Vito Sperduto 00:06

Hello and welcome to Strategic Alternatives, the RBC Capital Markets podcast, where we uncover new ways to raise capital, drive growth and create value in an ever changing world. I'm your host for this episode Vito Sperduto, Head of RBC Capital Markets, U.S. Today, we're stepping back to look at the bigger economic picture. We'll explore five major disruptors reshaping the US economy, the “pattern breaks” complicating forecasts, and what these dislocations mean for businesses, investors and policy makers. To help us make sense of it all, I'm joined by Francis Donald RBC, Chief Economist, Francis, great to have you.

Frances Donald 00:49

Hi, Vito. I think it's a real privilege to join you on my favorite podcast, Strategic Alternatives, so thanks for the invite.

Vito Sperduto 00:55

Love it. I'm looking for this conversation. For the benefit of the audience of this podcast, it's important to keep in mind we're recording this on September 5th, less than two weeks before the Fed September 16 and 17th meetings and markets are intensely focused on whether policymakers are going to deliver a rate cut or hold steady. Now our house view, our head of U.S. Rate's Strategy, Blake Gwinn, has framed September as a 50/50 call right now, and his base case is leaning slightly to a pause in September, with the first cut likely in December. But there is a caveat. There is a contingency, as he's put out in his plan. It's that he said a September cut would likely depend on two things, unemployment rising into the 4.3% range, with weak payrolls and benign inflation prints in the days ahead. So this morning, with the August jobs report, it delivered one half of that equation. Payrolls were light at about 22,000 which was well below expectations, and the unemployment ticked up to 4.3% which kind of hit the number of Blake was talking about. So that's the highest in nearly four years. So this softness is exactly what our rates team was flagging as a potential catalyst. And I think it just raises the odds a bit in terms of what we're going to see from the Fed in September, and pushing it more towards a potential cut. And as we look at the backdrop, obviously, everybody's really mindful of what's going on in the equity markets, the bond markets. The equity markets, although it's been a slower week, it's still sitting very near all-time highs. And you know, one of my favorite metrics, I always look at global M&A volumes, and we're up nearly 30% year over year. So there are some bright spots out there, but, this is the real time backdrop, so why don't we get into it? And I think the first place I want to really talk about Francis is the US economy right now seems really full of contradictions. How do you characterize the current environment? Is it still behaving differently than history would suggest? Talk to me about some of these disconnects.

Frances Donald 02:50

That's exactly the right way to put it, which is disconnects. And absolutely, the US economy seems, in many ways to be an anomaly. There are pockets of record high strengths, and there are pockets of record low weaknesses, or weaknesses that are consistent with what we'd see in a great financial crisis, for example. Now, if you ask me for my one liner, maybe my elevator pitch on the US economy, we say the US economy is in stagflation lite. That is, growth is slightly below comfort level, and inflation is slightly above comfort level, and you're going to see both sides of that story head in the wrong direction. So growth is more likely to slow, and inflation is more likely to re accelerate. But what I find clients are often looking for is putting us back to where are we in the cycle? Are we early, mid, late cycle? Are we headed towards a recession or no recession? Really trying to pinpoint this into the binary bad or good type of environment. And in the past year, we've been trying to come up with a framework to understand these anomalies, to try to understand why this stagflation-lite type of environment has occurred, and are we going to go back to more normal economic models? Vito, you might remember like me, in summer of 2022 when 100% of economists on Bloomberg forecasted a 2023 recession, and it didn't materialize. I'm probably not the only economist who stays up at night wondering what happened and why those models broke. What we've come to realize is it's not that the economic data is wrong. It's not that economists have no value, says the economist, of course, it's that there are this series of pretty sizable dislocations or disruptors to the US economic cycle that have to change the way we read economic data. They have to change the way we think about the US economy, moving away from early, mid, late cycle dynamics towards a more fragmented type of economy. In fact, multiple economies happening underneath the surface. And unfortunately for economists, it also means we got to work through lunch and maybe stay after five o'clock, because it's getting more complicated to read the US economy. But it's not impossible. We just need a different lens, and actually we'd put forward we need five new lenses to think about what happens next in the US and how it can help our clients navigate both the market environment and their own operating environment.

Vito Sperduto 05:17

And that's a great transition Francis, I'd love for you to kind of go into a little bit more of an outline of, each of these disruptors and how do they tie into that stagflation lite perspective?

Frances Donald 05:28

Yeah, absolutely. We have to separate what's historical and what's new, but there's also a separation that all five of these themes bring forward, and that is we have to spend a lot more time thinking about what is the cyclical dynamics in play? That's what we're most used to. And what are the structural dynamics that are in play? Now structural trends are not new. I think what's new in the past year to two years is that structural trends, in our view, are starting to trump the cyclical trends. We see this in everything from jobs data to inflation data that no longer can we look at a standard, for example, non-farms payrolls number and say this is a really good indicator of where we are in the cycle. So we have to separate out those two factors, and we've never had to do that more than what we have to do right now. And unfortunately, there's not just one structural factor that is creating disruptions to the cycle. There are five. So as you mentioned, what are these? Well, the first one is the disruption that's created by tariffs and the behaviors around it. And interestingly, we think of this as being sort of a short term disruption, but in our view, in taking a look at some of the patterns from the pandemic and the supply shocks there, we actually think it could be many years before inventories get back towards a normal cycle here, before import behavior comes back into more private sector traditional type of approach. And meanwhile, as we try to assess what's happening in the US economic cycle, we're constantly trying to parcel out where are we in this inventory front-load environment? We also know at the exact same time that tariffs and trade wars are going to change structural dynamics, and having to parcel out in the data what is a short term shock versus a long term one is becoming more difficult and never more critical. So the second theme that is very disruptive is the segmentation and fragmentation that's occurred across the United States. We've seen this in a variety of different countries as well, and it means that there are segments of the economy, particularly higher income households, that are doing substantially better than low income households, and that's creating a range of distortions to our data and meaning, if you want to have a sense of what's going to happen next, you might be biasing yourself more towards the economic outcomes for high income households versus low income. But if you want to help everyday Americans, you got to look at a whole different set of data, and that's new, of course, as well. We're big believers in this third structural dynamic that America needs workers, and that the labor market's biggest challenge in the next several years is not going to be the shortage of jobs, but the shortage of people available to do those jobs. And while it's tempting to think that that's a comment on immigration policies, it's actually more of our focus on the aging population. And as we assess a lot of the labor market, the data that comes through, we're also trying to get a sense of how much of this story is demand and how much of it is supply. Of course, a lot of focus from just about everybody, and of course, global bond markets on big government spending and what it means. But maybe a little less focus on how it implicates the economy, how it puts actually a break on how fast the economy can grow, but also a floor underneath it. And last, but not least, you mentioned in your intro, housing market dichotomy at play right now. In the United States, of course, that housing market really leveraged the long end of the curve, and there's this huge development, which is that the housing market absolutely frozen in a recession for multiple years now, if I may say so, a lost growth engine. Very disruptive for a lot of our economic models, Vito, because housing traditionally has led the cycle. It hasn't done it this time. Might not do it in the next one, either. So putting those stories together, you can see that there's a lot of core themes. One of the big ones is that this changes our concept of the economic cycle. All of these have a little bit of an inflationary bent to them, Vito. I hate to say it, they all sort of push prices up gradually over time. And they also speak to the need to look at not just one economy, but the multiple economies that are happening underneath it. We think these are really the core themes for America, not just on a five year basis, but also in the next three to six months, as the economy heads through this stagflation lite type of environment.

Vito Sperduto 09:37

Well, Francis, that's all wonderful detail. But how do you see tariffs shaping growth and inflation and even Fed policy over the next several years?

Frances Donald 09:46

Right now, we're still waiting effectively to see the final size and duration of what current US trade policy will look like, although I'm extrapolating from the first Trump administration, a majority of those tariffs were not reversed in the next one. As we're recording this, there are some challenges to the legality of some of the tariffs that are in play, and we'll need to keep an eye on that as well. But even with what we've had so far since Liberation Day back in April 2, we are expecting that that shock, in and of itself, will be disruptive for medium term. And that might seem a little extreme of a comment, right, like if tariffs disappeared tomorrow, wouldn't the tariff impact disappear again tomorrow? But if that seems extreme, maybe consider that we're only now, five years after the pandemic, seeing a normalization in goods inflation in the United States. It has taken five years for inventory dynamics to return to a more natural cycle, almost like you drop a rock into a river and all those ripples go out and out and out and out and before you see the calm of the water, it's a significant period of time. So when we observe that these supply shocks can take several years before we see a normalization that weighs on our mind. But maybe the bigger thing is just how complicated it is to assess when we're going to start to feel tariffs in the economy. You might think you'd feel them right away, and there's some evidence that they're already in the system. For example, we know that there's a significant amount of tariff revenue that's already been collected. So the question is, who's going to pay that? And the answer to that has a significant impact on where the US economy goes in the next one to two years. If we do see businesses pass that on to consumers, then, yes, you will see higher inflation, just mechanically. But if businesses choose to absorb some of that shock, I'm not sure that that's necessarily a better outcome, either, because they'll have to look for cost cuts in other areas. They'll have to either improve efficiencies or look for productivity gains, or they're going to have to cut America's largest business expense, which is labor costs. We don't think we're going to have a real good handle on that until, I’ll hold your hand, as I say this Vito, the middle of 2026. And then, of course, it's going to take time for the economy to absorb that shock. At the same time, we're still questioning things like the age old ‘End of American exceptionalism.’ We're not personally believers in that. We still think the general regulatory environment and business environment is very friendly, particularly relative to others. But constantly trying to get a source out of how much outflows from the United States was cyclical versus structural, that's a trend in play as well. So we're trying to caution our clients to just be aware that the answer to the “who pays the tariff question” is probably several months out and will take us multiple years in order to recover from that shock through. And I think that's the real takeaway for me right now, is that this is a cycle disrupter, maybe more than it is like a change to the general outlook in its entirety.

Vito Sperduto 12:41

And maybe just to kind of dig into a couple of factors together, because I kind of see them linked, and maybe you're going to tell me, I'm wrong but, when I think about the split in the household environment, you know, where high income households are somewhat insulated and doing well from a savings perspective, participation in the stock market and the like. And then you look at the low income households, and they're being squeezed. Higher financing costs, rising credit delinquencies, and to be honest, rents outpacing the wages that are being paid out there. I still tie that to the labor market as well. If you think about those two factors, how are they going to play going forward in terms of the consumer, but also in terms of, you know, how are we going to interpret the signals we're seeing out of the labor market?

Frances Donald 13:30

So that's two critical themes for the consumer, but also for anyone who is providing goods and services to consumers that maybe need to be around them. So absolutely, my favorite topic is this concept of two Americas. And maybe that even simplifies it more, because there's probably 10 Americas in place right now. There's sort of a fan of outcomes. This one really gets to the core of why a lot of our economic data has sent mixed signals. While it's always been true that high income households have spent more than low income households, traditionally, almost all households have operated along the same economic cycle. Prior to 2023 we were in what I think of as an E shaped economy. If high income folks are doing better, low income folks are doing better, and vice versa. But in 2023, off the back of very material increases in interest rates and then a stock market boom, something peculiar happened, which is that it knocked low income households into a different economic cycle than high income households. High income households saw tremendous benefits from that period, and we saw their particular spending accelerate meaningfully, and low income and middle income households, their spending data flatlined over that period. So all of a sudden, if I were to hand you one GDP number, it was basically substantially underestimating the strength and momentum of high income folks and overestimating low and middle income. If I do a consumer confidence survey, it measures everybody equally. So whether you're low income or high income, you all get the same vote. Unfortunately, in the economy, though low and middle income Americans take up a smaller share. So they were generally really feeling pessimistic about the general state of the economy, and rightfully so, but their spending is less significant than high income folks, and this whole situation created this big break between soft data, which is confidence data, and hard data, which is more real spending that happened in the economy. This is really critical, because it changes the way that we use confidence data on a go forward basis. What I'm doing with almost all confidence data and all spending data, is looking at it by income groups. And of course, the biggest risk to the US economy right now is that upper end of that K high income households start to feel any sort of pressure. So we look at things like discretionary spend items like hotels and restaurants, for signs that that might happen. And I'm listening to earning reports more than I ever have, Vito, because I'm looking specifically for any mention of any sort of break that's happening there. So that really creates this dichotomy between the traditional one America towards looking at it from different income groups. So how does that relate to the labor market? Well, lots of focus right now on declining labor force participation rates, and focus that this may be driven in part by immigration policy. And yes, we have seen labor force participation rates decline for several months now for non-citizens in America. But what worries us more actually, or what we think is more impactful, is actually mass retirements. We have 2.2 million people that retired over the past 12 months, the most ever. And retirements in the United States are accelerating very sharply in the past two years; much more than the linear trend would suspect, and much more than our models, and many of our clients' models, had anticipated. And when you start having a higher share of your economy that's retiring, there's a variety of issues with that. Right now, we have three retirees for every one unemployed new entrant in America. So that's a big issue. The second one is retirees, well, actually, they operate a little differently. They spend far more. They deplete savings. And my most favorite fact about America right now is that 20% of all income in the United States is now government transfers. Checks from the government. This is so significant because it means whether we're in a recession or we're in boom times, that segment of income stays pretty stagnant over that period. It basically becomes a cyclical element. But most importantly for us is that this is creating fewer and fewer Americans that are available to work. Sometimes there's a bit of a narrative shift on that. I hear, you know, “There's lots of young men sitting in their parents' basements who need work. As an aside, if my boys would like to live in my basement for the rest of their lives, I'm totally okay with that. This would be a great development for me. No bias against that at all. But this isn't reflected in the underlying data. So prime age workers, between the ages of, you know, 24 and 54, they actually have their highest labor force participation rate ever. We've extracted a lot of the labor that exists. So when you see a Non-Farm Payroll number, for example, that comes through, maybe it looks something like 50,000 we now have to ask, “Is that really reflecting less jobs, or does it reflect fewer people?” I might extrapolate that even further, we have an unemployment rate, Vito, of 4.3% and you mentioned in the intro, that's the highest in four years. Also, you and I have both lived through a few cycles. That's an extraordinarily tight labor market, that is a very, very low unemployment rate. So while it's creeping upwards and we're creating fewer jobs, we have to remember this fundamental idea that we actually need fewer jobs in the economy in order to keep the labor market at its current level. And historically, if I told you that the unemployment rate was at 4.3% you would probably have told me, If you woke up from a coma, that that was a really strong labor market. This is some of the dichotomies that are occurring under the surface here that change the way we have to think about US data.

Vito Sperduto 19:12

Francis, just if we think about the impact that government is having with some of its actions, especially around the way that it's propped up growth How do you think about balancing the stabilizing effect of government spending with the long term risks of debt sustainability and, again, market distortion?

Frances Donald 19:30

These are all really correct concerns, right? And this is a bond market that's already telling you those are big concerns. They're happening globally as well, Vito, I should say. That long end is pushing up in all majors right now, as this concept of fiscal sustainability is creating a lot of weight. I suppose maybe I have some secondary questions about this idea of big government that maybe get lost when we become concerned about the sustainability, or a frequent question I get is, “Well, when does it all blow up?” That's a really important question. It's a really hard one, and I really defer a lot to our rate strategists on some of these underlying details. But as an economist, there are things that I think are happening in the US economy as a result of very large government that don't get enough attention when we just focus on what's the X date. When you have government spending that is this large, it becomes mathematically way more difficult to generate two quarters of negative GDP, i.e. create a recession. There's just so much fiscal support in the system that your private sector gets a little bit smaller. But remember that government spending is largely a-cyclical. So it doesn't follow the typical business cycle. In fact, you might even say it's counter cyclical, that it tends to rise when you hit into some form of recession. That's the Keynesian approach to government; that's exactly what it should do. So when we look at the economy and talk a little bit about housing, but there's some significant weaknesses that have not flowed through into headline GDP, the size of government is one of them. And this is another reason why, if I want to give a client a good understanding of where they are in the economic cycle or how their customer base needs to operate in, I kind of want to move away from this GDP concept and more towards what sector specifically are they in, and what is their sector X government look like. The other element here is that huge segments of the US economy are leveraged to the belly and the long end of the curve. And so as global markets become much more concerned about fiscal sustainability and that long end rises, it's holding elements of the US economy hostage. Meanwhile, what historically was the first question anyone would ever ask me, “What does the Fed do next?” is actually more a middle of the meeting or end of the meeting question, Vito, particularly if we're not talking specifically to rates products. Because whether or not the Fed cuts in September or December is not going to have a material impact on this US economy. It's not going to have a material impact on housing, unless…. unless, here's the kicker, market believes the Fed is cutting into an inflation uptick and the long end rises off the back of that. That would actually be my biggest concern going forward. So we're used to talking about the economy as being monetary driven, that the Fed will tell you where the cycle is going. Some will say the Fed reacts to the economic cycle. But this interest rate at the front end of the curve is decreasingly relevant, and we're increasingly operated with this idea that fiscal dominance is taking precedence over monetary dominance. That's a huge change to the way we talk about the economy, and it's also a change from how markets talk about it. Take a look at the divergence between the front end of the curve and the 30-year, you don't typically tend to see that front end decline as the long end rises. And that's telling you that there's a structural break in this economy, and it's semi-permanent. And you know, not to give too much heat to the US, it's also global in nature. How do we measure the strength of an economy? I would say you got to look much more at the private sector. It wouldn't be a surprise to me. My moonshot idea is that we're going to start talking about GDP as just private sector GDP, and having to strip it out. Or private sector jobs. You know, 30% of jobs in the United States are healthcare or government. 30%. And add in social assistance. So I'd like to see a Non-Farm payrolls number that just comes out on my Bloomberg screen with here's cyclical job growth that takes out the government story. I mean, we could do it in an Excel spreadsheet, but I wouldn't mind being saved the 25 seconds along the way. So I think this is changing the way we have to think about private sector versus public sector cycles, and we have to start thinking about the economy as through the private sector lens only.

Vito Sperduto 23:36

Why don't we talk about one of the other disruptors, housing and, you know, we've kind of mentioned it a bit but homeowners that have mortgages at the 3% level aren't going to move, which is limiting supply. We're seeing housing activity near the lows of the global financial crisis, and we talked about rents continuing to climb. So the critical question is, is housing still the growth engine it used to be? You know, how do you think about that? And is it a reliable barometer for the economy as we go forward?

Frances Donald 24:07

Sometimes I wonder whether the housing market is a fifth disruptor in and of itself, or whether the housing market is being held hostage by the long end of the yield curve and is a corollary to the US government being so large. And yet, there are a few things happening within housing that I think is maybe worth pulling it out. So thinking back to that period in 2022/2023 when economists felt so certain that there would be a recession, part of that was just this absolute collapse in existing home sales and sentiment around housing in 2022 and into 2023. And yet it didn't materialize into a pull down in growth. Now since then, do you know housing has dragged on GDP, it’s been a negative contributor to GDP in nine of the last 14 quarters. I mean, it is really pulling down on headline growth in a very serious way. Existing home sales, many listeners probably know this, are at their lowest level since the great financial crisis. And if you just take a look at confidence data, consumer confidence and buying conditions for a home. It's at its record low. Record low. We've never had lower confidence in conditions for buying a home right now. Couple things happening, of course, the lock-in effect. So those who locked in mortgages at sub 3%. And it makes me think, rather facetiously I suppose that when the Federal Reserve cut rates to 0% they basically did that for 30 years, because that's the length of a mortgage. And if you got in there, they provided easing that you cannot undo through one channel for 30 years. That's the way that I think about that, and that's why I think this is more than just about the long end the yield curve. But of course, we know this is keeping mortgage rates quite elevated and making it very difficult to see any sort of reacceleration. So if I do very simple charts, you could see that home sales activity has entirely decoupled from growth, and not just over a one quarter or two quarter, but for several years at this point. And we think about it now as sort of a lost engine of growth in the United States, that the sector is no longer providing the upside. It has lost some of its cyclicality. This comes back to this overarching point, Vito, that we've talked about in this last half an hour or so, which is that all these engines that created this beautiful concept of the business cycle, that allowed us to define where are we in this sort of organic way that the economy operates, they're being disrupted and distorted by a series of facts that make this concept of the cycle less valuable to us. That doesn't mean that you shouldn't use economic data it just means that I have to assess the housing market, for example, as separate. I have to assess low income households as separate from the consumer story in its entirety. I have to think about inventories and imports in a different cycle, all on their own. So maybe, you know, when we talk about two Americas, we should really be talking about 100 Americas, because every single one of these variables, it's, you know, a new economy that requires new economics to approach it, and that's what we're trying to do, and get to the heart of over at RBC Economics.

Vito Sperduto 27:16

That's great. I think these have been some incredible points. So why don't we try to pull it together looking ahead, and let's say, into 2026 what are the key forces that are going to decide whether the US economy cools, further, stabilizes, or even re accelerates? And, what are the signposts? What are the things you're looking for?

Frances Donald 27:35

Our biggest question is, which side of this stagflation light ends up winning? Maybe winning is the wrong word, because if either side of that gets too extreme it's problematic for everybody, including markets. But the outcome for the United States that sees the labor market weaken so significantly that it pulls down consumption is a very different outlook than one that it has to fight inflation on a go forward. And while I made the point that I don't think, whether September or December rate cuts happen is the most material question for the United States, if we don't see tariffs passed on and companies absorb them and choose to cut costs via, for example, labor market costs, then you can get a much more substantial easing cycle from the Federal Reserve. If we start to see this really flow through into CPI, then I'm gonna get more nervous. As we talked about today we do think there's a structural floor underneath how weak the labor market can get. So my big focus is 100% on inflation data, but not., Vito, just CPI; CPI is the last place that we're going to see inflation come through. We got to look producer prices square in the face. We got to look at import prices. We have to listen to the earnings of major companies. We have to look at M&A activity, just as you do all of the time, to really see where is this going to filter through first. Because my concern is if we wait to see whether tariffs show up in CPI data, it will be too late for us to put together this outlook. I think the other challenge is that when you're sitting here at a bank and you're asked about the outlook, there's always a pull towards saying something like a big number, like “Oh, you think inflation is going to accelerate too far in one direction,” and that's your really big story. Maybe the element of the US economy that worries me most is not a really big inflation number or a really large increase in the unemployment rate, it's this kind of squishy in between world where growth is never quite as strong as it needs to be, and inflation is always just a little bit too high. That makes policy prescriptions really difficult, and it makes mapping a GDP and a CPI number onto an earnings outlook or a business decision even more difficult as well. And I think that's the motivation for our team to look for those pockets of interesting stories, as opposed to relying on this headline number to tell the entirety of the story itself. Because I no longer believe that the most interesting and important elements of this market or the economy lie in a forecast table anymore. They lie in all of the details underneath or page 10 of the client presentation, not page one.

Vito Sperduto 30:10

Well, that's a great point to end on. You know, Francis, thank you so much for joining me today. I always enjoy our conversations, and I'll admit, I always walk away from each one feeling a little smarter than when we started. So thank you.

Frances Donald 30:23

The feeling is mutual, and once again, so happy to be invited to this fantastic podcast.

Vito Sperduto 30:36

Thank you to our listeners for tuning in to Strategic Alternatives, the RBC Capital Markets podcast. This episode was recorded on September 5, 2025. Be sure to subscribe on Apple Spotify, or wherever you listen to your podcasts. If you'd like to learn more or continue the conversation, visit rbccm.com/strategicalternatives, or reach out to your RBC representative. Also, if you'd like additional detail, please read the report from Francis and the RBC economics team on the five disruptors to the US economic cycle. There's a link in the show notes. I'm Vito Sperduto. Thank you for listening, and we'll see you next time.