Market mayhem

Financial markets have tumbled in early August. At its worst, the U.S. S&P 500 was down by as much as 9% relative to its mid-July high (see next chart). Equity markets have responded roughly similarly in other countries.

Equities sold off on weaker U.S. economic data and recession fears

As of 08/05/2024. Sources: S&P Global, Macrobond, RBC GAM

Bond yields have also fallen sharply, with the U.S. 10-year down from 4.28% in mid-July to 3.88% now (see next chart). Credit spreads have also widened substantially.

Bond yields fell on imminent Federal Reserve cut

As of 08/05/2024. Shaded area represents recession. Sources: U.S. Treasury, Macrobond, RBC GAM

Expected volatility has also leapt higher for the U.S. stock market and moved palpably higher for bonds and currencies (see next chart). This is to say that markets fear further bumpiness.

Volatility surged in stock and currency markets

As of 08/05/2024. January 2007-100. Shaded area represents recession. Sources: Bloomberg, RBC GAM

Source of weakness

The central agitator for markets is their concern over a deteriorating U.S. economy. A secondary issue is specific to Japan, which saw an especially gigantic stock market decline (and then rebound). A consequential rate hike and a rapidly appreciating yen temporarily unmoored markets. The fact that these are the dog days of summer and thus that liquidity is light has probably exacerbated the market instability.

So what’s happening to the U.S. economy? Economic data has been decelerating and reliably disappointing markets since May (see next chart). While the situation is more acute in the U.S., other countries have also been slowing.

Economic surprises turn negative

As of 08/02/2024. Sources: Citigroup, Bloomberg, RBC GAM

Against this backdrop, there were two major economic catalysts last week: weak U.S. payrolls and a poor ISM (Institute for Supply Management) manufacturing report.

The most important data was located within the payrolls report. It thoroughly disappointed.

• The economy generated just 114,000 new jobs – the second-worst month since December 2020, and well below the 175,000 expected.

• Revisions unearthed 29,000 fewer new jobs created over the prior few months, subtly undermining the earlier trend.

• Aggregate hours worked fell by 0.3%, meaning that even though there were more workers in July, the entire workforce cumulatively worked less.

• Finally, and perhaps most importantly, the unemployment rate leapt from 4.1% to 4.3%. This doesn’t just signal a cooler labour market, but the unemployment rate has also now risen sufficiently to trigger a recession rule of thumb (see next chart). This certainly captured the market’s attention.

Unemployment increase approaches uncharted territory without recession

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

Alas, Hurricane Beryl apparently does not explain the weakness, and the hiring that did occur was less concentrated in economically sensitive sectors than would be ideal. Confirming the weakening labour market narrative, weekly jobless claims – while still low – have been inching higher for a while (see next chart). Metrics such as job openings and the quits rate have been in decline.

U.S. jobless claims have been inching higher

As of the week ending 07/27/2024. Sources: U.S. Department of Labor, Macrobond, RBC GAM

The other economic trigger for market weakness was the ISM manufacturing index. It tumbled from an anemic 48.5 reading to just 46.8 in July. Recall that a sub-50 number indicates contraction. The new orders component also fell (49.3 to 47.4).

Perhaps the scariest number was the employment index, which plummeted from 49.3 to just 43.4. That’s theoretically consistent with substantial layoffs, though in actual fact the payrolls report reveals that manufacturers actually added workers in July. Go figure.

The reason the manufacturing survey was the less consequential of the two data releases is that it has been complaining about a shrinking manufacturing sector for two straight years. This isn’t a new thing. The latest deceleration is unwelcome (see blue line in next chart), but the July data doesn’t actually take the survey out of the range it has been in over that timeframe. And that range, so far, has not been enough to trigger an economy-wide recession.

U.S. manufacturing sectors is in contraction territory, services sectors deteriorating

Manufacturing Purchasing Managers’ Index (PMI) as of July 2024. Services PMI as of July 2024. Shaded area represents recession. Sources: Institute for Supply Management (ISM), Macrobond, RBC GAM

Indeed, while the manufacturing sector has historically served as a useful bellwether for the broader economy, the ISM manufacturing index historically has to fall to a reading of around 43 to be consistent with an economy-wide recession. For the moment, it remains a sizeable four points above that threshold.

Some context

On the surface, the financial market’s outsized response to two weak but not horrific pieces of economic data seems outsized. It probably was, as evidenced by the tentative rebound now underway.

But it would also be fair to concede that financial markets were arguably underreacting to earlier signals of economic weakness. Data has been regularly disappointing since May. When the unemployment rate was rising in earlier months, financial markets were just as likely to celebrate the news with the view that it meant the economy was cooling off after a period of overheating. This was technically true, but as we have often noted in recent months, it is hard to distinguish a neat-and-tidy soft landing from the beginning of a messier hard landing. Both involve a decelerating economy. What differs is how far the process goes.

As such, if one posits that the recent large market response reflects not just payrolls and the ISM manufacturing print but the accumulation of several months of more tentative weakness, you can come closer to justifying it.

An alternative justification would be if the latest two data releases represent the straw that breaks the camel’s back – the last bit of evidence that makes a hard landing the most likely scenario – one could also justify the move. But for our part, we don’t believe that transition has occurred.

Happy offsets

If the ISM Services and Senior Loan Officer Survey had also been profoundly soft this week, we would have been highly tempted to conclude that a recession is again the most likely outcome. But they weren’t, and so it isn’t.

The ISM services index continues its schizophrenic journey, rebounding back above that critical 50 threshold, from 48.8 to 51.4 (refer back to the gold line on the prior chart). We can’t say with precision that it will now remain above 50 – to the contrary, it has crossed the threshold a remarkable four times since March. But, after a sharp decline in the prior month, the downward momentum has been arrested and service-sector businesses appear to again anticipate growth in the period ahead. If the economy was truly abruptly collapsing into recession, one would have expected this report to be quite a lot weaker.

The Senior Loan Officer Survey had been on a knife’s edge a quarter ago. After an extended period in which lending standards for businesses loosened steadily – a signal that the risk of recession was declining and that the economy was growing – the first-quarter data stuttered. This is to say, it backed up slightly, but without enough conviction to clearly convey a new trend. From that murky starting point, it was great news that the newly released second-quarter data now shows a significant amount of further easing in lending standards (see next chart). This means that credit can still flow, and that the recession signal associated with this variable remains firmly in the ’no’ bucket.

U.S. business lending standards are reversing helpfully

July 2024 Senior Loan Officer Opinion Survey on Bank Lending Practices. Shaded area represents recession. Sources: U.S. Federal Reserve, Macrobond, RBC GAM

Economic implications

Where does all of this leave us? It is undeniable that the risk of recession has gone up somewhat. We had long maintained the view that the 12-month rolling recession risk in the U.S. was a 35% probability: considerably higher than normal, but not the most likely outcome.

In light of recent economic softness, though tempered by these two recent heartening indicators, we now upgrade that risk to a 40% chance. This isn’t a huge change, but the recession risk is higher because of the decelerating economy and the recent trigger of a new recession signal (the aforementioned unemployment rate increase).

Still, in our view a soft landing remains more likely for several reasons:

• The latest data argues that the overall economy is still growing, even if it is slowing. Q2 GDP (gross domestic product) was recently reported at a robust +2.8% annualized. We also saw a surprising amount of consumer spending strength despite corporate complaints to the contrary.

• There is a fair amount of room for a further economic deceleration – which we anticipate and are factoring into our updated forecasts – without GDP shrinking outright.

• It would be truly bizarre if the U.S. economy succumbed to a recession in 2024 while other developed-world peers continue to sail along, given the materially lower level of interest-rate sensitivity in the U.S. and the country’s faster economic speed limit.

• The first half of 2024 constituted the period of maximum theoretical risk of a recession. We have now moved beyond that timeframe, meaning that the risk should be ebbing (though it is not gone).

• Bond yields have fallen significantly and central banks are beginning to ease. The Federal Reserve seems highly likely to begin its sequence of rate cuts in September – long our preferred starting point – and it may proceed more quickly than previously envisioned: by easing at consecutive meetings, and with the chance of a 50bps rate cut to start. Lower rates begin to remove the main economic headwind.

• While there are long and variable lags between interest rate movements and their effect on the economy, rate cuts should show up faster in the economy than rate hikes.

• The recent decline in oil prices also helps to boost the economy and creates more room for rate cuts via lower inflation (see next chart).

Crude oil prices fall on demand concerns, despite geopolitical tensions

As of 08/05/2024. Sources: Macrobond, RBC GAM

Our growth forecasts are in the process of being revised. Broadly, the U.S. growth forecast will be pared for the third quarter of 2024 to reflect recent evidence of an economic deceleration, but not all the way into a contraction. The downward adjustments to the growth forecast for the fourth quarter and the first quarter 2025 are set to be smaller. The growth outlook for other developed economies is also being shaved over the same time period, though to a lesser extent.

Market implications

The rally in the bond market presents an opportunity to realize some profits. The debate is whether to deploy the resultant funds into cash or equities. For the moment, cash has slightly more allure given the continued market volatility, the decent return still available in the asset class, and the possibility that the stock market will present an even better entry point at some point in the not-too-distant future.

That said, the stock market is itself incrementally more attractive than it was a few weeks ago, in part because of less challenging valuations and in part because we are not convinced of an imminent recession, even if the risk has increased.

Quick hits

On the geopolitical front, Middle East tensions remain elevated. Israel-Lebanon and Israel-Iran frictions are actively increasing. While oil prices have actually fallen and we do not ultimately anticipate a sustained broader conflict, a key upside risk for global inflation remains the price of oil in the context of Middle Eastern politics. Financial markets are presently focused elsewhere but could eventually return their gaze to this subject.

In the central banking space, the Bank of England opted to cut its policy rate from 5.25% to 5.00% on August 1, in line with our expectation. The market presently expects a pause in September, followed by further easing later in the year. The Fed is now the odd man out in its lack of action in recent months, though this should be resolved come September 18.

The People’s Bank of China also cut interest rates, reflecting its ongoing effort to stabilize its weak housing market and underperforming economy. We continue to think Chinese policymakers will ultimately succeed, and still anticipate moderate Chinese GDP growth of 5% this year.

Lastly, and as alluded to earlier, the Bank of Japan delivered a momentous rate hike on July 30, lifting its policy rate from the range of 0.0—0.1% to 0.25%. Recall that this is a country that long maintained negative or roughly 0% interest rates. The central bank also committed to halving the rate at which it conducts quantitative easing. This is the latest step in Japanese monetary tightening, coming on the heels of a range of actions over the past year that included targeting a higher 10-year yield.

Japan obviously finds itself in a very different position than much of the rest of the developed world, actively raising rates as others seek to cut them. This is because the country’s bout with high inflation arrived much later than elsewhere, and also because it initially tolerated the higher inflation as a means to reset inflation expectations after a long period of weak inflation. For Japan, the consequences of rate hikes could be outsized given the country’s enormous public debt load and thus challenging fiscal finances – a topic discussed in our last #MacroMemo.

U.S. tariffs

The prospect of additional U.S. tariffs has become very real. This is in part because there is a global trend toward protectionism (see next chart) and in part because both the U.S. Democratic and Republican parties have levied additional trade barriers in recent years. But it is mainly because Republican nominee Trump proposes aggressive new tariffs.

Global trade restrictions ballooned in recent years

As of 2022. Sources: Global Trade Alert, International Monetary Fund (IMF), iDi Intelligence, RBC GAM

A victory by Trump is far from assured as the Harris honeymoon continues (see next chart). But he still stands a considerable chance of claiming the presidency in November. Furthermore, presidents can implement tariffs without requiring new legislation from Congress, unlike many of the other planks of the presidential platform.

Leader of presidential race flips back and forth

As of 08/02/2024. Based on prediction markets data and RBC GAM calculations. Sources: Predictit, Macrobond, RBC GAM

In 2016, when President Trump was elected to his first term, his central motivation for delivering tariffs was that other countries were taking advantage of the U.S. due to the high tariffs they levied on the U.S, and that the U.S. was at a trade disadvantage as evidenced by the persistent trade deficit it runs with many countries.

What has happened since then (see next chart)? U.S. tariffs on China have soared from a weighted average 3.1% levy at the start of 2018 to 19.3% by the spring of 2023. Chinese tariffs on U.S. products were indeed higher at the beginning of the tussle, at 8.0% in early 2018. But these have also since increased substantially, reaching 21.1% in 2023. The gap has thus narrowed considerably, but Chinese tariffs are still a bit higher – fodder, it would seem, for further U.S. tariffs.

Furthermore, China’s economic advantage can be argued to extend beyond purely tariff lines, with a web of government support, favourable banking relationships and other arrangements providing further advantages to strategic Chinese industries.

U.S.-China tariff rates have both increased

As of 04/01/2023. Sources: Peterson Institute for International Economics (PIIE), RBC GAM

The U.S. also continues to run a trade deficit, with a particularly large fraction of the gap accruing to China (see next chart). Mexico, Germany and Japan are also material contributors to the U.S. deficit. Canada’s trade surplus with the U.S. is smaller.

U.S. trade deficit with China still tops the list despite Trump tariffs

Cumulative 12-month trade balance to Q1 2024. Sources: Census Bureau, Haver Analytics, RBC GAM

Given all of this, it is no surprise that Trump proposes further tariffs on China. But it is notable that despite his tough talk toward non-China countries during his first term, the average U.S. tariff on rest-of-world imports merely rose from 2.2% at the start of 2018 to 3.0% in 2020, which is where it remains today. This was and remains a secondary priority.

Trump’s official tariff plan reflects that view. He proposes a 60% tariff on China versus a smaller 10% tariff on the rest of the world.

Whether tariffs of that severity would actually be delivered in a hypothetical second Trump term is a matter for debate. On the one hand, Trump tacked less to the centre in his first term than most presidents do after being elected, suggesting he may not water down his platform. But there are practical constraints when governing. These include:

• the potential for legal challenges

• lobbying by adversely affected businesses

• push-back from within the Republican Party

• the threat of higher inflation

• transactional deals with foreign powers (such as threatening a tariff but then not levying it if the country agrees to increase its military budget, buy more U.S. goods or invest more into the U.S.)

These forces all potentially reduce the force with which these tariffs are actually delivered. We’d like to think any tariffs would be significantly smaller than what is currently proposed, but the idea of new tariffs is hardly one big bluff.

Tariff economic effect

How do tariffs theoretically interact with the economy (see next graphic)?

Theoretical tariff considerations for GDP

As of 07/12/2024. Source: RBC GAM

They undeniably hurt the country that has tariffs levied against it, via a reduction in the country’s capacity to export and due to inevitable supply chain headaches. These are partially offset by the advantage of a weaker currency.

Less intuitively, tariffs usually also hurt the country levying them. While that country might manage to deliver additional domestic production in the targeted sector and the government earns additional revenue from the tariffs, there are subtle costs that eat away at this advantage.

• A big one is that product prices usually rise in the protected sector as competition diminishes. This effectively imposes a tax on consumers, and in the present context complicates the effort to tame inflation.

• Companies become less specialized and thus less efficient as they seek to fill the many holes left by absent foreign competitors. Despite this effort, the selection of goods available to consumers decreases – a further economic cost.

• Finally, the country imposing tariffs usually experiences a strengthening exchange rate and a resulting loss of competitiveness as markets seek equilibrium in the face of the tariff distortion.

• Supply chain headaches also ensue for the country levying the tariff.

This combination of economic good and bad usually sums up to a net negative for the country introducing the tariff. And if the opposing country then reciprocates with a tariff of its own – as happened between the U.S. and China in 2016 to 2020 – the net result is always a negative for both parties.

That said, one of the lessons from the first round of Trump tariffs was that while they are bad for the economy and add to inflation, they don’t necessarily dominate the economy. You had to look closely to detect their presence in overall economic growth and inflation, and their impact was measured in tenths of a percentage point rather than multiple percentage points.

We can estimate the effects of Trump’s proposed tariffs with our large-scale econometric model (see next table).

Trump tariff economic implications

As at 08/05/2024. Deviation in level of GDP (gross domestic product) and CPI (consumer price index) from normal trend after two years. RBC GAM, Oxford Economics.

In the full-tariff scenario in which the Trump tariffs are implemented in full and other countries reciprocate nearly in full, the likely impacts include:

• U.S. GDP ends up 1.5% smaller than it would otherwise have been two years later.

• China’s economy is 1.6% smaller.

• Mexico loses 2.3%.

• Canada loses a big 2.5% (see the next chart for the list of countries most trade-exposed to the U.S.)

• The Eurozone is down by 1.0%.

• Overall, global GDP loses 1.1% relative to its normal upward trajectory.

Exports to U.S. are significant for some countries

Sources: International Monetary Fund (IMF), Macrobond, RBC GAM

In that full-tariff scenario, consumer prices are 0.8% higher in the U.S. after two years since the tariffs are effectively adding a tax to the price of its imports, whereas inflation is lower in most other countries due to the glut of products available in the rest of the world and the economic dampening effects.

These are fairly large economic shocks, but they do not create anything like an automatic recession, nor do they argue for inflation problems on the scale of those experienced in recent years.

In a more conservative scenario of partial tariffs – whether because the tariffs are negotiated lower via concessions from other countries or because the political will in the U.S. is not there – the impact is naturally smaller. This scenario assumes a 25% tariff on certain Chinese products and also certain targeted forms of European and UK industrial output. Here the likely impacts include:

• U.S. GDP ends up just 0.2% smaller than it would otherwise have been two years later.

• Effects on other major countries may  range from 0.0% to -0.3% for the GDP.

• Consumer prices rise 0.2% more quickly in the U.S. and are flat to down 0.2% elsewhere.

While these are mostly economically undesirable outcomes, they are pretty small overall effects, especially when spread over two years.

In both scenarios, it is interesting that there aren’t any major winners. It was tempting to argue that India, Mexico and Canada might win in a tariff scenario that constrains others but not them, given the potential to increase exports to the U.S. But that isn’t what the model finds. The damage and distortions to global demand are apparently enough to pull even these countries downward.

Some caveats to this analysis are in order. Individual companies and sectors will have varied experiences, with some winning and others losing. Models are by definition a simplification of the real world and so may fail to capture important nuances. There are other scenarios to be considered, such as what happens if the North American USMCA (United States-Mexico-Canada Agreement) trade deal is renegotiated in 2026. Critically, this analysis ignores other elements of the Trump platform, and similarly does not address the Harris platform.

Canadian shelter inflation

Canadian inflation has improved quite a lot, but shelter inflation continues to run hotter than the other major categories, up 6.2% over the past year. That’s nearly twice the next fastest category (see next chart). Due to shelter’s enormous 29.2% weight in the CPI basket combined with its still-rapid rate of ascent, shelter inflation is responsible for a startling two-thirds of Canadian inflation (see subsequent chart). As such, it is worth looking into why shelter CPI is so hot, and whether it might slow from here.

Year-over-year in Canadian inflation by category

As of 06/01/2024. Sources: Statistics Canada, Macrobond, RBC GAM

What contributed most to the latest Canadian annual inflation rate?

As of 06/01/2024. Sources: Statistics Canada, Macrobond, RBC GAM

We can break shelter inflation down into three main components (see next chart): home prices (homeowner’s replacement cost), mortgage interest costs and rent.

What are the key components to Canadian shelter inflation?

As of June 2024. Sources: Statistics Canada, Macrobond, RBC GAM

Home prices themselves are no longer the problem. Homeowner’s replacement cost (comprising 4.61% of the CPI basket) is actually falling by 0.5% per year in Canada, meaning this component is technically a source of deflation. Our forecast for Canadian home prices anticipates a roughly similar trend over the year ahead.

Mortgage interest costs (5.58% of the CPI basket) are currently the largest individual contributor to shelter inflation. These costs are recording easily the fastest rate of price increase within the category, currently up 22.3% year-over-year (YoY).  But it is not a mystery where this comes from – it is a lagged version of mortgage rates, more or less – and we know that as bond yields have fallen and as the Bank of Canada cuts rates, this pressure should gradually abate. It won’t vanish overnight: many Canadians will continue to roll their mortgages into the higher interest rate regime over the next few years, keeping this as a significant inflation driver. But mortgage interest cost inflation should slow gradually. Already, it has fallen by 8.6 percentage points since last August.

But the key thing to understand about mortgage interest costs, at least from a monetary policy perspective, is that they won’t prevent the Bank of Canada from cutting rates. In fact, it is the opposite: unlike virtually every other component of CPI, mortgage interest inflation encourages the Bank of Canada to cut rates because lower interest rates help to reduce mortgage interest costs.

That leaves rent. Rent inflation (7.18% of the CPI basket) is currently rising at a distressing +8.8% YoY. Unlike the other two categories, rent inflation has descended only microscopically from its peak.

The challenge with rent inflation is that it is difficult to predict with much precision. In theory, it should respond to population growth (this is very strong in Canada right now), to home prices (previously strong but now soft) and to mortgage rates given that rentals are a substitute for owning a property (mortgage rates are high but falling).

We have constructed a simple econometric model that uses lagged versions of these variables to predict rent inflation. The model argues two things.

1. Rent inflation today should be more like +6.1% YoY rather than +8.8% YoY.

2. The model further posits that Canadian rent inflation should slow by around 1.5 percentage points by the end of the year, largely on the basis of falling mortgage interest inflation and flat home prices.

This is promising, though some caveats are in order. Rent inflation is fickle. Our model can only explain 42% of what is happening to rent inflation. The remaining 58% is coming from other uncaptured drivers. That leaves a lot of room for rent inflation to surprise in either direction.

Our suspicion is that the model may be too conservative in its forecast due to the way it downplays the importance of population growth (historically, population growth was fairly stable until recently, which makes it look unimportant to the model). The model may also not adequately account for the existence of a housing shortage in Canada, and that renting is notably cheaper than buying an equivalent property at current mortgage rates.

Rent inflation thus remains something of a wild card and in our view the key upside risk for Canadian inflation. But we take some comfort that it has begun to ease and that our simple model argues it can fall further.

-With contributions from Vivien Lee and Aaron Ma