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In this episode, Chief Economist Eric Lascelles discusses the Fed’s latest interest rate hike, and what the central bank’s intentions for future hikes could mean for the broader economy - including an elevated risk of recession. He also provides some thoughts on labour market trends and jobs data in the U.S. and Canada. [23 minutes, 53 seconds] (Recorded May 9, 2022)

Transcript

Hello and welcome to The Download. I'm your host, Dave Richardson, and I am joined today by the hardest working economist in Canada, Eric Lascelles. Eric, we got lots to talk about today. Always appreciate your time. Thanks for joining us.

My pleasure. Thanks for having me. Hi, everybody.

But not a lot of smiles and chuckles, really, overall. Why don't we start with the Fed? We'll go to the jobs report, and then we'll put together the whole impact. Federal Reserve raises the rate, the target rate, by 50 basis points last week, and then has a lot to say afterwards. What did you make out of that announcement and was it expected? Then where do you see us going from here?

Yes, certainly. They did raise rates and it's nothing new. That's not the first hike of the cycle, nor, I'm afraid to say, is it set to be the last. They're not the first central bank to raise by 50 basis points. You'll keep in mind that the normal pattern is a bit more cautious, 25 basis points. But they're not the first to do that. Bank of Canada did that, not long before. In fact, quite a number of central banks have been targeting a faster rate of tightening to get where they think they need to go a little bit quicker. The central banks are really arguing. There are two parallel motivations for tightening policy. One, of course, is that inflation is much too high. That's the sinister side of things; the part we don't much like. The other side, though, is the economy is quite tight. Unemployment rates are about as low as we've seen, certainly in the cycle, but in some cases in a generation or longer. It's a very tight economy as well. You just can't keep trucking along at that velocity indefinitely. They’re raising rates to try to cool that down. Keep in mind, rate hikes are, first of all, well intentioned. Second of all, they are arguably necessary. They are a good thing. It does make all of our mortgages a bit more expensive and short-term losses on bond portfolios and all those things that we don't like quite so much, but it's a necessary and good thing in the end, because the goal of central banks is to avoid bad outcomes. Their view is that raising rates very much reduces the risk of structurally high inflation. That's the worst-case scenario we're all trying to avoid here. Also, to the extent the economy is overheating, it maybe increases your chance of the economy getting to survive for a few more years as opposed to just overheating and tumbling down. The rate hikes are good and welcome, but nevertheless, particularly given the focus on making sure inflation doesn't get structurally high, it does add to a number of factors that suggest the risk of recession is quite considerable over the next 18 months or so. Between rising rates and high inflation and commodity shocks and a few other things— I'm sure I'm forgetting at this point in time— but headwinds, certainly, there are a number of them. Your risk recession is high over the next few years. Of course, markets are forward looking. That's why the stock market is down 15% in the U.S. and so on. That’s not to say the stock market has to go down sharply from here necessarily. The going down that's been happening has very much been priced in, and these kinds of things. That's already fairly well appreciated at this point. But to pull it back to central bank, so they're raising rates. They've got some distance left to go. It looks like policy rates— the Fed just went to 1%— could well be 2.5% or something like that in a year's time. It's not impossible that 3% gets touched, which would be about as high as we've seen in a few decades. We're seeing a fair bit of movement here. Again, it's just because it's so important to crack inflation. If that's accomplished, that's a win. Ideally, it's accomplished and recession is avoided. But you know what? Just cracking inflation, even if there were to be a recession temporarily along the way, that's a good outcome, too, in the sense that the key is to make sure we don't get stuck with a decade or a generation of high inflation, that central banks don't lose all the credibility they built up over the last generation and to the point that they could luxuriate and trying to maximize the economy and not just minimize inflation. That's job one. I think they've shown a lot of willpower here. I think they have a pretty good chance of pulling that off. That’s quite important. Then, just in terms of the other considerations within this latest Fed decision, they're now beginning to sell bonds as well. The quantitative easing ended a while ago; quantitative tightening is now underway. It's ramping up actually very similar to what we'd expected. They're ramping up to close to $100 billion a month in bond sales within a few months. It will still be a good three or four years before the balance sheet is down to a size they'd like it to be over the long run. That's going to be an ongoing process. I should say as much as it's entirely relevant— and it's part of the reason that bond yields have increased so much— it's equally not a huge driver of yield. For instance, if you sell $100 billion of bonds a month for 12 months or for a year, you'd argue the policy rate is equivalent to a policy rate that's about 25 basis points higher. It's like an extra rate hike per year is what the quantitative tightening is. It’s there, but it's not the main driver. The main driver is policy rate that's going from zero up into the twos anyhow.

Okay. The big key is we do not want to, from a fashion or economic perspective, go back to the 70s. We've got to deal with inflation. A lot of reasons not to want to repeat the 70s. As you said, markets are forward looking, stock market reaction and some other things. But a more rearward looking number is the jobs number. Just very quickly, that was a pretty good number in the U.S. and Canada.

Precisely. That's right. As you say, job numbers are looking backwards. Not that far backwards, just April data; it's not like we're looking at December numbers in May, but nevertheless, I guess the idea is actually economic momentum has been fine over the first four months of 2022. Let's not lose sight of that. It's actually been a decent to good beginning to the year. As per that, U.S. payroll is up 428,000 jobs, actually a little above consensus. It's quite a good number, by any reasonable standard. Normal might be 100,000 a month. This is, I should say, not post-pandemic normal, but normal. This is still absorbing excess supply of labour and businesses that are still keen to hire, which says something about their optimism for the future, which is, I guess, a good thing as well. We see hourly earnings rising, still in the 5.5% type range. Again, great for workers, good for consumer spending, not great for employers paying the wages, though I don't think we should cry too many tears for the businesses because in general, they've increased their own output prices even more. Actually, real wage growth is negative right now. They're getting their workers, if anything, a little cheaper than before, as opposed to more expensive. I'm not sure that actually does have to do much damage to margins, at least as it stands right now. But again, we're seeing wage growth that's pretty quick. Then unemployment is sitting at 3.6% in the U.S. 3.5% was the low before the pandemic, but that was a generational low. It wasn't just an average cycle low. These are very low numbers. I know you can quibble and say, if you were to adjust the number of workers in the U.S., it’s still a bit shy of the prior peak. It’s true. I would say that is ultimately not proving all that helpful, though, and interpreting where the economy is or where the labor market is right now. You've just had some people early retire, you've had some other people make some lifestyle or life changes. We need to acknowledge that if anything: this labor market feels tighter than a 3.6% unemployment rate. You look at quits rates and job openings and things like that. It looks like it's a 2% unemployment rate, whatever that means. It's extremely tight labor market, so get further to the need to cool things off a bit. It's extremely hot right now. Then the Canadian side wasn't quite as strong. Canada added 15,000 jobs. Now we have seen some pretty heroic months in the not-too-distant past, and the Canadian numbers are also famously choppy. We lost sight of that recently because it was always so positive. Whether it was 100,000 and it was really 150 or really 50, it didn't really matter. It was just big. But now we're kind of settling down a bit and you're seeing that volatility a bit more visibly. Unemployment ticked a little lower to 5.2%. For Canada, that's quite low. I'll admit the series only goes back several decades, but it's the lowest over that period of time. Canada normally has an unemployment rate actually a couple of percentage points higher than the U.S. If the U.S. is 3.6%, we should be 5.6%, if you wanted to say we were equivalent, just with more seasonal industries and more generous unemployment insurance and things like that. We are, if anything, with an even tighter labor market than the U.S. But again, the main message is just that the labor market is looking quite good. I will say I'm expecting hiring to slow in the coming months, just given market turmoil and given the idea that rates are rising and growth should significantly slow. I'd be surprised if companies were quite so desperate to continue hiring. But equally, a lot of them are behind the curve here and they have not got as many workers as they need. You hear anecdotally that there are so many businesses unable to get the workers they need. Even if they suddenly realize they need 1% fewer workers, it could still be they need 2 or 3% more than they have, just to throw completely random numbers out there. I expect hiring to slow. I wouldn't say at all is visible, though, that we're going to suddenly see firing outpace hiring.

The anecdotal stuff is funny. I'm in California right now. I spent the last couple of days in Orange County, just south of LA. I'm in Palm Springs. I'm not a chief economist, but I have an economics degree and I'm always interested in what's going on in markets. This is my job and this is what we talk about. I'm always looking for that anecdotal evidence. Talk to a real estate agent and find out what's going on in the real estate market. You're starting to just get that little bit of a feel— because I was down here in March as well— that things are slowing off a little bit. You still do see, from an employment perspective, lots of short staff stores. You go into a coffee shop or a restaurant and it feels like there should be three or four people working a particular area of the restaurant, and there's two. Everything's a little slower. It's funny, but on the real estate front, it actually feels like things are slowing down a lot. Where are we? Where do you think we go from here?

Well, let's start on the real estate side for a moment, which is, of course, as interest rates go up, you would expect housing to cool. In fact, I would say the combination of what could be a weaker economy plus higher rates, plus affordability. Of course, it isn't what it was a couple of years ago. In many cases, it wasn't all that great then either, but it's certainly gotten worse. It does suggest cooler housing. I would say my expectations in the U.S. context— that's where you are right now—, I'm not convinced it's going to cool a lot. Canadians look down with envy, home prices and the affordability and so on. Maybe that gives us a distorted impression. But nevertheless, I would say I'm expecting a cooler housing market in the U.S. I think there are some real risks in Canada, though. Obviously, we've had quite a remarkable run up. If you look at the average monthly mortgage payment versus incomes and so on, you'd say it's a good 25% offside nationally, in terms of home prices versus affordability. Not that's given us any kind of precision over the last 20 years in terms of what home prices do next. I'm hesitant to make precise predictions, but affordability is about as bad as we've seen over the couple of decades. Of course, interest rates are rising quite a bit. The U.S. 30-year mortgage rate has gone from three-something to 5.5% in quite short order. In Canada, the five-year rate, which is the benchmark here, hasn't moved quite that much, but it's still moving in that kind of vicinity. That makes things more expensive. Of course, in Canada, also regulatory tightening as foreign home buyers are not allowed and so on. So potentially some dampening of demand. My assumption right now is that we will see home prices potentially cool down somewhat in Canada. We could see some actual declines. I don't think it's going to be a crash. That's not been the right thing to bet on in the past. Again, unemployment is low and savings are high and on interest rates, people have been tested on interest rates left and right over the last several years with regulations requiring quite a really significant buffer against rising rates. I think we should talk about a cooler housing market, potentially home prices that are down somewhat. I'm not convinced it's a full resolution of a 25% off site home price kind of story. Keep in mind, the first and the most important thing that moves when interest rates go up is housing. It's the most interest rate sensitive sector. If you want an economy to cool off and you want to raise rates in doing that, well, housing is what you want to cool. I think that's fairly likely. Then more generally, again, we've talked for a long time about 2022 being a year of decelerating growth. I think that's very much still on. I think 2023 is where things get tricky or harder to read. I would say a further deceleration. The question is whether it is the deceleration that ends in recession or if it's one that we’d just managed to avoid with a soft landing. If it was a recession, is it a mild or a deep one? Frankly, you can present some pretty good arguments for that as well. I would say the main message is one in which 2023 could be significantly more challenging. When you're combining an oil shock with an interest rate shock with an inflation shock, any one of those could make a recession. That could well be the outcome here. But let's not focus exclusively on that, again for the reason we talked about at the start, which is just that markets get this. They've already priced a lot of it in. It doesn't mean necessarily that markets have to go down a lot further from here. Then the other one would just be it's hard to get timing exactly right here. I would say to the extent there might be a recession, it would be a useful recession if it tames structurally inflation, and that then sets us up for a pretty good decade or two thereafter in which we're back to a low inflation world and growth can thrive and unemployment can be low and so on. For long-term investors, actually, if anything, we're tilting in a more constructive multi-decade outlook as opposed to a less constructive one. I think that's an important consideration as well for you.

Eric, what's your view then on the possibility of a recession at this point? Historically, the Fed has had a real challenging time engineering the soft landing. Central banks, really all around the world. Do you think they have more tools in the toolbox, more experience that they learned more over the years to make it more likely that they can engineer the soft landing, or are they basically in the same spot that they've always been in on this? It's just a hard plane to land.

Right. I think central banks have learned some things, and it's very helpful to have learned from the 1970s, as an example, to avoid repeating them as just one example. Historically, it depends on who you ask and the numbers vary, and it can get very technical. But the classic number is eight of eleven tightening cycles since World War II have ended in recession. You can quibble a little bit. You can whittle that down to half of them if you really wanted to be optimistic. But central banks may be better at what they do these days than a few decades ago, so that improves the odds. But then on the flip side, of course, you simultaneously have oil prices that have shot higher. Every time inflation has gone up this much, there has been a recession. In the end, I would say— and this is very much a penciled-in number and it could get changed— I think there's about a 70% chance of recession over the next couple of years. I think it's more likely than not. Not a certainty. 30% is also a real chance. Soft landings can and do happen. Just to paint that scenario, just to emphasize that it's a real scenario, maybe central banks raise rates a bit, and guess what? People start buying fewer houses. People start buying fewer durable goods, and the durable goods side fixes the supply chain issues potentially. Suddenly all that weird inflation pressure goes away quite quickly. To the extent people drive less, suddenly the oil price side is resolved. It's possible some of these acute pressures that are separate just from an overheating economy get addressed with a fairly subtle twist in interest rates. There are very much ways in which that settles down. Hey, we managed to keep growing. It's entirely possible. But equally, recession risk is quite considerable at this point in time. Dave, we've been saying for a long time, it’s not time to take as much investment risk as a year ago. Even the business cycle kind of rhymes with all of this in the sense that at the start of the cycle and early, that tends to be the incredible period for markets. Then we've been talking mid cycle for the last nine months or so. Indeed, for most of it, that's how markets were behaving. We're still getting mid-cycle readings there. But the late cycle is shouting a little louder these days. Again, you don't tend to do quite as well. Even if this recent experience proves to be a blip, it's not a time in which you're maximizing your investment risk taking right now, because realistically, the returns aren't going to be as big. They're less likely to be double digit returns than a year and a half ago.

Yes, markets are reflecting that. We look particularly at the U.S. markets; the Canadian market, because of the structure, hasn't shown the weakness or isn't foretelling the weakness that you're seeing coming forward. U.S. markets, more broadly diversified, are showing that. They've already been acting like there's a recession or at least a pretty significant slowdown down the road. Then, as you say, as we move from mid cycle to late cycle, this is when you'd be taking some risk off the table. Not surprising. Again, you still know— just to get back to what you've already talked about—, you're still showing those mid-cycle indicators, but you're starting to see the later cycle creeping.

Yes, that's right. Previously, a quarter ago, we also had a mid-cycle reading, but early cycle was also making a significant bid, and it's not anymore at all. Late cycle is now still short of the mid-cycle claim. But it wouldn't surprise me if next quarter it exceeded it or matched it. We can see the cycle is moving forward quite quickly. We’ve talked really for the last two years about how maybe the business cycle would be shorter than before. I must confess, in our own minds we were thinking maybe it would be five years instead of ten. It's not impossible that it's three or three and a half years instead of ten. That's quite possible. But keep in mind as well, on the market side, one of the remarkable things to me has been, ever since the global financial crisis in which arguably markets overdid it— of course, it was historic buying opportunity in many regards— markets have been much more rational. I never would have guessed how little the stock market went down during the initial phase of the pandemic. I mean, you had a global economy that lost 15, 20, 25% of output and the stock market went down pretty sharply, but not nearly to that extent. And the market was rising within a few weeks of the pandemic, really hitting, which boggled my mind to the extent that we didn't even really understand the pandemic fully at that point in time. I mentioned that just because I think markets learned a lot from the global financial crisis and they're much less likely to get too caught up in emotion, to overdo it. Even as we talk about risks of recession again, it could well be that 15% decline— which is what you've already got on the table in some markets— is more than ample. I mean, if you want to do things the proper way and say what's the present value of the future stream of earnings and you think it's a recession that lasts six months or something like that, you can already see the stock market as well overreacted to that. Markets were pretty good at basically saying, okay, 2020 is going to be junk in terms of earnings and we're just going to look through it. We recognize there's a recovery here. They were quite right. If anything, they underestimated the extent of the recovery we've since had. It wouldn't surprise me again if markets were maybe surprisingly resilient even in the face of recession. I think through all the different scenarios, the best-case scenario is a soft landing. We'd love the economy to keep growing and inflation gets tamed and it all works out perfectly. Of course, that would be a great outcome. But the second-best scenario in my mind is a recession, but one in which inflation does get cracked. I could see the market actually being pretty happy about that because it avoids all sorts of nasty trouble later by fixing inflation. So recession scenarios aren't necessarily that bad if they achieve the desired goal.

Yes. That's really the key. Maybe just one really quick last question as we go back to the Fed, because the Fed is going to have to stick to it to engineer what you discuss. Even that recession that ends up being beneficial in that it resets, and then we move forward from a nice base and have the opportunity to grow. Do you think the Fed is showing the resolve that you think they need to have, or are they still a little bit on the slow side here?

I think central banks, in fairness, they and other central banks, should have been going in the second half of last year. They are behind the curve. There was a policy error, so let's not commend them too much. Indeed, I would say there was policy drift over the last few decades, and they were focusing mostly on inflation a few decades ago. They said, oh, the inflation is so tame. Let's really try and fine tune the economy as well. They did that. Of course, they threw in financial market conditions, I think, rightly. But nevertheless, that became a big focus. More recently, inequality and climate change things, of course, very important policies, but just not necessarily things you can properly address when you have one lever to pull. I must say they did lose their way a little bit. I do think that they found their way again, though. It's very clear that inflation is the sole priority as it stands right now. That's a good thing. It makes me more confident they're going to succeed in taming inflation. But to your point, that means that the Fed [put] probably isn't there. Every other time the economy starts to weaken, oh, dear, let's cut rates and just get that economy roaring again. They probably can't do that this time because the focus is on taming inflation. If inflation gets tamed really fast, faster than we expect, then it's possible that the economy gets to keep moving forward as well. But to the extent that those two goals are in conflict, inflation is going to be the dominant focus here. There are scenarios in which a recession is starting and the Fed is still raising rates. Again, it just means that the recession is all the more likely.

Wow. You see, this is why everyone comes to listen to The Download podcast, Eric, because you're never behind the curve, always disciplined, nose to the grindstone.

You're going to have to rename it The Downer podcast if you keep interviewing me.

No no. The least dismal scientist I've ever met, as they call him. Eric, always great to catch up with you and thanks for all your insights today. Really important time to be checking in on the global economy and nobody does it better. Thank you very much.

Thanks, Dave.

Disclosure

Recorded: May 9, 2022

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