INTRO

For this episode of The Navigator, we’re bringing you a conversation from Strategic Alternatives, a podcast published by our colleagues at RBC Capital Markets.

Vito Sperduto

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

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

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

Vito Sperduto

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

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

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

Vito Sperduto

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

Vito Sperduto

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

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

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

Vito Sperduto

Frances Donald

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

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

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

Vito Sperduto

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