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by  Eric Lascelles May 31, 2022

In this video, Chief Economist Eric Lascelles reviews the recent rally in financial markets as inflationary expectations decline. Other factors, such as cooling housing markets and a slowing economy, are also improving the inflation outlook. And though these signs of economic weakness – as well as ongoing rate hikes – may signal a coming recession, history tells us it’s not certain.

Watch time: 14 minutes 46 seconds  |   Hover your cursor over the video to see chapter options

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Hello and welcome to our latest video #MacroMemo. As usual, there’s quite a lot to cover this week.

We’ll talk about the bounce in risk assets, including equities, that’s recently taken place and a little bit about what’s going on beneath the surface there.

We’ll turn our attention to economic weakness, which continues to brew, and we’ll talk about just how much of that there is and where it’s coming from.

We’re a little bit less worried about inflation, though I should say, still pretty worried, but we’ll talk about that nuance.

Recession risk still elevated, central banks still very much tightening. And the peace dividend has arguably been lost; that’s another way of saying that we’re fracturing into different groups as per before the Cold War and in the context, of course, of this war with Russia right now.

Let’s jump into markets. And so, markets have actually been quite pleased, as I record this, over the last week or so, significantly unwinding a lot of financial market damage that had been taking place over the prior several weeks. And in particular, markets acting as though they’re a little bit less worried about inflation, and so they don’t think it will necessarily be persistently high anymore.

Now that’s not the final word on the subject, I should emphasise, but nevertheless, it’s a welcome development. It’s also notable that when you look at stocks and bonds, for quite some time, we were seeing a positive correlation between those two asset classes and that wasn’t a good thing. People who invest in a diversified portfolio, normally, you expect one of those asset classes to go up and the other to go down and provide a bit of a ballast or a bit of stability to a portfolio. They weren’t doing that. When you’re worried about high inflation, both asset classes suffer. I’m happy to say we’re starting to see that correlation weaken and even, to some extent, turn negative, which is more the normal course of events and it’s a good thing for portfolios.

Right now, it seems like markets are now debating more just whether we’re going to get a recession or not. That’s a tough debate. It’s a hard one. There is no obvious clear answer. I’ll give you a sense of that a little bit later. And for the moment, markets are feeling a bit better about the situation as opposed to a little bit worse, hence the rally in risk assets.

I’d warn that maybe this might not be the end of stock market headwinds. I would say, in particular, it’s striking to me that we haven’t seen any significant adjustment to earnings expectations. And if you think the economy is decelerating, as I do, and that the risk of recession is elevated, as I do, then conceivably, there could be more adjustment to earning expectations yet to come. So do be warned of that. But of course, there are no guarantees when it’s come to predicting where markets might go from here.

In terms of the economy, well, economic weakness is becoming visible, we think. We have downgraded our growth forecasts a little bit further. We have the U.S. growing at just 1.4% now for next year, for 2023; Canada, just 1.1; the Eurozone, just 0.9. Those are weak numbers. Those are a percentage point or two below the consensus which is a significant deviation.

Simultaneously, I can say that those are about the weakest numbers we’ve seen over the last decade, with the exception of 2020. And so, even if growth manages to survive, it’s probably not going to be a year of fast growth. And it does reflect an elevated risk of recession.

The consensus outlook is also in motion. The consensus outlook is actively falling for most countries for both 2022 and 2023. So the growth outlook is weakening, not strengthening, is a pretty safe comment there.

And we can see the economic data becoming less good. So for instance, the Citibank Economic Surprise Index, which we track quite closely, it’s gone from being pretty materially positive about a month ago to being pretty substantially negative now for the U.S. And for the G10, it’s not quite negative, but it’s rapidly declining.

And so economic data is turning. Makes sense; we are encountering higher borrowing costs. We’re encountering higher gas prices and higher product prices in general. People are feeling poorer. And U.S. retailers are now starting to reflect that. They’re beginning to report more cautious consumer behaviour, in particular, a shift from discretionary spending, optional things to buy, toward household essentials. People are hunkering down a little bit and focusing on what they need as opposed to what they want.

Shoppers are also reported quite widely to be downgrading to cheaper brands, so looking to save money where possible. And so that suggests the consumer spending outlook isn’t great from here.

It also suggests some margin compression for businesses. We’re no longer in a situation in which people are willing to pay whatever is necessary to buy something. They will be selective if needed. And so, businesses can’t necessarily pass through every penny of cost increase that they encounter.

We’ve seen for some time now, consumer and business confidence also hit to some extent. And so I guess the risk in that is just that, could consumers go on a buyer’s strike? Maybe they have enough money in the bank to buy something. Maybe they still have a good job, but they’re simply not pleased by how much things cost. Or maybe they’re fearful that they might not be able to afford things in the future if they’re worried about job losses or something like that. So there is the risk that consumers spend less, not because they can’t spend, but because they’re too worried perhaps to spend.

Business confidence is in a similar position. We’ve seen the Conference Board’s Global CEO Confidence Index fall pretty sharply over the last quarter or two. It’s gone from being, I would describe as robust to being quite weak. And we’ve already seen businesses report quite diminished in inventory investment intentions. The question is whether that lack of confidence could translate into less hiring and less CapEx. And of course, if that happened, then you could start to have a problem.

I should say, so far, we’ve seen good CapEx. So far, we’ve seen hiring slow a little bit, but it’s still been quite good. And we’ve seen jobless claims rise a little bit, but they’re still quite low. So no real evidence of trouble, other than maybe the slightest of turns there.

Now, I should emphasize there’s no certainty whatsoever that consumers and business activity does weaken materially from here. It’s simply we’re getting a few little hints that it might. There’s certainly a path for consumers and businesses continuing to spend, but it’s worth flagging that there is maybe a widening path toward that activity becoming less enthusiastic.

And maybe the other thought just in the economic space is just we’re starting to see a bit of evidence of housing markets cooling. And that makes complete sense. This is what you’re supposed to get when central banks raise rates. And so we’ve seen, for instance, U.S. new home sales fall by 17% in the latest month. They are now actually below the pre-pandemic level, having been quite elevated for the last two years.

And in Canada, we’re getting little pockets of weakness. You can see home prices starting to come down in some of the markets that were the hottest previously. And so, again, it would make sense if we see some housing market softness as well.

Let’s turn to inflation. And so, I guess, main comment would be, inflation is still very high, inflation still frankly quite worrying at these heights, but maybe it’s a little bit less worrying than it was a few weeks ago. And I say that just because some of the original drivers of high inflation are starting to ease and a few other variables have turned in a more friendly direction as well.

And so, for instance, U.S. car prices, still very expensive, starting to fall particularly for used cars. And that’s an important trend. They were a big driver of inflation over the last few years.

We think dwelling costs should become a bit less inflationary as the housing market softens. And so that should be a source of weakness instead of strength in the not-too-distant future.

When we look at market-based inflation expectations, those have also declined nicely from their peak, not low, but nevertheless, off their peak. People are thinking inflation won’t have to stay high forever. And that can be a self-fulfilling prophecy.

U.S. wage growth might be slowing a little bit if you look at it with squinted eyes. I would say, it doesn’t quite match with theory. We have very tight labour markets. I would have thought wage growth would still be accelerating. But in practice, it’s actually slowed a little bit. That might take a bit of inflation pressure off.

And of course, more generally, if the China lockdown manages to ease, which seems to be happening in Shanghai right now, if the global economy slows more generally, that takes some pressure off inflation.

So inflation can fall from here. That is entirely plausible, and some important variables are pushing in that direction. I think it’s worth emphasizing, it’s not a certainty we’ve turned the corner on inflation. The breadth of inflation pressures is now so remarkably wide. It’s no longer just about car prices and home prices. In fact, you look at things like coffee and citrus fruits and dry-cleaning and toys, and they’re all surging. And I would challenge anyone to find a connection between those four categories or to draw a direct link back to the war in Russia or necessarily to supply chains, in some of those cases.

And so we’ve just got broad inflation that’s going to take some time to tame. But nevertheless, some of the important underpinnings are getting a little bit better. And so I guess we tend to think of this as the inflation risks are becoming a bit less skewed to the upside. Inflation is still, though, a problem for the moment.

Recession risks. Well, recession risks are high, probably the highest they’ve been in quite a while. But maybe they also fell slightly in recent weeks as that inflation outlook improved a little bit.

And it’s worth actually looking at past monetary tightening cycles. Kind of the standard observation is that 10 of the last 13 U.S. tightening cycles ended in recession; that’s a 77% probability. Sounds like a recession is practically inevitable in that context.

But there is some nuance to this. I think that those numbers obscure some important issues beneath the surface. And so, for instance, when you look at many of the historical recessions, several arguably were caused by things other than the monetary tightening that took place just before.

For instance, the pandemic recession wasn’t because central banks were raising rates over the prior two years. Those are unconnected things. You can even argue as to whether the global financial crisis had anything to do with the rate tightening that took place before. The rate hikes before started in 2004; you got a recession in late 2008. Are those two things connected? Or were there other forces at work?

And so, if you become a bit more selective, you can say maybe just 7 of the 13 tightening cycles created a subsequent recession. That’s pretty much a coin toss. And so that makes you feel a little bit bitter.

And actually, if you look at the last six tightening cycles, many of them, actually, you can dispute just why recessions happen and whether they were truly linked to the tightening. And so you can become quite optimistic, if you slice the numbers in the correct direction.

On the other hand, you can say, well, listen, this particular tightening cycle is motivated by high inflation. Let’s look at past episodes of high inflation. That takes you to the late ’60s, the ’70s, and the early 1980s. And unfortunately, in that context, every tightening cycle ended in recession.

So clear as mud might be one way of walking away from this. I would say that, as it stands right now, recession risk is elevated. The fact that central banks are tightening does mean that the risk is pretty high, but it’s not quite the certainty maybe that you would imagine. It’s simply a pretty high risk.

Let’s talk about central banks. So central banks, I guess, more of the same in the sense that they’re now pretty firmly embedded in tightening cycles and, you can say, moving four times faster than usual in terms of monetary tightening right now. Normally, central banks tighten at 25 basis points when they raise; this time, they’re going 50 basis points. Normally, central banks raise rates at every second meeting; this time, they’re going every meeting. That’s four times faster. Wouldn’t say that’s going to be a permanent condition. This is pretty much a summer phenomenon where we’re going to get two or three 50-basis-point rate hikes and likely some slowing thereafter.

But nevertheless, that’s where we are right now. The Bank of Canada, at least as I record this, is about, it seems, to raise rates by 50 basis points. The U.S. Federal Reserve set to do so in a couple of weeks, and then likely all over again later in the summer. And so, a lot of tightening, and of course, with big effects on borrowing costs and on growth as well. That’s a huge drag to economic growth.

On the ECB, the European Central Bank, hasn’t gotten as much attention, hasn’t actually done any tightening. It is now talking tightening. It looks like we will get some rate hikes from them.

And that’s a pretty big deal, actually; bigger than you might think, in the sense that, first of all, the European economy is enormous. It’s not that much smaller than the U.S. Second, the Eurozone policy rate, the ECB policy rate is negative; it’s minus 0.5%. It will be very useful, I think, if Europe can escape from negative interest rates. You get distortions and things like that that result.

In fact, just on the expectation of that, we’ve seen the fraction of the world’s bond market that trades with a negative yield shrinking from an astonishing 30% of all bonds had negative interest rates to just 5% today. And I think that’s a useful thing for fixed income investors, but maybe a good thing more broadly as well.

Europe also is more important than you might think just because all the bond buying that the ECB has done has compressed the peripheral sovereign yields; that’s code for Greek yields and Italian yields, the countries that had trouble over the 2010s, had lower interest rates than they would have because of all that buying. As that buying abates, we’re starting to see those spreads widen, and those countries are going to have to pay maybe a sharper increase in borrowing costs than others. It should be okay, but it merits watching.

And then lastly, because interest rates were so negative in Europe for so long, a lot of money, trillions of dollars, fled Europe and went to other markets and bought bonds there, depressed those bond yields. And so as this process now perhaps begins to work in reverse, you see some upward pressure on other countries’ bond yields, including the likes of the U.S. and Canada.

Let me finish with a thought on the peace dividend, lost, that is. And so, you should know that the term peace dividend was widely used after the Cold War to refer to many of the benefits, societally and economically, that accrued after the Cold War ended, and you saw military spending fall, and that money could be reallocated towards other things. It was the classic guns-versus-butter dilemma, resolved in favour of butter, I suppose. There was a boost to trade, a boost to globalization; cliques of countries faded; international trust rose; technology transfers increased; and human suffering declined empirically.

And so, unfortunately, now we’re going the opposite way. And so we’ve seen, of course, Russia attack Ukraine, and the West has recoiled against that. There are countries that support Russia. All of this does the opposite—more military spending, less spending in other things; trade gets damaged; growth gets damaged; globalization is hurt, and so on.

And so, unfortunate; unavoidable, I think, at this juncture. Something that does exert a bit of a drag on economic growth over the long run, a bit of a drag on society more generally, and it adds a little bit to inflation, all else equal.

Okay. I’ll stop on that slightly downward note. Thanks for sticking with me. I hope you found some of this useful. And I wish you well with your investing. Thanks so much.



For more information, read this week's #MacroMemo.

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Publication date: May 31, 2022

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