Hello and welcome to our latest video MacroMemo. It’s a familiar set of topics we’ll be talking about.
Ones we’ve talked about repeatedly over the last year. But they are so important, and they are in flux, and so I think it’s worth doing. And so, let me stop teasing you and start talking about those subjects. One is inflation. It does look tentatively as though inflation is peaking, which is quite important. We’ll talk about the transition, from an economic perspective, from falling confidence, which we’ve been seeing for a while, into perhaps falling activity, which is less desirable but a logical consequence.
We’ll talk about negative wealth effects briefly, and the idea that weaker markets do damage consumer spending in particular. And then lastly, and as has been a familiar theme as well, we’ll talk about recession risks and recession prospects and just what that might look like, if it comes to fruition.
But first, let’s talk inflation. So inflation does continue to appear to be peaking, and inflation is the most important macroeconomic variable out there right now. High inflation’s bad by itself to the extent that it damages everyone’s cost of living; it’s bad for economic growth by itself; it’s a corrosive force. It’s forcing central banks to do a lot of rate hiking, which of course, is hurting borrowers and hurting the economy as well, and so it’s a big part of the economic slowdown story.
It’s also highly relevant to markets; a higher inflation environment requires a repricing of both bonds and stock valuations, both in an undesirable direction. And so it at least temporarily challenges classic asset allocation theory, in which you have stocks balanced out by bonds. But both do badly when inflation is high.
And so it matters for all those reasons. Again, inflation does seem, though, now as though perhaps it’s finally starting to peak. And so when we look at what we think are the two or three most important drivers of inflation, it would be commodity shock, a supply chain shock, and perhaps overly generous central banks. And central banks are now tightening policy. Commodity prices have now fallen fairly broadly, largely on expectations of demand destruction, essentially, expectations the economy will be weaker in the future.
And then supply chains are clearly improving. They’re not completely fine, but they are clearly improving. The cost of shipping is falling globally. The number of ships waiting at port has gone down significantly, at least in a North American context. Google searches for the term supply chain have significantly faded over the last six months or so.
Talks of discounting are returning, which is fascinating. It struck me only recently. I haven’t seen many sales out there for a couple of years, and it seems as though maybe we can expect to start getting more sales, which says something about the ease with which retailers are procuring items.
And manufacturers apparently in China are starting to call retailers, asking them if they have any more business for them. Whereas the story of the last year-and-a-half has been completely one in which retailers are calling manufacturers, begging for more production and not able to get it off. And so that balance is starting to shift, which we think is a signal of supply chains getting better.
And then when we turn to, I suppose, real-time measures of inflation, the Cleveland Fed in the U.S. runs a nowcast for inflation. And it suggests for the moment that July could be the month when we see a fairly significant drop in inflation; though I would warn, as I record this, about half of July hasn’t happened yet so that’s a bit of a premature claim. But we’re getting some nowcasting measures that suggest some easing as well.
So perhaps inflation peaking. Let me, though, pour a little bit of cold water on the amount of excitement at least we should have around this subject. And so, I guess the first thought is just we shouldn’t expect miracles here. Inflation may become a little bit less hot. It’s unlikely to snap back completely to normal overnight.
And so turning back in fact to some of those key drivers on the commodity front. Yes, commodity prices are down, but there’s still arguably some upside risk to natural gas prices, perhaps to oil prices, likely to food prices as well as harvests perhaps don’t come in as much as hoped for.
On supply chains, certainly there’s some improvement but we do still see in particular a big backlog of ships in Asia, a significant backlog in Europe. So the story is not completely solved and there is still the risk of further Chinese lockdowns. In fact, Chinese COVID cases are rising again.
And on inflation, inflation expectations have fallen beautifully in the market, in financial markets. Less obviously so when you ask households and businesses what their inflation expectations are. And so those are still high and, if anything, rising, and may well be the more important measure of expectation to the extent that’s what’s going to drive the willingness to pay, and consumer spending, and business investment plans.
And so, again, on all counts we think we’re seeing some improvement but we’re not expecting miracles. And we do recognize there are a lot of potential echo effects out there as well. And so, for instance, higher transportation costs still just working their way, still ricocheting their way into higher product prices in many cases. Natural gas prices in the open market soared and went up many months ago, but only now are starting to be passed through to retail customers in many jurisdictions where there’s a smoothing function essentially in effect.
Companies up and down the supply chain are still haggling over who needs to absorb what costs. It wouldn’t surprise me at the end, the person absorbing that cost was you and I, not the businesses as well.
And on wage growth, well we do think labour markets are beginning to soften and will soften further, and so perhaps that will ultimately cap wage growth. But at the same time, we’re aware that when you look historically at prior periods of high inflation, it’s not clear that workers permanently lose, that wages end up under-pacing inflation permanently. And so there should be some sort of catch-up in terms of real wages down the line, which could also just keep inflation percolating.
And so, again, inflation seemingly peaking; likely to come down somewhat. Probably inching our way past the worst, but I wouldn’t want to pretend this is going to be a monotonic function in which inflation just zips its way back to normal. It’s going to be a choppy path. We are still going to see some periods of fairly high inflation, and again, inflation could well be partially reviving in a few months’ time, depending on how some of those other factors play out.
Okay. Onto the next matter, which is more purely economic in nature. And so really just an observation of the economic weakness beginning to mount. And so we first saw it in, really, confidence variables. Consumer confidence plummeted. Business confidence and expectations fell fairly significantly as well. And so that’s largely happened and is now quite weak.
We’re now starting to see more specific intentions and expectations start to dim. And so, for instance, on the business front, capital expenditure plans in the U.S. are now significantly less boisterous than they were a few months ago. They’re not horrible, but they are coming down. Similarly, from an employment perspective, we look at ISM Manufacturing and Non-Manufacturing Employment Indices, those are now consistent with shrinking labour forces as opposed to growing labour forces. And so the specific intentions are starting to weaken, and we’re just beginning to see actual economic activity softening as well.
And so, for instance, if you looked at U.S. job numbers, well, the headline number was actually pretty good. But there were a few details. The household survey number was outright down. Weekly jobless claims have been inching higher for several weeks—in fact several months now. And when we look at real-time credit card and debit card spending in the U.S., still up relative to a year ago, but less and less. And if you adjust for inflation, I think it’s fair to say not at all. And so we think we’re starting to see the weakness show up in the real data, which is what you’d expect to eventually happen. So this economic deceleration still very much in place.
On wealth effects—and so this is really just one way of thinking about the economic headwinds that exist—clearly, we’ve seen a big hit to financial markets. We are beginning to see a hit to housing markets and home prices in some jurisdictions, and that does damage to consumer spending. And that’s called the wealth effect, and it’s a negative wealth effect right now. And so the U.S. stock market has lost around $10 trillion of value over the span of the first half of 2022. And usually for stock markets use a $0.02 on the dollar adjustment to figure out the wealth effect, and so just mapping that on to consumer spending, you’d expect consumer spending to be about 1.5% weaker because of those $10 trillion in stock market losses. And if you were to add on bond market losses and a few other things and maybe accommodate the possibility of a further decline, maybe there’s a 2% hit to consumer spending just based on what financial assets have been up to.
You can do something similar for the housing market. In fact, housing markets are even a little bit more closely weighted to consumer spending and use often a $0.04 on the dollar multiplier in terms of the hit to wealth versus the immediate hit to spending. And so, using a pretty conservative assumption of just a 10% drop in, say, Canadian home prices, you can argue for a 2% hit to consumer spending on that basis as well.
And so again, there is a multiple-percentage-point hit to consumer spending that comes just from wealth effects, setting aside interest rates, setting aside gas prices, and these sorts of things. And so again, it’s consistent with the idea that we should expect a significantly less enthusiastic consumer going forward.
And then that brings us lastly to recession risks. And so we’ve been flagging these for quite a while. We’ve had below-consensus growth forecasts. We’ve been revising down our growth forecasts, and we’ve been flagging a very high recession risk. I have to say in my own head, I think there’s something like a 75% chance of recession in the developed world over the next 18 months or so, so through 2023. So significantly more likely than not.
And others are starting to glom onto this view. There was a recent poll of American citizens found 71% expect a U.S. recession by the end of this year. The drop in commodity prices that we’ve seen quite universally reflects that expectation. It’s an expectation of demand destruction from an economic slowdown.
Consensus growth forecasts have been falling fairly significantly with a rising number of forecasters predicting recession. And inflation expectations are falling, which is a wonderful thing, but again, likely reflects expectations of weaker economic activity.
When we look at the yield curve that one of the classic indicators is the 2-year/10-year spread, and when that inverts, that is classically a recession signal; that did just invert. The other two yield curve measures we look at haven’t inverted yet, but they’re working on it and so I think you can expect them to get there in the not-too-too distant future.
And so recession risks are increasingly being reflected by markets as well, which is a good thing, by the way, because it means that the pain we’ve suffered in markets so far is factoring in this economic bad news. There isn’t necessarily that much more economic bad news that has to come down the pipe as a result.
Maybe the last thing I’ll finish on is just to think a little bit, if we were to get a recession, what might it look like. And in the past, we’ve said, and we still think this, that a recession would likely be a middling kind of recession in terms of its peak-to-trough decline, something like a 2.5% decline in GDP, which is quite significant, not as bad, though, as the pandemic or the Global Financial Crisis.
In terms of length of recession, well, two or three quarters would be most likely to our eye, so pretty average if not slightly shorter than average recession, just on the basis of the things that need to be fixed before the economy can recover.
And in terms of the pace of the subsequent recovery, which is maybe getting a little bit silly, since we don’t even know for sure if there is a recession, that’s now some distance off, nevertheless, in terms of the pace of the subsequent recovery, well, probably a fairly middling recovery pace as well.
So just to give you a sense of this, we saw an extraordinarily fast recovery after the pandemic. You had 11 percentage points chopped off, slashed off the unemployment rate in the span of two years, which is not normal, that’s incredibly fast. Conversely, the recession before that, or the recovery before that, after the global financial crisis, you took the better part of eight or nine years to recover the labour market back to normal. And so we think the real answer for this coming cycle, if there is one, is somewhere between the two, which is it doesn’t take eight or nine years to get back to normal, neither does it snap back in a year or two. And so something in the middle makes sense.
And maybe a last thought is just, to the extent a recession does come, the labour market probably a bit more resilient than normal in the sense that we know that companies wish they had more workers right now. They’re likely to do a little bit of labour hoarding. If there is economic weakness, they’ll probably be a bit less keen to lay people off. And so, we’re assuming that even a middling recession would only add 2 or 3 percentage points to the unemployment rate, which would take them higher than desirable levels, but which would not take them to double-digit levels or even really to particularly high single-digit levels. So the labour market does a little better than normal, though certainly doesn’t come out unscathed, if there were to be a recession.
Okay. I’ll stop there and say thanks so much for your time. Hopefully, you’ve found this interesting and please tune in again next time.