Overview

Financial markets remain extraordinarily choppy and have continued to sour. While it would be premature to promise that valuations have reached their extremes, the opportunities are arguably growing for contrarian investors. We discuss currency moves and their implications below.

This week’s note also tackles the myriad economic challenges confronting the U.K., the new sensitivity of the bond market to fiscal matters, important developments with regard to the conflict in Ukraine, some thoughts on China’s upcoming National Congress, a mix of economic thoughts -- including the implications of recent hurricanes -- and a review of key geopolitical risks.

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Dollar strength

Some of the most notable recent swings in financial markets have occurred in the currency space. The pound, euro and yen have been particularly weak. However, the story is as much about remarkable U.S. dollar strength as weakness on the other side of the pairing (see next chart).

U.S. dollar has strengthened against currencies of most developed countries

As of 09/27/2022. Source: Macrobond, RBC GAM

Incidentally, while Canadians perceive their own currency to be weak given the nearly exclusive focus on its pairing with the greenback, it has actually been quite strong relative to most developed-world peers.

U.S. dollar strength is the result of several things. Of greatest importance, during a time of concerns about the global economy and heightened risk aversion, the superior safety and liquidity of the U.S. dollar makes it highly attractive, drawing in capital and strengthening the currency.

Another important dollar driver is the relatively more hawkish U.S. Federal Reserve. Not only does the Fed have a higher policy rate than the currency laggards, but its latest policy announcement revealed plans to tighten significantly further from here – potentially to nearly a 5% fed funds rate. This, in turn, is pressuring some of the laggards to raise their own policy rates by more than previously envisioned.

Lastly, the U.S. economy has been relatively more resilient so far. We still expect economic weakness for the U.S., but the deceleration to this point has been milder. The nadir there is likely to be less extreme than in the Eurozone or U.K.

Under normal circumstances, a big foreign exchange move like the 16% appreciation of the U.S. dollar versus the euro over the past year – carrying it past parity with the euro – would elicit considerable hand-wringing on U.S. shores about deteriorating competitiveness. But that has not been the focus. The U.S. is mostly thankful that its currency strength helps to dampen imported inflation and that investors are not fleeing its markets as problematically as in some jurisdictions.

In turn, talk of a coordinated international effort to weaken the dollar – as was implemented in September 1985 in the Plaza Accord – seems unlikely at present despite the desire of the weaker countries for a solution. The difference was that in 1985 the U.S. also disliked the strength of its currency. That same attitude is not visible today.

Another important difference from 1985 is that many of the countries with the weakest currencies arguably need this softness. For the Eurozone and U.K., this currency weakness – and the competitive boost it affords – helps to offset the competitiveness shock the countries have suffered as their energy costs have soared. For a manufacturer in Germany paying eight times more for electricity than it did before the pandemic, a sharply lower currency is critical to continue competing on the international stage.

This isn’t to say that countries love the full extent to which their currencies have weakened, nor the speed at which the move has occurred. Case in point, the Bank of Japan recently intervened to defend its currency. The yen had fallen by significantly more than other major currencies, in large part due to the unwillingness of the Bank of Japan to raise rates given its desire to change the inflation mentality in Japan. The implicit floor on the yen appears to be holding. China has also intervened to defend the yuan, while the U.K. has just cancelled part of the fiscal package that was drawing the ire of investors (discussed below).

Looking a little further down the road, if one envisions fading risk aversion in 2023 and a return to economic growth by the second half of 2023, it seems reasonable to expect some reversal of dollar strength. The temporary factors at work in the currency market today provide a further reason why a formal accord to alter currency valuations may not be necessary.

Pound problems

The weakness in the British pound has been particularly extraordinary. The currency recently hit a record low versus the dollar.

The rationale for this weakness includes the aforementioned forces – risk aversion, a relatively hawkish Fed, relative U.S. economic resilience, deteriorating competitiveness in Europe – plus a mix of made-in-the-U.K. complications.

The U.K. was arguably living beyond its means for years, as evidenced by a significant current account deficit that indicates spending was substantially outpacing production. This competitiveness was further damaged by Brexit, which erected barriers and sowed regulatory chaos. With natural gas prices soaring, the U.K. is now reliant on huge flows of foreign capital to remain operational (see next chart). When investors become skittish, these flows become more grudging, weakening the currency.

U.K. current account deficit yawns wider

As of Q2 2022. Source: U.K. Office for National Statistics (ONS), Macrobond, RBC GAM

The country then went through a period of rapid political change, with a new monarch and prime minister arriving within days of one another. New Prime Minister Truss and her finance minister Kwarteng recently proposed large tax cuts. Financial markets took this extremely poorly, with the pound collapsing and U.K. yields surging. In the span of a week, the British 10-year yield rose from 3.29% to 4.60%, while the pound tumbled from 1.14 to as low as 1.03. These markets have since partially unwound those moves as the Bank of England first intervened with emergency temporary bond purchases. More recently, the British government cancelled a portion of the planned tax cuts.

Why was the reaction so negative? Under normal circumstances, financial markets might have celebrated tax cuts that looked to increase the competitiveness of U.K. businesses through lower corporate income and dividend tax rates. Some reasons for the response include:

1. The proposed legislation was arguably the straw that broke the camel’s back, in that fiscal stimulus further spurs inflation at a time that the British economy is already suffering from high inflation. The Bank of England has to raise interest rates even more in its effort to cool the economy. Markets shifted from an expected peak policy rate of 4.72% two weeks ago to a huge 5.98% last week. Markets now price a giant 1.25ppt rate increase for the November meeting alone. However, calls for an emergency intermeeting rate hike have dulled somewhat.

2. The fiscal stimulus arguably had the wrong focus, cutting taxes disproportionately for the wealthy at a time of suffering for those with lower incomes. The announcement gave off a whiff of amateurism in the way it wasn’t professionally costed first.

3. Certain British financial actors – pension funds most prominently – proved unprepared for the sudden leap in bond yields given the amount of leverage they were carrying. This triggered giant margin calls, forcing liquidation attempts at a time when the market was not particularly receptive to such efforts. This was a prime motivation for the Bank of England’s temporary bond purchases. More broadly, it reflects poorly on British regulators that they allowed this pension sector vulnerability to form. The British mortgage market has also been profoundly affected as mortgage rates soar and some banks have proven reluctant to lend into such a volatile rate environment. The British housing market is now likely to follow a materially more negative trajectory in the coming quarters.

4. Despite the fact that the Bank of England has tentatively managed to calm markets, the U.K. has a surprisingly small quantity of currency reserves with which to defend sterling against depreciating pressures. The U.K. is thus particularly attractive for speculators to bet against.

5. As previously discussed, the U.K. current account deficit was already large before this proposal, having increased significantly on the back of natural gas subsidies just a few weeks before. The new tax cuts will add to the deficit, exacerbating the situation. The U.K. gross public debt-to-GDP ratio breached 100% in recent weeks – a symbolic threshold and an undesirably high level.

6. Currency weakness gets passed powerfully on to British inflation, with a multiplier of 0.2 to 0.3. This would suggest an extra percentage point or two of inflation just from recent currency weakness.

Rising fiscal sensitivity

For over a decade, sovereign debt markets have been mostly dismissive of concerns about mounting public debt loads. Countries could run substantial and lasting fiscal deficits without being punished via significantly higher yields. There were a few exceptions – prominently involving peripheral European sovereign borrowers – but they constituted the exception.

Two main factors largely explain that period of fiscal indifference:

1. Borrowing costs were so low that countries (and everyone else) could borrow a lot more than before without experiencing particularly burdensome debt-servicing costs. There were still limits on what countries could afford, but the limits had suddenly leapt well beyond actual debt levels.

2. Central banks delivered repeated rounds of quantitative easing over the past 13 years, buying many trillions of dollars’ worth of bonds in the process. This constituted a large new source of demand that created a shortage of bonds for other investors. For significant stretches of time, central banks were absorbing more than the entire net supply of new debt.

It goes without saying that both of these forces are now in significant reversal. Borrowing costs are soaring. Quantitative easing is being unwound even as fiscal deficits remain fairly large. That means the supply and demand of public debt is again becoming a relevant determinant of bond yields.

A long-standing rule of thumb is that a 1 percentage point increase in the public debt-to-GDP ratio should map onto a 3–5 basis point increase in a country’s 10-year yield. That rule worked loosely before the global financial crisis, failed utterly during the post-financial crisis era when deficits and debt simply didn’t matter, and could be starting to re-assert itself as borrowing costs rise again.

In fact, U.K. yields actually rose by more than the rule would suggest in response to the proposed fiscal package. This raises the possibility of a higher-than-normal fiscal sensitivity, albeit in the context of an especially troubled U.K. economic picture.

This newly rediscovered fiscal sensitivity could prove relevant elsewhere, before too long. As economies weaken and threaten to tumble into recession, governments will be sorely tempted to deliver additional fiscal stimulus. Indeed, one of our central theses is that we are operating in an era of larger-than-normal governments. Some may be punished in the bond market for the decision.

Ukraine war

The Ukraine war continues to evolve in important ways. The net implications are ambiguous.

On the one hand, Ukraine continues to make significant geographic gains. The country managed to reclaim another chunk of territory in recent days, having celebrated a large advance last month.

On the other hand, Russia is responding by escalating. It is calling up potentially hundreds of thousands of new troops and preventing military-aged men from leaving the country. It has made repeated nuclear threats and held a sham referendum in an attempt to cement its legitimacy over the Ukrainian territory it occupies. This provides a convenient context for Russia to further escalate the conflict when Ukraine seeks to reclaim what Russian now deems to be its own territory.

One might argue that the war has shifted from a predictable stalemate to an unpredictable war, and possibly even to an unpredictable end-game. It could go very well indeed if Ukraine continues to make large gains versus Russian bluster. It could go extremely badly if Russia were to cut off the rest of its oil and gas supplies or, in an extreme scenario, if Russia deployed a tactical nuclear weapon.

As an aside, and at the risk of delving too far down an unlikely path, while tactical nuclear weapons inflict considerably less damage than larger strategic nuclear weapons, the nuclear bombs dropped on Japan to end World War II were roughly on the same scale as modern-day tactical nuclear weapons. Thus, they are not to be trifled with both with regard to their initial destructive force and the radiation they unleash, let alone the risk of tit-for-tat nuclear escalation.

From an economic standpoint, none of this changes the view that sanctions on Russia will persist. In fact, they are more likely to intensify than they are to ease in the coming quarters. The natural gas situation in Europe is getting worse as pipelines are now not only being slowed, but outright sabotaged. The supply of oil remains highly uncertain with the risk that Russia materially clips its exports in early December.

Europe likely has enough natural gas to get through this winter – presuming some conservation in the realm of the 15% year-on-year decline Germany has already managed and assuming the winter is not especially cold. However, that still leaves the region in precarious shape for the subsequent winter, as inventory levels will be quite low and capacity to rebuild them will be limited over the summer of 2023.

China’s National Congress

The National Congress of the Communist Party of China begins on October 16. It has the potential to be consequential not just for China but for the world.

Of greatest significance, and despite rumours of some discontent within the Communist Party, President Xi is likely to be re-appointed for an unprecedented third five-year term. The government eliminated the two-term limit in 2018.

Xi has strengthened his hold on the government over the past decade, and as such can be expected to use his next term to further his desire for more control over the Chinese population, for a more assertive China versus the rest of the world, and for a further pivot back from private institutions toward public institutions. Entrepreneurs, private-sector businesses and market forces have all been diminished in recent years. None of these ambitions seem ideal for Chinese economic growth, which has already decelerated significantly over the past five years.

China’s zero-tolerance COVID-19 policy is unlikely to be materially altered until the spring. Significant COVID-19 waves tend to happen over the winter, and the country will want to prevent unnecessary transmission during Chinese New Year travel and festivities. If those restrictions then ease in the second quarter of next year, that would provide an important if temporary tailwind for the Chinese economy.

The Chinese property market may also be in focus. Close watchers of China doubt that significant changes will emerge from the National Congress – at least in the form of large-scale support. The government continues to emphasize that “housing is for living not for speculation.” Nevertheless, housing is one of the key sectors in play, and some further effort to stabilize it is possible.

From a more general economic perspective, China could reintroduce a growth target, possibly in the realm of +5.5% per year. This is less than the country previously achieved, but considerably more than is likely in 2022.  Key ongoing economic themes should include:

• enhancing the country’s “common prosperity” (code for reducing inequality)
• upgrading manufacturing
• achieving greater supply chain security in the context of food, energy and semiconductors
• continuing de-carbonization efforts.

Economic developments

Hurricane effects

Hurricanes Fiona and Ian have inflicted considerable damage in the Caribbean and along the Atlantic seaboard.

Preliminary estimates are that Hurricane Fiona caused between C$300M and $700M of insured losses in Canada. Estimates for Hurricane Ian in the U.S. are in the realm of $40B to $70B.

In addition to the tragic loss of life and property, there will inevitably be an effect on the economic numbers for late September and October. Between power outages, property damage and tens of thousands of displaced people, some businesses have simply not been able to operate at their normal clip. Florida GDP could be 6 percentage points lower in the third quarter, with U.S.-wide GDP up to 0.3ppt below normal.

Of course, natural disaster-driven economic losses are usually fully reclaimed in subsequent quarters. Perversely, areas hit by hurricanes tend to have stronger economic activity over subsequent years as reconstruction occurs. The timing could be particularly opportune for construction workers given the sagging performance of the U.S. housing market.

Economic data

A significantly negative global signal came from the latest FedEx earnings report, which announced a recent decline in global volumes, both internationally and in the U.S¹. In principle, FedEx should be a useful proxy for economic activity.

The Institute for Supply Management (ISM) Manufacturing Index descended from 52.8 to 50.9 in September. That’s just a hair above the threshold between growth and decline for the sector (see next chart). Providing a hint of things to come, the new orders component fell from 51.3 to 47.1, and the employment component dropped from 54.2 to 48.7.

U.S. manufacturing activities deteriorating

As of September 2022. Shaded area represents recession. Source: ISM, Haver Analytics, RBC GAM

Forecasts for U.S. Q3 GDP data continue to decelerate. The St. Louis Fed’s GDP nowcast has fallen to +0.55% annualized growth. The Atlanta Fed’s nowcast has slipped to +0.3%. Meanwhile, the Blue Chip consensus growth forecast for the third quarter has actually slipped into slightly negative territory.

All of that said, it is hardly the case that every economic signal is weak. The U.S. remains among the more resilient economies, with jobless claims recently reversing its earlier deterioration (see next chart).

U.S. initial jobless claims improve again

As of the week ending 09/24/2022. Source: Department of Labor, Macrobond, RBC GAM

Strangely, and in contrast to deteriorating growth forecasts, the OECD’s weekly economic tracker for the U.S. has actually been accelerating recently (see next chart).

Organization for Economic Co-operation and Development (OECD) Weekly Tracker of GDP growth, U.S.

Weekly Tracker as of the week ending 09/17/2022, actual GDP as of Q2 2022. Weekly GDP levels approximated using actual quarterly GDP and linear interpolation. Source: OECD Weekly Tracker (Woloszko, 2020), Macrobond, RBC GAM

The main conclusion is that while some economic data is weakening, it is not yet universal and a full-fledged recession is not yet upon us.

Housing pass-through

The housing market tends to be the most adversely affected part of the economy when interest rates rise. The direct effect of this has been well documented for the U.S., including sharply lower housing market sentiment, lower housing resales, a tentative decline in housing starts and a slight drop in building permits (see next chart). So far, residential construction employment and home prices have not yet been significantly affected, though they should eventually be. All should soften further over the coming quarters.

U.S. housing metrics reveal burgeoning weakness

Case-Shiller Home Price Index as of July 2022; building permits, housing starts, resales and employment as of August 2022; National Association of Home Builders (NAHB) Housing Market Index as of September 2022. Source: Bureau of Labor Statistics, U.S. Census Bureau, NAHB, National Association of Realtors (NAR), S&P Dow Jones Indices (SPDJI), Macrobond, RBC GAM

Housing weakness, in turn, is starting to bleed into adjacent industries such as furniture manufacturing and furniture sales (see next chart).

Housing weakness translating into lower furniture sales and employment

As of August 2022. Source: U.S. Census Bureau, U.S. Bureau of Labor Statistics (BLS), Macrobond, RBC GAM

Labour market distortions

We have regularly mused about why the labour market is so tight today. Prominent explanations include:

• The ferocity of the aggregate economic rebound over the past few years, to the point that many things in the economy are overheating, including the labour market.
• A shift in sector preferences with regard to the desires of consumers and the supply of workers, each at odds with the other.
• Significant early retirement during the pandemic (several million people in the U.S.).
• Younger workers also dropping out of the labour force to a significant extent (a few million people in the U.S.).

We have generally ascribed the altered behavior of these final two groups to shifting family priorities, the fear of getting sick, and surplus wealth built over the first two years of the pandemic. At that time, financial market and housing valuations both soared and households were saving more than normal.

But there is another plausible answer for the reduced supply of workers: many people may still be sick. We refer not to those who happen to have a weeklong bout of COVID-19 at any particular moment, but instead to long COVID: having persistent symptoms for months or even indefinitely. There have been two recent efforts to approximate the effect this has on the U.S. labour force:

• The Brookings Institution estimates a startling 3 million full-time equivalent workers are out of the labour force due to long COVID². That would significantly account for the shortfall in the labour force participation rate.³
• Conversely, a recent study from academics at Stanford and MIT figure “just” 500,000 people are missing from the labour force due to long COVID. That falls well short of explaining the entirety of the labour force gap, but still represents a significant number of people.

A further and unrelated labour market distortion of a more temporary nature is that more people have been taking vacations than over the prior few years. This plausibly requires more backfilling by businesses and thus temporarily exacerbates the tightness of the labour market. Approximately 4.8 million workers took vacation or personal days during the reference week in June versus 3.7 million the year before. However, it is unclear if more people are vacationing versus the pre-pandemic norm due to accumulated vacation days, which is the real question.

Geopolitical risks

Geopolitical risks rarely feel low: one can always drum up a few things to fret over. But they genuinely appear to be particularly elevated right now. This is partially a structural comment: we now inhabit a multipolar era – one in which there are multiple sheriffs in town, all vying for influence.

But there also rather specific near- and medium-term risks.

One begins, naturally, with the potential for a significant escalation of the war in Ukraine. Russia is threatening nuclear attacks in a manner that nuclear powers simply haven’t done before. As the country runs out of other options to save its dignity, the risk of a nuclear strike is not zero.

Another highly consequential but relatively low probability risk – albeit, as with Russia, a risk that is rising – is that China invades Taiwan. This could trigger a war between the U.S. and China, with cascading economic consequences that would dwarf the effect of Russian sanctions. We intend to write more about this in the coming weeks.

Iran represents another point of risk. The country is literally on the cusp of developing nuclear weapons, and it is an open question whether the U.S. or Israel might try to stop this acquisition via force. Efforts to secure another deal with the U.S. have stalled. It’s possible that Iran is delaying as it puts the finishing touches on its nuclear program. Iran’s influence has grown considerably over the years, now permeating not just Syria and Lebanon but also significant parts of Iraq and Syria. Fascinatingly, this has made for odd bedfellows as Saudi Arabia, the United Arab Emirates, Egypt and Israel find themselves tentatively united in opposition to Iran. The Middle East matters enormously to the global economy given that OPEC nations still produce about 40% of the world’s oil.

U.S. polarization is another obvious geopolitical risk. By some measures, this polarization is even greater than it was during the Civil War (see next chart). So far, that polarization has had surprisingly little effect on the U.S. economy. However, one worries that it eventually could, be it through more extreme (and thus arguably worse) public policy, from declining trust (both among businesses and people), due to a rising risk premium inserted into U.S. borrowing costs, or even via a coup. The upcoming U.S. midterms don’t appear set to upset the apple cart, but the 2024 election could.

U.S. Congress partisan polarization intensifies

As of 09/07/2022. Measured as the difference between median scores for the Democratic and Republican members in the House of Representatives and Senate. Source: Voteview.com, RBC GAM

Political issues are not confined to the U.S. A number of European countries have recently shifted quite far right on the spectrum, including Italy and Sweden. To the extent skepticism about the European Union is a feature of some of these groups, there could yet be existential complications at the super-sovereign level for Europe.

The list of geopolitical risks runs on and on. Will there be significant unrest after the Brazilian election? Might Russia’s empire-building aspirations eventually include a bigger chunk of the Arctic, of consequence to Canadians? Could skirmishes between China and India – the world’s two most populated nations – eventually degenerate into a full-fledged war? Might emerging-market countries turn on the developed world, demanding massive reparations for the damage done by climate change?

Few of these are likely to manifest in the near term, and it is generally not advisable to invest primarily on the basis of geopolitical risks. But, every once in a while, such risks end up mattering quite a lot – as in the lead-up to Russia’s invasion of Ukraine.

-With contributions from Vivien Lee, Vanessa Adams and Aaron Ma