. Public sector debt has increased sharply, while private sector finances have broadly improved. This story can be told via stock market valuations and household savings rates, but also in the form of fewer bad things happening to private-sector actors.
Despite the deepest recession in multiple generations, it is astonishing that measures of private-sector financial distress have also declined. Using Canadian data, business bankruptcies and proposals turned sharply lower over the past two years, outpacing the structurally improving trend that predated the pandemic (see next chart). There has been a similar pattern in many other countries, including the U.S.
Business bankruptcies in Canada at record low
As of Feb 2021. Source: Haver Analytics, Macrobond, RBC GAM
Even more powerfully, Canadian consumer bankruptcies, bankruptcy proposals and mortgages in arrears have plummeted during the pandemic (see next chart). As government support fades, one might expect these improvements to be partially unwound. But the main message remains one in which private-sector businesses and households are in surprisingly good shape despite the trauma of the pandemic.
Canadian consumer insolvencies improved during the pandemic
Bankruptcies and proposals as of Jul 2021, mortgages in arrears as of June 2021. Shaded area represents recession. Source: Haver Analytics, Macrobond, RBC GAM
Canadian real-time activity rises
A relatively new measure of real-time business activity from Statistics Canada finds that Canadian businesses actually accelerated across the summer, making up for lost time after bouts of weakness during two earlier lockdowns in 2021 (see next chart). This is in contrast to the U.S., which palpably slowed in July and August as the Delta variant took hold.
Business conditions in Canada have improved after the third wave
As of 09/13/2021. Equal-weighted average of Business Conditions Index of Calgary, Edmonton, Montreal, Ottawa-Gatineau, Toronto, Vancouver and Winnipeg. Source: Statistics Canada, RBC GAM
But the divergence between the two countries may not be all that long-lived. The latest tick in the Canadian business conditions index is slightly lower, suggesting that the later-arriving Delta wave in Canada may now be dimming growth there, too. Still, we are not especially concerned: Canadian infections did not surge to the extent that they did in the U.S., suggesting minimal economic damage.
As an aside, Canadian GDP was reported to have fallen by 0.1% in July – somewhat contradicting the real-time data and puzzling economists. Statistics Canada’s flash estimate for August now claims a big 0.7% rebound that more than eliminates that curious stumble.
Bank of Canada to renew mandate
The Bank of Canada is set to renew its mandate with the Canadian government over the coming month. This happens every five years. In past cycles, the central bank has considered a range of options including price-level targeting, a lower inflation target and even a higher inflation target.
It is a time of ferment for central banks. For example:
- The U.S. Federal Reserve has shifted from its old dual mandate to an average inflation targeting regime that effectively tolerates additional inflation at times like this when inflation was previously running persistently below target.
- More subtly, the European Central Bank tweaked its inflation target from “close to, but below, 2%” to 2%. The ECB also afforded itself greater flexibility in pursuing its inflation target, and emphasized the symmetry of its goal (with the implication that it is no more problematic for inflation to now be moderately above target than the prior experience of it being persistently below target).
In general, these moves allow central banks to be slightly more dovish in the current environment than otherwise – leaving rates lower for longer and permitting inflation to run a bit hotter.
Conversely, the Reserve Bank of New Zealand was asked by its government to factor home prices more fully into its decision-making. While this mission has not (yet, at least) been added to the RBNZ’s official mandate, the central bank will nevertheless pay greater heed. In the current context, with housing markets booming globally, this has hawkish implications for the RBNZ. It is also a theme that one might imagine other governments taking up over time.
Where will the Bank of Canada ultimately land?
The best guess is that its 2% inflation target remains unaltered, as it has been through the prior five such reviews. The Bank of Canada, and the economy more broadly, have performed well under the existing target. The Bank appears to be less concerned about prior inflation undershoots than its peers, and the cyclicality of the Canadian dollar reduces the risk of Canada being constrained by the zero lower bound.
Looking to the long run, Canada has fewer (deflationary) demographic challenges than most developed countries. All of this argues there is no need to aggressively shift the country’s inflation mandate to counter deflationary forces.
To be fair, it would be tempting to follow the U.S. pivot toward average inflation targeting to avoid developing any significant interest rate differential with the country that might prove problematic for Canada. A recent Bank of Canada study found that average inflation targeting and a dual mandate performed roughly as well as classic inflation targeting in a number of different tests spanning various shocks, models and assumptions.
But one shouldn’t jump to a new mandate just because a different approach worked approximately as well as the existing approach. It would need to be significantly better. Further, there are ways to incorporate elements of average inflation targeting and a dual mandate into the existing framework. The Bank of Canada’s paper says precisely this: “it would be worthwhile to examine the scope for capturing key elements of [average inflation targeting] and the dual mandate within [the current inflation targeting] framework.”
In the end, and in keeping with prior incremental efforts at past mandate reviews, the Bank of Canada is likely to stick with a 2% inflation target, but accord itself slightly more flexibility in pursuing this target. That could mean leaving rates a bit lower when inflation is temporarily overshooting, as it is now, with the recognition that these distortions will pass with time – but not to the point of formally incorporating a historical dependency as with average inflation targeting.
Modern Monetary Theory revisited
The ideas behind Modern Monetary Theory (MMT) have received a great deal of attention in recent years. The central concept is that governments should reclaim control over the supply of money from central banks, and print money for use in new government programs until the point that inflation rises undesirably, at which time those excesses could be restrained by raising taxes – slowing the economy and eventually lowering inflation.
We remain generally skeptical about the workability of these ideas. Ultimately, printing more money without simultaneously increasing the productive capacity of the economy is likely to be inflationary. When such a policy is pursued to the extreme, it produces hyperinflationary disasters like those experienced by Weimar Germany, Zimbabwe, Argentina, Venezuela and post-World War II China.
This naturally begs the question why there hasn’t been extremely high inflation over the past decade, despite two major episodes of money printing in the form of quantitative easing conducted by central banks. There are two answers.
- The money printing occurred at a time when the money multiplier and the velocity of money were collapsing due to adverse economic conditions. The monetary base had to be bigger just to get a normal amount of money out into the actual economy. Another way of thinking about this is that commercial banks just didn’t have trillions of dollars of additional customers suddenly in need of funds, so much of the extra money was returned to the central bank.
- The money printing is/was temporary – it is/was later unwound. True, some central banks such as the U.S. Federal Reserve never fully unwound its money printing after the global financial crisis. But this was arguably because its banks were forced to structurally deleverage as part of the crisis recovery. The implication is that a permanently larger monetary base was needed to keep a reasonable amount of money circulating in a less leveraged world. So the money printing in response to the pandemic should eventually be mostly unwound. Any vestige would be a benign response to what appears to be a structurally declining velocity of money over a long period of time.
In contrast, there is no mechanism for reversing the money printing within the MMT framework. The money is printed and then distributed to citizens. The central bank cannot cancel this money once it is out in the wild, in contrast to the current arrangement.
In both cases, inflation was avoided because of very special economic factors that cannot be expected to persist indefinitely into the future.
While MMT advocates emphasize how much more government spending might be possible in a structurally low inflation environment, it has less to say about a high inflation environment like today. In theory, government spending programs would have to be cancelled or taxes would have to rise – unattractive options at a time when economies are still operating below their potential.
In fact, if taken at face value, MMT would have low inflation eras deliver major spending increases, and high inflation eras implement higher taxes. This is a recipe for a perpetually expanding government. There would, in fairness, be nothing stopping a more right-leaning government from delivering tax cuts during low inflation environments and spending cuts during high inflation environment, though this doesn’t generally align with the politics of those advocating for MMT. Worryingly, in both cases, the implementation or elimination of major policy decisions would be determined by the rate of inflation rather than a stable, long-term policy vision.
It is important to recognize that by printing money and spending it on the government’s priorities, everyone and everything not prioritized are slightly poorer once adjusted for the resultant increase in inflation. If the government spends more money and the country’s productive capacity is unchanged, someone is being shortchanged elsewhere.
While MMT advocates argue that it is strange and undesirable to leave money printing decisions in the hands of unelected officials at central banks, it would arguably be much more concerning to have politicians make those same decisions. In fact, that is generally what happened in countries that experienced hyperinflation. Politicians are famously myopic, preferring to maximize short-term growth even if it comes at the expense of worse outcomes later. Those are a later politician’s problems. This is particularly relevant when it comes to controlling inflation, as decisions made today affect inflation with a significant lag – one could jam through quite a lot of money printing before it began to show up in the inflation numbers.
Much like Austrian Economics became popular during the global financial crisis (as well as an aversion to fractional reserve banking), it seems that the past decade of low inflation and substantial quantitative easing has created an interest in MMT because there is the appearance of free money up for grabs. But appearances can be deceiving.
All of that said, it is certainly true that fiscal limits are more distant than once imagined, largely because interest rates are so low. But governments are arguably already taking full advantage of this in the form of big spending programs both during the pandemic and tentatively afterward.
-With contributions from Vivien Lee