Speaker 1:
Hello and welcome to Macro Minutes. During each episode we'll be joined by RBC capital markets experts to provide high conviction insights on the latest developments in financial markets and the global economy. Please listen to the end of this recording for important disclosures.
Speaker 2:
Hi everyone. Welcome to the April 18th edition of Macro Minutes, entitled Ebbs and Flows, being recorded at 9:00 AM Eastern time. Rate volatility continues to be elevated with policy rate expectations swinging around as determining the terminal rate and what happens afterwards is proving complicated. The unwinding of banking sector concerns accelerated into a more meaningful selloff as Fed expectations coalesce around a May hike with a possibility for June while the BOC redirected markets to the risk of further tightening from their side. Uncertainty remains high on the final resting place for the ECB and BOE as well.
To navigate this environment, we have a strong mix of RBC experts. I will kick things off on the recent BOC meeting and our view going forward. Isaac will provide views on the Fed's data dependence and where they may land. And Kahal will discuss diverging views within the BOE and ECB. Alvin Tan will join from the FX side to give views following Chinese Q1 GDP overnight, and Lori will discuss the current earning season why she thinks the bearish case for equities has been overstated and views on sector positioning.
So starting with Canada, I'll kick it off. The Bank of Canada kept overnight rate unchanged at 450 last week, but the balance of changes and communication clearly leaned hawkish. These included adjusted language at the statement on whether rates have gotten restricted enough and concerns about getting inflation all the way back to 2%. The press conference noted rates were likely to be restricted for a prolonged period and explicitly pushed back against cut pricing in the market, something that's fairly unusual for the Bank of Canada to comment on.
Market pricing has shifted from significant cut pricing last month during peak banking concerns to moderate/reasonable cut pricing pre-BOC meeting to a roughly flat profile and even high pricing in the upcoming meetings currently. Our base case has not changed. We see the bank on hold for the rest of the year with elevated underlying and core inflation expectations and wage growth, keeping the bank from reacting too quickly to a mild recession.
We think it's useful to outline how we think different scenarios might play out. How another hike might play out, we would say this is a material risk that has clearly risen, following the bank meeting. Labor markets continue to outperform and remain tight, driving wage growth higher. If a stronger than expected Q1 GDP passes off to affirm Q2, leaving the bank's gross slowdown message challenged, then that's also another consideration that would push them in that direction. Slowing headline inflation is welcome, as we saw this morning, but with underlying inflation pressures remaining above 2%, the BOC will not be complacent and decides to act in this scenario.
In terms of the case for the next move being a cut, what would we need to see? Clear signs of softening emerging labor markets and Q2 growth looks decidedly weak. Alongside moderation in inflation, this allows the bank to stay on hold in the near term. With a better balance between demand and supply in both labor and output markets, leading to declining concerns on underlying inflation pressures, the BOC eventually starts cutting. So this is similar to our base case scenario. So our base case is on hold for 2023 and cut early in 2024, but this could also materialize either earlier or later than our base case.
In terms of the market, given the elevated level of yields for the GOC 10-year, for example at 309 as I'm speaking, we do like long duration trades here. So our 10-year yield forecast at the end of the year is 270, so we do like that long duration. On the curve, we continue to see it as too early for front-end related steepens, but do think 530 steepens look interesting again here around minus nine basis points. And that's it for me on Canada. I'll flip it over to Isaac to discuss the Fed. Over to you.
Speaker 3:
Thanks, Simon. So as the Fed weighs its policy options, post-bank failures, the most important dynamic might be the balance between a backwards looking and a forward-looking approach. Up until mid-March, backwards looking prevailed. The steady trend of swelling, inflation, labor and economic data was needed to end the hiking cycle, but bank failures have changed that calculus. The message from the March FOMC was caution in the face of the unknown impact of a potential pullback in bank lending.
Under a forward-looking approach, the Fed might forego further hikes, assuming tightening bank credit will do some of the work for them. However, the degree to which such a pullback may happen and in turn its impact on inflation and growth remains very uncertain. We've heard from some Fed officials that are supportive of being forward looking in the face of this expected credit tightening, while others remain in the backward looking inflation focused camp.
We think that more officials are likely somewhere in the middle, where they need to see at least some data to support the credit tightening argument. We think the balance can shift enough towards forward-looking that the May hike is indeed the last one, but the Fed's experience with forward-looking didn't end well last time. Remember transitory? So this time, we think they require some clear signs of credit tightening and its impact on the economy. For that reason, many are closely watching the H8 banking data, the upcoming senior loan officer survey, and other indicators, but so far, we haven't seen much evidence of an impact. Meanwhile, inflation remains elevated and we doubt bank failures have erased the concerns about its persistence.
While our base case is still a final hike at the May meeting and a terminal rate of five and an eighth, if economic data remains strong and bank lending isn't collapsing, it'll be tough for the committee to agree to end the cycle then and there. If that's the case, then the Fed may have to signal another hike for the June FOMC and potentially more to come. It'll really depend on how they opt to balance this realized data from expectations about future data. We're currently pricing some probability of a June hike, but beyond that, 2023 pricing is all about cuts. If the Fed remains backwards looking, that would likely have to change.
Until then, we're monitoring everything that might hand to credit tightening and paying close attention to Fed speak. And of course, the big caveat here is that we're assuming the worst of the banking stresses are behind us. Our resurgence and pressures on the banks would likely mean the end of the hiking cycle then and there. Thanks, Simon. I'll pass it back to you.
Speaker 2:
Great, thanks very much, Isaac. Now onto Kahal for the situation in Europe.
Speaker 4:
Thank you, Simon. I think reflecting what you said at the top of the call about the complications around formulating monetary policy at present and in some of those emerging differences that Isaac just discussed there, it's a very similar picture here in Europe and I would highlight the debate we are seeing within our two main central banks, the ECB and the Bank of England.
Now, the backdrop here is very similar to I suppose what you described there in respect to the Bank of Canada and Canada itself. Inflation here in Europe, perhaps not falling as fast as expected, as particularly true in the Euro area and respect of core inflation. Our labor markets remain very tight, continuing to place upward pressure on wages. Just this morning we had the latest labor market from the UK showing wage growth much higher than we had anticipated this month. We were expecting wage growth to slow materially around this time, but in fact, it just moved sideways in the latest data release this morning.
And indeed, similar to what Isaac mentioned there around the US, there's uncertainty around the outlook just due to, we still don't know what the impact of recent financial [inaudible 00:08:19] will be on bank lending going forward. Although, I will point out that in the Euro area, we're already seeing a mark slowdown in credit growth even before recent events. And probably a key next data point here in Europe will be the ECBs bank lending survey which comes out on the 2nd of May.
Now, reflecting all that backdrop, the central banks are having... We're now increasing public discussions here on the way forward for policy. Now, in the case of the ECB, this debate has been out in the open for some time now and I suppose amplified to a certain extent by recent events in the banking sector. On the one side you have the doves on the governing council, who are proposing either posing or raising rates at the next meeting in May. I should say posing or raising rates by 25 basis points at the meeting in May. They point to the slowdown in credit growth that I just mentioned. They also cite the lags in the implementation of monetary policy. So we're yet to feel the impact of ECBs actions to date. And also, the falls of headline inflation on the back of big drops in energy prices here in Europe. And as they would point out, the ECB's target after all is headline inflation, not core inflation.
Now, on the other side of the debate you have the hawkish members of the ECB, centered around, as you would expect, the Bundesbank and also the Austrian members of the governing council. Now, they are proposing rate hikes of somewhere between 25 and 50 basis points. And what they will point to is the still high and rising core inflation, the more resilient growth backdrop than we had expected, and the continuing tightening of the labor market as all factors behind need to stay on the front foot and respect the fight of inflation.
Our view was that the two sides are probably likely to meet in the middle, so to speak, at the forthcoming meeting on May 4th and a compromise will be found around a 25 basis point rate increase. Now, we still look for two more hikes after that, given the guidance the ECB have provided us. But just to highlight, there is an increasingly public debate within the ECB around where rates should be at present and what action the ECB should be doing at the moment as they edge towards what we think will be the terminal rate in coming months.
In the case of the Bank of England, we have a much smaller policy setting committee, only nine members on the NPC. There are already two votes on that nine person body for no change, for a pause. Indeed, we think that at least one member on the governing council, sorry, on the monetary policy committee is actually quite close to voting for a rate cut at present. On the other hand, you still have voices calling for vigilance and respect of the fight against inflation and they need to continue to bear down on inflationary risks in the economy. There's less of a focus here on credit growth in the UK at the moment. The bigger focus is on the labor market, which as alluded to earlier, remains very tight and wage growth uncomfortably high for the Bank of England.
So the bank itself has pulled back quite a bit from guidance, much more dependent on data now. So while we think the bank has probably peaked in terms of rates, we've not had an explicit communication of oppose. And indeed, that data dependency means that we are going from meeting to meeting now. The key data ahead of the next meeting on May 11th will be the CPI data for March. So just to highlight here in Europe, reflecting in our developments elsewhere, as we reach peaks, as we reach terminal debate within our central banks around the appropriateness of the policy path at that moment, and I think a bumpier path than we had expected as we reached that terminal point. But with that, I'll hand back to Simon.
Speaker 2:
Great. Very interesting, Kahal. Now we're going to shift gears and move to Alvin to discuss China.
Speaker 5:
Hello. Hi, I assume can hear me. So the IMA recently forecasted China to lead an overall GDP global growth over the next five years, followed by the US and India. Indeed, China's first quarter GDP numbers overnight did not disapppoint. On the year-on-year basis, China's first quarter GDP grew 4.5%. Again, that's a year-on-year basis and this was again, [inaudible 00:13:13] expectation of approximately 4%. And the March key growth indicators that were reported alongside the quarterly GDP figures showed that consumption again led China's post-COVID economic rebound. Retail sales rising 4.6% year-on-year, for example, much stronger than anticipated. Industrial production and fixed asset investments were slightly weaker than expected, but the strong balance in retail sales and in general for consumption are more than made up for the shortfall in terms of industrial production and fixed asset investment.
If you look at the seasonally adjusted quarter-on-quarter growth rate, the first quarter, quarter-on-quarter growth rate, digital and acceleration from the rate of quarter-on-quarter growth in the fourth quarter, [inaudible 00:14:09] there was also a sequential rise in the GDP growth momentum. And as we get into the second quarter, the base comparison actually will become even more favorable, particularly for a year-on-year comparison, which is the typical headline reported for the Chinese economy because the second quarter of last year was very negative to the affected by the Shanghai lockdown.
So all in all, basically, Chinese economic growth is easily on track to hit the government's growth around 5% on growth, a growth target for the year. I mean, I think one needs to be mindful of the fact that the growth target is a moderate one. Again, this is around 5%. And also, there's asking to be in the fighting awareness of that huge stimulus in China. And alongside that, of course, there's also weak external demand from the rest of the world, given the slowing US and European economies.
So that does suggest that China's GDP growth acceleration will likely plateau sometimes around midyear. The momentum could continue to accelerate into the third quarter. But essentially, in the grand scheme of things, certainly about historical experience, it is a relatively modest economic rebound, but nonetheless, there is an economic rebound underway in China. So in a nutshell, the Chinese growth data continues to its positive post-COVID run, but modestly. And that's all from me. Thank you.
Speaker 2:
Great. Helpful insights there, Alvin. And we'll finish up with Lori on US equity markets. Over to you.
Speaker 6:
All right. Thanks everyone. So I thought I'd talk a little bit about earnings, which are just kicking off in the US. I also wanted to just address the bear case on the US equity market, which we think is somewhat overstated. And then just wrap up with a couple thoughts on sector positioning.
So first on earnings, that's just gotten underway. We're right in the middle of the big banks starting to report. In general, I do think this has been a strong start. We will see how it ends up going. I think we've still got a lot of wood to chop here, but I think the financials are really pivotal going forward. That was a sector that had seen mostly upward revisions last year, while most other sectors were seeing downward revisions. And financials along with energy and REITs and utilities have really been one of the big sources of downward revisions in 2023. So if we're going to get some stabilization in earnings expectations, I do think we're going to have to work our way through these banks downward revisions.
In terms of forecast, my number is at 200. The street has been around 220 on a bottom up basis. I do think my model is pretty conservative and I think most buy siders have been around the 205, 210 type area based on our conversation. I have been reminding people that while we are neutral on the market, I've got a 4,100 target. I think it's going to be a choppy finish to the year. I'm not overly bearish on the earnings impact, the stock prices from here, even though I think numbers are too high. And really, that has to do with the fact that stocks tend to bottom three to six months before earnings forecast stop falling and we do normally see cuts completed by April or May. I'm happy to talk about that more offline with anyone individually, but that's the gist of our argument.
Now, moving on to the bearish case in the market, I think this has been one of the big focuses of our conversations recently with investors. And I have a lot of investors coming to me who have been pretty bearish and saying, "Look, the market hasn't been taken its cues from the bearish thesis, so what's going on? Send me all your bullish charts," those sorts of requests. I really think that a lot of the bear case has rested on the idea that earnings forecast are too high, need to come down, and that'll take markets lower. And again, we've done a ton of work on that showing that that's just an overly simplified way of thinking about it.
But putting that earnings issue aside, I would highlight a couple things, is one, our PE model says we can get to a 21 times PE if you bake in things like 3.4% on PCE, 5% on Fed funds, and 3.5% on the 10-year yield. Our model bakes in data going all the way back to the 1960s. And I think that multiple discussion is where a lot of people are struggling right now, but we do think the market is really basically trading in line with where it should be based on those assumptions for year-end on those macro variables.
I would also say several sentiment indicators have hit peak fear. You can see it on the AAII net bull bear survey. I think the MOVE index is also interesting to me because it recently returned to LTCM highs. And the weekly rate of change in money market fund assets is back to past highs over the past few weeks. I would also just point out that our cross asset indicators for stocks are getting a little bit better to start the year. And if you look at the momentum behind the rotation into non-US equities, it's started to weaken on a number of our indicators, things like EM positioning, flows into non-US equity funds, and US valuations relative to Europe.
I also think it's worth noting, if you want to put the banking crisis into context, WorldCom ended up being a clearing event back in the 2002 time period, really ushering in an extended bottoming process in the stock market. And I do think SVB is probably going to end up serving that same function in the equity market today. I have been reading very closely what companies are saying about direct and secondary impacts of the banking crisis, and so far, the message we're seeing is that the secondary impacts are pretty minimal. People are focused on lending tightening and regulation obviously, but beyond that, the impacts seem to be pretty mild and it seems to be a pretty well-managed crisis.
I think the other thing that's happening is that the market is looking to 2024 as a recovery year on both GDP and EPS forecast. I think 2023 was largely already priced in October. And then the last thing I would just say on the macro is that people keep asking us why is the stock market ignoring a recession, it's never done this before, and that's actually not quite accurate. We had a piece out yesterday basically pointing out that in 1945, as the US economy was transitioning from wartime to peace time, it experienced a technical recession from February to October that was completely ignored by the stock market. It was a weird recession. Some similarities to today, obviously some big differences, but it's not unprecedented for the stock market to ignore a recession. It has happened once before.
And then I'll just wrap up quickly and say on sectors, we think it's going to be a choppy finish to the year. Stay balanced between defense, growth, and value. On the defensive side, I like healthcare over utilities. I think you have a better valuation story there. I think tech is still my favorite growth vehicle. Valuations are more reasonable for most stocks than people realize. And energy would be our top pick on the value cyclical side. We are waiting for industrials to get cheaper. That's an area we're neutral, but we like the story outside of valuations. And that's it from me, Simon. I'll pass the call back over to you.
Speaker 2:
Great, thanks Lori. And that will conclude the macro strategy call for today.
Speaker 7:
This content is based on information available at the time it was recorded and is for informational purposes only. It is not an offer to buy or sell or a solicitation, and no recommendations are implied. It is outside the scope of this communication to consider whether it is suitable for you and your financial objectives.