Monthly webcast

Our monthly economic webcast is now available, entitled “Recovery continues, despite high-inflation environment”

Overview

There have been more negative than positive developments in recent weeks.

There are two key positives:

• The U.S. economic recovery appears to be enjoying a mini-acceleration.
• There have been major breakthroughs in antiviral medications. Once they are produced and distributed, they should greatly reduce the hospitalization and fatality rate of COVID-19.

However there are many negatives:

• Globally, COVID-19 cases are beginning to rise again.
• Inflation remains very high, and may increase slightly further.
• Central banks have become more hawkish.
• Supply chain problems persist.
• The business cycle has advanced from “early cycle” to “mid cycle”.

COVID-19 cases rising again

Globally, COVID-19 cases are rising again after a multi-month decline (see next chart). The increase is most notable in the developed world, but a tentative shift is also visible in the emerging market data.

COVID-19 emerging market versus developed market infections

As of 11/07/2021. Calculated as the 7-day moving average of daily infections. Source: WHO, Macrobond, RBC GAM

The increase in infections is especially notable in Europe. U.K. cases remain high, French cases are edging higher and the numbers in Germany, the Netherlands and Poland have veritably exploded (see next chart). Fatalities remain much more limited thanks to vaccines, but they are a lagging indicator.

COVID-19 cases and deaths in Germany

As of 11/07/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

Russia is also particularly notable as it sets new records (see next chart). Moscow recently implemented an intense if short-lived lockdown.

COVID-19 cases and deaths in Russia

As of 11/07/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

Of course, this reversal is far from universal. Many countries continue to report improving case counts. Japan is a prominent example (see next chart).

COVID-19 cases and deaths in Japan

As of 11/07/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

The U.S. and Canada remain in fairly good shape, having enjoyed a lengthy period of improvement. However, it appears that the U.S. infection rate recently stopped falling (see next chart). Some of Canada’s larger provinces have also recently hooked higher (see subsequent chart).

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

As of 11/07/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

Spread of COVID-19 in Quebec

As of 11/07/2021. 7-day moving average of daily cases and deaths. Source: Government of Canada, CTVNews.ca, Macrobond, RBC GAM

Virus science

New sub-variant

The bad news from a scientific perspective is that a sub-variant of the Delta variant -- called AY.4.2 –appears to be something akin to a “Delta-plus”. It may be around 10% more contagious than the Delta variant. This helps to explain the ongoing high infection rate in the U.K. (where 96% of such cases can currently be found). There is speculation that this may also help to explain the rising number of infections in continental Europe. 

Fortunately, the variant represents much less of a leap forward than did the Alpha relative to the original virus, or the Delta relative to the Alpha. Both of these were around 50% more contagious than their predecessor. Nevertheless, it means that incrementally more caution (or an incrementally higher vaccination rate) will be needed to keep it under control. Happily, the new sub-variant does not appear to be any more resistant to vaccines.

Another wave?

This sub-variant is likely to take much longer to spread across the world given that it can only barely outcompete the existing dominant variant. Nevertheless, it may partially explain the increase in cases. Countries are also generally less willing to lock down than in the past and must grapple with colder weather in the northern hemisphere plus reopened schools. Protection may also be waning among those who were inoculated first. As such, it is certainly possible that infections will rise from here. 

However, we are inclined to think that any future wave will be smaller and less problematic than earlier waves for several reasons:

• Natural immunity is rising. 
• Booster shots are becoming available to top-up vaccine-induced immunity. 
• Treatments are improving for those who have been infected (see subsequent discussion).
• Governments are getting better at implementing vaccine mandates and passports as needed.

Vaccinations

A major symbolic milestone has been reached: just this week, more than half of the world’s population has now received at least one dose of vaccine. While this still leaves the other half, and many have not received their second dose, it is nevertheless a remarkable feat that vaccines have reached more than 4 billion people. The competition may become a bit more heated as developed countries now seek to inoculate their children and secure third doses for their most vulnerable citizens, but production capacity is also actively rising.

Therapeutic pills to the rescue

The health care system has become much better at treating COVID-19 patients over time, but there is still room for improvement. That improvement may come in the form of three new therapeutic drugs that are set to be added to the roster of treatments. All reduce the severity of the disease among those who have already been infected.

• Merck’s molnupiravir reduces the risk of hospitalization and/or death by around 50% in at-risk patients with mild to moderate symptoms. 
• Pfizer’s new pill purports to reduce this risk by an even greater 89%. 
• Meanwhile, fluvoxamine, a repurposed antidepressant, appears to reduce the risk of death by 90% and the risk of needing intensive medical care by 65% in the same population. It has the advantage of being widely produced, well understood and inexpensive.

In theory, pills such as these could reduce the infection fatality rate for COVID-19. The rate could drop from around 0.27% today to perhaps 0.03%. (If this number seems low, it is because it is different than the case fatality rate, which fails to capture asymptomatic or unreported infections). That’s before any effort to combine the three candidates into a more potent cocktail. 

Astonishingly, this would take COVID-19 from being around three times more deadly than the flu to, theoretically, three times less deadly than the flu on a per-infection basis. Just to be clear, COVID-19 is also around three times more contagious than the flu, so one’s risk of dying from COVID-19 might still be as high as or higher than of dying from the flu. But these new medicines nevertheless argue that COVID-19 should be a much smaller problem in the years to come.

Animal reservoir 

Alas, a recent study found that up to 80% of deer in Iowa have been infected by COVID-19. Beyond the risk to hunters, this implies that even if humans managed to eradicate the virus among people and domesticated animals, wild reservoirs would still exist. In turn, the virus could continue to mutate in animals and perhaps occasionally leap back into humans. This is a daunting thought.

Business cycle now “mid cycle”

Our U.S. business cycle scorecard finds that the cycle has likely now advanced from “early” cycle to “mid” cycle. Technically, the scorecard shows a dead heat between the two. But to the extent that only 36% of the inputs point to a cycle that is early or younger, while 64% argue it is mid cycle or later, the latter claim is clearly the more compelling one (see next chart).

U.S. business cycle score

As of 10/29/2021. Calculated via scorecard technique by RBC GAM. Source: RBC GAM

This pivot is not surprising: a rotation has been visible for several quarters. Nevertheless, it is consequential. It confirms that the business cycle is indeed advancing quite quickly, such that perhaps this cycle will only last something like five years rather than the 10-year norm of the prior two cycles. Economic growth tends to be fine during mid cycle, though risk asset returns tend to be less heroic than during early cycle. That said, even “late cycle” often generates positive returns – it is only “end of cycle” and “recession” that usually generate losses.

Fortunately, there are usually several years of economic growth left once mid cycle begins. In addition, various recession models we rely on attest that a) we are not in a recession right now; and b) a recession remains fairly unlikely for the coming year (though the risk is rising slightly).

Hawkish central banks

Central banks have turned in a more hawkish direction over the past several months – and especially over the past month – as they increasingly recognize that while high inflation is probably transitory, transitory may mean “for a year or two” rather than “for a few quarters”.

Accordingly, financial markets have pulled forward the timing and amount of rate hikes for the world’s developed central banks. Bond yields have increased as this has happened, and also in direct response to the high inflation itself.

U.S. Federal Reserve

The U.S. Federal Reserve recently announced that it will begin scaling back its bond purchases by the end of November, with an eye to ending the net purchases altogether by the middle of 2022.

While the central bank’s dot plots continue to point to just one 25 basis point rate increase in 2022, they have not been updated since September. Market pricing anticipates two hikes in 2022.

The path of monetary policy has been well telegraphed in advance since the earliest phase of the pandemic. However, the Fed indicates it has now entered a new era of data dependency. There are a sufficient number of uncertain tailwinds and headwinds that the future course for monetary policy can no longer be precisely defined. This makes sense, but it adds an element of uncertainty to monetary policy and thus bond yields that has not existed for a few years.

Bank of Canada

The Bank of Canada acknowledges persistently high inflation and also flags that supply chain problems have effectively reduced the production capacity of the Canadian economy, with the implication that economic conditions are tighter than they would otherwise be. Both of these have prompted the central bank to pull forward the start of its tightening cycle to the second or third quarter of 2022, from the third or fourth quarter. Despite these changes, markets arguably now price too much in: nearly five rate hikes by the end of that year.

Bank of England

The Bank of England has mused of rate hikes that could even occur by the end of this year, though it failed to deliver on those expectations at its most recent meeting. The country suffers from worse supply chain issues than most, though its economy is also further than most from returning to normal. More than three rate increases are priced by the end of 2022.

ECB

The European Central Bank is in much less of a rush, though markets now price in a single rate increase by the end of 2022.

Our take

Our economic forecast is for below-consensus, decelerating growth in 2022, and while we anticipate above-consensus inflation, it is nevertheless likely to be dulling by the middle of next year. In turn, central banks are unlikely to be panicking as they evaluate their options at that time.

In turn, we tend to take the “below” bet in gauging when and how much central banks will tighten monetary policy next year. Furthermore, even among those who anticipate significant tightening next year, there is a grudging admission that the neutral policy rate is likely somewhat lower than it was a decade ago, and certainly much lower than it was at the turn of the millennium. That is to say, central banks don’t have all that far to travel.

U.S. accelerates

We have speculated for more than a month that the U.S. economy may be enjoying a mini-acceleration after having slowed during the summer. However, we still believe the broader trend is one of gradual deceleration toward more normal growth rates over the coming year.

Recent data has tentatively confirmed this acceleration.

U.S. employment in October rose by a massive 531,000 jobs, and upward revisions added a further 218,000 jobs to the prior month’s tally. Consequently, the unemployment rate has now fallen from 4.8% to just 4.6% – though the labour force participation rate remains somewhat lower than before the pandemic and there remain 4.2 million fewer jobs than before the pandemic.

The job gains were focused in the service sector – in construction, health care, retail, finance and wholesale trade. This makes sense in the context of an economy reviving after a wave of infections.

Significant wage pressures are visible, with hourly wages now up to +4.9% year over year (YoY), though it must be conceded that this still represents negative real wage growth given that inflation is running even hotter.

Elsewhere, the Institute for Supply Management (ISM) manufacturing index logged another month with a strong reading of 61, impeded only by supply chain limitations. Meanwhile, the ISM services index blasted to an all-time high of 66 in October, up from 62. Within the index, the business activity and new orders components also hit record highs. There was breadth to this strength as well, with all 18 industries growing. While supply chain issues were cited, it is clear that the service sector is reviving wonderfully after people shied away from it during the wave of infections over the summer.

This pattern of improving growth is also visible in the quarterly gross domestic product (GDP) data. Third-quarter U.S. GDP grew by just 2.0% annualized – fine for normal conditions but anemic for the pandemic recovery. Fourth-quarter GDP is now tracking a big +8.0% annualized.

Real-time indicators also point to this mini-acceleration. Our U.S. economic activity index composite has accelerated over the past month (see next chart).

U.S. economic activities pick up in fourth quarter

As of 10/30/2021. Economic Activity Index is the average of nine high-frequency economic data series measuring the percentage change versus the same period in 2019. Source: Bank of America, Goldman Sachs, OpenTable, Macrobond, RBC GAM

Similarly, the San Francisco Fed’s news sentiment index has suddenly reclaimed half of its recent losses (see next chart). To be clear, we stop well short of predicting a total economic renaissance, but the autumn appears to be somewhat better than the summer for the U.S. economy.

Daily News Sentiment Index in the time of COVID-19

As of 10/31/2021. Source: Federal Reserve Bank of San Francisco. Macrobond, RBC GAM

One curious outlier to all of this is that U.S. consumer confidence has recently tumbled (see next chart). Some of this makes sense in that the past several months have been marked by the Delta wave, high inflation, supply chain issues, and so on. But the decline is out of proportion to other economic indicators, and actually quite bizarre when considered in the context of rapid job creation, keen consumer spending and robust household finances. And yet consumer confidence according to the University of Michigan survey is worse than it was at the most frightening moment during the early stages of the pandemic? This is almost inconceivable.

U.S. consumer confidence has declined since summer

As of Oct 2021. Shaded area represents recession. Source: The Conference Board, University of Michigan, Macrobond, RBC GAM

We expect consumer confidence to rebound to more logical readings shortly, and don’t put much weight in the view that a sharp drop in consumer confidence of this magnitude is a precursor to a recession. Our many recession models disagree with that diagnosis.

Canada slows?

While the U.S. economy is enjoying a mini-acceleration, we believe Canada is experiencing a mini-deceleration. This makes sense as Canada sailed through the summer while the U.S. was taking on water, so this represents a degree of convergence with the U.S.

Canadian employment added a moderate 31,000 new jobs in October, less than one-fifth the (stupendous) September tally. There is nothing to worry about here for a few reasons: 

• The jobs were all full-time and generated by the private sector. 
• The country has already recovered all of its lost employment.
• The unemployment rate fell from 6.9% to 6.7%. 

But it does suggest some economic slowing. Curiously, whereas U.S. wage growth is now 4.9% YoY, Canadian hourly earnings remain at an anemic 2.0% YoY. Granted, U.S. inflation is also higher, but not to the same extent.

Lagging sectors like accommodation and food services may have a problem: as they now seek to hire staff, not only have most Canadians already returned to the workforce, but these sectors may now be viewed less favorably as places of employment after the traumas of the past two years.

Further to the economic deceleration story, Canadian GDP in September was tentatively reported to have been flat. If the U.S. experience is any guide, the Canadian economy should again be expanding more enthusiastically in no more than a few months.

U.S. fiscal update

After months of torturous (and tortuous, for those who like near-homonyms) negotiations, the U.S. has delivered one of its two big infrastructure priorities: the bipartisan physical infrastructure bill. The bill is widely cited as being worth $1 trillion, though really only consisting of around $500 billion in new money. It is now set to be signed into law by the White House, eliminating one source of uncertainty.

The partisan human infrastructure bill – read: spending on people – could be delivered very soon as well. It is a mere one to two votes shy of clearing the Senate, and has already been whittled down from $3.5 trillion to around $1.8 trillion. For all of the implications of the bill – more green initiatives, more spending on a variety of social programs – it doesn’t actually move the needle on short- or medium-term economic growth all that much because much of the spending will be funded via tax increases that neutralize any stimulative effect. Recall also that this spending is set to drip out over the span of a decade, so the sums involved are not quite as extraordinary as they first seem.

Nevertheless, the stakes are high from the perspective of President Biden. The Democrats underperformed in recent gubernatorial elections, hinting that the standard Presidential rebuke may be coming at midterm elections that now loom less than a year away. Not only would passage of this bill boost Democrat prospects, but it may represent their greatest achievement during President Biden’s term. Even a slight tilt toward the Republicans would remove the Senate from Democratic Party control and render future legislative achievements elusive.

Supply chain problems

Supply chain problems remain intense. As we have posited in the past, the worst of these problems are likely happening right now, and should become incrementally less troubling once the Christmas shopping season and Chinese New Year are complete. The holiday season is, of course, a period in which the demand for consumer goods is unusually high. The Chinese New Year effect is also important: Chinese demand is high in the lead-up to the holiday, and just as crucially, factory production then closes down for a week, allowing shipping backlogs to be resolved.

Supporting the assertion that supply chain problems may be peaking, shipping costs for both containers and dry bulk have now come off of their highs (see next two charts).

Shipping costs peaked but still elevated

As of the week ended 11/04/2021. Source: Drewry Supply Chain Advisors, RBC GAM

Shipping costs abated from recent high

As of 11/04/2021. Shaded area represents recession. Source: Baltic Exchange, Macrobond, RBC GAM

The backlog of ships waiting at anchor to unload in Southern California has also diminished slightly. However, we made the same observation several weeks ago and then the figures deteriorated over the intervening weeks – so it would be premature to call a top here (see next chart).

Container ships at anchor or holding areas in Los Angeles and Long Beach

As of 11/05/2021. Source: Marine Exchange of Southern California, RBC GAM

Turning to the medium term – that is to say, the bulk of 2022 – we expect the most severe supply chain constraints to fade, but not all:

• It will take time for the unusually high demand for goods to fade. Backlogs cannot be significantly resolved until after demand has normalized.
  
  
• Supply chain problems do not merely reflect a single stressed link in the chain. There are many, many stressed links, including: 
  
  
  • Factories in China are struggling to get enough electricity and workers.
  • Factory warehouses are overloaded.
  • Port throughputs are overloaded as are port warehouses.
  • There are insufficient ships and ships operating well below their normal efficiency. 
  • There are insufficient trucks and truck drivers, and trains, and so on. 
    
  All of these need to be fixed to solve supply chain problems, so it seems realistic to expect the untangling to take the better part of a year.
  
  
• Once supply chain problems are resolved, businesses will want to catch up on inventories and capital expenditures.

As delays have accumulated, the throughput of ships has declined. Because ships must now wait to unload, and because the unloading itself is also slower, a voyage from China to the U.S. West Coast now takes a whopping 73 days, 83% longer than in September 2019. In turn, the throughput per ship has fallen by a startling 45%. At precisely the moment that demand for ships is high, there are effectively fewer.

The labour shortages that limit many industries are also hurting the supply chain. A shortage of truck drivers appears to be especially extreme. Perverse incentives are at least partially to blame. Non-unionized truck drivers are paid by the load rather than by the hour. As backlogs grow at ports, it takes longer for trucks to pick up their loads. In turn, truck drivers are effectively earning less per hour. The result is that many opt not to drive in such conditions. Major trucking companies are attempting to combat this, offering higher salaries and higher bonuses.

It is a similar situation for warehouse workers, who tend to be paid a fairly low wage. Naturally, these workers are capitalizing on the hot job market to find higher paying and/or less grueling work.

Turning to the longer run, we then believe the great bulk of the supply chain problems will be resolved by 2023, but a few may linger:

• The demand for computer chips is structurally higher, but chip fabrication plants take a few years to build.
• It will also likely take a few years for carmakers to fully meet the pent-up demand for vehicles.

Canadian ports

The situation on Canada’s west coast appears to be somewhat less extreme than in the U.S., with shipments moving somewhat more fluidly. Nevertheless, many products remain in short supply, generating significant inflation, if less than in the U.S.

Chinese electricity

One problem reported along the supply chain is an electricity shortage in China. This is for a mix of reasons, including more aggressive environmental targets and the high cost of natural gas and coal.

Fortunately, we can directly observe electricity production in China (see next chart). While the electricity growth rate recently slowed, the level remains higher than a year ago, and – on a seasonally-adjusted basis – continues to trend higher. As such, the problems may not be quite as severe as feared, as least through the end of September.

Electricity production in China

As of Sept 2021. Source: China National Bureau of Statistics, Macrobond, RBC GAM

Inflation heat persists

Inflation pressures remain intense and we maintain modestly above-consensus inflation forecasts for the coming year. However, we do not buy into the argument that inflation will be high indefinitely.

Real-time inflation indicators argue that whereas inflation pressures were high but steady over the past several months, they may now be accelerating again. The U.S. Consumer Price Index (CPI) for October will be released later this week, and appears set to reflect this message. The consensus forecast is for CPI to leap from +5.4% YoY to +5.9% YoY. That would be the highest reading since 1990 – a long time ago and a very different inflation landscape.

Sourcing inflation

Much of the high inflation continues to be sourced from a small handful of distressed sectors. Case in point, used car prices remain extremely hot as new and used cars prove unavailable and many people pivot from public to private transit. Used car sales are down 10% relative to a year ago. Accordingly, the Manheim Used Vehicle Value Index shows a giant 9.2% increase in the month of October relative to the prior month alone. That likely explains at least some of the anticipated leap in CPI in October.

But it must be said that inflation breadth is also rising. We can no longer explain away all of the inflation pressures via gas, car and electronics prices alone. In fact, of the 10 major inflation buckets in the U.S., nine are now running at or above the 2% inflation target (see next chart). Only apparel prices have underperformed.

Prices have gone up since the start of pandemic for almost all categories

As of Sept 2021. Source: Bureau of Labor Statistics, Haver Analytics, RBC GAM

The sources of inflation heat are quite varied. The price of wheat recently pushed past US$8 for the first time in nearly a decade after poor growing conditions hurt harvests. Elsewhere, rideshare services continue to charge surge pricing for a large fraction of the day as their erstwhile drivers unexpectedly failed to return after government benefits expired.

Second-round effects

We assume that some of the strongest direct drivers of inflation will become less intense over the next six months. Oil prices are in backwardation, for instance, meaning that the oil market expects lower oil prices down the road. Yet there are second-round effects that may keep inflation from completely normalizing over the coming year.

The pass-through from higher energy and shipping prices is incomplete. Many of the products affected by these inputs have not yet reached store shelves. When they do, prices will increase with a lag. Some retailers locked in their costs in advance, meaning that higher prices only affect them (and their customers) with a lag.

We also suspect wage growth could remain warm for some time after inflation has cooled. Wage pressures continue to rise (see next chart), especially among less skilled workers. Workers appear to have the upper hand given extreme worker shortages in many sectors, and they will want to make back the money they have lost from high inflation.

Wages of U.S. low-skilled workers rising a lot faster than non-farm average

Limited-service restaurants as of Aug 2021, total private non-farm as of Sept 2021. Source: BLS, Macrobond, RBC GAM

This discussion of inflation has amounted to a long list of why it makes sense that inflation is high. Just to reiterate, we do think some of the primary drivers will become less intense over the coming six months, and we ultimately believe inflation will return to normal over the long run.

-With contributions from Vivien Lee and Aaron Ma