Inflation peaking

Of arguably greatest relevance, our inflation peaking scorecard for the U.S. has made another significant leap toward an affirmative answer over the past month (see next table). In late July, the scorecard had six metrics arguing that inflation was turning lower, 10 that gave a “maybe” answer and seven that indicated “no.” Today, 12 indicators say inflation is turning lower (a slight majority of the measures), five say “maybe” and six indicate “no.” Almost all would have said “no” last spring.

Scorecard shows U.S. inflation is peaking

As at 08/22/2022. “Turning” identified using mix of M/M/ and Y/Y methodologies. “Pandemic-boom goods” is used vehicles + sports vehicles (including bicycles). Source: RBC GAM

Variables moving in a less problematic direction include:

• headline Consumer Price index (CPI)
• median CPI, Producer Price Index (PPI)
• real-time inflation
• the cost of pandemic-boom goods
• consumer inflation expectations
• business plans to raise prices.

It is important to concede that the scorecard’s progression is not necessarily a one-way street. Some newly behaved inflation measures could misbehave again, weakening the argument that inflation has peaked. But, for the moment, the great majority of measures argue “yes” or “maybe.” This is consistent with our view that inflation probably reached its peak in June of this year, even if the subsequent deceleration is likely to be choppy and it will probably be some time before inflation has fully normalized.

July inflation

A central component of the argument that inflation has peaked is that consumer prices softened quite significantly in July. In the U.S., the monthly consumer price change was 0.0% (see next chart – the bar for July is invisible since it sits precisely on the 0.0 axis). To two decimal places, prices in July were actually slightly lower than in June. This is quite a contrast to the prior month, when prices rose by an incredible 1.3% in a single month.

U.S. Consumer Price Index (CPI) monthly trend softens

As of 07/2022. Source: U.S. Bureau of Labor Statistics (BLS), Macrobond, RBC GAM

The key driver of this abrupt inflation reversal in July was a 4.6% decline in energy prices. On the other hand, food prices continued to rise robustly (+1.1% in July), as did shelter costs (+0.5% month over month - MoM). These three categories easily contributed most to the monthly inflation rate in July (see next chart).

Declining energy prices led categories most affecting latest U.S. monthly inflation rate

As of 07/01/2022. Source: U.S. Bureau of Labor Statistics (BLS), Macrobond, RBC GAM

The U.S. was not alone in experiencing a sudden reversal of inflation pressures in July. Most countries reported something very similar given the universality of the decline in gasoline prices. Canada’s inflation print fell from +8.1% year over year (YoY) to +7.6% YoY.

Looking to August and beyond

Turning to August, it would appear that commodity prices (excluding natural gas) have remained roughly flat or continued to decline. As such, there should be more downward pressure on consumer inflation in August.

The Cleveland Fed’s nowcasting model anticipates a mere +0.13% increase in consumer prices in August. This is a muted reading even by historical standards. A proprietary real-time inflation measure argues that inflation continued to actively decelerate across the month.

Indeed, when one parses through the four sectors of the price basket that have collectively driven around three-quarters of the inflation surge over the past year, all four present reasonable arguments that inflation should ease in the future:

1. Gas prices have already turned lower as Russia production has been sustained and global demand is expected to soften.

2. Transportation costs are beginning to flatten out as car prices begin to mean-revert and airfare falls.

3. Shelter costs have not yet shown much evidence of softening, though the housing market itself has cooled profoundly in several developed countries. There are a variety of lags to consider such that shelter costs are unlikely to prove deflationary any time soon in many countries. However, the underlying pressure is surely beginning to abate. (A counterpoint is that the cost of renting continues to rise due to the more expensive carrying cost of a home resulting from higher mortgage rates, and given that the big run up in home prices has not yet been fully reflected in rental costs).

4. Food prices have begun to soften at the commodity level. Food sector experts increasingly predict that this will trickle down to consumer-level food prices within several months.

Calibrating recession risk

The risk of recession is still high, but has arguably diminished slightly. We are inclined to think that the risk of a U.S. recession by the end of 2023 has fallen from around 80% back to 70%. The risk remains higher (and the prospective recession even deeper) in the U.K. and Eurozone.

We are also increasingly of a mind that any recession in the U.S. might be slightly milder than previously envisioned. In the past, we have talked about a middling U.S. recession in which real output falls by around 2.5%. Indeed, that is the mean depth of the peak-to-trough decline for U.S. recessions since 1948. It nevertheless slightly exaggerates the contours of a normal recession by including the incredibly deep (and artificial and brief) pandemic recession in early 2020. Excluding that episode, the average U.S. recession has instead experienced a GDP decline of 1.8% and a decline of that order now seems most likely.

What has incrementally reduced the probability of recession and its likely depth? Several things have lately been going right for the global economy.

1. As just discussed, inflation has begun to fall. High inflation has been an economic headwind both directly as consumers and businesses pull back on spending due to diminishing purchasing power, and indirectly as high inflation necessitates aggressive monetary tightening. To illustrate the change via the price of West Texas Intermediate oil, a barrel of oil peaked at US$124 on March 8. It has since fallen to $87 in late August. This constitutes a significant saving for people filling up their gas tank. However, oil is still significantly more expensive than its 2021 average of $68.

2. Financial conditions have eased slightly. Bond yields have recently declined as inflation fears and central bank expectations have been scaled back, and as recession expectations have been priced in (see next chart). The stock market and other risk assets have also mounted a partial recovery.

U.S. 10-year Treasury yields have fallen

As of 08/19/2022. Shaded area represents recession. Source: U.S. Treasury, Haver Analytics, RBC GAM

3. Supply chains have continued to make incremental improvements. It seems reasonable to expect further improvements as pinch points are finally resolved.

4. China’s economic situation – while still challenging and precarious – may not be quite as problematic as it was a few months ago. At that time it had appeared that large swaths of the country would have to repeatedly lock down in response to COVID-19 outbreaks. Of the four factors, this is admittedly the one that is improving with the least enthusiasm.

The improvements across these four factors are not sufficient to warrant a soft landing as the base-case economic scenario. But should these continue to make large improvements, that scenario becomes increasingly possible.

The general economic trend remains one of gradually softening activity. However, there have been some recent notable exceptions. Jobless claims actually fell in the latest week, and the University of Michigan’s long-dire (and, frankly, still-dire) consumer sentiment measure rose slightly in August.

Recession silver lining

We have argued in the past that a recession in this environment isn’t the worst thing in the world since it can help to prevent high inflation from becoming structural – a necessary achievement if the standard of living is to continue rising significantly over the coming decade.

In addition to constituting an opportunity for savvy investors, a recession might also help to purge other problems:

• Economic activity – in particular the labour market – is overheating to a nearly unprecedented extent. It cannot continue along this path indefinitely, and delaying any effort to normalize the economy could result in a worse downturn later. Cooling off the economy now via a mild to middling recession might be the path of least pain.
• Housing excesses had grown to worrying proportions before interest rates recently began to rise. A proper recession would help to right-size the housing market, restoring some measure of affordability for future generations.
• Ultra-low interest rates and outright negative interest rates were beginning to do significant damage via distorted incentives. Higher policy rates and higher interest rates are arguably worthwhile if they eliminate these distortions, even if the initial adjustment results in a brief recession.

Assessing emerging-market challenges

The global economy has suffered as food and energy prices rose and interest rates increased over the past year. Emerging-market nations have arguably experienced even more pain than most.

The increase in food prices is particularly problematic for emerging-market countries given that food constitutes a larger fraction of poorer countries’ spending baskets.

The increase in borrowing costs has been even greater for many emerging-market countries. Not only has the risk-free rate gone up over the past year (loosely, U.S. government bond yields), but the emerging-market specific borrowing risk premium has also increased on top of this. The result is an especially sharp rise in emerging-market borrowing costs (see next chart).

Emerging market bond yields reach highest level in over a decade

As of 08/19/2022. Source: J.P. Morgan, RBC GAM

Finally, the strength of the U.S. dollar is also a problem for many emerging-market debtors as their external debt is frequently priced in dollars. As the U.S. dollar has appreciated, the amount of debt these countries owe has also effectively increased relative to the size of their domestic economic engines.

As a result, approximately 20 of the 70 main countries in the emerging-market bond universe are experiencing some measure of financial distress. This is approximately in line with the level of distress emerging-market bonds experienced in 2020 and in 2008. In contrast, the corporate sector has so far remained more resilient.

It is mostly the smaller frontier markets that are struggling. These tend to be the smallest components in the bond index, limiting the damage. Further, not all distressed countries eventually default.  Also, financial markets are forward-looking and so have already substantially priced these issues into the market.

But the main point is that emerging-market economies are arguably suffering more from recent economic headwinds than are the developed countries that tend to attract the bulk of the attention.

Watching U.S. midterms approach

The U.S. midterm elections are just over two months away. President Biden remains quite unpopular despite a smattering of recent legislative success. In addition, presidents normally shed significant support in mid-term elections. As such, the widespread expectation up until a month ago was that the Republican Party would claim both the House of Representatives and the Senate from the current Democrat incumbents.

That thinking has now, tentatively, changed. While the House of Representatives is thought likely to remain in Republican hands (see next chart), polls now argue that the Democrats should maintain their Senate majority (see subsequent chart). Of course, at a 79% and 60% chance, respectively, and with a track record of shifting allegiances in recent months, these numbers could yet change before the election.

Who will control the House after the 2022 midterm election?

Source: FiveThirtyEight, RBC GAM

Who will control the Senate after the 2022 midterm elections?

Source: FiveThirtyEight, RBC GAM

From a legislative perspective, one can argue that it doesn’t much matter which way the Senate goes. A Republican House of Representatives will likely impede White House legislative efforts, and vice-versa. But this is too simplistic a stance, as the Senate makes crucial decisions including appointing Supreme Court Justices.

The stock market is usually fairly happy when Congress is divided between two parties. Theoretically this is because the resulting political gridlock means that public policy will not be radically changed and so won’t undermine existing business models.

At the state level, 36 governorships will be up for grabs. Polls currently suggest that 17 will go to the Democrats and 17 to the Republicans, with two presently a toss-up (see next chart). However, with more Republican states contesting elections, this is nevertheless tracking for the loss of approximately three Republican governors.

How many governorships will each party win in the 2022 gubernatorial races?

Note: There will be 36 gubernatorial elections in 2022. A toss-up is defined as when both parties have <60% probability of winning. Source: FiveThirtyEight, RBC GAM

Observing population trends

The United Nations (UN) came out with its latest long-term population projections over the summer. There are several fascinating takeaways from this.

1. The pace of worldwide population growth is set to continue decelerating. The truly extraordinary global population explosion that began with the Enlightenment in the late 1600s will be effectively complete by the end of the 21^st century (see next chart).

Global population boom now coming to an end

Source: McEvedy and Jones, 1978, Atlas of World Population History, Factors in File, Biraben, 1980, An Essay Concerning Mankind’s demographic evolution, Wikipedia, UN World Population Prospects 2022, Macrobond, RBC GAM

2. Global population growth was particularly slow in 2020 and 2021. This is presumably in part due to excess deaths from the pandemic and the pandemic response and in part because fertility rates fell particularly far during the pandemic.

3. The UN has slashed its end-of-century population forecast by more than 500 million people. This leaves a population of 10.35 billion people by the year 2100 (see next chart).

The UN has lowered its peak global population forecast since 2019

As of 2022. Source: United Nationals Department of Economic & Social Affairs (UNDESA), Macrobond, RBC GAM

4. The old UN forecast (from 2019) envisioned the global population continuing to expand beyond the year 2100 end of the forecast horizon. The new forecast now predicts that the world’s population peaks in 2086, before beginning to decline (refer to next chart).

World population is expected to peak at 10.4 billion as growth slows



As of 2022. Source: United Nations Department of Economic & Social Affairs (UNDESA), Macrobond, RBC GAM

5. We suspect the true peak population will land below the projected 10.43 billion and the population peak may occur somewhat sooner. This is in part because the UN has made a habit of revising its population forecasts downwards and so future downward adjustments may also prove necessary. It is also partially because some of the projected fertility rates are assumed to naturally stabilize in the vicinity of 2 children per woman (a level that results in an approximately flat population). In practice, however, developed counties that have fallen to that fertility rate have continued to decline from there.
6. Whether a declining world population is good or bad depends entirely on the perspective. It is arguably a positive outcome from the perspective of environmental sustainability, food supply and perhaps quality-of-life. However, a shrinking population is arguably negative from the perspective of economic growth and stock market returns.

5. The relative power dynamic between continents is set to continue shifting (see next chart). In purely population terms, North American, Latin America and Europe are already afterthoughts. They are set to represent an even smaller fraction of the world’s population by the turn of the century. Asia is the current behemoth, containing 59.5% of the world’s population today. But with very low fertility rates, this share is set to collapse to just 45.2% by the end of the century. On the other hand, Africa is set to experience a further population explosion. Africa currently contains 17.4% of the world’s people, and is on track to more than double that share, to 37.9% by the year 2100. Africa may well be the land of economic opportunity over the coming decades if this forecast comes to fruition.

The changing faces of world population

Source: UN World Population Prospects 2022, Macrobond, RBC GAM

Asian fertility rates

Japan is famous for its old population and low fertility rate. But, in truth, it is not especially notable when compared to other wealthy Asian nations. In fact, with a fertility rate of 1.3 children per woman in 2020, this puts it near the head of the pack, in an approximate tie with China and with a significant lead relative to the fertility rates of Singapore, Taiwan, Hong Kong, Macau and South Korea. South Korea’s fertility rate is the lowest of the bunch, at 0.8 children per woman. At that rate, each generation should be well under half as large as the prior generation. Combine this with Asia’s distaste for immigration and some truly extraordinary developments await.

These observations also make the case that China’s fertility rate is unlikely to significantly revive even as it lifts its one-child policy. If anything, China is at the high end of the region’s (wealthy country) fertility rates. Moreover, in the years since China began easing its restrictions, there has been little evidence of a population revival. This may limit China’s geopolitical clout over the long run.

Millennials versus Boomers

It has been widely reported that there are now more American Millennials (born 1981—1996) than Baby Boomers (born 1946—1964). This has led some to argue that successful businesses (and investors) would be well advised to pivot their attention toward Millennials.

Setting aside the fact that marketers already tend to target “prime aged” people, a group that presently happens to include Millennials, the generational pivot isn’t nearly as profound as it first appears. Baby Boomers still deserve special heed as an unusually large generation that dwarfed both the generation that preceded it and the one that followed (Generation X: born 1965—1980). They were special because they represented an extraordinarily large fraction of the population at their peak.

It is true that the Baby Boom generation is now beginning to die off, and the Millennial cohort is slightly larger than normal since many are the offspring of the large Baby Boom generation. But, absent a shock like the end of World War II, and with a rising U.S. population over time, it is natural for each generation to be modestly larger than the prior generation. It just happens to be the case that it took two generations for this gradual growth to result in a generation that numerically exceeds the Baby Boomers. It remains possible that the subsequent generation (Generation Z: born 1997—2012) could eventually exceed the peak population of the Millennial generation depending on the rate and composition of future immigration. For that matter, it is inevitable that Generation Z will eventually exceed the Millennial population when the Millennial generation ages and eventually begins to die in significant numbers.

The most important observation is that Millennials represent a far smaller fraction of the overall U.S population than did the Baby Boom at its peak. (As an aside, the Baby Boom generation cheats significantly in claiming a 19-year time period whereas the other generations receive just 15—16 years. However, this doesn’t fully undermine the generation’s size advantage at its peak).

In short, Millennials are not as important relative to the broader population as the Baby Boomers were in their heyday. This means societal trends and marketing campaigns need not be as focused on them as prior iterations were on Baby Boomers.

-With contributions from Vivien Lee, Vanessa Adams, Aaron Ma and Andrew Maleki