Monthly webcast

Our monthly economic webcast for January is now available, entitled “Omicron is the latest hurdle for economic recovery”.

Quarterly outlook

Our quarterly economic outlook – focused on the prospects for 2022 – is available here.

Overview

The latest MacroMemo covers familiar terrain, but with new information and perspectives. Topics include Omicron trends and properties, lockdown implications, the hawkish Fed, and weakening economic data, plus a review of China, supply chain problems and inflation.

Infections

Globally, the world now reports more than twice as many new COVID-19 infections each day as the prior peak (see next chart). Fatalities remain far lower than earlier peaks due to less-severe infections, though the variable responds with a lag.

Global COVID-19 cases and deaths

As of 1/7/2022. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

The bulk of the new infections are in the developed world, though emerging-market cases are now beginning to rise as well (see next chart).

COVID-19 EM vs. DM infections

As of 1/6/2022. Calculated as the 7-day moving average of daily infections. Source: WHO, Macrobond, RBC GAM

Incredibly, the pace of reported Canadian infections now outdoes the prior daily record by more than five times. The U.S. briefly recorded more than a million infections in a day (admittedly distorted by adjacent holiday days), with every U.S. state now reporting a rising infection trend. The fraction of countries reporting rising infection rates is the greatest since the earliest stage of the pandemic (see next chart).

Countries reporting rising daily new COVID-19 cases

As of 1/6/2022. Change in cases measured as the 7-day change of 7-day moving average of daily new infections. Source: WHO, Macrobond, RBC GAM

It is an open question whether emerging markets will be as adversely affected as developed countries by Omicron: the fact that South Africa experienced a huge number of infections and EM populations tend to be less vaccinated argue “yes,” but the variant has been slower to spread in many EM countries so far and such countries have built up a high level of natural immunity from prior waves. Indian infections are beginning to rise – a key test will be how badly EM nations will be hit.

It is fair to criticize official infection estimates because they underestimate the true number of people becoming sick. While this has been true to varying degrees throughout the pandemic, it is arguably most true today given an extreme shortage of tests relative to demand. The percentage of tests returning positive results offers a hint as to the degree of under-counting, and the test positivity rate is now higher than it has been at any other point of the pandemic, including the early days (see next chart). So, even as infection counts set records, these numbers are likely underestimating the true infection rate to a record extent.

COVID-19 cases and positivity rates in the U.S.

As of 1/6/2022. 7-day moving average of daily new cases and test positivity rates. Source: Our World in Data, WHO, Macrobond, RBC GAM

It is a similar story in Canada (see next chart; it isn’t clear whether the recent decline is real or a function of an earlier testing bottleneck).

COVID-19 cases and positivity rates in Canada

As of 1/6/2022. 7-day moving average of daily new cases and test positivity rates. Source: Our World in Data, WHO, Macrobond, RBC GAM

Understanding Omicron

Our initial assumptions about Omicron have proven correct: the variant is indeed more contagious, more vaccine-resistant and less deadly. What has changed is that there are a growing number of figures to substantiate those qualitative claims.

More infectious

Rough estimates put Omicron’s natural reproduction rate (absent special measures to mitigate spread) at as high as 10. This means that each sick person would infect 10 other people – quite a leap from the original strain that had an (also high) reproduction rate of around 2.5. The Delta variant may have had a natural reproduction rate of nearly 7, for context.

Of course, the world is currently aware of COVID-19 and taking precautions. When Omicron first arrived, it had an effective reproduction rate – the rate at which it was actually spreading against a backdrop of the moderate precautions taken last fall – of three to four. To put the virus into retreat, that effective reproduction rate needs to be driven down below one.

For historical context, Omicron is not the most contagious virus of all time as narrowly defined by its natural reproduction rate. That honour goes to measles: each sick person with measles can expect to infect 15 more people, versus around 10 for Omicron.

However, Omicron may well be the most contagious virus of all times via a broader definition. Each generation of measles infections is spaced by around 12 days (meaning that the 15 people become sick 12 days after the first person was infected). In contrast, each generation of Omicron infections is only 4 or 5 days apart. As such, the person sick with Omicron becomes ten people, then a hundred, and finally a thousand people in the same time it takes measles to infect 15. By this standard, Omicron is truly incredible.

Lower vaccine efficacy

Vaccines and antibodies from prior infections don’t work as well against Omicron. Indeed, that partially explains its high level of real-world infectiousness.

The efficacy of mRNA vaccines appears to decline from 50—80% versus the Delta variant to just 20—25% when pitted against Omicron. Fortunately, a third booster then increases the vaccine efficacy rate against Omicron back up to around 75%.

Scientists estimate that people who were previously sick are five times more likely to be infected by Omicron than by the Delta variant.

Fortunately, not all of the news is bad. Evidence is mounting that being infected by the Omicron variant then provides future protection against a future Delta infection. This is key, since all of these Omicron infections would do little for achieving herd immunity unless the antibodies and T-cells left behind protected against the Delta variant that is still circulating (and more deadly).

Further, while vaccines appear to be less effective at protecting against Omicron, the second line of defense – in the form of cell memory and the body’s T-cells – still mostly functions. This explains why people with vaccines or earlier infections can still become sick but frequently have milder symptoms than the unvaccinated. One study finds fully vaccinated patients spend just four days in the hospital, on average, versus nearly two weeks for those who are unvaccinated.

Omicron less dangerous

It is hardest to speak with precision about how much less deadly Omicron may be versus earlier variants. Medical experts frequently describe it as operating more in the upper respiratory system as opposed to lower respiratory – with the implication that the symptoms tend to be less severe.

South Africa reports an 80% reduction in hospitalizations per case of Omicron versus other variants – a huge decline. Studies from Denmark, Scotland and New York State claim around a two-thirds reduction.

However, these estimates may exaggerate the true decline in the intensity of Omicron infections. More people are vaccinated or have natural immunity today relative to earlier waves. Surely this accounts for part of the milder outcomes. Work done by the World Health Organization and Imperial College argues that, controlling for these variables, the risk of being admitted to a hospital for a day or longer is 40-45% lower than with Delta.

Of course, infections have risen so much that the decline in bad outcomes per infection still leaves most hospitals with surging demand (see next chart) and many hospitals entirely overrun. This is curiously variable: hospitals in South Africa were never overwhelmed relative to earlier waves; those in the U.K. are similarly well below earlier peaks, whereas the likes of Canada and the U.S. are already setting records (albeit with better average outcomes for the people hospitalized). Further, while the average person admitted spends less time in hospital than during prior waves, this nonetheless may mean there are far, far more people spending at least some time in hospital than during prior waves.

COVID-19 hospitalizations in developed countries

Based on latest data available as of 1/9/2022. Source: Our World in Data, Macrobond, RBC GAM

When does Omicron peak?

The Omicron wave has already peaked in South Africa, with daily infections more than half way back to normal (see next chart). There are reports that London – another early-affected location – is beginning to come down as well. As such, it may be that this wave is unusually tall but also quite brief.

COVID-19 cases and deaths in South Africa

As of 1/7/2022. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

Some epidemiologists predict that the U.S. and some other countries could experience a peak in their daily infection rate in January. This doesn’t seem entirely unreasonable: people are socializing less, the holiday season is now in the rear-view mirror, infections fell sharply in January last year and the fraction of the population with immunity – whether artificially or organically acquired – is rising.

All of that said, it should theoretically take quite a lot to shift an infection with an effective reproduction rate of three as of late December down to a rate of less than one (allowing the virus will fade). If governments ease their restrictions in the coming weeks or people begin to behave less cautiously again, it is entirely possible that Omicron infections heat up again.

Further, and approached from a different angle, it seems unlikely that vaccination campaigns plus Omicron infections have blanketed enough of the population in the span of less than two months to reduce the number of individuals vulnerable to infection by a factor of three. That’s what would be needed to get the reproduction rate from three down to one. In turn, we flag the possibility that Omicron begins to fade in January but then revives shortly thereafter as restrictions ease, burning through additional people until something approaching herd immunity has been achieved.

While prior waves were generally defeated for good once the infection rate began to fall, the circumstances for each were arguably special – the first wave ended when people learned to wear masks and socially distance, and as warmer weather arrived. The second wave ended with the introduction of vaccines. The most recent Delta wave never had a chance to be resolved before the Omicron variant overran it. Perhaps warmer weather will lend a helping hand when the spring arrives.

Lockdowns intensify

The Omicron wave is now inflicting economic damage via three main channels.

First, many countries are tightening their rules, not just with regard to mask requirements and capacity limits, but to the point of shifting school online, ending in-person dining, and closing gyms, bars and entertainment venues.

Second, people are behaving more cautiously as they perceive the risk of infection to be greater.

Third, and arguably a more powerful consideration than during prior waves, the large number of people getting sick is having a real effect on the supply of labour. Many workers are out sick, isolating due to contact with someone ill or taking care of someone who is sick. This limits economic activity. There are widespread reports of significant absenteeism among hospital workers, ambulance drivers, teachers, bus drivers, flight attendants, dock workers, and more.

How much economic damage?

There are a few ways to estimate how much economic damage could occur as a result of the Omicron wave.

Historical context: Canada’s lockdown in April-May 2021 subtracted 1.5 percentage points off the level of GDP during that period. This time should be a bit worse: government restrictions are similar but more people are sick and so unable to work. Abstracting away from Canada, it would seem reasonable for the economic damage of this wave to be somewhat greater than for the several previous waves, but considerably less than the first wave.

Lockdown severity: Our lockdown severity measure argues that behaviors have changed significantly over the past month, to a greater extent than at any other point since the first wave (see next chart). In turn, the economic damage should be greater. It must be conceded that this metric always seems to fall around the holidays, but the drop in most countries is greater this year than last year (and don’t forget that there was also a wave of infections at this time last year, so some of that damage was real).

Severity of lockdown varies by country

Based on latest data available as of 1/3/2022. Deviation from baseline, normalized to U.S. and smoothed with a 7-day moving average. Source: Google, University of Oxford, Macrobond, RBC GAM

Goldman Sachs estimates its own effective lockdown index for the world, and figures that about one percent of global economic output has been lost to the latest tightening of the screws. To the extent that restrictions are disproportionately concentrated in the developed world, one might argue the temporary damage could be as much as twice that in developed nations.

It is important to understand that temporarily losing 1% of economic output does not mean that annual GDP growth will be 1 percentage point lower. That would only be true if the level of output was depressed for a full year. To the extent that output might be depressed here for a month or two, the net effect should only be a few tenths of a percentage point off of annual GDP.

Rough calculations: We can also approximate the economic damage via back-of-the-envelope calculations. If we imagine that every second person will miss five days of work due to the Omicron variant (either because they are sick, isolating or taking care of someone), that represents the loss of 1% of the entire year’s economic output, and as much as 5.5% off the level of output over the few months of the disruption. But this almost certainly exaggerates the damage since companies may hire more workers to fill this hole, existing workers may work overtime, some may work from home while isolating or even sick, some will deploy vacation days that would otherwise have been used at a different time, and some may simply work harder when they return.

Combining these different approaches, it seems reasonable to expect the Omicron variant to impose temporary damage of between 1% and 3% to the level of GDP, with considerable variation by country. Our bias is toward the smaller end.

Hawkish Federal Reserve

Alongside surging Omicron infections, the hawkish U.S. Federal Reserve has been the other key macro theme of the past two months. Recently, stock markets have expressed some trepidation about the Fed’s newfound enthusiasm for tightening, and the tech sector in particular has been affected given the impact that interest rates have on the worth of future earnings.

In truth, this mounting hawkishness is not a new theme, nor is it unique to the U.S. This trend has been significantly afoot since at least last summer, and most countries’ central banks – China is a rare exception – have been tilting in a more hawkish direction, either raising rates or signaling that such increases are on their way for 2022.

In the U.S. case, the Fed had already indicated in mid-December that its pace of bond buying would decelerate twice as fast as previously planned, to the point that its net purchases will be done by this spring. Further, the Fed now anticipates three rate hikes across 2022, in line with market expectations.

The latest news has come from the Fed minutes – a delayed-release summary of the discussion surrounding the central bank’s mid-December decision. In it, Fed participants expressed a greater urgency with regard to unwinding stimulus than previously expressed.

The timing of “quantitative tightening” is now being discussed. This refers to the process of actively selling bonds and thereby reducing the size of the central bank’s balance sheet – the next step after tapering. Fed Chair Powell has indicated that whereas quantitative tightening didn’t begin until three years after quantitative easing had ended in the aftermath of the global financial crisis, the gap need not be nearly so great this time.

Since then, some Fed participants have indicated that rate hikes could come as soon as March.

The motivation behind all of this, of course, is that the U.S. unemployment rate is now below 4% while inflation is above 6% – quite low and high levels, respectively, and both arguing for tighter monetary policy.

We should emphasize that, while higher interest rates represent a headwind for short-term economic growth and have created trepidation in financial markets, this monetary hawkishness is hardly all bad. The main reason is that rate hikes appear to be entirely appropriate: to leave the policy rate at just 0.125% in the face of multi-decade inflation highs and a tight labour market would be inappropriate, and risk bringing about a premature end to the business cycle.

Furthermore, our own research finds that, while the stock market tends to be choppy around the time of the first rate hike, more often than not equities continue to advance over the 12 months after a first hike, albeit at a more moderate rate than in the year before that hike.

It should be noted that the Omicron wave has intensified since the Fed last formally expressed its views, and that the U.S. job numbers undershot expectations. These could slightly dampen the Fed’s enthusiasm, but probably not significantly.

Real-time economic data weakens

Real-time economic data has begun to weaken in response to the Omicron wave. With implications for the many businesses serving office workers, office occupancy has collapsed over the past month (see next chart). It is normal for office occupancy to fall somewhat during the holiday season, but not nearly to this extent. Incredibly, a number of U.S. cities now sport office occupancy rates that are below their worst reading from the spring of 2020. These will obviously rebound when the Omicron wave recedes, but they speak to the severity of this wave relative to earlier waves.

Office occupancy of U.S. metropolitan cities

As of the week ending 12/29/2021. The Barometer represents the weekly office occupancy based on swipes of access controls. Source: Kastle Systems, Bloomberg, RBC GAM

U.S. air travel is now declining again. This is not the first time that has happened, but the decline is notable. This move is not all demand-driven, as the supply of airline pilots and flight attendants has been slashed by illness.

Air travel in U.S.

As of 1/6/2022. 7-day moving average change compared to same weekday of prior years. Source: TSA, Macrobond, RBC GAM

Lastly, we note that the Bank of America’s real-time consumer spending measure has faded over the past month (see next chart).

U.S. aggregated daily card spending

As of 01/01/2022. Total card spending (7DMA) includes total BAC card activity which captures retail sales and services which are paid with cards. Does not include ACH payments. Source: BofA Global Reserarch, RBC GAM

Traditional economic data mixed

The traditional economic data has been more mixed, in significant part because it is now dated relative to the arrival of Omicron.

U.S. employment in December rose by 199,000 net new positions, less than half the consensus forecast, though still solid by any non-pandemic standard. Financial markets didn’t express too much concern, buoyed by the reduction in the unemployment rate from 4.2% to just 3.9%, robust hourly earnings and ongoing strength in other labour market indicators including jobless claims, the quits rate (see next chart) and the number of job openings relative to unemployed people (see subsequent chart).

Voluntary separations in U.S. surged

As of Nov 2021. Estimates for all private nonfarm establishments. Shaded area represents recession. Source: BLS, Macrobond, RBC GAM

U.S. labour market shortage

There are more jobs than unemployed

As of Nov 2021. Source: BLS, Macrobond, RBC GAM

Canadian employment, in contrast, managed to best expectations in December, rising by 54,700 positions versus a consensus of just half that. Full-time additions were particularly notable, and Canada’s unemployment rate also passed a milestone, falling from 6.0% to 5.9%. For context, a “normal” unemployment rate in Canada is about 2 percentage points higher than the U.S., so the two countries appear to be in broadly similar positions (though the U.S. labour force participation rate fell more powerfully, such that the U.S. is still several million jobs shy of pre-pandemic levels, whereas Canada has already exceeded that threshold).

Promisingly, employment in British Columbia was flat – a positive outcome in the context of the record flooding that took place in late November and early December. Further evidence that the floods weren’t quite as damaging as feared is that the flash estimate for Canadian GDP in November was +0.3% – a positive reading in contrast to fears that the country might shrink during the month as a result of the natural disaster.

In the European Union, the unemployment rate has fallen to 7.2%, nearly as low as the pre-pandemic norm. That said, the accomplishment isn’t quite as impressive as it first sounds. The EU unemployment rate never rose as high as in North America because the region’s governments pursued a policy of paying people to remain associated with their employer throughout the crisis.

Turning to Purchasing Manager Indices (PMIs), with the exception of China’s strong PMI, most other countries are reporting slightly weaker readings, while remaining consistent with solid economic growth. The U.S. ISM Manufacturing Index fell from 61.1 to 58.7 in December. The ISM Services Index tumbled from a giant 69.1 to 62.0.

The Eurozone Composite Purchasing Manager Index edged lower, from 55.4 to 53.3 in December. We suspect these readings will soften further in January with the onset of the Omicron wave.

Inventory plans

A source of anticipated economic strength for 2022 is inventory accumulation. Businesses express an unprecedented enthusiasm to increase their inventory levels (see next chart).

U.S. businesses plan to build inventory

As of Nov 2021. Shaded area represents recession. Source: NFIB Small Business Economic Survey, Haver Analytics, RBC GAM

There is a risk that businesses could be misguided in their aspiration to build inventory levels because a) they have been traumatized by recent supply chain problems that will soon begin to fade; and b) they expect sales to remain elevated indefinitely (whereas sales in some goods sectors will likely recede when the service sector revives).

However, most of the desire to increase inventories appears to be legitimate: the inventory-to-sales ratio is low relative to where it stood before the pandemic (see next chart). Furthermore, the drop in the inventory-to-sales ratio is not merely because sales are running especially hot right now. The raw level of inventories has also declined (this is an important consideration – the spike in the inventory-to-sales ratio that manifests each recession has less to do with inventory levels rising than with sales falling).

U.S. inventory-to-sales ratio continued to decline

As of Oct 2021. Real inventory-to-sales ratio of all manufacturing and trade industries. Shaded area represents recession. Source: BEA, Haver Analytics, RBC GAM

China

The good news out of China is that the country’s government is now focused on “stability” and thus supporting growth during what has been a difficult period for the economy. Reflecting these efforts, the country’s purchasing manager index recently turned significantly higher, and China’s credit impulse has finally turned positive again after a long period in negative territory (see next chart).

Chinese credit impulse turned positive

As of Nov 2021. Measured as year-over-year change of 3-month rolling average of sum of total social financing excluding equities and local government bond issuance as % of GDP. Source: Haver Analytics, RBC GAM

Still, we continue to highlight the significant economic challenges that confront the country. In addition to structural demographic issues and supply chain problems, China’s zero tolerance policy in the face of among the most contagious viruses in history is set to create problems. China has already locked down a number of cities, including Xian (population 13 million) and Tianjin (population 14 million). Further, China’s lockdowns have tended to be much more aggressive than those in other countries, preventing people from leaving the city, and prohibiting going outside for anything other than essential purposes.

This will inevitably do damage to Chinese manufacturing production and exports. China’s main COVID-19 vaccine is also reported to perform particularly poorly against the Omicron variant. As such, China could experience some of the most adverse economic consequences from Omicron, despite having relatively few cases.

Elsewhere, the problems with Chinese builders continue, even as the credit impulse turns higher. The trading of Evergrande shares was temporarily halted and the company was ordered to tear down an entire block of apartments that had been illegally constructed. But that distracts from the main issue, which is that the company (and several others) have defaulted on their foreign debt, and now Evergrande is negotiating with domestic creditors to delay payment on its domestic debt. At a minimum, the company has significant liquidity problems. At worst, it may also have solvency problems.

On a different Chinese front, the South China Morning Post reported that, over the past 11 months, more than three times as many small Chinese businesses have closed as have opened. The rate of closures has not exceeded openings in two decades. This would suggest that not all is vibrant with the Chinese economy. We remain comfortable with our below-consensus sub-5% GDP growth forecast for 2022, though we do believe the government will succeed in stabilizing growth once the Omicron wave has washed through.

Fiscal tidbits

Efforts by the U.S. White House to deliver a major spending bill were quashed by maverick Democratic Senator Manchin, who refused to support the initiative. As a result, the Democrats fall one vote shy of delivering a major accomplishment for President Biden. The White House will now pivot toward a more modest vision.

Among a wide range of consequences, any future spending won’t be particularly stimulative for the economy since it will have to be substantially funded by higher taxes. U.S. climate change mitigation initiatives also have a more difficult path toward implementation.

Turning to Canada, the country’s fall fiscal update unleashed an additional $67 billion in new spending over the next six years. This doesn’t make the projected debt-to-GDP ratio any worse as fast growth and (especially) high inflation have improved the projected fiscal balance by even more than that. Nevertheless, it represents money that might have been spent to reduce the deficit or even pay off the debt – leaving less room to deal with future crises.

Supply chain contradictions

It remains hard to judge whether the supply chain is starting to improve or not. We are inclined to say “yes, slightly”, though Chinese lockdowns could temporarily exacerbate the problem, and there is certainly no shortage of indicators that still claim the situation remains quite bad.

Such measures include the New York Fed’s new Global Supply Chain Pressure Index, which is in the realm of its worst-ever reading (see next chart). Other key indicators we track – including the cost of shipping by water and the number of ships waiting to unload in southern California – are still quite sour.

Global supply chain pressure at record high

As of Nov 2021. Shaded area represents U.S. recession. Source: Gianluca Benigno, Julian di Giovanni, Jan J.J. Groen, and Adam I. Noble. “A New Barometer of Global Supply Chain Pressures,” Federal Reserve Bank of New York, Liberty Street Economics; Macrobond, RBC GAM

There is no evidence that rabid demand for computer chips has significantly eased, as evidenced by surging Taiwanese electronics exports (see next chart).

Taiwan electronic product exports

Taiwan Ministry of Finance, Macrobond, RBC GAM

So what makes us feel even slightly better about supply chains these days? There are four things.

First, air cargo rates have plummeted from mid-December peaks. Companies were willing to pay a premium to get their products to market for the holiday season, and that urgency has now faded.

Second, and continuing with the seasonal theme, the first quarter is normally an opportunity for supply chains to catch-up as demand tends to be weakest during the quarter. This should really kick in once Chinese New Year (February 1) is over.

Third, we suspect many companies have front-loaded their purchases. Faced with a difficult procurement environment, many will have over-ordered in an effort to get ahead of any further deterioration. That may translate into reduced shipping needs later.

Fourth, and meriting the heaviest weight in our evaluation, the ISM Manufacturing supplier deliveries index and prices paid index have both improved significantly (see next chart). The supplier deliveries index is suddenly at a 13-month low, which is a welcome development and signals real improvement. To the extent this is the one measure actually asking businesses how their supply chain is functioning, it is quite promising.

U.S. manufacturers complain less about suppliers and prices

As of Dec 2021. Source: ISM, Haver Analytics, RBC GAM

Inflation toppish?

Inflation remains extremely high. The Eurozone recently announced a +5% year-over-year (YoY) inflation print for November, its highest on record. Japanese core inflation, while still extremely low by any international standard, just leapt to +0.5% YoY and may increase further. It would have been higher were it not for government-mandated cuts to the cost of telecom services.

The next U.S. inflation release is imminent and is expected to yield another modern-day record of +7% YoY.

Oil has continued to rise, imposing further short-term pressure.

However, we believe inflation is not far from a peak.

From a purely base-effects perspective, it will be hard for the year-over-year inflation measure to continue rising beyond the spring, as future monthly gains would have to outpace the big monthly increases falling out of the equation from a year ago.

The two key drivers of high inflation are supply chain problems and high oil prices. But supply chain issues may be starting to resolve, as discussed earlier.

We also continue to expect somewhat lower oil prices in 2022. The oil futures market remains in backwardation (a signal that the market is betting on lower prices later), and the International Energy Agency forecasts that oil supply will again exceed demand before too long.

As mentioned earlier, the ISM Manufacturing prices paid index recently fell quite sharply, suggesting that companies are experiencing some relief.

Finally, the real-time inflation measures we track have recently hooked slightly lower. While the move is hardly definitive, at least they aren’t actively rising. And it should be noted that, for the U.S., the measure argues that U.S. inflation should currently be around +4% rather than nearly +7%.

-With contributions from Vivien Lee and Aaron Ma