Hello and welcome to our latest video #MacroMemo. We'll talk about a number of things this time around:

• We'll speak about the Chinese economy and the extent to which it continues to rather significantly underwhelm. We will talk about what Chinese policymakers are doing about that, whether that's enough and so on. We'll take a look just at more generally what's happening in the economy, including a peak of debt, the most recent set of job numbers and a few other directions.
• We'll speak about the Chinese economy and the extent to which it continues to rather significantly underwhelm. We will talk about what Chinese policymakers are doing about that, whether that's enough and so on. We'll take a look just at more generally what's happening in the economy, including a peak of debt, the most recent set of job numbers and a few other directions.
• We'll talk inflation and just reframing our thinking on the subject.
• We'll talk inflation and just reframing our thinking on the subject.
• And then lastly, we’ll revisit the U.S. debt rating, which was downgraded. I just want to talk through a little bit of the motivation and the implications that emerge from that.

China’s economy: Let's go right back to the top and start with China's economic woes. It's been pretty rough for the Chinese economy.

The back story, of course, is one in which the Chinese economy was very much locked down for large swaths of last year, then reopened pretty abruptly in very late 2022. It had a good go for a while and was moving fairly quickly. But it's just really been sputtering ever since.

It's continued to underwhelm. Just to give you an example of that, real retail sales growth in China over the last year is up just 2.8%. For context, this is the consumer sector, which is meant to drive the economy into the future over the long run. It's not doing much of that.

Keep in mind, this is a country that's officially targeting 5% growth in 2023. So to have a big engine of that growth growing at something like half of that rate isn't all that great. We're not getting a lot of spending growth.

Chinese consumers in particular are feeling very cautious for a number of reasons. But in large part it’s because the housing market is so soft. The bulk of Chinese household wealth is stored in housing and home prices are falling.

For people who bought a new property, including a lot of builders, are struggling. Those properties aren't getting built and people's money is locked up in companies that might well be bankrupt. So you can understand why Chinese consumers don't feel like spending money right now. That's been a difficult situation.

Chinese exports are down 14% year-over-year. Now let the record show a lot of that is currency swings and bit of deflation even, and so on. But Chinese exports are down a lot and they are still down if you get it on a real basis. Of course, that reflects the rest of the world not wanting goods as much and it says something about the Chinese economy as well.

When we look at both of the manufacturing purchasing manager indices that are published in China, both of those are sub 50. In theory this means contraction for the manufacturing sector, which is classically China’s bread and butter.

Total social financing – which is a fancy term for credit growth in China in the private sector – is still growing, but it’s decelerating. It’s now about the weakest we’ve seen in a few decades.

Home prices are still falling, and home sales are still falling. Another big Chinese builder, this one called Country Garden, is now defaulting on its debt. So it's been rough all the way around.

For the Chinese renminbi, the exchange rate is down by 12% from its high at the start of the year, reflecting a lot of this weakness. Just to put a cherry on top, China is also now suffering a bit of slight deflation. Its Consumer Price Index is actually a little bit lower than a year ago.

In fairness, a lot of countries would probably secretly celebrate if they managed a little bit of deflation right now. So many countries have suffered from too much inflation for the last couple of years and wouldn't mind unwinding a bit of that.

China is different, though, in the sense that it didn't really get the “too much inflation” part. And so it's not really looking to unwind a whole lot of anything. It's viewing deflation more in the classical way, in a negative lens, which is just to say that when prices are falling, people don't feel like spending because things get cheaper later. So the economy gets weaker and prices keep falling. The risk is you get stuck in a deflationary spiral.

To be clear, I'm not predicting a deflationary spiral for China, but it's just another headache for China to deal with. The question that emerges from all of this is: what are Chinese policymakers doing about this?

And I will say upfront, there is not as much help and not as much stimulus as you would hope for given the scope of the challenges that exist right now. It should, in theory, be fairly simple for China. Interests are aligned, shall we say, meaning that inflation is too low, the economy is too weak. Both those things call for more monetary and or fiscal stimulus.

It's trickier in a lot of countries where inflation is too high and then they're worried about the economy. And what do you do? These are conflicting interests.

There really aren't conflicting interests in China, so you think they could do more. I will say I think they're doing more than people think, but they're not doing as much as maybe they should.

The reason we think they're doing more than a lot of people think is, in part, just because China tends to do many small things rather than one big thing. China tends to lean a little more on the “tweaking rules” side of stimulus as opposed to the “spending money” side. So between those two, there is no big multitrillion dollar stimulus package coming up, but they have done a fair amount. I don't think that should be ignored.

As an example, some of the key housing levers have been pulled as China tries to stabilize and restore that sector back to some measure of strength. China has instructed banks to lower mortgage rates for existing mortgage holders and to allow more leverage for people applying for mortgages. Those are pretty powerful boosts, in theory, to the housing market.

China has delivered rate cuts – not as many as hoped for, not as big as hoped for. They've been 15 basis point rate cuts, a couple of them. It hasn't been all that much, but they have helped a little bit there.

I think the reason they haven't helped more is because the currency has been so soft. When you're cutting rates and everyone else is raising rates, that really can do a number on your currency. China’s currency is already down about 12%, I don't think they want it to go a whole lot further.

The point is the weaker currency is actually helping, in the sense that it will import some inflation -- which, if you recall, they want right now. It will improve China's export competitiveness, which would also help the economy. So they're getting some help from the currency, even if interest rates aren't doing as much as you might otherwise have thought.

China's local government debt problems are fairly famous. We've talked about them in this forum. They are being tackled more seriously. They've put up a trillion renminbi against it, about $150 billion.

It isn't enough. They'll need to do more. But nevertheless, they are beginning to do things.

They are making business policies easier and friendlier for entrepreneurs and so on, including a small business tax cut recently. And they're even doing some structural things that people have been calling for – for years, if not decades, including what's called hukou reform.

It really just means that in China, people don't so much have national citizenship as they have local citizenship. And you can't just move from the rural area to a city and live there permanently. You don't have access to public health care, public education. You may not be allowed to buy a property. So people are still anchored to their location of birth.

The hukou reform that's been proposed and planned to be implemented quite quickly is to eliminate those restrictions altogether for China's smaller cities, up to 3 million people, to make a significant change. Also, the reform will ease hukou for cities 3 to 5 million people as well.

In theory, that's a long-term boost to the economy if people can actually move to where jobs are and where they'd like to live. The bottom line to me is that when you tally up the Chinese stimulus that's been announced, it is actually pretty significant.

I think it's sneaky big. It's bigger than a lot of people had thought. Not clear it’s enough, but I think it's a bit more than people think. So for the moment at least, we still think China might pull off something in the range of 5% growth this year, but it's not looking likely it runs a whole lot faster than that.

Interest rates: Okay, let's talk about interest rates for a moment. Of course, we've had lots of central bank monetary tightening over the last year and a half.

Bond yields have, of course, gone off. But we've seen bond yields rise pretty materially over the last several weeks to the point that the U.S. 10-year yield is now sitting at about 4.35%. That's around 40 basis points higher than it was in early August and it's nearly a percentage point higher than it was in the spring. And it's the highest level this cycle, I should mention, as well.

So yields are at the higher end of what we're used to right now. Some of that certainly is just central banks did raise rates a bit more over the last few months than they had been planning back in the spring. Some of the story for the U.S. is that recent data has been fairly resilient, including U.S. retail sales.

Part of it, we think, is the U.S. debt downgrade, which I'll get to in a moment. Part is because after that debt ceiling adventure, there's been a lot of bond issuance since. The Treasury seeks to replenish its coffers, essentially to have a bit of wiggle room for spending, which it eliminated nearly completely back in late May.

Also because the U.S. is running big deficits, there’s just a lot of bonds being issued. Those have to be absorbed and people need to be induced to absorb them via higher interest rates.

Also a bit of an international flair, which is that as Japanese yields rise and Japan is tweaking its own interest rate policies, that is pulling money out of the U.S. and other markets and attracting it to Japan. So that's another reason for higher U.S. rates.

Also, China is defending its currency, at least somewhat. We can see in the data. So that is pulling money out of the U.S. and putting it elsewhere.

In the end, yields have gone higher because the implications from that are that there's a drag on the economy that emerges. Here we are in a position in which the economy runs a little slower than otherwise because the functional cost of borrowing – you and I don't get to borrow at the overnight rate or the federal funds rate – is significantly higher than it was a few months ago.

That's obviously an opportunity as well for fixed income investors. We're inclined to think that the buying is fairly good at these sorts of interest rates, an opportunity to invest at a higher yield.

Economy: Couple quick thoughts on the economy, really just flashing back to earlier job numbers that came out. U.S. payrolls managed 187,000 new jobs in July. It’s perfectly fine, in fact, it's pretty decent.

I will say, though, it missed expectations. There were 49,000 negative revisions to earlier months. The number of aggregate hours worked, so not just workers, but hours put in actually fell 0.2% in the month of July. That's actually the latest in a string of declines, and temporary employment kept falling for a sixth straight month.

We think we're seeing, at least, hints of weakness beneath the surface and even becoming a little bit clearer here.

On the Canadian side, jobs were down 6,000, which was the second decline in three months. The twist for Canada is that the one month of gain was so big that you really can't say there were net job losses across the entire time frame. But still, two declines in three months does suggest that all is not perfectly well there.

Indeed, Canadian monthly GDP, while fine for May, is now tracking to be negative for June. And you wonder if it could be soft in July as well, particularly given the number of distortions hitting the Canadian economy.

There are going to be temporary economic hits that emerge from all that.

I should say it’s not purely a Canadian story either. In the U.S., there were devastating fires in Hawaii. There’s been an unusual tropical storm/hurricane on the west coast. All certainly tragedies and relevant beyond the economic scope. But in purely economic terms, there’s a small negative in the short run and then you get a rebound in subsequent months.

Inflation: Inflation, just for a moment, we've been arguing for a number of weeks that while the official inflation numbers are around 3% – and indeed the latest reading is 3.2% in the U.S., 3.3% in Canada. The true inflation reading we were saying was more like 4-6% when you looked at the annual pace for other things, smoother things like core inflation, or inflation ex gas, or median CPI.

That's true, but actually in retrospect it slightly misses the mark. I don't think we should be saying 4-6% is the real inflation rate because the numbers are somewhat stale. Annual numbers are picking up all sorts of gremlins from nine, ten, eleven, and twelve months ago.

When we look at the more recent trend, even for those stickier measures, they're actually a fair bit better than that. For instance, the three-month annualized trend for core inflation is actually now down to 3.1%.

It's really in the realm of where headline inflation is. For CPI ex gas, the three-month trend is running at a 2.6% annualized pace. For median CPI, it's 3.8%. I guess the point is we were thinking for a while that, okay, official inflation is around 3%, but real inflation we were saying was 4%, 5%, 6%.

I think the real story is official inflation is around 3%, but maybe real inflation is running 3% to 4% or something like that. So, yeah, there's a little more work to be done than the headline number makes you think, but maybe not quite as much work as you would first guess.

U.S. debt downgrade: I'll finish with just a thought on the U.S. debt downgrade that came on August 1st. That was an AAA to AA+ rating downgrade by Fitch, which is one of the big three ratings agencies.

It's relevant in large part because two of the three agencies now assign something less than AAA. S&P did this way back in 2011. Didn't matter, though, because two of the three were still saying AAA. Two of the three now say AA+. So functionally, it's AA+.

I think there are two questions: was it appropriate and what are the implications on the appropriate side? We think ultimately, yes, for the first question, in the sense that the U.S. debt ratio is more than high enough to warrant a downgrade.

The size of the U.S. deficit is also more than large enough. The political problems also probably warrant the downgrade. We’ve had these debt ceiling nightmares, we've had government shutdowns that reflect problems in the budgeting process. There's no medium-term fiscal plan. There's a huge political schism between the two main parties. I think ultimately you can say it is warranted.

Then in terms of the implications that come from that, well, I guess we're seeing them in the sense that this has been one of the things driving bond yields higher. There's a small risk premium that's been inserted to reflect the slightly riskier status of the U.S. debt relative to before. Not the end of the world, though I would emphasize, in the sense that the U.S. is not likely to default in any kind of sustained way. It has ample economic resources.

AA+ is still a pretty good rating, by the way. Plenty of countries have lower debt ratings and are just fine, including France and South Korea and the UK and all major emerging market nations. It's not the end of the world, but it is a rebuke to the U.S. and hopefully alerts U.S. politicians that they should start doing something on the fiscal front. But I must confess I'm not holding my breath.

Okay, that's it for me. Thanks so much for your time. I hope you found all of this useful and interesting and I wish you very well with your investing. I hope you tune in next time.