Inflation fears ease

The inflation revival that so concerned markets over the first three months of 2024 continues to fade. The U.S. consumer price index (CPI) decelerated further and substantially undercut expectations in May (see next chart). It marked another month of improvement with a flat monthly reading in the headline index (versus +0.1% expected) and a mere 0.16% increase in the core index (versus +0.3% expected).

U.S. consumer price index eases further

As of May 2024. Shaded area represents recession. Sources: U.S. Bureau of Labor Statistics (BLS), Macrobond, RBC GAM

Intriguingly, both headline and core consumer prices technically fell in May versus April. It is just that once the data is seasonally adjusted, the two price levels ended up flat and up 0.16% respectively. This is to say that it is normal for raw inflation to be slightly lower in May versus other months. Still, for the average person life became outright cheaper in May.

The granular data was also quite favourable (see next table). Gas prices fell, as expected. Food prices were up just 0.1%. New vehicle prices fell 0.5%, with apparel prices down 0.3%. Even motor vehicle insurance managed a price drop, after several months of massive increases – as we had predicted.

U.S. inflation data improves in May

As of May 2024 for Consumer Price Index (CPI) and Producer Price Index (PPI). As of April 2024 for Personal Consumption Expenditure (PCE) measures. Sources: U.S. Bureau of Economic Analysis (BEA), Bureau of Labor Statistics (BLS), Federal Reserve Bank of Cleveland, Federal Reserve Bank of Dallas, Macrobond, RBC GAM

Medical care service prices decelerated from +0.4% to +0.3% month over month (MoM), leaving prices for services excluding shelter down slightly on the month. This had previously been a source of inflation pressure.

Shelter inflation remained sticky at an unchanged and robust +0.4%. This last item remains the largest contributor to elevated inflation of +3.3% YoY, materially above the U.S. Federal Reserve’s 2.0% target. But shelter inflation should ease somewhat as lags play out over the coming months.

We aren’t leaping to pencil in further sub-0.2% core inflation increases in future months. The stars aligned in May, whereas 0.2% and occasionally even 0.3% monthly increases are probably more realistic for the months ahead.

An upside risk comes from rising shipping costs. These provide an ominous if muted echo of the supply chain crisis of 2021—2022 (see next chart).

Shipping costs rising after seasonal lull

As of the week ending 06/20/2024. Sources: Drewry Shipping Consultants Ltd., Macrobond, RBC GAM

But we do believe that inflation can realistically decelerate somewhat further over time. This is evidenced by swooning measures of real-time inflation (see next chart) paired with diminishing price pressures from a slowing economy.

U.S. Daily PriceStats Inflation Index drops

U.S. Daily PriceStats Inflation Index as of 06/17/2024, Consumer Price Index (CPI) as of May 2024. Sources: State Street Global Markets Research, RBC GAM

Fed policy rate remains unchanged

The U.S. Federal Reserve (the ‘Fed’) then had an opportunity to lay out its plan for the future. The fed funds rate remained unchanged, as expected, and the wording of the statement was only minimally altered. However, it did evolve in a dovish fashion with the introduction of a note that there has been “modest further progress” toward the central bank’s inflation target.

The timing of the meeting was awkward, coming mere hours after the aforementioned inflation report. While Fed participants were given the opportunity to revise their forecasts after the data was released, most opted not to. Whether that was because they didn’t have time to properly crunch the numbers or because one data print doesn’t substantially alter their thinking is up for debate.

Among the 19 canvassed Federal Reserve officials, four preferred no rate cuts at all in 2024, seven recommended a single 25bps cut, and another eight favoured two such cuts. Although the mean and median both point to a single rate cut, we suspect updated Fed thinking may be closer to two cuts, for two reasons:

• Some forecasts post-CPI were slightly stale.

• The single most popular option is for two cuts.

For context, the Fed had anticipated three rate cuts when last surveyed in March, so this represents a retreat. Financial markets currently price just under two full rate cuts by the end of the year. This is approximately in line with our thinking. The market currently prices in a 75% likelihood of a 25-basis-point rate cut by the Fed’s September meeting, with a further 25-basis-point cut mostly priced for December.

Looking further out, Federal Open Market Committee (FOMC) participants now anticipate a 3.25% policy rate by the end of 2026. They also point to a neutral policy rate of between 2.4% and 3.8% over the long run. We favour a slightly lower range of 2.0% to 3.5%.

U.S. liquidity edges higher

As the U.S. nears its first rate cut, it is worth stopping for a moment to reflect on the other ways central banks influence the economy and inflation. An obvious example is that many central banks – including the U.S. Federal Reserve – switched from quantitative easing to quantitative tightening a few years ago. Quantitative tightening involves pulling money out of the economy, and so imposes a drag on growth and inflation. This is above and beyond the direct adjustment of short-term rates.

Central banks do even more than this. As an example, the Fed was also in the business of providing special temporary funds (liquidity) to troubled banks over the past 15 months.

Conventionally, one looks at the overall size of the Fed’s balance sheet for evidence as to whether liquidity – which one might think of as stimulus – is being subtracted from the overall economy versus being added (see next chart). The blue line argues that the Fed’s balance sheet has been consistent with its rate hiking over the past few years, removing stimulus and helping to tame inflation.

Fed balance sheet is shrinking, but liquidity is rising

As of 06/17/2024. Sources: U.S. Federal Reserve, Macrobond, RBC GAM

But some monetary experts argue this isn’t quite the right metric to use. There is chatter about and rising support for an alternative net liquidity metric. This is displayed as the gold line in the prior chart which tracks liquidity. It is calculated as the Fed’s balance sheet minus reverse repos and the Treasury General Account.

It makes sense to remove the Treasury General Account because this is money the Treasury Department has pulled out of the economy and stored at the Fed. It should hardly be interpreted in the same light as money that has been injected into the economy by the Fed. The reverse repos represent the Fed temporarily selling securities in exchange for cash – a net draw on liquidity rather than a boost.

The net liquidity metric argues that, instead of declining, U.S. liquidity has been edging slightly higher over the past year. In turn, one might posit that this helps to explain why the economy in the U.S. was so resilient over the relevant time period, why U.S. inflation fell less willingly than elsewhere, and perhaps even why the U.S. stock market was so strong over the relevant period (see remarkable correlation in next chart). To be honest, we aren’t fully sold on this measure given some lingering questions about the logic behind it. But it is worth watching and has undeniably correlated well with the three aforementioned variables.

S&P 500 Index closely follows net liquidity

As at 06/17/2024. Sources: U.S. Federal Reserve, Macrobond, RBC GAM

The next obvious question is where this metric goes from here. Logically, you would think that the  ongoing quantitative tightening should gradually take over, pulling the liquidity down modestly. But that isn’t certain, given uncertainty not just around reverse repos but also regarding how long quantitative tightening will last and the opposing effect that the imminent arrival of rate cuts might indirectly have on the Fed’s balance sheet.

U.S. economic slowdown continues

The U.S. economic deceleration story continues. Economic surprises remain modestly negative. Retail sales were barely up in May. Weekly initial jobless claims continue to edge higher (see next chart). Housing starts also fell by 5.5% in May, to their lowest level since the pandemic lockdown.

U.S. jobless claims are ticking higher

As of the week ending 06/15/2024. Sources: U.S. Department of Labor, Macrobond, RBC GAM

Economic data in other developed markets has also trended in a slightly softer direction lately, reversing the acceleration they had enjoyed earlier in the year. As an example, the Eurozone Composite Purchasing Manager Index dipped in June from 52.2 to just 50.8 – barely in expansion mode. The Citi economic surprise indices for both the Eurozone and Japan have recently flipped back onto the negative side.

Dr. Copper declines

Even copper – the metal so attuned to economic conditions that it is purported to have a PhD in economics – has been slipping recently (see next chart). A fair part of the decline is the result of softer Chinese demand given the country’s depressed housing market. Reflecting this, Chinese copper inventories are now quite high (see subsequent chart).

Copper prices fall on weak Chinese demand and high inventory

As of 06/18/2024. Shaded area represents U.S. recession. Sources: London Metal Exchange (LME), Macrobond, RBC GAM

Chinese copper stocks rise to highest level in four years

As of 06/10/2024. Sources: Shanghai Futures Exchange, London Metal Exchange (LME), CME Group, Macrobond, RBC GAM

However, we are not too worked up about copper’s recent weakness for three main reasons:

1. Prices are still quite high and well above year-ago levels.

2. China normally has a copper inventory spike in the first half of the year (though this one has been bigger and lasted longer than the norm).

3. Copper inventory levels for the entire world are described as “dangerously low” (refer back to prior chart). So Chinese demand weakness would appear to be offset by ex-China strength.

Probing elsewhere in financial markets for hints of weakness, it is fair to observe that credit spreads have edged higher in recent weeks. Sometimes this is a sign of rising anxiety about the economy. But this time it appears to be largely the result of a different dynamic.

Credit these days trades primarily on the basis of its all-in yield, as opposed to its spread over government bonds. Thus, as government bond yields have fallen since April, the credit spread has widened to maintain a steady all-in yield. It does not appear to be a reflection of concern about credit quality or the economy in general.

A final thought on the decelerating economic trend: it still looks pretty benign to us. This is to say, it looks more like the desired soft landing that takes pressure and inflation out of the economy without imposing too much hardship, than it does a hard landing. Arguments in favour of this cheery interpretation include the gradually rising unemployment rate and gradually decelerating economic growth. This is in contrast to the more abrupt slowdown common in recessions.

Consumer vignettes show rising worries

We have paid special attention in recent weeks to the state of the consumer, with pieces on rising consumer price sensitivity and U.S. consumer worries.

It is still a subject of great interest, and what follows are some additional vignettes. There is certainly evidence of some additional stress. S&P 500 companies are suddenly very focused on the plight of lower-income consumers (see next chart), presumably because these have been most adversely affected by higher interest rates.

Concerns for lower-income consumers surged in latest quarter

As of Q2 2024 (partial data used for the quarter). Includes transcripts from all investor calls, investor days and capital markets days for Russell 3000 companies. Sources: Bloomberg, RB GAM

Those companies are also now highly attuned to the ’trading down’ phenomenon. This is where people scrimp by purchasing lower quality or cheaper goods than normal (see next chart). Budgets are being stretched by higher interest rates and in some cases the legacy of high inflation.

Mentions of ‘trading down’ in company transcripts have gone up recently

As of Q2 2024 (partial data used for the quarter). Includes transcripts from all investor calls, investor days and capital markets days for S&P 500 companies and Russell 3000 companies. Sources: Bloomberg, RBC GAM

But this is not to say that all consumers are financially distressed, nor that all activities are being scaled back. Prominently, air travel continues to surge. Some part of the latest increase is presumably seasonal, but current U.S. passenger throughput is now even higher than it was before the pandemic (see next chart).

Air travel in the U.S. is surging

As of 06/20/2024. 7DMA of TSA passenger throughout. Sources: U.S. Department of Homeland Security, Macrobond, RBC GAM

We continue to expect muted consumer spending growth over the remainder of 2024 and 2025, with the hope that declining interest rates may ease financial pressures in a way that begins to revive the consumer over the second half of next year.

Political developments heat up

U.S. debate

The first U.S. presidential debate is scheduled for this week on Thursday June 27. There are just two debates scheduled for this election cycle, making it potentially consequential. Given that Biden and Trump are the two oldest major-party presidential nominees in U.S. history, the debate is expected to be at least as much a referendum on how they sound – implicitly, their mental and verbal faculties – as what their policy positions are, or who delivers the best jab.

Then again, academic research increasingly finds that debates have virtually no impact on election outcomes. This is presumably in part because of the fragmentation of the media landscape that saps viewership, and in part because the remaining audience is composed mainly of political enthusiasts who already hold strong preferences.

International elections

This has been described as the year of the election given the unprecedented fraction of the world’s population voting in national elections this year. But truth be told, the results were until recently mostly on-consensus and only mildly consequential.

Then, the recent elections in India, South Africa and Mexico shook things up somewhat. All returned the incumbent party to power, but with altered levels of support that concerned markets.

• In India, the concern was that Prime Minister Modi might not be able to continue with his successful economic reforms given diminished congressional support.

• In South Africa, the worry was that the diminished African National Congress (ANC) Party would ally with parties advocating for sub-optimal economic policies.

• In Mexico, conversely, the concern was that the incumbent party had won by too great a margin – again, with potentially negative implications.

Fortunately, several of these political worries have now faded. India appears capable of continuing on its economic reform path. South Africa has formed a coalition deal that includes the country’s pro-business party. Conversely, Mexico’s landslide victory for the Morena party still elicits economic concerns.

Turning to Europe, the European elections in early June revealed a significant anti-establishment and sharply rightward tilt, with the European Conservatives and Reformists group capturing the second largest number of seats. The group possesses eurosceptic views that oppose further unbridled European integration.

In response to the rightward tilt within France’s portion of the EU elections, French President Macron has called a snap election for June 30, with a runoff on July 7. This gives the appearance of having backfired, with the far-right populist National Rally Party (previously National Front) in the lead (33% in the latest poll) and a coalition of left-leaning parties trailing in second place (27%). It is thus entirely possible that President Macron’s own centrist party (20%) does not even make it into the two-choice runoff.

This dynamic is creating concern not just in France but across Europe and in financial markets. French government bond yields have spiked wider versus Germany (see next chart). The MSCI Europe Index has also dropped since the election call.

Realistically, the risk of a French exit from the Eurozone or European Union (EU) is low. The National Rally Party and leader Le Pen advocate reforming the EU rather than exiting it altogether. The right-leaning Italian government may provide a template for how the party could temper its plans upon gaining power.

But in such a scenario, France might nevertheless be seeking to disentangle itself from some elements of the European project. These include exiting the continent’s common electrical market (like Spain), and asserting greater border controls (like Denmark and Sweden).

French-German bond yield spreads spiked on snap elections with the far-right party leading in polls

As of 06/18/2024. Spread of French and German 10-year government bond yields. Sources: Macrobond, RBC GAM

Some have compared France’s political situation to the UK’s so-called ‘Liz Truss moment’ in 2022 when the bond market panicked in response to an ill-advised budget. There is a certain parallel, but the main lesson from the UK is that the politicians pivoted in response to the concern expressed by markets, and financial markets then returned to normal.

Still, France is tracking a budget deficit of nearly 6% of gross domestic product (GDP) this year, which is unremarkable in comparison to some countries but nevertheless enormous by any historical standard. It is becoming more costly as the country’s debt rolls into higher rates. The two leading parties both have significant spending plans, to boot, including lowering the retirement age by two years. Compromise will be needed, both with the bond market and with the European Commission.

Meanwhile., the UK – no longer a member of the EU, of course  – appears to be on track for significant change of its own in its July 4 election. The Labour Party is all but certain to end 15 years of Conservative Party rule. Despite the anticipated change, the proposed changes to economic policy are fairly small. Among the highlights, the corporate and personal income tax rates will not rise, the party pledges to deepen ties with Europe, to reform immigration in favour of a points-based system and to build 1.5 million new homes.

Weight-loss drugs evolve

We have lately rhapsodized repeatedly about the promise of new technologies that could help to revive stagnant productivity growth. Generative artificial intelligence – and artificial intelligence (AI), more generally – normally captures the lion’s share of this attention. AI stands the best odds of becoming one of the general-purpose technologies that propel productivity forward across a wide range of industries and alter everyone’s lives. If realized, this will prove critical to offsetting the long-term economic headwinds coming from deglobalization, climate change, falling fertility rates and aging populations.

But there are also other new technologies that could prove significant for society, the economy and productivity. Quite a number reside within the health care space, including further deployment of mRNA, CRISPR gene editing, and eventually protein folding.

Another major health care breakthrough – and the focus of this section – is the development of a family of weight-loss drugs called GLP-1 that significantly and permanently reduce a patient’s weight (albeit through continued use). The best of these drugs results in an average of 21% weight loss, with new drugs in the pipeline that could exceed this.

Availability is so far fairly limited. This is due to their high price, limited on-label use and ineligibility under some health care plans, including U.S. government health insurance. But the price should come down with time, approved usage is broadening and as a result the drugs are likely to find their way into more health insurance plans before too long. If the drugs can be converted from an injection to a pill, that would be a further important step toward increasing uptake.

The promise of these technologies is not lost on the stock market, which has bid up the value of the two biggest such drugmakers over the past three years (see next chart).

Stock prices of drugmakers of new generation weight-loss drugs surged

As of 06/21/2024. Stock prices in USD and rebased. Food and Drug Administration (FDA) approved Ozempic for blood sugar control in adults with type 2 diabetes on 12/05/2017. Sources: Bloomberg, RBC GAM

As these drugs are democratized, they could begin to have society-wide implications. The most obvious result is simply that people will be thinner, achieving at least part of the weight loss they desire. But the implications could extend well beyond that, in a number of fascinating ways:

• The drugs work by reducing food cravings. This is good for those plagued by such cravings. However, it is notable in an investment context that this has negative implications for food companies in the broad sense that caloric consumption declines about 40% for users of the drugs. There’s an especially acute hit for those that sell the sorts of snacks that are consumed in response to cravings.

• Use of the drugs is already linked to fewer weight-adjacent illnesses such as diabetes, heart attack and stroke. It may also help with some kidney problems. This is obviously a huge plus from a health and well-being perspective. From an investment standpoint it represents a threat to companies currently treating such illnesses, and a big opportunity for those developing GLP-1 drugs.

• GLP-1 drugs appear to improve the cognitive function in some patients with Type 2 diabetes – albeit seemingly by reducing the cognitive-diminishing effects of the diabetes rather than uncovering some other reservoir of intelligence.

• GLP-1 drugs appear to help with other reward-system related disorders in animal trials. Cravings for cocaine, amphetamines, alcohol and nicotine all declined. If transferable to humans, this could be an effective tool for resolving many types of damaging addictions.

• There is a largely theoretical debate as to whether the decline in cravings could also reduce the pleasure in undertaking other activities, perhaps increasing depression and reducing one’s motivation to undertake useful tasks. In practice, these effects have not yet been widely observed, and for reasons not fully understood depression may actually fall in animals.

• One might imagine health care costs declining, possibly even to the point that government fiscal positions improve. Then again, if people are living longer, they may encounter age-related diseases at a greater rate later in life and may require larger pensions. More seniors’ homes might be needed if people are living longer, especially for those of limited financial means who are at present statistically more inclined to be overweight.

• Overall, being lighter and healthier could allow individuals – and if extended broadly enough, society – to live longer, be more active and socialize more. People may also participate in the workforce to a greater extent, and potentially be more productive when working.

The implications extend in practically every direction. Let us see whether governments opt to cover the costs of GLP-1 drugs, how widespread their use becomes, just how effectively they can be fine-tuned, how successful they truly are at reducing other forms of cravings and weight-adjacent diseases, and whether any other benefits or negative side-effects arise. But, on the whole, this could be a very good thing for humans, and a moderately good thing for the economy via higher labour force participation and greater productivity.

Canadian economy continues to move forward

We continue to nowcast Canadian monthly and quarterly GDP. Monthly GDP for April is now tracking 0.3%, in line with the Statistics Canada flash estimate. Second-quarter GDP is currently tracking +2.6% annualized – a fine number.

Unlike many developed countries, Canada’s economic surprises are still trending more positively than negatively. This was demonstrated by the latest retail sales report, which managed a 0.7% gain that was paired with an outright-strong +1.8% ex-auto gain. It should be conceded that the subsequent month is tracking a negative number, but the point is that overall economic activity in Canada is moving forward at a decent clip.

The Bank of Canada’s summary of its June 5 deliberations was also published recently. It was mostly a fairly pedestrian summary of the already-rendered decision, with no major surprises relative to the June 5 statement and press conference.

But the list of risks cited in the deliberations were very interesting. First, the summary acknowledged that the meeting participants could not agree on whether the risks tilted more toward higher inflation or lower inflation. Second, the list itself had some intriguing components that were far more granular than the usual pablum (such as growth could be stronger / growth could be weaker), These arguably merit further investigation:

• Many households have mortgages that reset into higher rates and higher payments in 2025.

• Alternately, the housing market could forcefully revive in response to rate cuts.

• The combination of weak productivity growth and strong wage growth – what Canada is currently experiencing – could create further inflation pressures in the service sector.

• The government’s plan to slow non-permanent immigration could affect the economy and inflation, with a particularly large influence on rents.

• Geopolitical risks are higher than normal, not just in the context of international conflicts, but also with regard to labour disruptions and climate events such as wildfires in Canada.

Canada’s shadow economy is growing

Canada’s underground economy in 2021 was officially estimated to be 2.7% of total GDP or C$68.5 billion by Statistics Canada. This includes both illegal activities and otherwise legal activities that are conducted under the table, such as to avoid issues of permitting, income tax and sales tax. The underground economy is heavily skewed toward the housing market. Fully 35% of underground economic activity is in the form of residential construction, with another 13% via the leasing of real estate. Retail trade and accommodation and food services are the sectors with the third and fourth largest contributions to the underground economy.

Estimating the size of the shadow economy is obviously an inexact science. Furthermore, such estimates are normally best left to statistical agencies. But we speculate that Canada’s underground economy has probably grown significantly since 2021. And, it may continue to grow significantly over the next few years due to the substantial and rising number of people in Canada on expired visas.

Canada’s immigration minister recently estimated that there are between 300,000 and 600,000 people living in Canada without valid documents. This is a huge number, and almost certainly much larger than in 2021. CIBC Economics has estimated that the number may be even higher, at about three-quarters of a million people. Call it between 1% and 2% of the population.

And this is a moving target. The recent surge in temporary foreign workers and international students has quadrupled the number of temporary foreign residents since 2015 to 2.7 million today.

This is a group that would seem to be at particular risk of remaining in Canada without valid documents since they have already settled in Canada, have had a taste of living here, have frequently formed a connection to the workforce, and then are asked – but not forced – to return home when their visas expire. These 2.7 million people will see their visas expire over the coming several years, and some will presumably remain, especially if the government continues to muse about extending amnesty to those without documentation.

Even as the number of temporary visas is reduced by the government, there will still be additional smaller cohorts entering in the future, with a similar decision to make upon the expiry of their visa.

It is impossible to say whether 1% or 5% or 50% of those with expiring visas will remain in Canada, but it stands to increase the undocumented fraction of the population significantly further.

In turn, Canada’s shadow economy should grow substantially. These people are highly motivated to work due to their inability to access the country’s social safety net plus they are ineligible to work in a formal work environment. That leaves the shadow economy.

On the one hand, it is heartening that the Canadian economy is larger than it looks and has perhaps been growing faster than it appears as the number of undocumented workers rises quickly. However, the government does not enjoy the benefit of taxing the underground economy, and working conditions and the products produced by it are unregulated. It is certainly preferable to minimize the size of the underground economy and keep everything above board.

-With contributions from Vivien Lee, Vanita Maharaj and Aaron Ma