U.S. Economic Outlook
Vito Sperduto: The U.S. economy is doing better than expected, with over 5% growth in the third quarter of 2023. But consumer headwinds are emerging. Could they disrupt a soft landing?
Michael Reid: A soft landing is certainly achievable. Inflation data is on track, but, as you’ve flagged, third quarter growth was revised up to 5.2%, and consumer spending was revised down. Those consumer headwinds you mentioned could potentially slow growth and weaken the labor market. We don’t expect a recession in 2024, but we do see downside risks for GDP and upside risks for inflation. Housing prices have a long runway to push inflation lower, as OER lags home prices by 22 months.
"Consumer confidence is split. Real income growth is slow, but unemployment is low, job openings are high, and payrolls are rising."
Michael Reid, U.S. Economist
Real income growth is slowing and that’s hurting consumers. Inflation expectations depend on gas and food prices, both of which hit consumers hard. Energy prices eased in 2023, but food prices rose. Durable goods are also harder to buy with high debt rates. Existing debt, such as credit cards and loans, also weighs on consumers through non-mortgage interest payments. I would say that consumer confidence is split right now. Higher prices hurt confidence, but the labor market is strong. Unemployment rate is low, job openings are high, payrolls are rising. So, we expect some weakening in 2024, but no job losses by the end of the year.
Sperduto: Let’s talk about the Fed and monetary policy. In the first week of December 2023, Federal Reserve Bank of New York President John Williams reiterated that the Fed's benchmark lending rate is at or near its peak level. He expects inflation to fall in 2024 and hit target in 2025. What’s your view?
Gwinn: The last rate hike was in July 2023 and the Fed won’t hike again unless inflation reaccelerates. So, the timing of cuts is the new story – market volatility has really switched to that theme. I think it's going to become appropriate for the Fed to start paring back on some of the hiking they've delivered as a soft landing adjustment. They will balance the risks: inflation is cooling down, but there are signals that unemployment is potentially rising. They will have to act on that. It’s about preventing a hard landing rather than responding to one.
Larry Grafstein: What about the dynamic between the Fed's balance sheet and quantitative tightening on the one hand and the rise of interest rates on the other? How does that play into the dynamic for both economic growth and rates from your perspective?
Gwinn: There’s a lot of commentary about rate policy and not much about balance sheet policy. The Fed want rates to be the main policy tool. They want the balance sheet wind down to be uneventful. A key point that people often miss is that you can’t just look at what the Fed is doing, because it also matters what kind of treasury securities are replacing the ones that the Fed is selling. Treasury has a choice here. They could issue all treasury bills with three-month maturity or they could replace the Fed with all 30-year securities. Those have very different implications for markets. They affect financial conditions and how much tightening the economy faces. Generally, I would think that the longer the bills that Treasury issues, the higher the rates will go, the more the economy will tighten versus the shorter the bills they do, the less the economy will feel the impact. What we’ve seen so far is that Treasury has been less keen on long term bills than markets expected. They actually scaled back a bit from what the markets anticipated for long term issuance and I think they showed some flexibility to use more short-term bills if long term rates rise.
Sperduto: In terms of cuts, how much of this outlook is already priced in? Could there be some upside depending on what happens?
Gwinn: We’ve long called the first Fed cut to be in June 2024, and that call was out of consensus and market pricing until recently. The crowed trade was to bet against any Fed cuts next year. Now, as rate markets have rallied, the consensus has shifted to our view. More Fed speakers and commentators are talking about adjustment cuts. The Fed pricing reflects our call for five 25-basis point cuts in 2024. Even if the Fed cuts as we expect, I think rates can rally more and curves can steepen further.
"We’ve long called the first cut to be in June 2024, and that call was out of consensus until recently."
Blake Gwinn, Head of U.S. Rates Strategy
Grafstein: What are some of the geopolitical curve balls that could upset your overall outlooks?
Reid: Some of the issues in the Middle East could push up oil prices. The conflict between Russia and Ukraine could also affect the market. Ukraine is a big food exporter, so longer-term conflict there could keep food inflation high.
Gwinn: Apart from geopolitical curve balls, I would say that the year ahead has fewer risks than many others in my career. In general, it’s hard to find signs of over-leverage or worrying signs in the data or financial markets. There are no big imbalances in funding or other markets. I’ve talked to a lot of clients on this and they also aren't seeing any kind of big issues building up in data or market information.
Sperduto: Do you think some of that confidence comes from having managed far more uncertain markets over the last few years?
Gwinn: Some of the recent risks, especially for issuers, were about when rate levels would stop rising. We’ve seen many false starts on when hiking would end. I think the market has often confused pandemic effects on inflation with a secular shift. As inflation keeps falling, the idea that we are in a new 4% inflation era is fading. And so are the risks of the Fed hiking to 6% or above or of ten-year yields hitting 7%. Those are rare scenarios now. I’m very confident that we have seen the peak and that those fears will stay low as we enter 2024.
Canadian Economic Outlook
How does the big picture look for the Canadian economy?
Nathan Janzen: We’re seeing growing evidence that the economy is softening. Per-capita GDP growth looks likely to have declined for five straight quarters.
There are still very large GDP growth tailwinds in Canada from higher population growth. Every time you add a new unit of population to Canada – and that growth has been coming mostly via immigration – you’re adding additional labor supply, and a new consumer. That’s part of why slow GDP growth numbers are concerning, because they look significantly worse on a per person basis.
Labor markets appear to be softening. The unemployment rate is historically still very low, but the increase that we’ve seen to date has been statistically significant, and is the kind of increase you typically see in the early stages of a labor market downturn.
How bad can the economic outlook get? From our perspective so far, the economic data is tracking in line with a mild economic downturn.
The good news is that inflation growth has been slowing. We’ve seen that not just in Canada, but elsewhere.
What does that mean for interest rates and consumer spending?
Janzen: Central banks do look like they’re being successful at getting inflation back under control. So we view further interest rate hikes as unlikely.
We think the Bank of Canada is still going to be very cautious about taking their brakes off the economy. We’ve had a pretty significant inflation scare over the last couple of years, and they want to ensure that inflation is truly getting back to a 2% target rate on a sustained basis. But it is increasingly likely the next move will be a cut in interest rates, rather than a hike.
One of the concerns is that we still haven’t felt the full pain from interest rate hikes to date. In the early stages of interest rate increases, households in Canada soaked up those costs surprisingly well, in come cases by taking on more debt. But that’s left households very vulnerable to a labor market downturn.
One of the big questions for Canada is what happens with our housing markets. A huge share of household net worth is in the form of equity in real estate markets, so the strength of household spending is to an extent tied to the strength of housing markets.
"We still haven’t felt the full pain from interest rate hikes to date."
Nathan Janzen, Assistant Chief Economist, RBC
What’s the longer-term inflation outlook for Canada?
Janzen: Interest rate levels in the longer run will probably remain higher than households and businesses have been used to, pre-pandemic. The Bank of Canada’s overnight rate peaked pre-pandemic at about 1.75. We don’t expect them to cut back to those levels.
There are numerous reasons for that, many related to structural changes in the economy. For one, the share of the population over the age of 65 is continuing to grow. That means a larger share of the population that is retired, still consuming but no longer working. You have more demand growth than supply growth, potentially adding to underlying growth in inflation and persistent shortages.
Also, the pace of globalization has slowed, and has probably started to reverse a little. For decades, globalization has been putting downward pressure on goods price inflation, and that won’t be repeated in the decade ahead.
Added to that, there are still significant issues in terms of geopolitical risks, which risk having an impact on things like global commodity prices. All that means central banks will probably have to be a little more responsive to inflation than in the past, and that the exceptionally low interest rates in the decade pre-pandemic won’t be repeated in the long run.
What effect will the energy transition have?
Janzen: We do in Canada have a renewed push on the fiscal side to try to support an acceleration of the energy transition. Canada still significantly lags the size of support through the IRA in the U.S., but they are coming.
Thus far Canada hasn’t seen a significantly increased share of energy coming from renewable sources overall. But we do expect that to change.
From an economic growth perspective, the amount of investment dollars that are required to facilitate that transition are quite large, and will be a tailwind for business. RBC’s estimates that $2 trillion of investments in the next three decades will be needed for Canada to achieve net zero.
"We are one of the few countries that hasn’t seen a significantly increased share of energy from renewables."
Nathan Janzen, Assistant Chief Economist, RBC
European Economic Outlook
What are the prospects for growth in 2024?
Cathal Kennedy: We have seen growth weaken in the second half of 2023 in both the UK and the Euro area. We’ve had households under pressure as inflation has outstripped wage growth. We’ve also seen the impact of central bank action really begin to feed through.
The outlook is essentially for more of the same subdued growth, certainly in the first half of next year. Indeed, we’re only penciling in growth to 0.2% in both the Euro area and the UK for 2024.
The reason is that we are continuing to see the cumulative effect of policy tightening weigh on the economy. In the UK, in the next three quarters, a lot of the Bank of England’s policy is being transmitted through the mortgage market, as two-year deals agreed prior to Q3 2022 come up for renewal.
In the Euro area, the impact so far has shown up more in investment. We’ve seen corporate loan demand, for example, soften in recent surveys, with firms citing higher interest rates and reduced need for investment.
There is a glimmer of hope, though: we expect inflation to drop more sharply than wage growth in 2024. That means real incomes should rebound in the second half of next year.
"We expect inflation to drop more sharply than wages; that means real incomes should rebound."
Cathal Kennedy, Senior European Economist, RBC Capital Markets
How is the employment market affecting this picture?
Peter Schaffrik: I’ve been saying for the best part of a year that we’re in a jobs-rich slowdown. The hope is that we’re essentially re-establishing some of the lost disposable income as real wage growth turns positive.
Kennedy: The conundrum we’ve been trying to answer is why, with this very weak output growth, has employment remained strong? We have seen the labor market loosen a bit, but from a very tight starting point.
In the UK, so far, the cooling we’ve seen has been of what I would describe as the benign variety. We’ve had vacancies and inactivity come down, boosting labor supply: less true job losses, and more a supply response. In the Euro area, employment numbers are high, but hours worked are still below pre-pandemic levels.
If you are to engineer more cooling in the labor market, it’s going to have to be of a more painful variety: increased unemployment via reduced employment. We just do not see that happening as of yet.
Will the central banks win the battle against inflation?
Schaffrik: The market is clearly expecting that inflation returns back to target and stays there by the middle of 2024. It has priced in a relatively aggressive rate-cutting path – for instance, the ECB cutting rates by around 100 basis points over 2024. The risk is that central banks will not be able to deliver what is priced in.
Kennedy: In 2023, most of the inflation drop we’ve seen has come from energy and food. Now we are seeing core inflation begin to fall.
The latest Euro area numbers on core inflation surprised to the downside – we think mainly due to manufacturing goods. In the UK, quite a bit of the drop has come from household goods, the kind of thing associated with housing transactions, which as we said have been impacted by central bank action.
Services inflation is still high, and we think probably more challenging to bring down. In the UK, private sector wages are still running close to 8%, almost double what the Bank of England consider consistent with their inflation target. Until you see some easing of wages, it’ll be hard to bring about that easing of services inflation on a sustainable basis.
By the end of the year we see inflation still above target – more so in the UK, at around 2.7%, and around 2.4% in the Euro area.
"The market is expecting that inflation returns to target – it has priced in a relatively aggressive rate-cutting path."
Peter Schaffrik, Chief European Macro Strategist, RBC Capital Markets
How should investors be responding?
Schaffrik: We think it’s still too early to position on the long side in the bond market. If people are buying bonds, we would recommend them to stay in shorter maturities as a better risk-reward trade-off, and probably add some credit spreads over duration risk.
We also think there is something to be done here in selling government bonds against other assets such as swaps, or against credit, or maybe even selling some volatility, because we think the market is probably expecting too much movement from the central banks.
But this is an environment where risky assets are probably going to do reasonably well, because the economy is not falling into an abyss, and we are already seeing equity and credit markets doing well.
Australian Economic Outlook
What is the current macroeconomic forecast for Australia over the longer term?
Robert Thompson: We expect that activity will continue to soften as we move through 2024, with GDP growth likely to run well below trend. While recession is not our base case, we are increasingly seeing pockets of stress crop up amongst lower-income and highly indebted households and in rate-sensitive sectors.
Peak in inflation should be behind us, but Australian progress on getting towards the RBA’s 2-3% inflation target is slower than amongst many of its peer countries.
Is monetary policy currently running in line with investors’ expectations?
Thompson: We have been fielding questions from clients on why Australia has been lagging in this inflationary cycle, both on the way up and the way down. To answer this, we have consistently pointed to the significant degree of inertia in the Australian wage-setting processes. Embedded inflation in energy and rents is also holding us back from calling the end of the Reserve Bank of Australia (RBA) cutting cycle.
Monetary policy is now unambiguously restrictive with the RBA lifting the policy rate to 4.35% in November, but still only modestly so. There’s considerable disagreement amongst investors we speak to about where the RBA should set the cash rate. Many domestic investors tend to think 4.35% is already too high (thanks to the powerful mortgage rate channel in Australia), while overseas investors may believe 4.35% is too low.
Our base case is a further increase in the cash rate to a 4.60% terminal rate in February, followed by a lengthy on-hold period until cuts begin only in 2025. It is a close call though, and we acknowledge the RBA might be able to sneak through without having to tighten again.
How is the Australian consumer reacting to these economic conditions?
Thompson: Per capita household spending is already on a decline and is expected to experience a significant further slowdown.
The consumer is facing several headwinds from higher mortgage rates (including the ongoing rollover of low COVID-19-era fixed mortgage rates to variable) to the ongoing cost of living pressures. Negative real household disposable income will continue to squeeze consumer’s ability to spend and subdue consumer confidence.
In the conversations we have had, investors have been curious to understand the extent to which mounting headwinds for households will continue to be offset by positives including a surprisingly resilient labor market and still-sizeable savings buffers. While the labor market is starting from a position of considerable strength heading into 2024, including multi-decade lows in unemployment and highs in participation, early signs of loosening are becoming apparent including in youth unemployment and hours worked.
What will be the outcome of a loosening labor market?
Thompson: We are starting to see declining vacancies, rising applications per job ad, and increasing rates of labor underutilization.
We expect the unemployment rate to continue drifting higher to around 4.6% by the end of 2024. This will add to pockets of stress for some households, but at the aggregate level it is still not far from the Non-Accelerating Inflation Rate of Unemployment (NAIRU).
Investors should remain vigilant for the potential risk of the labor market deteriorating more rapidly than anticipated in our baseline scenario. If the unemployment rate were to reach 5% next year and show a trajectory indicating more loosening is to come, this could prompt the RBA to consider implementing rate cuts.
What is the 2024 outlook for fixed income markets?
Thompson: From a duration perspective, peak policy rates and moving beyond peak inflation across the G7 should provide the catalyst for decent bond market performance over 2024.
Early next year, benchmark 2-10yr bond curves should steepen as markets grow comfortable central banks are done hiking interest rates.
"Peak in inflation should be behind us, but Australia’s progress on getting towards the RBA’s 2-3% inflation target is slower than amongst many of its peer countries."
Robert Thompson, Macro Rates Strategist
What challenges do you anticipate for fixed income investors as we move into the new year?
Thompson: Clients have expressed broad support for our overarching views on curve and duration. We continue to advocate they remain patient and wait for the right levels and appropriate position sizing as the best answers to challenges they are facing in the current environment.
What is the overriding sentiment for credit markets in 2024?
Thompson: Credit markets should face periodic challenges as central banks continue to withdraw liquidity and higher rates squeeze profitability through tougher refinancing. Banks will likely have elevated funding needs as the remainder of the RBA’s term funding facility rolls off in Q2 2023.…
If Australia can avoid recession, we expect credit will perform reasonably well. While spreads look tight relative to the last 18 months, they are still quite attractive in broader historical terms.
Higher superannuation fund allocations to fixed income will likely also continue to provide support, particularly if this broadens out from a current skew to bank debt.
What swing factors can we expect to affect the Australian economy in 2024 and with what result?
Thompson: Here are four key things we are watching out for:
- Inflation – will we see smooth disinflation or a bumpier ride? This will be crucial to determining all asset class returns in 2024.
- The unequal distribution of rate-hike pain among younger mortgagees and poorer renters.
- The fiscal impulse. Government spending remains too high and should be tighter to better complement monetary policy. Stage 3 tax cuts, subsidies, and a crowded state infrastructure pipeline could add to the RBA’s task by keeping aggregate demand too high and keeping inflation sticky.
- The housing/immigration debate. While temporary easing in some forms of migration might ease some housing pressures it may also have offsetting ramifications on labor supply and wages.
"The rates and inflation outlook across the G7 sets the stage for strong bond market performance from a duration perspective."
Robert Thompson, Macro Rates Strategist
