Hello and welcome to our latest video #MacroMemo. Within the next several minutes we’ll cover off a pretty wide range of economic and economy- related topics, including a quick touch on COVID and the war in Ukraine. From there, we'll dig into some meatier subjects, including banking stress and the extent to which it might be relevant for smaller banks, which haven't been in the limelight recently.

We'll talk about the business cycle, what our work there is suggesting right now. We'll discuss lending standards which are tightening quite a lot. That’s one of the stronger recession arguments out there. We’ll talk about Canada in the context of recession and how we used to think any Canadian recession would be worse than the U.S. and we’re actually less convinced of that now.

We’ll talk as well just about the idea that this is a highly anticipated recession and what that means not just for the economy, but what it means for financial markets. It might actually be a less intense hit to markets if they can see it coming. We'll also spend a moment on the debt ceiling, which is nearing, and also on the idea that housing markets seem to be bottoming out, arguably prematurely – and can that be sustained?

So that's a lot to cover off. Let's whip our way through the first few so that we can stay on time here. And so just to start with, on the COVID file, and it hasn't been a relevant driver of the economy since China reopened in December, but it may be symbolically notable that the World Health Organization declared that the pandemic was officially over as of May 11th.

Inevitably, there are still variants circulating. There are, in fact new variants. The XBB.1.16 sub-variant is the latest and is circulating particularly eagerly in India, and in at least 30 other countries. But it doesn’t look like there's anything that will break through the significant immunity that's been acquired over the past several years, and it seems quite unlikely that economic restrictions will be imposed. So it's very much a side story for the foreseeable future.

In Ukraine, while the war continues, alas, Ukraine did make some gains recently, and that's after several months in which Russia was, if anything, making incremental gains. And so that's a bit of a reversal. We are still, in theory, waiting on a Ukrainian spring counter-offensive that's been anticipated for some time.

The expectation is that Ukraine does perhaps capture some territory, though there was leaked U.S. intelligence recently suggesting that that gain might ultimately prove underwhelming. And so maybe the bigger point here is just that there are not major changes afoot in the Ukraine. It's a grinding war and one that seems likely to continue at this point in time.

We continue to think about it in an economic context, mainly in the sense that if it were to intensify further or if Russia felt more threatened, you could conceivably see energy prices go higher. The supply of Russian energy was further constrained. And so that's maybe where the main risk lies.

Let's switch over to banking stress. So banking stress has been an acute issue in the U.S. mid-sized banks since early March. We've now had three banks fail, including one that failed since we last recorded one of these videos. It was for the usual set of reasons. It was a bank that had suffered bond market losses on the asset side of the ledger, and its depositors withdrawing their money on the liability side. And that just wasn't a viable combination.

There are still a number of vulnerable mid-sized banks in the U.S. that are in the eyes of markets right now. And so I can't promise that's the end of the story. There could be somewhat more to it. But I will say as we look at the broader U.S. banking sector, it's clear that larger banks seem to be okay. They have more capital, they're more diversified, they hedge their bond market holdings, they're more heavily and arguably better regulated. But the question we hadn't seen answered and we pursued this was: “What about the thousands of small banks in the U.S.?”

The U.S. is famous for having many of these very small banks, and in theory you could think there might be vulnerability there. They're very geographically concentrated. They have a relatively homogenous customer base. We haven't heard much about them. It's hard to track thousands of banks all at the same time. So we looked into that.

And as it turns out, they actually looked surprisingly okay. Small banks in the U.S. are, on average, better capitalized than both medium- and large-sized banks. They have more liquid assets than mid-sized banks. They have a larger fraction of their deposits that are insured. They have a smaller exposure to commercial real estate, which is thought to be a problem area in the U.S. going forward. And so overall, they look surprisingly good.

Certainly there can be considerable variation within the set of small banks when you're talking about thousands of them. There are no doubt some poorly run businesses. It's actually fairly common for small U.S. banks to fail, but they are small and so they have limited consequences and they're not publicly traded. And so there's no direct impact on investors. I guess the takeaway is we're right to continue focusing on mid-sized U.S. banks and there may be some further trouble there. We don't think it metastasizes or becomes a truly systemic issue.

Let me pivot to the business cycle. I can say on that front that we recently updated our business cycle scorecard saying really the same thing as a quarter ago, which is that we are likely at the end of a business cycle. It looks like the cycle is still advancing.

We see fewer late cycle counterclaims, we see more recession counter claims. This is a model where the different variables vote and they disagree with each other. But we can see where the central tendency lies, and the central tendency is still an end-of-cycle reading, but it's still certainly advancing. I guess the point is that we are getting readings that are quite consistent with a cycle that is very close to being at the end.

And as we’ve said for a while now, we think there's about an 80% chance of a North American recession over the next year. Now, one of the things that may be supporting that argument is that lending standards keep tightening. And that's true in a number of places. It's true in Canada, it's true in Europe, but it's perhaps most true and the data is richest in the U.S.

And we did recently get a new quarterly print in the U.S. Some optimists note that we didn't see as much further tightening of lending standards by U.S. banks over the last quarter, as you might have guessed, based on this sudden arrival of banking stress over that quarter. But you know what? It was still a significant amount of further tightening.

And I think even more importantly, lending standards had tightened quite a lot in prior quarters to the point that the willingness to lend now looks pretty similar to prior recessions. So this is an unfriendly lending environment and the demand for loans has also now fallen quite sharply. That would suggest households and businesses are also perhaps hunkering down a little bit in anticipation of some economic weakness ahead.

And so I would say the lending standard data provides probably some of the more compelling arguments that a recession is more likely than not at this point in time. Now, with that acknowledged, I would say that for most of the last year and a half, we've been saying if a recession comes, Canada probably does worse than the U.S.

And the argument was fairly straightforward. Canada had more household debt, a worse housing market outlook, and so the experience could be more troubling as interest rates rise. That still seems like a fair statement, but I will say we're now of the view that maybe Canada doesn't do any worse than the U.S. over the next year or so. And that's because a number of other things have gone right.

One would be that Canada has really ramped up its immigration and that adds to economic growth. It limits the scope of any recession.

Number two would be that the terms of trade have been favorable toward Canada. Yes, commodity prices are down recently, but they're still higher than they were a few years ago. And that's Canadian companies making more money. Canada has a lot of resource producers.

The fiscal picture in Canada isn't perfect. There are still deficits, but it's actually a lot better than in most countries. Most developed countries are going to have to engage in some real austerity over the next few years, and Canada arguably isn't. And that's a helping hand.

Housing is recently stabilized. I'm not convinced that continues, but more on that in a moment. It's at least not hurting to the way it once did.

Also, Canada has somewhat lower inflation than the U.S., which is good at this point. It has seemingly healthier banks, which is quite helpful as well.

I know for that big, long list of happy things, it sounds like I'm saying no recession. I still think a recession is more likely than not, but it's not obvious at all that Canada needs to have a worse experience despite being a more interest-rate-sensitive economy right now.

Let's talk now about the most anticipated recession in history. If we get one, it has been the most anticipated in history. We've debated before whether that makes the recession more likely or less likely. And you can say less likely just because it means there's more time for businesses and households to get their houses in order to avoid big problems.

But you can also argue it's more likely because there can be a self-fulfilling prophecy. Businesses stop spending and households stop spending and it creates the recession, even if one wasn't strictly necessary beforehand. We've generally concluded that perhaps recessions are a little more likely as opposed to less when it's highly anticipated. But we haven't talked before about what it means for markets, and markets are forward looking.

And if a recession is anticipated, then markets should have priced at least some of that in, in advance. In fact, I think you can argue some of the weakness in 2022 was precisely pricing that in. So in theory, an anticipated recession should result in a less extreme market hit when the recession itself arrives. And so maybe we will see again, a less extreme hit to risk assets if and when we get this recession.

Okay. Two last subjects for me. One, the debt ceiling. So as I'm recording this – and this is a mid-May recording – the debt ceiling is drawing near in the U.S. It looks as though it will become a binding constraint in or around June 1st. It's a tricky one given that Congress is divided. The Republicans have said they're going to fight fairly hard on this one.

They don't want to raise the debt ceiling. They'd like to see a lot of spending cuts. And we've seen a significant wedge form between T-bills that mature before the debt ceiling expiry date and those that mature after.

So bond investors are paying attention to this. Markets are not ignoring it. I do think a deal is still possible before the deadline. Negotiations did become serious in recent days.

Both sides recognize that spending cuts are needed, even if the magnitudes are disagreement. There are some exotic options that you hear about sometimes: trillion dollar coins, deploying the 14th Amendment or issuing bonds at a premium. But it's fairly unlikely we see those used.

I think more likely is that if a deal isn't reached by the deadline, it's likely the Treasury will prioritize debt payments over other things. We might see something like a government shutdown. Government workers don't get paid for a period of days. And hopefully the screaming that results from that gets politicians to the table and finding a solution.

Of course, that's not an ideal outcome. But I would note we've been through two government shutdowns in just the last couple of years, and so it wouldn't be an unprecedented development.

It's much less likely that an actual technical default happens on U.S. debt. Pundits are arguing it's a 1-3% chance or thereabouts. You would get all your money back later even if there was a default because the U.S. is not insolvent, it’s just having political problems.

But it’s fair to say the debt downgrade does affect the ability of some parties to own U.S. debt, which could have a ripple effect. If money market funds broke the buck, that could have a ripple effect. If corporations were counting on bills maturing and using that money to spend or to pay their own bills, that could be a problem.

So this is worth watching. We may see some market distress. We would view any market distress as a buying opportunity just because it's effectively inevitable that the debt ceiling does get raised and these problems are addressed. But it will be a very interesting period, with a few ways this could go over the next several weeks.

Let me finish on housing strength. In a North American context, after a year of fairly profound housing market weakness, we are now seeing a significant housing rebound in recent months. And that's true in both the U.S. and Canada.

Home prices are rising. Prospective buyer traffic is up. There are instances of multiple bids. And in the U.S., the National Association of Homebuilders Sentiment Index is rising quite clearly off its lows, though I should add, it's still quite weak. But it's rising. And so it's really important to get this housing call right. Is this rebound sustainable or not?

If the housing market rebounds sustainably, it's a lot harder to get to a recession. Housing markets are usually a bellwether for recession, and we wouldn't get one necessarily if housing were rebounding.

Can inflation keep falling if home prices start to rebound? That has been the biggest driver of U.S. inflation recently. And so it really complicates the story if the housing market is rebounding.

It's fair to say that U.S. homeowners are well-sheltered from higher rates, that's a helping hand in the U.S.

It's very fair to say that Canada has a big influx of immigration and there's a housing shortage. And so on all of those fronts, you could certainly argue that housing could continue to rise.

For the moment, though, we'll take the other side of the equation. We're still skeptical this rebound can be sustained.

A few thoughts to that effect:

One would just be it is not unusual to get a seasonal uptick in the spring. This could be just a seasonal story. It might peter out in the summer and into the fall.

Number two, the number of homes for sale is extremely constrained right now. You have buyers looking to buy, but sellers don't want to crystallize recent losses. Homes for sale are in the vicinity of two-decade lows, and so as a result of all of that, there's just an artificial shortage that's boosting prices. Supply will come to the market over time. That might resolve that.

Third, we're looking for a recession. There's a bit of circularity to that logic. But if we do get a recession, that would normally be a weaker, not a stronger housing market.

Four, housing affordability is bad in the U.S. and it's awful in Canada. And it's quite unusual to start a new housing cycle from that starting point.

Fifth, most housing downturns just take longer than this. We just did a study. We looked at historical housing downturns across the developed world. The median downturn lasts 6.6 years, not one year. In fact, the shortest downturn was 1.3 years. And this one has been one year. And so it would be very unusual for this to have been it.

The median home price decline, for what it's worth, is 26%. During such experiences, the decline has been less. This doesn’t have to be the exact median experienced, but history would suggest it’s likely that there’s some further weakness ahead. Maybe we can reconcile the differences by citing one trend you see – and this is true, by the way in Canada in the early 1990s – you see a couple of years of sharp decline in home prices, which arguably we've just experienced.

And then you see a period of three or four years of essentially stagnation. There's a malaise. Home prices are roughly sideways. It's a weak housing market. So maybe that's the story ahead. We're not looking for a further housing bust, but we do think that there's still some weakness. We don't think this will be a driver of an economic recovery.

Okay, I'll stop there. Hopefully you found some of this interesting. Thanks so much for your time and I wish you well with your investing.