Too Soon To Focus On Growth Risks? - Transcript

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 June 28th edition of Macro Minutes. We continue an ebb and flow between market focus on inflation and growth risks, with the latter taking more prominence in recent sessions as concerns that a recession is coming spike. With inflation still not having peaked and central bank concerns on inflation expectations elevated, is such a shift too soon? To provide some insights on this landscape, we have a full lineup of RBC experts today. Peter will provide an update on the ECB and BOE and discuss the move lower and breakevens. I will look ahead to the July 13th BOC meeting following Wednesday's very firm, a CPI report in Canada. Daniel will update us on the LAD and FX space. Lori will give reviews on earnings, midterm, elections, and positioning in the US equity market. And Michael will discuss recent developments in the oil market. Finally, Tom'll cover the latest developments out of the US.

Speaker 2:

With that, I'll turn it over to Peter.

Speaker 3:

Thank you, Simon. What I thought I'd do is given that I'm the first speak, I'll probably say something about the market more broadly, and then I'll focus on the European side of things more specifically. So you mentioned it already, Simon, the market is ebbing and flowing between growth concerns and inflation concerns. And with the former currently sort of having the upper hand a bit. And I think this doesn't really come as, as too much of a surprise because there's quite a few things that have changed over the last couple of weeks that are worth highlighting.

Speaker 3:

For starters, I think if you just look at the magnitude that had been priced into the front end, pretty much in every market, I think it's fair to say that we are almost certainly now at levels that are beyond where most people consider neutral, even if you sort of give a little bit of grace period or a little bit of grace area for higher levels of neutral because of high levels of inflation. So in the US where we work pricing close to 4% over here in Europe, where the ECB was priced at the peak at 250, all of these levels are generally considered to be north of neutral and therefore sort of stifling growth to some degree.

Speaker 3:

And secondly, what that led to is at the longer end of the yield curve, and we've talked about this before, we have seen an quite significant increase in real interest rates. So for instance, 10 year real treasury yields are now close to 50 basis points positive, where just two weeks ago, they were zero roundabout. And we're not that far away anymore from the peak levels that we've seen in 2018 in the European markets, both in sterling, as well as Europe, we've surpassed them.

Speaker 3:

And at the same time in economic data, what you see is the particularly of leading indicators over here in Europe, we had the PMI that are coming down relatively sharply and survey data in particular is also turning down. So it's very clear that whilst the market had been implied relatively high rates and the leading indicators are pointing down, that the market had sort of a little bit of a wobble. Now, on the other hand, what I think the market requires to have a more lasting positive fixed income environment, is that you need confirmation, that the actual headline data starts turning down significantly. And you'd also need some confirmation that the central banks are not going to hike over and beyond what's already priced in because inflation and particularly coinflation is on the way up. And that is in my mind too far, the turnaround in the headline inflation, even though it's coming, it's not there yet. And we need confirmation, I think at this stage. So personally I think it is probably a bit too early to really buy in to fixed income at this stage.

Speaker 3:

Now let me zoom in very quickly on both the ECB and the Bank of England. Now we'll start with the latter. Since we last spoke, we had the latest ECM, Bank of England meeting, excuse me, and one of the key outcomes here was that the bank was not being very explicit about it, left the market, thinking that 50 basis point rate hike rather than a 25 base point step that they have done so far is on the table by changing the wording in their minutes slightly. Now there wasn't a press conference, so we can't really sort of read too much into it, but certainly the market is leaning that way.

Speaker 3:

We have changed our forecast accordingly, and we think in August, the bank will go in a 50 basis point increment before reverting back to 25 basis point steps. As far as the ECB is concerned, we've spoken about this before, the market is firmly expecting a 50 basis point step to come after the initial 25 then in July and then September respectively. And that hasn't really changed all that dramatically. What has changed, however, nothing that's worth highlighting as far as Europe is concerned, is that the ECB is now much more concerned about the spread developments I've highlighted before, how the BTP spreads or Italian spread has widened and the ECB had conducted a special meeting and emergency meeting came out with the statement, said that they put the staff to the task to present something soon and press leaks thereafter suggested various details that I'm happy to go into if somebody is interested at the later stage, what that might look like.

Speaker 3:

But the end result was that we've now seen a sort of a soft cap being put in, particularly on the peripheral severance. Now it has opened up a gap between the credit markets and the sovereign market. And we'll see whether the credit market is holding at round about 550, I would say, in the ITREX crossover so far, that seems to be the case, but we'll have to see about that. So I think we're seeing on the one hand, the ECB putting a cap in the spread markets, but on the other hand, trying to raise interest rates for the market at the shorthand at the same time, which is a fairly new phenomenon. And that's something I guess, that will enable them so that if they're able to keep spreads at bay, that is enabling them to raise interest rates more aggressively at the front end.

Speaker 3:

And with that, I'll probably leave it and hand back to Simon.

Speaker 2:

Thanks very much, Peter, for those insights. Yeah, so I'll go now shifting to Canada, there looks to be increasing likelihood that the bank will follow the fed 75 basis point hike earlier this month with one of their own on July 13th and would say there's also non-trivial risk of an even higher hike. So even 100 basis points, indeed market pricing is showing more than 70 basis points, price for the July meeting with no meaningful decrease in the recent move lower in terminal rate pricing that Peter was talking about that occurred more globally.

Speaker 2:

We noted two weeks ago that the bank did open the door to a 75 basis point hike at their last meeting on June 1st saying that they're prepared to act more forcefully if needed. The fed's 7.5 basis point hike as well, lowers the hurdle for the bank following suit. And last Wednesday, the may CPI report printed well above consensus up 1.4% month on month to 7.7% year on year, upper revisions to April for all three of the core measures and they rose again in May. So now averaging 4.7% from 4.2% originally in April.

Speaker 2:

While gasoline was a key driver, food prices and shelter prices were both steady at elevated levels. And they're really broader price gains evident elsewhere, so such as clothing and footwear, household operations and furnishings. We will be discussing the BOC call with our economics colleagues ahead of the July meeting.

Speaker 2:

More broadly, the continued rise in headline inflation and the core measures combines with increasing signs of rising wages from multiple recent reports. So these include quarterly national and productivity accounts data, the SEP payrolls fixed industry weight measure, and the latest LFS average hourly earning numbers. These developments all present increasing risk of higher inflation becoming embedded in the economy, something that may be evident in the bank's business and consumer surveys that come out on Monday and also something the bank would push aggressively to avoid.

Speaker 2:

So alongside continued economic strength in Q2, so we are tracking 6.5% annualized with incremental gains expected at this Thursday's monthly GDP report. And the BOC is likely to keep a strongly hawkish stance near term. Well, we do think growth slows materially in the second half of the year, and inflation does start moving lower. It looks too soon for the BOC to shift focus at this point. And consequently, we do see the recent steepening as a good opportunity to enter flattener. So for example, we've had a six month forward twos, tens flattener on previously, and we think that those kind of trades look nice here. And with that, I'll shift over to Daniel to discuss LAD and FX.

Speaker 4:

Thank you, Simon. From the emerging market effects, based on Latin America, we have seen some relief in the last week after University of Michigan survey in the US and the FX market, but the FX market will still be on the look of close for the fed meeting. And therefore we expect the EM FX market to likely remain range bound until further information from the fed tightening the larger performance that we have seen in EM versus G10 in the first quarter of this year, it has been almost caught completely with the asset class down on average, around 5% year today versus G10 on a DXY measure around 9%. The main catalyst for this cut of performance in EM has been the CNY depreciation in April. And after that, the [inaudible 00:09:51] have been breaching new all time highs.

Speaker 4:

For now the renewable sentiment on long software in Chinese equities is helping the Ram E consolidation and some installation in EM, but our FX strategy, our Asia FX strategy believe that domestic pressures to revive the economy ahead of the 20th party Congress in the fourth quarter of this year will likely grow and more powerful fiscal being one employed. The growth imperative suggests that for their rate depreciation may be expected, helping to serve as pressure both to support the economy. Thus, we believe that for the second half of the year with an outlook of $40s US dollar appreciation, and there is for additional [inaudible 00:10:36] evaluation will continue to approach to the asset class and we have been recommending clients to remain nimble and to co exposures encourages highly exposed with to CNY like the Chilean peso and in contrast, we have actually seen some meaningful performance of currency, more exposed to the US, like the Mexican peso. With that, I just pass it down to Lori.

Speaker 2:

Thanks, Daniel. Yeah, we'll shift over to Lori to discuss US equities.

Speaker 5:

This is Lori Calvastina, I'm the head of US equity strategy here, and I've been on the road much of the last two weeks crisscrossing the middle states. So I thought I'd really just touch on what we've been talking to investors about. And what's been an incredibly sort of interesting time in markets. And I would say the number one thing that investors I've been talking to have been focused on on the equity side have been, what is the E going to look like in the PE discussion? There is obviously a sense that earnings expectations on the sell side are too high for individual companies. And what's been interesting to me is that as I've talked to investors, I'm finding that they really just want certainty in the E, they don't necessarily want washout valuations in terms of things that will entice them to sort of get off the sidelines and start buying stocks.

Speaker 5:

But as we've explored the E question, it's really a situation in which they need more clarity on what the recession is going to look like if we end up getting one. And I do think that most of the clients I've been talking to have sort of put the question of whether or not we're going to have a recession aside, they really, whatever their views are there, they really just want to think about what one will potentially look like. There is, in my conversations, a bias towards thinking any sort of economic downturn will be shorter, shallower. I've heard terms like manmade, technical, engineered, and as I've talked it through with clients, there's been a sense that if there's a second half recession in 2022, that's starting relatively soon and that it's contained and we start to get back to the road to recovery in 2023, the setup for equities is actually not that terrible.

Speaker 5:

So after sort of a week of having these conversations, I put pen to paper and outlined potential paths for earnings growth. And I want to stress that I did not change any estimates. I really just wanted to do some scenario analysis to kind of deepen the conversation with clients. And we laid out two paths, one to kind of capture that idea of a shorter, shallower downturn. We modeled out the 2020 path for the recession and implications for earnings. We came up with the numbers 187 and 235. We also looked back over the past three recessions, which frankly are the only ones that we really have good earnings data for on the S&P. And we came up with the numbers for 190 for this year and 164 for next year. So there's obviously a massive divergence between the 235 for 2023 on a short recession and the 164 on a longer recession.

Speaker 5:

And I'll tell you, as I talked to investors, one client mentioned to me on the 2023 idea that the 235 seems too high, just simply because we don't have all the stimulus coming. So something more like 200 or 210 seems more reasonable in their minds, maybe a little higher than 210. Where I get some consistent pushback on the idea of our 187 or 190 on the 2022 stats was people said, "Hey, look, 2Q's going to be great. And that's going to get us a lot of cushion for this year." And that's pretty much already in the bag. So we'll see if that thesis comes to fruition in the next few weeks. And I also say another sort of common theme in the earnings discussion was that the technology sector can provide some buffer.

Speaker 5:

And I think particularly sort of the bottom up portfolio managers that I've talked to are very aware that tech operating margins are structurally much stronger than the S&P. Tech net income is a much bigger share of S&P earnings than it's been in the past. And so investors are already starting to sort of think about things sector by sector and how that could potentially limit some downside.

Speaker 5:

I will say just in terms of kind of moving on from the earnings theme, the second thing that really jumped out at me is that equity investors are thinking about the midterm elections as a potential catalyst. And this shocked no one more than me. When I sort of got to my third or fourth meeting and had someone else shove another midterm election chart in my face, but what the investors are latching onto is the idea that if you just look at the historical data set, equities tend to sell off before midterms and inflect in early October, about a month before the midterm happens. And my response to that frankly, was "Look, the Republicans are going to do well." That's pretty much well understood at this point. I'm not sure what surprises there really are there, but clients really do seem to be latching onto this idea.

Speaker 5:

One thing that I pointed out is that if you think the midterms are going to help the market and on the equity side, I also wonder if it would help consumer sentiment. And so one of the things we've been flagging to people is that if you look at the Michigan consumer sentiment data, the Republicans are really dragging down the various outlook measures, much more so than the Democrats at this point in time. And that was eye-opening for some people.

Speaker 5:

And then just sort of wrapping it up on positioning and I'll try to give you my closest thing to a trade idea, but I would say a common theme of conversation is what's the risk at this point? You'll notice if you look at a chart on Bloomberg of sector performance over the past few weeks, energy has been hit quite hard. It's the worst sector over the past month. Materials is the second worst. Inflation trades are coming off. We've also seen some give back on the REITs and those had previously been very, very strong areas. We have one chart where we basically look at the different sectors and how bad they had fared as of the year to date low in equity markets. You can see that things like consumer discretionary, communication services, which are outperforming over the past month, they had come very, very close to their average draw downs at the market low for what we tend to see in recessions and energy sort of stuck out like a sore thumb. It normally gets hit pretty hard. It does outperform, but it was sort of up at the time of about 35% year to date.

Speaker 5:

So we think there's simply just been some give back as recession fears have been building. We do typically see sort of the cyclical areas of the market underperform as GDP growth expectations are slowing. And so we think that's sort of happening with a vengeance.

Speaker 5:

I will tell you, in terms of the conversation about de-risking we've told people to watch consumer discretionary, but broadening out a bit, small caps. This has been a big point of conversation, even with people who don't focus in the space, because it does give you a very good lens into the broad market. I think small caps are your best candidate for things that have priced in recession. At this point, they've been underperforming pretty sharply since March of 2021. The valuation multiple on the small cap space right now is about 12 times. It typically bottoms in a range of 11 to 13 times.

Speaker 5:

The performance versus large has been so bad that it is consistent with a plunge in ISM manufacturing to historical lows. And if you look at the CFTC positioning data on small cap or below financial crisis lows. So that would probably sort of be our best place to point people to, for something that has been derisked. And if you look at small versus large, as well as growth versus value, frankly, on your Bloomberg, you'll see both trades have been moving sideways for the past month. So it is really, the market is telling us that the small caps may have seen sort of the maximum amount of pain they need to see on a relative basis, at least. And I would just say the last thing we've been talking about, how it does feel too late to go defensive on certain sectors, like staples, which are over owned and close to peak relative valuations against the S&P and defensives generally look close to peak relative valuations if you look at them versus secular growth sectors and cyclicals. That's it for me, Simon. And I'm happy to pass the call over to Michael.

Speaker 2:

We'll just shift to actually Tom to discuss the US.

Speaker 6:

I think that there's a couple of things to highlight first someone asked yesterday, "Hey Tom, what's your recession probability model doing?" Really? Is that what we're talking about now? I mean, is this is the most telegraphed slowing that we've had in the history of the United States. I mean, that might be hyperbole a little bit, but I think it's pretty darn close to accurate. I don't think anyone should be worried about what the probability is, I think should be talking about what it's going to look like. I just think just to pick up on a couple of things that Lori put out there, I think for starters, I think that, look, I tend to agree that if this will probably want to be a sort of a shortish, shallowish recession, if that's actually where we're going.

Speaker 6:

The other thing I wanted to highlight here was inflation. We've written about this a couple of times now. I think what you have to keep in mind is that inflation is, at the headline level, you're going to rise pretty meaningfully in the current month. We'll get that in the next couple of weeks. You're looking at least a one handle, or excuse me, are you looking at least 1% month to month gain. That'll drive the year and year to close to 9% from the current 8.5%. That obviously means that the fed and that 75 are locked. In fact, what I would say is just watch that inflation number. I know everyone keeps on saying 75 is locked. I don't know why we're not talking about 100. I mean, to me, that seems like a completely reasonable conversation in the context of the inflation print that we're going to get.

Speaker 6:

And then base effects will keep the headline elevated for the few months thereafter, meaning September's also locked for, again, at least the 50. So the fed doesn't really have much of a pass over the next couple of months, again, as we get toward the end of the year, we'll see how things sort of unfold. But by that point, there's only going to be two meetings left. I mean they could probably slip those hikes in if they really wanted to. But again, we'll have more to say on that over the coming week. That's it for me.

Speaker 2:

Great. Thanks very much, Tom. And now we'll go back to Michael on the oil market.

Speaker 7:

Hi, everyone. Look, as you know, we've been bullish on the oil market for the past 18 months, and we continue to see the oil complex as one that really remains in a structural multi-year tightening cycle that will really go as far as demand will take it. And that's a really important point on the demand side. And I'll get to that in a second, but the reason why we think that this market remains in a tightening cycle is because the supply side of the equation has been largely derisked. And so there are just simply fewer downside supply driven catalyst to really torpedo oil prices right now. And why do I say that the supply side has been de-risked? Well, really because of three steps.

Speaker 7:

So, number one, we spent the past 18 months really running down global inventories and we continue to do so. Number two, we've run down OPEC's spare capacity now to historically low levels. And number three, the market is getting to a place where it's so tight that there is a call on US shale production. So we need more barrels from US producers to come online, to prevent oil prices from getting overheated. So step by step, we've been really removing the shock absorbers from the oil market over the course of the past 12 to 18 months. And this is important because it was always the supply side equation, like the surge in US production, or OPEC price wars that played spoiler to the oil market on every single occasion over the course of the past decade. So as such, I think the market has really stuck in a bit of a push pull between the current shaky global macro backdrop and the potential threat of a recession, really pitted against the strongest fundamental oil market set up in decades, maybe ever.

Speaker 7:

Now oil's been choppy over the course of the past several weeks. It's largely hung in there relative to other asset classes. So I'll make three points here. Number one is with our client dialogue that we've had, there's not a lot of high degree of panic right now. I think most would agree that the fundamentals have not changed over the course of the past several weeks, despite some price softness. I will say that in many of my conversations, I asked a question, look, given the recent weakness in the oil market is crude, which has seemingly been one of the few financial asset classes, not pricing into major economic slowdown, really beginning to crack under the bearish macro picture?

Speaker 7:

And we often get mixed answers on that. But one comment from one of our sharpest commodity PMs that we talked to, he said something that really resonated with me. And he said, "Look, what do you mean that the oil market isn't pricing in a recession? We've been pricing in a recession for weeks. The recessionary fears are exactly why we've been stuck in this 110, 115, $120 barrel price range over recent months when it should otherwise be pricing at $150 a barrel." Now, I don't disagree with this logic because we're getting to a point where scarcity risk is going to be priced in quite aggressively in this market if we continue these draw downs. And again, look, we're we're in the beginning of summer right now. Now look, the market has to respect the global macro backdrop, but I do think that dips will be ferociously defended. There will likely be a lot of volatility, because like I said, we're in a push pull between the fragile macro economic backdrop paired against the strongest oil market fundamental setup in a really long time.

Speaker 7:

I'll just touch really quickly here on demand destruction. Look, all of our conversations are centered around demand destruction now. Why? Because the supply side of the equation, like I mentioned, has derisked. So when you look at the amount of demand destruction right now, given high record gasoline prices, there's been really an immaterial amount, surprisingly so, given how strong gasoline prices have been given how strong crack spreads have been, but I would really be remiss if I didn't mention that a lot of our real time indicators are suggesting that there are some consumer changes really at the margin here. So if you remember our [inaudible 00:23:57] indices, what we've seen here is that there are some indications that search interest for future travel, so search interest for air travel and accommodation are down pretty aggressively. So low double digits over the course of the past month, that's really important to keep in mind.

Speaker 7:

And also this idea that we're seeing some signs of switchability between modes of transport. So what we've seen is US wide congestion has softened by about 10.5% traffic wise over the course of the past month, whereas public transit usage has increased by just over 5%. So I think that's really important in terms of thinking about, well, gasoline prices getting really aggressive, so we're going to switch to instead driving my car, I'm going to switch to riding public transit.

Speaker 7:

The last point I'll make really quickly here is just on government policy. Now, given where we sit in the cycle, the oil market has been singularly focused on trying to solve for refilling global oil inventories and inventories are at, at multi-decade lows for things like diesel crude inventories are at decade lows, and this is why the product crack spreads are just so, so, so important to watch. And this certainly has been a market led by higher gasoline prices and diesel prices.

Speaker 7:

Now there's been a lot of talk about the Biden administration administering a gasoline tax holiday that would effectively lead to further demand preservation throughout the summer. I think what's really important here is that that policy leads to unintended consequences of further drawing down product stockpiles and keeping product prices higher and elevated for longer. Because if you don't have some degree of demand destruction this summer, this is going to leave the market in an even bigger inventory hole for gasoline prices, diesel prices exiting the summer, which means like I mentioned, these prices will be elevated for longer period of time than otherwise would be the case. If there was some degree of demand destruction this summer. That's what the market is searching for, is a demand destruction event. But with that happy to leave it there.

Speaker 2:

Great, thank you very much.

Speaker 9:

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