Overview

This week’s note tackles falling COVID-19 cases; a wide range of economic developments; and the big three issues right now: the Chinese economy (a rising concern), supply chain issues (a serious but slightly diminishing concern) and inflation (a serious and steady level of concern). We then examine some long-term themes including the revival of business travel and the increasing clout of labour at the expense of capital.

Infections mostly falling

COVID-19 remains mostly in retreat around the world (see next chart). This is true across most of the U.S. and Canada, and indeed the bulk of the developed and emerging world.

Global COVID-19 cases and deaths

As of 10/17/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

That said, a few prominent exceptions do exist. It is notable that places like Australia and Singapore, which both recently abandoned zero-COVID policies, have experienced a surge of new infections (see next chart).

COVID-19 cases and deaths in Australia

As of 10/17/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

Further, there is tentative evidence that infections are beginning to rise again in parts of Europe. This includes Germany, France and the Netherlands (see next chart). As we discuss later, Europe has been particularly eager to normalize certain activities such as working in offices and business travel.

COVID-19 cases and deaths in Germany

As of 10/17/2021. 7-day moving average of daily new cases and new deaths. Source: WHO, Macrobond, RBC GAM

Economic developments

We tackle a range of economic developments below.

Traffic congestion

Real-time measures of traffic congestion find that European traffic levels at both morning and afternoon rush hours are now back to their pre-pandemic norms. This is somewhat ahead of most North American and Asian cities, which remain shy of prior norms.

We view this as a proxy for a return of workers to offices, but it also says something more broadly about the normalization of daily life. Admittedly, to the extent that public transit has become less popular, it likely exaggerates the extent of normalization.

What is strange is that in economic terms Europe is lagging rather than leading in the pandemic recovery. Perhaps its traffic reflects a rigidity in European work practices as much as true economic normalization. Europe was also notable for the quick rate at which its workers returned to the office after the first lockdown in 2020, and yet its economy did not lead then, either.

News sentiment continues to sour

The San Francisco Fed’s Daily News Sentiment Index continues to sour. This is a trend we have flagged in the past, but it recently pushed substantially lower (see next chart). In our view, the measure has actually done a good job of conveying the ebb and flow of activity over the past few years. Indeed, U.S. economic activity has been decelerating for several months.

Daily News Sentiment Index in the time of COVID-19

As of 10/03/2021. Source: Federal Reserve Bank of San Francisco, Macrobond, RBC GAM

The latest drop likely reflects negative headlines associated with Chinese problems, supply chains and inflation – all addressed later in this report. All of this acknowledged, we do wonder if we are in the realm of the news sentiment trough. There’s some tentative evidence that the U.S. economy is beginning to recover more quickly again and the prospect of some of the world’s problems becoming a bit less intense.

Mixed traditional U.S. data

U.S. payrolls for September landed at +194,000 jobs, less than half the consensus. But this disappointment was tempered by the fact that upward revisions uncovered 169,000 additional jobs over the prior months, and more workers were absorbed than would be strictly required to keep abreast of population growth. Although five million more Americans remain unemployed than before the pandemic, the unemployment rate has nevertheless fallen to just 4.8%.

It should be said that while the rate of hiring has seemingly slowed, the level of initial jobless claims has continued to improve enthusiastically. It registered just 293,000 new initial claims in the latest week. This number isn’t far from the 222,000 registered in the last week of 2019 – a half-century low – and is galaxies away from the more than 6 million new jobless claims registered in the worst week of 2020!

U.S. jobless claims hover around pandemic low

As of the week ending Oct. 2, 2021. Shaded area represents recession. Source: Department of Labor, Haver Analytics, RBC GAM

The twin Institute for Supply Management (ISM) indices for September argued that the U.S. economic deceleration may be coming to an end. The manufacturing component rose to a robust reading of 61.1, the highest in four months. And the service measure clocked a good 61.9. This was the second highest reading in four months and spectacular by any normal standard.

As such, the Federal Reserve can probably still begin its tapering operations before the end of the year. This has been sufficiently well telegraphed that it should already be priced into the bond market.

Elsewhere in U.S. public policy, the debt ceiling was delayed until early December, in line with the extension of government funding until that date. It is likely that the U.S. infrastructure bill, government funding and the debt ceiling will all be addressed at that point in a mad dash.

Canadian strength, but possibly to soften

Canada’s September employment report yielded a gargantuan 157,000 new jobs, bringing the unemployment rate down from 7.1% to 6.9%. That brings Canadian employment up above the pre-pandemic peak, though further hiring is necessary to fully eliminate labour market slack given that the country’s population has grown over the intervening two years.

Canada’s late-breaking Business Outlook Survey also screams strength. The summary measure is easily the strongest on record. While firms are no longer as convinced that their sales will rise more quickly than over the past year (really, how could they?), capital expenditure plans and hiring plans are both the highest on record.

The report also revealed an unsurprising amount of capacity pressures and inflation heat. Wage growth expectations are the highest on record and firms are reporting the most intense labour shortages in the 22-year history of the series. Input and output prices are also expected to rise quickly, with a record number of firms anticipating inflation of above 3% over the next two years.

When firms are asked what obstacles would prevent them from being able to meet an unexpected increase in demand, the most popular answer is labour shortages. Supply chain issues also receive a significant, but lesser, vote.

Canada-U.S. divide

It is interesting to note that whereas Canada’s employment level is now setting records, its level of economic output is still a few months away from making the same claim. Conversely, the U.S. economy exceeded its pre-pandemic peak way back in late May, while it has further work to do before the labour market can make the same claim. This dichotomy is unusual, to the say the least.

Who is better off? That depends on your perspective. The U.S. is certainly admirable in that it has evidently achieved a considerable amount of productivity growth to be able to produce so much with fewer workers. Financial markets naturally prefer this state. Conversely, Canada’s productivity performance looks much worse, but it can at least say that its labour force is no longer badly suffering – a key objective for policymakers during economic recoveries.

Regional restrictions

After several months of rapid economic growth in Canada as the country plays catch-up, a new pandemic headwind of moderate proportions awaits. Two regions of the country have significantly increased their restrictions due to high COVID-19 caseloads recently: Atlantic Canada and the Prairies region (see next chart).

COVID-19 restrictions reimposed in some parts of Canada

As of 09/29/2021. Atlantic region includes New Brunswick, Newfoundland and Labrador, Nova Scotia and Prince Edward Island; Prairies region includes Alberta, Manitoba and Saskatchewan. Source: Bank of Canada, RBC GAM

China slowdown

The Chinese economy slowed sharply in the third quarter, reporting a mere 4.9% year-over-year increase. But the real story was hidden within this figure. We already knew the results for three of the four quarters encased within that year. The new quarter – the quarter from July through September – yielded a mere 0.2% increase. This is a tiny addition for a country like China that is used to a growth rate around seven times faster.

Growth should be somewhat better in the fourth quarter, but still significantly lower than normal. Further, we budget for a sub-5% 2022 growth rate for China. This is well below its pre-pandemic norm and somewhat below the consensus forecast, albeit still quite good by the standards of nearly any country other than China.

To be clear, none of this is because China’s pandemic economic recovery is stalling out. The economy long ago recovered from most aspects of the pandemic. Instead, it reflects several more recent headwinds:

• Insufficient electricity for factories
• Global supply chain problems
• A Chinese corporate crackdown, skewed toward the tech sector
• Housing market woes as government rules tighten and builders buckle

Of these, the electricity issues should be fairly short-lived, though some restraints could persist for several months as coal and natural gas shortages are resolved. A portion could also endure to the extent it reflects new climate commitments from China.

Global supply chains will likely remain significantly distorted for several more months, moderately affected for several quarters, and then less affected for up to a few years (discussed in more detail shortly). But the most intense constraints may already be starting to ease.

The tech sector crackdown is certainly significant. However, it may ultimately prove to be a neutral or even positive force over the longer run if it unleashes additional competition into the economy.

The housing market concerns are harder to dismiss. Not only is the government cracking down on housing, but housing was arguably in a significant state of excess beforehand, and sentiment has turned among homebuyers. It is not unreasonable to think that property sector weakness will subtract in the realm of 1.5% off the country’s growth over the coming year.

Apartment sales were already down 20—30% in September relative to a year ago, even before Evergrande and its ilk began to reveal liquidity problems. Indeed, one might posit that sudden cooling of demand is a significant reason why developers are now faring much worse.

Evergrande – the country’s second largest builder – continues to fail to fully deliver interest payments on its foreign debt. Investors are complaining that the company has not engaged in a “meaningful dialogue” with them since missing payments in September. Evergrande has $37 billion in debt due within a year, out of an overall pool of $305 billion in liabilities.

Other builders are running into similar trouble:

• Modern Land asked for a three-month extension for bonds due in October.
• Fantasia failed to pay the principal on one of its senior notes a few weeks ago.
• China Fortune Land defaulted on an offshore bond way back in February.

Investors have shied away from all of China’s high-yield property bonds, resulting in yields that have regularly traded above 20%.

When we wrote about China’s troubled property developers in late September, we posited that the government was unlikely to fully bail out the companies, but that some sort of conversion to a state-owned enterprise was possible. The situation is still fluid and this remains an option, but recent remarks from the People’s Bank of China suggested a disinclination to take major governmental action. The problem was described as “controllable” and not likely to spread. Further, the government issued a scathing critique of Evergrande, saying “the company failed to manage its business well and to operate prudently amid changing market conditions … instead it blindly expanded and diversified.”

Many have debated whether this is China’s Lehman moment. It probably is not – China has the resources, if necessary, to avoid the sort of full-scale financial crisis that unfolded after Lehman Brothers failed in September 2008. Instead, it may be more useful to draw parallels to two different events: the earlier failure of Bear Stearns in mid-2008 and the Japanese bust that began in the early 1990s.

The parallels to Bear Stearns relate to housing and financial market excesses, of course. But ultimately it relates to the idea that Bear Stearns proved manageable and revealed excesses that proved significant later. The key now is for China to ensure that the problems don’t snowball from here, creating a later Lehman moment.

The parallels to Japan are that the Japanese economy suffered a sudden and permanent economic deceleration in the early 1990s when its housing bubble burst, against the backdrop of poor demographics and high debt. China also has a big, hot housing market, poor demographics and quite a lot of debt. But, even if China were to permanently lose some of the strength generated by a housing market – estimated to be between 15% and 25% of the country’s gross domestic product (GDP) -- it is highly unlikely to slow to a near-zero growth rate. It is still considerably poorer than Japan was at the same time, meaning there should still be considerable natural buoyancy as the country converges toward developed-world living standards. Further, Chinese policymakers are unlikely to repeat Japan’s decade-long string of policy errors that contributed to the country’s problems.

Supply chain issues ease slightly

Supply chain problems are likely to persist to some degree for years.

The auto industry has been particular affected due to a shortage of chips. As a result, there just aren’t enough vehicles to meet demand, mainly because of a shortage of chip inputs. Not for lack of demand, Chinese passenger car sales in September fell by 17% relative to a year ago, with sales down 25% in the U.S.

However, it must be conceded that there have recently been several important improvements to the supply chain dynamic, and that the intensity of supply chain problems should fade with time. For example:

1. The number of container ships waiting at anchor or in holding areas for their turn to unload at either of Southern California’s two main ports has begun to edge lower for the first time since last spring (see next chart). Part of this may be attributable to the fact that the Port of Los Angeles will now operate 24 hours per day (in keeping with most other major ports). The two ports unload an incredible 25% of American imports.

Container ships at anchor or holding areas

As of 10/14/21. Marine Exchange of Southern California, RBC GAM

2. Shipping costs are seemingly starting to fall, also for the first time in nearly six months (see next chart). The Drewry World Container Index remains quite elevated, but recently declined slightly. Beneath the surface, there are reports that the cost of shipping from China to Los Angeles has fallen by as much as $17,000 per container to $8,000, practically overnight. This abrupt move may be in part because agents who had bought up capacity are now seeking to unload it as they think the market has peaked. Long-term shipping rates for the route are already dipping below $5,000.

Shipping costs soared during the pandemic

As of the week ended 10/14/2021. Source: Drewry Supply Chain Advisors, RBC GAM

3. The ISM Manufacturing Supplier Deliveries Index and Prices Index have both now retreated somewhat from their highs (see next chart). This is another indication that the situation is no longer actively deteriorating.

U.S. manufacturers grapple with elevated raw material prices and slow delivery from suppliers

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

4. In theory, products destined for the holiday shopping season should be on boats by the middle of October, allowing them to make landfall and be unloaded two to four weeks later. That means the crunch time is now through the next month, with the possibility of a reprieve later.

This is all very helpful. However, it doesn’t mean that supply chain issues are about to vanish completely.

Even as shipping constraints become slightly less intense:

• Shipping costs are still extremely high, as are port backlogs.
• There are record numbers of shipping containers waiting to be picked up by trucks within the U.S. and other destination markets – there aren’t enough trucks and rail to handle the additional volume.
• There are also severe backlogs within Chinese factories. Their warehouses are full and they are increasingly refusing or are unable to produce more until their customers pick up their orders and bring them to ports.
• Ships, trucks and trains are all less efficient when they have to wait to load/unload their goods – you need more of them just to deliver a normal supply of products, let alone address current elevated demand. Southern California ports are taking around twice as long as usual to turn around a ship.
• The actual cost of shipping wasn’t a major reason for higher product prices – it is a pretty small fraction of most price tags.
• The cost passthrough from broader supply chain issues should operate with a lag. Retailers have contracted ships at higher prices, and the affected products won’t hit shelves for weeks or even months.

Additionally, keep in mind that supply chain issues aren’t just about shipping constraints. They are also because:

• Consumers are buying more and different things than usual. This alters supply chains in problematic ways, and shows little sign of reversing. RBC Capital Markets estimates via geospatial intelligence data that there has been a 29% rise in the number of containers into the Los Angeles and Long Beach ports. If the demand for goods remains elevated, a full solution will have to wait until a new fleet of ships can be constructed — a multi-year process.
• Certain critical inputs remain in short supply, not just because they are waiting for a boat, but because there isn’t enough production capacity in the world for them. This can take up to a few years to resolve via new chip fabrication facilities and the like.
• Existing factories have their own problems, including electricity outages in China and India, a pandemic wave across Southeast Asia and reluctant migrant workers in China.
• Supply chains continue to possess very little slack or redundancy, which means that they have only a limited capacity to play “catch up” even when the most acute constraints are lifted.

In short, the situation looks a bit better than before, but it is far from completely resolved. We expect significant disruptions for several more months, moderate disruptions for several quarters, and then some lingering distortions that persist for a few years. This is both growth-negative and inflation-positive.

Inflation tidbits

We maintain an above-consensus inflation forecast for 2021 and 2022, not because we believe a structural change is afoot, but simply because there are so many short-term inflation drivers at work right now. These include supply chain issues and a jump in commodity prices.

The term “transitory” in the context of “high inflation is transitory” has been stretched to within an inch of its life. What was initially thought to be an inflation spike lasting a few months last spring shows little sign of abating. Nevertheless, we do ultimately believe that pressures will become somewhat less intense in 2022, and that more normal looking inflation will prevail over time.

Here are several new thoughts on inflation:

Real-time inflation steady and high

While real-time measures that track internet-based inflation ceased rising in the U.S. and Canada several months ago, neither have they fallen. They continue to report persistently high inflation, albeit of a 4% variety rather than the 5.4% rate recorded for September. The main point is that there isn’t yet compelling evidence of high inflation abating, even if it isn’t actively getting worse.

Interestingly, the same real-time inflation measures for Germany and Japan are accelerating to new highs right now. This would seem to suggest that higher inflation is hitting non-U.S. markets with a lag. If true, that would help to explain why global forces conspired to push U.S. prices so much higher than those in other markets – an initially puzzling development. It may be that the dynamic U.S. economy is faster at passing along cost increases into consumer prices.

Energy costs keep inflation high in short-run

Energy costs long ago revived from their initial pandemic collapses. They have lately pushed significantly beyond the pre-pandemic norm. West Texas oil is now at $82, the highest in seven years.

Natural gas prices have increased to an even greater extent, with UK and EU contracts trading at up to 10 times their start-of-year levels. Russia may yet ease some of the most extreme constraints for Europe by furnishing additional supply.

Coal prices have now also soared, in significant part as coal is used as a substitute for natural gas, but also due to a dispute between China and Australia. The global benchmark thermal coal price is now trading at triple the price of late 2019. This has greatly constrained Indian electricity production in particular. China’s refusal to use Australian coal may now be easing out of necessity, and the country plans to increase its own coal production.

All of these developments are broadly bad for economic growth (with exceptions for energy-producing nations) and contribute to higher inflation. Although most of the rise in the price of commodities is likely already complete, there can be a lag until the increase fully appears in the consumer price index. As such, some further upward pressure in consumer prices is likely over the next few months. The increase in the cost of natural gas prices alone could add as much as 1.5 percentage points to inflation in the most affected countries.

But these pressures should begin to abate shortly thereafter, and by the end of the winter it seems reasonable to expect somewhat lower energy prices.

This episode also illustrates that this new era of decarbonization brings with it a few important implications as demand pivots away from fossil fuels. Companies and investors are now reluctant to invest further into fossil fuels because peak demand likely arrives within a few decades. In turn, one should expect greater energy price volatility because suppliers will respond less enthusiastically to positive demand shocks or negative supply shocks. That is arguably part of what is going on now.

Further, while one might imagine that lower demand for fossil fuels should mean lower prices, it depends entirely on whether suppliers cut their production by less or more than demand. There is a real chance that they cut their production more aggressively than demand as they seek to avoid being left with stranded assets, which would translate into an era of higher-than-normal energy prices rather than lower-than-normal ones. At a minimum, decarbonization does not guarantee low fossil fuel prices.

Housing inflation high in medium run

Home prices across much of the developed world have increased to an extraordinary extent across the pandemic. This is inflationary.

Housing is 40% of the U.S. consumer price index (CPI), and represents a large fraction of the price basket for most countries (though with remarkably different methodological approaches).

However, for various reasons, rising home prices take time to appear in the CPI. In the U.S., this is because higher housing costs are picked up via the cost of rent for renters, and for homeowners, by how much they could rent their property for. In short, it is the cost of renting that matters much more than the cost of owning. During the pandemic, rental costs initially increased less quickly than home prices. But now they are catching up, with the implication that inflation should retain at least one key upward pressure over the coming year.

In Canada, the cost of owning a home is reflected via the cost of maintaining a mortgage on the property. Because many people bought their home years ago, Canadian home price inflation effectively represents the average home price increase over the past 25 years. This naturally smooths the series quite a lot. But the extraordinary increase in home prices during the pandemic can nevertheless add significantly to that tally, and in turn, to the rate of inflation. And that extra heat will remain in place for years.

Business travel revives surprisingly quickly

We are on the record with the view that personal travel will eventually completely revive, but that business travel will not. Certain activities – in particular internal meetings and some conferences – will likely remain permanently virtual. Conversely, sales-based travel seems likely to mostly return.

All of this said, we are surprised at how quickly business travel is picking up in some regions. European corporate trips are now up to 49% of their 2019 level according to travel-analytics company ForwardKeys. U.S. business travel is now up to 42% of normal.

If the post-pandemic normal for business travel is something like two-thirds of the pre-pandemic norm, that would mean Europe and the U.S. are already at 73% and 63% of their “new normal” for business travel.

Framed differently, it is remarkable that business travel has revived so much when most U.S. cities continue to report far fewer than 50% of their normal worker volume within offices. We would have thought that offices would revive first, followed by business travel. But apparently not. This is certainly a win for airlines, which earn a large fraction of their revenue off of business travelers.

Labour over capital?

It feels as though the tides are turning in the battle between labour and capital. After decades of capital “winning” – that is to say, corporate profit margins rising and wage growth relatively underperforming – there are a number of new forces now pushing in the opposite direction.

The pandemic has seemingly spurred a greater focus on people over finances. It has also unleashed experiments with a radically larger social safety net, some of which may become permanent or at least be re-introduced come future recessions. Simultaneously, with immigration quieted by lockdowns and significant early retirements, a labour shortage has put workers in a position to demand higher wages. Wages are certainly rising more quickly (though not fast enough to keep pace with red-hot inflation, making the final interpretation somewhat blurred). Anecdotally, there are reports of a rising number of strikes, though an increase is not yet visible in the official statistics.

There was arguably already the beginning of a shift underway toward labour over capital, even before the pandemic. The rise of populism in recent decades arguably represents one such manifestation. The latest elections in Germany, Canada and the U.S. all yielded left-leaning governments. Anti-trust movements are strengthening, with China and Europe in particular going after large tech companies. Inequality is receiving greater attention, and there have been significant increases in the minimum wage and now a framework for a new minimum global corporate tax of 15%. The retirement of baby boomers creates a relative shortage of workers. In the U.K., this is further exacerbated by the banishment of EU-origin workers after Brexit.

All of this suggests there may be less room for profit margins to rise further in the future – a challenge for investors who have benefited from the prior increases. Wage growth may rise somewhat more quickly, and workers may succeed in negotiating other perks such as working from home. Inflation could be somewhat higher, all else equal (though we think demographic changes and several other forces remain net deflationary and may outmuscle this effect).

-With contributions from Vivien Lee and Aaron Ma