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A hawkish pivot from the U.S. Federal Reserve has mapped its way inonto markets and into the economy in many different ways. This episode, Chief Economist, Eric Lascelles unpacks the latest from the Fed, as expectations mount for a faster stimulus wind down and future rate hikes. Eric also provides a look at taper tantrums throughout history, and dives into the latest jobs numbers in Canada and the U.S. [14 minutes, 47 seconds] (Recorded January 7, 2022)

Transcript

Hello and welcome to The Download. I'm your host, Dave Richardson. And wow, it's got to be a really happy New Year. We've got Eric Lascelles, Chief Economist at RBC Global Asset Management, the hardest working economist in Canada. Did you take any time off, though, over the holidays, Eric?

Yes. I wasn't the hardest-working economist over the holidays. Two weeks off… I'm just back at it. I think I know what's going on. We'll soon find out though, Dave. What are your questions here?

Well, I know you know what's going on because of my present to you. I was very kind to share with you a copy of the Fed (the U.S. Federal Reserve) minutes from December, which has created quite a stir in the markets this week. What was in those Fed minutes that has really made the market nervous or been viewed as a change in the Fed's position and a different tone than what we've seen coming from them for much of the last few years?

Right. Well, they were hawkish, I guess that's maybe the one-word answer. You could say many central banks have been pretty hawkish ever since late last summer, so it wasn't a brand new pivot of any sort, but it was just more hawkish than the prior round of comments they've given. We had already known as of mid-December, the last Fed official meeting, that three rate hikes was their default plan for 2022. And the market more or less has that priced in. I guess the extra bit was just that there was a feeling of urgency by the Fed in terms of the actual discussion itself. Let the record show, that still only yielded three rate hikes as the plan. It's not as though suddenly it's five instead of three. But nevertheless, there was a feeling of urgency behind that. Simultaneously, some talk about quantitative tightening. We've talked a lot about quantitative easing, which was the buying of bonds. And we've talked more recently about tapering, which was buying fewer bonds. That's still the phase that they're in. They're still set to be tapering through the spring of this year, the spring of 2022. But they're talking a little bit about what to do after that. Do we start shrinking the balance sheet? Tongues are now wagging that conceivably over the second half of this year, the Fed might be starting to shrink what is a $9 trillion balance sheet. That would mean selling bonds. A bit of extra upward pressure on yields. Long story short, a hawkish Fed -- and that's mapped its way onto markets and onto economic making in a few ways. Of course, more rate hiking tends to mean a little bit less economic growth. Let the record show, we've been below consensus for a bit. I think we're pretty well positioned for that. I don't say that with too much glee, but we've been on the right side of things, in any event. We've seen that the tech stocks in particular have been choppy and even down to some extent. There's a linkage there to the extent that tech companies are really betting on the future. Future earnings are heavily influenced by the discount rate that you apply to them. How much do we care about earnings five or 10 years from now? As interest rates go up, you apply a bigger discount rate, and you care less and you get less, effectively, out of the future earnings. So that's been kind of a mathematical hit to the tech sector in general. I would emphasize that as much as there's a general qualitative thought that rate hikes are bad, it's not quite so simple as that. What you really want is central bank not making policy mistakes. Certainly easy to envision: when things are bad, we want rate cuts and that's good. But when things are pretty good— and I would say things are pretty good economically right now—, rate hikes aren't the worst thing. We're trying to prevent the economy from overheating, which is a nontrivial concern in a world of sub 4% unemployment, and more than 6% inflation. To my eye, rate hikes are the appropriate action. I can understand how you do need to adjust some valuations, given what we just talked about in a discount rate context. But equally, we don't want them making an error of being too stimulative and allowing the economy to overheat and spill into recession in a year or two. We're trying to avoid that. I'm pretty at peace with what the Fed and other central banks are up to. I'll admit, nevertheless, they are in motion for the first time in a while, and that does create some choppiness, at least.

Yes. I think we've got to have some historical perspective here as well. We're talking about going from zero to something, when we're talking about the Fed funds rate. We're talking about a 10-year treasury that's at 177 basis points, 1.77%. For those of us who grew up in the 70s and early 80s, that would have been unfathomable at that point in time. Just one question, though. Out of what came out of those Fed minutes, from a forecasting perspective -- again, from a technical economist --, the idea you'd be very familiar with different rate tightening cycles historically, but the Federal Reserve has never had a $9 billion balance sheet before and unwinding that. Do you have a good feel for how you think that plays out in the market, or does that create some additional uncertainty, since this is something we really haven't seen happen before in markets— going from a $9 billion balance sheet to a 4 or 5 billion?

Trillion, Dave.

Sorry, trillion! Trillion, yes. Unfathomable...

Perfect question. We do have some precedent for this. Keep in mind, we had a lot of stimulus delivered during and after the global financial crisis. And like some fraction of that was unwound, we did eventually see rate hikes. We had a little taper tantrum in there, which is something we've been thinking about as well as a risk. Maybe we're getting a sliver of that, though I don't see why we have to get much more. Ultimately, anyone who participated in the earlier taper tantrums were not rewarded in the sense that they reversed fairly quickly. So, I wouldn't suggest that should be a key theme by any means. But the Fed did eventually get around to shrinking its balance sheet, and it didn't take it all the way back to where it had been that time, simply because other things were happening. Banks were deleveraging and so on. It was a world where you just needed a bigger monetary base to get a normal amount of money into the economy. But some parallels there. We did see the balance sheet actually rolling off. This is not totally uncharted terrain. You're right, we didn't have a $9 trillion balance sheet; I think it might have been 5 or something. Or 4.5, I think, maybe was the peak last go around. But it should be fairly similar. The thinking is, it's a multiyear process. When you start that quantitative tightening, perhaps in the second half of this year, it's two, three, four years of unwinding that takes place. And of course, the entire goal of the Fed is to do these things in a way that doesn't damage the economy that allows a pretty smooth trajectory. It does have relevance. Our fixed-income teams are hard at work sorting out just what part of the curve might be tackled first and whether the bonds mature naturally versus be actively sold. There is some talk about how the Fed might suffer a loss in some of these things, depending on just how long it holds some of them, which I don't think is all that relevant to them, to be honest; they're not a profit maximizing operation, but nevertheless a lot of considerations like that. But I think the key is, it's going to be pretty slow going and they're not in a rush to get back to where they were, I don't think.

Okay. So that lays the backdrop and what we heard from the Fed this week, which brings us to today and the main reason why we set this time aside each month: jobs reports in Canada and the U.S. come out this morning. Anything in those results that would change the view of a central banker dramatically from what we've just talked about?

Probably not dramatically, I would say. We've talked about the Fed and the U.S. so far, so why don't we start there. The U.S. job creation numbers for December weren't quite as high as what had been hoped. The consensus forecast was 450,000. There was a big ADP survey number a few days ago. And jobless claims are low. So, the thinking was, it could be a big heroic December number. It ended up being just pretty good. It was 199,000 jobs that were created, which is more than enough to absorb population growth and still consistent with the recovery. And indeed, consistent with that, the unemployment rate fell again. It went from 4.2 to 3.9%. We're into the three handles again, which is quite good. It does speak to a pretty strong labor market, as does a high quits rate and high job openings. All the things that we're familiar with before still broadly stand. I think the thesis that the Fed can still continue at this enthusiastic tightening clip— I guess «continue» is not quite the word, they haven't really started—, but nevertheless they can still proceed in 2022. In part it is just, hey, the unemployment rate is now sub 4%. So here we are in a world of sub 4% unemployment, greater than 6% inflation; like, why are you sitting there with a .125% Fed funds rate? I think that basic argument still applies, even if maybe job creation wasn't quite what was expected. And then the other one is, earnings growth and wage growth are still pretty hot. We're still talking in the realm of 5%, which you could equally say is negative 1%, real wage growth. Maybe people aren't getting quite as rich as they think they are with those wage gains. But still that's pretty fast wage growth and likely sticks around for a bit to my eye for the year ahead. So I think the Fed is still broadly on, but at the margin, I guess it's a tiny bit less pressure than before. To me, the other development of relevance is the Fed, when it made its decision in mid-December, wasn't putting too much weight on the Omicron variant, which of course has taken over the world pretty thoroughly over the subsequent several weeks. And so that's of some relevance. I guess the debate there is, if South African experience is any guide, conceivably, it could peak in a few weeks, and conceivably could be fading from there. You're left with a pretty palpable hole in the January data. Let's brace ourselves for some not-so-good economic data in January. In some places like Canada, it's really a function of lockdowns, which we've seen pretty thoroughly. In places like the UK, they've done some, but not a lot. In the US, they haven't really locked down much at all. So there's quite a variation. But I still think a lot of countries are going to look fairly similar because people voluntarily behave more cautiously as well. Americans can go to restaurants but just not to the same extent as before. You get not quite the same outcome, but a similar one. And then maybe the most relevant one— and this wasn't really a factor in prior waves because we didn't see as startlingly high rates of infection, more than a million a day in some cases in the U.S. and Canada. None of these numbers are fully believable now that we've run it to tests and people are being told not to get tested. So, the numbers are higher than we think and certainly setting records. But just the number of people who are actually sick and off work— I mean, you get stats out of Southern California ports and out of airlines and certainly hospital workers and things. Ambulance workers— I think a third of New York City ambulance workers are out sick right now. Of course, they're dealing with Covid each and every day. It wouldn't be the same for bankers as an example, but nevertheless, a nontrivial fraction of the workforce is going to be out for a couple of weeks or isolating or taking care of someone. And it's ultimately a manageable thing. But we should brace ourselves for some not-so-great economic data in January. I personally think, probably a bigger hit than we saw over the prior few waves to be recovered quickly thereafter. But nevertheless, let's be aware of that. And again, I suspect central banks will look through that and take a multi-year view. But that, to me, is a more relevant twist than the U.S. job numbers today. I should mention briefly, Dave, at the risk of trying your patience here, the Canadian numbers are actually pretty good. 55,000 new jobs in Canada. That was twice what was expected. I would say good news there. Unemployment also passing a milestone of sorts. In the U.S., it went under 4%, and Canada has just gone under 6%. We've gone from 6 to 5.9%, and that's pretty good. Canada normally runs an unemployment rate about twice as high as the U.S. So, I would say we're roughly on par with them. This would also qualify as being pretty close to pre-pandemic levels. I was delighted to see— you may recall, it's hard to remember with Omicron and the holidays and other things getting in the way—, but of course, BC flooding was quite a thing in late November and into early December. It's taken some time to get the infrastructure going and some still isn't going, but they're making good progress. It was happy news within that Canadian employment report that BC employment was flat in December. That's kind of a win when you think about those challenges that existed there. Really the theme there has been that the economic damage hasn't been quite as big as initially feared. For instance, we thought maybe, at one point, November GDP for Canada would be negative. And no, Stats Canada's reporting tentatively, they think there was at least a modest gain for that month. So that damage is not quite as big as feared, which is, I guess, a nice thing as well. Then, of course, with the twist— and of course, all of this is dated—, a lot of the hiring in both places were service sector and combination food services, and we're probably going to lose some of that in January, and then hopefully get that back through the spring. But nevertheless, these job numbers are maybe a bit more stale than usual, given all that happened since then.

Yes, I think it is an important point, and you did make it earlier, that you've been fairly cautious on your view of growth in the U.S. and Canada for quite some time. And that's proven to be quite a prudent view because you've had all these little hiccups along the way. I shouldn't say that, some are major things that are affecting our lives and people's lives, so “hiccups” is probably the wrong way to position it. But things are happening that just cap the breaks here and there and keep growth a little bit below what other forecasters have expected. I'm sure you're very happy with where you come in from a forecasting standpoint, more growth than less, from an economics perspective.

If I were an investor and so on, I'd be more than happy for wonderful numbers as far as the eye can see. But yes, that's right. We've been getting the forecast right so far. Keep in mind that rate hiking we're talking about is a bit of a drag on growth, and there are a few other factors to consider on that front as well. Still a recovery, just a more muted recovery, we think, for 2022.

One of the really interesting things, though, as you do bring up Omicron, is the way markets have seemed to view it, which is to almost look right past it again. Hopefully that means that we do repeat the South African experience in other parts of the world with it, despite the fact that we have had millions of new cases, if I get my “illions” right this time. It seems like billions or trillions, but it's millions or hundreds of thousands, and it's really quite something to watch.

Yes. We certainly established it as much more contagious than anything that's come before. But equally, it does look to be significantly less deadly or damaging. You can debate just how much less. You see wonderful stats from South Africa where the hospitalization rate per case was four times lower than before, and then the intensive care and the ventilator usage, and so on, were maybe four or five times less per hospitalized person. So you're multiplying those good news items together. Now, you could say that more people are vaccinated than they were in prior waves, and for that matter, more people have natural immunity than in prior waves, by virtue of those prior waves, and so, some of the math says, it's less dangerous. Maybe it's only 50% less likely to send you to a hospital for someone who's unvaccinated, or in the same position as in prior waves. It still needs to be treated with caution. It was something much more contagious, somewhat less deadly. That combination is still presenting quite a challenge for many hospitals and so on. But equally, if South Africa proves to be a precedent, you can conceivably look past that over the next month or two, and markets have been pretty darn good at looking past Covid-type issues. Sometimes when I'm briefing our portfolio managers, I kind of feel badly wasting their time with all this Covid talk at the beginning because it seems to rarely impact markets all that directly. But still, it is relevant from an economic standpoint. It's important to get a sense of whether the next wave or the wave after that, heaven forbid, might be different in some way. And so it's still important to watch. But it hasn't been a big driver of markets, it's completely fair to say.

I guess the bottom line on that is, it is not going away and may never go away, but the way markets react to it is adjusting over time. Well, Eric, that was just a fantastic update. We got into a ton there. Clearly, I think you were reading and keeping up to date on things over your vacation, so you still get that hardest working economist moniker. You've earned it again. I just want to thank you always for doing this each month, to give everyone an update on these important job reports, and subsequently, how that affects policy that is clearly having an impact on markets. So, thank you very much again.

Thank you and happy New Year to everybody.

Disclosure

Recorded: January 7, 2022

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