Overview

Financial markets continue to struggle, with the U.S. 10-year yield now up to a towering 3.1% and the S&P 500 index down 15% from the start of the year. The market’s concerns revolve primarily around soaring inflation and whether this might become a structural problem. Other top concerns include brisk monetary tightening, the ongoing commodity shock, China’s economic slowdown, and the real risk of a recession over the next 18 months.

Among the key ideas in this report:

• Inflation spikes of this magnitude have historically ended in recession, though the silver lining is that the recession then pulls inflation down.
• Consumers are not currently behaving as though they expect inflation to be high for a long time.
• The labour market and economy are even tighter than they look.
• Our business cycle scorecard argues that it is still only “mid cycle,” but with indicators that are increasingly tilting toward a later interpretation.
• Economic growth appears to be decelerating, in line with our expectations.
• The present episode has parallels to many different time periods, including most obviously the 1970s and 1994. However, the similarities to the late 1940s are also striking and heartening.
• China’s economy continues to struggle badly.
• Central bank tightening continues, with significantly more to come.
• Housing markets should weaken in this rising rate environment, with Canadian home prices potentially set to fall.
• COVID-19 is of limited consequence outside of China.

High inflation

Inflation remains extremely high. The next U.S. CPI reading arrives later this week, and while the monthly rate of change is expected to decelerate, we flag the risk that it continues to exceed expectations. Our inflation forecasts look for some deceleration around the middle of this year, but remain firmly above the consensus.

Inflation remains challenging for a number of reasons. Supply chain problems are not resolving as quickly as previously imagined now that China has locked down and Russian sanctions have mounted. The labour market appears to be even tighter than official estimates would suggest (more on that shortly). And inflation has broadened in a way that makes it much harder to put back into the bottle (refer to our discussion in an earlier #MacroMemo).

Inflation and recessions

Much of the recession debate thus far has centered around how often central bank tightening cycles have culminated in recession, or the extent to which commodity shocks result in recession. These are useful analyses and suggest that the risk of recession is high over the next 18 months.

There is another, inflation-centric, way of highlighting this elevated risk of recession (see next chart). Put simply, every time inflation has risen this sharply, a recession has resulted. The sample size is admittedly small:  there are as few as three historical episodes (the big inflationary leaps of the late 1960s through early 1980s) or as many as six if smaller inflation leaps are counted.

U.S. inflation surges to multi-decade high

As of Mar 2022. Shaded area represents recession. Source: Bureau of Labor Statistics, Macrobond, RBC GAM

The inflation itself is no doubt partially responsible for the subsequent recessions. However, it should be noted that central bank tightening was also involved in the great majority of episodes.

A significant comfort is that, in all cases, inflation fell sharply thereafter. It was not quite a complete fix across the 1970s, when the inflation troughs became progressively higher, but inflation nevertheless fell by three to 12 percentage points across each of those three episodes.

Indeed, this is a useful way of thinking about the economic outlook. The risk of recession is now quite elevated, but any recession would likely be a “useful” recession insofar as it cracks inflation. That’s the most important target for the economy over the next few years, far outweighing any brief interlude of economic decline.

Further, financial markets have already given considerable thought to the prospect of recession. The stock market has already declined in anticipation of less favourable economic conditions ahead. While a further decline is entirely possible, it cannot be ruled out that markets might celebrate the taming of inflation even if it comes with economic costs. Or, markets might prove as forward-looking during this coming episode as they did during the initial phase of the pandemic. At that time a colossal economic decline was tolerated given the prospect of a full recovery later.

Consumer attitude toward inflation

It is fascinating to note how differently consumers responded to inflation in the 1970s relative to today (see next chart). In the 1970s, high inflation was viewed as a reason to pull spending forward, on the presumption that the cost of products would continue to rise rapidly, rendering them even less affordable in the future.

In contrast, today, the dominant thinking by consumers is that it is now a bad time to buy things given that their cost has recently risen so substantially.

So far, consumers are acting like high inflation is temporary – unlike in the 1970s

As of Mar 2022. Shaded area represents recession. Source: University of Michigan, Macrobond, RBC GAM

In principle, this is a good attitude to have. It means households don’t believe high inflation will be permanent. To the extent that expectations help to determine inflation outcomes, it reduces the risk that inflation will become structural.

The bad news, of course, is that it also means that consumer spending may weaken from here. Big-ticket buying intentions are already sharply lower. Some companies are reducing their production on the expectation of weaker consumers. At the same time, discount retailers and discount brands are beginning to report superior outcomes as consumers become more cost-conscious.

Of course, and at the risk of giving the reader whiplash, some consumer spending caution might well be an ideal outcome. Consumer spending – especially on goods – is presently overheated and any normalization could sharply reduce supply chain pressures. This in turn could help to tame high inflation without requiring too much economic suffering.

Labour market tightness

The U.S. labour market is supposed to be looser than it looks, but it is actually tighter. Let us unpack that claim.

The standard means of gauging labour market tightness is the unemployment rate. By this measure, the U.S. unemployment rate has essentially returned to pre-pandemic lows. This gives the impression of a moderately tight labour market.

But the standard criticism is that the unemployment rate fails to capture those who have dropped out of the labour market. Indeed, the level of U.S. employment is still more than a million workers below the pre-pandemic norm, and this despite the fact that the population has grown over the two intervening years. Viewed through this lens, there is still a secret reservoir of economic slack remaining.

However, we posit it is the opposite. It would appear that enough people have retired early or permanently exited the labour force that the decline in workers does not add significant slack to the labour market. Furthermore, via more finely tuned measures, the labour market is the tightest it has ever been.

The number of people feeling sufficiently emboldened to quit their jobs is now well beyond the peak of the past several cycles (see next chart). Meanwhile, businesses are attempting and frequently failing to find new workers. This is evidenced by job openings that are nearly 50% higher than the prior peak as a share of the number of employed people (see subsequent chart). Company-level anecdotes abound to this effect.

Voluntary separations in U.S. surged

As of Feb 2022. Estimates for all private non-farm establishments. Shaded area represents recession. Source: Bureau of Labor Statistics, Macrobond, RBC GAM

U.S. job openings rate hovers near record high

As of Feb 2022. Estimates for all private non-farm establishments. Shaded area represents recession. Source, Bureau of Labor Statistics, Macrobond, RBC GAM

Examined by a different set of measures, it is notable that wage growth is unprecedentedly strong among fast-food workers – a sign that even the least-skilled workers in the labour force are in high demand (see next chart). Another frequently neglected group – part-time workers -- has nearly caught up to the wage growth of full-time workers (see second chart).

Wage growth of U.S. low-skilled workers surged

Limited-service restaurants as of Feb 2022, total private non-farm as of Mar 2022. Source: Bureau of Labor Statistics, Macrobond, RBC GAM

Wage growth of part-time workers is catching up to full-time workers

As of Mar 2022. 12-month moving average of median wage growth. Source: Federal Reserve Bank of Atlanta, Macrobond, RBC GAM

All of this is to say that this isn’t just a tight labour market, but a generationally tight labour market. In turn, the economy really is overheating. This economic momentum constitutes an important source of high inflation, albeit alongside others. Central banks and fiscal policy are also partially to blame for the tightness of the economy. It will accordingly take more than just an easing of supply chains to bring inflation back down – an economic deceleration is also necessary.

European inflation pressures build

We have generally been less concerned about inflation in Europe than in North America. After all, the Eurozone economies are not overheating to the same extent. Their inflation rate has been reliably lower than in the U.S., their aging populations are inherently deflationary, and the Eurozone has a history of undershooting its inflation target.

However, a number of factors now conspire to make European inflation as problematic as in North America:

1. Most obviously, European economies are most exposed to Russian sanctions and the commodity shock.
2. Relatedly, a surprisingly large amount of Chinese-made goods destined for Europe transit via train through Russia. A total of 24 million metric tons worth of goods made the trip in 2020 alone. This is no longer possible and so the goods attempt to crowd onto already over-burdened ships.
3. The level of unionization is much higher in the European Union (EU), averaging 23% versus 10% in the U.S. Wages are more likely to be indexed to inflation in Europe, or to rise in response to inflation. This may make it harder for the EU to tame inflation later.

Consistent with this view, Eurozone inflation rose quite sharply in March. It jumped from +5.9% year over year (YoY) in February to +7.4% YoY. It is now a mere percentage point below the U.S.

Wage and price controls unlikely

A key component of the 1970s inflation experience was the imposition of wage and price controls by the U.S., U.K. and Canada. This was in an attempt to tame inflation by manually forcing down wages and prices, sidestepping the underlying economic forces that were generating the inflation.

Ultimately, these attempts were unsuccessful, at least in any regard other than temporarily boosting U.S. President Nixon’s popularity in the months leading up to the 1972 election.

In practice, it proved very difficult to control prices and wages. A massive bureaucracy formed around the attempts.

Distortions immediately arose in the economy. It was no longer economical to sell some products. The supply of meat took a particularly sharp hit. Investment decisions were distorted based on the extent to which controls arbitrarily pinched or expanded profit margins in different sectors. Manufacturers were motivated to avoid price-controlled domestic markets and instead sell their products to foreign markets where they could receive a fair price.

As the program stumbled from problem to problem, increasingly convoluted rules were added. In some cases, wages were allowed to rise, but only to a certain cap. Food and energy prices were eventually exempted, meaning that the most volatile inflation components were no longer under the purview of the program. In some cases, companies were allowed to increase their prices if their own costs had gone up (which, one would imagine, applied to virtually all businesses). Hearings had to be held to justify price and wage changes.

Wage controls didn’t apply to job changes or promotions. This motivated workers to leap from company to company. In an attempt to limit the damage, companies were incented to create ever more labyrinthine organizational charts to permit dubious promotions.

Of even greater importance, the wage and price controls didn’t ultimately succeed. Already leaking, as soon as they were lifted, prices snapped back to where they would have been absent the measures.

Given the stench associated with the initial attempts, it seems unlikely that policymakers would seriously wish to go down this path again. In the U.S. context, a divided Congress renders such programs all but impossible. But it isn’t impossible that politicians will muse about such programs if inflation remains persistently high and interest rates begin to bite. Programs like wage and price controls represent the sort of magical (if impossible) solutions that are attractive to voters.

Deflation later?

In theory, one might expect a period of weaker-than-normal inflation at some later point, as various price distortions abate. Supporting this notion, it is hard to imagine that shipping costs must remain permanently high, that used cars must be forever so much more expensive than before, or that food prices must be permanently higher even after farmers adjust to the new supply-demand dynamic.

But these prospective reversals don’t guarantee a period of weak inflation or outright deflation. After all, these reversals may occur at a time when inflation pressures are still somewhat elevated, meaning that inflation might be lower than otherwise, but not strictly low.

Furthermore, wages have now accelerated and there is normally a resistance toward nominal wages falling later. This is to say that any increase in wage costs is likely permanent. As such, prices have to remain somewhat higher than before for companies to finance this permanent burden.

Presented from a completely different perspective, after a decade of high inflation in the 1970s, the 1980s were not a decade of deflation or unusually low inflation – the rate of inflation normalized but the level of prices never returned to the 1960s trajectory.

Key to understanding this idea is that central banks target the rate of inflation, not the level of prices. They just want to get back to 2% inflation, not to undo the overshoot in prices that has already happened. To them, a period in which inflation is lower than target is just as undesirable as a period of high inflation. And so a normalization of inflation is more likely than a significant undershoot, though we do flag the risk that inflation could be temporarily low in the event of a deep recession.

Business cycle advancing

Our U.S. business cycle scorecard continues to point to a “mid cycle” conclusion (see next chart). That brings with it a fairly benign interpretation from both an economic and a financial market standpoint.

U.S. business cycle score remains “mid cycle”

As of 04/29/2022. Calculated via scorecard technique by RBC GAM. Source: RBC GAM

However, the cycle continues to rush forward at an unusually fast clip. Whereas the “early cycle” score was nearly as high as the “mid cycle” score a quarter ago, the “early cycle” claims have since plummeted, and have been replaced by a significant rise in the “late cycle,” “end of cycle” and “recession” scores. In fact, according to the scorecard, it is almost as likely that the cycle is at “late cycle” or beyond as that it is “mid cycle.”

We have tended to opine that this business cycle will likely be shorter than prior cycles, perhaps on the order of a five-year cycle rather than a 10-year cycle. But, with the distinct possibility that the cycle could look “late” within the next quarter or two and given elevated recession risks, it could be that this cycle only ends up lasting three or four years instead.

U.S. economic weakness

U.S. hiring remained strong in April, adding 428,000 workers. The unemployment rate remained at a low 3.6%. Hourly earnings continued to grow in the realm of +5.5% YoY.

Canadian employment added a more modest 15,000 new workers in April, though the unemployment rate ticked to a new generational low of just 5.2%.

We suspect hiring will slow somewhat in the coming months. Businesses still express enthusiasm about adding workers and it could be that they remain keen even as the economy decelerates given prior struggles to achieve their targeted workforce size. However, it seems more likely that the pace of hiring will ease from here.

Indeed, some economic deceleration is visible elsewhere. The U.S. Institute for Supply Management (ISM) Manufacturing and Services indices have both decelerated recently, though they are consistent with further moderate economic growth.

The New York Fed’s Weekly Economic Index – which had been utterly boring over the past two years given its nearly constant rate of ascent – has now rolled over. This seems to reflect worsening economic conditions (see next chart).

New York Fed Weekly Economic Index has rolled over

For the week ended 04/23/2022. Change vs. 2019 derived by linking WEI for current and WEI for the same week a year ago. Source: Federal Reserve Bank of New York, Macrobond, RBC GAM

Similarly, if less clearly, the Organization for Economic Co-operation and Development’s weekly tracker for U.S. gross domestic product (GDP) has also begun to edge lower (see next chart).

OECD tracker of U.S. GDP growth is edging lower

Weekly Tracker as of the week ending 04/23/2022, actual GDP as of Q1 2022. Weekly GDP levels approximated during actual quarterly GDP and knew interpolation. Source: OECD Weekly Tracker (Woloszko, 2020), Macrobond, RBC GAM

All of this makes sense given the headwinds presented by high inflation, a commodity shock, rising interest rates, a slowing China and declining confidence. Our forecasts continue to anticipate a substantial deceleration in growth across 2022 and remain below the consensus for both 2022 and 2023.

One curious and seemingly contrarian indicator is U.S. commercial and industrial loans. They have accelerated at precisely the moment most other indicators are slowing (see next chart). Perhaps borrowers were locking in borrowing at guaranteed rates before the increase in borrowing costs. Or, maybe they are borrowing on a precautionary basis on the view that their access to credit might diminish later and that additional liquidity could be useful during an economic downturn.

U.S. credit growth climbing

As of the week ending 04/13/2022. Source: Federal Reserve, Macrobond, RBC GAM

Un-intuitively, the fact that U.S. GDP shrank by 1.4% annualized in the first quarter of the year does not constitute a further argument that economic weakness is upon us. That reading arguably did not reflect the broader economic conditions in the country. It was undermined by two forces:

• a huge inventory build in the prior quarter that made the latest quarter appear relatively anemic
• a surge in imports that reflected domestic U.S. economic demand even as imports constitute a mathematical negative for GDP.

Late 1940s parallels

It is useful to seek out historical parallels for the current economic experience in the hope of gleaning what comes next. The most obvious parallel lies with the 1970s, when inflation was also extremely high. We have written about the similarities and differences to that experience in the past, and will likely revisit it in the near future. There are also some parallels to 1994, when central banks delivered sudden and aggressive rate increases – another parallel for future discussion.

Today, we spend a moment contemplating the similarities to the 1946-1950 experience in the U.S, in the immediate aftermath of World War II. There had been a high level of household savings during the war, and a limited ability to spend – much like during the pandemic.

With soldiers returning home, there was a boom in demand as many entered the workforce, got married, and bought homes, appliances and cars. There has been a similarly positive demand shock today as pandemic restrictions have faded and economies restarted. In the late 1940s, there were supply shortages as manufacturing plants were being retooled from military to civilian purposes. The underlying reasons are different today – having more to do with lingering pandemic lockdowns and altered demand preferences – but the outcome is quite similar: insufficient supply relative to demand.

Inflation accordingly rose sharply in the late 1940s, much as it is rising quickly today. And central banks intervened then, as they are doing today.

What was the end result? A fairly mild recession occurred in late 1948 through 1949, subtracting 1.7 percentage points off the level of economic output. The unemployment rate peaked at a tolerable 7.9% and prices actually fell somewhat thereafter.

The stock market tumbled by 17% from its peak in June 1948 to June 1949 (a fairly small decline relative to some recessions), and had already recovered that lost ground by early the next year.

Clearly, the situation is not a perfect parallel to today: price controls were part of the mix in the late 1940s and are unlikely to be used today. The unemployment rate was actually rising in the late 1940s given that there had been virtually zero unemployment during the war. While inflation is high today, prices do not tend to be as volatile today as they were then. Outright deflation is thus less likely to accompany any economic slowdown.

Perhaps the most important difference between then and now is that the late 1940s came after a war while this episode came after a pandemic. This is not a trivial distinction. Historically, wars tend to be inflationary while pandemics tend to be deflationary.

Despite these caveats, there are more similarities than differences. The four key takeaways include:

1. A recession resulted.
2. It was fairly mild.
3. High inflation was successfully tamed.
4. The stock market decline wasn’t much larger than the present retreat, and was quickly unwound.

These wouldn’t be such bad outcomes if they prove true for this cycle.

Weakness in China’s economy continues

Recent examples from the country’s official economic data include:

• Chinese exports rose by just 3.9% YoY in April, down from a +15% YoY gain in March.
• Retail sales are now down 3.5% YoY. This is an extremely rare decline for a country with an economy that normally grows 6-8% per year on a real basis and 7-11% on a nominal basis.
• Chinese car sales fell by 10.5% YoY in March. This is an unusual development for a country with a rising middle class.

The real-time data makes similar claims. Chinese traffic congestion has lately declined (see next chart). While that is lovely for Chinese drivers, it reflects weaker economic conditions. Subway traffic remains quite depressed, though it is slightly less low than a few weeks ago (see subsequent chart).

Index shows lower traffic congestion in China

As of 05/04/2022. Indexed to January 2021. Index reflects congestion in China’s top 15 cities by vehicle registrations. Source: Bloomberg, Baidu, RBC GAM

Subway traffic in major Chinese cities remains depressed

As of 04/27/2022. Index is the weighted 7-day rolling sum of subway trips in Beijing, Guangzhou, Nanjing, Shanghai, Suzho and Zhengzhou. Source: Chinese metro agencies, Macrobond, RBC GAM

Naturally, all of this is happening due to the country’s zero tolerance campaign against COVID-19 infections. Shanghai has, if anything, locked down further over the past week, while Beijing continues to teeter on the edge of a broader lockdown. This has impeded Chinese demand and production, and now also spills over into the rest of the world through the aforementioned deceleration in exports. Incredibly, the volume of goods exported from the Shanghai port fell by 23% between mid-March and mid-April.

The Chinese government continues to endeavor to support the economy through this difficult period, recently announcing a pause in regulatory changes crimping the technology sector. Still, it seems quite unlikely that policymakers will be able to achieve their targeted +5.5% growth rate for 2022.

Despite these many challenges, a key positive thought remains. Eventually, these lockdowns will end and China will be unleashed. It is unclear when that tailwind will arise. It could come in the next few months whenever Shanghai restrictions are lifted (see next chart for the remarkably rapid decline in Hong Kong infections – possibly a bellwether for China). Or it may take place after President Xi has been elected to an unprecedented third term and the country takes a less draconian stance toward COVID-19, or at a different time after China inoculates its population with more effective mRNA vaccines. If we are lucky, the revival might happen around the time that the global economy is otherwise stumbling into an economic slowdown, tempering the extent of the dip.

COVID-19 cases and deaths in Hong Kong have fallen rapidly

As of 05/08/2022. 7-day moving average of daily new cases and deaths. Source: Our World in Data, Macrobond, RBC GAM

Central banks continue to tighten

To no one’s surprise, central banks continue to tighten monetary policy and with a sense of urgency.

As anticipated, the U.S. Federal Reserve hiked the fed funds rate by 50 basis points on May 4, lifting the policy rate to 1.00%. The central bank will start selling off its distended balance sheet on June 1. The accompanying commentary emphasized that the Fed is “highly attentive” to inflation risks and that “ongoing” tightening remains appropriate. The market quite reasonably expects further 50 basis point rate increases at each of the June 15 and July 27 meetings.

The Bank of England has been marching to a somewhat different drummer, to its credit starting its tightening cycle in late 2021 (before the others). It is now somewhat more questionably proceeding in just 25 basis point increments. Its policy rate has increased to 1.00%, but appears on the cusp of being left behind by the U.S. policy rate.

Housing risks

Housing markets are at particular risk as interest rates rise, given that they are among the most interest rate-sensitive sectors of the economy.

In the present context, central banks are focused to the exclusion of nearly all else on high inflation, meaning that they are willing to tolerate economic weakness as they raise rates. The significant run-up in home prices over the past two years likely means they won’t cry too many tears if home prices actually fall modestly.

On this note, affordability is significantly worse than it was a few years ago, by virtue of truly gargantuan home price gains in many developed nations. That represents a further housing market headwind.

Finally, should economic activity actually slow, that would exert a third downward pressure on the housing market.

On the other hand, during a period of high inflation, real assets such as real estate tend to be highly valued to the extent they provide a natural hedge against inflation.

U.S. housing should cool

U.S. housing should cool – and already is, according to a number of metrics including mortgage applications. However, the downside should be fairly limited for a number of reasons:

• Home builder sentiment, while declining, is still quite confident.
• U.S. household debt-servicing costs remain extremely low.
• Affordability is not bad by historical standards, and quite good by international standards.

American homeowners traditionally have 30-year mortgages, meaning that very few existing homeowners will have to renew at a higher mortgage rate. Prospective new buyers will, of course, be substantially affected (see next chart). But the setup looks nothing like the global financial crisis (which had more to do with lending practices than a housing bubble).

U.S. mortgage rates are rising rapidly

As of 04/25/2022. Source: Freddie Mac, Macrobond, RBC GAM

Our best guess is that U.S. home prices will flatten but not fall significantly as rates, affordability and a slowing economy bite.

Canadian housing is at high risk

Canadian housing is also seemingly now cooling (see next chart). Housing starts and building permits are now settling back down, and resale activity is in modest decline. Sentiment in the market also seems to be souring.

Canadian housing starts have been falling since last summer

As of Mar 2022. Number of units of housing starts and value of building permits. Source: Canada Mortgage and Housing Corporation (CMHC), Haver Analytics, RBC GAM

Fundamentally, Canada’s housing market would appear to have more headwinds than the U.S., and indeed than most markets (see next graphic).

Housing is at risk in many countries as rates rise after a big price run-up. Canadian housing is particularly vulnerable to correction.

As at 04/28/2022. Source: RBC GAM

While mortgage rates are rising everywhere, the popularity of the five-year term in Canada means that, in addition to new buyers having to pay higher mortgage rates, a non-trivial number of existing mortgage-holders will have to grapple with a higher borrowing cost over the next few years. Those with floating home equity lines of credit will have to pay more immediately.

Housing affordability has deteriorated particularly badly in Canada over the last few years, and is now conservatively 25% offside. A return to more historically normal mortgage rates would render home prices more like 35% too high (see next chart). Granted, housing has been expensive in Canada for years and that hasn’t served as much of a depressive force. But the difference could be that the affordability gap is now approaching levels not reached since the early 1990s, after which the Canadian housing market suffered an enduring bust. Incredibly, Canadian home prices since the turn of the millennium have more than tripled, nearly doubling the U.S. rate of appreciation over the same time period.

Canadian housing affordability gap

As of Q4 2021. Fixed floor imposes a minimum “normal” mortgage rate in the affordability calculations, and so reveals how affordability would look at “normal” mortgage rates. Source: Canadian Real Estate Association, Statistics Canada, Haver Analytics, RBC GAM

Presented in a different fashion, while Canadian households are now spending an unusually small share of their income servicing the interest on their debt, they are spending a significant amount servicing the interest plus principal on their debt (see next chart). With the interest portion set to rise significantly, it won’t take much for household debt servicing – expansively defined – to command a record share of income.

Canadian household debt service burden fell during the pandemic

As of Q4 2021. Debt-service ratio defined as cost of interest payments on debt only. Average effective interest rates since 1995. Source: Statistics Canada, Macrobond, RBC GAM

Unlike in many jurisdictions, Canada is simultaneously tightening its housing market rules. The most recent change is to ban foreign buyers. This comes on top of other measures designed to take some of the loft out of the market. These include initiatives to achieve greater transparency in the bidding process and to discourage the ownership of multiple properties. There are also initiatives in some provinces to increase the supply of housing – a worthwhile initiative, but one that could soften home prices.

An important counterpoint for Canada is that immigration is set to be unusually high over the next few years as the government seeks to compensate for under-immigration during the pandemic (see next chart). That should help housing demand.

Canada now bringing in more immigrants than in pre-pandemic times

As of Feb 2022. Source: Immigration, Refugees and Citizenship Canada (IRCC), Macrobond, RBC GAM

Furthermore, after the global financial crisis, economists searched for measures that might predict housing market/household debt busts. It turned out that this was surprisingly elusive. Arguably the best metric focused on the extent to which household credit growth was running unusually faster relative to the historical norm. Fascinatingly, on this basis, the risk of a household credit bust in Canada is apparently quite low right now (see next chart).

Household credit vulnerability turns lower as economy reopens

As of Q4 2021. Trend calculated using Hodrick-Prescott filter on quarterly data with lambda of 500,000. Source: Haver Analytics, BIS, Bank of Canada, RBC GAM

It is also heartening that most Canadian households were able to meet their financial obligations going into this period of rising interest rates (see next chart). Canadians are protected, in part, by incremental rule tightening over the last 15 years. Among other things, this shift requires highly leveraged Canadian home buyers to be tested against significantly tougher mortgage rates than those that prevailed at the time of their home purchase.

Little evidence of borrower stress

Residential mortgage in arrears for 3+ months. Non-mortgage delinquency rate of 90+ days. Source: Canadian Bankers Association, Equifax, RBC GAM

Thus, it isn’t all bad for Canadian housing. The real X-factor relates to home buyer psychology. For the last two decades, newly formed households have been highly motivated to enter the housing market as quickly as possible given that home prices have really only gone in one direction – upwards – and have generated enormous returns when one accounts for the leverage deployed by most homebuyers.

As such, the first instinct in response to any decline in home prices could simply be renewed demand as buyers perceive homes to be “on sale.” This is what happened in early 2017 after only a few months of sharp regulation-induced declines in home prices.

Alternately, home buyer mentality could change more enduringly, in which case a substantial and sustained decline in home prices might occur.

Scenario analysis is useful to sketch out possible outcomes. A realistic base-case scenario is for a 10% cumulative decline in Canadian home prices by the end of 2023. Combined with rising incomes (and partially offset by rising rates), that would nibble away at the affordability problem without fully resolving it. Presuming interest rates overshoot neutral, a subsequent decline in interest rates back to a neutral or below reading might help eliminate half of the affordability gap.

A positive scenario (for homeowners and the economy in the short run, if not for aspiring home buyers) is home prices that rise by 5% over the next 18 months, where a soft economic landing is achieved and interest rates don’t have to rise as far as currently imagined.

A negative scenario is for home prices to fall by 25%, fully resolving the affordability gap and unwinding much of the extraordinary run-up in home prices from the past two years. A decline of this magnitude could result in material distress for some recent homebuyers, with spillover effects.

COVID infections

Despite the circulating Omicron variant and a variety of sub-variants, global infections and deaths have declined nicely since early 2022 (see next chart).

Global COVID-19 cases and deaths have declined

As of 05/08/2022. 7-day moving average of daily new cases and new deaths. Source: Our World in Data, Macrobond, RBC GAM

Most developed-world cases are again in decline, while the lagging U.S. may be near peaking.

Of potential note, South African infections are rising again as southern hemisphere winter approaches.

We assume there will be something like two virus waves each year going forward, but that they will have only a limited economic impact given high levels of vaccination and natural immunity, and given a reluctance by governments to lock down again.

The World Health Organization and others estimate that the BA.4, BA.5 and XE sub-variants may be in the realm of 10% more contagious than the BA.2 variant that currently dominates the world. It is unfortunate that yet more contagious variants continue to manifest, but the difference is far slighter than prior advances, and it is heartening that these latest variants have failed to make a major leap in immune escape or severity.

Lastly, a new U.S. study calculates that 58% of Americans had infection-induced COVID-19 antibodies as of February. Given that the antibodies fade over time, that suggests well over 58% of Americans have been infected at some point over the past two years. That sounds about right.

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