Global Investment Outlook

We are pleased to announce the release of our quarterly Global Investment Outlook. You can find our economic outlook contained within it.

Overview

This week’s note provides fresh information on the Omicron variant and COVID-19 infection trends. Next we check in with hawkish central banks and their effect on the yield curve. We then acknowledge recent strong economic data alongside early indications of weakness to come. We end with an update on key themes including Chinese growth, high inflation and troubled supply chains.

Overall, we feel slightly better than a few weeks ago. This is primarily because our confidence is growing that Omicron could be less dangerous than earlier variants. Although central banks have become more hawkish, this isn’t necessarily a bad thing to the extent it helps to tame high inflation.

Virus cases

The Omicron variant is not yet visible in the global data, which continues to show a slight improvement as some countries begin to tame the earlier Delta variant (see next chart).

Global COVID-19 cases and deaths

As of 12/15/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

For the moment, U.S. infections are roughly flat (see next chart), whereas Canadian cases are clearly rising (see subsequent chart). Even Canada’s western provinces are beginning to see higher infections again.

COVID-19 cases and deaths in the U.S.

As of 12/16/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

COVID-19 cases and deaths in Canada

As of 12/16/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

Omicron’s effects are most visible in the countries that were first introduced to the variant. Naturally, South African infections remain extremely high (see next chart). The U.K. is now reporting a record number of new infections per day (see subsequent chart). Denmark and Norway have also been hit particularly hard.

COVID-19 cases and deaths in South Africa

As of 12/16/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

COVID-19 cases and deaths in the U.K.

As of 12/16/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

Outside of Africa, the Omicron is not particularly visible in the emerging market (EM) data. Most EM countries maintain low infection rates for the moment. However, all of that may be about to change, as discussed in the next section.

Omicron update

As more data becomes available, the Omicron narrative remains largely in line with our initial assumptions. This is to say, the variant appears to be significantly more contagious than the Delta variant, significantly more resistant to vaccines, and (thankfully) significantly less dangerous. This last point remains somewhat contentious, but the evidence so far mostly supports the assertion.

Let us review each of these claims in turn.

More contagious

The Omicron variant certainly appears to be quite contagious. We have uncovered studies reporting that it is anywhere from 1.3 times to 4 times more contagious than the Delta variant. It is hard to fathom that it can truly be several times more contagious than the Delta variant as that would make it among the most contagious viruses in history, but it is certainly highly contagious.

The U.K. reports that Omicron infections are doubling every two days or less in the U.K. right now – an unprecedented clip. The U.K. Health Security Agency indicates the country’s infections may reach an unfathomable one million per day by the end of the month. Omicron has quickly taken over all of the countries that first encountered the variant – even countries that had previously been in the thrall of the Delta variant.

One can construct arguments that South Africa and the U.K. could be inherently more vulnerable than other countries. South Africa also struggled with the Beta variant that never gained much traction elsewhere and the country has a large population of HIV patients with depressed immune systems. The U.K. relied disproportionately on the AstraZeneca vaccine that appears to be particularly ineffective against the Omicron variant. In addition, the country was already struggling with a high level of COVID-19 infections before Omicron came along. But it stretches credulity to claim that these factors could explain the entirety of the Omicron surge in both countries.

One fascinating side note is that South African COVID-19 infections have been trending sideways for the past week, albeit at a high level. Supporting this development, wastewater analysis for central Pretoria has shown a declining concentration of virus particles over the past two weeks.

It makes sense that a particularly aggressive COVID-19 strain would experience not just a higher peak but a quicker one to the extent the population of susceptible people would be inundated more quickly. Still, it is surprising that this is happening already. Prior infections are not thought to provide particularly strong protection against Omicron, and the number officially infected by the latest variant in South Africa is still just a fraction of the population. Only time will tell whether this is a blip or instead means that a much larger fraction of the population has already been infected (and were asymptomatic).

Vaccine resistance

Scientists anticipated that Omicron would probably be capable of evading vaccines more successfully than earlier variants given the mutations to its spike protein. Some studies have claimed as much as a 32-fold to 41-fold reduction in the ability for antibodies from two Pfizer shots to neutralize Omicron.

Translated into vaccine efficacy, scientists estimate that two doses of Pfizer vaccine have an efficacy of just 22% to 33% against Omicron. This compares to an 80%-plus efficacy against earlier variants (though the interpretation gets quite messy when one considers that other studies have found that the efficacy against earlier strains of the virus had fallen significantly in the months since vaccines were administered). The protection afforded by the AstraZeneca and Johnson & Johnson vaccines appears to be even lower. Protection via prior infection also appears to be greatly reduced.

Fortunately, those who received vaccines and had also been previously infected still enjoy a high level of protection. Also, those who recently received a third booster shot enjoy an efficacy rate that rebounds to 70—75%: nearly as high as the protection two doses provided against earlier variants. Finally, even for those with just two doses, the protection against serious illness requiring hospitalization appears to be around 70%. This is lower than the nearly 99% levels initially reported against earlier variants, but is still considered good by epidemiologists.

Pharmaceutical companies are now busy working on vaccines that better target Omicron. However, these will take the better part of a quarter to develop and then another quarter or longer to manufacture and distribute. As such, they will be helpful for the second half of 2022, but less so for the first half.

Less deadly

Finally, after two pieces of bad news, it is heartening that there is one very important piece of good news: Omicron appears to be significantly less deadly. It should be noted that this is not yet proven, with a handful of studies making the opposite assertion. But the evidence is mounting in favour of the more optimistic interpretation:

• A variety of studies argue that Omicron is 1.2 times to 5 times less likely to require hospitalization or induce death, and is even less likely to require intensive care or a ventilator among those who are hospitalized.
• South African doctors report that the viral load from Omicron appears to be lower than for earlier variants – this theoretically maps onto less severe infections.
• They also report that the Omicron tends to be more of an upper respiratory infection (like the cold) than the lower respiratory infection that damaged the lungs of many victims.
• South Africa reports that the average hospital stay is only around half as long for those infected by Omicron versus earlier variants – so those who do go to the hospital are generally not as severely afflicted.
• Indeed, at least in the early going, a remarkable 76% of South African patients were incidental COVID-19 admissions: people who went to the hospital for a checkup or procedure and were found through standard screening to have the Omicron variant.
• South Africa reports that just 1.7% of identified Omicron cases were admitted to the hospital by the second week of their infection, versus a much higher 19% for the earlier Delta wave.
• Our own work with South Africa’s hospitalization data (see next chart), finds that the number of patients in the country’s intensive care units is far smaller relative to the number of cumulative cases reported over the prior month than at any point during the prior Delta wave – and by a factor of about four times. This is very promising. The number of COVID-19 patients in intensive care units has even declined somewhat in recent days.

Infections in South Africa grew exponentially due to Omicron, but risk of severe disease appears lower so far

Rapid antigen tests included in daily case counts starting 11/23/2021. Source: National Institute for Communicable Diseases, WHO, Macrobond

The main takeaway is that a record number of people will likely be infected by the Omicron in the coming weeks. But it isn’t clear that this will map into a record number of hospitalizations. If Omicron proves to be, say, twice as contagious as Delta but three times less deadly, hospitals may not be as full as during earlier waves. Conversely, it is possible that Omicron is three times as contagious as Delta but merely two times less deadly. In that scenario, hospitals will be very challenged indeed.

Economic implications

Our pessimistic economic scenario now looks significantly less likely given that Omicron probably isn’t more deadly than earlier variants.

Our optimistic economic scenario that the world reaches herd immunity via Omicron without too much suffering remains possible. But to the extent that a prior Delta infection doesn’t appear to offer much protection against Omicron, it is far from clear that Omicron antibodies will snuff out the more aggressive Delta variant.

By the process of elimination, our base-case scenario has become increasingly likely. This assumes a bigger, milder wave of COVID-19 infections versus prior waves, resulting in significant but not enormous economic damage. This damage is done via several channels:

1. While one can debate whether governments need to significantly restrict interactions if the virus is milder (South Africa has largely opted not to), there is already considerable evidence that many countries are veering toward more restrictions. International travel has been restricted, personal trips are being discouraged, governments and companies are encouraging workers to return to remote working, capacity limits are falling, some schools are closing, and so on. This does economic damage.
2. If the wave is indeed as large as feared, many people will be temporarily out of the workforce while ill or while isolating after exposure to an infected person over the coming months. This could be a major hit to hours worked, not to mention spending.
3. Government support programs are now substantially less generous than during earlier waves, meaning that an equivalent number of economic restrictions could do outsized economic damage.
4. The long-awaited pivot from goods spending to services spending would be delayed, delaying demand-side healing in the supply chain.

All of this adds up to more economic damage than over the past few waves, albeit far less than during the initial outbreak. As discussed in an earlier note, we believe up to a percentage point of economic activity may be temporarily shed over the first quarter or two of next year, before snapping back later.

Hawkish central banks

U.S. Federal Reserve

Central banks have maintained a hawkish tilt since last summer. This inclination was on full display over the past few weeks, when most major central banks in the developed world delivered their final verdict for 2021.

In the U.S, the Federal Reserve met expectations with a plan to double the pace at which it tapers its bond purchases – from a $15 billion/month reduction to $30 billion/month. However, it stopped short of announcing a plan to allow the balance sheet to begin shrinking thereafter.

U.S. rate hikes are not quite around the corner – the Fed plans to wait until maximum employment is reached – but the committee’s dot plots reveal that three hikes are now on the menu for 2022. It wasn’t long ago that the Fed’s first hike wasn’t planned until 2023 or even 2024. As for timing, the Fed is set to complete its bond buying operations in March 2022, and Chair Powell indicated in his press conference that the Fed no longer sees a reason for a long delay between the end of bond buying and rate hikes. Thus, the spring to summer of 2022 is very much in play for the first hike.

The motivation for this hawkish turn is primarily persistently high inflation, which few central banks had anticipated earlier in the year. The Fed’s latest forecasts contain an upgrade to each of the next three years. Inflation is expected to be above target not just in 2021 but through 2024. Remarkably, not a single of the Fed participants submitted an annual inflation forecast below 2.0% for any of those years. The unemployment rate has also been lower than the Fed had previously forecast. This has also contributed to recent hawkishness.

Bank of Canada decision

The recent Bank of Canada decision yielded no rate change and a mixed assessment of present conditions. Economic momentum was strong recently, but BC floods and Omicron could weigh on growth. In the end, the output gap remains on track to close in the second or third quarter of 2022, and the Bank has indicated that this would be an appropriate time to begin raising rates. This is the same message from the meeting before, but it is nevertheless fairly hawkish relative to most other central banks. We flag the possibility that it takes a little longer for the output gap to close, and in turn that the central bank does not have to raise rates as much as the market currently anticipates (an aggressive five 25bps hikes over 2022). Indeed, we tend to think most central banks will hike a bit less than the market currently budgets, though we certainly don’t deny that tightening is coming in 2022.

The Bank of Canada also recently renewed its mandate with the government for another five years. Unusually, the mandate was actually changed, with employment taking a more central role. At the margin, this has slightly dovish implications to the extent that the labour market has not quite fully recovered (whereas inflation has already overshot its target). However, ultimately, the change has limited consequences:

1. The Bank has not actually switched to a formal dual mandate – inflation remains the primary target.
2. The statement indicated that “monetary policy should continue to support maximum sustainable employment,” but this is not a new idea. Inflation targeting has always been in significant part an exercise in predicting where the output gap will go in the future. The labour market is critical in estimating the output gap.

Other central banks

The Bank of England whipsawed markets by failing to hike in November despite expectations of an inaugural move, and then raising rates in December after expectations had receded. The Bank is gambling that the economic damage from Omicron will be fairly small, and that inflation will remain high. In contrast, we fret that the country may suffer a fair amount of economic damage from Omicron. It is the first G7 central bank to raise rates. It can’t be said that U.K. inflation is any worse than in the U.S. or elsewhere, so this action largely comes down to different tolerances for high inflation rather than different economic environments.

The European Central Bank has taken the opposite stance to the Bank of England, opting to look through high inflation but dwell on the economic damage from the virus. The ECB indicates it still doesn’t expect to raise rates in 2022.

The Bank of Japan announced a taper to its corporate bond and commercial paper purchases, but still has no plan to raise rates. This appears to be nearly a permanent stance. In fairness, Japanese inflation has not increased, unlike other countries.

Yield curve flattens

The U.S. yield curve has flattened significantly in recent months (see next chart), for a number of reasons. The yield curve refers to the gap between short-term rates and long-term rates. Normally, long-term rates are somewhat higher and that gap has lately shrunk.

U.S. Treasury spreads narrowed lately

As of 12/14/2021. Shaded area represents recession. Source: Federal Reserve Board, Macrobond, RBC GAM

A central driver, of course, is that central banks have become more hawkish. This has pushed up short-term rates. It explains 56 of the 76 basis points of flattening that has occurred between the U.S. 2-year yield and the 10-year yield since the end of March.

However, some of the flattening has also happened because longer-term yields have fallen by the other 20 basis points. There has been some speculation that this has happened because markets are pricing in a policy error by the Federal Reserve. The idea is that the central bank might tighten rates too much, causing a recession or worse economic conditions later.

However, we don’t find that to be true. In actual fact, the expected average central bank rate over the next decade has been rising. Instead, it is the term premium portion of the long-term yield that has been falling. This is subject to a variety of technical considerations, including simple supply and demand.

If the Fed delivers on expected rate tightening, it is possible that the yield curve could be approaching a flat reading in a year. That would get tongues wagging about recession risks to the extent that an inverted 2-10 yield curve classically signals a recession 18 months later. For the moment, we believe the risk of recession is manageable, but the slope of the yield curve will merit close examination over the next few years.

Strong economy may weaken

Recent economic data strong

Recent U.S. economic data has been quite strong. The four-week moving average for jobless claims is now at its lowest level since 1969, which is remarkable (see next chart).

U.S. jobless claims inching lower

As of the week ending December 11, 2021. Shaded area represents recession. Source: Department of Labor, Haver Analytics, RBC GAM

U.S. Q4 gross domestic product (GDP) is presently tracking +7% annualized. Canadian Q4 GDP is set to be fairly good despite a drag from BC flooding.

We also observe that the U.S. economic surprise tracker has now rebounded to a modestly positive reading (see next chart). This means economic data has been exceeding expectations again. While this would normally hint to us that it might be time to switch to an above-consensus growth forecast, we expect the Omicron variant to dim near-term activity.

Global economic surprises rebounded a bit in Q4

As of 12/16/2021. Source: Citigroup, Bloomberg, RBC GAM

Real-time data demonstrates Omicron drag

Indeed, we have begun to see signs of economic damage from the Omicron variant. Global restaurant reservations have begun to dip (see next chart).

Restaurant reservations

As of 12/15/2021. 7-day moving average of % change vs. 2019. Seated diners from online and phone reservations and walk-ins, based on a sample of restaurants on OpenTable. Source: OpenTable, RBC GAM

The San Francisco Fed’s news sentiment index has begun to fall again (see next chart).

Daily News Sentiment Index in the time of COVID-19

As of 12/12/2021. Source: Federal Reserve Bank of San Francisco, Macrobond, RBC GAM

Lastly, U.S. travel by air appears to be ebbing again (see next chart).

Air travel in U.S.

As of 12/15/2021. 7-day moving average of change compared to same weekday of prior years. Source: &SA, Macrobond, RBC GAM

China slowdown

This is a good time to provide an update on the Chinese economic slowdown story. To recap, the Chinese economy is decelerating due to a mix of housing headwinds, a regulatory crackdown, supply chain problems and deteriorating demographics. The country is also especially vulnerable to new virus variants such as Omicron.

Even as supply chain problems start to ease, this may not help the Chinese economy as much as imagined. After all, the main supply chain story is that people are buying more goods than normal, and China is supplying them. To the extent that additional demand fades, that creates a hole in the Chinese manufacturing sector.

Recent housing data confirms the deceleration in that sector. Property sales and housing starts are 20—30% lower than a year ago. Home-buying intentions are also quite low. New home prices just fell in the latest month by the largest amount in six years. Major builder Evergrande has now formally defaulted, as have several smaller builders (Kaisa, Fantasia, Modern Land and Sinic).

Elsewhere, Chinese consumer spending is rising more slowly than the consensus forecast and cap-ex intentions are fairly soft.

China has now reported several cases of Omicron. Given the country’s zero-tolerance policy, it is already shutting down parts of the country, including an area with a heavy manufacturing base.

For all of these reasons, our forecast for 2022 Chinese GDP is just +4.6%. This is below the consensus (though fine by any standard other than China’s illustrious history of rapid growth).

However, outright disaster is unlikely, and some economic recovery is likely in 2022. There are three key signals supporting this assertion.

1. A provincial government and the Chinese central bank have said they will cooperate to lower Evergrande’s risks and to achieve a steady property market. This can be taken to mean that policymakers have reached a consensus over what to do about beleaguered builders and that Evergrande will likely be restructured.
2. The People’s Bank of China announced a cut to its reserve requirement ratio. This is to say, it is now delivering more monetary stimulus in an effort to stabilize growth, even though many other countries are presently tightening rates. Additional support is likely.
3. The Chinese government’s top decision-making body has indicated that “stability” is the top priority for the country’s economy in 2022. This suggests growth will be supported after a year in which sometimes disruptive restructuring was the key theme.

High inflation

Unsurprisingly, inflation readings remain extremely high. The latest U.S. Consumer Price Index (CPI) print was a massive +6.8% year-over-year (YoY) for November. Canada clocked in with a +4.7% YoY reading. This would be in the realm of +6% if used cars were properly factored into the equation.

Shelter costs are now rising quickly, representing a potentially persistent source of inflation pressure even as oil prices and supply chain pressures eventually abate.

Producer price indexes also remain quite hot, with the U.S. version up by a large 9.6% YoY in November.

Additionally, a recent U.S. Conference Board survey finds that companies are planning 3.9% wage increases for 2022, the most since before the global financial crisis. We think the actual increase could be greater.

On a more optimistic note, real-time inflation measures have peaked. They have even edged slightly lower for North America in recent weeks, though they remain consistent with quite high inflation. These measures continue to accelerate in several other markets, including Japan.

Our forecast remains for above-consensus and high but ultimately decelerating inflation in 2022, with inflation eventually returning to normal levels over the next few years.

Supply chain update

We begin with a piece of bad news: while it superficially appears that the backlog of ships waiting at anchor to unload their wares in Southern California has improved, this is just a mirage created by a new vessel queuing process that encourages ships to “slow steam” to port. A proper accounting finds that these ships are still at a record high (see next chart).

Container ships at anchor or loitering around Port of Los Angeles & Long Beach

As of 12/15/2021. Source: American Shipper, Marine Exchange of Southern California, RBC GAM

While shipping costs have declined, the improvement has been fairly slight and has recently stagnated (see next chart).

Shipping costs declined but still elevated

As of the week ended 12/16/2021. Source: Drewry Supply Chain Advisors, RBC GAM

When we examine other proxies for supply chain issues, the story is similar: a slight improvement but still a long way to go. For instance, Chinese bicycle exports – which enjoyed a particularly large increase during the pandemic – have declined somewhat, but remain very high (see next chart).

China’s bicycle exports surged and remain high during the pandemic

As of October 2021. Source: China General Administration of Customs, Haver Analytics, RBC GAM

The cost of shipping by air freight surged recently, from $8 per kilogram at the end of August to $14 now. But this makes sense and should soon abate: products manufactured too late to be included on a ship must be sent by plane to arrive in time for Christmas. The urgency will soon diminish.

There is reason to expect a notable improvement in supply chain conditions over the first quarter of 2022. Not only will the holiday crush (and Chinese New Year) be over, but spending tends to be unusually low in the first quarter, and that usually manifests in the form of lower imports (see next chart). That will give ports a chance to catch up.

Port of Los Angeles import containers

As of October 2021. Source: Port of Los Angeles, Macrobond, RBC GAM

On the subject of computer chips – a key supply chain pinch point – the evidence is mixed. Major car companies including General Motors and Ford have indicated that the worst of the chip shortages have now passed. Some sources indicate that some companies may even be stockpiling chips, leading to an eventual glut. Investment in new chip production capacity has increased by a third over the past year, and by 50% since before the pandemic.

On the other hand, a Wall Street Journal article claims “the global semiconductor shortage is worsening, with wait times lengthening.” An expert quoted in the article says that some buyers are being told their orders won’t be delivered until 2024, and that the smartphone industry is set to grow only half as quickly as initially planned this year because of chip shortages. Other experts predict that chip shortages will last into 2023, and that legacy chips are receiving less than one-sixth of new investment spending, suggesting shortages could persist there.

We are inclined to take a middle ground: some shortages may persist into 2023, but chip supply problems should abate substantially across 2022. In fact, that assessment nicely describes the supply chain situation more broadly, and we are somewhat less negative on the outlook for supply chains on the whole than we were a few months ago.

-With contributions from Vivien Lee and Aaron Ma