Hello and welcome to our latest video #MacroMemo. It's been a while since we've done one of these, and so I'm going to cover a few topics that we've been dealing with and thinking about over the last month or so, and those include recent market mayhem. We've seen a lot of ‘chop’ in markets recently, and a fair chunk of that revolves around economic growth concerns and recession fears.

And so that's certainly right up my alley. So we'll talk about that.

I will do some quick hits, come recent central bank actions and geopolitical issues and so on. And then we'll jump into two meatier topics. One is tariffs. The U.S. presidential campaign amazingly winds up in under three months at this point in time, and tariffs are very much on the menu, particularly on the Republican side.

Let's talk through what that might mean for the economy. We'll also, on a related subject, talk about the medium-term fiscal situation. Lots of governments are running big deficits, and how might that get resolved and which countries are looking good and which countries are looking bad.

So that's the plan. Let's circle around to the top and we'll begin with market mayhem.

Market mayhem: At least as I record this, in fairly early August, markets fell quite sharply over the last several days. They've staged a mini rebound since then. But nevertheless, there's been a degree of concern expressed. At its worst, the U.S. S&P 500 was down by as much as about 9%.

It's since recovered significantly, but we’ve seen similar declines elsewhere. Bond yields are down by nearly 50 basis points in the U.S. and down materially elsewhere. Credit spreads are wider. So a significant move in markets. As I said, there has been a good amount of settling since, but it is worth working through why that happened. Some of it is low liquidity in August and things like that.

There were some funny things in Japan in terms of a big currency move and Bank of Japan hikes and some particular turmoil there. But I do think you can trace most of this back to economic concerns. For most of the spring and summer, economic data had been slowing, but markets were actually generally applauding that. They were of the view that the economy was too hot, the economy needed to cool, and the economy was cooling.

So markets felt pretty good about that. But recent economic weakness has been even sharper than before and sharper than expected. And markets have suddenly reconsidered whether that slowdown is a benign or a good thing, or whether it might actually be pointing to an approaching recession.

There were two particularly weak indicators recently.

• One was the payrolls number for July, it added only 114,000 jobs. 175,000 had been expected. Unemployment rate rose from 4.1 to 4.3%. It had been 3.4% at one point. So this is the continuation of a notable upward trend.
• The other indicator was the ISM (Institute for Supply Management) manufacturing index, which fell pretty sharply.

It was at 48.5, which wasn't great. It fell to a 46.8, which is even less great. And the employment component fell quite notably.

So you had two weak indicators that came in quick succession. Suddenly it looked like the economy was maybe crumbling before our eyes.

I should say we had been of the view in recent months that markets had been a little too complacent about risks.

It's one thing to say that, yes, the economy needs to slow. But it’s something else to kind of clap your hands with glee every time it did slow, and see risk assets rally, which seemed like a little bit too much. So maybe there is a bit of a comeuppance here. It makes sense that markets are now behaving a bit more cautiously.

But I must say, neither does that mean that a recession, in our view, is now guaranteed. Certainly, the recession risk has gone up. We have seen a notable deceleration in growth over the past several months. We've just increased the odds of a recession for the U.S. over the next 12 months from 35%. That was really our standard number, in recent quarters, it hadn't changed at all.

We've upped that now to 40%. So it's an increase. The risk is higher. 40% isn't that much lower than 50%. Still, we do not think a recession is now the odds-on view. And indeed, since then, I'm happy to say, we've got a few economic reports also out of the U.S. that look better. And so the ISM services index, sort of the twin to the manufacturing index just mentioned, it bounced nicely.

It's back above 50, which means that sector is reporting growth again. We were nervous when it was reporting a contraction at the same time as manufacturing. Then we got the quarterly Senior Loan Officer Survey for the U.S. recently. There had been sort of an unclear reading the prior quarter, the prior year plus had seen a nice easing of lending standards to businesses.

That was part of a growth story. Wasn't clear how that worked. It was sort of sideways the prior quarter. I'm happy to say this latest data showed further easing. So banks are still willing to lend. Conditions are fairly friendly. That would suggest the economy hasn’t secretly suddenly tumbled into recession.

So there's a risk there. We think, though, it's more likely just that we get a further economic deceleration that stops short of recession. Just thinking through it from a logical perspective, it would be strange if the U.S. had a recession but others didn't, because other countries aren't showing this degree of weakness right now. It would be a strange one because the U.S. economy is usually more dynamic.

It has a faster growth rate. It is, in the present context, less interest-rate sensitive. So that would be a weird one. We think that can be avoided, that weirdness at least.

Similarly, I can say in theory the period of maximum recession risk for the U.S. was the first half of 2024. That was the most logical time to get a recession.

If you were going to get one in the context of rate hikes and all of that, not to say the risk falls to zero, as of July and August of this year, but the risk does start to shrink organically a little bit. So we still think that a soft landing can be pulled off, but with a bit less conviction than before.

Okay, let's pivot from there. Just a couple quick hits here.

Quick hits: So one would just be on the geopolitical front. I think it would be fair to say turmoil has intensified further in the Middle East. And I won't go into great detail there. I'll just say that there has been an upside risk to the price of oil and thus to inflation from that conflict. That hasn’t been realized.

I should emphasize we're not actually expecting it to be realized, either. That's not our base case forecast. But the upside risk for oil prices and therefore for inflation has maybe magnified a little bit recently as that turmoil has grown. So let's be aware of that.

Second, this is now maybe ancient memory, but in mid-July we had that significant IT outage, the CrowdStrike software that failed and computers were crumbling left and right.

There were a couple of days of maybe pretty serious economic disruption, and then a few weeks in which a few companies still struggled. I think the way to think about that is, first of all, it's temporary, but maybe just more usefully, it does rhyme with natural disasters. We get a natural disaster, you get a short-term dip, you bounce back fairly quickly.

It does distort the numbers in the short run. It doesn't have a long-lasting effect. I think that's roughly what we're talking about here. So we could get incrementally weaker data for the month of July and August in the U.S. and around the world. But we think that it will be short lived and ultimately not a lot of long-lasting consequences there.

Central banks and interest rates: And then on the central banking front, central banks have been busy, Bank of England joined the rate-cutting club on August 1st and delivered a rate cut. The Fed (Federal Reserve) hasn't yet. It's the one big central bank still on the sidelines, but, boy, markets feel pretty confident that September is going to deliver that first rate cut – in fact, to the extent that markets are now pricing in the possibility of a 50 basis point rate cut.

That might be a little bit too much. But you know what it is quite possible is the Fed (Federal Reserve), like some other central banks, including the Bank of Canada, could cut rates at consecutive meetings, which really wasn't thought to be all that plausible not that long ago.

And I'll mention that the Bank of Japan as well, which is just going in the opposite direction. It's raising rates. It had less inflation, its inflation came later. It's now grappling with that now. And so it's not in the rate-cutting club. It's in the rate-hiking club. Okay.

Tariffs: Moving now into those meatier subjects, let's talk tariffs. The U.S. election is close again. It’s been sort of a wild ride over the last few months. We've got a new Democratic candidate in Kamala Harris, a new vice-presidential candidate just announced as well.

As I record this, of course, Trump survived an assassination attempt, which was quite wild.

We saw quite a number of things: a very poor debate by Biden, the list goes on. So lots of things shaking up that election. For a moment, it looked like it was going to be a cakewalk for Trump and the Republicans. It has now really tightened up. There's a Kamala Harris honeymoon of sorts going on and it’s anyone's guess whether that persists through to the election or not.

But it's a close one and we need to take seriously both candidates’ platforms. It's notable that neither party is all that pro-free trade these days. The Republican Party, or at least candidate Trump is very specifically proposing significantly higher tariffs on the rest of the world. He proposes a 60% tariff on China, which would be a huge tariff, and a 10% tariff on the entire rest of the world, which would be quite consequential as well.

The existing average tariff from the U.S. on the rest of the world is 3% now, for context.

In theory, certainly countries being hit by tariffs are hurt economically. They have fewer exports, plus supply chain headaches.

There are some benefits to the country imposing a tariff: more domestic production, some tariff revenue also collected. In fact, Trump is proposing to use that to cut taxes, although I don't think it could pay for the entirety of a tax cut.

And there are subtle costs for the country imposing a tariff.

• Product prices go up at home because there are fewer cheap things coming in across the border.
• Companies domestically don't get to specialize as much. They have to try and make more things for more different tastes, where foreign firms might have otherwise filled that hole. And so that's, a productivity loss.
• Consumers have less selection. Usually you do end up with a smaller range, a narrower range of products. And so that is a small economic cost as well.
• Obviously, you have big supply chain headaches domestically as well, as you lose access to certain products that are traditionally imported.
• The country imposing a tariff usually has a strong currency, a stronger currency as a response. And so there's a competitiveness loss, there.

So usually tariffs are a net negative not just for the country getting hit, but the country imposing it as well. And if the country getting hit, by the way, reciprocates with tariffs of its own, it's sort of a guaranteed loss for all parties. And that's more or less how it played out from 2016 to 2020.

We did do some economic modeling on this subject, and this is very loosey goosey, and there's nothing precise in models or simplifications of reality. But were we to get the full Trump tariffs – and we're a bit skeptical about that – but if we did, you would expect the U.S. economy to be about 1.5% smaller than otherwise a couple of years later.

So not a recession, just growing less and ultimately an economy that's smaller than it would have been.

• China ends up 1.6% smaller than otherwise.
• Canada -2.5%.
• Mexico -2.3%.

You can see the really trade-oriented, closely tied countries to the U.S. really get hit especially hard. U.S inflation goes up about 0.8%. And so not desirable at a time of high inflation, though neither extravagant.

Maybe more realistically, if you were to get partial Trump tariffs, you end up with the U.S. economy about 0.2% smaller than otherwise. China, Canada, Mexico, about 0.3% smaller than otherwise. And just a little bit of a hit to CPI (Consumer Price Index).

Certainly those numbers are consequential. They are almost universally, economically undesirable. There aren't really any obvious winners here, just big losers and small losers.

But unless delivered full freight, unless you get the giant tariffs, the effect is fairly small. So I think the way to think about this is that, realistically, tariffs are set to be something of an economic drag over the medium run, over a multi-year horizon – but not an automatic recession, not even an automatic recession if you got the full tariffs, although I would be a bit nervous about that.

It does complicate the inflation picture. Certainly worth watching. Again, we'll get more clarity as this election draws nearer as to who might win and then what actually gets implemented afterwards.

Fiscal health check-up: Let me finish briefly just on the fiscal front. We've been worried for a while. A lot of countries are running big public debts and have huge deficits, really just almost unprecedented for times of economic growth.

In response to that, we've created a fiscal health index that assesses 27 different countries, really the big countries of the world, and tries to get a look at who's doing well and who looks healthy and who has a more challenging path ahead of them. And just to summarize, Italy comes last, Italy does the worst. It has a very challenging situation.

The U.S., the UK, Japan and Brazil are also very poor according to our fiscal health index. And those are some big countries that we all care about and probably invest in to varying degrees.

There's a long list of countries that are simply poor, not a lot of good countries, by the way. Canada is in the poor list, so not nearly as bad as some, but not great either.

That's mostly a statement about high public debt. Pretty short list of countries that are in good health: Denmark, Sweden, Ireland. Maybe you throw in Russia, Australia, Netherlands, but not a lot of countries that have a decent fiscal position.

So the question is how does this get resolved? And of course, the extravagant extreme solution is you default on your debt.

We're not expecting that. You can sort of inflate away some of the debt. Maybe that's a little bit of what's happening recently, but it backfires pretty fast when the bond market wakes up. And we don't think that's going to be a practical strategy.

Faster growth, faster economic growth is ideal, but it's pretty hard to engineer. Maybe we get lucky with technology change, but you can't totally count on that.

Ultimately, it does come down to fiscal austerity. You’ve got to raise taxes or cut spending or some combination not politically palatable whatsoever. And you need a lot of it. The U.S., as an example, needs 4.5 percentage points on fiscal adjustment. That's up to a 4.5% or so GDP drag that needs to be delivered. And maybe they spread it over five years or ten years so it doesn’t dominate the economic narrative.

But it is reasonable to think a lot of countries are going to have to feel some amount of economic drag over the second half of the 2020s. The U.S. is maybe the trickiest case of all, because it has more rope, because it's the world's reserve currency and there's less political will. And so maybe the U.S. does less than most and just lets that debt continue to grow.

But for a lot of countries, I think we can realistically expect their economies to be a little bit underwhelming between 2025 and 2030 or so.

And with that, I'll say thanks very much for your time. I hope you found that useful and interesting. Wish you well with your investing, and please tune in again next time.