Welcome to the latest video #MacroMemo. As always, we have a lot to share and to discuss. And we'll start with some current events in terms of some challenges, higher oil prices, higher yields, higher tariffs. And we’ll just talk through that and our thoughts in the short run. We will then jump ahead to really more thematic issues.

One is just the observation that U.S. borrowing costs are now materially higher than in China. We'll talk about why, how much and so on. We'll take a peek in an AI context at the data centre backlash currently underway -- which rhymes a little bit with AI-related concerns that have surfaced recently, just in the context of AI becoming too powerful.

And so all sorts of concerns there right now. We'll spend a moment on the midterms just in a stock market seasonality, technical sense, how the stock market normally does into the midterms, how it often does coming out.

We will spend a moment on the European economic numbers generally, some resilience being shown here. And maybe all is not lost for Germany, despite the auto sector hurting right now.

We’ll finish with maybe the longest section, I'm afraid to say, Canadian productivity.

Just revisiting. It's been a tough story. There are some improving prospects, we think. There's an important investment summit happening in Toronto, as I'm saying these words, and so we'll fit all of that together.

Okay, let's start with those current events though. And so it’s certainly fair to concede that there is more adversity than not, just in terms of recent developments in recent weeks and in recent months. And perhaps most prominently, of course, higher tariffs, most relevantly in a U.S.-Canada context. A bit less relevant, one might say, for the rest of the world.

Here we are grappling with seemingly ever higher oil prices as the war in the Middle East continues, and there have been strikes recently on a critical Saudi pipeline that is greatly complicating the outlook. The Red Sea is looking a little bit more fraught as the Houthis take over some strategic islands and so more challenging there.

Higher bond yields at the long end as well, in part related to the oil and the inflationary implications. And collectively more tariffs, higher oil, higher yields do add to inflation, do subtract from growth. And so of course, not directionally things that we're looking for.

I should emphasize, in all cases at this juncture, we are assuming there is some scope for reversal over the coming year.

We're working on the view that the jump in Canada-U.S. tariffs may decline over a roughly two- quarter time horizon. We're working on the view that the tensions between the U.S. and Iran will perhaps diminish somewhat over the span of the next year. Our fixed income teams are of the view that higher yields are justified, but don't expect them to necessarily rise a whole lot further, at least not in a sustained way.

But in all cases, there's no guarantee here. And to the extent these unfriendly trends continue, they do start to compromise the fairly happy growth outlook currently in place. So we need to watch these things quite closely. For the moment, we're still comfortable with the view that economies can continue to rise. And for that matter, markets can go up as well.

Just in terms of recent data, we did get the latest U.S. inflation figures. The PPI numbers as expected, were hot. The U.S. CPI numbers for August were also fairly warm. And there's something of a theme to that around the world. And of course, oil prices and energy prices in the mix as a result. As we've talked about in recent months, this is now the beginning of a new monetary tightening cycle globally.

And so the European Central Bank hiked again, has signaled more tightening is coming. The Danish central bank also recently raised rates. And at least as I'm sharing these words, the Fed is now in focus. And as I'm recording this, tomorrow – it may already have happened for you – the Fed is set to render a rate decision and seemingly is on the cusp of initiating a rate tightening cycle and delivering a first 25 basis point rate hike on September 16th that is widely expected.

It's over 90% priced in. We're hopeful it does help to tame some of the longer-term bond yield concerns. You could envision it perhaps tempering inflation expectations a little bit – maybe tempering the term premium a very little bit, just given that some of that reflects policy credibility concerns in the U.S. Then again, to the extent the markets almost fully priced it, we shouldn't expect too much, but nevertheless, perhaps it helps to prevent long-term yields from continuing to rise.

For the moment, we are taking the under on the market’s expectation for four rate hikes priced over the next year. We think it could be a little bit less. We believe there is some scope for inflation to settle over the next year and so on. But again, that does circle around to the view that perhaps the energy shock diminishes in intensity somewhat.

And that just hasn't happened yet.

Let's turn over to U.S.-China borrowing costs. And so U.S. 10-year yields are much higher than in China, roughly triple the Chinese10-year bond yield. Normally, certainly over the 2010s, U.S. 10-year yields were lower than in China. The U.S. borrowing cost was the cheaper of the two. So there's been a big reversal here.

Obviously, the question is, what's going on? Mechanically, U.S. yields have been rising more or less since 2020. Mechanically, Chinese yields have been falling more or less, though much more gradually and steadily since 2018. And so it really is both parties pushing in the opposite direction. Why is that happening though?

And so from a U.S. standpoint, we've discussed this before.

Of course, inflation has been chronically too high. Now the Fed is perhaps set to start tightening. And so that's contributing somewhat to higher yields. The fiscal position is certainly not pretty in terms of large chronic deficits, a large and rising public debt. There is some element of policy confidence issues we think reflected in that term premium. And of course, quantitative easing is no more used to depress yields.

It doesn't anymore. There has been a shift in what reserve managers are buying, and it seems to be a little bit less Treasury debt. And there's more supply competition. Right.

Artificial intelligence and the big hyperscalers and friends are doing a lot of bond issuance. That's doing a bit of crowding. And of course, a lot of other countries have fairly large sovereign debt loads and deficits as well.

And so they are also crowding the U.S. somewhat. And so it's all adding up to higher yields.

Conversely for China, why are Chinese yields falling? Well, Chinese inflation has been chronically low. Indeed, it has flirted with deflation quite regularly. Its central bank therefore has been inclined toward rate cuts. If anything, there could be more to come. China, for the moment, structurally needs low rates.

It's going through a pretty severe housing bust that classically is a time when you hold rates down. And the Chinese economy is still doing okay. But certainly, in the short run at least, it has been slowing, so that tends to lower yields, too. And Chinese investors don't have a lot of options. There are still strong capital controls limiting their international options.

And so a lot of their savings – and China's private sector saves an awful lot – does get funneled into the sovereign bond market. So, holding yields down, you're kind of in a weird situation, you might say, in which U.S. yields are up for broadly not great reasons. Maybe the one benign reason or good reason is the U.S. economy is pretty strong.

And so that's good. But the others are mostly bad reasons.

Meanwhile, Chinese yields are down, also for mostly bad reasons. And so this spread has opened up for bad reasons, driving in the opposite direction. Still you would say, I guess advantage China, just in the sense that when push comes to shove, low borrowing costs are helpful. And so Chinese government and companies get to borrow more cheaply.

And related to that, the hurdle rate for investment decisions is lower in China. And so that is at this juncture an advantage for China.

Okay. Over to AI and the data centre backlash. And so just the context, this is a time when concern about AI is manifest – and the concern about the rate of advanced of AI has been mounting in particular.

And you've seen some of the frontier model makers in the U.S. express concern and aspire to perhaps slow things down. And you've got a midterm election in which the public will perhaps express their views on AI and AI developments as well.

So in focus, let's talk about one element of concern, which is AI data centres. And so those can increase electricity costs.

They consume water. They consume space. They don't employ that many people after the construction is complete. And so they are getting less popular over time, particularly in the U.S. Now, interestingly, when you look internationally, data centres, as you say, AI in general, but including data centres, still quite popular in Asia. And so there is a real geographic divide.

They are least popular in the, you might say, Anglosphere – in Canada, Great Britain, the U.S., Australia, New Zealand. So there is a real divide in terms of some countries are embracing and others less so. In the U.S., there are slowdown efforts underway. Some states have temporarily blocked new data centres, including at the local level. And so that could slow things down.

I guess our message would be the big pipeline underway isn't being stopped. So, data centres are currently underway, still being built. That should ensure a sufficient supply, or at least the intended supply, over the next few years. We do see scope for geographic arbitrage between states, between countries, in a way that probably get these data centres built one way or the other.

And so our conclusion would be the unpopularity of data centres certainly does constitute a risk, and a risk of AI underperforming expectations. But maybe it's a little bit overstated. We're not convinced that's going to be the absolute pinch point.

Okay. Onward from there. Let's talk about really the midterm elections. And we actually spoke extensively about this a couple of months ago.

You can find on our website a pretty extensive medium-term preview of the macro implications and the market implications. But let's just look at it from a seasonality perspective. Here we are, now under two months from the midterms. From a purely seasonal S&P 500 stock market perspective, it's worth flagging that historically, stocks have underperformed in the two months leading up to the midterms, and then historically, they've outperformed in the two months afterwards.

Now there's no guarantee there. But there is a fairly strong seasonal pattern. The outperformance after does depend somewhat on the nature of the election outcome. And so historically, the best outcome has been actually what might be the most likely outcome right now, which would be a Democratic sweep in Congress versus a Republican president. So you would call that a divided government.

And historically, the stock market rebound after has been greatest there.

Interestingly, the second most likely outcome, and it's almost as likely as the most likely, is a Congressional split in which the Democrats pick up the House and the Republicans maintain the Senate. Of course, the presidency is unaltered. And that historically is the weakest outcome. But I should emphasize that's also a stock market rebound outcome historically over the subsequent few months.

And so I think the main theme is that stocks can wobble a little bit with uncertainty in the midterms. So far, not a ton of evidence of that, but we need to be on guard for it with still six or so weeks to go.

And then often I guess there's an expression of relief afterwards and the stock market tends to rally.

I would not say this is the main investment theme right now. AI is in flux. Energy prices rising, inflation is high. The Fed is moving. Potentially tariffs are moving. Economic growth is pretty good. Other things should dominate the investment dialogue. But it's useful to know as the midterms approach. And it might well prove to pivot to a slight tailwind in the coming months.

Okay. Let's talk about Europe and really just the European economy for a moment, just to flag things, because we sometimes don't spend enough time in that part of the world. Economic data in Europe has actually been surprisingly good in recent months. Indeed, it’s the most surprisingly good in terms of economic surprise indices that we've seen in about three years.

So this has been a good run. Various leading indicators. We're talking sentiment metrics and PMIs and confidence indicators have turned green in the late summer. And so that's all very nice.

Germany, I think, merits particular mention here. And of course, you know, the headline in general has been that Germany's auto sector has struggled as China has eaten its lunch essentially. And China is booming as an auto producer and an auto exporter right now.

But Germany actually has some merits here. And so one would be that Germany seems particularly well positioned for the military investment surge that seems to now be underway. Its industry is just well oriented in that direction.

The other thing is, even though German auto exports are notably down in recent years, German technological exports, a lot of it is AI-related, by the way, and contributing to data centres being built around the world.

That's surging and rising almost as much in recent years as the auto exports have fallen. So, you know, there is this other driver that exists, I think has been a bit underappreciated.

Now, there is a caveat for Europe right now, and that is that the surge in natural gas costs has not yet been fully passed along to the economy.

The government is eating some of that. It may start to pass that along in the coming months. That will be a new headwind. So let's be alert to that.

But in general, more good news than bad news for Europe economically at the moment. And again, more positive than negative surprises.

Okay, I'm going to finish with this: Canadian productivity, And so certainly a challenging history. Canadian productivity has not risen in the last four years.

It's the same level as it was about four years ago, which is quite unusual and very much not good. Chronically Canadian productivity growth has under-paced the U.S. for decades. Canada's relative productivity was nearly 100% of the U.S. level in the early 1980s. It's down to about 73% today. So, a big underperformance and lots of really just money left on the table, you might say, in terms of financial prosperity due to that underperformance.

You look at it from a sub-sovereign standpoint – that's fancy language for saying when we look at the 50 U.S. states and look at the 10 Canadian provinces and try and tally up who is the most productive and who's the least productive and whose incomes are the highest and lowest. Only Alberta and Saskatchewan are in the top half of those 60 jurisdictions, in terms of Canadian provinces.

Ontario is only forty-eighth out of 66. Canadian provinces, including Quebec, are in the last six positions. And so certainly not a pretty picture.

Now, this is a bit of an extreme comparison. It just directly factors through Canada's weak currency. And so, you know, Canadian wages and U.S. dollars look bad because the currency is weak.

The actual Canadian cost of living is not as bad as that currency conversion would suggest. So it's a little bit unfair to Canada, but nevertheless you just convert that exchange rate and Canadian wages, you might say, are among the lowest of the bunch.

Now, maybe this is overstating Canada's bad performance. You compare Canadian productivity to the rest of the G7 over the last 20 years, and Canada's productivity growth looks pretty familiar.

But still, the U.S. shows what's possible here. It is Canada's closest neighbor. There are very real economic similarities between the two. It is the country that Canada should be shooting for, so there is a real underperformance here.

The next question is, well, why has Canadian productivity been so bad? And all sorts of answers, as it turns out. It's popular to try and pin it all on one thing taxes are too high or some variation on that.

Maybe they are. In fact, probably they are, but less than you might think. It's actually multifaceted, we  think. We do believe there is an element of public policy, probably more regulation, though, than taxes. The economic structure itself is in some ways challenging. This is a large country with a harsh climate and with a small scale versus the U.S. or China or Europe.

And so those are just inherent difficulties. We do believe there may be a cultural component, a somewhat risk averse culture, and that's honestly hard to change, or at least very slow to change.

There are global forces. It's not just Canada. We've gone through a multi-decade period of slower than normal productivity gains with maybe less exciting technologies until quite recently coming along.

There are temporary acute issues. There was an immigration surge in Canada that hurt productivity. The pandemic, we think, hurt productivity. Also, some business decisions – and businesses tend not to get the blame here. And it tends to be focused more on public policy. But it's pretty astonishing that the average Canadian business spends less than half as much as the average U.S. business on CapEx per worker, and that's an extraordinary divide.

We thought maybe that was a distortion because the big U.S. tech companies were doing so much investment. But when we control for sector, an even bigger divide appears. And so that is not the reason. And it predates the AI boom as well. So Canadian businesses just are not investing as U.S. businesses are. And it's a very similar story with Research and Development. Canada spends barely half as much on research and development as a share of GDP as the U.S.

And so that holds back the ability for productivity to rise.

There's some good news here. As we look to the future, we do see some changes happening. Immigration policy has changed, arguably for the better from a productivity standpoint. Pandemic constraints are gradually fading as time passes. Globally, we think we might be shifting from a slow productivity regime to a fast productivity regime.

And so Canada could be along for the ride there, even without domestic changes. But there do happen to be some domestic changes, though. Public policy is changing under this new government. There have been some mild tax cuts.

Importantly, though, including a broader R&D tax credit, which was the previous criticism. Importantly, there is a lot of deregulation happening, making it easier to invest in infrastructure and resources.

The proof, of course, will be in the pudding in the coming years, to the extent that happens. There are strong efforts to attract capital in Canada. And of course, you know, a big part of this will be whether businesses opt to embrace this and invest more of themselves in their businesses. And that is, in fairness, still an open question.

Bottom line for us is we do think Canadian productivity growth can, at a minimum, start to rise. Of course, it didn't over the last four years on the net. And can we think aspire to grow more quickly than its historical norm. 1% per year is what Canada has averaged over decades. We think plausibly this could be 1.5% a year going forward, maybe a bit more.

And that's really important for prosperity and corporate profits and wages and so on.

Okay, I'll stop there and say thanks for sticking with me. Hope you found some element of that interesting and perhaps useful in your investing. And please tune in again next time.