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by  Eric Lascelles Jan 25, 2022

Globally, Omicron seems to be retreating slightly but the arrival of a new subvariant is raising concerns. Geopolitical tensions between Russia and Ukraine as well as monetary policy uncertainty are contributing to higher volatility in the financial markets. Chief Economist Eric Lascelles shares his views on these developments and whether more rate hikes will hinder the economic recovery.

Watch time: 12 minutes 49 seconds  |   Hover your cursor over the video to see chapter options

View transcript

Hello and welcome to our latest video MacroMemo, and much on the agenda, as always. We’ll start with a discussion of the Omicron variant and the extent to which we’re actually seeing some small improvement on that front. We will at the same, though, acknowledge what could be a new subvariant that could yet induce future waves. We’ll talk about economic damage created by the latest wave, but also the prospect of an economic recovery to come in the not-too-distant future thereafter.

Ukrainian geopolitics and that Ukrainian-Russian relationship figures centrally so we’ll get to that before too long, and also acknowledge some recent financial market challenges. Markets have been glum recently and we’ll talk through why that is, the degree of market uncertainty out there, and arguably, the big reason for that, which is central banks that have become significantly more hawkish.

Let’s start with Omicron. And so the Omicron numbers are, broadly speaking, improving. That is to say, when we look at the global caseload, they have declined slightly, though they are still very high. The number of countries deteriorating in terms of a rising caseload has fallen from almost 90% of countries to just over 50%. And so, the glass-half-full perspective on that is it’s a big improvement. The glass half empty is, of course, that most countries are still seeing some deterioration.

So this isn’t done just yet. But we can see some countries that have clearly moved into the improvement phase and those would, of course, include the likes of South Africa but now also the UK. And so the UK has actually seen its daily caseload fall by about half since the worst of the Omicron wave. So there is a light at the end of the tunnel, I suppose.

And we do see some tentative improvement in Canada with a test positivity rate that’s fallen from about 40% of tests down to about 20% and a bit of a decline in the actual official infection numbers. The U.S. is a little bit harder to discern but perhaps the slightest of declines in the infection rate there as well.

And hospitalizations proving a little more recalcitrant. We still see very high numbers in a lot of countries. This, of course, tends to operate with a lag, and we can see some of the most advanced countries, including South Africa and the UK and Israel, seeing—or enjoying, I should say, declining hospitalizations as well. So, we do think the Omicron wave will de-intensify somewhat over the next month or so.

I should say for all of that, that, unfortunately, there has been a new subvariant of Omicron identified. And that’s not in itself brand new. We’ve seen subvariants come and go across this pandemic and most haven’t proven particularly relevant. This one could, though, in the sense that it has now been identified in 40 countries in fairly short order.

Denmark, in particular, reports that over half of its cases are now of this BA.2 subvariant variety. Details are still a little bit sketchy, but it does seem to be outcompeting Omicron to the extent that it is now the dominant variant in Denmark and seemingly rising as a share of the total in quite a number of other countries. Some estimates suggest it could be twice as transmissible as the Omicron variant, which seems hard to fathom to the extent Omicron was among the most contagious things in the history of viruses as far as we know. But nevertheless, that’s what we’re getting right now.

So there is a risk, unfortunately, of another wave over the next few months. It could struggle to be as big of a wave as the Omicron wave just because so many people are getting sick and achieving immunity with the Omicron wave. But nevertheless, it does need to be paid close attention to, at a minimum.

Now, we have seen some economic damage that has emerged from the Omicron wave. Case in point, some of the December figures have been soft in the U.S. For instance, retail sales and industrial production shrank outright in December. And as we start to get the January data, we’re seeing a similar story, and so, one in which the flash PMIs are now out for a number of countries and down, and in particular, down for service sector activity, which is what has been most affected by lockdowns and the like.

I can say as well that the real-time economic data we look at tell a similar story—falling hotel occupancy, restaurant reservations in decline. Globally, credit card-based spending also declining to some extent, showing some caution from consumers.

So we are seeing some real economic damage, which, I should emphasize, we budgeted for and do figure already into our below-consensus growth forecast. It makes sense. We’ve had lockdowns, of course. We’ve had people behave voluntarily more cautiously. And we’ve seen a real hit to the labour supply, which has been a somewhat unique characteristic of Omicron; so many people getting sick that actually a lot of companies just don’t have enough workers.

Of course, this is temporary. And I should say, as we turn to the outlook over the next year, we still think the outlook is fairly good for 2022. We believe it will still be a year of economic recovery. We’re seeing lockdowns easing, at least in the form of announcements to that effect, but implementation as well. When we look at businesses, they are still talking very enthusiastically about engaging in more capital expenditures, about building inventories, about hiring quite a bit as well. And so still seems to me that recovery story is in place once we get past these various virus waves. And when we talk about recession risk, that recession risk still seems to be fairly tame. The classic yield curve recession model gives an 8% chance of recession in the U.S. for the next year, which is a pretty small number. Our work on the business cycle still says it’s roughly midcycle, though I’ll admit we’re going to be revisiting that shortly. But I have no reason to think that’s changed aggressively.

Let’s talk about Ukraine and Russia and geopolitics. Certainly, those are the most important geopolitical relationships at this particular moment. When we look at some of the betting markets out there, they do assign as high as a 75% chance of a Russian attack on Ukraine. So this is a real chance. However, do note that these betting markets are defining any kind of bloodshed and so that could range between a full-scale takeover of the country, which is probably quite unlikely, and Russia perhaps claiming parts of Eastern Ukraine that it’s already functionally controlled for the last seven years, ever since 2014. And so, of course, that would be a less extreme scenario.

I suppose the bottom line is, there is significant risk of conflict here. I’d be inclined to put it under 75% myself. It’s significant but perhaps less than that. It seems to me that NATO is getting organized and is getting serious in a way that it didn’t in 2014 when Russia took Crimea from Ukraine. We see NATO with some pretty powerful sanction tools and talking aggressively about using them in a way that could dissuade Russia from attacking. And keep in mind as well, there are ways that Russia can win without an actual invasion. And so, President Putin has already enjoyed a resurgence of his domestic popularity simply with this, the threats that have been made.

It may well—these events may well encourage political change in Ukraine to the advantage of Russia. It will perhaps discourage future countries from aspiring to joining NATO, which is one of Russia’s goals. And so, on a number of fronts, it doesn’t have to end in outright military conflict, though there is very much a risk of that right now.

I would say, note that much of this happened seven years ago in 2014 and Russia did claim part of Ukraine and it didn’t end up moving financial markets all that enduringly or affect the global economy all that much. And so, I guess long story short, this isn’t a central feature of our 2022 growth outlook. It has the risk of becoming relevant, but as it stands right now, it’s not guaranteed to be the dominant force for 2022 by any means.

I will certainly note that natural gas supplies are a particular tricky point. And so Russia provides a lot of energy to Europe, and so you can imagine that being a pinch point and a leverage point perhaps for Russia. Keep in mind, though, Russia didn’t cut off the natural gas in 2014. If Russia did cut off the natural gas, that would be very damaging to Russian financial revenues and would also be very damaging long run because Europe would recognize that it wouldn’t be in a position to trust Russia in terms of the supply of energy over the long run, so Europe would go in a different direction.

Let’s talk about financial markets for a moment. And keep in mind, I’m the economist, not a portfolio manager here, but nevertheless, even I can acknowledge that financial markets have been fairly glum to start 2022—very choppy; net down for the stock market as much as a 10% intraday drop as it pertains to the S&P 500 as something of a benchmark index. And it’s been the low-quality, the previously high-flying names that have suffered most, and those are the stocks that were outperforming to the greatest extent in earlier quarters and years.

In terms of why this is happening, well, it seems to me it’s mainly about central banks. Just some trepidation about the federal reserve and other central banks being on the cusp of a tightening cycle and what that might mean. We’ll talk about that in a moment.

Less so to my eye about Omicron and Omicron damage. I think markets are responding less so to Ukraine, though, certainly, you can say the Russian market and other local markets are responding. But globally, I don’t think it’s a story of Ukraine; it’s a story of central banks. And likely, this concern passes once tightening is underway.

One thing we’ve been watching in the context of markets is high uncertainty or high expectation of financial market volatility. And to be sure, there is a fair amount of uncertainty for this year and for some of the reasons just discussed. I will say, though, that when we actually look quite closely at the expected volatility in markets—and we can do that through the VIX index and other fairly sophisticated measures—they’re all up, but they’re not at unprecedented levels. They’re nothing like they were in the spring of 2020. In fact, they’re really around levels that you see about once a year, on average.

And so, this is, again, not standard business, but we can say it’s not unfamiliar. It’s the kind of thing you do get every once in a while. And we can see it similarly in a measure of U.S. monetary policy uncertainty, which is also higher than normal. But again, the kind of uncertainty you get every year or two, not just once in a decade. And really, maybe that’s what we’re seeing in financial markets as well, which is a kind of a volatility you do get something like once in a year and perhaps nothing more than that.

Let me finish with some talk about central banks. And so, again, that seems to be the focal point for markets right now, and central banks on the cusp of tightening. Here we are with the U.S. Federal Reserve—as I record this at least—likely to signal a March hike imminently and to continue its tapering and perhaps to signal some quantitative tightening for the second half of this year.

You have the Bank of Canada, which, actually, more likely than not at this point in time, could be raising rates in the next few days as I record this. And so, the Bank of Canada conceivably raising rates before the end of January, seemingly on a path of multiple rate hikes across the year.

And it seems to us it’s broadly the right decision in the sense that inflation is very high, which is a motivator, and unemployment rates are now fairly low, which is also a motivator. So you would struggle to say that central banks are making a mistake in talking about and beginning to raise interest rates from these rock-bottom levels. But still, it’s understandable that there is some trepidation. It’s been a while since central banks last tightened. There is still some concern about the economy with the pandemic not completely solved.

Central banks have been talking fairly aggressively. They’ve been talking about a fair number of rate hikes and with a degree of urgency we hadn’t heard before. And so markets don’t love that level of urgency.

Similarly, central banks are arguably planning to raise rates mainly because of high inflation more than high growth. And so, the high inflation scenario is one that’s viewed a little less favourably. Markets say, okay, if growth is strong, we’re happy for you to raise rates; if inflation is strong, that’s a less benign reason for raising rates. And so you can see some trepidation about that.

And maybe lastly, I don’t think raising rates is a policy error. In fact, I think it’s largely appropriate, given what we know about the economy. Nevertheless, I would say maybe what’s been revealed is that there was a bit of a policy error that took place earlier, over the last—second half, rather—of last year. Maybe central banks should have been moving as inflation was so high. They thought it was going to be a very short-lived affair. It’s proven more enduring.

It’s not so much that the rate hikes themselves are a policy error. They’re arguably fixing one. But still, somewhere in there, we’ve kind of come to the—to our attention that maybe there was a policy error that took place at one point.

Lastly, on that central bank front, I can say we can put numbers to this. And so, for instance, if the U.S. Federal Reserve would have raised rates four times this year, do a bit of quantitative tightening as well, that chops something like 0.6 percentage points off U.S. GDP growth for the year, and so that’s a significant sum. Helps to explain why we have a below-consensus growth forecast.

But this is not the stuff of recessions, if that makes sense. This takes them from maybe what would have been 4% growth to a 3.25%-type of growth rate. And that’s still a recovery. It’s still perfectly fine. And so you’d need to see a lot of rate hiking before you’d talk seriously about the central bank killing the economy and resulting in a recession. We still think that risk is fairly low. We still look for economic growth over the coming year.

Okay. With that, I’ll stop and say thanks very much as always for sticking with me. Hopefully, you found some of that interesting and I wish you very well in your own investing.

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


Publication date: January 25. 2022

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