Overview

• Financial markets have rebounded significantly over the past week, and are acting less like inflation is going to be persistently problematic.
• The war in Ukraine has, if anything, become slightly more problematic from an economic standpoint.
• Economic weakness continues to mount in the latest figures, with the risk that a negative confidence shock joins the various real economic shocks.
• Inflation is still quite high and problematic, but may be slightly less frightening than before as some of the products whose prices rose early start to settle down and expectations ease.
• The risk of recession remains high, but is perhaps slightly less high thanks to diminished inflation concerns.
• The peace dividend that helped to drive growth over the past three decades has now been lost. This shift has a variety of subtly negative implications.
• China’s economy could be about to stabilize as restrictions ease and stimulus is applied.

Signs of market reversal

High and rising inflation is, of course, bad for most traditional investments. It pushes bond yields higher (and thus bond prices lower). It usually hurts the stock market as future earnings become less valuable given higher discount rates. In this environment, stocks and bonds can both weaken at the same time. That’s bad for investment portfolios.

Promisingly, this undesirable dynamic is becoming less pronounced. In recent weeks, there have been significant stretches of time when the two asset classes were moving in opposite directions. Most visibly, bond yields fell significantly (bond prices rose) while the stock market also tumbled. This hints that markets are becoming a bit less worried about structurally high inflation, if more worried about the risk of recession. While recessions are hardly something to cheer for by themselves, they are preferable to structurally high inflation.

Most recently, risk assets including equities have been rising as Chinese lockdowns ease and as inflation fears have diminished slightly (seemingly without adding to recession fears).

While predicting the direction of markets is never easy, there is the distinct risk that markets have bounced too far recently. Our risk appetite metric remains consistent with the considerable risk of a recession (see next chart).

Investor risk appetite weighed by inflation worries and Russian invasion

As of Apr 2022. Measures risk appetite based on 45 normalized inputs. Grey area represents recession. Source: Bloomberg, BofAML, Consensus Economics, Credit Suisse, Federal Reserve Bank of Philadelphia, NedDavis, Haver Analytics, RBC GAM

The stock market decline since the start of 2022 reflects a re-evaluation of what constitutes fair value for the tech sector and a decline in broader market valuations to more historically normal readings. But it has not yet reflected a significant re-thinking of corporate earnings in an economic slowdown. Corporate earnings were still strong in the most recent reported quarter and analyst forecasts have not yet priced a significant hit to earnings in the future.

Furthermore, there is some risk to corporate margins. Corporate margins have expanded seemingly without limit over the past several decades, explaining in large part the outperformance of the stock market versus the broader economy. Up until recently, companies had passed through the entirety of their dearer input costs to their customers. But, increasingly, consumers are beginning to push back as they shy from making discretionary purchases and opt for down-market brands. This could reduce margins for the remainder of the cycle.

All of this is to say that we remain somewhat more subdued in our investment risk-taking than we were in 2021, even as the market enthusiastically rebounded over the past week.

The inflation tax

As a sobering aside, and illustrative of how hard it is to make money in a high inflation environment, even if the stock market were to rise by 10% over the coming year – a robust outcome – at an 8% inflation rate and a 25% tax rate that translates into a -0.5% inflation-adjusted return! Unless you are earning more than 10% per year on a nominal basis, you aren’t actually getting any wealthier right now.

Alas, there aren’t any easy ways to dodge this inflation tax. The outcome would be even worse in anything yielding less than 10%, or in vehicles that receive less favourable tax treatment than the stock market.

Still, one can nevertheless identify theoretical winners and losers in a high inflation environment.

Losers include:

• The overall economy
• Those borrowing at a variable rate
• Companies with weak pricing power
• Retirees on a fixed income
• Investors in long-term bonds

Conversely, winners include:

• Investments in real assets, such as property or precious metals (though neither seem particularly well positioned to fully benefit this cycle)
• Resource producers
• Companies with strong pricing power
• Retirees with indexed pensions
• Those borrowing at a fixed rate

The stock market lands somewhere in the middle. It benefits from faster nominal earnings growth and the ability to raise prices in response to higher costs. But it is hurt by lower valuations due to a higher discount rate.

Update on Ukraine war

On the military front, Russia continues to make incremental advances in eastern Ukraine. Pundits play up Ukraine’s various small victories and the balance may yet tilt in Ukraine’s favour as the U.S. commits to $40 billion of support versus the gradual degradation of Russian weaponry. Yet it can’t be said that a pivot has happened yet.

The odds of a ceasefire by December 2022 remain low – markets assign just a 17% chance. In fact, sanctions and trade restrictions remain more likely to rise than fall from here. In particular, Russia’s oil and natural gas supplies could yet be crimped further.

Fracturing Western resolve

Some fracturing of the Western resolve against Russia is now becoming visible. After Russia blocked pipelines that send natural gas to Poland and Bulgaria – presumably seeking to sow discord – Bulgaria struck a deal outside of the European Union (EU) with Russia to resume natural gas shipments.

EU efforts to ban the importation of Russian oil have stumbled after Hungary refused to cooperate and Slovakia has expressed concern. A deal may still be possible with certain carve-outs.

Meanwhile, Turkey is blocking Finland and Sweden’s efforts to join NATO. This may eventually be overcome via some form of sweetener for Turkey, but the point is that the West is no longer speaking with a single voice about Russia.

As the war in Ukraine slips from the front pages, there is the risk that governments will cease to be as willing to fund the war, proffering further advantage to Russia.

Commodities

We continue to flag upside risks to energy prices. In theory, the 2 million barrel per day mismatch in the oil market could justify substantially higher prices in the future. Even if that doesn’t come to fruition, U.S. refineries are sufficiently stretched by the reconfigured global oil market so that U.S. gasoline prices could yet rise significantly further.

On natural gas, the risks lie at both ends of the pipelines. Not only is the West trying to wean itself off Russian natural gas, but Russia is now actively blocking certain flows. Ukraine has itself at times limited the flow of certain gas pipelines that transit across the country. So there are several ways that natural gas could become scarcer.

Data showing economic deceleration

The economic data continues to decelerate, as flagged in our prior MacroMemo. Our own growth forecasts remain below the consensus and the consensus outlook for most countries fell over the past month.

The Citigroup Economic Surprise Index has plummeted into negative territory for the U.S., and is falling fast across the G10 (see next chart). This is to say, economic data is underperforming expectations after having regularly exceeded them at the start of the year.

Global economic surprises plunge U.S. in negative territory

As of 05/25/2022. Source: Citigroup, Bloomberg, RBC GAM

A number of retailers are beginning to report more cautious consumer behavior. Walmart announced underwhelming earnings and observed that profit margins were shrinking. Both Walmart and Target reported that buyers are shifting toward household essentials, shying away from discretionary spending. That’s a sign that consumers are becoming stressed by high inflation. Along similar lines, and as reported by a range of retailers and manufacturers, shoppers are resorting to buying cheaper brands as cost pressures build.

The appetite for big ticket purchases has been depressed for some time and continues to fall, though it should be conceded that the relevant survey has indicated a moderate distaste for such items across the pandemic, even though actual spending was quite strong for much of the period.

Negative confidence shock

Rising borrowing costs paired with higher fuel and grocery bills are damaging pocketbooks. They have also bled into confidence readings.

Business confidence has fallen sharply according to the Conference Board’s CEO Confidence index, descending from robust readings over the past two quarters to outright weak ones in the second quarter of 2022. Responses are now more negative than positive, and are especially negative in Europe.

Businesses have already significantly scaled back their inventory-building plans. The obvious risk is that they also scale back their hiring and capital expenditure plans – decisions that would have wide-ranging implications for the economic outlook. The U.S. rate of hiring has decelerated slightly in recent months, and weekly jobless claims have begun to edge higher (see next chart).

U.S. jobless claims starting to rise, though still around pre-pandemic levels

As of the week ending May 21, 2022. Shaded area represents recession. Source: Department of Labor, Haver Analytics, RBC GAM

Consumer confidence has also been hit, with consumers beginning to alter their behavior. The question is the extent to which battered consumers opt to go on a buyer’s strike, withholding spending on discretionary items that they deem to be “too expensive” due to rampant inflation, or because they are fearful of future job losses, even if they technically have sufficient funds to afford the items.

Housing begins to turn

As interest rates rise, the most interest rate-sensitive sector is inevitably beginning to turn lower. In the U.S., new home sales fell by a large 17% in April, with the rate of sales now below pre-pandemic levels after a long period of elevated activity (see next chart). For the moment, housing starts are still holding up (see subsequent chart).

U.S. new home sales have been declining after initial pandemic spike

As of Apr 2022. Shaded area represents recession. Source: U.S. Census Bureau, Macrobond, RBC GAM

U.S. housing starts remain robust throughout the pandemic

As of Apr 2022. Shaded area represents recession. Source: Census Bureau, Macrobond, RBC GAM

Elements of the Canadian housing market are also beginning to turn, including the outer suburbs of Toronto reporting lower prices.

Other trends

A few other economic trends merit highlighting.

The first is that Germany’s weekly economic activity index is seemingly rebounding after a challenging spell during the initial phase of the war in Ukraine (see next chart). It remains to be seen whether this can be sustained. We are assuming not.

Deutsche Bundesbank Weekly Activity Index rebounding for now

As of the week ending 05/22/2022. Weekly Activity Index estimates the trend-adjusted growth rate of economic activity by comparing the average over the past 13 weeks to the average of the preceding 13 weeks. Source: Deutsche Bundesbank, Macrobond, RBC GAM

Finally, we flag that U.S. new business applications are retreating, but from an extremely high level (see next chart). This probably isn’t something to worry about given that the level of entrepreneurial zeal remains nearly double the pre-pandemic norm. It isn’t entirely clear why there was such a surge in business applications during the pandemic. Competing explanations include that society was refashioned so substantially during the pandemic that many new business opportunities appeared; that so many businesses failed that there was room for new businesses to form; that a lot of people lost their jobs during the pandemic and some became entrepreneurs; or that government financial supports were sufficiently generous that people had the financial means to start new businesses.

U.S. business applications in retreat, but from very high level

As of week ending May 7, 2022. 1-year moving average. Source: U.S. Census Bureau, Macrobond, RBC GAM

Easing inflation worries

Inflation remains extremely high and is thus quite worrying. European inflation recently joined the U.S. in the realm of 8%-plus readings and most inflation prints continue to land above the consensus expectation.

But we are perhaps a bit less concerned than we were a few weeks ago. This is because several original contributors to rising inflation are themselves beginning to reverse, or seem on the cusp of turning.

Car prices – especially used car prices – soared over the past two years. These are now finally beginning to decline (see next chart), though they have a long way to go before they resemble pre-pandemic norms.

U.S. vehicle prices are starting to decline

As of 04/2022. Source: U.S. Bureau of Labor Statistic (BLS), Macrobond, RBC GAM

Dwelling costs should generate less inflation pressure as home prices cool.

The fact that people are downgrading their purchases to cheaper brands suggests a measure of price-sensitivity among consumers, such that corporate pricing power will likely decline. Companies will lose customers if they continue to ram prices higher at the current rate.

Inflation expectations have finally turned lower, in large part because so much monetary tightening is now priced in (see next chart). Expectations can be self-fulfilling, so this is a useful development.

U.S. inflation expectations high but falling

As of 05/25/2022. Source: Bloomberg, RBC GAM

The rate of U.S. wage growth could also be starting to slow, at least when measured on a 3-month percent change basis (see next chart). This runs counter to theory given the tightness of the labour market and the intensity of inflation, so it could prove temporary. Then again, if hiring were to continue slowing in the coming months, the trend could become more sustainable.

U.S. wage growth may be slowing

As of 04/2022. Source: BLS, Macrobond, RBC GAM

If China’s lockdown materially eases – as discussed later in this report – that would be an important amelioration to supply chains and might reduce inflation pressures.

Finally, the global economic deceleration itself should take some pressure off inflation.

This isn’t to say that the case for lower inflation is air-tight – merely that it has strengthened. There is still a worrying amount of breadth to inflation pressures. Inflation is no longer coming from just cars and homes and bicycles. Foods seemingly unconnected to Ukraine or Russia, including coffee and citrus fruits, are now surging (see next chart). So are services that would not seem to be in particularly high demand, like dry cleaning costs (see subsequent chart).

U.S. food inflation surging in citrus and coffee

As of 04/2022. Source: BLS, Macrobond, RBC GAM

U.S. laundry and dry cleaning costs also rising

As of 04/2022. Source: BLS, Macrobond, RBC GAM

As discussed earlier, there remains upside risk to energy prices for three main reasons:

• There is the prospect of more intense restrictions on Russia.
• We’re seeing disciplined production from other energy producers.
• The oil market was already tight before the Russian war.

Supply chain problems also remain intense and have proven more difficult to resolve than expected.

Even as the demand for goods fades, the demand for services is picking up and there are theoretically more inflation pressures to be felt in that space, especially given that the goods sector already hired much of the available labour.

To reiterate, the inflation risks are now less skewed to the upside. But it is not a certainty that inflation will descend smoothly from here, despite several favourable signals.

Recession risk musings

The risk of recession over the next few years is considerable – the highest it has been in some time. This is a subject we have already addressed at length in recent MacroMemos here and here.

That said, a continuation of the economic expansion over the next few years is entirely achievable, if requiring some good luck to achieve. Inflation would have to fall faster than generally expected, perhaps because of a rapid improvement in supply chains, or an earlier resolution to the war in Ukraine. Or the economy would need another boost to growth, perhaps if the Chinese economy re-energized especially enthusiastically.

Still, there have been a pitter-patter of conflicting recession signals recently.

Small businesses report that inflation is the most problematic that it has been since the early 1980s (see next chart). This suggests damage is starting to be done to the business sector, which, via hiring and investment decisions, could rapidly infect the rest of the economy.

Inflation is becoming increasingly problematic

As of Jan 2022. Shaded area represents recession. Source: NFIB Small Business Economic Survey, Haver Analytics, RBC GAM

Longer-dated bond yields have fallen over the past month. As short-term rates continue to rise on rate hiking, this begins to flatten the 3-month to 10-year yield curve – a signal of rising recession risk.

Central banks are certainly anticipating economic damage from efforts to tame inflation. In the U.S., Federal Reserve Chair Powell predicts “some pain” while former New York Fed President Dudley argues that a recession is inevitable as inflation is squeezed from the system. The Bank of England explicitly predicts a recession in the U.K. in 2023.

Conversely, a closer examination of historical monetary tightening cycles suggests recessions are somewhat short of certainty after monetary policy tightening cycles. Yes, 10 of the past 13 U.S. tightening cycles (77%) are associated with a recession that arises within the next few years (see next chart).

U.S. monetary tightening cycles are associated with a recession

As of 04/2022. Recession shading in grey

However, this obscures some important nuances:

Several of the recessions arguably had causes other than monetary tightening. At a minimum, it is clear that the pandemic-induced recession of 2020 had nothing to do with the monetary tightening cycle of the prior few years. One can also debate whether the monetary tightening between 2004 and 2006 could possibly have been the primary cause of the 2008—2009 recession when so much time had passed and given poor lending and borrowing practices.

The list goes on. An optimistic interpretation might conclude that just 7 of 13 tightening cycles created subsequent recessions. That’s only 54% of tightening cycles – close to a coin toss.

Even more promisingly, only one of the last six monetary tightening cycles obviously created a recession. Each of the others had other plausible explanations (though monetary tightening was likely partly to blame). So extreme optimists can claim that the risk of recession from a modern tightening cycle is just 17%. However, there are a sufficient number of other economic headwinds and recession signals today that the risk is surely higher.

On the other hand, one might observe that when tightening cycles are dealing with very high inflation – as were the tightening cycles from the late 1960s to early 1980s – a recession resulted 100% of the time.

For that matter, it is cheating to insist that the monetary tightening cycle of 2016—2019 managed to avoid a recession at the end. We’ll never know: the pandemic got in the way. Prior to that, there had been mounting late cycle and end of cycle signals, yield curves were inverting, and so on.

Rather than attempting to assign precise causality for every recession, it is perhaps more useful to observe that it seems like quite a coincidence that recessions come into view so regularly right after monetary tightening occurs. In many cases, recessions are the result of particular sectors overheating, and it just so happens that central banks also tend to be tightening when things are overheating. Given this, it is still reasonable to associate monetary tightening cycles with things about to go wrong somewhere in the economy. But it isn’t a 100% guarantee, especially in the modern era.

Recession timing hypotheticals

Were a recession to occur, when might it happen? There is a fairly wide range of options. Given the recent decline in confidence, it is conceivable that a recession could happen as soon as late this summer, though that would require quite a deterioration over the next few months.

Conversely, and at the opposite extreme, a recession might not happen until the middle of 2023. Classically, it takes a year or two for monetary tightening cycles to induce recessions.

Recession depth hypotheticals

Would a hypothetical recession be shallow or deep? This is also hard to say – it really could be either. But it is still useful to lay out the arguments on both side of the ledger.

There are several arguments for a deeper than usual recession. This monetary tightening cycle is more aggressive than usual, and central banks are less likely to cut rates to soften any recession. Historically, mild recessions have sometimes failed to tame structurally high inflation – a deeper economic decline might be needed. For that matter, economies are arguably operating well past capacity. This isn’t formally reflected in output gap estimates or even in unemployment rates, but it certainly feels that way based on job openings and quit rates. A mild recession might barely reduce economies to their potential level of output, and so would be insufficient to properly tame inflation. Finally, there are so many headwinds conspiring at once against growth that a deep recession is quite possible.

On the other hand, a mild recession is also possible. The main argument – and it is a powerful one – is that there aren’t great excesses in the economy that need to be wrung out. There isn’t a financial crisis brewing or a massive dot-com bubble. All that is really needed is an attitudinal change toward inflation.

After all of this recession talk, we feel compelled to reiterate once more that while the recession risk is undoubtedly high, it is not certain.

Central banks continue to tighten

North American central banks are moving about four times faster than normal this tightening cycle. In the past, they have tended to deliver 25 basis point rate hikes at every second meeting, whereas today they are raising their policy rates by a large 50 basis points at every meeting.

The Bank of Canada is poised to deliver another 50 basis point rate hike this week, and another similarly-sized action later in the summer. The U.S profile is the same, albeit lagged by two weeks. Quantitative tightening efforts are also getting underway.

The European Central Bank has been a late-comer to this monetary tightening cycle, but has finally signaled rate increases starting later this summer. The decision was particularly tricky in the Eurozone given that, due to the war in Ukraine, the region grapples with the greatest inflation pressures but also suffers the most economic damage. These, of course, argue for opposite monetary remedies. But inflation is the dominant focus at present, necessitating higher interest rates.

The path of Eurozone monetary policy may be more important than commonly appreciated, for several reasons:

• The Eurozone has an enormous economy, not much shy of the U.S. – so European monetary policy matters.
• It is arguably useful for the Eurozone to escape from the negative interest rate environment it has been stuck in for the better part of the past decade. This created a variety of distortions and made life very difficult for investors who were confronted by as much as 30% of the world’s bonds sporting a negative yield. Merely on the expectation of rate hikes, this has since plummeted to just 5% of bonds (see next chart).

Share of bonds with negative yields has dropped substantially

As of 05/23/2022. Percentage of bonds in Bloomberg Barclays Global Aggregate Bond Index trading at negative yields. Source: Bloomberg, RBC GAM

• European Central Bank bond purchases compressed peripheral European sovereign spreads. Ending these buying programs means that borrowing costs in countries like Greece and Italy may increase more sharply than elsewhere. There is already some evidence of this (see next chart). The risk of a sovereign debt crisis seems manageable, but it is no longer near-zero.

Eurozone periphery-German yield spreads have risen on rate hike worries

As of 05/27/2022. Spread of Eurozone periphery countries and German 10-year government bond yields. Source: Macrobond, RBC GAM

• The search for yield during the era of ultra-low interest rates meant that trillions of dollars of European money fled the Eurozone in search of higher-returning bonds. This created big financial flows, but also served to depress bond yields in other markets as demand exceeded supply. Some of these flows and effects may now begin to reverse.

Peace dividend lost

It is worth examining the old concept of the “peace dividend” as the world now grapples with what it means for western nations to be newly in opposition to Russia and, to a lesser extent, China.

The peace dividend refers to the economic and societal benefits accrued after the Cold War ended. Most visibly, countries were able to reallocate military spending toward other areas – the classic guns vs butter debate – or to reduce their fiscal deficits. As military borrowing and spending ceased to crowd out other objectives, economies benefited.

The peace dividend also encompasses the boost to trade and globalization after newly peaceful countries were in a position to interact more meaningfully with one another. International cliques dissolved, international trust rose, technology transfers increased and human suffering decreased. With a lag, literacy rates and life expectancy rose after the end of the Cold War in Eastern Bloc countries, and infant mortality rates fell.

Of course, in the present context, all of these forces are now running in reverse. The peace dividend has been lost due to recent Russian actions on top of gradually mounting antagonism between China and the West.

The International Monetary Fund conducted some research into the effect of military spending on the overall economy. The gist is that in an environment of rising military spending, the economic impact is roughly neutral over the first five years as extra military spending is balanced by less spending elsewhere. This is followed by a moderate economic hit in subsequent years as second-round effects prove negative. Over the long run, and in the context of NATO members conceivably increasing their military spending in the future from around 1.5% of GDP to the targeted 2.0% of GDP, their economies may end up around 0.3 percentage points smaller than otherwise.

This is not a lot of damage, but it is counterintuitive given that governments are considering increasing spending rather than decreasing it. The study arguably underestimates the full economic cost of losing the peace dividend, failing to capture the direct damage to globalization from things like sanctions and redirected supply chains.

We wrote specifically about the challenges to globalization in mid-April. An additional thought worth sharing – albeit a contrarian one – is that there is some evidence from the mid-19^th century and from the 1970s that periods of high inflation are followed by periods of strong globalization as companies desperately look for ways to control their mounting costs. Given the simultaneous increase in geopolitical strains today, that feels like an optimistic assessment. But it is not impossible, and is worth keeping in mind.

China to stabilize?

Globally, COVID-19 has retreated from earlier peaks, and seems poised for a sleepy summer (see next chart). What future variants may bring in the fall and beyond is another matter, and unclear at present.

Global COVID-19 cases and deaths have retreated

As of 05/29/2022. Source: Our World in Data, Macrobond, RBC GAM

Conversely, China has struggled with COVID-19 significantly in recent months (see next chart). It is not that China’s absolute case load has been especially high. But caseloads have been high by Chinese standards and China remains committed to its zero tolerance policy. It should be noted that Chinese infections are now in significant decline. Shanghai appears to be under control after a long lockdown and is now re-opening. Beijing has, improbably, managed to fend off the highly contagious BA.2, BA.4 and BA.5 variants now circulating, thanks in significant part to an extensive testing campaign.

COVID-19 cases and deaths in China are in significant decline

As of 05/29/2022. Source: Johns Hopkins University, Macrobond, RBC GAM

This zero tolerance policy has done a lot of economic damage. The latest figures reveal an 11% year over year (YoY) decline in Chinese retail sales in April, with a big 47% YoY decline in auto sales. Factory production has now dropped by 2.9% YoY, with industrial output in the Shanghai area down by 14.1% YoY in April. The level of Chinese employment has now declined in eight of the last nine months. This is not quite as disastrous as it sounds, as China’s working-age population is also now in perpetual decline.

Even as COVID-19 fades, it is far from automatic that the economy immediately revives from here. A significant chunk of the damage comes not from lockdowns, but from people behaving more cautiously given that a single positive case in their office or a shopping mall or their apartment building could result in immediate mandatory quarantining in that location. COVID-19 could also yet prove challenging for Chinese cities other than Shanghai and Beijing.

But Beijing appears to be showing that an extensive testing campaign (a test every third day for the entire population) can work. And policymakers are now delivering stimulus to revive the economy. Another rate cut was recently announced at the national level, and the Shanghai municipal government recently announced a 50-point stimulus plan for reviving the city’s economy.

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