July 16, 2021 | 13:21
Midsummer Recovery Checkup
Let’s briefly review the recovery’s progress from this week’s key events:
The steady downward drift in bond yields remained in place this week, despite this long menu of unfriendly events, clearly revealing the underlying market bias. Obviously, this was a cherry-picked list from the many data points this week, and not all were bond-bearish, including a pullback in oil prices, a slip in U.S. consumer sentiment and a dip in the Philly Fed. But the most important—CPI and retail—would have normally hit Treasuries but didn’t turn the tide. Seemingly everyone has their own theory to explain the bond rally, from seasonal factors, to positioning, to a potential Fed policy mistake. (Ha! The biggest risk of a policy mistake seems to be letting the economy run far too hot for far too long and juicing inflation.) From a macro lens, one could simply assert that: a) global growth has peaked; b) commodity prices have peaked; and, c) the Delta variant threatens to delay the recovery, certainly for the travel sector.
All three of those assertions ring true. First, on growth. As discussed last week, we have chipped away a tad at our growth forecasts, in both North America and some other major economies. The latest U.S. consensus survey (conducted just this week) saw a slight slip in the 2021 GDP growth outlook to 6.6% (BMO is 6.8%), the first trim since last October. The BoJ as well as consensus lowered Japan’s growth outlook. And while European forecasts had been moving up in recent months, the rapid rise in virus cases in many key nations threatens to reverse the gains. Make no mistake: we are still looking at a powerful 6% advance in global GDP this year and a follow-up 5% gain next year, versus trend growth of around 3%. But, yes, we are likely already past peak growth rates.
Second, on commodity prices. This one is a bit more nuanced, with much uncertainty still swirling around the big dog in the neighbourhood—oil. While broader fundamentals still look constructive over the medium term, crude took a step back this week to around $72. The apparent OPEC+ deal will likely allow the UAE to produce more oil but, more importantly, suggests cracks are forming in the cartel’s previously impressive solidarity. Potentially more damaging is the recent upswing in U.S. oil production, which has climbed 0.5 million barrels per day since May, as producers are belatedly responding to $70 oil. Meantime, non-energy prices look to have peaked two months ago, with high-flying lumber giving back all of its 2021 gains, copper easing, and some crop prices off their highs. After a terrific run, our commodity price index took its first monthly step back in June since last October.
Third, on the Delta variant. I will spare you any deep analysis on this one, other than to note that the broad rise in new cases is prompting varying degrees of new restrictions in many economies. At the very least, this dampens the growth outlook for the second half of this year, and casts some doubt on next year’s expected strong gain. As per usual, Canada is going its own way, with case counts hitting lows not seen since last summer, and vaccination rates rapidly rising to the top of the global board. This has allowed some of the longest lockdowns in the world to finally end (and there was much rejoicing), and prompted an easing in U.S.-Canada border restrictions. But that sunnier backdrop for Canada is clouded by the milder outlook almost everywhere else.
Tying these three strands together can at least partly explain the slide in yields, which has taken U.S. 30-years down 50 bps in the past four months. But standing on the other side is the relentless rise in inflation, especially in the U.S. With the huge high-side miss in June, the consensus has now underestimated headline CPI by a cumulative 1.3 percentage points in the past four months, and 1.4 ppts on core. Put another way, core CPI has risen by 2.3% (not annualized) in the past three months alone, overshooting the 2% annual goal in a single quarter. Markets have blithely ignored the drumbeat of wild overshoots in CPI, apparently agreeing with the Fed that this, too, shall eventually pass. Consensus forecasts on inflation have steadily marched higher since the start of the year, largely just marking-to-market (i.e., building in the latest readings), although the view on the core PCE deflator has risen to 2.5% for 2022 (from 2.1% three months ago).
Bottom Line: Any mild shaving to the real growth outlook for the U.S. and global economies has been at least countered by a big step up in the inflation outlook. Essentially, the wave of locked-up demand is crashing against supply constraints (bottlenecks, shortages, labour hesitancy), and driving more of the nominal spending growth into price increases than volume gains. As long as consumers remain willing to spend—and they appear plenty willing—the risks to the Fed’s transitory theme will mount.
The Bank of Canada essentially recognized that inflation risk in this week’s undramatic policy decision. Its latest quarterly projections bumped the inflation outlook to an average of 3% this year, to the very top of its 1%-to-3% tolerance band. And, the Bank still sees inflation holding above the 2% target through the forecast horizon. Buried later in the Monetary Policy Report was the six major risks it sees to the forecasts. Curiously, one of the six big risks was housing. One would imagine that with home prices surging 24% y/y, rivalling the great bubble of the late 1980s, the central bank would be fretting about the inflationary risks. But, oh no; instead, the Bank believes that the biggest risk from housing is a potential correction in home prices. Seriously?
Home sales did decline in June by 8.4% on a seasonally adjusted basis, the third monthly drop in a row, which naturally triggered a slew of headlines about a softening market. Yes, things are weak, desperately weak, devastatingly weak… so weak that sales were only the highest ever for any June and up about 25% from 2019 levels. Oh, but the 24% jump in prices is all because of weak supply. Yes, supply is so weak, so desperately weak, that new listings have hit an all-time high over the past 12 months (in a pandemic). And, housing starts have averaged a mammoth 266,000 in the past year, the highest since the 1970s. Suffice it to say, we respectfully disagree with the Bank on which way the biggest risks lie for Canadian housing.