• What's in this article:
• Market turmoil
• Economic weakness
• Counterpoints
• Tariffs
• Cdn election update
• Toronto population

 

Market turmoil:

• Financial markets have been choppy throughout 2019, but volatility ramped even higher over the past week, with the U.S. S&P 500 Composite Index recording swings of more than 1% in five out of the six trading days between August 12 and 19. August 14 was, by far, the most violent, with a sharp 2.9% decline.
• At its worst, the equity index closed down 6.1% relative to its late-July peak. 
• Subsequent days have managed to reclaim a fair chunk of the decline, with the August 19 reading now a mere 3.2% lower than the late-July peak, and level with readings from a few weeks ago.
• Bond yields have mostly continued their lengthy downtrend, with the U.S. 10-year yield now just 1.59%, which is nearly 50bps lower than a mere month ago, and well over a percentage point lower than a year ago.
• The macro-related motivations for these market jitters include slowing growth, mounting protectionism, the aging business cycle, Brexit expectations and the perception that the U.S. Federal Reserve Board (Fed) is treading too gingerly in its delivery of monetary stimulus.
• Notably, the U.S. 2-year to 10-year bond spread temporarily inverted last week. Although it has since re-normalized, this was a big part of the financial market’s sudden concern as the 2yr-10yr spread is considered by many to be an even more important signal of coming recession than the 3m-10yr spread that has already been inverted for several months. Loosely speaking, the former is considered better for predicting recessions, while the latter is better at predicting central bank rate cuts. In reality, it is not binary – both say something about the economy and monetary policy. It is notable that the 3m-10yr spread also unwound its first inversion earlier in 2019, only to re-invert more enduringly later.

Economic weakness:

• To recap global economic weakness, manufacturing indicators have fallen substantially since the start of 2018.
• The decline in service-sector industries has been less prominent, although now substantial.
• In contrast, consumers have mostly hung on – U.S. consumer confidence is notably robust, and the sector constitutes the greatest share of GDP – although the Recreational Vehicle (RV) industry is now tracking a 20% decline in 2019 shipments, on the heels of a 4% drop in 2018. The sector often serves as a long-leading indicator given the high cost and discretionary nature of RV purchases. The prior two recessions experienced a similar multi-year decline in RV shipments prior to the downturn.
• Germany just reported its second quarterly decline in economic output in the past year, leaving the annual rate of GDP growth at a bare +0.4%. This is not an utter shock considering the precipitous decline of Germany’s manufacturing sector, although that is, in itself, somewhat surprising given that Germany is far removed from the U.S.-China trade dispute. Chinese deleveraging may be at least in part to blame, given the two countries’ close commercial ties.
• In aggregate, this economic weakness is unwelcome, although it falls well short of a recession, although the case for one continues to mount. Our business cycle scorecard argues for a “late cycle” interpretation. While acknowledging that the “end of cycle” argument is strengthening, The New York Fed’s yield-curve model points to a sizeable 31% chance of a recession over the next year, and the model will likely reveal a higher probability when its next monthly update is published.

Counterpoints:

• Fortunately, a variety of forces for good are pitted against the gloomy economic trend.
• Central banks have been the most prominent agents for a re-acceleration of growth, thanks to their pivot toward monetary stimulus. The U.S. and China are already active on this front, along with a variety of lesser central banks.
• In fact, China has just announced that it will better align its policy rate with the actual borrowing rates that bank customers pay. This has three positive implications: First, in a general sense, the move increases the power of market forces relative to government edicts – a positive given criticism that China’s financial markets are overly managed. Second, the change will allow the central bank to better control actual borrowing conditions in the country. Third, the mechanics of the move are such that it could have the equivalent stimulative effect of a rate cut of nearly 50bps.
• The U.S. Federal Reserve will soon have its own opportunity to convey additional dovish signals: the annual Jackson Hole Symposium begins this Thursday August 22, with Fed Chair Powell delivering a speech the next day. The Symposium is famous for providing a backdrop for important U.S. monetary policy messages.
• The coming meeting revolves around the theme of “Challenges for Monetary Policy.” Many of the sessions will be academic in nature, conceivably exploring such issues as the evolving shape of the Phillips Curve, the effect of globalization on monetary policy, how monetary policy propagates through the confidence channel, the allures and pitfalls of price-level targeting, and the efficacy of negative policy rates.
• Expectations are that Fed Chair Powell will work to reverse concerns, which arose following the central bank’s last meeting, that the Fed is only lukewarm toward further rate cuts. Given subsequent economic weakness and now financial market volatility, Powell will likely seek to confirm market expectations for additional easing, although he will probably fall short of promising an inter-meeting move or a lumpy 50bps cut. That said, Powell will also likely seek to emphasize the relative health of the U.S. consumer and trumpet the improvement in financial conditions.
• In comparison to Jackson Hole, the release of the FOMC Minutes at midweek should attract less attention given their relative staleness.
• Fiscal policy is the other obvious mechanism that policymakers could use to try to restart economic growth. Despite a smattering of expansionary budgets, including considerable action from China, the global fiscal impulse is actually set to turn negative over the coming year, which means that fiscal policy could become a drag rather than a boost to GDP growth (see first chart).
• A chunk of the fiscal drag anticipated by the IMF reflects the natural ebbing of U.S. fiscal stimulus, as has long been anticipated.

Global fiscal stimulus to be less supportive

• Note: As of 8/6/2019. Percentage of bonds in Bloomberg Barclays Global Aggregate Bond Index trading at negative yields. Source: Bloomberg, RBC GAM
• The real question is whether governments will step up to the plate and deliver more fiscal stimulus in the coming months, forcing the IMF to revise its estimates upward. This is plausible. The German Finance Minister just acknowledged a willingness to deliver something on the order of 50B euros of fiscal stimulus in the event of an economic downturn. Others have been less candid, but suffice it to say the fiscal lever still exists and Keynesian principles are still widely followed. The fact that public debt loads are already high is concerning, but not enough to stop governments from doing what they want: the cost of borrowing, after all, is stunningly cheap. The question, as always, is whether fiscal policy can move fast enough to arrest a hypothetical downturn. Given the complexities of budgets, parliamentary procedures and a divided Congress, the risk is that any stimulus comes too late.
• Lastly, on the positive side of the ledger, we continue to acknowledge the possibility that the economic expansion defies fears and continues to trundle forward. Plausible justifications for this include the increased clout of the (relatively smooth) service sector, the possibility that more economic slack exists than commonly imagined, the possibility that inverted yield curves are sending a false signal, the fact that central banks have been unusually proactive this cycle, and a lack of “big problems” waiting to blow up the cycle.
• For investors, it may be advisable to think in terms of scenarios and with the goal of balancing short-run and long-run goals. In the short run, the downside risks appear larger than usual while the upside return is likely smaller than usual. This argues for more conservative investing than normal. However, moderating the extent of this inclination, the long-run story is one in which the relative valuation of stocks is substantially superior to that of bonds, and equities can be expected to deliver a significantly better long-run return. It still adds up to a diminished equity weight relative to earlier points in the cycle, but hardly the abandonment of risk assets altogether.

A moment on protectionism:

• Protectionism remains a serious issue for the economic outlook, and is more likely to get worse than to get better.
• However, a small olive branch was recently offered by the U.S. to China. The planned imposition of a 10% tariff on $300B-$325B in Chinese (mostly consumer) products, beginning on September 1, was softened slightly. Now, roughly half of the products – including high-visibility items such as laptops, cellphones and toys – will not be subjected to a tariff until December 15. Furthermore, a variety of other products, such as bibles, will be excluded altogether.
• For the moment, we are disinclined to revisit the damage estimates we published two weeks ago, as a three-month delay does not materially change the total economic impact spread over the next several years. Furthermore, additional tariffs may be implemented in the fall, be they pressure tactics on Japan and Europe or other measures targeting the auto sector more broadly.

Canadian election update:

• Canadian election prospects continue to evolve in the lead up to October 21.
• The Conservative Party had enjoyed a significant lead in the polls last spring, both in terms of popularity and in the likelihood of forming a government.
• However, as we noted at the time, much could yet change between then and the election, and the polls were likely to tighten.
• Precisely that has happened. The Conservatives retain the polling lead, with 33.7% support versus 32.7% for the Liberals, but they are significantly diminished. For context, the NDP enjoys 13.7% support and the Green Party 11.0%.
• Furthermore, parliamentary seats are not allocated based on nationwide popularity. The distribution of votes also matters enormously (see next chart).
• The Liberals benefit significantly from this, as current polling gives the Liberals a 60% chance of victory – a 37% chance of a majority versus a 23% chance of a minority government.
• Conversely, the Conservative odds of victory have fallen, with just a 12% chance of a majority and a 27% chance of a minority government. That adds up to just under a 40% chance of forming the next government.
• Framed differently, there is a roughly 50% chance that Canada’s next government will be a majority and a 50% chance it will be a minority government. Minority governments are always tricky affairs in that the governing party is perpetually at risk of a non-confidence vote and must wheel and deal with third parties to secure passage of budgets and other major legislative acts. On this front, the Liberals would likely have a much easier time of it as they align more closely ideologically with the NDP and Green Party than do the Conservatives.
• We conclude in the same fashion as we did when writing on this subject several months ago: there is still plenty of time for polls to change as campaigns have not yet officially begun, the major parties have not yet released their platforms and who can say what election-influencing domestic or world events may yet transpire. We’ll keep watching.

The Liberal Party is catching up in polls

• Note: As of 8/15/2019. Source: CBC Poll Tracker, RBC GAM

Toronto’s population growth:

• Toronto has enjoyed remarkable population growth in recent years, sustaining a building boom that has raised eyebrows in terms of the number of cranes on the skyline, but ultimately aligns fairly well with actual housing demand.
• We find that the Toronto metropolitan area is enjoying the second-fastest population growth among North America and European cities, adding around 120K new residents per year (see chart).

Toronto is the second fastest growing metropolitan area in North America and Europe in terms of population growth

• Note: Based on metropolitan area. Source: Statistics Canada, U.S. Census Bureau, Office for National Statistics, RBC GAM
• Only Dallas sneaks slightly ahead of Toronto. Sunbelt boomtowns such as Phoenix and Houston lag moderately behind. Interestingly, behemoths such as New York, Los Angeles and Chicago are in outright decline.
• In a Canadian context, Toronto is responsible for nearly a quarter of the country’s overall population growth (+530K over same period).
• In percentage terms, Toronto’s population growth is running at 1.9% per year given a population of 6.4 million. This growth rate is sizeable, and roughly double the national rate, but not wild.
• The city’s population growth is supported by a variety of factors, including a vibrant economy; increasing economies of scale; a high level of national immigration; strong immigrant communities; and a robust service sector that includes major financial institutions, a myriad of head offices and a rapidly-growing tech industry.