Hello, welcome to our video #MacroMemo. As usual, there's quite a lot to cover.

• We'll spend some time on recent market anxieties and I'll give you some hints as to our updated economic forecast through our work in progress – which is why we're operating with hints as opposed to formal numbers. It will give you a sense where it's going, though.
• We'll talk about the economy and just the fact that it does show evidence of continuing to grow, which is nice.
• We'll talk a little bit about what happens next. And by that, I mean, is this a new cycle that's beginning or are we continuing the old cycle? How many years might we be in whatever comes next? And so what we'll talk to that.
• We'll spend some time on the U.S. immigration surge, and that's actually quite consequential for growth. It might actually be the secret fourth reason why the U.S. economy moved so quickly over the last year.
• And then we'll finish with some thoughts on China. A couple of thematic items, but most importantly, I think, focusing in on housing and really trying to nail down Chinese housing affordability, Chinese housing demand, kind of the fundamentals underneath it. Many questions swirl around China's housing market.

There's the plan.

Market anxieties: Let's start with those market anxieties and some tweaks to forecasts that we're in the midst of making. And so I think the main macro and market theme right now is the world is still grappling with this realization of higher-than-expected inflation. U.S. CPI (Consumer Price Index) came in above consensus in three straight months, raising some questions as to whether inflation is actually improving.

That has sent interest rates higher because it undermines the ability for central banks to actually cut rates in some markets. Markets are only pricing in a little more than one rate cut for the Fed over the next year, or I should say, by the end of 2024. And of course, higher interest rates in turn are worse for the economy. And so the economic outlook gets pulled back a little bit, and of course the stock market has also pulled back somewhat.

So we have an S&P 500 in the U.S. that's down, at least as I record this, around 5% from its peak in late March. So that's pretty tame stuff. It's still around where it was two months ago. But still there has been some pullback on anxiety about inflation and rates.

For context, the U.S. 10-year yield is, as I record this, up to about 4.64%. And so that's quite a move. It was in the high threes not that long ago. Yields keep going up and as I mentioned, central bank rate cut expectations keep fading. Clearly, the economic implications of all this are negative. Higher inflation itself is a little bit bad for economic growth.

Higher interest rates are negative for growth as well.  So let’s talk through how that math works.

Inflation: But first, let's actually talk through the inflation forecast side. I think, unsurprisingly, after some upside inflation surprises, we find ourselves tentatively upgrading our inflation forecasts. We're adding up to half a percentage point to the inflation outlook for 2024, up to a third of a percentage point to the prior inflation outlook for 2025.

So these are some upgrades. They're not overwhelming upgrades. It is ultimately just a higher starting point and we're assuming a slower journey downwards. So still a journey downward, we still think there are some factors that we’ll get into the moment that support the view that inflation can get somewhat better, but it's less certain and it's less quick as well.

And our forecasts at this juncture are assuming that inflation doesn't get down to or below that, that 2.5% kind of level, which isn't the target, but it’s sort of close enough that you'd stop worrying as much. We think we don't get down to 2.5 in the Eurozone and in Canada until the spring of 2025. That used to be the assumption for later this year, the second half of 2024.

We're assuming we don't get there, below 2.5 inflation for the U.S. and UK, until the fall of 2025. So it takes longer, that is our assumption right now. That's certainly an altered trajectory and it means central banks move more slowly and so on. We do still think it makes sense for inflation to get somewhat better.

There is still, we believe, a gravitational pull toward 2%. So much time has been spent there in the last three decades that there is a certain tendency for wages and corporate pricing and other things to gravitate toward 2%, all else equal.

Don't forget, central banks are targeting 2%. And so that helps to pull things in that direction as per expectations that central banks might not cut rates as much.

Now, keep in mind that higher rates help to slow the economy, which in turn helps to pull inflation down. We see inflation expectations that aren't perfect. They're not anticipating 2.0% inflation, but they are expecting inflation a bit lower than it is right now. So that provides some help.

Wage growth is slowing. There are some lags that suggest shelter inflation should come down somewhat further.

There's also a line of reasoning that seasonal factors have distorted recent inflation numbers. Q1 inflation data –   January, February, March – might have shown up a little hotter than it actually was due in some of those distortions. Those distortions should come off as we work our way into the spring. So we should see some inflation improvement, maybe not all that fast, that’s where we’re ultimately landing.

Growth forecasts: In that environment, in an environment in which rates aren't cooperating quite as much as previously hoped for, you do have to downgrade the growth outlook at least over the second half of this year and into the first half of next year, and that's because of higher interest rates.

And just to give you a sense for things, if you see a 50-basis point increase in interest rates, that argues you would subtract between about a quarter of a percentage point and three quarters of a percentage point off the level of the economy a year out.

So it's a real hit. It's not a recessionary blow, but it is a real hit. And that has informed our forecasting. I should emphasize other things are going on at the same time. Centrally, population growth has been quite fast, which I'm going to get to in a moment. Economic growth has been unusually, surprisingly quick over the first half of 2024, and so we're downgrading the second half of the year, upgrading the first half of the year.

On the net, actually, the 2024 GDP (gross domestic product) forecasts look a little better despite the effect of higher rates. But the 2025 outlook does look somewhat worse, and that is from the higher rates. And as much as no one likes to see weaker economic growth, maybe that is something to celebrate just because what we need is somewhat weaker economic growth to help get inflation down and to allow interest rates to settle as well.

Okay.

Economic data: Onto the next section with really just a quick look at economic data. The economic data is consistent with ongoing growth. We're still getting some pretty good data out there. The Eurozone PMI (Purchasing Managers’ Index) just came out as I'm recording this and it looks pretty good, particularly on the services side, suggesting growth there. The U.S. Beige Book, which is a qualitative assessment of business conditions also came out. It had been quite weak about a quarter ago.

It continues to improve. It's looking pretty good. U.S. retail sales moved quickly, maybe a little too fast, raising concern about inflation, certainly growth.

And we look at some of the more obscure indicators and neat moderate new type metrics. For instance, there are some X (Twitter) economic sentiment indices in which you have natural language models parsing X (Twitter), looking for how the economy is doing.

Those argue the economy is fine. If anything it’s accelerating a little bit. Similarly, when we look at recent transcripts of S&P 500 earnings calls and corporate reports, we find that references to the word ‘recession’ continue to fade quite nicely. And so it doesn't look like we're falling into one. Indeed, the economy is looking pretty good and so still getting signs of economic growth.

What happens next? That brings us to our next section, which is what happens next. And so that's a bit of a cryptic question, but maybe more clearly, if we manage to avoid a recession, which, by the way, isn't a certainty, we think there's a 35% chance there. But if we manage to avoid a recession, what does happen next?

The obvious question is, well, I guess the economy grows instead of shrinks, but not necessarily very fast.

And the real question or the real set of questions is, is it a new cycle and how long can we expect for the economy to keep growing if we get to continue growing?

We don't think it's a new cycle. In terms of new cycles, normally they are defined by a starting point that has a high unemployment rate and a weak economy and low inflation and low interest rates and low corporate profits and all these criteria. Really none of these are being met right now.

Right now we have high inflation and a fairly strong economy and fairly low unemployment and fairly high rates. It really is almost the opposite of a new cycle. So I don't think we should say it's a new cycle so much as a continuation of the prior cycle. The next question is how much longer can this cycle go?

And so theoretically not that long. We already have a low unemployment rate. Where can it go from here? That would maybe be the crux of the issue. Historically, you see a few precedents. So 1967 is one, 1995 is another. These were times when unemployment was fairly low, the economy kept growing for a while. You had a bit of a stutter, which is what we had recently.

And then you managed, of course, to correct and continue to grow for a while. But those two examples, you bought basically 2 to 5 years of more growth, not maybe the ideal of a 10-year new cycle. And so you were assuming that there were a number of years of growth ahead of us, but not lots and lots of years of growth, if that makes sense.

Of course, any effort to predict a cycle with any precision is laid bare by the fact that you get exogenous shocks here and there that can undermine the best laid plans. So let's not pretend we can say this precisely. But all else equal, there should be a number of years, but not a lot of years of growth ahead of us. Okay.

U.S. immigration: Let’s move onto that U.S. immigration surge that I cryptically referenced earlier. Officially, if you look at the Census Bureau data, officially U.S. population growth has been around half a percentage point a year in 2023 and 2022. Pretty uninspired, pretty unexciting. Yes, there are a lot a lot of news from the southern U.S. border about undocumented immigrants and illegal immigration.

But in theory, the Census Bureau captures that. And so in theory, you would think that would be the final answer. However, they're very conservative in terms of the assumptions they make about illegal immigration. And it seems as though maybe they've been missing some things to the extent that there has anecdotally been quite a surge of undocumented immigrants into the U.S. in recent years.

And so the Congressional Budget Office (CBO) actually has done quite a nice job of trying to tease that out and figure out the real numbers and what is actual U.S. immigration and population growth. And it looks like it may have been quite a bit faster by virtue of 3 million plus undocumented immigrants coming in in each of the last few years, which is quite a high figure.

And the CBO thinks the real number might be closer to 1.2 to 1.5% population growth, which for Canadians watching isn't all that much. Canada's growth has been above 3% for a while, which is quite wild. But still, this 1.2 to 1.5 is the fastest the U.S. has seen in quite a number of decades – and population growth mechanically does in theory help to drive economic growth.

Population plus productivity is how you get to the economy. And so this growth may have been maybe the secret fourth reason for why the U.S. economy has done so well recently – the other reasons being fiscal stimulus and enthusiastic consumer spending and a low level of rate sensitivity. So this has provided quite a helping hand.

The CBO thinks that 2024 is also going to see quite a lot of this undocumented immigration.

So that's a tailwind for 2024 as well. They forecast fairly fast growth over subsequent years. But I have to say with a presidential election and an election in which immigration is a big, big issue, I would say that any prediction beyond 2024 is extremely policy dependent. Republicans are more anti-immigration than the Democrats, though Democrats do seem to have plans to slow things down as well so they're rowing in the same direction, but maybe at different rates.

The bottom line here is that for the moment, this is a pretty big U.S. tailwind with certainly complicated policy and societal implications. But economically it is adding to growth.

China: Let me finish on China. So some China themes I'm going to touch on two very briefly, one more extensively. The first is just that the latest Chinese economic data looks pretty good.

We've seen a slight acceleration. Chinese GDP growth is running above 5% year over year. So tales of China's economic demise are a little bit overstated.

The second quick theme is just Chinese productivity, which has slowed a lot. It used to run at 14% a year at its incredible peak several decades ago. It's been decelerating for quite a while.

It's still running at about 5% growth, though. So as much as it's tempting to be quite glum, having seen 14 and now experiencing five, I think the bigger story is 5% productivity growth is pretty fast. It's probably faster than most people would have guessed, given the economy isn't even growing at 5% a year. But of course, that's how the math works when your population is shrinking.

Productivity growth is mechanically faster than economic growth.

Incidentally, 5% productivity growth means that your financial prosperity doubles every 14 years, which is pretty fast. Every generation is three or four times more prosperous than the prior one. That's still more than enough to keep the Chinese economy in a fairly happy place. Certainly we think that will slow going forward and there's less emphasis on the corporate sector and so on.

Nevertheless, the productivity story maybe isn't as bad as people might imagine.

And then the last one, a little bit meatier is China housing. You can go in so many directions here and you can talk about quasi-insolvent builders and local governments in trouble and any number of subjects weave together. But I'll just speak to two things.

One is housing affordability, the other is housing demand. So kind of the fundamentals. And on housing affordability, China is pretty awful. We're talking about a home price-to-income ratio that is 30 times. That is not, in theory, a sustainable number. You cannot spend 30 years of income buying a property if you're only working 40 years and paying taxes and paying interest and so on.

It's not quite as simple as that because incomes rise over time and home prices on average have historically risen over time. And so the math does get a bit murky. But let's just say this is more than double the international norm for home prices in terms of affordability. And that is also a bit expensive right now, and so you would think that there will be downward pressure on Chinese home prices, not just for the next year, but potentially for quite an extended period of time.

So that's the home price side. On the housing demand side, well, it’s tempting to say China doesn't need any housing. After all, their population is shrinking. But that's not true because old properties have to be replaced and urbanization is continuing.

People are moving to cities and the average size of a Chinese household is shrinking. So even if the population is going down, you don't necessarily have fewer households and they do need houses. The IMF (International Monetary Fund) figures they need between 800,000-1.2 million new houses per year. That's a fair number. That's over the coming decade per year. But it should be noted that China needed about 1.7 million more houses per year over the last decade because of more favorable demographics and urbanization and so on.

So really what the IMF is saying is that China needs 35 to 55% fewer houses per year over the next decade than the last decade. That's quite a drag. That's why builders are consolidating, and that suggests quite a lot less construction going forward. So the bottom line here is Chinese housing is unlikely to be a major driver of the economy for a long time.

These are multi, multi-year adjustments that need to take place both on the affordability side and I suppose the housing supply side.

I'll stop there and so I'll say thanks so much for sticking with me. Hopefully some interesting things in there and I'll talk to you next time.