Market anxieties

Financial markets are still rightly anxious about sticky U.S. inflation, which casts doubt over the ability of the U.S. Federal Reserve (the Fed) to lower its policy rate. The narrative has thus pivoted, from one of peaking yields and imminent rate cuts, to one of rising yields (see next chart) and delayed and diminished rate cuts (see subsequent chart). It now appears we may not even see two 25bps rate reductions by the end of 2024.

Bond yields rise on potential rate-cut delay as inflation proves to be sticky

As of 04/19/2024. Shaded area represents recession. Sources: U.S. Treasury, Macrobond, RBC GAM

Market expects rate cuts to start in 2024

As of 04/15/2024. Sources: Bloomberg, RBC GAM

Financial markets now price virtually no chance of a rate cut at the Fed’s imminent May 1 meeting.

These higher interest rates are raising concerns about the ability of the economy to survive a longer-than-expected bout with elevated interest rates. More on that in a later section as we revisit our economic forecasts.

In turn, the stock market has been fretting about the negative effect of higher interest rates on valuations and earnings. The S&P 500 Index has pulled back approximately 5% from its end-of-March high (see next chart). For context, this is about the same level as two months ago and so is hardly disastrous. Earnings season is now underway, which could boost market confidence.

U.S. stock market has pulled back

As of 04/19/2024. Sources: S&P Global, Macrobond, RBC GAM

Why growth?

The shoe is suddenly on the other foot. As markets have soured in recent weeks, it is suddenly necessary to defend economic forecasts that call for further growth. Admittedly, there have long been a variety of cracks in the economy, including rising household credit delinquencies and falling small business confidence. The risk of recession is not trivial. We continue to peg it at about 35% for the U.S. over the next year. That’s at least triple the normal risk level.

But the damage from the recent increase in interest rates theoretically shouldn’t be enough to trigger a recession all by itself (though there are admittedly many moving parts and unclear tipping points).

What can be said with the greatest confidence is that the U.S. economy has weathered higher interest rates remarkably well so far. The Institute for Supply Management (ISM) Manufacturing Index is again above 50 after a year and a half of contraction. A number of recession signals have recently reversed. U.S. first-quarter gross domestic product (GDP) is tracking a 2.9% annualized increase, which is pretty good.

Another Beige Book was recently released, and our sentiment indicator shows a further strengthening after a period of notable weakness (see next chart).

Beige Book Sentiment Indicator improves

As of April 2024. The indicator quantifies the sentiment of local contacts by assigning different weights in a spectrum of positive and negative words used to describe overall economic conditions in the Fed Beige Book. Sources: U.S. Federal Reserve, RBC GAM

A variety of natural language artificial intelligence models are now being put to work to gauge consumer economic sentiment via X (formerly Twitter) tweets. A Goldman Sachs version argues that real-time consumer sentiment has been pretty good for the last year, and then rose significantly in recent weeks. This appears to lead more conventional measures of consumer confidence like the University of Michigan Consumer Sentiment monthly survey.

Another unconventional approach – parsing the text of S&P 500 company transcripts for certain key words – argues that downside risks have also shrunk. The word “recession” has been used less and less frequent in recent quarters, to the point that the term now appears less than a third as often as in the second half of 2022. Companies see economic conditions in real time, and so it is heartening that steadily fewer are concerned (see next chart).

Mentions of ‘recession’ in S&P 500 company transcripts has fallen steadily since late 2022

As of Q1 2024. Includes transcripts from all investor calls, investor days and capital markets days to S&P 500 companies. Sources: Bloomberg, RBC GAM

U.S. retail sales rose by a big 0.7% in March, on the heels of a 0.9% gain in February. These are large gains for individual months, confirming that the consumer is still advancing.

U.S. population growth also continues to be faster than conventionally recognized – a subject addressed in detail later in this report.

The point is that there is overwhelming evidence that the U.S. economy continues to grow, with only modest evidence of adverse effects from higher rates. While rising rates are a threat to further growth, keep in mind that bond yields were even higher last fall, and yet the economy survived that encounter.

Revisiting forecasts

We are in the midst of the quarterly process of updating our economic and inflation forecasts. It is best to talk in qualitative terms rather than imbue preliminary numbers with false precision, as they have not yet been hashed over with the RBC GAM Investment Strategy Committee and so are subject to change.

In general, the 2024 developed-world growth outlook is being upgraded. It’s rising by up to half a percentage point, depending on the country.

Beneath the surface, two things explain this:

1. The growth profile for the first half of 2024 is being revised higher given recent impressive economic momentum. We had assumed that even if economies avoided recession, they would experience a period of subdued growth over the first half of the year. That simply isn’t visible in the data.

2.  Higher interest rates should somewhat diminish economic growth, with a lag. We have modestly downgraded the growth outlook for the second half of 2024 and the first half of 2025. For context, a 50 basis points increase in bond yields and the policy rate (or 50bps less rate cutting than previously assumed) should subtract something like 0.25% to 0.75% from the level of output over the subsequent year.

The 2025 growth outlook is accordingly being downgraded, but by less than the aforementioned figures given that we assume a later partial reversal in yields, and given a variety of other factors at play.

Somewhat more subdued GDP growth in 2025 may be for the best, as it should help to tame inflation, still the number one priority.

In short, inflation begins at a higher starting point and proceeds downward more slowly than previously envisioned, but still edges in the direction of normal inflation over time.

The inflation outlook has, of course, been upgraded in response to recent inflation strength. Three consecutive months of heated U.S. inflation are challenging the notion that inflation can ease further if the economy can keep moving forward at a brisk pace. This is why financial markets are now operating in a mode in which bad economic data is bad, mediocre economic data is good, and strong economic data is bad. Developed-world Consumer Price Index (CPI) forecasts for 2024 are as much as 0.5ppt higher than before.

But we still expect a slight diminishment of inflation pressure over the remainder of 2024, and then a further decline across 2025, with CPI forecasts for that year “only” raised by a third of a percentage point or less.

Practically speaking, that means annual Eurozone and Canadian CPI don’t fall to 2.5% or below until next spring, with the same threshold not crossed in the U.S. and U.K. until next fall. In short, inflation begins at a higher starting point and proceeds downward more slowly than previously envisioned, but still edges in the direction of normal inflation over time.

Why should anyone expect inflation, especially U.S. inflation, to fall over the next two years when it has shown no inclination to do so in recent months? There are several reasons:

• We posit that there is still a basic gravitational attraction toward 2.0% inflation. It has been the basis for wage-setting and price-setting behaviour for three decades, making it a relatively easy groove to settle back into.

• Central banks are actively working to achieve 2.0% inflation, and markets are trying to anticipate their next move – recently pushing bond yields higher in a way that should incrementally tame inflation.

• We still expect decelerating economic growth into the second half of 2024 and the first half of 2025, which should enable some further reduction in price pressures.

• Inflation expectation metrics vary widely, but as a loose approximation they expect inflation to get stuck in the 2.5-3.0% range. This isn’t ideal, but it is materially lower than the current U.S. CPI reading of 3.5% year over year (YoY), meaning some progress is expected.

• Wage growth continues to decelerate, and forward-looking wage indicators anticipate a further improvement.

• The breadth of high inflation has been narrowing helpfully in recent quarters (though not, it should be conceded, over the past few months).

• The lags built into the shelter component of CPI still argue for somewhat less pressure in the coming quarters.

• Some experts believe the recent upward pressure from rising auto insurance prices is lagged as one-year insurance contracts reset, implying less upward pressure later.

• U.S. CPI may be seasonally distorted in the first quarter of each year. This is counterintuitive since CPI is already seasonally adjusted, but the official adjustments don’t do a good job of capturing abrupt changes in consumer behaviour. Some experts argue that recent behavioural changes have resulted in exaggerated CPI readings in January, February and March – the three recent “hot” months.

• Perhaps most reassuringly, elsewhere in the developed world year-over-year core inflation has either continued to come down or is operating at a lower level than the United States. Lower inflation is evidently possible for the U.S., too.

This is a good set of arguments and represents the core of our belief that inflation can decline further. That said, it doesn’t present an airtight case. So much depends on the economy cooling from here. There is undeniably an alternative scenario in which inflation remains too high and central banks either can’t cut rates at all in 2024 or are even forced into temporary additional hikes.

What happens next?

If a recession has been avoided, what happens next? Embedded within this are a few other questions:

• Are we starting a new business cycle, or merely continuing the prior business cycle? There isn’t a definitive answer, and our own business cycle scorecard is somewhat divided on the subject. Some inputs indicate this is the beginning of a new cycle, while others argue that the prior cycle is continuing.

Logically, whatever happens next should probably be regarded as a continuation of the prior cycle as opposed to something brand new. The reason has entirely to do with the fact that new cycles usually start with a high unemployment rate, economic weakness, low corporate profits, cheap stock valuations, low interest rates and subdued inflation. These conditions then enable a long period of robust growth. None of those conditions apply today (see next chart). Unemployment is low, the economy is pretty strong, corporate profits are strong, stock valuations are high, interest rates are high and inflation is elevated.

Not much room remains for cooling the economy without triggering a recession

As of March 2024. Unemployment rate is 3-month moving average. Sources: U.S. Bureau of Labor Statistics, National Bureau of Economic Research (NBER), Macrobond, RBC GAM

It is therefore wise to think of what comes next as the continuation of the prior cycle.

• How fast can growth be over this coming period of expansion? How long can it last? Not that fast, and for not that long.

A good guess would be that the economy might manage to squeeze out another 2-5 years of growth, but not another decade. That said, we are sympathetic to the idea that the business cycle might be becoming more muted than in the past, creating a tendency toward longer economic expansions, all else equal.

With already low unemployment and high inflation, economic growth needs to run at or below the economy’s potential growth rate, rather than above it. This is to say, economic growth can be fine but not spectacular.

From a timing perspective, there aren’t a lot of precedents for what happens next. The best one can say is that the situation could rhyme with 1967 or 1995.

In 1967, unemployment had been flat to rising for a period of time, like today. What usually happens next is that the unemployment rate spikes and a recession ensues. But, instead, the unemployment rate managed to start falling again in 1968 and 1969 – buying another two years of growth before a recession struck.

In 1995, the unemployment rate went sideways for a period of time as a recession was barely avoided, and then the economy managed another five years of growth before the recession of 2001.

As such, a good guess would be that the economy might manage to squeeze out another 2-5 years of growth, but not another decade. That said, we are sympathetic to the idea that the business cycle might be becoming more muted than in the past, creating a tendency toward longer economic expansions, all else equal.

Just-in-time inventories dampen the inventory cycle that used to occasionally trip up the economy. (Via the “bullwhip effect”, a retailer in the old days with a big warehouse full of products would see demand dip slightly, cancel all orders from their supplier, and push the manufacturing sector into contraction; in contrast, the nimbler smaller inventories of today tend to encourage steadier flow of products from manufacturer to retailer).

Today’s economy is also more service-oriented, which argues for less volatility than the goods-oriented economies of old. This is especially the case now that many services are becoming automatically recurring, such as monthly cell phone payments and music subscriptions.

As a result, the economy is still vulnerable to exogenous shocks. We saw this with the pandemic of 2020, the global financial crisis of 2008 and the combination of the dot-com bubble and 9/11 in 2001. But at the same time, the economy may suffer from fewer self-induced business-cycle collapses.

Still, the unusual positioning of the economy right now argues for fewer rather than more years of expansion left to come.

Big versus small businesses

You get a very different sense of the economy depending on whether you focus on big businesses or small businesses. Big businesses have been feeling better lately, as proxied by the ISM Composite Index. This has stabilized at a level consistent with modest economic growth (after a long deceleration from extremely high readings during the post-pandemic boom). Conversely, the National Federation of Independent Business Small Business Optimism Index – a proxy for the state of smaller businesses – has just retreated to its weakest reading in over a decade (see next chart).

Sentiment gap between overall businesses and small businesses

Note: As of Mar 2024. Shaded area represents recession. Source: ISM, NFIB, Haver Analytics, RBC GAM

Small businesses apparently feel awful, while larger businesses – or at least the overall business sector – feel OK. The fraction of small businesses reporting that their biggest problem is ’poor sales’ is still low, but it has risen notably in recent months. They also report diminishing hiring plans.

A look at the chart of the sentiment gap between small and larger businesses shows that the gap that currently exists has actually been in place for most of the past 14 years.

The situation is not quite the same in the stock market given that most public corporations are pretty large. But a considerable variation in performance is nevertheless also visible here on the basis of size. The S&P 600 small cap index is underperforming the S&P 400 mid cap index, which underperforms the standard S&P 500 Index, which in turn underperforms the S&P 100 mega cap index using data back to 2018 (see net chart). Size is winning here, too.

Returns relative to S&P 500 Index rise with company size

As of April 5, 2024. Sources: Haver Analytics, RBC GAM

Why does this size divide exist? There are several theories.

It has always been the case that scale is an advantage in the business world, at least to a certain point. Fixed costs can be spread across a larger volume of sales. So there is a natural tendency for larger businesses to win.

But there is supposed to be a limit to the extent to which size is an advantage, or else one conglomerate would eventually rule the world. The theory as to what constrains the maximum size of effective businesses is that market forces don’t operate as freely within companies as they do between them. Labour and capital may not be allocated as efficiently within a sprawling enterprise, and the difficult decision to kill certain business lines or shift their focus may not happen as quickly. In turn, a business becomes inefficient, unfocused and runs into trouble when it gets too big. General Electric is a classic recent example.

Perhaps big businesses are becoming better at allocating their resources internally, keeping them efficient even as their size grows. It is undeniable that the other constraint on large businesses – anti-trust rules – were applied less aggressively for several decades, enabling some oligopolistic businesses to become very large. Corporate concentration at the sector level has increased markedly in recent decades.

A cyclical reason for greater small business pessimism is that smaller companies tend to have more floating-rate debt. This, of course, has rendered them more immediately exposed to rising interest rates.

Normally, creative destruction prunes existing businesses: new ideas arrive via small new companies, undermining older larger businesses. But to the extent productivity growth has been underwhelming over the past two decades, perhaps the effects of creative destruction have also diminished, leaving the incumbents in charge.

The internet has heralded a winner-take-all environment. The marginal cost of additional customers is close to zero in many industries, allowing first-movers and/or high-quality fast-followers to build up impregnable leads. This has created a host of enormous, largely unchallenged businesses.

Industries that have expanded with particular vigour in this tech age are not easily disrupted by small businesses. Indeed, another look at the chart of the sentiment gap between small and larger businesses shows that the gap that currently exists has actually been in place for most of the past 14 years. Small businesses are usually more dour than larger businesses, making their current sour attitude less remarkable.

A cyclical reason for greater small business pessimism is that smaller companies tend to have more floating-rate debt. This, of course, has rendered them more immediately exposed to rising interest rates.

Another cyclical reason for small business pessimism is that government support programs that disproportionately benefited smaller businesses have been expiring. This has exposed many small businesses to the harsh reality of market forces that they were partially shielded from for several years. Some are proving not to be viable.

Until recently, one could also argue that business sector strength was quite narrowly based. A small number of sectors were performing extremely well, whereas many industries were performing poorly (see the share of industries reporting growth in the following chart). But over the past few months there has been quite a leap in the fraction of businesses reporting growth, undermining this argument.

U.S. ISM Manufacturing New Orders Index rose as 12 of 18 industries reported growth

As of March 2024. Sources: ISM, Macrobond, RBC GAM

Does it matter that small businesses are doing worse if the overall economy is OK? Certainly “yes” for the small businesses themselves. And perhaps it says something concerning about the dynamism of the overall economy. But ultimately, if the larger businesses are thriving in a way that keeps the overall economy moving forward at a decent rate – creating jobs, paying taxes and earning profits – then it seems unwise to predict an imminent recession.

U.S. immigration surge

We normally use the U.S. Census Bureau’s population estimates when generating economic forecasts. It is an important input, as economic growth is fundamentally the result of population growth plus productivity growth. On a trend basis, the population side contributed less and less to economic growth from the early 1990s until quite recently.

The official Census Bureau numbers would have you believe that this tepid trend had continued through 2022 and 2023, with official estimates of about half a percentage point of population growth in both years.

But this may not be right. Although the Census Bureau numbers endeavour to include undocumented immigrants, it is not particularly nimble at adjusting to changing patterns of immigration. There has anecdotally been quite a surge of undocumented immigrants into the U.S. in recent years, and this was largely missed.

In contrast, the Congressional Budget Office estimates that actual immigration was perhaps as much as three times faster than assumed for both 2022 and 2023, with the result that actual population growth may have been closer to 1.2% in both years (see next chart). That’s the fastest the U.S. population has increased dating back to the early 1960s.

U.S. population has grown with rapid immigration

Data for 2023-2027 uses RBC GAM assumptions and calculations. Sources: U.S. Census Bureau, Congressional Budget Office, RBC GAM

This is a huge difference, and arguably constitutes the fourth big reason for why U.S. growth exceeded expectations in 2023 and so far in 2024 (alongside fiscal support, eager consumers and low interest rate sensitivity).

Incidentally, the gap also appears to explain in part the giant divide between the payroll employment survey and the household survey. The former has been quite optimistic and is not directly reliant on population growth assumptions. The latter has been quite pessimistic, is very reliant on population growth as an input, and has been using the Census Bureau’s cautious numbers.

Looking forward, the Congressional Budget Office (CBO) projects further rapid immigration in 2024, followed by a gradual deceleration to still-elevated levels through 2026. If this comes to fruition, the potential U.S. GDP growth rate may be around a half percentage point higher than otherwise assumed over that period of time.

But illegal immigration is a major issue in this year’s presidential election. Both parties wish to change the status quo, such that it is quite conceivable that actual immigration deviates from the CBO’s forecast. Both parties talk about tightening border controls, though the Republicans more profoundly.

On the other hand, refugee flows are rising globally and pressures could continue to mount on the U.S., with the opposite implication. All else equal, it is probably more likely that the flow of undocumented immigrants slows more quickly than assumed by the CBO, but there are many conceivable scenarios.

Some Chinese themes

Let’s run through some important Chinese themes.

Chinese growth is improving

First, contrary to popular belief, the Chinese economy isn’t just growing but it is technically accelerating. The country reported a 5.3% YoY GDP increase in the first quarter (see next chart).

Chinese economic growth continued to improve in Q1 2024

As of Q1 2024. Sources: China National Bureau of Statistics, Haver Analytics, RBCM GAM

The property sector is still quite weak – more on that in a moment. But retail sales are rising, albeit cautiously, and the manufacturing sector is rebounding with some enthusiasm as policymakers prioritize it. Not all of this rebound is being welcomed internationally as it represents China expanding in a fashion that seemingly prioritizes scale over profits. This is creating concerns about a global overcapacity in certain green industries and elsewhere.

While nominal Chinese exports are still down on a year-over-year basis, this is in significant part due to Chinese products getting cheaper (linking to the overcapacity concern, cited above). Measured instead by volume, Chinese trade is now rebounding nicely (see next chart).

China’s trade volume has been growing

As of January 2024. Shaded areas represents U.S. recession. Sources: Netherlands Bureau for Economic Policy Analysis (CPB), Macrobond, RBC GAM

Chinese productivity

Chinese productivity growth has been decelerating for nearly two decades. It has fallen from a peak of +14% per year in the late 2000s to more like 5% growth today. But there is more good news than bad news in this data (see next chart).

China’s productivity has been on a download trajectory over the last decade

As of Q4 2023. Trend estimated using Hodrick-Prescott filter. Sources: China National Bureau of Statistics, Macrobond, RBC GAM

First, 5% productivity growth is still quite good. It is more than triple the U.S. trend rate. This is fast enough that living standards double every 14 years – meaning that each Chinese generation is nearly four times richer per capita than the prior generation. A country’s productivity is a proxy for its financial prosperity, and China is still advancing nicely on this front.

The productivity growth rate may seem surprisingly fast given that economic growth is set to be just 4.5% in 2024 and to slow to the 3-4% range over the next few years. However, keep in mind that China has a shrinking population, so it makes sense that productivity growth is faster than economic growth.

To be sure, Chinese productivity growth probably slows from here as the country gets richer, but it isn’t showing any sign of collapse, despite a great deal of handwringing about the Chinese economy in recent years.

China’s fundamental housing challenges

Much can be written about China’s housing market problems. Its builders are quasi-insolvent, its local governments cast about for new revenue sources, its households ponder what to do now with their savings, and so on.

Let us focus on the two most fundamental questions about the Chinese property market: where will property prices and residential construction likely go from here?

In both cases, the answers aren’t encouraging.

Chinese housing affordability is quite poor. It was pretty poor in 2010 when the average home cost 15 years of average income, and it has since gotten much worse, to the point that a jaw-dropping 30 years of income are now required (see next chart).

China’s housing affordability is still poor even after recent drop in home prices

As of 2024. Sources: Numbeo, Macrobond, RBC GAM

When it comes to housing affordability, it is maddeningly hard to say what is reasonable and what is unreasonable. Some counties in the U.S. have home price-to-income ratios that are multiples of other counties, and yet the expensive counties don’t crash, the cheap counties don’t surge, and life goes on.

But there are some absolutes. If you assume that the average person works 40 years, it is pretty hard to fathom that three-quarters of their pre-tax money for their entire career must go to buying an apartment. That’s what a home price-to-income ratio of 30 implies.

But now, at a time when home prices are much less likely to rise, the calculus is far less friendly.

Atrocious housing affordability in China didn’t matter so much when home prices were surging, as buyers could count on selling the home for a profit at a later point, regardless of their cashflow.

Optimists will note that the Numbeo formula from whence these estimates originate assumes just 1.5 income earners per household whereas there could easily be two or even more (though there could also be one). In China, it is reasonable to expect one’s income to rise significantly over the span of a mortgage, greatly improving the effective affordability over time. Further, not everyone owns a home.

On the other hand, people must pay tax on their incomes, and mortgages incur large interest charges over decades. Conservatively, interest alone could consume another 15 years of income, leaving negative five years of income to pay for income taxes plus the rest of life’s expenses! Certainly, the norm in other countries is less than half the number of years of income. Also note that housing is extremely expensive in a lot of countries right now, just far less so than in China (see next chart).

China’s home price-to-income is among the highest in the world

As of 2024. Sources: Numbeo, Macrobond, RBC GAM

Atrocious housing affordability in China didn’t matter so much when home prices were surging, as buyers could count on selling the home for a profit at a later point, regardless of their cashflow.

But now, at a time when home prices are much less likely to rise, the calculus is far less friendly. At a minimum, it seems unlikely that home prices will rise much over the next several years. Fortunately, given the country’s fairly fast productivity growth plus the assumption of modest inflation, rising incomes paired with flat home prices over 10-15 years would probably suffice to return housing affordability to the expensive but tolerable level of 2010.

But will home prices really be flat for over a decade? That would exact its own toll on the Chinese economy.

Chinese property construction probably needs to decline over time as well. The country’s population is shrinking, which obviously limits the demand for new units.

The possibility that Chinese home prices are twice as high as they should be and that residential construction may have to decline by 35-55% are daunting thoughts. They argue that the property sector is unlikely to be a driver of economic growth over the entirety of the next decade.

But let us not exaggerate the impact of a shrinking population. A significant number of new homes will still be needed in China to replace old properties that have exceeded their useful lives, to enable urbanization as migrants move to cities, and as the number of people per household declines. This is to say that China will still need new homes, on the order of 800,000 to 1.2 million new properties per year over the next decade as estimated recently by the International Monetary Fund (IMF). This is considerable.

But Chinese housing demand rose by 1.7 million units per year over the past decade. Thus, housing demand is set to be 35-55% lower over the coming decade than over the past. As a result, Chinese builders face greatly diminished prospects going forward, and at a time when pivoting to other sectors is presumably infeasible given that the country is also looking increasingly well-endowed in its other forms of infrastructure.

The possibility that Chinese home prices are twice as high as they should be and that residential construction may have to decline by 35-55% are daunting thoughts. They argue that the property sector is unlikely to be a driver of economic growth over the entirety of the next decade. China has other sources of growth, to be sure, but the country is set for a diminished economic trajectory.

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