Monthly economic webcast

Our latest webcast is now available, entitled “Financial stress complicates macro picture.”

Banking stress

We wrote about the banking stress that emerged in March in our last #MacroMemo. What follows are a few updates.

As efforts continue to gauge the severity of recent banking stress relative to that of the global financial crisis, it is initially concerning that liquidity lines are being tapped nearly to the same extent today as they were in 2008-2009 (see next chart).

Emergency lending to banks by Fed soared amid latest bank failures

As of week ending 03/30/2023. Source: Federal Reserve Bank, Macrobond, RBC GAM

However, in our view, the comparison is flawed. The liquidity on offer today is much more generous than it was during the global financial crisis, making banks more willing to pursue it. A key feature of the Bank Term Lending Facility introduced last month is that it accepts bonds as collateral at their face value, rather than their diminished market value. In contrast, the alphabet soup of programs introduced in 2008 and 2009 were initially more limited in the scope of collateral they accepted, and then later demanded a haircut (applying a reduction to the value) or an insurance premium when riskier bonds were posted.

Though not visible in the chart above, elements of the Fed’s balance sheet have actually begun to shrink in recent weeks. This is a good sign that the intensity of the need for liquidity is starting to ease (see next chart).

Emergency lending to banks by Federal Reserve has started to fall

As of week ending 04/06/2023. Source: Federal Reserve Bank, Macrobond, RBC GAM

The true measure of the amount of peril banks are in can be approximated via their credit spreads. In both the U.S. and Europe, these are massively less concerning than during the global financial crisis (see next three charts).

Swap spreads in the U.S. and Eurozone rise during banking crisis

As of March 31, 2023. Source: Bloomberg, RBC GAM

U.S. funding stress indicator surges amid banking turmoil

As of 03/28/2023. Spreads between forward rate agreements and overnight index swaps. Source: Bloomberg, RBC GAM

European funding stress indicator remains elevated despite government interventions

As of 03/30/2023. Spreads between 3-month Euribor and Euro short-term rates. Source: Bloomberg, RBC GAM

To be sure, there are still concerns about individual financial institutions. For instance, First Republic shares in the U.S. continue to trade at just one-tenth of their level from two months ago, despite a U.S.$30 billion infusion of capital by other large American banks.

Furthermore, higher interest rates may continue to surface financial distress, as they usually do. The U.S. commercial real estate sector is also under a great deal of scrutiny. This is due to the trifecta of falling demand due to the working from home phenomenon, rising interest rates, and a disproportionate reliance on the very same small and mid-sized American banks that are now under pressure.

While we believe the economic outlook is incrementally darkened by recent banking stress, a key transmission channel is often via tighter financial conditions. These haven’t actually tightened all that much over the past month (see next chart). Of course, other transmission channels continue to deteriorate, such as bank lending standards.

Global financial conditions tightened again recently

As of 03/28/2023. Source: Goldman Sachs, Bloomberg, RBC GAM

Economic resilience

Across the G10, economic data has picked up somewhat over the past few quarters, though not to the point of signaling outright strong growth (see next chart).

Global economic growth has ticked up

As of 04/06/2023. Source: Citigroup, Bloomberg, RBC GAM

Consistent with this, the global manufacturing Purchasing Managers’ Index (PMI) has been edging higher, though it remains uninspired on a level basis (see next chart).

Manufacturing improved in developed countries while emerging markets continued to expand

As of March 2023. PMI refers to Purchasing Managers’ Index for manufacturing sector, a measure for economic activity. Source: Haver Analytics, RBC GAM

Despite this middling picture, the economic data has significantly exceeded expectations over the period, as demonstrated by substantially positive economic surprises (see next chart). This is the say, the consensus was for weak economic data, but it wasn’t as bad as that.

Global economic surprises are now positive

As of 04/06/2023. Source: Citigroup, Bloomberg, RBC GAM

The North American labour market remains stubbornly strong. U.S. job creation may be a lot slower than it was a year or two ago (see next chart), but it is still consistent with an actively tightening labour market. Another 236,000 jobs were added in March, slightly above the consensus and sufficient to reduce the unemployment rate from 3.6% to 3.5%. That said, the pace of wage growth continues to slow, which is significant since the main concern about a tight labour market is that it might continue to spur inflation.

U.S. job growth slows, but still remains strong

As of March 2023. Shaded area represents recession. Source: U.S. Bureau of Labor Statistics (BLS), Macrobond, RBC GAM

In Canada, 35,000 new jobs were added in March, keeping the unemployment rate steady at a low 5.0%.

There remain exceptions to the story of resilient economic data, of course. The U.S. Institute for Supply Management (ISM) Manufacturing Index continues to tumble, now sitting near the historical recession threshold (see next chart). The ISM Services Index also fell substantially in March.

U.S. manufacturing activities now contracting

As of March 2023. Shaded area represents recession. Source: ISM, Haver Analytics, RBC GAM

Global trade also continues to descend. Of greatest relevance, trade on an inflation-adjusted basis has declined, which is rare (see next chart). This has historically boded ill for the economy.

Global trade fell in both nominal and real values

As of January 2023. Shaded area represents U.S. recession. Source: CPB Netherlands Bureau for Economic Policy Analysis, Macrobond, RBC GAM

Waiting on inflation

Another set of monthly inflation prints arrive soon. The tentative evidence remains supportive of a decent decline in inflation in March. Most informatively, a key real-time inflation measure argues that inflation didn’t just continue its gradual deceleration in March but may have tumbled lower (see next chart).

U.S. Daily PriceStats Inflation Index shows sharp decline

PriceStats Inflation Index as of 04/02/2023, Consumer Price Index (CPI) as of Feb 2023. Source: State Street Global Markets Research, RBC GAM

In our view, the central issue with inflation right now is that, even though core goods inflation has largely vanished, core services ex shelter remains somewhat too high and shelter costs – as measured by the Consumer Price Index (CPI) – are actively accelerating (see next chart). The latter should begin to abate around the middle of this year due to overwhelming evidence of a weaker housing market and the lags involved. But it would be nice to physically see this as opposed to taking it on faith.

Shelter and core services are now the drivers of sticky inflation in U.S.

As of February 2023. Source: Bureau of Labor Statistics (BLS), Haver Analytics, Macrobond, RBC GAM

Tight economy

The best predictor of core services ex shelter inflation is the tightness of the labour market and economy. On this subject, there are many varying opinions. We have combined five different takes on the size of the U.S. output gap (see next chart).

U.S. economy is running above full capacity

Congressional Budget Office (CBO), GAM model 1 and 2 estimates as of Q4 2022, International Monetary Fund (IMF) estimates as of Oct 2022, Organisation for Economic Co-operation and Development (OECD) estimates as of Nov 2022. GAM model 1 estimated using Congressional Budget Office (CBO) natural rate of unemployment, GAM model 2 estimated using Hodrick-Prescott (HP) filter trends. Shaded area represents recession. Source: Macrobond, RBC GAM

The most optimistic estimate came from the U.S. Congressional Budget Office. It insists the U.S. still has 1.0 percentage point of economic slack before the economy reaches its potential. That would argue that too much economic demand is not a factor in high inflation.

One of our own models emerges as the most pessimistic view. It argues that the economy is substantially overheating, running a big 1.7 percentage points beyond its sustainable capacity. That argues a significant fraction of the inflation blame falls on the shoulders of an overheated economy.

The average of the models says that the economy is moderately overheating, and we would editorialize that it probably needs to cool somewhat before inflation can fully normalize. We forecast a recession in part because there are sufficient economic headwinds for this to constitute a likely outcome. Also, a recession may be needed to take enough air out of the economy so that the inflation objective can be met.

Consensus inflation forecast

The consensus outlook remains for 2023 U.S. inflation to be roughly half the rate of 2022, and for 2024 inflation to again be significantly lower (see next chart). This is good news. But the consensus believes that inflation will remain moderately above 2.0% even next year, and the consensus forecasts have been edging slightly higher in recent months after disappointing prints in January and February. Our own forecasts remain slightly below – more optimistic than – the consensus.

U.S. consensus inflation forecast rises for 2023 and 2024

As of March 2023. Source: Consensus Economics, RBC GAM

The consensus inflation outlook is somewhat more promising when regarded internationally. The fraction of countries with a rising inflation forecast has shrunk markedly over the past year. Conversely, the fraction with a falling inflation forecast has increased significantly, if not quite catching up to the former (see next chart).

Inflation outlook for a number of countries has been revised down

As of March 2023. Shaded area represents U.S. recession. Source: Consensus Economics, RBC GAM

Who wins and who loses during an unexpected, temporary inflation shock?

It is widely appreciated that there are more losers than winners when inflation unexpectedly spikes, as occurred over the past two years (see next table).

Who loses when inflation spikes?

Source: RBC GAM

Households lose because wage growth usually doesn’t pick up quickly enough to compensate for the drop they experience in purchasing power.

Some companies lose (though, as we will discuss shortly, not all), especially if they suffer from low pricing power, or if they have a growth orientation. Future earnings become much less appreciated in an elevated inflation environment due to a higher discount rate.

Those who make fixed-rate loans – whether financial institutions or bond owners – are invariably punished by an unexpected increase in inflation. The previously agreed-upon interest rate fails to adequately compensate for the additional erosive power of inflation.

Those who hold physical cash suffer an even faster depreciation than normal.

Equity investors enjoy a natural hedge on the revenue and earnings side of the equation. However, they nevertheless suffer a drop in the valuation of their holdings due to the aforementioned higher discount rate that diminishes the present value of future earnings.

Investors of all stripes suffer a higher real effective tax rate on their investment earnings. Put in simple language, governments tax nominal returns, not real returns. When inflation rises, the taxes extracted increase even when the inflation-adjusted return doesn’t.

Finally, the economy generally does slightly worse when inflation is hotter due to a variety of small frictions. Economic performance can then considerably worsen if central banks are actively working to counteract the extra inflation, as they are doing today. This incrementally hurts all economic actors.

In contrast, and to much lesser acclaim, there can also be winners from an unexpected leap in inflation (see next table).

Who wins when inflation spikes?

Source: RBC GAM

Some companies thrive with higher inflation. They manage to use their superior pricing power to fully protect their earnings from inflation, or even to extract higher margins. Companies with large labour costs will generally fare better since wages are initially less responsive to inflation. Capital-intensive businesses can also do well since they have already acquired the bulk of their capital stock before the inflation arrived.

As evidenced by soaring revenues in recent government budgets, governments can do very nicely in the short run when inflation rises. Government revenue accelerates quickly as sales tax revenue rises in line with prices, as corporate earnings similarly increase, and as private-sector wages go up (albeit with a lag and less fully).

At the same time, many government expenses take longer to respond to inflation. If a certain sum of money has been committed to a program, nothing changes in the short run. Government wages respond with a lag. So do the indexation of pensions and the greater cost of servicing public debt. Governments also get to collect a higher effective tax rate on investment income, as discussed earlier.

The government debt-to-GDP ratio also becomes more manageable. The nominal GDP denominator rises more quickly in the short run (this consists of real GDP plus inflation), while the nominal government debt numerator doesn’t change.

Finally, fixed-rate borrowers win because they borrowed money at fixed rates when inflation was expected to be lower. This means their real borrowing rate is lower than would otherwise have been agreed upon once inflation has risen.

There is a final third group: those who do not significantly win or lose (see next table).

Who is relatively unaffected when inflation spikes?

Source: RBC GAM

Variable-rate lenders and variable-rate borrowers should come out roughly neutrally so long as markets are correctly pricing the spurt of inflation once it has begun. This is to say, borrowers pay a higher nominal rate and lenders receive a higher nominal rate, but these theoretically disappear on a real basis. This may be truer in theory than in practice, since the real rate can rise once central banks respond to the excessive inflation.

Those holding real assets should theoretically be compensated for the extra inflation, but no more.

Fewer implications if the extra inflation is permanent

Counterintuitively, if the extra inflation is permanent and anticipated, the implications are much smaller.

Fixed-rate borrowers no longer lose and fixed-rate lenders no longer win because inflation that has been anticipated can be properly priced into the borrowing cost. It is the same for governments. Over the long run, government wages should keep pace with any extra inflation and program expenses should mount to match faster revenue growth.

What remains are only negatives, though it’s a pared down list relative to when inflation shock is temporary.

• The holders of physical cash continue to lose.
• Equity investors still suffer lower valuations due to that increased discount rate. The real effective tax rate on investments remains somewhat higher due to the application of taxes on nominal rather than inflation-adjusted earnings.
• The economy itself remains slightly weaker, in part because of the corrosive effects of higher inflation. It’s also in part because central banks presumably continue to wage war against the extra inflation (unless the actual inflation target were to increase, which is a rare occurrence and not likely in the foreseeable future).

Our own long-term inflation forecasts anticipate that inflation could run between a few tenths of a percentage point and half a percentage point higher than the normal 2.0% target, making these observations potentially relevant for the coming years.

Polarization and indictment

Former President Trump has been indicted on a number of charges related to hush payments made during his first presidential campaign. Opinions abound on who wins and who loses from this action.

Trump may enjoy a boost in popularity given his anti-establishment base, but he could lose the centrist voters who are needed to elect a president in 2024. These is also a chance he is convicted, though jail time is unusual for a first-time offender.

The Republican Party’s fate is no longer quite as tied to Trump as in the past, but it is still significantly influenced by his prospects.

Finally, this could be a win for the Democratic Party if Trump is convicted, or a loss if he is found not guilty. Even if Trump is convicted, this could simply open up the Republican nomination in 2024 for a more viable presidential candidate.

Additionally, many believe prosecutors have overstepped in pursuing felony charges over a matter that would normally not elicit such a harsh punishment. Furthermore, some believe that it would have been preferable to first pursue more serious allegations against Trump such as those pertaining to his role in the January 6, 2021 attack on the Capitol.

What is clear is that U.S. political polarization remains extreme, with 94% of Democrats approving of the indictment and 79% of Republicans disapproving. Polarization has been rising and societal trust has been falling for some time, a subject we wrote about in April of 2022.

To recap, we continue to look for evidence that the loss of trust has become sufficiently large that commercial transactions become less smooth, that U.S. risk premiums are increasing, or that public policy has drifted sufficiently far from centre that society or the economy suffers. While the last item is highly subjective, there is little evidence of the latter two problems. As such, we remain on watch. The other obvious U.S. political flashpoint in 2023 is the debt ceiling quagmire that will have to be resolved just past mid-year.

-With contributions from Vivien Lee, Thao Le and Aaron Ma