Global Investment Outlook | Summer 2023

Q1: Should investors be concerned about the health of the U.S. banking system?  00:12

When interest rates rise, things do tend to break. We saw that last fall with British pension funds running into trouble when rates rose quickly in the UK. We've seen that again now in the U.S. with mid-sized banks in some cases running into trouble in early March. The problem underlying was that these banks had bought a lot of bonds.

Those bonds declined in value as interest rates went higher and in combination with some deposit outflows that just proved unviable for the least stable of those banks. So it has proven quite significant. I can't say with precision that we're through all of that. There are still some vulnerable banks. I can say that the government has stepped in and has credibly put together a plan that should prevent too much further trouble.

But nevertheless, there are still some vulnerable banks. I will say that when we look a bit more broadly, we look at the largest U.S. banks, they seem to be mostly fine. When we look at the smallest U.S. banks, they seem to be mostly fine. It is those mid-sized regional banks that ran into trouble and say something similarly internationally, which is to say that elsewhere in the world that we're seeing banks that are in reasonably good shape, including in Canada, so it doesn't seem to be something that's repeating itself elsewhere.

But nevertheless, when this happens, banks are now not in as good a position to lend. We're seeing lending standards tightening quite a bit, most profoundly in the U.S., but not exclusively there. It's also happening in other countries. We can see the quantity of loans in the U.S. actually shrinking to some extent. I guess to frame this as a recession kind of argument, this is an extra force that's now a headwind on growth.

It's an extra reason why a recession is more likely than not, and it's a particular headwind in the U.S. context. I suppose I should step back and say, and as we look at these interest rates that have gone up, there's a reasonable chance there are going to be some other problems that emerge over time, perhaps elsewhere in the world.

Again, it's a function of levered players running into trouble. It's a function of players that perhaps owned too much fixed income that run into trouble when bond prices fall.

Q2: What is the risk of recession?  02:15

We think the risk of recession is quite high. We've assigned an 80% chance for the developed world falling into recession over the next year, and that's really because we have a number of different signals all pointing in that direction. We have big econometric models that are suggesting a recession is more likely than not, largely because interest rates have gone up so much over the last 18 months and that exerts a drag.

I can say that when we look at various heuristics, simpler models, simpler rules of thumb – and we look at about a dozen of those – most of those are also pointing toward recession. Prominent examples would include an inverted yield curve, which is a classic recession signal. The fact that inflation has risen quite a lot has also historically presaged recession.

Even the fact that central banks are raising rates normally culminates in recessions. So simple rules of thumb are saying probably a recession. Then similarly, our business cycle work makes a similar claim, so we are getting end-of-cycle readings from that business cycle scorecard. And so that's consistent with a cycle that would come to an end within the next few quarters.

So we do believe a recession is more likely than not. To play devil's advocate, I can say that that still leaves a 20% chance that there isn't a recession. You might imagine that scenario playing out in part just because the economy has managed to hang on surprisingly long through 2023 at a time when there have been significant headwinds.

Perhaps that just gets to keep going. It's undeniable that we've been through quite an unusual number of years and the economy has done some pretty strange things at times. You can't quite rule out another strange turn. But even if we were to avoid a recession in the near term, our suspicion is essentially you wouldn't be able to tame inflation properly.

Service sector inflation wouldn't fully normalize. Central banks would have to raise rates further. You probably just get a recession later as opposed to sooner. And so not to be quite so fatalistic about it, but we do think a recession is more likely than not. If there is a silver lining, maybe it's that we don't believe the recession needs to be particularly deep, could be mild to middling in nature, not as deep as the last couple of recessions, not especially long lasting either.

Again, as we look at this, the recession seems more likely than not. Probably the second half of 2023 or thereabouts, but not forever, providing opportunities for savvy investors and with a fairly long runway of economic recovery in 2024 and beyond.

Q3: Is higher inflation the new normal or is it set to decline?  04:40

We think inflation can continue to fall from here. It should be noted it's fallen rather substantially from the peak last summer. We've seen progress that is to be celebrated as much as there's more work to be done. The four big drivers of high inflation, we believe, have all turned. We've seen commodity prices materially unwind, in particular, natural gas costs in Europe.

We've seen supply chain problems very significantly improve. Central banks have gone from extreme stimulus to quite substantial restraint in terms of the level of interest rates. And even governments aren't spending money quite as freely as they were a couple of years ago. Again, all of the original inflation drivers have turned. We've seen inflation accordingly turn.

We believe inflation can continue to fall and we are ultimately optimists on the inflation front. We see nice progress happening in business pricing plans. They're planning on raising their prices far less than they were a few years ago. We can see the breadth of inflation narrowing quite significantly. Just the percentage of things that people buy that are going up quickly is really starting to come down, in particular, the fraction that are rising 10% a year or more in cost.

And we can see wage growth starting to come down as well. I think the stage is set for inflation to fall fairly comfortably towards something like 3%. The question is where do we go from there? Can we make the rest of the journey down to something like 2%? And I think that's going to be a harder trip.

In particular, I can say it's the service inflation that's proving a little bit resistant. Unfortunately, what you need to tame service sector inflation is a weaker labour market. To get a weaker labour market, you probably need a recession, and so you likely need a recession to get most of the way back to 2%. Briefly, just over the long run, we're assuming long-run inflation is a little higher than 2%.

That's different than what we would have thought a few years ago. It really is because de-globalization has picked up. Climate change is becoming more relevant to inflation. Workers are gaining a little clout as well. So we're budgeting for a little more than 2%, even over the long run.

Q4: How will the recent developments of generative AI potentially impact economic growth?  06:40

It's an exciting time for new technologies in the world right now. Prominent ones would include generative AI, which has been in the news quite considerably. But there are exciting advances as well in health technology, in green technologies, in quantum computing, in quite a range of technologies in a way that could prove quite consequential for long-run productivity growth.

We're excited about that. We have been long-run optimists on productivity growth for a while, and some of that is simply because productivity growth was so weak in the 2010s that we feel pretty good about beating that low hurdle. Part of it is because China has essentially reached the technological frontier and you can think of it as the world for a long time had about a billion people pushing forward, inventing new technologies, and we just got another billion joining us.

So that technology and knowledge will diffuse to the rest of the world over time. But again, the big one is just that there are some exciting technologies out there. We're looking for faster, long-run productivity growth. We're not sure it'll be quite enough to offset some demographic challenges which exert a headwind on economic growth, but it should be at least an important partial offset that keeps the economy moving forward.

The bigger question mark is: “by how much?” And it's awfully hard to say. I don't think I have an intelligent answer for that. Some people in particular are arguing that generative AI technologies could be as big a deal as the internet. And if that was the case, you could imagine quite significant boosts happening going forward. Or perhaps more realistically, it might not be quite that large, but nevertheless enough to show up in the numbers.

I will say that in the short run it's a whole lot more ambiguous what the implication is. It usually takes a surprisingly long time for technologies to show up in the productivity data to be used effectively across a wide range of businesses. Maybe we can say we should expect more capital expenditures in the short run as companies scramble for specialized chips and to see how their businesses can adapt.

We may see more of that, we may see some positive wealth effects as some stocks go up quite a bit, and that adds to the money in the economy. But at the end of the day, I would say the main implications are more long-term in nature. We don't think this this mini tech boom is enough to offset some of the recessionary forces in the short run.

Q5: Is the housing slowdown in Canada and the United States over?  08:55

There's been a significant housing rebound in recent months in many countries in the world, including in the U.S. and Canada. This is an important development and really an important question as to whether this continues or not. If it were to continue, you could imagine that it's hard to get a recession when the housing market is reviving.

Normally, housing is driving a recession, not opposing it. It's hard to control inflation if housing is reviving. Shelter costs are the biggest single component for CPI, and so the entire economic forecast is thrown out of kilter. This is a new sustained housing rally after what had been a fairly brief decline over the prior year. I would say the bull case, the optimist’s arguments would be essentially that there's good momentum right now, that unemployment is still low, wage growth is still good, that housing supply is constrained, and that demand is growing quickly, particularly in Canada, where there's a lot of immigration happening right now. You can construct a reasonable argument that housing can rise from here.

We're a little more sympathetic to the more pessimistic side of things. The more pessimistic side would say, well, this might be a seasonal blip, often in the spring is when housing markets revive. We know that affordability is pretty atrocious still, and it's very unusual for housing markets to boom when affordability is as bad as this. And similarly, I can say that historically when we look at housing busts, we see that the average housing bust takes six years, not one year.

This would be an extremely short-lived correction if it was only to be one year. So we think it's incrementally more likely, particularly if we do get that recession, which of course hurts the unemployment and hurts the wage growth data. We think it's incrementally more likely that housing will return to a softer state, probably not the free fall that we saw across the last year, but something like a malaise might last a number of years as affordability issues are worked out and as economic issues are worked out as well, reflecting the very high-rate environment that exists relative to the norm of the last decade or so.

I will say that as a result, we still feel fairly confident in forecasting a recession, but it's undeniable that the housing market is one of the bigger sources of uncertainty right now.

Q6: How is the Canadian economic outlook changing?  11:07

We still think a recession is more likely than not for Canada. But I have to say we are ultimately feeling somewhat better about Canada in recent months. Don't get me wrong, we acknowledge that Canada has a lot of household debt. Canada has a housing affordability problem. These are drags and challenges that are more intense for Canada than quite a number of other countries.

So Canada is not purely in a positive state. This is still a risk and a challenge, but we see a number of positive things that have happened and that are ongoing. One would be the housing market is no longer in freefall, and so that's just less of a drag than it previously was. The Canadian dollar is fairly cheap by fair value standards, and so that gives a competitiveness advantage to Canada.

Canada is enjoying a terms of trade benefit. That means that Canada exports a lot of commodities and commodity prices are fairly high right now. So that's generating extra profits that are circulating through the Canadian economy, letting Canada buy things more cheaply with that money that's earned abroad. I can say as well that from a population perspective, Canada has about the best immigration profile and population growth profile in the developed world.

So that's a helping hand as well. The fiscal situation in Canada is not perfect. There are still deficits broadly that are being run, but they're pretty small deficits. If you look around the world right now, a lot of countries are running very large deficits and will have to engage in fiscal austerity at some point in time. The last factor is really just that in the U.S. at least, we've just seen some banking stress that is an extra headwind for the U.S., and Canada's banks seem to be sailing through that particular experience fairly well.

We tally that up again, it doesn't mean no recession. We're still looking for a recession in Canada, much like in many other developed countries. But previously we thought maybe Canada would have a worse recession experience because of the household debt, because of the housing vulnerabilities and the rate sensitivity. Now we're thinking it might look a bit more similar to other countries because of these other advantages that Canada possesses.