#MacroMemo: June 5 – June 9, 2017

Watch our June economic webcast:

Watch out latest monthly economic webcast, called “Mixed Economic Readings”: https://media.rbcgam.com/email/redirects/geo-monthly-webcast.html?date=201706  

Where do recessions come from?

There are three kinds of recessions: shock-based, balance sheet and business cycle.

1. Shock-based recessions can result from geopolitical (military/political) developments, natural disasters or sudden changes in competitiveness (from currency swings, changes to labour laws, productivity shocks, etc.).
2. Balance sheet recessions come from a distended financial balance sheet. On the asset side, these look like the tech stock bubble that burst in 2001. On the liability side, they resemble the debt-induced global financial crisis of 2008—2009. Balance sheet recessions tend to be especially deep and long lasting.
3. Last but not least, business cycle recessions are the most common species. It is an oft-heard claim that central banks cause these recessions by accidentally raising interest rates too much. This does occasionally happen, but we dispute the notion that central banks always play a central role.

 There are several other factors that naturally incline economies toward recession once an economic recovery has eaten through all available slack:

• Rising inflation is an unavoidable result of a tightening economy, and high inflation motivates people and businesses to retrench by spending less and saving more. This, in turn, weakens the economy and can create the sort of vicious circle between consumers/workers and producers that eventually translates into a recession.
• The inventory cycle can also contribute to a natural downturn. When the going is good, companies build their inventory levels in anticipation of further robust sales growth. If this fast growth fails to appear, companies must then overreact by not just pulling their production down to a more sustainable notch but by furthermore reducing their production to unwind the earlier inventory-building. This “under-production” can then contribute via layoffs to under-consumption and create a vicious circle.
• As an economic cycle progresses, confidence and risk-taking generally rise alongside it. This is broadly a good thing, but towards the end of a cycle it can start to go too far. When these lofty expectations are not met, confidence can tumble and take the economy down with it.
• Lastly, interest rates absolutely do play a role in the cycle. Very low rates encourage investment in the early going. But borrowing costs tend to rise over time, gradually discouraging further investment and even undermining the business case of prior investments. This creates economic pain and can cause an economy to backslide. However, we are not convinced this last part is all the fault of central bankers. Borrowing costs tend to rise over the cycle even without the help of central banks (though monetary policy does tend to nudge this along as well); it would be awfully strange if central banks repeatedly created accidental recessions and never learned from their mistakes; and keep in mind that the risk of a balance sheet recession would rise exponentially if the policy rate was instead left at a rock-bottom rate forever.

To be clear, a tightening central bank is certainly correlated with a maturing economy, and so can be used as a signal that the business cycle is indeed advancing. However, we are not convinced the causality runs directly from the former to the latter. Rather, both are reflective of more fundamental economic developments. While a recession is hardly imminent, the fact that central bankers have been slow to liftoff does not necessarily delay the end of the business cycle.

A rising tide for low income earners:

• Low-end wages: Wage growth in U.S. limited-service restaurants (fast food) is now +6% per year, much better than ~2.5% in the broader private sector. This is partly just a cyclical story – fast food wages tend to swing more broadly across the cycle than the average. And it is partly reflective of higher minimum wages in many states. Regardless, it is good when low end workers are doing better since they suffered the most during the financial crisis.
• Confidence: Consumer confidence has increased materially across all segments of society over the span of the past several years. While the lowest third of income earners unsurprisingly are less confident than the rest, their current level is actually higher than the peak of the prior cycle. The same cannot be said for the top third of American earners.
• Spending: First, the bad news. In contrast to other income groups, the bottom quintile (20%) of U.S. income earners are still spending less on a real per household basis than they did 33 years ago. However, this spending has finally begun to rise over the last few years, and may be about to exceed those prior highs based on the aforementioned wage and confidence trends.

All of this is positive news from several perspectives:

• It provides a mild pop to the economy via more consumer spending (though the effect is fairly small since this group is naturally not a consumer powerhouse).
•  It is good news for its own sake: these are people who have been struggling.
•  It suggests inequality might be declining, for the moment at least.
• It could soften some of the populist forces in the U.S. in the lead-up to the 2018 midterm elections.

Defending the honour of Canadian GDP:

Canada’s happy first-quarter GDP print of +3.7% annualized has been impugned by some for being hollow.

Here are a few negative perspectives:

• Inventory accumulation contributed 3.6 percentage points out of the quarter’s 3.7% gain, with the suggestion that very little honest economic growth occurred once this is stripped out.
• Trade subtracted 4.4ppt from growth.
• The long-awaited and much celebrated business investment gain of 10% in the first quarter is actually just a meagre uptick when compared to the 22% drop in the prior quarter.

However, we still feel pretty good about this report and also the Canadian economy:

• Leading economic indicators are still very strong, and we believe the underlying economy is growing at a faster than normal pace, if not quite a sparkling 3.7% clip.
• Within the report, inventories may have generated 3.6ppt of growth, but consumption plus housing generated another 3.7ppt all by themselves. How is this possible? Recall that trade subtracted 4.4ppt, so the total of all the positive factors has to offset that drag, too. The point being, inventories weren’t the only part of the economy to grow.
• Cutting through the noise, final domestic demand rose by an excellent 4.7% annualized. This is the measure of actual spending by Canadians once inventory and export distortions have been removed.
• Trade may have fallen sharply in the first quarter, but for context it contributed a nearly identical +4.3ppt to the prior quarter’s growth. The latest weakness is mostly just a balancing out. Although U.S. protectionism looms, we continue to see half-decent trade numbers in the near future based on active tracking and built-in currency effects.
• Although inventories are likely to pose a drag at some point over the next few quarters to balance out recent strength, the absolute size of the inventory stock looks quite reasonable relative to the heft of the overall economy.

The bottom line is that we can hardly look for economic growth to remain as strong in the coming quarters as it was in Q1, but it should remain decent until more serious protectionist and housing challenges eventually mount.  

Geopolitics swirl:

We continue to highlight geopolitical uncertainties as a key market risk. There is much happening at present.

• Another tragic British terror attack over the weekend highlights ongoing unrest in the Middle East, the particular vulnerability of Europe, and is seemingly catalyzing a muscular response from British Prime Minister Theresa May with an election just days away.
• Relations within the Middle East are fracturing further as Saudi Arabia, Egypt, the United Arab Emirates and Bahrain have all closed diplomatic and transportation connections with Qatar. The U.S. ally, 2022 World Cup host and world’s leading exporter of liquefied natural gas seems to have upset its neighbours on multiple fronts. Part relates to an alleged $1 billion payment to extremist kidnappers to free members of its royal family. Part relates to its warming relations with Iran and support of the Muslim Brotherhood movement. Recall the proxy war fought between Saudi Arabia and Iran in Yemen in recent years. The concern in global markets is that this split could hurt OPEC’s ability to limit oil production as per a recent agreement, with oil prices accordingly lower on the news.

In the U.S., fired FBI director James Comey will be testifying on Thursday June 8th to the Senate about President Trump’s actions, with significant potential for fresh revelations (particularly given Comey’s history of memorable performances at past testimonies).  

Data medley:

• U.S. payrolls review: U.S. job creation continued its subtle deceleration in May with “just” 138,000 new workers. There were also significant downward revisions to earlier months. While disappointed, we are not overly worried. This is still a fine rate of job creation, exceeding the stall speed that might hint of (or lead to) an underperforming economy or a rising unemployment rate. The simple reality is that it gets harder and harder to hire workers as the unemployment rate nears its natural floor (current unemployment is just 4.3%). We suspect the heyday of 250K+ new jobs per month came to a close some time ago. Other labour market metrics such as weekly jobless claims are still constructive.
• U.S. ISM Manufacturing review: It was something of a placeholder ISM Manufacturing print in May with yet another figure around the 55 level. This is consistent with robust economic growth, though also with the view that the pace of activity may have peaked a few months ago. Outsized equity market gains become less likely at this stage but the broader environment is still reasonably happy.
• U.K. election preview: With the British election now just days away (June 8), polls continue to narrow precipitously. The latest suggest the incumbent Conservatives hold no more than a mid-single digit lead over Labour – less than a quarter of the initial advantage a few months ago. The Conservatives are still quite likely to win (betting markets assign around an 85% chance of a Conservative win), but the possibility of a mere minority victory is no longer quite so improbable. The election is a high stakes one given Labour’s sharply left-leaning vision. The recent series of terror attacks may favour the Conservatives given their harsher stance on immigration.
• ECB preview: Although European economic data continues to point higher and political risks to date have largely been dodged, the ECB seems likely to stick with a fairly dovish message.
• Canadian employment preview: Step up to the roulette wheel that is Canada’s employment statistics. The best advice in recent quarters has been to bet on an above-consensus outcome, though this failed for the first time in months with April’s release. For May, we pencil in 15K new jobs based on the fact that just about everything continues to signal an unusually healthy Canadian economy. The job market may have gotten a little ahead of itself earlier (which is why we don’t forecast even more), but there is little in this data release that could cause us genuine concern about the Canadian economy.

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