Global Investment Outlook

RBC Global Asset Management’s Global Investment Outlook Fall 2021 is now available. The economic outlook article begins on page 15, and is entitled “Glide path toward normal growth.”

Overview

This week’s #MacroMemo covers a wide range of thematic topics. It begins with a cursory review of the latest COVID-19 trends, before moving to other important topics including China’s property market in the context of Evergrande, the broader Chinese regulatory crackdown and the recent Chinese economic trend. The report then pivots toward public policy, reviewing the latest U.S. Fed Reserve decision, U.S. political developments and the German and Canadian elections. Finally, we investigate two inflation-related subjects: the surge in natural gas prices and persistent supply chain issues.

There is no shortage of new negatives to consider:

• Higher financial market volatility
• High natural gas prices
• Chinese property market troubles
• Ongoing and arguably intensifying supply chain issues

However, these are balanced by equally salient if less surprising developments on the opposite side:

• COVID-19 infections continue to tumble
• There is tentative evidence that the recent U.S. economic slowdown is stabilizing – which makes sense, as the Delta variant now represents less of a headwind.

Volatile markets

Financial markets have been choppier and generally less happy over the past month than they were earlier. This isn’t entirely shocking as economic growth has slowed and a number of new headwinds and risks have arisen.

Nevertheless, the situation needs to be put into context. The economic outlook remains fantastic by any standard other than that of the past year. The additional volatility (and anticipated volatility) is pretty slight relative to prior bouts (see next chart).

Volatility returned to pre-pandemic levels

As of the week ending 09/24/2021. Jan 2007 = 100. Source: Bloomberg, RBC GAM

Infections

The pandemic situation continues to improve – new infections are still falling nicely for both emerging markets and developed nations (see next chart).

COVID-19 emerging market vs. developed market infections

As of 09/26/2021. Calculated as the 7-day moving average of daily infections. Source: WHO, Macrobond, RBC GAM

At the national level, previous emerging market holdouts – including Vietnam and Malaysia – are now finally improving, potentially removing some pressure on manufacturing in Southeast Asia.

In the developed world, U.K. cases remain high, but if Scotland continues to be a leading indicator, they may shortly begin to decline. Continental Europe’s infection numbers are broadly improving, including in Germany, France, Italy and Spain. Japan’s case count has plummeted.

U.S. infections are in significant retreat at the national level, and in most states (see next chart). Canadian infections are flat to declining slightly.

Transmission rate, U.S. states

As of 09/26/2021. Transmission rate calculated as 7-day change of underlying 5-day moving average of new daily cases, smoothed with 7-day moving average. States above dotted line at one have increasing new daily cases. Includes Washington, D.C. Source: Haver Analytics, Macrobond, RBC GAM

The last wave?

Does this signal the final significant wave of the pandemic? Maybe. No other variant seems poised to hurdle past the Delta variant. Vaccination rates continue to rise, and the supply of vaccines should be sufficient to provide boosters that ensure those who are currently protected do not become vulnerable again.

But there is still the possibility of future waves. There could yet be a more contagious or more damaging strain of the virus that eventually emerges. People could let down their guard too much, increasing the transmission rate above current levels. Colder weather could increase the transmission rate, as it did last year, though that isn’t yet visible.

The return to schooling could also increase the rate of infection: a recent study found that opening schools increases a region’s infection rate by 25% over the subsequent four weeks. Fortunately, the U.S. is now more than a month into the school year, and while there have been many school-based cases, this has not been enough to outweigh other forces that are pushing downward on infections. The next 1—2 weeks should be informative for Canada on this front.

Hospitalizations

Policymakers continue to make decisions about the pandemic based in large part on how full hospitals are. The good news is that hospitalization rates never rose as high during this latest wave as earlier waves, and that the most adversely affected countries are now reporting declining hospitalization rates (see next chart).

COVID-19 hospitalizations in developed countries

Based on latest data available as of 09/13/2021. Source: Our World in Data, Macrobond, RBC GAM

Vaccinations

Vaccinations continue at a rapid rate, now tilted more toward emerging market countries. Over 6.13 billion shots have now been administered.

Pfizer’s tests have concluded that the company’s COVID-19 vaccine is safe and produced a robust anti-body response in children aged 5 – 11. Authorization from governments should occur fairly quickly.

A DNA vaccine has now been developed and several more are under development. These work in much the same way as the RNA vaccines: sending instructions to the body’s own cells to create spikes, which the immune system then learns to fight. The advantage is that a DNA vaccine is theoretically easier to transport and store because it doesn’t require as cold a temperature.

The U.S. government has authorized Pfizer booster shots for older and at-risk individuals, as well as for some front-line workers. However, the U.S. continues to refuse to mix vaccines, so those who initially received the Moderna or Johnson & Johnson vaccine must still wait. Relatedly, Johnson & Johnson reported that a second dose of its vaccine increased efficacy to a high 94%, suggesting that additional doses will be forthcoming.

China: property market

China’s housing market plays an outsized role in the country’s economy and wealth. A huge 25% of the economy is connected to the housing market, and Chinese investors have long preferred investing in real estate to financial markets, viewing it as a low-risk, high-return investment. As such, anything that affects the housing market’s trajectory is of great significance to the country as a whole.

For some time, Chinese regulators have been trying to put the brakes on China’s ever-ascending property market. The country’s top banking regulator warned of “bubbles” last spring. A year ago, regulators introduced a system of “three red lines” that seeks to limit the extent to which property developers can leverage themselves relative to their overall assets, their liquid assets and their equity. There is some evidence that the property market is now cooling, with land transaction volumes down significantly from a year ago.

These rules, in combination with uncertainty in the market as to how much further Chinese regulators might venture, have contributed to the sizeable problems at Evergrande, the country’s second largest builder. One estimate puts its share of China’s property market at 3-4%. The company is struggling to make interest payments on the $305 billion in debt it owes.

The company ranks 122 on the Fortune Global 500, having completed construction projects in over 170 cities in China. It mostly constructs and sells apartments to middle and upper income buyers, and has more than a million units sold but not yet completed. Evergrande also dabbles in other sectors, running two theme parks, holding a large stake in an electric vehicle company, and having built out health, insurance and pork divisions.

The company is not necessarily insolvent, having an estimated $350 billion in assets. However, it has serious liquidity issues, meaning that it has more short-term debt to deal with than it has liquid assets to service the debt. A liquidity problem can turn into a solvency problem when assets are sold at fire-sale prices, as Evergrande is reportedly having to do.

There are any number of affected parties. Many people have bought apartments that Evergrande has not yet completed. Many retail investors own Evergrande Wealth Management Products – a term for a lucrative type of bond that the average investor views as being risk-free, but arguably isn’t. A whopping 128 banks are thought to own some of the company’s liabilities. Equity-holders have already been substantially wiped out. Other Chinese builders are also now feeling some pressure, including Fortune Land and Sunac.

The intensity of market concerns has seemingly faded a little now that Evergrande is past a coupon payment that came due last week. Nevertheless, the company’s liquidity problems are real and solvency problems are not impossible.

This isn’t obviously a Lehman moment to the extent that the underlying system-wide problems seemingly aren’t as great. Furthermore, even as the Chinese government shows a reluctance to fully bail out Evergrande, it has a long history of successfully addressing past debt excesses. These have ranged from problems that accrued in the early 2000s to worries about local government debt and wealth management products over the past decade.

One plausible outcome is that Evergrande could be turned into a state-owned enterprise. Equity holders would be wiped out, the company’s debt would be handled – possibly with haircuts – and the company could be split into pieces and gradually wound down and/or sold off to willing buyers. The big winners would be homebuyers, who would not lose their downpayments, and retail wealth management product investors, who would likely get their money back.

China: regulatory crackdown

China’s tightening rules around the property sector are capturing the greatest attention right now, but the country is also cracking down on other sectors, most aggressively the tech sector.

The motivation behind these actions is twofold. The primary goal is to limit the excesses of tech monopolies – ensuring that smaller firms can compete and that customers have choices.

A secondary goal is to re-exert the power of the Communist Party, ensuring that the party maintains control of the country at a time when technology – especially social networks – threaten to usurp some of the government’s traditional influence.

Examples of major government action include:

• The government introduced anti-monopoly legislation focused on internet companies offering a wide range of services on a single platform.
• Internet retailer Alibaba was fined $2.8 billion in an anti-monopoly probe, and competitor JD.com was also fined.
• Meituan – a meal delivery app – was fined $1 billion for abusing its dominant market share.
• Fintech company Ant saw its public offering unilaterally suspended two days before shares were to be issued.
• Ride-hailing app Didi was removed from the Chinese app store and told to stop signing up new users until a cybersecurity review could be conducted. This punishment may also have been in part due to the company’s recent fundraising in the U.S. market.
• The government plans to supervise more closely overseas capital-raising by Chinese companies.
• The entire education/tutoring sector has been barred from earning profits. It had been a lucrative industry with many Chinese students studying in the evenings with private tutoring firms.
• Recently, China slashed how much time children can spend playing videogames online to three hours per week, and limited the use of a popular social network by children to 40 minutes per day.
• China has also endeavoured to crack down on the influence of celebrities.
• The property market has been slowed as discussed in the prior section.
• High-profit firms are being encouraged to contribute more to society.

Are these measures good or bad? In the short run, most are bad for company profits, bad for the economy and bad for financial markets.

However, it is a more nuanced conversation about the long-run impact. To the extent these rules incrementally reduce corporate concentration, encourage new competitors and prune away excesses, it is possible that the economy and financial markets (and society) will benefit over the long run. Of course, some of the measures are also about flexing government muscle, which weakens this conclusion somewhat.

One sees similar trends afoot in other markets. Europe has also pursued anti-trust measures against tech giants with aggression, and the U.S. – under both President Trump and now President Biden – is seemingly tilting in that direction as well. This may be a very important theme for the years ahead. China represents an example of the sorts of changes that might occur, and also gives a green light to the U.S. to pursue its own anti-trust measures against the tech sector. There is no longer a risk of losing global market share due to more permissive Chinese regulators.

China: economic trajectory

The Chinese economy appears to be decelerating. Retail sales are now just 2.5% higher than a year ago and the country’s Caixin Manufacturing Purchasing Managers’ Index (PMI) fell below 50 for the first time since the spring of 2020. We have been flagging the country’s negative credit impulse for several quarters – often a precursor to slower growth.

The slowdown appears to be for several reasons:

• The government has imposed stricter rules on several sectors, discussed earlier.
• Evergrande is putting a chill into the property sector.
• China’s cities and factories never recovered all of the migrant workers they lost during the pandemic – several million have opted to remain home ever since.
• The Chinese economy doesn’t like high commodity prices, as these are key inputs for many of the products the country produces.

In response, the Chinese government has begun to deliver more stimulus. The country’s policy rate was recently cut by 0.5 percentage points, and further easing is possible. Still, China’s near-term growth trajectory is likely to remain somewhat diminished.

More hawkish central banks

Notwithstanding China’s dovish central bank, there is something of a trend toward tighter monetary policy elsewhere.

The recent U.S. Federal Reserve decision re-iterated the central bank’s signaling at the Jackson Hole summit in August, pointing toward a likely start to U.S. tapering in late 2021. Further, half of Fed officials now anticipate a rate hike by the end of next year, followed by three further 25bps rate hikes in 2023. The Fed also updated its forecasts, mimicking the changes already made by private sector forecasters to downgrade growth outlooks and increase inflation outlooks.

Contrary to fears of a taper tantrum, markets continue to take the prospect of diminishing quantitative easing in stride.

Elsewhere, a handful of developed countries have now actually increased their policy rates. South Korea, the Czech Republic, Iceland and Norway have all now raised rates. New Zealand was close to tightening before an outbreak of COVID-19 prompted it to delay.

U.S. fiscal matters

This is an extremely busy week on the U.S. fiscal front. The week is expected to include a vote on the country’s bipartisan infrastructure package, a vote on the $3.5 trillion partisan package, and also efforts to suspend the debt limit that soon strikes.

That said, none of these are certain to be finalized this week. The Republicans have already rejected an initial effort to suspend the debt limit, though the Democrats should be able to defer any government shutdown from September 30 until a month or two later, delaying the showdown.

The bipartisan infrastructure package is likely to eventually pass, while the partisan one is likely to be significantly reduced from $3.5 trillion to perhaps the $1.5 trillion to $2.0 trillion range. This is still quite large, though it should be noted that it is set to be partially offset by significant tax hikes (currently budgeted for $2.0 trillion, but likely to be somewhat smaller). Also recall that the spending will then dribble out over a multi-year period, meaning that this stimulus is far less powerful on a per annum basis than the efforts undertaken in 2020 and 2021. Tax hikes on corporations may subtract approximately 5% from after-tax earnings – a significant sum, though far less than they have recently increased.

Canadian election

Canada’s election campaign swung from early thoughts of a Liberal majority to the midway possibility of a Conservative minority to a familiar Liberal minority government in the end. Very little changed with the election: not only does the Liberal minority continue, but the number of seats per party was barely altered. The Liberals rose by two seats to 159 (170 would be a majority), the Conservatives fell by two (to 119), the Bloc Quebecois added one (33), the NDP added one (25) and the Green party shed a seat (2).

Nevertheless, it was a fairly close race. For a second consecutive election, the Conservatives captured more votes than the Liberals, but had a significantly less efficient distribution of votes across ridings.

The election theoretically extends the Liberal mandate by an additional two years, back to four years, though it is difficult to predict what the government might accomplish in years three through four relative to the counterfactual of an election two years from now.

Minority governments are now quite familiar to Canadians, representing the result of five of the last seven Canadian elections. In practice, the Liberals are not especially limited in their actions, as they can expect support for their progressive agenda from the NDP.

The campaign has unearthed additional promises. The Liberals have promised more spending – $78 billion more, to be precise – over the next five years beyond previously committed sums. Thanks to ultra-low borrowing costs, the bond market is opting to look past this fiscal largesse for the moment.

Key policy initiatives include:

• Continue to roll out the previously announced $10/day childcare across the country.
• Maintain most existing pandemic supports and add programs to subsidize tourism and cultural events.
• Limit housing demand via new foreign ownership restrictions and an anti-flipping tax. Simultaneously, the party has promised more housing supply. However, all of this is partially undermined by further measures that would strengthen housing demand: cheaper mortgage insurance and tax-sheltered savings accounts for down-payments.
• Additional support for low-income workers, low-income seniors and those with large student loans.
• Additional taxes on large banks and insurers.
• The continuation and expansion of green initiatives: the carbon tax will continue to rise each year and further targeted efforts are planned.

The financial market response has been muted, which makes sense. After all, this was the expected outcome and it represents a continuation of the prior trajectory. If anything, the most immediately economically consequential act will be to allow a higher-than-normal level of immigration over the next few years, making up for minimal immigration during the initial phase of the pandemic. This should boost Canadian growth over the next few years.

Financial markets are less partisan than commonly imagined – illustrating this, they have done well under both President Trump and President Biden in recent years in the U.S. There isn’t reason to think that the story will be greatly different in Canada. However, proposed targeted corporate tax hikes and green initiatives do adversely impact some sectors, and there are still widespread concerns that the new government might raise investment, business or top personal tax rates.

German election

Germany’s election yielded the expected result: the centre-left SPD won the most seats, ousting the long-governing centre-right Union parties (CDU/CSU). Germany’s system of proportional representation means that the Social Democratic Party (SPD) won just 25.7% of the vote, and so will require coalition partners. The party is expected to partner with the Green Party and the Free Democratic Party (FDP) – in line with pre-election prognostications. Remarkably, negotiations are expected to take until the end of the year. Existing Chancellor Angela Merkel will preside over the government until a coalition can be formed. There is a small chance that the CDU/CSU might find a way to form a different coalition, but this is unlikely.

Germany’s next Chancellor should be Olaf Scholz. He is no stranger to government, having served as Finance Minister in the country’s grand coalition leading up to this election. He is known for fiscal prudence, but with a pragmatic twist – he was key to the European Union’s (EU) implementation of its 750 billion euro recovery fund. As such, Germany could be slightly more willing to spend in the future. The policy agenda going forward includes more housing and a higher minimum wage. One might also expect the environment to feature centrally given potential Green Party support, much as it is in many countries.

Financial markets rose in response to the election development, happy at the prospect of a fairly centrist government and that the pro-business FDP appears set to be in the coalition. The far-right Alternative for Germany earned a diminished 10.3% of the vote, down from its 12.6% share in the last election.

Spiking natural gas

Natural gas prices have risen to several times higher than their normal level in many markets (see next chart). The new levels are a record in many markets and are particularly extraordinary in Europe and Asia.

Natural gas prices around the world have jumped during the pandemic

As of 09/24/2021. Prices of front month futures. Source: Investing.com, Macrobond, RBC GAM

There are many reasons for the increase in natural gas prices:

• The pandemic initially reduced demand for natural gas, prompting a reduction in supply. But demand then snapped back and supply is taking longer to normalize.
• Structurally, there is less investment in fossil fuels as climate change mitigation efforts mount. This makes it harder for natural gas to ramp up production significantly when the situation demands.
• Last winter was unusually cold in Europe and Northern Asia, drawing down natural gas inventories.
• Inventories have been further depleted by a hot summer in Asia and (ironically) a cold summer in Europe.
• Other climate events have also contributed: a drought in Latin America pushed the continent to use natural gas over hydro; northwestern Europe has experienced less wind than usual, shifting energy demand from wind to natural gas; and hurricane season in the U.S. brought higher precautionary demand for natural gas given the risk of a production outage.
• There have also been a few idiosyncratic shocks: maintenance has taken some natural gas production offline (though this is surely a regular thing); and there was a fire at a Norwegian liquid natural gas plant.
• Countries are now trying to build their inventories in advance of a winter that some forecasters predict will be colder than normal.
• Meanwhile, higher coal prices have discouraged countries from rotating their energy usage as much away from natural gas and toward coal as would normally occur.
• Russian supply has been less price-sensitive than expected. Some speculate that the country could be behaving strategically to gain approval for another pipeline into Europe.

Clearly, most of these problems will resolve with time. All the same, from such a low level of inventories, it will take many months for the natural gas market to return to normal.

There are a number of consequences from this bout of high natural gas prices. Inflation is naturally a bit higher, though it should be noted that natural gas occupies just a 0.7% share of the North American Consumer Price Index (CPI) basket. Of course, higher natural gas prices indirectly increase the prices of manufactured and transported products as well. The consequences are surprisingly wide-ranging, including the supply of meat.

From an environmental standpoint, higher natural gas prices have resulted in a partial shift back to electricity production via coal in Europe (and likely China) – with negative consequences for the climate.

Finally, and of arguably greatest relevance, some British energy firms have now collapsed as their strategy of buying natural gas in the spot or near-term futures market and selling it at a fixed price to customers has backfired. The existing companies are capable of taking over most of the hundreds of thousands of affected customers, though state-backed loans may prove necessary as it is not economical to take on new customers at current elevated prices.

Supply chain issues

We keep returning to the subject of supply chain problems. This may well be the most important issue in the economy right now as it has sent inflation undesirably high and is crimping growth, and there isn’t a good sense for how long these issues will persist.

Shipping costs are extremely high right now, having increased by approximately five-fold for both container shipping and bulk shipping (see next two charts). One positive note is that several of the world’s biggest carriers have announced a freeze on freight rates for the time being – so conceivably the inflation pressures won’t get much worse from here. Then again, prior price increases have not been fully passed through, with some major retailers having locked in lower shipping rates that will gradually expire into a higher cost environment.

Shipping costs soared during the pandemic

As of the week ended 09/23/2021. Source: Drewry Supply Chain Advisors, RBC GAM

Shipping costs at highest since the Financial Crisis

As of 09/21/2021. Shaded area represents recession. Source: Baltic Exchange, Macrobond, RBC GAM

Fortunately, shipping costs are not actually a large part of the cost of most products. To illustrate, the cost to ship an article of clothing might increase from 10—15 cents to 20 cents – not a game-changer. Of course, the cost depends entirely on the ratio of the size of a product to its cost. Large, low-cost products will experience a larger price increase on a percent basis, while small, high-cost products will not experience a visible change in cost on a percent basis.

Supply chain issues are still quite problematic in other ways.

For instance, it now takes longer to receive many products. Anecdotes abound of lengthy waits for cars, chairs, stoves, phones and tires – and that barely grazes the surface. Whether this shows up directly in gross domestic product (GDP) and inflation or not, there is a cost to not receiving products when you want/need them.

Supply chains also need to be thought of in the context of pinch-points. It isn’t so much that things cost more to ship, but that certain things just aren’t available when needed. If a single part of a car isn’t available, the car cannot be sold. This is presently happening across a wide range of industries. Naturally, this has a negative effect on economic output.

Where have these supply chain issues come from? It is mainly higher demand, but also in part issues relating to supply.

Higher demand:

• People are buying more things during the pandemic – shipping from Asia to North America is up by 27% relative to pre-pandemic times.
• Demand preferences have changed, requiring a reworking of supply chains.
• Demand has shifted from services toward goods: products that must be shipped. Even as some of this pattern begins to reverse, it remains problematic.
• Inventories are now very lean, so every supply chain hiccup is immediately visible and consequential.
• Companies now understand that supply chains are struggling, and so orders are being placed ever earlier – creating a lengthening queue and a vicious circle.

Limited supply of ships:

• The supply of ships has long been boom or bust. Before the pandemic, there were few new ships under construction. Further, carriers idled 11% of the world’s ships at the start of the pandemic, betting (incorrectly) that demand would remain persistently lower.
• It takes 2—3 years to build a new ship, and there are just 120 shipyards worldwide today versus 300 in 2008 at the end of the prior shipbuilding boom. Further, while there are now some new orders for ships, others are reluctant to dive in for fear that the extra need proves temporary: household preferences could easily revert to pre-pandemic norms and backlogs will eventually be worked through.
• Simultaneously, tougher environmental regulations for ships take effect in 2023, requiring the retrofitting of a large fraction of the world’s ships. This will presumably take more ships offline.
• Ships are now having to wait longer to unload, exacerbating the situation. The port at Long Beach on the U.S. west coast now has 92 ships waiting off the cost to be unloaded in recent days, versus just 11 in the fall of 2020. In turn, each ship can make fewer trips.

Other supply-side issues:

• Supply chains have little slack or redundancy built into them. They are actually quite fragile. This is in part how companies have managed to increase their profit margins to such impressive heights over the years. It is very hard to restart a supply chain smoothly because a single missing item halts everything else. Supply chains are not built for the kind of stop-and-go demand that has been and continues to be a feature of the pandemic.
• The Delta variant has hit Southeast Asian manufacturers harder than prior waves, though the worst now appears to be over.
• Several million migrant workers never returned to Chinese factories after the initial wave of the pandemic.
• It has gone underreported that Chinese efforts to achieve energy consumption targets are prompting Chinese local governments to limit manufacturing output in several key hubs.
• In the U.K., Brexit is further complicating British supply chains because of new patterns of supply and demand. Also, there are fewer foreign workers to drive trucks that ship the goods. It has become so acute that some gas stations have had to be closed and some grocery stores have run low of products to sell.

Some big retailers are responding to all of this by renting their own ships, putting themselves in control of shipping costs and at the front of the line to secure shipment of goods. This is good for those retailers, but it isn’t clear that it solves the economy-wide issue of too few ships and too many goods.

More companies are shipping products by air rather than boat. This makes sense in that airplanes are otherwise being underused, though air transportation costs around 10 times more than by ship. That kind of cost increase can be quite visible in the price of a product.

Outlook

Some supply chains will be permanently altered by the pandemic (and do not forget that companies and countries were already beginning to reduce their reliance on China and develop more robust supply chains before the pandemic). However, much of the increase in shipping costs and all of the product and input shortages should eventually abate.

But first, the frenzy of the holiday shopping season should keep shipping costs extremely high over the next month or two. Traditionally, a product needs to be on a boat by mid-October to arrive in time for the holiday season.

Supply chain experts broadly predict distortions that will endure for another six months to a year. Some companies even anticipate distortions persisting into 2023. We should concede that we initially expected most of the labour supply-demand mismatch that formed last spring to be resolved by this fall, but the process has been surprisingly slow. The lesson appears to be to bet on pandemic distortions taking longer than one might normally expect to resolve.

Perhaps the twist in all of this is to recognize that as supply chains eventually become less problematic, this should be a deflationary and pro-growth force -- a reversal of recent pressures. While companies might like to hang onto the higher prices and turn them into fatter profit margins as costs abate, competitive pressures suggest this is unlikely. It is notable that the price increases so far have mainly come from fewer promotions rather than actually raising sticker prices. In turn, effective prices can go back down without actually cutting listed prices simply by reintroducing the normal pattern of promotions.

-With contributions from Vivien Lee