Overview

This week’s note tackles several key items:

• Inflation continues to show signs of peaking, though the remarkable breadth of existing inflation (as measured a few different ways) and the prospect of inflationary echoes mean that inflation is unlikely to snap back to normal quickly.
• Supply chains continue to make significant improvements, with talk of coming discounts for some oversupplied items and reports of manufacturers starting to ask retailers for more business – the reverse of the prior situation.
• The transmission of negative economic shocks continues, from falling confidence to falling intentions, with new hints of falling activity.
• We continue to see a recession as substantially more likely than not, and yield curves and the consensus are now beginning to agree. The magnitude of the depth, breadth and recovery from a hypothetical recession is discussed.
• We find that falling stocks and home prices have the potential to chop multiple percentage points from consumer spending growth via the wealth effect.

Other developments not addressed in more detail later include:

• COVID-19 infections are rising across a wide range of countries (see next chart), signaling that the latest wave continues to form. Fortunately, countries such as South Africa and Portugal have already largely recovered from the variant driving this wave. This argues the consequences should be mild compared to prior waves.

Transmission rate below one means COVID-19 is decelerating

As of data available on 07/11/2022. Source: Our World in Data, Macrobond, RBC GAM

• Additional COVID-19 cases were detected in Shanghai, prompting concerns that another lockdown could be coming. Conversely, China is planning infrastructure stimulus and allowing an additional US$223 billion in local government debt issuance to support the property market.
• The Bank of Canada appears to be on the cusp of its first 75 basis point rate increase. Markets may be revising down their expectations for peak policy rates, but not the urgency with which central banks will be acting over the next few months.
• Recent political turmoil includes the resignation of British Prime Minister Johnson, the assassination of former Japanese Prime Minister Abe and the fall of Sri Lanka’s government amidst accusations of economic mismanagement.

Monthly webcast

Our economic webcast for July is now available: “Searching for peak inflation.”

Inflation debate continues

Inflation is extremely high and potentially peaking. This is thanks to:

• a recent decline in commodity prices on expectations of demand destruction
• easing supply chain constraints
• lower market-based inflation expectations (see next graphic for key inflation drivers over different time horizons).

Inflation very high right now, expected to ease over next year and beyond

As of 07/07/2022. Source: RBC GAM

To this end, the Cleveland Fed’s nowcast calls for a materially lower month-over-month U.S. inflation print in July (see next chart). However, the month is still fairly young.

U.S. inflation: sign of peaking?

Actual as of May 2022, Cleveland Fed inflation nowcast as of 07/05/2022. Source: U.S. Bureau of Economic Analysis (BEA), Federal Reserve Bank of Cleveland, Macrobond, RBC GAM

Inflation expectations

The decline in market-based inflation expectations merits particular attention given its magnitude (see next chart). Markets have gone from expecting around 4% annualized inflation over the next five years to around 2.5% inflation. That’s an enormous decline, taking expectations to a level that would permit fairly normal economic growth and financial market performance. It isn’t clear that we even want inflation to return all the way to pre-pandemic levels given that there were concerns about disinflation for much of the prior decade.

U.S. inflation expectations now falling

As of 07/06/2022. Source: Bloomberg, RBC GAM

A key complication is that inflation expectations are not yet falling among households and businesses. Consumer inflation expectations continue to rise for the moment (see next chart). Meanwhile, business inflation expectations also continue to mount. In Canada, 53% of businesses now expect Canadian inflation to remain above target for at least two more years. Compare that to just 38% as recently as at the start of the year. It would seem, unsurprisingly, that households and businesses place a greater weight on adaptive expectations. In turn, it isn’t quite certain that inflation falls happily from here.

U.S. survey-based inflation expectations have been rising but market-based expectations have started to fall

Market-based inflation expectations as of 07/08/2022, survey-based inflation expectations as of Jun 2022. Source: Federal Reserve, University of Michigan Surveys of Consumers, Haver Analytics, RBC GAM

There are mounting anecdotes about certain inflation pinch-points finally easing. Among them, auto production is now positioned to rise on a year-over-year basis. Some retailers are expected to begin heavily discounting certain items for which they possess too much stock – particularly bulky objects such as large couches, appliances and patio furniture. Chip shortages may also be starting to ease, in part as production rises and in part as pandemic-induced demand finally fades and the cryptocurrency mining boom abates. Target recently announced plans to offer discounts and it seems plausible that the word “sale” might re-enter the lexicon of retailers after two years of markups.

Corporate profit margins are at considerable risk as consumers become more price sensitive and as wage pressures persist.

Inflation unlikely to fall sharply

As some inflation pressures ease, it is important not to expect a sudden collapse in inflation. We have detailed in prior #MacroMemos the extent to which inflation pressures have broadened, complicating any subsequent normalization. Providing a further window into this, inflation pressures come from a mix of demand- and supply-side pressures, as estimated by the San Francisco Fed (see next chart). That means it isn’t enough just to weaken the economy: that would resolve the demand-side pressures, but less so the supply-side.

Both supply-and-demand-driven factors contribute to inflation

As of May 2022. Source: Federal Reserve Bank of San Francisco, BEA, RBC GAM

Analyzed through a completely different lens, we find that, even as U.S. core inflation has recently eased slightly, the non-COVID portion of the price basket has continued to accelerate (see next chart). Not all elements of inflation are settling down.

U.S. core Consumer Price Index: How COVID-sensitive items have contributed

As of May 2022. COVID-sensitive items include lodging away from home, used cars and trucks, cars and truck rentals, airline fare, televisions, toys, and computers and peripheral devices. Source: Haver Analytics, RBC GAM

Inflationary echoes

Inflationary echoes only become visible with a lag.

The adjustment process to higher energy costs is ongoing, with higher costs bleeding into other sectors via transportation and climate control costs.

Meanwhile, some parties are only becoming exposed to higher energy costs now. Natural gas prices tend to be heavily regulated at the retail level. In Canada, provincial regulators are only now passing through a portion of natural gas price increases that occurred in the spot market many months ago.

Walmart has announced it is passing higher transportation costs on to its suppliers. In the short run, that represents inflation avoided by consumers. But, over the medium run, those extra costs could still bleed through to consumers in the form of higher wholesale prices that circumvent Walmart’s efforts. The point is that economic actors are still playing “hot potato” with rising costs.

Even as the labour market begins to soften – more on that in a moment – wage growth may not be done exerting upward pressure on inflation. Wage growth has been badly outpaced by inflation over the past year, leaving real wages well behind. But history finds that workers do not usually suffer a permanent loss of income during periods of high inflation. As such, some wage catch-up remains possible, keeping inflation percolating.

All of this is to say that inflation is likely peaking and should come down somewhat over the next few months, but it is unlikely to reach normal levels in the near term. Additionally, there is even the chance that some of these inflationary echoes could temporarily revive inflation later.

Supply chains improve

Supply chain pressures continue to ease. The New York Fed’s aggregate supply chain measure now shows a material improvement (see next chart). Similarly, U.S. manufacturers are now complaining much less about supplier deliveries (see subsequent chart).

Global supply chain pressure has eased but still elevated

As of June 2022. Shaded area represents U.S. recession. Source: Gianluca Benigno, Julian di Giovanni, Jan J. J. Groen and Adam I. Noble, “A New Barometer of Global Supply Chain Pressures.” Federal Reserve Bank of New York Liberty Street Economics: Macrobond, RBC GAM

Supplier deliveries return to normal ranges, price increases seem to be stickier

As of June 2022. Shaded area represents recession. Source: Institute for Supply Management, Macrobond, RBC GAM

Anecdotally, some companies are now cancelling a portion of their third- and fourth-quarter orders as they re-evaluate the strength of economic demand over the remainder of the year. Meanwhile, at least one retailer has reported that Chinese factories have begun calling them to ask what they need, in contrast to the past two years when the calls were going in the opposite direction. All of this suggests supply chains are coming unstuck.

On the other hand, shipping backlogs cannot be said to have been completely resolved. Whereas port congestion has rapidly improved in North America, it is still quite intense in China and Europe (see next chart).

Port congestion in China, U.S. and the North Sea starts to ease

As of 07/01/2022. Percentage of global container ship cargo capacity tied up due to port congestion. Ports included: Georgia, Guangdong, Hong Kong, North Sea, Shanghai, Southern California, Southern Carolina, Zheijang. Source: Kiel Institute, Macrobond, RBC GAM

Real-time economic indicators remain challenging

Economic data remains mostly challenging. News sentiment, in particular, has sunk back down after a brief revival (see next chart).

Daily news sentimental during COVID-19 declines again

As of 07/03/2022. Source: Federal Reserve Bank of San Francisco, Macrobond, RBC GAM

Curiously, credit growth continues to run in a contrarian direction. It decelerated across most of the recovery after the extraordinary stimulus delivered in 2020. It has only recently begun to revive at the same time that the broader economy weakens.

U.S. credit continues to grow for now

As of the week ending 06/22/2022. Source: Federal Reserve, Macrobond, RBC GAM

Confidence and activity weaken

Consumer and business confidence has been plummeting for several months (see next two charts).

Consumer confidence is falling: U.S., euro area and U.K.

As of June 2022. Shaded area represents U.S. recession. Source: The Conference Board, European Commission (DG ECFIN), GfK UK, University of Michigan, Macrobond, RBC GAM

U.S. business expectations composite also drops

As of May 2022. Principal component analysis using National Federation of Independent Business (NFIB) optimism and business conditions outlook. ISM Manufacturing and Services new orders and The Conference Board CEO expectations for economy. Source: The Conference Board, ISM, NFIB, Macrobond, RBC GAM

Canadian sales expectations have also plummeted, though with the significant caveat that the question merely asks whether the growth in sales will slow, rather than whether the level of sales will decline (see next chart). Despite this, past sharp declines in the metric are still closely associated with recessions, not just with periods of decelerating growth.

Canadian Business Outlook Survey: Future Sales index declines

As of 2022 Q2. Source: Bank of Canada, Macrobond, RBC GAM

Now, the next natural progression is becoming apparent. Hiring and capital expenditure plans are both falling (see next two charts).

Employment Index for manufacturing and services sectors contract

As of June 2022. Shaded area represents recession. Source: ISM, Macrobond, RBC GAM

U.S. capex expectations dropping off quickly

Capital expenditures in 6 months (June 2022, in 3-month lead) are 3-month moving average of an aggregate of normalized indicators of future capex from surveys on manufacturing and non-manufacturing firms conducted by NFIB, the Federal Reserve Bank of Chicago, Dallas, Kansas City, New York, Philadelphia and Richmond. Real equipment investments as of Q1 2022. Source: Haver Analytics, RBC GAM

What remains is for actual economic activity to significantly weaken. This is still mostly speculative, but elements are starting to become visible. U.S. hiring in June was a fine +372,000 net new workers according to the payrolls survey, but was down in the more volatile household survey. Initial jobless claims have now been rising for several months (see next month). In Canada, employment actually fell by 43,000 net positions in June.

U.S. initial jobless claims hooking higher

As of week of June 27, 2022. Source: U.S. Department of Labor, Macrobond, RBC GAM

On the expenditures side, Bank of America’s real-time card spending metric reveals a deceleration to the point that consumer activity is now just barely above year-ago levels (see next chart). Given the high rate of inflation, inflation-adjusted card spending would likely be below the year-ago level.

U.S. aggregated daily card spending declined

As of 07/02/2022. Total card spending includes total BAC card activity which captures retail sales and services which are paid with cards. Does not include ACH payments. Source: Bank of America COVID-19 and the consumer weekly publication, RBC GAM

On a month-to-month basis, inflation-adjusted personal consumption in the U.S. fell in the month of May, though that must be viewed as an outlier so far, given that it is just the single month (see next chart).

U.S. real personal consumption growth also fell

As of May 2022. Source: U.S. Bureau of Economic Analysis (BEA), Macrobond, RBC GAM

Recession risks rise

We continue to view a recession as more likely than not, with perhaps a 75% chance of triggering over the next 18 months. This is no longer an outlier view. Expectations are increasingly shifting in this direction, as demonstrated by steady downgrades to the consensus growth forecast, falling inflation expectations and declining commodity prices.

The bond market is also pivoting toward a recession view. The U.S. 2-year to 10-year curve is now slightly inverted and two other key bond indicators also racing toward inversion (see next chart).

Yield curve indicators suggest rising recession risks

As of 07/06/2022. Near-term forward spread measured as forward rate of 3-month Treasury bill six quarters from now, minus spot 3-month Treasury yield. Shaded area represents recession. Source: Engstrom and Sharpe (2018). Feds notes. Washington: Board of Governors of the Federal Reserve System, Bloomberg, Haver Analytics, RBC GAM

Individual Americans feel similarly: a CivicScience poll conducted in late June found that a remarkable 71% of Americans expect the U.S. to be in a recession by the end of 2022.

Technically, the U.S. is at risk of recording a second consecutive quarter of declining GDP in Q2 of this year, having already suffered a decline in Q1. The much-respected Atlanta Fed’s GDPNow indicator predicts a 1.2% annualized decline for the second quarter. However, others have pointed out that the indicator may assume too much of an inventory drawdown and not enough of a trade rebound. Either way, without a simultaneous significant decline in employment, it can’t genuinely be said that a recession has already happened.

Any recession, should it happen, would likely be of a middling depth – perhaps a 2.5% decline in output spanning two or three quarters. It would likely start later this year or in early 2023. Of course, that decline would be in contrast to a “normal” 2% rise in GDP. So the full difference between normal growth and recession would be in the realm of a 4.5 percentage point swing.

Given that companies seem to want to employ far more people than they are able to right now, we assume that the unemployment rate would rise by a relatively tame amount given labour hoarding. Applying an Okun’s Law multiplier of 0.5, a 4.5 percentage point underperformance for growth would add something like 2.25 percentage points to the unemployment rate. That would leave a U.S. unemployment rate of just shy of 6%, and a Canadian unemployment rate of just over 7%. These are undesirable levels, but not nearly as dire as those reached during the prior few recessions.

Any subsequent economic recovery – now we’re really getting ahead of ourselves – would be highly unlikely to match the unprecedented haste of the pandemic recovery when the unemployment rate collapsed by 11 percentage points in a mere two years. Equally, it shouldn’t take as long as the post-global financial crisis recovery, when a much smaller improvement took nearly a decade. A middling rate of recovery is most likely.

Wealth effects emerge

People have become poorer over the past few quarters as financial assets depreciated. Loosely, stock market wealth in the U.S. has declined by around $10 trillion since the beginning of the year. Assuming a stock market wealth effect of two cents on the dollar, this should subtract around 1.5% from the level of annual consumer spending. This, of course, ignores losses from other financial assets and assumes that financial asset valuations don’t fall further from here. It is arguably safer to assume a wealth effect of -2% for consumer spending.

That analysis neglects housing market wealth. So far, home prices haven’t fallen significantly in the U.S. But, in a Canadian context, even a conservative 10% decline in home prices (at a higher wealth effect of 4 cents on the dollar – as per a greater inclination to translate housing wealth than equity wealth into spending) would theoretically subtract about 2% off of Canadian consumer spending. It is possible that home prices will fall by multiple times that amount.

Add on to this the fact that asset prices were until recently rising and thus adding to consumer spending, and the potential swing in consumer activity is even greater.

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