MacroMemo | 17 July 2023

Economic weakness continues in China

China’s economic data continues to undershoot expectations (see next chart).

China’s reopening boom fizzled quickly

^{As of 07/14/2023. Sources: Citigroup, Bloomberg, RBC GAM}

The country just reported a weak second-quarter Gross Domestic Product (GDP) print that was up just 0.8% relative to the prior quarter (around +3% on an annualized basis). Industrial production and retail sales are merely 4% and 3% higher than the year before, respectively. Indeed, a wide range of Chinese economic indicators are trending downward or otherwise soft (see next chart).

Monthly economic indicators for China are trending downward

^{As of May 2023. Average of 2019 indexed to 100. Sources: Haver Analytics, RBC GAM}

We continue to anticipate more Chinese stimulus coming in response to this. China is hardly in an enviable position with regard to its economic situation, but at least it has the coherence of a weak economy and low inflation both arguing for the same policy solution.

Any further policy support is unlikely to be of the shock-and-awe variety that the U.S. is famous for, but rather targeted measures that tilt more toward rule changes than monetary outlays. For example:

• Struggling property developers were recently given an extra year to repay their loans.
• The process of implementing an initial public offering (IPO) was recently made slightly easier for businesses.
• More rate cutting is quite possible. Additional supports for the property market are also anticipated.

In turn, whereas there was too much optimism about China at the start of 2023, there is now arguably too much pessimism about the country.

Port strike in British Columbia disrupts trade

The dock workers at 30 British Columbia ports recently staged a 13-day strike. This left as many as 63,000 shipping containers stranded on ships and disrupted around C$10 billion in trade. It goes without saying that the strike will temporarily reignite supply chain woes within Canada. Some products will be harder to procure, the economy will be slightly weaker, and inflation may be slightly higher.

However, the effects are temporary, and the economic cost is much less than C$10 billion. That represents the value of the goods impeded from transiting through the ports. But those goods will eventually reach their destinations. Furthermore the value-added normally provided by the ports for these goods is much less than C$10 billion. Shipping a million-dollar piece of equipment through a port does not add a million dollars to GDP – producing the equipment generates most of that sum, and the shipping value-added is comparatively modest.

Of course, to the extent businesses were counting on receiving their delayed goods, there is also a temporary loss via their diminished ability to operate normally.

One academic estimate puts the damage to Canadian annual economic output on the order of -0.02% – a tiny sum. But this damage could prove visible in the monthly economic data, temporarily subtracting 0.2% from a single month’s output before that loss is reclaimed in subsequent months. The effect could well be a percentage point or more off of British Columbia’s monthly economic output, though again only on a temporary basis. The effect on inflation is less clear, but one would imagine no more than a few tenths of a percentage point of temporary extra inflation.

Economic data weakens slightly

While economic data remains far from bad, the major data releases for June tilted slightly negative. The Institute for Supply Management (ISM) Services index continued its choppy sideways pattern. The ISM Manufacturing index remains outright weak and on a slight downward trend. It is already consistent with a contracting manufacturing sector, and only a few notches from the point at which the broader economy usually joins in (see next chart).

U.S. manufacturing and services sectors shift lower

^{As of June 2023. Shaded area represents recession. Sources: Institute for Supply Management, Haver Analytics, RBC GAM}

The U.S. job numbers were similarly weaker for June. There was nothing wrong about the 209,000 new jobs created in an absolute sense – it is entirely enough to keep the economy moving – but most other aspects of the report encouraged a worse interpretation. The figure was below the consensus forecast. It was almost 100,000 jobs weaker than the prior month (see next chart). In fact, it was the softest single month of job creation in two and a half years. There were also 110,000 of downward revisions to the prior two months.

U.S. job growth persists, but slowing

Additionally, the jobs that were created in June were skewed toward government, health care and social assistance jobs. These are perfectly fine jobs, but not the sort of hiring that signals business leaders are feeling great confidence about the future. In other sectors, we continue to track gradually deteriorating U.S. jobless claims and job openings.

North of the border, Canadian employment managed to add an impressive 60,000 new jobs in June (with +110,000 full-time positions added and 50,000 part-time positions lost). However, the ebullience with which this should be interpreted must be tempered by the prior month’s 17,000 job losses and the fact that with roughly a million people per year currently moving to Canada, the country theoretically needs to add upwards of 50,000 new jobs per month just to keep pace. Reflecting this second observation, the unemployment rate actually rose from 5.2% to 5.4% in June, a further increase from the 5.0% low recorded in April. Like the U.S., job creation was also tilted toward sectors that say less about business sentiment: health, education and public administration.

Elsewhere, while Canadian GDP growth was reported at just 0.0% in April, preliminary indicators pointed to a large 0.4% gain in May. Conversely, the Bank of Canada’s Business Outlook Survey was considerably more sour. For example:

• An aggregate indicator was incrementally softer yet again.
• The survey reported softer business conditions.
• Sales expectations were still modest.
• Investment intentions have been weakening.
• Worries about customer demand have been mounting at the same time as worries about labour shortages and supply chains have declined.

Consumer tidbits show mixed spending trends

Inflation-adjusted consumer spending continues to make incremental gains (see next chart).

U.S. consumption remains resilient

^{Personal consumption as of April 2023, retail sales as of May 2023. Sources: U.S. Bureau of Economic Statistics, U.S. Bureau of Labor Statistics, U.S. Census Bureau, Macrobond, RBC GAM}

From a theoretical standpoint, this shouldn’t be happening. Consumers should be ready to put away their wallets. Stimulus cheques have largely vanished. Inflation has eroded consumer purchasing power. Higher interest rates have likewise eaten their disposable income, outmuscling robust job creation over the past few years. The U.S. personal savings rate is now unusually low and credit card borrowing is surging at more than 15% per year.

It was thus with great interest that we now see companies remarking on diminishing consumer enthusiasm. Not all of this is new: lower-end retailers have been capturing market share from mid-tier retailers for over a year. But the latest Amazon Prime Day revealed deeper discounts than usual. This was a boon to shoppers, but also a signal that consumers are being more fickle. Other signs include:

• The crowds at Disney amusement parks this summer are notably thinner than in past years.
• Higher end restaurants are seeing less splurge spending.
• Some airport volumes are reportedly peaking.
• Home renovation spending is pivoting toward smaller remodeling projects.

In the immediate future, 45 million Americans will experience an abrupt (average) $400 per month increase in their expenses as student loan payments resume after a long pandemic pause. This means $70 billion in annual payments will resume, chopping approximately 0.6% from personal income and around 0.2% from personal spending.

The Biden Administration’s effort to eliminate some outstanding student loans altogether was recently quashed by the Supreme Court.

One open question is the extent to which the consumer spending boom of recent years was not merely due to stimulus and catch-up spending, but because people also re-evaluated their lives after the trauma of the pandemic and realized they hadn’t been enjoying themselves enough beforehand. If this is the case, it could warrant structurally higher consumer spending on hobbies and other personal goods and services, though perhaps at the expense of less spending later in retirement.

Recession musings lead to shift in our forecast

The long-anticipated recession still refuses to arrive for most countries. A year ago, this revelation would have been a surprise given that many headwinds were set to exert themselves over the intervening 12 months. The U.S. economy continues to hover just above its theoretical stall speed (see next chart).

U.S. economy hasn’t quite descended below “stall speed” yet

^{As of Q1 2023. Stall speed calculated as a smoothed function of the Gross Domestic Product trend growth rate minus 1.6 ppt. Shaded area represents recession. Sources: U.S. Bureau of Economic Analysis, Macrobond, RBC GAM}

Despite this, we continue to believe a recession is more likely than not, albeit with a probability that we hereby downgrade from 80% to 70%. The reduction reflects the observation that the economy has held on for so long, plus the fact that certain headwinds such as the inflation and energy shock have ebbed considerably in recent quarters.

The recession call itself remains rooted in three things:

1. The magnitude and speed of the interest rate shock over the past year and a half is theoretically consistent with a recession according to our most sophisticated econometric model. Indeed, several central banks have recently delivered or plan to deliver slightly more monetary tightening than previously envisioned.
2. Our scorecard of recession heuristics continues to point to a high probability of a recession, informed by such factors as an inverted yield curve.
3. Our business cycle work argues this is likely an “end of cycle” moment, or at the very least a late point in the business cycle.

Smaller motivations for the recession call include:

• The plump point in the inventory cycle argues that the risk of a downturn is higher than normal (see next chart).

U.S. firms have fully replenished their inventories (and then some)

^{As of March 2023. Real inventory-to-sales ratio of all manufacturing and trade industries. Shaded area represents recession. Sources: U.S. Bureau of Economic Analysis, Haver Analytics, RBC GAM}

• The U.S. Federal Reserve staff continues to forecast a recession.
• The inflation-adjusted fed funds rate continues to soar higher as inflation falls. Effectively, monetary tightening is continuing whether central banks are raising the nominal rate or not (see next chart).

U.S. real fed funds rates rise quickly as Fed hikes aggressively

^{As of 07/17/2023. Shaded area represents recession. Sources: Federal Reserve Board, Macrobond, RBC GAM}

• A few regions have already tumbled into recession, including Germany, the Eurozone and now New Zealand. Each was admittedly the victim of a kaleidoscope of special factors that limit the implication for other parts of the world. For example, the energy shock hurt Germany and the Eurozone; bad weather and a strike damaged New Zealand – but weakness is undeniably in the air. One might even argue that China has been suffering from something resembling a recession. In the emerging market space, growth of less than 3% per year is sometimes described as being the equivalent of a recession, and China slipped below that threshold last year, and again in the second quarter of this year.

Where the recession debate requires the deepest thought is with regard to its timing. We had forecast a recession occurring in the third and fourth quarters of 2023, in large part because the theoretical maximum headwind from interest rates arrives at that time. That’s now. Technically, the window opened several weeks ago, and yet no recession is visible.

Granted, economic data arrives with a lag, and it will be weeks to months before we have a comprehensive picture of July, let alone August and September. And, yes, recessions can start with lightning speed. But, realistically, the probability of this happening in the next month or two is not great. As such, we shift our base-case recession call to the final quarter of 2023 and the first quarter of 2024 while acknowledging there is still a chance that it arrives sooner than that.

Inflation cooperates in June

Inflation continues to trend nicely lower in most countries. The June decline in the U.S. was especially notable, from +4.0% year-over-year (YoY) to +3.0% YoY in a single swoop. In fairness, most of the decline was due to favourable base effects as the gargantuan price increase from June 2022 fell out of the annual equation. But the latest June print was also genuinely tame, rising by just 0.18% month-over-month (MoM).

More importantly, core inflation – which has declined much less willingly over the past year – rose by just 0.16% MoM. The prior three months had all notched big 0.4% gains, so this core Consumer Price Index (CPI) deceleration was a revelation. It’s the lowest reading in multiple years (see next chart).

U.S. Consumer Price Index shows notable decline

^{As of June 2023. Sources: U.S. Bureau of Labor Statistics, Macrobond, RBC GAM}

Other notable trends:

• Car prices have begun to decline again.
• Shelter costs are beginning the long-awaited deceleration prophesied to begin in the middle of 2023.
• Goods inflation continues to fall sharply.
• Service inflation ex-shelter is now moving significantly lower.
• Shelter inflation is beginning to correct (see next chart).

U.S. goods and services inflation is falling, shelter inflation on the cusp of turning lower

^{As of June 2023. Shaded area represents recession. Sources: U.S. Bureau of Labor Statistics, Haver Analytics, Macrobond, RBC GAM}

The U.S. Producer Price Index is on the cusp of deflation, now rising just 0.1% YoY (see next chart).

U.S. inflation is declining

^{As of June 2023. Shaded area represents recession. Sources: U.S. Bureau of Labor Statistics, Macrobond, RBC GAM}

Importantly, the breadth of inflation also continues to narrow. Whereas 33% of the U.S. consumer price basket was rising by 10%-plus per year last September, the latest share is just 8% (see next chart).

High inflation in the U.S. is becoming much less broad

^{As of June 2023. Share of Consumer Price Index components with year-over-year % change falling within the ranges specified. Sources: Haver Analytics, RBC GAM}

It must be conceded that the real-time inflation prints appear to be improving somewhat less quickly in early July relative to the prior few months. However, they are still declining (see next two charts).

U.S. Daily PriceStats inflation index improves slowly

^{PriceStats Inflation Index as of 07/10/2023, Consumer Price Index as of June 2023. Sources: State Street Global Markets Research, RBC GAM}

Canada Daily PriceStats inflation index also improving slowly

^{PriceStats inflation index as of 07/10/2023, Consumer Price Index as of May 2023. Sources: State Street Global Markets Research, RBC GAM}

In contrast, U.K. inflation is behaving much less well. Wage growth is experiencing a sharp acceleration that may make it difficult to tame inflation without materially tighter monetary policy (see next chart).

U.K. average weekly pay rises sharply

^{As of April 2023. Sources: U.K. Office of National Statistics, Macrobond, RBC GAM}

Upside inflation risk

Headline inflation has improved a lot. But it arguably exaggerates the sustainability of the inflation improvement. Gasoline prices have fallen sharply over the past year, helping a great deal. But this trend is unlikely to continue declining indefinitely. Whereas overall U.S. inflation is just 3.0% YoY, inflation excluding motor fuel is still 5.3% YoY (see next chart). Inflation without the artificial helping hand of gasoline deflation is still three-plus percentage points from normal. Inflation still has a fair distance left to travel.

U.S. gasoline inflation cooling down much faster than other goods and services

^{As of June 2023. Shaded area represents recession. Sources: U.S. Bureau of Labor Statistics, Haver Analytics, Macrobond, RBC GAM}

It is no longer likely that inflation gets stuck at 10%, but as an upside risk it remains possible that inflation gets stuck in the 4-5% range. (For the record, our base-case forecast is that inflation returns to the mid-2s.)

Downside inflation risk

At the opposite extreme, it remains somewhat of a stretch to think that deflation represents a serious risk. However, it is always worth appreciating that there is a real scenario in which inflation arrives materially below consensus. Monetary policy has pivoted from extreme stimulus to substantial restraint, commodity prices have fallen significantly, supply chain problems are mostly resolved and a recession may be in the offing.

Prices rose too much for some products for varying reasons: raw materials were temporarily more expensive, there were shortages, and/or market conditions enabled profit margins to expand. Some of these drivers can reverse, not merely stop. At the corporate level, some companies such as Whole Foods and Walmart are reportedly putting pressure on their suppliers – a potentially deflationary impulse. Car prices are again falling after massive earlier increases. Computer chip prices continue to trend lower after their earlier spike (see next chart).

Chip shortage is easing

^{As of June 2023. Mainstream density DDR4 chip used in the DDR4 8GB 1Gx8 2400/2666 MHz chip. Sources: InSpectrum Tech, BloomBerg}

At the international level, two countries illustrate the downside inflation risk. The first is Spain, which now reports just +1.9% CPI YoY, slightly below the European Central Bank’s (ECB) 2.0% target. Amazingly, this is less than a third of the German inflation reading.

What can possibly explain this remarkable softness? It is a mix of economic conditions, structural factors and government policy. Spain brandishes the highest unemployment rate in the European Union (EU), limiting capacity-oriented pressures. The main structural factor is that the Spanish natural gas network is less integrated with the rest of the EU than its peers. This means that the country’s energy costs did not skyrocket to the same extent as Russia cut off access.

Helpful government policies have included a gas price cap, a sales tax cut for fruit and vegetables, and new rent controls limiting increases to 3% per year. (It should be noted that while these policies have helped to limit inflation in the short run, they are not necessarily economically optimal over the long run.)

The second country is China, which now reports a CPI rate of 0.0% YoY, and whose Producer Price Index fell by 5.4% over the past year. China is quite different than other countries. It never had much of an initial inflation spike, in large part because it didn’t deliver the sort of pandemic stimulus that other countries did. Also, as the point of origin for many supply chains, China’s own supply chain woes were considerably tamer than most. In addition, because its economy was more open than most across the bulk of the pandemic, there wasn’t a mad scramble to spend as restrictions faded.

Conversely, you could argue that China is simply on a lagged timeline relative to other countries. It reopened just seven months ago, and so could be about to experience a surge in inflation with the same one-year lag after reopening that other countries have. If this line of thinking were to prove correct, China could encounter considerably more inflation next year. But without the jostling of other countries simultaneously reopening and with an economy that is relatively weak, Chinese inflation is likely to remain relatively controlled.

The circumstances of Spain and China are sufficiently distinct that they don’t provide a particularly helpful roadmap for other countries seeking to escape inflation. But they do illustrate that it is entirely possible for inflation to be normal or even low in the present environment. Some countries are likely to join them, and inflation could undershoot expectations more broadly.

Central banks continue raising rates

Central banks are on track to deliver more monetary tightening than had been imagined just a quarter ago. The Bank of Canada is already up to a 5.00% overnight rate, beyond its previously planned 4.50% ceiling. The U.S. Federal Reserve appears to have at least one more hike ahead, also beyond earlier expectations.

To put it simply, if the most interest-rate sensitive sector of the economy – housing – is reviving at a time when the economy is already too hot, then interest rates simply aren’t high enough to achieve the goal of normal inflation.

But after the soft U.S. inflation report came out last week, market expectations have dipped somewhat. The Fed is expected to stop after that next 25bps move, and the market now assumes that the Bank of England will halt around 6% rather than 6.5%.

Will this last tightening of the screws prove especially potent? Economic theory generally argues that every 25 basis point rate hike has about the same dampening influence on the economy. As such, an extra 50 basis points or so of monetary tightening is hardly a big deal. But, with all due respect to the economic models, one can mount a reasonable argument that this latest tightening is perhaps slightly more potent than usual:

• First, policy rates are now not just considerably higher than their 2019 cycle peaks but also starting to exceed their 2007 cycle peaks. In other words, these are the highest policy rates since the turn of the millennium. Unfamiliarity with interest rates this high could have an outsized effect on the behaviour of businesses and households.
• Second, by tightening slightly further than previously expected, central banks are signaling that they aren’t about to give up on achieving their inflation goals. If inflation continues to elude their grasp, then they will raise rates even further. That could have a chilling effect on borrowers.
• Third, and possibly just a more specific example of the prior point, this extra tightening is a signal to housing markets to cool it. Housing markets began to revive when they thought the tightening cycle was done, and central banks are saying “not so fast.” Perhaps the housing market will think twice before rebounding as quickly again.

A final thought on central banks: emerging market central banks should be heeded. They led the way higher, recognizing far sooner than developed nations that higher inflation had to be combatted and undertaking serious monetary tightening a full year earlier. Emerging market nations are hyper-sensitive to inflation as they have much less well anchored expectations, a larger share of their price basket is composed of volatile commodity prices, and central banks must also worry about capital outflows.

These same emerging market central banks could now act as a leading indicator for developed world central banks in the opposite direction. China has already cut rates, though it admittedly marches to its own drummer. Tongues are wagging about other Asian giants such as India, South Korea and possibly Indonesia cutting interest rates this fall. Brazil could cut its policy rate as soon as August. Developed nations are probably not cutting rates until 2024, with advanced warning potentially coming from the emerging market space.

Society in decline? Part II

There is the impression that society is decaying all around us, with possible relevance for the sustainability of economic growth over the long run. We first tackled this subject late last year, in a section called “Society in decline?”

Our conclusion was less apocalyptic than feared. Using U.S. data, some aspects of society did show mounting problems. For example, overdose deaths are rising, prominently. But other social trends are more positive:

• While of deep concern, the extent of homelessness is less than commonly imagined.
• The number of single-parent households has stabilized.
• The divorce rate has fallen remarkably.
• The crime rate – while higher than before the pandemic – is still sharply lower than prior decades.

Over the intervening months we have constructed additional societal barometers that provide further insight. They also point to a nuanced conclusion.

Let us start with the bad news. The share of the U.S. population with obesity continues to rise, at least through the 2019 data publicly available (see next chart). This has negative effects on quality of life and longevity, among other implications.

Share of U.S. population with obesity continues to rise

^{As of 2019. Sources: Organization for Economic Co-operation & Development (OECD), Macrobond, RBC GAM}

Tragically, the suicide rate has been rising for several decades. Incidentally, and not taking away from this longer-term upward trend, it is surprising that the suicide rate fell to an unusually low level in 2020 during the most stressful phase of the pandemic. It was still no higher than the pre-pandemic norm in the most recent year (2021).

Overall suicide deaths also rising

^{As of 2021. Sources: Centers for Disease Control & Prevention, National Vital Statistics System (NVSS), RBC GAM}

The fraction of the U.S. population with a disability continues to rise (see next chart). But this isn’t actually as bad as it looks. Census Bureau research finds that the increase is much less prominent (or even non-existent) if one controls for the rising age of the average American.

Share of U.S. population with disability rising

^{As of 2021. Sources: National Institute on Disability, Independent Living and Rehabilitation Research, Macrobond}

Surprisingly, and now pointing in a more optimistic direction, mental health disorders have actually been in decline since the turn of the millennium (see next chart). It is fair to concede that they were beginning to rise when the latest data was released in 2019, but not to the point of annulling earlier gains. It is admittedly perplexing that mental health disorders were declining while the suicide rate was rising across the 2010s.

Share of population with mental health disorder declines since 2000

^{As of 2019. Mental health disorder includes depression, anxiety, bipolar, eating disorder and schizophrenia. Sources: Institute for Health Metrics & Evaluation, Global Burden of Disease, Our World in Data, RBC GAM}

Lastly, educational attainment continues to rise at an impressive clip (see next chart). There are far more high school graduates than even a decade ago. The same goes for post-secondary graduates. Pessimists will note that the quality of that education has been in relative decline, but overall it is safe to conclude that human capital is rising rather than falling.

Share of U.S. adult population with at least a high school degree rises

^{As of 2021. Source: U.S. Census Bureau, Macrobond, RBC GAM}

There is no easy way to quantify the relative importance of obesity versus education, or the suicide rate versus the crime rate. The best we can do is to acknowledge that some non-economic societal markers are most certainly getting worse, while some are getting better. The latest set of indicators tilt a bit more toward the negative, but the earlier set of indicators published in December tilted more toward the positive. Nearly all are nuanced.

Certainly there is room for improvement and there are many ills to be addressed. But, despite the popular impression, western society is not actually circling the drain in every way.

-With contributions from Vivien Lee, Thao Le and Aaron Ma