Monthly economic webcast

Our latest monthly economic webcast, entitled “Probing economic resilience”, is now available.

Business cycle update

Our business cycle scorecard has been updated for the latest quarter (see next chart). The simplest interpretation is that the U.S. cycle is now in the ‘late cycle’ stage, as that is the single best estimate generated by the scorecard. That would mean the cycle has retreated slightly, as in the prior quarter it showed ‘end of cycle.’

U.S. business cycle score has retreated slightly

As of 02/02/2024. Calculated via scorecard technique by RBC GAM. Source: RBC GAM

But that arguably misses two rather larger points:

1. There continue to be a cluster of votes that span ‘late cycle,’ ‘end of cycle’ and ‘recession.’ Most of the input variables are still saying the business cycle is quite advanced – highlighting the elevated risk of a downturn – even if they can’t agree amongst themselves as to the precise location within the latter portion of the cycle.

2. A tentative trend we identified a few quarters ago has suddenly become much more forceful. The ’start of cycle’ stage had been rising subtly for a while, but enjoyed a large jump over the past quarter. This argues for the beginning of a new cycle, and thus that a recession may have been avoided. To be clear, the distribution of votes across the scorecard still indicates that it is materially less likely that a new cycle is beginning (with just 19.6% of the vote) than that an old one is nearing an end (65.9% of the vote). But a soft landing is nevertheless about twice as likely as a quarter ago according to our business cycle scorecard.

Soft landing odds rising

We argued in the January 9 #MacroMemo that the odds of a soft landing had increased, and that the probability of a hard landing had fallen. It was still more likely that a recession (hard landing) arrives in 2024, but no longer a slam dunk. Since then, the risks have continued to tilt away from recession and toward a soft landing. Both are still entirely conceivable, but – as per our business cycle analysis in the prior section – the possibility of a soft landing is coming into particularly clear view.

Recent good news includes:

• U.S. economic data has remained not just robust, but surprisingly so. January payrolls revealed the addition of 353,000 more workers, nearly double the consensus expectation.

• The ISM (Institute for Supply Management) Manufacturing Index remains weak, with a sub-50 reading. But it has nevertheless been on a path of less and less weakness, leaping from 47.1 to 49.1 in January – the highest in 15 months (see next chart).

• The new orders sub-component rose even further, bursting past the 50 threshold to 52.5 for the highest reading in 17 months. This is theoretically a leading indicator for the overall index.

U.S. manufacturing activities now reviving

As of January 2024. Shaded area represents recession. Sources: Institute of Supply Management, Haver Analytics, RBC GAM

Elsewhere, U.S. housing is also staging a tentative arrival. As a rate-sensitive sector, this carries some weight at a time when high interest rates are meant to be the main antagonist to the economy.

Some economic indicators previously emitting recession signals have recently reversed, including the willingness of Americans to purchase durable goods (now reviving – see next chart), recreational vehicle sales (also reviving – see subsequent chart), inventories (now falling – see third chart), and profit margins (now stabilizing – see fourth chart).

Buying conditions revive for large durable household goods

As of December 2023. Sources: University of Michigan, Macrobond, RBC GAM

U.S. shipments of recreational vehicles are also reviving

As of December 2023. Annual data before 2017. Shaded area represents recession. Sources: RV Industry Association, Macrobond, RBC GAM

U.S. manufacturing and trade inventory-to-sales ratio is falling

As of November 2023. Real inventory-to-sales ratio of all manufacturing and trade industries. Shaded area represents recession. Sources: U.S. Bureau of Economic Analysis, Haver Analytics, RBC GAM

S&P 500 profit margin reviving again?

As of January 2024. Shaded area represents recession. Sources: RBC Capital Markets, Bloomberg, RBC GAM

Risk assets have continued to trend higher over the past several weeks, providing a further positive wealth effect and potential positive confidence loop.

Key economic data points in a handful of other developed countries have also skewed in a positive direction:

• Canadian gross domestic product (GDP) surprised to the upside, with a 0.2% month-over-month (MoM) print in November that exceeded the 0.1% consensus, and a preliminary December print of +0.3% MoM. That adds up to a 1.2% annualized growth rate for Q4 GDP, well in excess of the roughly flat reading that had been anticipated (if not strong in an absolute sense). Canada has seemingly managed to avoid two consecutive quarters of declining GDP yet again.

• Eurozone GDP arrived flat in Q4 2023, only a hair better than the -0.1% (non-annualized) that had been anticipated, but symbolically important.

• The S&P Global UK Composite Purchasing Managers’ Index is now up to 52.9. This represents a fourth-consecutive monthly improvement and a reading consistent with an expanding business sector.

For the purposes of emphasizing that we continue to believe a recession is also still entirely possible, let the record simultaneously show that:

• Our aforementioned business cycle work continues to favour the interpretation that the cycle is old and thus vulnerable.

• The 5+ percentage point increase in short-dated interest rates should theoretically have a significantly negative effect on the economy. At a minimum, it would be exceedingly bizarre if the U.S. economy just continued to zip along as if nothing had happened.

• There is some accumulating evidence of pain from higher interest rates, with U.S. consumer loan delinquencies clearly rising and a subset of U.S. banks experiencing pain.

• Some of the special supports that kept the U.S. economy moving forward in 2023 should become less supportive in 2024, including fiscal policy and consumer spending.

• There are myriad indicators currently flashing red that have never failed to anticipate a recession. These include inverted yield curves, contracting inflation-adjusted global trade, declining U.S. temporary employment and the substantial retreat in the U.S. Conference Board’s Leading Economic Index (see next chart).

U.S. leading economic indicator has continued to fall

As of December 2023. Shaded area represents recession. Sources: Conference Board Macrobond, RBC GAM

It is a nearly impossible time to be forecasting the economy, when compelling and even “never before wrong” indicators find themselves on opposite sides of the soft landing / hard landing debate.

Do recessions require panic?

When recessions happen, the economy usually does worse than what a strict tally of the headwinds would argue. This is to say, there may be a psychological element at work.

At a minimum, we can say that recessions are usually over-reactions. The economy never stays long in its diminished state – rebounding fairly shortly thereafter, and often with vigour. Businesses regularly lay off more workers and curtail capital investments more sharply than is optimal from a medium-run perspective, requiring them to scramble post-recession to rehire lost workers and get back on track in their capital expenditure plans. Famously, the stock market usually tumbles far more deeply in a recession than a sober-minded analysis of the net present value of future earnings would warrant. In a similar vein, we have written in the past about the concept of a stall speed, below which the economy usually tumbles into recession – presumably because people panic when the economy starts to look even a little bit feeble, making a bad thing worse.

One can’t say with certainty that these are examples of irrational panic. A portion of the overreaction probably arises because businesses and investors face acute liquidity constraints during periods of economic underperformance, such as from tighter lending standards and less receptive credit markets. They are thus forced to do things that they know are not optimal.

But to the extent that some of the sub-optimal behaviour is probably due to fear-based decision-making, the question then becomes whether this psychological response is avoidable or not. Perhaps, like the flight or fight instinct, it is simply ingrained within human brains. Or perhaps we have some control over it.

It is notable that non-U.S. developed economies have suffered a considerable economic underperformance over the past year, and they yet have not succumbed to an outright recession. Nor have the countries’ financial markets collapsed. In the U.S., could it be that a recession has been prophesied for so long that people just aren’t scared of it anymore, taking emotion out of the equation?

The odds feel better than usual that people can control their emotions this time, possibly side-stepping a recession. But there are still real economic headwinds to grapple with, and it is unclear how much of any economic overreaction is the result of binding liquidity constraints rather than mere emotions.

Monetary cycles and recessions not always causally linked

Historically, monetary tightening cycles are strongly associated with recessions. A remarkable 10 of the past 13 major U.S. rate hiking cycles (77%) have been followed by a recession. The assumption is that the higher rates impose a sufficiently harsh brake on the economy as to temporarily force it into contraction.

Today’s monetary tightening cycle has so far failed to deliver that outcome. It is still early yet. History suggests, on average, a recession still wouldn’t be expected to arrive for another few months. But it is arguably worth exploring the idea a bit more deeply.

From a theoretical standpoint, it is surprisingly tricky even to reach the conclusion that higher interest rates hurt economic activity. After all, for every borrower who suffers as interest rates rise, there is a lender who celebrates. The economic damage that usually results is instead the result of more esoteric considerations beneath the surface.

When one looks back on the past several monetary tightening cycles, it is actually a stretch to say that the trailing recessions were specifically the result of higher interest rates (see next chart).

U.S. monetary tightening cycles and recessions not always causally linked

As of January 2024. Recession shading in grey. Red text = recession outcome, green text = no recession, blue text = debatable causality. Sources: Federal Reserve Board, Macrobond, RBC GAM

While a recession did faithfully follow the central bank rate hikes that took place in the late 2010s, one cannot honestly ascribe the 2020 pandemic and its initial economic consequences to interest rates.

While the global financial crisis of 2007—2009 was partially triggered by rising interest rates that contributed to the bursting of a U.S. housing bubble, the crisis was more directly the result of a prior housing boom (not solely driven by low interest rates), and very specific failures among regulators, financial institutions and securitized product markets.

Before that, the 2001 recession arguably had less to do with interest rates (though, as seemingly always, they were actively rising into the recession), and more to do with the bursting of the dot-com bubble and later the side-effects of 9/11.

One has to go all the way back to the early 1990s to find a traditional monetary policy recession in which an overheating economy pushed inflation higher, forcing central bank rate hikes, resulting in a recession. Yet even this recession is disputed. Some attribute it to the Persian Gulf crisis. Others point to the slow-motion collapse of savings and loan institutions and fiscal austerity. Thus one would need to venture back to the early 1980s and the 1970s to find classic monetary policy recessions.

This list proves nothing other than that recessions can happen for reasons other than monetary policy. But it is nevertheless interesting that it has been three if not four decades since the last episode when rising interest rates were the dominant recession-inducing agent.

While the contours of the current episode fit well into that historical template, we cannot speak with much precision about what the economic impact of the rate increases should be when so many structural changes have occurred to the economy over the intervening decades. It isn’t that an interest-rate induced recession is necessarily less likely in the modern era (it could instead be more likely). Rather, it’s that the overall impact is less clear, adding to forecasting uncertainty.

As an aside, the number of times recessions have followed rising interest rates – even when rates were not the main driver – is eerie. It is hard to imagine this is a complete coincidence. It may be that higher interest rates act as the straw that breaks the camel’s back, piling on top of the other, larger eroding forces. The confluence of these events may not be coincidental. Higher interest rates are usually delivered when an economy is overheating and other excesses (and thus problems) are most likely to come to light. Thus, rising interest rates could be as much a signal as a catalyst.

U.S. employment data send mixed signals

The latest payrolls number was robust yet again, nearly doubling expectations with 353,000 net new jobs in January. There were also +126,000 revisions to the prior two months, with the effect that the December hiring figure leapt to a similarly impressive +333,000. The unemployment rate remained unchanged at a fine 3.7%. Wage growth leapt to +0.6% MoM.

The tentative conclusion from all of this is that the U.S. economy is doing very well indeed, downplaying the risk of an imminent recession. If one wanted to critique the headline data, it would be to question the sustainability of such torrid growth, as it isn’t clear that inflation can further normalize in such a robust environment.

But what boggles the brain is that, after all of that, several important details of the jobs release tell a different story. A different component of the very same payrolls survey shows that while there were many more Americans working in January, the total number of hours they logged fell by a substantial 0.3%, the third monthly decline of the past four months. American industry is now using less labour – on an hours-adjusted basis – than it did last August.

Meanwhile, other surveys reported far less hiring. The ADP survey announced the addition of just 107,000 new workers in January – less than a third of the payrolls survey. And the admittedly volatile household survey argued that the U.S. actually shed 31,000 workers in January. By itself that might be easy to dismiss, but it constitutes the third decline in the past four months.

In short, the U.S. is either hiring at an unusually fast clip (and then squandering the extra potential hours of output these workers bring?) or laying them off at a disturbing rate (despite that fact that initial jobless claims remain quite low, as per another survey). It is hard to make coherent economic forecasts on this questionable foundation.

The number two returns to the inflation story

After several years in which inflation has logged readings as high as +9% year over year (YoY), it is a delight to observe the expanding set of inflation metrics that again begins with the familiar number of two. Given that developed-world central banks mostly aim for +2.0% targets, this is a highly symbolic development.

This is not to say that inflation problems have been fully resolved. Standard inflation metrics such as U.S. headline Consumer Price Index (CPI) and core CPI are still deeply ensconced in the threes (+3.4% YoY and +3.9% YoY, respectively). Even those in the twos are generally toward the upper end. But it is progress.

Catching the eye in recent weeks was the publication of the December Personal Consumption Expenditures (PCE) deflator and core PCE deflator. These have long been described as the Fed’s “favourite” inflation metric and both now repose below the +3% threshold. The headline PCE deflator sits at +2.6% YoY and the core PCE deflator just fell to +2.9% YoY.

To be sure, there is still an enormous range of inflation estimates (see next table), ranging from +5.1% YoY for median CPI to just +0.9% YoY for the headline Purchaser Price Index (PPI). Sector-specific readings vary even more widely (from +6.2% YoY for shelter costs to -1.9% YoY for gasoline).

Inflation estimates vary widely

As of December 2023. Sources: U.S. Bureau of Economic Analysis, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Dallas, Macrobond, RBC GAM

The news is somewhat more promising when one pivots from the 12-month rate of change to the 3-month change. This introduces additional noise, but at the advantage of revealing fresher data. The PCE deflator has increased by just 0.5% annualized over the period, with the core PCE deflator up by a tame 1.5%. The median and trimmed-mean inflation measures have also descended into the twos in recent months.

While further inflation progress is likely to be choppy and slower than the initial plummet over the past 18 months, there is still theoretically room for further improvement. In the U.S., over half of the latest monthly CPI price increase was the direct result of shelter costs, which should continue to ease with a lag. Real-time inflation metrics have also begun to tentatively decline after a multi-month wobble, arguing that CPI can also dip further from here (see next chart).

U.S. Daily PriceStats Inflation Index continues to dip

PriceStats Inflation Index as of 01/28/2024, CPI as of December 2023. Sources: State Street Global Markets Research, RBC GAM

The prize for most unconventional chart goes to this measure of online prices from Adobe, which shows that for goods purchased online, the pre-pandemic trend of moderate deflation has again been restored (see next chart). If anything, the present-day rate of decline is a little faster than the pre-pandemic norm.

U.S. online prices are already in deflation

As of December 2023. Adobe Digital Price Index captures the prices consumers paid for 18 categories of goods purchased online. Sources: Adobe, U.S. Bureau of Labor Statistics, Macrobond, RBC GAM

As one might have imagined, online prices rose unusually quickly during the earliest phase of the pandemic when many stores were closed and high-touch sectors were being avoided. By the middle of 2022 they were back to their usual spread versus overall core CPI goods inflation.

Inflation and geopolitics

Some of the most obvious upside risks to inflation extend from the turmoil in the Middle East. Oil prices have gyrated in recent weeks, reflecting the centrality of Middle Eastern nations to the global supply of oil. Tensions heightened recently after Iranian proxies bombed a U.S. military base in Jordan, prompting an ongoing U.S. response.

From a supply chain perspective, the Red Sea remains precarious as Iran-backed Houthi rebels in Yemen attempt to strike civilian vessels transiting through the Suez Canal.  The cost of shipping has been affected (see next chart), not just between Asia and Europe, but globally as the additional 10 days of travel time in each direction draw ships away from other routes.

Shipping costs rise on tensions in Red Sea

As of the week ending 02/01/2024. Sources: Drewry Shipping Consultants Ltd., Macrobond, RBC GAM

The additional shipping cost remains nothing like the supply chain crisis of 2021 and 2022, but it has nevertheless tripled. There is preliminary evidence that the cost is starting to decline again, presumably as U.S. and British military vessels provide protection. There is also the recognition that unlike last time, the underlying demand and supply have not been skewed by pandemic distortions. There are no logjams at ports and global containership capacity is expected to be 25% bigger by the end of this year than in 2021. There is still some extra inflation likely for Europe, but hopefully nothing too profound or long-lasting.

Central banks think rate cuts

U.S. Federal Reserve

The latest decision by the U.S. Federal Reserve on January 31 revealed an unchanged policy rate and a reluctance to commit to near-term rate cuts. The Fed doesn’t expect to cut rates until it has “greater confidence” that inflation is moving toward 2%. We have been saying for some time that a March rate cut is unlikely absent a recession, and indeed that appears to be the case.

The market still prices 57% of a 25bps rate cut for May 1. That date is entirely in play but could also be too early if the economy or inflation don’t point substantially downward over the next few months.

Will the Fed be affected by the 2024 U.S. election?

Questions are mounting as to how the U.S. Federal Reserve’s decision-making could be affected by the timing of the Presidential election in November of this year. The idea is that central banks proceed more cautiously around elections so as not to affect their outcome (or to be blamed for affecting them).

There is a grain of truth to this, but we are inclined to think the implications will be fairly small in 2024, for several reasons:

• The Fed is theoretically independent, such that it isn’t supposed to take into account political considerations beyond the economic implications of fiscal and regulatory policy generated by politicians.

• The Fed is likely to have already delivered several rate cuts before the election arrives. It is less controversial to keep moving in the same direction during an election, as opposed to setting off in a new direction.

• It is arguably less problematic to cut interest rates before an election than to raise them, as the incumbent will be happy and the challenger may be reluctant to criticize a decision that is popular with voters. The Fed is more likely to be cutting than hiking in 2024.

• The Fed delivered two large rate cuts in the month leading up to the 2008 presidential election, one less than a week before the vote, the other an unscheduled globally synchronized cut. When the situation demands it, the Fed will do whatever is necessary, regardless of the political calendar.

If for some reason the Fed hasn’t begun cutting rates before the fall, and if it finds itself on a knife’s edge as to whether September 17 or November 8 is the superior starting point from a purely economic standpoint, then the tie breaker could well be the November 5 election, pushing the decision to November 8.

In another scenario, if the Fed is cutting rates by 25 basis points at every second meeting, one might similarly imagine that it would prefer to cut immediately after the election rather than immediately before. But these are fairly niche scenarios, and such small perturbations don’t make much of a difference over a medium-term horizon.

Bank of Canada

The Bank of Canada continues to take a more cautious approach in its pivot from hiking to cutting than the Fed. Whereas the Fed is already talking rate cuts, the Bank of Canada’s incremental step at its latest meeting was to abandon the prior statement that it “remains prepared to raise the policy rate further if needed.” Outright interest rate cuts were deemed to be somewhat further off.

We remain intrigued by the rather different stances of the Fed and the Bank of Canada. On purely economic grounds, you would think the Bank of Canada should be the more dovish of the two, rather than the reverse, given Canada’s weaker economy and greater interest rate-sensitivity (a slight offset would be the less certain path downward for Canadian shelter CPI). We continue to believe the main difference between the two central banks is in their communication strategy. The central banks seem likely to ultimately follow an approximately similar path downward.

Emerging market central banks

As we discussed several months ago, a growing number of emerging market central banks are already beginning to cut their policy rates. Hungary, Colombia, Chile and Brazil are all prominent recent examples. Inflation in these countries has declined, allowing for lower rates.

Emerging market central banks are not a perfect leading indicator for the Fed or the developed world given that every country is unique in its own way. But it is nevertheless notable that emerging market central banks previously led the way higher, and now appear to be leading on the way down. This is just another small hint that rate cuts should indeed be coming in the developed world before too long.

Our diffusion index of the world’s central banks shows that far fewer central banks are raising rates today, that a rising fraction are cutting rates, and that cutting is now officially outpacing hiking (see next chart).

Central banks are pivoting to rate cuts

As of 01/25/2024. Based on policy rates for 30 countries. Sources: Haver Analytics, RBC GAM

China in four acts

Let us briefly examine China in four different ways – the current state of its economy, what the government is doing by way of stimulus, what it means that China is now experiencing deflation, and how China’s demographics may evolve over the coming decades.

Chinese economy

The Chinese economy is underperforming expectations. Gross domestic product (GDP) rose by just 4.1% annualized in the fourth quarter of 2023, with retail sales continuing to undershoot expectations, and the jobless rate up from 5.0% to 5.1%. Conversely, industrial production exceeded expectations in December.

The real issue remains the Chinese housing market. It is both incredibly critical to the economy – generating as much as a quarter of GDP under normal circumstances – and a source of profound weakness at present. Property investment is down 9.6% YoY on a year-to-date basis. Property sales are down 6% on the same basis. An index of Chinese home prices across 70 cities is down 0.9% YoY, the latest in nearly two years of falling prices.

China’s housing market has an outsized effect on consumer spending, as Chinese households have the vast majority of their wealth tied up in real estate. When it is underperforming, they don’t spend.

A great deal of the country’s debt is also real-estate linked, and China’s local governments are struggling as they find themselves unable to plug budget holes with land sales given weak housing demand. A Hong Kong court ordered mega-builder China Evergrande to liquidate, though its jurisdiction is disputed. It is clear that several Chinese builders are functionally insolvent, with the risk that this becomes a problem for the investors and banks that lent to the companies.

Our economic forecast for China in 2024 is for a below-consensus 4.3% gain.

Chinese stimulus

China has just delivered a 50-basis point rate cut, its largest single move since 2021. There is some debate as to whether the action is intended to revive the economy or just to provide additional liquidity during the Lunar New Year. It could well be both, providing liquidity in the near term and then providing economic assistance after that.

If the question is why China isn’t cutting rates even more given evident economic pain, the answer is threefold:

1. Reviving the housing market could be a dangerous game given the history of past excesses.

2. China’s banks already have record-low net interest margins, and lower rates might increase their pain.

3. China is already worried about its weak currency, and rate cuts could exacerbate that.

China has already delivered a few rounds of fiscal support, but more is likely. There could be another one trillion renminbi of special bonds to support growth, with a major Congress meeting in March potentially capable of unleashing more. Eventually, the bad property debt may have to be directly cleaned up.

The country’s stock market has also suffered mightily in recent quarters, with Premier Li calling for efforts to stabilize the market. Over just the past few days state-backed entities are now said to be purchasing Chinese stocks in large quantities.

Chinese deflation

Chinese producer prices have been in outright decline for a few years now, reflecting the combination of a weak economy and the normalization of global goods prices after earlier explosive gains (see next chart).

Producer prices in China have declined, may be bottoming

As of December 2023. Shaded area represents U.S. recession. Sources: China National Bureau of Statistics (CNBS), Macrobond, RBC GAM

Now, Chinese consumer prices are also falling outright, with the annual measure slightly negative (see next chart). Consumer prices have fallen on a month-over-month basis in seven of the past 12 months (see subsequent chart).

Deflationary pressure in China persists

As of December 2023. Sources: CNBS, Macrobond, RBC GAM

China grapples with deflationary pressure

As of December 2023. Sources: CNBS, Macrobond RBC GAM

Falling consumer prices are a bit surprising in light of the following:

• The Chinese economy – while underwhelming – is nevertheless doing better than it was during the 2022 lockdown.

• Much of the rest of the world grapples with excessive inflation.

• China’s currency has depreciated over the past two years (a theoretically inflationary force via higher import prices).

So why are Chinese consumer prices falling? The best answer is some combination of an aging population – drawing further parallels to Japan – underwhelming economic growth, and China’s ineffective focus on supply-side stimulus for what is arguably an inadequate-demand problem.

For the record, we are not convinced China gets stuck in deflation. It will probably run somewhat less inflation than many countries, but low positive numbers are likely over a multi-year horizon.

Still, in the meantime, Chinese deflation has raised several concerns. Some have worried about China exporting deflation to the rest of the world. We would respond that this isn’t exactly a problem in the short run given that the rest of the world has too much inflation.

Over the long run, would it be so bad if China exported deflation? It exported deflation over the past several decades in the form of ever-cheaper consumer goods, and that was a boon to the world, permitting higher consumption and lower interest rates than otherwise possible.

The bigger story, in our view, is simply that deflation is reflecting Chinese economic weakness. That means Chinese demand isn’t helping the global economy as much as it might otherwise.

Chinese demographics

China’s demographic challenges are reasonably well known, but there are still some astonishing statistics to share. Despite abandoning the country’s one-child policy several years ago, the fertility rate has continued to fall, from 1.7 in 2017 to approximately 1.0 in 2023. Like many countries, the pandemic sharply lowered China’s fertility rate, with no evidence of a subsequent rebound. Even if the fertility rate stabilizes from here, each Chinese generation will be about half the size of the prior generation. China has minimal immigration.

The number of babies born in China has fallen from about 16 million in 2012 to fewer than 10 million in 2022. Similarly, the number of new marriages in the country have fallen from 13 million in 2013 to just 6.8 million in 2022.

Even based on the United Nation’s medium-fertility variant forecast for China, the country was set to shrink from 1.4 billion people today to just 767 million by the end of the century. Combined with the assumption of modest population growth in the U.S. (to 394 million people), China goes from a population that is more than four times greater than the U.S. today to less than double the U.S. by the turn of the century (see next chart).

China’s population advantage is already shrinking

Data based on World Population Prospects 2022. Sources: United Nations, Macrobond, RBC GAM

But those projections are probably unrealistically optimistic for China, as they embed fertility rates far higher than what is being realized today. While there could yet be a turning point that sends China’s fertility rate back up, there is no evidence of that at the moment and little precedent for it internationally.

If China instead follows the UN’s low-fertility variant forecast (which itself could still be too high given recent developments!), China’s population will shrink from 1.4 billion to just 488 million by the end of the century. This would be a startling development and render China far less exceptional from a population perspective (see next chart). A disproportionately large fraction of that population would be elderly, to boot. Population is hardly everything, but when it comes to geopolitical clout and economic growth, it is a significant factor. China faces limitations ahead if the current trajectory continues.

United Nations projections show declining China population

Sources: World Population Prospects 2022. United Nations Department of Economic & Social Affairs (UNDESA), Macrobond, RBC GAM

U.S. education declining

The U.S. is not immune to fundamental economic challenges of its own. Despite a track record of impressive productivity gains, a recent point of vulnerability is the diminishing educational attainment of Americans. The fraction of the U.S. adult population with a college degree fell in 2022 for the first time in decades.

The number of students enrolled in U.S. colleges has been declining steadily for the past decade (see next chart), having been on a steady upward ascent prior to that.

Number of students enrolled in college declining since 2010 high

Sources: National Center for Educational Statistics (NCES), Digest of Educational Statistics 2022, RBC GAM

Similarly, the fraction of Americans proceeding straight from high school to college has fallen rather abruptly over the past five years. The rate has dropped from 70% in 2016 to just 62% in 2021 (see next chart).

Immediate college enrollment rate has declined since 2016

Data represents the annual percentage of high school completers who immediately enroll in 2- or 4-year college program. Sources: NCES, RBC GAM

Granted, college attendance is not the only thing that matters when it comes to assessing the state of a country’s human capital. Other important considerations include the quality of schooling, the subjects studied, whether the most talented students are the ones finding their way to college, the composition of full- versus part-time, junior colleges versus universities, and whether students later acquire professional or graduate degrees. Similarly, there are ever-expanding options for acquiring knowledge outside of a college setting, including via on-the-job training (formal or informal), certifications, free online courses, and the internet more generally.

Still, it is distressing that fewer Americans are accessing post-secondary education. Why has this happened? There are several potential explanations. Pandemic-related explanations include:

• The fear of becoming sick turned people away from school.

• Lower quality schooling during the pandemic rendered some unqualified for post-secondary education.

• Some had insufficient information about their college options when high schools and guidance counsellors operated virtually.

• Many did not want to pay full tuition for the limited experiences afforded by an online education.

• The later phase of the pandemic had an exceedingly strong job market that pulled many people out of school.

While the pandemic was temporary, the educational consequences can be lasting as it can be hard to return to school after leaving.

Given that several of the educational trends pre-dated the pandemic, other explanations include:

• College in the U.S. has become very expensive. On an inflation-adjusted basis, the average all-inclusive cost is 2.8 times higher than it was in 1980. Many out-of-state and private institutions charge far more.

This additional cost has two implications. The first is that some people are simply priced out – they cannot attend. The second is that the return to education diminishes. While highly educated people still earn substantially more than those with less education (see next chart) and enjoy a lower average unemployment rate (see subsequent chart), the internal rate of return on a university education has been in decline. After accounting for expenses and the foregone years of work, a substantial subset of majors generated an outright negative return, and others are simply less lucrative than before.

Earnings increase with educational attainment

Data as at 2022 and shows median usual weekly earnings for full-time workers aged 25 and over. Source: U.S. Bureau of Labor Statistics

Unemployment rates decrease as educational attainment increases

Data as at 2022 for persons aged 25 and over. Source: U.S. Bureau of Labor Statistics

• Whether a function of the declining rate of return on post-secondary education, discontent over perceived political leanings or concern that colleges are not preparing students sufficiently for the working world, surveys show that Americans have less confidence in the value of a college education today.

What are the implications of diminishing U.S. educational attainment? The obvious risk is that U.S. productivity growth slows, and that the earnings of Americans from one generation to the next do not rise as quickly as in the past.

There are at least two optimistic productivity counterpoints:

1. The U.S. has scored lower than many other advanced nations on international standardized tests for decades, and yet it regularly leads the way when it comes to innovation, cutting-edge companies and household incomes. It may be that the U.S. will be fine so long as most of the world’s great scientists, entrepreneurs and business people continue to be attracted to the U.S., regardless of the state of the average American’s education.

2. We continue to be optimists about technological advancement in the in the years ahead. There are a lot of exciting technologies in the pipeline that could drive rapid productivity gains whether the average American is becoming slightly less educated or not.

-With contributions from Vivien Lee, Vanita Maharj and Aaron Ma