Hello and welcome to The Download. I'm your host, Dave Richardson. And it is Economics Fridays with Eric Lascelles, Canada's hardest working economist. Eric, you must be trying to figure out how to squeeze 25 hours into a 24 hours day, these days. The economic news is just unbelievable; the flow right now.

We may need Elon Musk. I think Mars might have a 25-hour day or something. Or 26 hours. I can use that right now.

I like it. And as usual, at the very least, you fill in all 24. They can't see the video. It looks like Eric has not slept in several days. One of the things that might have been keeping you up last night was the report that came out early this morning on U.S. inflation. Maybe you were right in not sleeping or maybe you should have gotten some rest so that you have lots of energy to deal with it. A surprising number, kind of in the wrong way, but what is it and how do you interpret it?

Yes, well, just more inflation strength. So what else is new? That's been the theme almost constantly since the spring of last year. We're dealing with a year and a quarter at least of this, at this point in time. Yes, overall, consumer prices in the U.S. rose a percentage point in a single month. That's quite a bit. We like it when those go up two percentage points in a year. One per month, not good. Core, not as hot, but nevertheless up 0.6%. Particularly on the headline side, setting another 40-year record in terms of annual inflation of 8.6% in the U.S. So a lot of strength. As mentioned, it was more than had been budgeted for. Again, that's also been a pretty constant refrain. I have to say we got wise to this about a year ago. We have been pretty reliably sporting above consensus forecast. We did think it was more likely to be higher than people thought than lower. But equally, I can't say I'm pleased by that outcome. But of course, it brings all sorts of implications. I guess first and foremost, it means that the purchasing power of the average person is further compromised, which isn't good. That's why we don't like high inflation. We also don't like it much because, of course, it forces central banks into action. It suggests that, all else equal, central banks have to do more as opposed to less. We're already in this world of central banks going up 50 basis points at a crack and doing that seemingly at every opportunity. You might have caught wind— and this is now me blurring geographic borders, I guess—, that Bank of Canada governor was hinting in the last day or two that they could do a 75-basis point move. They might need to go even faster. Previously they talked about wanting to get to 2 to 3%, and they were saying, gee, maybe we need to get to 3% plus. Unfortunately, this high inflation is suggesting that interest rates, at least in the short run, probably have to go faster and further than before, which isn't particularly welcome given the recession risks that are already not trivial. In fact, given yield curves that are now getting pretty close to inverting at different points in the curve, which of course is a traditional recession risk indicator and is being driven to this point by the fact that people are having to increase those short-term rates to reflect what central banks might have to do about all this. Not a great set up, unfortunately. We were still dealing with this high inflation. I will say, given the luxury of thinking a little further down the line, that we do see some slight improvements to supply chains, which have been a big inflation driver. Shanghai ports are becoming a little bit unstuck. Some shortages are easing. Some obviously are not, but nevertheless, some are easing. That's a welcome thing. We keep thinking that commodity prices, well, they’ll probably stay high. Maybe they even have to go a little higher, but they probably don't jump as aggressively over the next year as they did over the last year. That takes some pressure off. It's not unreasonable to think that we're not that far from a peak in inflation, but equally particularly, given just how broad inflation has gotten, and suddenly you're finding it in citrus fruits and dry cleaning costs and toys and things that we would think would have very little connection to Ukraine and Russia and certain constraints elsewhere. It's going to take a while to tame this inflation. I think central banks have it in them, but nevertheless, there's some work to be done here. It's not settling down naturally after the initial shock of the war in Ukraine, which I think some people had hoped would happen.

Yes. And, as we've been talking with some of the portfolio managers, there was even some hope that we’d actually started to see signs that we were getting past the peak in inflation. This number kind of eliminates that thinking. Is that too pessimistic for you?

Certainly, it's not wrong. There's nuance, I guess, to the answer. For instance, let's recognize we got 1% month over month price gain in a single month. That's a big number. It was a 1.2% gain two months ago. We have seen slightly more intense monthly increases. That was the worst, I should admit. We shouldn't celebrate too much. We do see car prices starting to roll over. We think it's more than credible to think that dwelling costs should at least be less inflationary going forward as interest rates start to bite. We'll see how this adjusts, based on this number, but we have seen market inflation expectations become a little bit less high. I still think it's right to think that, within a quarter or so, we're probably at the peak year number that we're going to see. I think that's still a reasonable guess. It's not obvious that U.S. CPI has to work its way into the double digits or anything like that. I think we're not far from a peak, but equally, it's going to take some time to work this back down. The longer this stays high, the more tightening, as I said, and the more tightening, the worse it looks for the economy. We already have, as you know, a below consensus growth forecast. We've said we think the recession risk is pretty high. I'm not really changing my forecast at all on this basis, but I think maybe the market is to some extent catching up to us, if I want to be charitable to us. Unfortunately, that has included risk assets declining in response to this latest number.

As a former scholarship earning cross country runner, often people are trying to catch up to you. But just for the record here, because we haven't had you on for a month, where do you have your recession risk right now?

Well, gosh, it's a good question. I will start by acknowledging there are absolutely scenarios that a soft landing can occur. You need a little good luck, but we could have an economy that just keeps growing the next couple of years, do not forget. I'm going to give you the bad news. At the moment, I've reversed the order of how I should deliver these things— I'm not a good doctor in terms of the bad news and then the good news after. But starting with the good news, this economy would have grown pretty fast in 2022 if it wasn't for all of these awful headwinds that have struck. It's an economy that does want to grow quickly. If we can just dodge some of the bad things, it could well still grow. It's not impossible that supply chains improve a little quicker than we're assuming. It's quite conceivable that China snaps back open faster than we've assumed. We've been very pleasantly surprised that Beijing hasn't had to do a full lockdown. It's possible that inflation starts to turn more abruptly than we're thinking in the next few months, particularly as some of the original drivers start to abate. It's possible that commodity prices come off, notably to the extent that weaker economic conditions are anticipated. And that would be a helpful thing. There are ways growth can continue. I do think, though, that into my eye, the recession is more likely over the next 18 months or so. In my head, I feel like there's a 70% chance of a recession. I would emphasize that recessions are temporary. They're not a forever phenomenon. Markets are often enthusiastically rebounding before they're even over. If it were to happen, this is unlikely to be a recession on the scale of the initial pandemic, which was 10, 15, 20, 25% drop. We're talking about 1, 2, 3% drops here, which is quite a different equation. It's unlikely to be as deeper or the same experience as the global financial crisis. In our head, the last couple of recessions were doozies, and this one, more likely a conventional one where there's a couple of quarters of palpable weakness. There's some suffering that comes with that. But it's not a forever story, and you bounce back fairly nimbly off that— in this case, once high inflation has been vanquished—, and that maybe is the main point to make. We've been saying, listen, obviously the best-case scenario here is that the economy keeps growing, inflation comes down, all is neat and tidy, and some markets would be euphoric, I think, in that scenario. Arguably the second-best outcome here is you get a recession. Sounds bad, but it's a useful recession that fixes inflation and sets us up for rising prosperity over the next decade and the next generation, because it's hard for that to happen when inflation is as high as it is. And so, I'm not claiming that markets are going to be clapping their hands and cheering if there is a recession, but that markets might be surprisingly tolerant of that outcome to the extent they recognize it serves a greater good, which would be taming inflation. That's the goal of central banks right now. I think markets recognize that's the right priority to have.

The inflation reports a real time snapshot of what's happening in the economy. A week ago, we had the jobs report from the U.S. Today we had the jobs report from Canada. That's more of a rear-view mirror in terms of economic activity. What did we see there, and does that give us any signs of where we are going in the future, given all the other economic data that's coming out?

The numbers were not bad. In fact, they were pretty decent. In fact, really, by any non-post-pandemic standard, they were amazing. But we've kind of gotten used to amazing rates of job growth and economic growth more broadly. The numbers look fine. I will say— and I'll speak more of this in a moment—, that we're seeing maybe a subtle deceleration behind the scenes. The first part of 2022 has been pretty fast growth, actually, by our estimations. It's a bit blurry in the U.S. It actually had a negative first quarter GDP, but it was kind of weirdness in inventories and imports. To me, the true trend was one in which Americans were enthusiastically spending. So I'd stand by the claim that momentum was pretty good at the start of this year, even for them. But on the specific numbers— so this is May data—, U.S. job numbers added 390,000 positions. Steady state versus population would be no more than 100,000. So this is still eating through— there's not really any economic slack left— eating through something, certainly tightening the economy, I suppose. The unemployment rate stayed at 3.6%, which is like a tenth above the pre-pandemic low. As we've said many times, we think if anything, labour markets are even tighter than an unemployment rate would make them seem, which helps to explain why inflation is so high. Good number there for Canada, really very similar. You and I were talking just before we started recording, Canada had a 40,000 gain. That's almost mathematically identical to what the U.S. did, if you adjust the population. It's also a good number and actually was even stronger than it first looked because it was all full time. In fact, it was all full time and then some. They added 135,000 full time jobs. So tThere were some part-time workers who lost jobs. We're hoping those are the ones who gained the full-time jobs. Canadian unemployment is now down to 5.1%. We were already at a 40 plus year low, so just even lower on that front. The labour market is extremely tight. The economy was evidently still growing in May. I don't think we're talking recession happening right now. I will say we can see some evidence of business sentiment turning right now. Businesses have been saying they want to do a lot of capex and a lot of hiring. They haven't quite backed away from that fully. We're going to learn a lot on Monday when the National Federation of Independent Business reports on that front, but they haven't quite changed their tune fully. But business sentiment is definitely sour. There's a recognition that this is a tricky time with supply chains, inflation, China, war, oil prices, all those things swirling together. My assumption is that we're going to continue to see a deceleration in the rate of hiring. If you were to get a recession at some point, there would be job losses. I'm not quite sure I'm predicting that for the next few months or anything as near as that, but I would expect some deceleration to happen. But for the moment, it is coming from a period of just unusual labour market strength. You really need to squint your eyes to complain about the labour market these days. You could say, for instance, that in the U.S., weekly jobless claims are starting to inch a little higher. They were down sub 200,000 for a while. They're back up to 220,000 or something per week, and so higher being bad. We're seeing, I think, a little bit of a turn there but for the moment, it's mostly conjecture that the labour market could weaken.

You talked a little bit about the consumer, but very specifically when we talk to the consumer, are they still in great shape? Then on the inflation front, they're in great shape— we've seen strong wage gains— are they demonstrating any behavior in terms of inflation expectations that suggest that they're holding back from some of these purchases and just saying, hey, I'm not going to pay that higher price, which might constrain some of the pricing power that businesses have?

That's a great set of questions. By the way, I forgot to mention something of relevance to that, for the Canadian job numbers. Canadian wage growth, kind of weirdly, despite a very tight labour market, wasn't keeping pace with the U.S. and some other markets, and we weren't quite fully understanding of why. I still don't know why, but I will say the difference just shrank a lot. Canadian hourly wage growth is now rising 4.5% year over year. It was running 3.4% as of the prior month. So that's a big acceleration in the month of May, if that sticks. That looks a lot more like the U.S. experience. It makes more sense, given how tight the labour market is. My answer is extremely mixed in terms of your question. And so let me see if I can sort this. I'm probably going to fail and do “good/bad/good/bad” a few times to start with. You're certainly right. Household saved a lot of money over the pandemic. There's a nice little buffer that exists, a multi hundred billion dollar buffer in a Canadian context that you would think would bail some people out as rates go up and gas prices go up, or if people lose their jobs and things like that. That's quite helpful. Now it's fair to say that money is maybe disproportionately in the hands of wealthier people, so it's not equally distributed. That maybe isn't a perfect set up. But nevertheless, there's more money and a lot of money is still being held in checking and saving accounts. That's liquid assets that could particularly easily be deployed if they had to. I do feel there's a bit more of a buffer against bad times than we might normally have. Certainly, that is quite good. Consumers have been spending. Consumers, though, are saying— and this is something you were asking, Dave— that maybe they're feeling a little less enthusiastic. For instance, in the context of high inflation, it is motivating people to pull back as opposed to spend more. That's bad for the economy, but maybe good for inflation. It does suggest that some of the corporate pricing power is maybe going to ebb, to the extent that consumers are becoming more price sensitive. That might reduce the amount of inflation that gets passed through. That's good for controlling inflation. Of course, that's not great for profit margins. There's good and bad that cascade in different directions. But in the end, I think job one is controlling inflation. If we can dampen some of the echo chamber effects, that's probably a good thing. It may be worthwhile hurting profit margins for a moment if it means there's isn't another round of price increases that gets passed through. Then, whether we're seeing signs of actual weakness— that's intentions—, are we seeing signs of actual weakness? Not that much. I would say it depends. I'm not a corporate analyst, but Canadian Tire reported in Canada, and they were saying they weren't seeing people shifting to cheaper brands or shifting to essentials or scaling back from the luxury products, particularly. Conversely, Walmart and Target reported not that long ago, and they were saying people are buying more store brands and buying more essentials, fewer discretionary items, and this sort of thing. I've seen some retail analysts suggest, I suspect that is probably the right story. It will happen eventually in a lot of places, if the economy were to weaken and everything suffers to some extent. But I saw one clever retail analyst making the comment that the high end may be fine, to the extent that high end consumers have saved a lot of money and are doing well, much less affected by higher food costs and things like that, just not a big fraction of their spending basket. That the low end is potentially sustainable, just because people are shifting to cheaper products and essentials must be bought and things like that. It's kind of the mushy middle, maybe, that's most at risk in that context. But bottom line, there are maybe some hints of consumers starting to pull back a little bit, but no evidence of a collapse of this junction.

Another number I heard yesterday was AAA in the U.S., or the equivalent of CAA in Canada, reporting that the number of calls they're getting from people running out of gas on the side of the roads is up 30%. I had my first over- $200 fill up in my car yesterday. You're really starting to see and feel the pinch right across the board, whether you're rich or poor. Obviously, it's harder on people with lower income. One of the questions again, we'll just finish off with this, Eric, and very briefly— because I know you think in terms of the broader impact it has on the economy then specifically looking at the housing market—, but I often get questions from people who listen to the podcast say, could you ask Eric a little bit more about housing and particularly the Canadian housing market? We’ve seen a little bit of softening there, but is there anything you're seeing that's concerning or outside of your expectations of what would have happened when you see interest rates start to rise and the risk of recession increasing?

I wouldn't say too many surprising things, but in the context, we're assuming housing weakens. So things are happening here. They're just happening as you would imagine they should when interest rates are rising at the fastest rate in at least 20 years, if not longer. Rates go up, interest rate sensitive sectors generally weaken. Housing is perhaps the foremost among those. Housing is cooling. It's an open question just how much. I'll give you a couple of scenarios in a moment, maybe, but it is cooling. In a Canadian context, I can say that we do see existing home sales declining. We do see home sales or inventory ratios turning in a less favorable direction for sellers and more favorable for buyers, which is a euphemism for a weaker market. But again, good for buyers but bad for sellers. And I can say as well, particularly visibly in the markets that ran up the most. I'm thinking of smaller cities in Southern Ontario as a particularly prominent example, though there are examples elsewhere as well. You do see, tentatively, home prices starting to hook a little bit lower. These aren't the highest quality metrics. You got to wait a few months to get those. These are ones that aren't quite as well quality adjusted. If people are selling more condos and fewer mansions, which throws things off. But nevertheless, I do think we're seeing what you would expect, which is that the hottest housing markets are cooling more, and the ones that didn't run up as much, including some of the bigger cities in Canada, which were just less hot than elsewhere, are not yet showing as much signs of weakness. That is starting to happen. When you combine poor affordability to start with— which was true before the pandemic, even more so after—, the prospect of mortgage rates going up more, a little bit of regulatory tightening that's gone on, it's just a little harder to buy a home. Foreigners can't do it as easily, as an example. A little easier to construct a home as some regulations are tweaked, which is probably good for the housing market but not maybe good for home prices in the short run. Then similarly, if you think, well, gee, maybe the economy is going to be a bit softer and unemployment could be higher, housing should be somewhat weaker. We're budgeting for that. Our base case scenario is a 10% drop in Canadian home prices, which by the way, still leaves them way higher than they were two years ago just about everywhere. An optimistic scenario would say maybe somehow home prices kind of hold on and stay flat to a little higher, which has surprised us a few times over the last 20 years when adverse things happen and housing didn't do as much as you thought it would on the weak side. A more pessimistic scenario— not a worst case, but a more pessimistic— would say maybe home prices have to fall 25%. Like that, that actually still wouldn't quite fully address the affordability issue or fully unwind what happened over the last couple of years. But I guess just to illustrate, there are scenarios in which the drop is a bit more profound. Hard to be precise beyond that, but we are assuming some housing market weakness. Here's where I'm going to start reading some scribbled notes— I didn't know you're going to ask this question— I was listening to the bank of Canada's financial system review yesterday, and of course, they were assessing various financial risks to the economy— and there are a number— but of course, housing markets and household debt are a pretty obvious one. On the good news side of things, they did emphasize that household net worth in Canada is a lot higher than it was a couple of years ago. Stock markets soared, and they're still way up relative to where they were before the pandemic. Home prices soared. Household wealth is way higher, and it includes for the most leveraged households. That gives you a pretty nice buffer. So that's a very useful thing. Household debt servicing costs are pretty cheap right now, and people who have locked in may not have to face any kind of change for quite a number of years. That's all fairly pleasant. Bank of Canada also looked at people who had taken out mortgages in 2020 and 2021, and make some assumptions about interest rates five years from now, when those people are presumably renewing, and on the median mortgage renewal, that person will be paying an extra $420 a month at that point. That's some distance off, but it makes the point that these are very real interest rate increases, and there is some real pain that comes from that. The share of investors could be particularly fickle. That has been higher than usual, not enormously, but it has been higher than usual. It's not a perfectly pretty picture when it comes to housing. I think that the risk is greater for Canada than elsewhere, but I would say very few parallels to the global financial crisis. You just don't see the poor lending practices, the poor borrowing practices, the disintermediation, the opacity of assets. I don't think we need to worry about that. I think we just need to think of it more as this has been a significant driver to the Canadian economy, and it's not going to be a big driver of the economy for a while. It's been a driver of wealth for Canadians, and maybe there's going to be a few steps backward on that front.

Yes, you just start to add it up: $400 on the mortgage, $60 to $70 on a tank of gas every time you fill up, a little bit more on the grocery bill, and it adds up to taking a lot of money out of people's pockets. By the way, my daughters were listening to that bank of Canada call yesterday, so maybe they'll give you a call and compare notes, because there are teenage girls— mine anyways— who are keenly involved in listening to economics broadcasts from the bank of Canada. That sounds like it was quite an exciting little conference call yesterday.

Hey, Dave, one last thing, a call back, if it were. We mentioned earlier how wage growth has picked up significantly. It's running quite high. I would just highlight this, though, which is that wage growth has not merely kept pace with inflation. People are getting big wage increases. However, they're not actually any richer. It's not compensating for the higher gas prices and the higher mortgage rates and those sorts of things. So that's one of the issues that could ultimately limit consumer spending; on a real basis, actually, adjusting for inflation, this is the worst wage growth we've seen going back decades. People are getting poorer at a rate that's been unprecedented. So that's really the challenge in a nutshell.

Eric, all joking aside, we would love to be getting on and painting a rosy picture of where we are economically right now. But we think it's really important on this podcast, for those of you who listen to us regularly, to give you the information straight, as Eric sees it, and that helps you make better decisions around your investment portfolio. Right now, one of the big signals is: be cautious, make sure you're talking to your advisor, making good decisions, not just about the short term, but thinking long term, how you want to be positioned for what we're experiencing right now, but also for what we're going to experience in the future. Eric talked about that with respect to slowing down, perhaps we even have a recession, but as long as we get inflation under control, that sets up a pretty nice picture long term for the economy. Did I overstate that in any way, Eric?

No, I think you got it. I would add, markets aren't dumb. Markets are also evaluating these different scenarios, maybe assigning slightly different probabilities to some of them, but very conscious of these risks and of these situations. That's why the stock market isn't as strong as it was at the start of the year. It doesn't necessarily mean that we need to see a whole lot of further weakness. That's a scenario, of course, to the extent that negative outcomes arise, but the markets have already at least partially priced this kind of thing. There are opportunities that arise in environments like this as well. Take a look at bond yields right now— all the way from government yields to investment grade to high yield—, these are the juiciest coupons that we've been able to clip in decades. That's a lovely thing for many investors who are on the fixed-income side. And it's worth looking past the fact that in the short run, of course, if you hold bonds already, you got a capital loss in there, but for the foreseeable future, you get to clip some bigger coupons and that's a net win over the long run.

Excellent. Well, Eric, we covered a lot today. It's always great to catch up with you. Thanks again. I know how busy you are right now. Thanks for joining us.

My absolute pleasure. Until next time.