Soft landing narrative remains intact

Economic activity continues to hold up, increasing the odds of a soft landing.

In the U.S., the Fed’s Beige Book had been arguing for something resembling a recession given the large fraction of regions observing flat or even declining business activity. It has now staged an impressive rebound. Our Beige Book Sentiment Indicator, which converts the qualitative assessments within the report into a quantitative score, shows an impressive rebound in the latest report.

Beneath the surface, eight out of 12 regions reported rising activity (see next chart). In the prior report from January, seven of 12 regions had claimed flat or declining activity. Future growth prospects were also described as positive. This is a marked improvement from the primarily negative assessments in 2023.

Beige Book Sentiment Indicator shows an impressive rebound

As of March 2024. Indicator determined by assigning differently weighted positive and negative numerical points to a spectrum of positive and negative words used to describe overall economic growth in the Fed Beige Book. Sources: U.S. Federal Reserve, RBC GAM

The New York Federal Reserve’s weekly economic index also continues to rise. This signals that the economy remains in growth mode (see next chart). Low and steady weekly initial jobless claims reach a similar conclusion (see subsequent chart).

New York Fed Weekly Economic Index continues to rise

As of the week ended 03/16/2024. The WEI is an index of 10 indicators of real economic activity, scaled to align with the four-quarter gross domestic product (GDP) growth rate. Sources: Federal Reserve Bank of Dallas, Macrobond, RBC GAM

U.S. jobless claims remain low

As of the week ending 03/16/2024. Sources: U.S. Department of Labor, Macrobond, RBC GAM

The San Francisco Fed’s Daily News Sentiment Index has rocketed higher in recent months. In fact, it recently reached its highest level since the end of 2019. The news doesn’t give any reason to believe trouble is brewing.

Daily news sentiment in the U.S. has rocketed higher

As of 03/24/2024. Sources: Federal Reserve Bank of San Francisco, Macrobond, RBC GAM

While it is just one sector, U.S. oil production continues to rise. It recently reached a record level of output (see next chart). This has become a material share of the U.S. economy, and oil demand is also a useful proxy for the state of the economy.

U.S. crude oil field production has been rising

As of the week ending 03/15/2024. Sources: U.S. Energy Information Administration, Haver Analytics, RBC GAM

Admittedly, the Institute for Supply Management (ISM) Manufacturing and ISM Services indices retreated slightly in February. But the level of the Services index is still fairly healthy and the Manufacturing index is still well off earlier lows (see next chart). Nothing suggests a sudden deterioration in activity here.

U.S. manufacturing activity has bounced off floor

As of Feb 2024. Shaded area represents recession. Sources: Institute for Supply Management (ISM), Macrobond, RBC GAM

On the employment front, large-scale layoffs are running somewhat higher than normal. But they aren’t spiking, and such activity has been elevated for more than a year without undue damage to the economy (see next chart). We still fret about certain labour market trends – a subtly rising unemployment rate and declining temporary employment, prominently. But so long as jobless claims are low and monthly job creation remains robust, it is hard to get too worked up about them.

U.S. mass layoff announcements and announced job cuts remain elevated but not spiking

Worker Adjustment and Retraining Notification (WARN) notices as of Dec 2023. Challenger job cuts as of Jan 2024. WARN notices for larger states: California, New York, Florida, Texas, Illinois, Pennsylvania, Ohio, Maryland, Washington & Virginia. Shaded area represents recession. Sources: openICPSR, Challenger, Gray & Christmas, Federal Reserve Bank of St. Louis, Macrobond, RBC GAM

The Atlanta Federal Reserve’s closely watched gross domestic product (GDP) nowcast is currently calling for 2.1% annualized GDP growth in the first quarter of 2024. This is distinctly less than the 3-5% rate achieved over the second half of 2023, but that was patently unsustainable. A 2.1% growth rate is still perfectly fine, especially coming on the heels of such rapid growth.

While the Canadian economy has certainly been running cooler than in the U.S., there is also no evidence of a sudden drop.

• Statistics Canada’s real-time Local Business Conditions Index has actually leapt higher recently (see next chart).

• The economy also added 41,000 new jobs in February.

This second point is mildly underwhelming in the sense that it slightly undershoots the rate of job creation needed to absorb the country’s recent remarkable population growth. But it is a more-than-sufficient signal that the economy was growing.

Business conditions in Canada have rebounded

As of the week of 03/18/2024. Equal-weighted average of Business Conditions Index of Calgary, Edmonton, Montreal, Ottawa-Gatineau, Toronto, Vancouver and Winnipeg. Sources: Statistics Canada, Macrobond, RBC GAM

Inflation is falling gradually

Inflation remains in the realm of 3%. This is a massive improvement relative to the 8—10% peak, and yet still significantly above 2% targets.

The U.S. Consumer Price Index (CPI) had something for everyone in February. It landed a bit hotter than the consensus had expected, yet still revealed a slight improvement. For example:

• Core CPI year-over-year (YoY) edged downward from 3.9% to 3.8%.

• Headline CPI is at 3.2% YoY.

• Gas prices were higher in February.

• Core inflation experienced a second straight 0.4% monthly increase – a disappointment after months of 0.2% to 0.3% increases.

The journey downward from here will be more difficult, though a further decline is more likely than not. This is in part based off the observable trend already underway, in part that wage growth continues to ease, and in part because shelter costs play such a large role and should improve.

While shipping problems in the Red Sea have not been fully resolved, the cost of shipping a container is continuing to decline after an earlier spike (see next chart). This is mildly helpful, with particular relevance for Europe.

Incidentally, even as the trade of goods through the region becomes incrementally less problematic, the exchange of services has lately become more limited. Undersea telecommunication cables in the Red Sea were cut, presumably by Houthi rebels or their allies. This has primarily affected the internet in Africa.

Shipping costs rose on tensions in Red Sea

As of the week ending 03/03/2024. Sources: Drewry Supply Chain Advisors, Macrobond RBC GAM

Looking ahead to March inflation, it appears likely that inflation will again be fairly warm.

• Gas prices have increased further.

• Real-time inflation metrics argue for further strength (see next chart).

• The Cleveland Federal Reserve’s nowcast similarly argues for another fairly robust month.

U.S. Daily PriceStats Inflation Index shows inflation remains warm

PriceStats Inflation Index as of 03/22/2024. Consumer Price Index (CPI) as of Feb 2024. Sources: State Street Global Markets Research, RBC GAM

Canadian inflation has proven more cooperative in recent months.

• February CPI fell from 2.9% YoY to 2.8%.

• CPI ex-food and energy fell from 3.1% to 2.8%.

Shelter costs remain the big question mark for Canada. Rent and mortgage interest cost inflation remain quite elevated. The latter would of course improve if the Bank of Canada cuts rates, meaning that the rent component is the one that should be the focus of the Bank of Canada’s attention. But it isn’t quite as simple as that. A deeper look at shelter costs in the country reveals that quite a number of inputs have been running hot (see next chart).

Canadian CPI Shelter Index shows shelter costs remain high

As of February 2024. Sources: Statistics Canada, Macrobond, RBC GAM

Inflation expectations provide guidance

Inflation expectations provide some sense not just as to where inflation is expected to go, but where it may actually go given that price expectations help to set actual prices. There are quite a number of ways of teasing out inflation expectations for the U.S., ranging from bond market break-evens to consumer and business surveys. Each has a slightly different take (see next chart). Opinions also vary across different time horizons (see subsequent two charts).

U.S. inflation expectations are no longer falling

Market-based expectations as of 03/04/2024, survey-based consumer and business expectations as of Feb 2024. Sources: Federal Reserve Bank of Atlanta, Federal Reserve Board, University of Michigan Surveys of Consumers, Haver Analytics, RBC GAM

U.S. medium-term inflation expectations have risen slightly

As of 03/05/2024. Sources: Bloomberg, RBC GAM

U.S. consumers’ inflation expectations for the near-term have fallen

As of February 2024. Shaded area represents recession. Sources: University of Michigan Surveys of Consumers, Macrobond, RBC GAM

It is initially difficult to draw clear conclusions from this hodge-podge of information. Some inflation expectations are falling, others are flat, and some are rising.

It is arguably more useful to focus on their levels. All remain somewhat elevated relative to their pre-pandemic norm. On average, they are in the realm of 0.5ppt to 1.0ppt higher than normal. This argues that inflation is expected to get stuck in the 2.5% to 3.0% range – a slight improvement on current readings, but not a complete normalization down to 2.0%.

We are tempted to think that inflation can work its way down to the lower end of this range, but it will be a choppy process, it will take time, and it remains unclear whether the final 0.5ppt gap to 2.0% can be bridged.

Without a hard landing to reset corporate pricing power and wages, and with structural upward pressures on inflation that include presumed pandemic scarring, de-globalization, the rising clout of workers, and climate change, inflation may simply run a little hotter than before. Alternately, if central banks prove stubborn in their pursuit of lower inflation, real interest rates may need to be somewhat higher than otherwise. At the same time, economic activity may need to be somewhat weaker than otherwise.

Central banks diverge

Central banks have been off in every direction recently.

Constituting a lagging indicator, the Bank of Japan (BOJ) just delivered its first rate hike in 17 years, lifting its policy rate from -0.1% to 0.0—0.1%. It also discontinued its yield curve control system. This means it no longer has an explicit cap on the 10-year yield. While government bond purchases continue, Exchange Traded Funds (ETFs) and Real Estate Investment Trusts (REITs) will no longer be bought. This represents a reduction in the amount of liquidity (and price support to those markets) provided by the BOJ.

Motivating these actions, the BoJ is encouraged by strong spring wage settings for a second straight year. BOJ also expressed confidence in private consumption.

But BOJ is limited in terms of how much more tightening it can realistically deliver. Inflation expectations are not yet solidly in the range desired by the central bank. With an enormously high public debt load, the cost of servicing debt would skyrocket if interest rates rose too far.

Perhaps the more pressing question is the extent to which the Swiss National Bank (SNB) constitutes a leading indicator. It just surprised markets by cutting its policy rate. But the situation in Switzerland is quite different than in the average developed nation. For example:

• The Swiss policy rate was just 1.75% before the rate cut. That’s less than half the rate in most major developed countries.

• Even more importantly, Swiss inflation is just +1.2% YoY. This is far lower than in other countries, and already in the middle of the country’s 0-2% target range. 

• Finally, Switzerland is a highly trade-oriented economy and the Swiss franc has been strong. This reduces the country’s competitiveness. Rate cuts should help to partially restore this.

As such, other countries are unlikely to precisely follow the SNB’s lead. However, it does appear that rate cuts are probably coming in the U.S., U.K., euro area and Canada over the summer.

There’s a maxim that central banks usually take the elevator down and the escalator up. But between the fact that central banks instead took the elevator up this time and the idea that rate cuts may arrive without the usual recession to spur them on, perhaps this time is different.

The latest U.S. Federal Reserve (Fed) missive continued to convey a plan for 75bps of easing in 2024. Fed Chair Powell commented that the Fed is “not far” from being confident that “inflation is moving sustainably to 2%.” Markets price a 64% likelihood of a 25bps rate cut for the June Fed meeting. This is entirely reasonable, though given resilient inflation and mounting soft-landing prospects, July is just as likely a starting point in our view.

The European Central Bank and Bank of England both signaled that rate cuts are not far away, with June or thereabouts also a reasonable starting point.

Historically, central banks have cut rates aggressively once they get going, with 200-plus basis points of easing within the first year fairly normal (see next chart). There’s a maxim that central banks usually take the elevator down and the escalator up. But between the fact that central banks instead took the elevator up this time and the idea that rate cuts may arrive without the usual recession to spur them on, perhaps this time is different.

Rate cuts tend to happen quickly after the first cut

As of February 2024. Sources: Federal Reserve Board, Macrobond, RBC GAM

The Bank of Canada’s latest decision was to leave the overnight rate unchanged at 5.00%, and to maintain an explicitly neutral bias about the future. Indeed, the Bank said it is “too early to consider cuts.” It remains more coy about the prospect of rate cuts than its peer institutions, although the economy and inflation rate in Canada provide at least as much cover for tentative rate cuts as in the other markets. We assume modest rate cutting will also begin over the summer, despite the recent protestations.

Survey of various developments continues

Let us run through a medley of relevant macro-related developments in short order.

U.S. goverment funded, again

The latest threatened U.S. government shutdown was again averted at the last minute. Unlike the prior rounds, which only kicked the can down the road by a month or two, this one funds the bulk of the government’s budget right through the end of the fiscal year in September. It didn’t make political sense to shut the government down this year given the approaching election.

Republican nominee set

Since the last MacroMemo, former President Trump clinched the Republican nomination after romping through Super Tuesday primaries and the departure of his remaining opponent. Barring ill health, the November presidential election appears set to be a reprise of the Biden-Trump race of 2020.

Canadian budget approaches

The Canadian budget is now set for April 16 – unusually late in the fiscal year. It is likely to contain significant spending promises given anticipated pharmacare commitments. It will also likely indicate additional military spending as the country seeks to meet NATO’s 2% of GDP target. Rising debt-servicing costs should also add to expenses. The unpopularity of the Liberals and the approach of a presumed election in 2025 could also motivate additional spending. The Parliamentary Budget Office conservatively predicts the deficit will be double that of the prior year. It should be noted that Canada’s deficit as a share of GDP is still set to be smaller than the yawning fiscal gaps in many countries.

More tweaks to Canadian immigration

After announcing a 35% reduction in the international student target for future years, the federal government has now committed to reducing the overall number of temporary residents from 6.2% of the population to 5.0% by 2027. Mechanically, that argues Canadian population growth should decline from its incredible 3%+ pace in 2023 to approximately 0.9% per year over the next several years. It should then revert to a 1.2% annual growth rate in 2028 (given the country’s underlying target for 500,000 new permanent residents per year).

Some uncertainty arises from the fact that the government is considering making it easier for a large and growing number of illegal residents to secure permanent residency. That could limit the reduction in the population growth rate.

Woeful Canadian productivity stretches even further back

Not long ago we reported that Canadian productivity – or at least a reasonable proxy in the form of real GDP per capita – was no better than it had been six years earlier. That’s the worst performance (outside of recessions) dating back to World War II. With the latest quarterly data, the news is even worse: now Canadian GDP per capita is no better than it was eight years ago (see next chart).

Canadian GDP per capita has been shrinking

As of Q4 2023. Sources: Statistics Canada, Macrobond, RBC GAM

In fairness, the recent outright decline in productivity is unlikely to continue. It mainly reflects the impact of temporary forces such as absorbing an unusually large number of newcomers into the workforce. Further, the performance doesn’t look quite as bad from a household level if one deflates the data based on consumer prices instead of economy-wide prices, though it is still pretty bad.

Despite those caveats, Canada has a genuine productivity problem and it just got worse with the latest decline.

Measures of economic output in conflict

There are multiple ways to calculate the size of a country’s economy. The most commonly cited approach is via expenditure-based gross domestic product (GDP), which tallies up the amount that everyone has spent, makes an adjustment for trade and inventories, and arrives at an estimate of output. Another approach is via gross domestic income (GDI), which adds up everyone’s income in a way that should yield the same result. Theoretically, GDP should be precisely equal to GDI.

In practice, GDP and GDI tend to vary slightly, for reasons relating to the imprecisions of data collection. Most of the time, the differences between the two are quite small. Occasionally, a gap forms. Recently, GDI has been significantly underperforming GDP. Whereas GDP claims that the second half of 2023 was a period of remarkable growth, GDI thinks the economy utterly stagnated (see next chart).

U.S. gross domestic product (GDP) vs. gross domestic income (GDI)

GDP as of Q4 2023, GDI as of Q3 2023. Shaded area represents recession. Sources: U.S. Bureau of Economic Analysis (BEA), Macrobond, RBC GAM

Simple statistical analysis argues that GDI may lead GDP slightly, with the implication that GDP could be about to tumble, just like GDI already did. But the evidence for this is less compelling than it first seems.

• In recent decades, the only time GDI led GDP lower was into the global financial crisis. It was contemporaneous into other recessions, and is also otherwise contemporaneous, whether during recoveries or periods of normal growth. So it is far from certain that weak GDI signals weak GDP to come.

•  Other proxies for economic activity mostly claimed that the economy was doing fine over the second half of 2023, from labour market indicators to the stock market. That supports the view that the economy was indeed growing over the period.

In the end, the economy probably wasn’t quite as strong as GDP claimed, nor was it anywhere near as weak as GDI claimed. The economy probably grew moderately. Looking forward, it is unlikely that GDP remains quite as strong as it has recently been, yet it is also unlikely that GDI remains so weak. Both will probably revert to a more moderate level in the quarters ahead, with GDI potentially outperforming for a period to make up for the gap that recently formed.

Private credit isn’t driving the lending market

Lately, there have been some claims that while the flow of bank credit has been fairly constrained in recent quarters, this underestimates the true amount of liquidity being injected into the economy because private credit is doing much of the work.

To be sure, private credit is growing and thus is becoming more relevant to the broader economy. With US$1.4 trillion of private loans now outstanding, it can certainly move the needle. But some context is useful (see next chart). Private credit is still less than 5% of the overall credit market in the United States. Commercial bank loans are more than 10 times larger. Corporate bonds are seven times larger. The mortgage market (combining mortgages with MBS) is 16 times greater. Even the asset-backed security market is slightly bigger.

Private credit remains small portion of U.S. lending market

As of 03/08/2024. Sources: Securities Industry and Financial Markets Association (SIFMA), Federal Reserve, RBC GAM

This isn’t said to downplay the importance of a growing industry that plays an important role in the allocation of credit. But it just isn’t big enough yet to be a central driver of broader American credit conditions.

Where’s the cap-ex boom?

We and many others are optimists about the coming rate of technological progress. There are several exciting new technologies being developed, with generative artificial intelligence potentially capable of being the next general-purpose technology that accelerates the rate of productivity growth across a broad range of sectors over a sustained period of time.

But such productivity gains usually arrive with a considerable lag. It takes time to find uses for new technologies and to properly incorporate them into the flow of business activity and daily life.

In theory, one should first see the economic benefits of new technologies in the research and development and capital expenditure data. Companies spend a lot of money developing new technologies, and then others spend a lot of money buying and deploying those technologies.

Surprisingly, this isn’t actually happening yet. Sure, NVIDIA and a handful of others are earning skyrocketing profits, and a range of tech companies have seen their stock market valuations soar. But it doesn’t appear to be big enough – yet – to really show up in the aggregate economic numbers.

For instance, U.S. research and development grew beautifully as a share of GDP over the past two decades, but it has actually fallen sharply over the past year – the period of time when generative AI has come to greatest prominence (see next chart). This decline may be in significant part due to a special factor: the R&D accelerated depreciation tax credit expired at the end of 2022, presumably encouraging companies to delay further R&D. This tax credit may yet be restored before too long. But the fact remains that we aren’t yet getting the prophesied AI-driven R&D boom.

U.S. investment in research and development has declined

As of Q4 2023. Shaded area represents recession. Sources: U.S. Bureau of Economic Analysis (BEA), Macrobond, RBC GAM

It is a similar story on the capital expenditures side (see next chart). The spending on software has continued to rise as a share of GDP, though not any faster than before. Meanwhile, the spending on computers and peripherals – which one might have guessed would surge as all of those advanced computer chips gets deployed – has actually fallen fairly sharply over the past year.

U.S. capital investment in technology soared during the pandemic

As of Q4 2023. Shaded area represents recession. Sources: U.S. Bureau of Economic Analysis (BEA), Macrobond, RBC GAM

To be clear, we still think there will be stronger R&D and capital expenditures as a result of artificial intelligence advances. But it is taking a bit longer to arrive than news reports would have you believe, and longer than one might have reasonably expected.

Puzzling mortgage delinquency rates

The difference in the mortgage delinquency rate between the United States and Canada is quite surprising. The U.S. rate is 2.8%, whereas in Canada it is just 0.18%. You read that right: the U.S. delinquency rate is somehow 15 times higher.

This runs completely contrary to what one would expect given that Canada has worse housing affordability, more household debt, a weaker housing market, and a greater and more immediate exposure to rising interest rates.

So what is going on?

It turns out that definitional issues explain a significant fraction of the difference.

Crucially, the popular U.S. mortgage delinquency rate is a 30-day measure, whereas Canada’s is a 90-day measure. Far more people fall one month behind in their mortgage than three months. Adjusting for this, the U.S. mortgage delinquency rate falls from 2.8% to just 0.57%. The gap between the U.S. and Canada accordingly shrinks from 15 times to just three times (see next chart).

U.S. 90-day mortgage delinquencies rise

Sources: Canada Mortgage and Housing Corporation, RBC GAM

Another definitional difference is that the U.S. figure includes private lenders, whereas Canada’s does not. Private lenders generally lend to riskier borrowers, so their exclusion understates the true level of delinquencies in Canada. The Canadian mortgage delinquency rate on private loans is nearly six times greater than on bank-generated loans, and is also rising more quickly (see next chart). Performing some back-of-the-envelope math, Canada’s mortgage delinquency rate is probably around 0.22% when private lenders are included.

Mortgages in arrears are rising for Canadian private lenders

As of Q1 2023. Mortgages that are delinquent for 90 or more days. Sources: Survey of Non-Bank Mortgage Lenders, Canadian Bankers Association, Statistics Canada, RBC GAM

But this is still less than half the U.S. mortgage delinquency rate on approximately like-versus-like terms. We hypothesize that the remainder of the gap – and then some, given that you would expect Canada’s housing market to have the greater stress – comes down to such factors as no-recourse mortgages in the United States (which makes it less problematic for people to stop paying their mortgage). Canadian banks also have deep and multi-pronged relationships with their clients that both incentivize and allow for adjustments to the payment schedule.

As a result, it is probably best to ignore the raw numerical difference in the mortgage delinquency rate between the two countries, and instead watch for significant deviations from normal for either. Both are rising so far, but not explosively.  An acceleration in either would signal trouble.

Canada is still theoretically more vulnerable than the United States. Recent research from the International Monetary Fund (IMF) warns Canada has the highest risk of mortgage default in the world, above even Australia, Sweden and the Netherlands.

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