Next Week's Risk Dashboard

• Recession and stagflation: odds, types and mitigants
• FOMC minutes: heard it all before?
• Australia’s election
• CDN Q2 bank earnings season
• Final week for Colombian election campaigning
• Counting down to Ontario’s election
• PMIs: US, Eurozone, UK, Japan, Australia
• RBNZ’s tightening lead to increase
• Ditto for the Bank of Korea
• Bank Indonesia may be dragged to a hike by the rupiah
• Turkey’s inept central bank
• Global indicators round-up

Chart of the Week

How seriously should one treat recession or stagflation risk? This question is at the root of concerns in financial markets and will probably continue to dominate calendar-based developments over the coming week. That’s especially true in terms of the state of the US economy since, if it truly faces either scenario, then spillover effects on the world economy and America’s closest trading partners could be acute. Some forecasters have been beating the drums on the topics while broader public concern is reflected in Google Trends in the US that show the recession and stagflation keywords at around levels that existed into the Global Financial Crisis and the pandemic.

Why It’s Not our Base Case

Scotia Economics is not forecasting either scenario as we expect growth to cool over 2022–23 and for materially cooler inflation to gradually emerge into 2023. Like many others, we see a higher probability of recession while closely monitoring conditions, but we don’t view either recession or stagflation as a likely base case at this point.

For starters, while an oil shock to net importers doesn’t help, it’s unlikely to behave in the same growth-destroying manner that it has in the past. The nominal price of oil is clearly much higher now than in the 1970s shocks, but the real (inflation-adjusted) price of oil today is no higher than back then and still lower than during the early 1990s Gulf War (chart 1). The US economy also relies much less upon oil and energy in general for every unit of economic output today than in the past (chart 2) as the economy has diversified, energy use has generally become more efficient, and the less energy-intensive service sector has risen. The oil futures curve may be signalling softer oil prices in future as peak sanctions and war effects dissipate and greater balance is restored to oil supply and demand conditions.


We also assume that supply chain shocks will gradually ease compared to the serial growth-restricting shocks we’ve been seeing this year. That could bring forward more rapid increases in production with shorter delivery times and fewer cost pressures. One manifestation of this could be China’s gradual easing of Covid Zero policies that it is combining with further stimulus measures to lift growth prospects in the second half of this year.

In addition, while inventories have grown through significant investment over recent quarters, it would take a large collapse in sales to make current inventory-to-shipment ratios as problematic as they have been into past recessions when production had to be rapidly cut in order to address costly financing and storage of excess inventories (chart 3). Today’s dynamic toward repairing supply-side hits to production is probably rather different.

The state of the US consumer’s overall finances is also looking strong and consumer spending accounts for about 70% of the US economy. Debt service payments are at a record low share of disposable income and were already at their lowest before the pandemic struck. The household debt to income ratio has fallen since the GFC as Americans deleveraged. Idle cash balances sitting on household balance sheets have gone up by 83%, or by an extra US$3.6 trillion since just before the pandemic; if there’s one thing that I’ve learned about American consumers it is that idle cash proves tempting to spend. Housing investment’s share of GDP today is about 60% lower than it was at its pre-GFC peak in 2005 and only just over one percentage point higher than the post-GFC low. Further, existing home inventories stand at 2.2 months and continue to hover around record lows whereas it had risen to 9–11 months just before the GFC. It’s also likely in our view that services spending remains at an early stage of recovery with demand rotating from the ‘nesting’ forms of behaviour during the pandemic toward re-engaging with other activities.

Labour markets may be positioned in fundamentally different ways this time as well. At Scotia we point to unusually elevated job vacancies and strong hiring intentions as indications within tight labour markets that employers may be highly reticent to let workers go should the economy weaken. If inflation gradually eases from current peaks then tight labour markets could restore positive real wage gains versus the present weakness that households are rationally smoothing through borrowing and sources of wealth.

Business finances are also sound. A rotation of earnings drivers is underway as the nature of economic activity shifts, but broad corporate finance metrics are healthy. Interest coverage entered the high rate environment at a record high and its deterioration is likely to preserve healthy conditions while debt ratios are steady (chart 4).


On financial market signals, Federal Reserve models of the yield curve as a predictor of recession that use traditional definitions of the curve (here, pending an update this coming week) continue to indicate a low probability of recession. This paper argues that a superior measure of the yield curve as a predictor of recession is nowhere close to signalling one. Stock markets and credit have repriced tighter monetary policy as a necessary step toward tightening financial conditions to cool growth and inflation but without necessarily portending a recession.

As for stagflation, talk of it seems premature. Textbook stagflation is not a short 6–12 month period of high inflation and softening growth and the term has been consistently bandied about in overly casual fashion for years. It’s typically a multi-year period of such conditions that alters behaviour and we’re not prepared to forecast years of inflation at present rates and years of very slow to no growth, although inflation may face structurally greater supports going forward than the past one or two decades.

Recessions Come in All Shapes and Sizes

Even if we’re wrong—and there are multiple uncertainties overhanging the outlook—a key issue that is usually not addressed by recession proponents is what one could look like this time. No two are ever fully alike in how they look and feel and in terms of their drivers, but a generation of folks may believe they’re all devastating experiences like the most recent experiences of the Global Financial Crisis and the pandemic. They’re not. A few stylized recession facts may be useful.

The cover chart this week illustrates the point about how the duration of recessions has been shrinking over the very long term but less so in modern times, while the duration of expansions has been dramatically lengthening including during modern times.

Chart 5 further expands on this point in that there is a very high dispersion of outcomes among individual business cycles measured in terms of lengths of recession and expansion with each individual dot representing one recession.


Chart 6 pairs the lengths and depths of recession together. The pandemic messes up the scale as a very deep but very short recession (with longer-lived and ongoing adjustments), but the point that remains valid is that some have been mere short-lived and shallow technical recessions while others have been drawn out and deep. Most recessions are in the middle.


Charts 7–10 trace what happened to GDP, employment, PCE inflation and core PCE inflation on a cumulative basis throughout past recessions. Again, there are vast differences across recessions in terms of how all of these measures perform. My hunch is that should a recession emerge, the conditions we face are more likely to make it on the milder end of the spectrum than some of the more devastating experiences.


Policy Options

Sometimes policy mistakes do indeed spark recessions. Sometimes recessions may be courted in order to contain imbalances and inflation. It’s unclear that in the present context the Phillips curve relationship requires vastly higher unemployment to control inflation instead of a modestly higher unemployment rate over time relative to a hard-to-define measure of full employment and aided by easing supply chain pressures.

Policy options to address an unexpected further worsening of conditions should still be considered. They could include easing off with fewer rate hikes if sharply weaker growth and tighter financial conditions rein in inflation.

While the ideas behind this recent IMF paper have been around for a long time, future shocks could make them more feasible. Whether it would work or even be entertained would depend upon the starting conditions as central banks directly depositing money could backfire if inflation is still running hot into a weak spot for the economy. Admittedly I don’t like this option since raising the inflation target could be more destabilizing under current circumstances and perhaps the Fed’s altered policy framework that was communicated at the Jackson Hole Symposium in 2020 contributed to Chair Powell’s tendency to downplay inflation risk throughout almost all of 2021.

Still, to the Fed’s credit—and other central banks and governments—the lessons learned in the GFC about confronting downside shocks decisively and powerfully served to negate the risk of deflation and depression. A similarly expeditious and powerful response in the face of a future deterioration could draw upon this experience.

As for the Fed’s policy rate, we think the terminal fed funds rate will peak at 3%. It’s possible it goes higher. If it goes sharply higher because inflation remains stubbornly sticky then we’d have to raise downside risks to the economy, but at 3% the real policy rate would only be moving into mildly restrictive territory and much less restrictive than into past recessions. Comparisons to the 1970s stickiness forget that it was a vastly different monetary policy regime at the time that did not seek to target inflation. It’s also not impossible that the fed funds target rate doesn’t go as high as some fear if supply-side drivers of inflation ease, and demand-side drivers cool on the back of tightened fiscal policy and broad financial conditions.

CENTRAL BANKS—THE EARLY, THE LATE AND THE DOWNRIGHT ABSURD

Across central bank developments, global markets will probably face modest risk in the FOMC minutes this coming week. Four regional central banks will make policy decisions and, in some cases, represent the fringes of policy responses.

Minutes to the FOMC meeting on May 3rd – 4th arrive on Wednesday (2pmET). A recap of what was done at that meeting and how markets reacted is available here. In short, they hiked 50bps, announced that the balance sheet would begin to contract starting on June 1st by allowing a maximum of US$47.5B of maturing Treasuries ($30B) and MBS (US$17.5B) to roll off without replacement for three months and then allow US$95B/month to roll off starting in September. Chair Powell said in the press conference that there was “widespread” support for 50bps hikes at each of the June and July meetings.

What sparked a rally in Treasuries, however, was when Chair Powell said during the press conference that the committee was not “actively considering” 75bps hikes and stuck by the 2–3% estimated neutral rate range instead of guiding that it may be higher. Markets had been modestly leaning toward the chance at a bigger-than-50 move. At the time, markets ignored what he said about how “it’s certainly possible” the FOMC hikes above the neutral rate range and that they see “restoring price stability as absolutely essential to the economy in coming years.” More recently, Treasuries sold off when Powell largely said the same thing at a WSJ event, perhaps indicating how volatile financial markets have become and what they choose to emphasize at any given time.

Still, the main market effects came when Powell went somewhat rogue in the press conference as opposed to the formal FOMC communications. That might indicate that the minutes could be rather dull with the committee’s script having been laid out. If anything, I’d watch for the following:

  • further discussion around both terminal and neutral rates;
  • discussion of recession risk;
  • further discussion of wage-price spiral risks that Powell doused in his presser;
  • a fuller discussion around the chosen pace of roll-off;
  • potential discussion around optimal reserves;

RBNZ—Earning its “No Regrets” Stance

The Reserve Bank of New Zealand is expected to hike again on Tuesday night (eastern time as always). Markets are mostly priced for a 50bps move to a 2% cash rate. Governor Orr is right to take credit for being “one of the first countries in the world to stop quantitative easing and to start raising our interest rates” while saying he has no regrets for tightening before most others. The BoC was also one of the first to stop QE after tapering began in October 2020 and net purchases ended last October but was slow to pivot to hiking. The BoK is a solid competitor to the RBNZ (see below). In all cases, bear in mind that the experiment isn’t over yet so let’s not see anyone getting too cocky.

Bank Indonesia—About that Currency

A minority of forecasters expect Bank Indonesia to hike its 7-day reverse repo rate by another 25bps on Tuesday. Most expect a hold at 3.5%. Headline inflation is running at 3 ½% y/y and core CPI inflation is at 2.6% y/y, both well within the 2–4% headline target range. As such, there is no pressing urgency to adjust policy, right? Maybe not so fast. As the Federal Reserve has turned increasingly hawkish, the effect has been to depreciate the rupiah that has lost almost 3% over about the past month. Concern over financial stability and imported inflation may prompt earlier tightening than it had guided at its prior meeting.

Bank of Korea—The Boss is Back

They hiked with no boss at the April 13th meeting. Now with a boss having been appointed—Governor Rhee Chang-yong—the Bank of Korea is expected to hike again and raise its bank rate by 25bps to 1.75%. That would make this the fifth quarter-point hike of the cycle that began last August and therefore gives the RBNZ a bit of a run for the money. Inflation is running at 4.8% y/y with core at 3.6% compared to the 2% inflation target.

Turkey—A Case in Political Meddling

What happens when politicians fire central bankers and tell their replacements how to behave? 70% inflation, that’s what. Welcome to Turkey. Market confidence has, well, left the building as the lira has depreciated by 130% since early 2021 and has kept sinking this year. President Erdogan’s, let’s say unorthodox belief to be polite about it, belief is that “We will pull down inflation and exchange rates with low-rate policy. High rates make the rich richer, the poor poorer. We won’t let that happen.” In reality, inflation is a highly regressive tax on the poor who have their President to thank for ruining their livelihood.

ELECTIONS COME IN THREES

Three elections are coming across markets followed by our clients with one set of results due this coming week as the other two enter their final campaigning stretches.

Australians head to the polls on Saturday and the results may impact Australian markets into the Monday morning open. Prime Minister Scott Morrison’s Liberal Party/National Party (L-NP) coalition has won the last three elections but is behind in the polls to Australian Labour Party (ALP) leader Anthony Albanese. As chart 11 demonstrates, that lead is tight and has recently shrunk. There is also a significant undecided component in the polls. Climate policies are a significant campaign issue and from a distance it doesn’t seem like either side holds the upper hand over the other on the matter, which might explain some of the undecided element.

This will also be the final week for campaigning ahead of the first round of the Colombian Presidential elections on Sunday May 29th. President Iván Duque is at his one-term limit of four years and the leading candidate to replace him is a leftist leader named Gustavo Petro. Petro seeks to reduce Colombian reliance upon energy exports in favour of sustainable sources of energy. Polls have Petro in the lead and almost assured of moving onto the second round on June 19th assuming it isn’t all settled with a surprise majority first-round outcome (chart 12).


The Canadian province of Ontario is also entering the home stretch for its election campaign ahead of the single round vote on June 2nd. Polls put Premier Doug Ford’s Progressive Conservatives firmly in the lead (chart 13). This attempt at converting polling into seats indicates the strong likelihood of another PC majority.


CANADIAN Q2 BANK EARNINGS

Canada’s second-quarter bank earnings season kicks off on Wednesday when BNS (my employer) releases along with BMO that same day. CIBC follows the next day along with RBC and TD. National Bank and Canadian Western Bank will round out the line-up on Friday. Chart 14 shows expectations.

KEY ECONOMIC INDICATORS

While much of North America will start off the week on holiday, the rest of the week will bring out multiple important releases covering most of the world’s major economies.

Another batch of global purchasing managers’ indices will arrive over the coming week. They’ll help us understand how growth, inflation, supply chains and hiring appetite continue to evolve through Q2. Tuesday will be the main day to watch as each of the Eurozone, UK and US gauges arrive for the month of May. The day before that we’ll get the Japanese Jibun and Australian measures. Charts 15–19 show how the headline measures have been tracking in relation to GDP.


Canadian markets will be shut on Monday for the annual Victoria Day holiday that is treated as the unofficial start to summer. The only indicator on tap will be retail sales for March and advance guidance for April on Thursday. Statcan had guided on April 22nd that sales were tracking a 1.4% m/m seasonally adjusted gain in March. That was only based upon about 37% of potential respondents compared to a normal full response rate of over 90%. The preliminary estimate has tended to underestimate the actual estimate and that’s especially true once all revisions are factored in over time. Still, April’s preliminary estimate may be more impactful in terms of new information.

The week’s main U.S. releases will include the following.

  • Durable goods orders (Wednesday): April’s estimate should benefit from a 1.1% m/m rise in capital goods prices within the producer price report for the month, plus continued momentum in core orders excluding air and defence, while plane orders were little changed on the month.
  • PCE inflation (Friday): Given that CPI was up by 0.3% m/m and core CPI posted a 0.6% m/m rise, the Fed’s preferred PCE inflation gauge is expected to rise by 0.2% m/m and core PCE is forecast to rise by 0.4%. PCE uses different weights that dynamically adjust versus the periodically adjusted CPI weights alongside other methodological differences.
  • Personal income (Friday): Incomes likely grew by about ½% m/m in April with much of the gain driven by an estimated 0.6% rise in wages and salaries driven by job growth with nonfarm payrolls up 428k plus wage gains.
  • Personal spending (Friday): Spending was probably up by about 0.7% m/m given that retail sales were up 0.9% m/m and account for just under half of total consumer spending while services spending is expected to drive the other half.
  • Home sales: New home sales (Tuesday) will probably follow lower the NAHB’s measure of foot traffic through model homes. Pending home sales (Thursday) are expected to continue declining given regional reports and the ongoing decline in mortgage purchase applications.

Europe’s macro calendar will focus on Germany. German retail sales volumes have nicely rebounded over February and March but dropping consumer confidence could put this to a new test when retail sales get updated either sometime this week or the following week alongside an expected update for consumer confidence on Wednesday. Germany also updates the IFO business confidence measure on Monday.

Other US releases will include the second swing at Q1 GDP after the initial estimate of -1.4% q/q was released on April 28th; no major revision is expected. Weekly jobless claims (Thursday) and the Richmond Fed’s manufacturing gauge (Tuesday) will round it all out.

Asia-Pacific releases will be light and only include Chinese industrial profits during April (Thursday), Australian retail sales in April (Thursday), Malaysian CPI (Wednesday), NZ retail sales for Q1 (Monday) and Singapore CPI (Monday).

LatAm markets only face bi-weekly inflation readings from Mexico and Brazil (Tuesday), Peru’s Q1 GDP that is expected to accelerate in year-over-year terms (Monday) and Mexican retail sales during March (Thursday).



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