About the Economy: Inflation, Equity Markets and Recession Fears
The stock markets have witnessed steep declines this year, inflation is at 40-year highs, central banks are increasing interest rates and recession fears are growing.
To help explain what is next for the economy, Craig Alexander, President of Alexander Economic Views and Chief Economist & Executive Advisor at Deloitte Canada joins the podcast.
Here are some of the questions Peter and Jackie ask Craig: How would you describe the rate of inflation we are seeing today? Labour shortages seem to be everywhere, where did the people go? Do you expect a recession in the United States and in Canada? What is your outlook for Canadian housing prices? Why do equity markets suffer when interest rates increase? What policy is better for clean energy policy from an economics perspective, the American ‘carrots’ or the Canadian ‘sticks’? Deglobalization is occurring, what are the implications for the economy? Longer-term, are you feeling optimistic or pessimistic about the Canadian economy?
Content referenced in this podcast:
- Energyphile Vignette “Bullish About the New Energy Market”
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Episode 173 transcript
Disclosure:
The information and opinions presented in this ARC Energy Ideas podcast are provided for informational purposes only and are subject to the disclaimer link in the show notes.
Announcer:
This is the ARC Energy Ideas podcast with Peter Tertzakian and Jackie Forrest. Exploring trends that influence the energy business.
Jackie Forrest:
Welcome to the ARC Energy Ideas podcast, I’m Jackie Forrest.
Peter Tertzakian:
And I’m Peter Tertzakian, and welcome back. Well Jackie, as we record this, I’m looking at the screen which is red for the markets. This is the week we’re recording where the bull market is officially over and we’re in a bear market territory when it comes to things like the Dow Jones Industrial Average. The economic indicators are not really good. I published a vignette a couple weeks ago about the bolt being back in the pen and the bear coming out of hibernation. As you know, there’s not a day that goes by where we don’t see headlines about recessions and interest rates going up and so on and so forth.
Jackie Forrest:
Inflation, and now we’re starting to see more about the strong US dollar and the negative impact that’s having on countries around the world. It’s kind of depressing to read the newspaper today, but it also leads to a lot of questions around, why are some of these things causing these other effects? And so, we’re really excited today to introduce our guest, Craig Alexander, president of Alexander Economic Views, and Chief Economist and executive advisor at Deloitte Canada, who is going to help explain all of the things that are going on today. Welcome, Craig.
Craig Alexander:
It’s a pleasure to be here.
Peter Tertzakian:
Great. Thanks, Craig. I don’t know, why don’t we just get started? Jackie mentioned everybody’s got a lot of questions about what’s going on and you’re the man who has all the answers. Why don’t we just start with inflation because that’s been the talk of the town now for a better part of a year, almost. Certainly, it’s been the story of 2022. How would you describe the level of inflation we’re seeing today relative to sort of historical norms?
Craig Alexander:
The world economy is still in the grips of a very pronounced inflation shock. Here in North America, I think we’ve seen the peak in inflation. But that peak, which it was probably only a couple of months ago, was at a 40 year high. We are still living through a quite pronounced inflation shock. And if we want to try to understand a little bit of how we got here, the starting point really is on the supply side. It’s a reflection of the fact that when the pandemic hit, global supply chains stopped functioning and people can remember going to the stores and seeing the empty shelves. If you’ve ever studied economics, what happens to prices when you have a contraction in supply? You end up with an increase in prices. And then we had the recovery in demand that came after the lockdowns. And when you have an increase in demand and you still have disrupted supply chains globally, that again is going to create some significant upward pressure on prices.
The combination of these factors has led to a real inflation problem, which has meant that central banks fell behind the curve. Inflation rates are many times the rates that central banks are comfortable with, and this is why we’re seeing central banks around the globe tightening monetary policy.
Peter Tertzakian:
In other words, raising interest rates.
Craig Alexander:
That’s right.
Peter Tertzakian:
I mean, I think this is the number one question, you go to a restaurant, they are short of servers, you go to a grocery store, they are short of employees. I mean, any service business it seems is short of people and a help wanted sign out front. And the question is, “Where did these people go?” I mean, surely, they didn’t all go back to school, and all didn’t retire.
Craig Alexander:
No. It’s actually a combination of, there was a drop in labor supply in the United States that was quite significant. In Canada, we actually didn’t have that Great Resignation effect. Employment of workers age 55 plus is still about 65,000 down from its pre-pandemic level, so some older Canadians did indeed leave the labor market. But if you actually look at prime working age individuals, age 25 to 54, the labor participation rate actually increased in Canada for those people. It’s because there were jobs, there was hiring, and businesses were offering more flexible workplaces and more remote work. One of the stories you don’t hear about is the fact that in Canada, we didn’t have that US style Great Resignation. The issue is really the labor shortages that Canada has been seeing and America has had also been driven by the strong growth and demand.
What’s happened also is shifts in employment by occupation. If you look at it in terms of by occupation and since the start of the pandemic, what you see is, we are still short about 380,000 frontline service sales jobs. This is a huge reduction of the people who, man the tills at stores. These are the people that are waiters and waitresses, but those individuals went and found employment doing something else. We’ve actually seen a lot of job growth in other occupations. There’s been a lot of compositional shifts in employment at the same time that unemployment has dropped to remarkably low levels.
Peter Tertzakian:
So, Craig, we’ve got the situation here where the central banks, both here and the United States have ratcheted up the rates. I think the target rate in the US is, I don’t know, 3.25, 3.5% or Canadian rates, 3.5%. Mortgage rates are well over five. I think in the US are over 6%. Wage inflation, 5%, 6%. What is it that the central bank here, the Bank of Canada, needs to see or hear before they stop ratcheting up rates? Just give us one or two metrics, what is it they’re waiting for?
Craig Alexander:
First of all, they want to see a turn in the inflation cycle, which we’re starting to see. We’ve only had a month or two of signals that inflation may have peaked, and they want to see it coming down. One of the things I’m looking at, which I’m sure they’re paying a lot of attention to, is what is happening to global supply chains and whether the global supply chains are normalizing, and I think they are. I definitely think they are. You can see this in terms of things like the Baltic Dry Index, which is a shipping cost index. It has dropped enormously. I think on the supply side, we’re seeing that happening. We’ve seen commodity prices fall significantly and I think the Bank of Canada is paying very close attention to that. The Bank of Canada also looks very closely at what is happening to inflation expectations.
This is a big one because if people expect inflation to be 4% or 5% and that’s what they build into their contracts, then that’s actually what inflation’s going to be. This is one of the reasons why the Bank of Canada has been very aggressive in raising interest rates. It was to send a really strong message that they will get inflation back to the 2% target no matter what. It was intended to shift business and worker expectations about inflation. And if we look at what’s called the breakevens, which is the difference in the yield between government of Canada bonds and what’s called real-return bonds, these are bonds that adjust for inflation. If you look at the differential, that tells you what is happening to inflation expectations. And what we can see is that both the Federal Reserve and the Bank of Canada have actually been very successful in bringing inflation expectations down.
Jackie Forrest:
What’s your view on the outlook for the Canadian economy?
Craig Alexander:
Well, I think we are headed for a hard landing. I think that we probably will see a recession in Canada, and I think we’ll probably see a recession in the United States as well. In the case of the United States, the US Federal Reserve is currently signaling that it’s going to take the Fed funds rate up to around 4.5% by the end of the year. This is an enormous interest rate shock for the US economy. I think if you look back in history, the early 70s, early 80s, early 90s, when inflation got out of hand and the central bank really pushed up interest rates very quickly, we had a period of economic contraction. There’s an old adage, “If the US has a cold, Canada gets pneumonia,” and if the US has a recession, I think Canada will have a recession as well.
Peter Tertzakian:
On that term, recession, because it’s getting thrown around a lot, there is a technical definition, which is I think two quarters of consecutive contractions in GDP.
Craig Alexander:
A recession has three qualities to it. It has to be a broad, in other words, a widespread drop-in economic activity that is prolonged. One of the three criterion is two quarters, but you actually have to have a broad-based decline in the economy. I think what we’re going to see is a drop in the real estate market that then weakens consumer spending. It weighs down on the trade front. Exports are going to be very weak and that’s going to impact export-oriented industries. What that does is the weakness in the economy then translates into job losses, higher unemployment for a period of time. Now, let me be clear here though, this isn’t going to be like the pandemic contraction, it’s not going to be like the financial crisis of ’08, ’09. This is going to be more like a typical recession like what we’ve seen in the 70s, 80s, the 90s, which was driven by inflation and central bank rate hikes.
What we’re looking at is a period of weakness that is probably six to nine months long then policy reverses directions, interest rates fall, and the economy starts to grow again. I also don’t think unemployment is going to skyrocket, and that’s another reason why I think that this recession could be milder than you might expect given what central banks are doing. The reason I don’t think unemployment is going to get up to very high levels is because of the labor shortages that we’re currently experiencing.
Jackie Forrest:
It won’t be as extreme because there won’t be as many people out of work as maybe the financial crisis or COVID extreme downturns like that.
Craig Alexander:
Right. I speak to businesses across Canada and when I talk to them about the likelihood of a coming recession, most executives and management teams are still primarily concerned with and struggling with the labor shortage issue. What I’ve been told is the vast majority of them have said that even if the economy is weak, they are going to hoard labor because it has been so hard to hire. And if they only think the weakness is going to be six to nine months long, well then, they’re going to try and look beyond the valley because from a labor point of view, hiring has been so difficult. As long as Canadians have jobs, the downside to the economy is limited.
Jackie Forrest:
What about the markets? Every time we hear about higher interest rates or even the thought that they could be coming, we get a step down in the equity markets and there’s been a big drop in the S&P 500 this year, over 25% or something like that. Why do the higher interest rates cause that, because obviously, that hurts people in terms of how wealthy they feel if their retirement savings have just been cut down by 25%.
Craig Alexander:
The higher interest rates impacting the housing market then weakens consumer spending, which then weakens the pace of economic growth. It weakens auto sales and that weakens your auto sector. The global slow down leads to lower commodity prices and that impacts your commodity sectors. So, when central banks are raising interest rates, it leads to slower economic growth. That weaker economic growth is a negative, it means less profits. And if you think about a stock, the value of a stock is nothing but the expected future earnings of a company. If you actually think companies are going to start losing money, you’re going to say, “Well, that stock isn’t worth as much now.” It’s basically, the market is pricing in a drop in profits.
Peter Tertzakian:
Well, speaking of drop, the other thing that’s dropped are housing prices. I think prices have gone beyond cracking. They’re starting to crumble. What’s your outlook given these rising rates? I mean, how much more can people in Canadian cities, especially the big ones, expect house prices to drop in your opinion?
Craig Alexander:
There’s the difference between the average sales price and the unit sales price. We’ve already seen a dramatic drop in average sales prices. And I think when people hear about, “Home prices are now down 18% from their peak,” keep in mind that that doesn’t mean each house is down 18%. In fact, the actual drop in prices so far has only been, on a unit basis, sort of 5 to 6%. The reason is that the average price is showing you what happens to the average sale price. If fewer higher-priced homes are selling, you get a drop in the average sale price. Imagine if you had a housing market where you only sold three houses, in one month, you sell three $1 million homes and the next month you sell three $500,000 homes, you’re going to get a average price decline of 50% but those unit houses, the value of each house may not have changed.
What’s happened is the higher interest rates are taking a lot of buyers out of the market and that means that people aren’t buying as many high-priced homes and that’s creating a lot of downward pressure on the average sale price. But then we are seeing the actual value of individual houses, like the actual dwelling prices are falling, but not as much as the average sale price. I think in the average sale price, I think we’ll probably see 25% drop in average sales prices. But what matters to people is the actual unit prices, and I think it’s going to probably be more like a 10 to 14% drop.
Peter Tertzakian:
Is that from off peak or from here?
Craig Alexander:
From peak. It’s also going to be very unequally distributed across the country because it’s going to be concentrated in the markets that are the most unaffordable. This is your Greater Vancouver area, your Greater Toronto area are going to feel it more than let’s say Calgary, Edmonton that didn’t have as much of a boom before. As a consequence, the downside in the market is significantly less.
Jackie Forrest:
We’ve got lower housing prices; we’ve got our value of our retirement savings going down. One other question I have that’s kind of making a lot of news recently is the US dollar’s becoming so strong versus other currencies, but they’re increasing their interest rates, but so are others. Why is that happening where we’re seeing the US dollar be strong compared to Canadian? I think Canadian dollar’s lost about 5%, and obviously over in the UK, they’re losing even greater amounts versus the US dollar.
Craig Alexander:
The domino effect is the fact that the US Federal Reserve is raising interest rates, and the US is going to raise interest rates by more than other central banks. And this is important. If for example, in Europe, they’re struggling with high inflation, but they’re also being very affected by and more directly impacted by the war in Ukraine that has disrupted trade and they’re facing a bigger energy problem coming from the loss of energy supply from Russia. The European Central Bank, for example, is going to raise rates, but only by a fraction of what the Federal Reserve is raising interest rates. Well, if you’re investing in US 3 Month Treasury Bills and you’re going to get paid a lot more interest than if you buy a 3 Month Treasury Bill that’s in euros with European interest rates. Well, the fact of the matter is that makes those US short-term 3-month bills look much more attractive as an investment and that pushes up the value of the currency, they’re denominated in.
Jackie Forrest:
So, it’s ultimately, whoever’s got the highest interest rates, they attract more money and that helps their currency out relative to others.
Craig Alexander:
The other dimension here is that when world financial markets become more risky and when there’s perceptions of more risk and worries about global recession, for example, you also get flight to US dollars as a safe haven. The US dollar acts like a world reserve currency. So, whenever there’s more risk, the US dollar appreciates as well.
Jackie Forrest:
In the UK, they’ve put in some policies that are making their future look a little less certain and that that’s made things worse. Well, let’s switch to some longer-term trends. We have a couple of questions we want to talk to about that. As many of our listeners are following very carefully, the United States recently introduced this Inflation Reduction Act, and it uses carrots to incent clean energy development. There’s something like 369 billion, a lot of that tax credits or incentives, subsidies. Meanwhile, in Canada, we’ve chosen a different approach. We’re using what they’d call the stick policy to incent a move to a cleaner economy, and that’s like carbon taxes. Basically, pricing pollution and making a price associated with that. And to avoid that penalty, you will invest in these clean technologies. As an economist, do you have a preference? What’s better, the American carrot method here or the Canadian stick method?
Craig Alexander:
You asked me from an economics point of view and the economics answer is from an economic theory point of view, carbon pricing is the most efficient method of achieving the objective because you’re effectively putting up price on something that isn’t priced and then letting the market figure out how to then respond to that pricing. But in truth, I think you probably want actually a balanced approach. You want a bit of the carrot and the stick. You need a mixed approach. From a Canadian point of view, I think that the green shift initiatives that are part of the US Inflation Reduction Act actually creates some challenges for Canada because I think from the point of view of Canada trying to do its green shift, now that America has put in place significant incentives, it’s a bigger competitor in a sense.
One of the challenges we’re going to have is, on the labor scarcity point of view, like there’s workers, we need to achieve the green shift and talent, we need to achieve our green shift. And now that America is heading in the same direction, I think competition for the workers to actually accomplish that shift is going to be more difficult.
Jackie Forrest:
I see what you’re saying, and I do agree with you that the American incentives are so great and it’s not just people, I think it’s going to be supplies of technical equipment and things like that. It’s going to be hard to get those in Canada, and the US is going to be sucking them all up.
Craig Alexander:
I mean if America’s made it more attractive for the capital and the materials and the talent to do their green shift, it creates a real competitive challenge for Canada to achieve it here.
Peter Tertzakian:
And embedded in that Inflation Reduction Act really is the repatriation of global supply chains to domestic manufacturing of all sorts of things. In other words, getting away from having solar panels and things manufactured in China, just bringing the jobs back to America, basically. There’s a large component of that. But I mean, we have been in a deglobalization mindset certainly since the pandemic. What are the other implications of deglobalization and getting away from historically cheap sources of labor on the other side of the planet?
Craig Alexander:
Well, one of the things that’s interesting is, if you actually look at trade like exports plus imports as the share of GDP, we’ve actually been seeing deglobalization since the financial crisis of ’08, ’09. Global trade as a share of world GDP peaked just before the financial crisis. And ever since then, we’ve actually been seeing a declining trend. We actually had a deglobalization trend that was taking place pre pandemic, that wasn’t getting really talked about. There already was a deglobalization trend taking place. I think geopolitical risks was accelerating that deglobalization trend, then the pandemic hit, and it revealed how vulnerable global supply chains were. There’s several clients I deal with that have been looking at supply chain diversification. It’s going to cost them more money, but they want to make sure that they’re not reliant on just one supplier or supplier from just one region for their inputs or their goods.
I mean, one of the challenges with the nearshoring and reshoring is the fact that at the end of the day, it will mean that it costs more. This is something that I’ve been talking to a number of central banks about. Many central banks believe that we aren’t going to see the disinflationary force of globalization, that was the dominant story for the last couple of decades. They don’t expect to see that present going forward. They think that as we move forward, we’re actually going to see that the cost of doing business is going to be higher.
Jackie Forrest:
Well Craig, unfortunately, we’re running out of time here. It’s been a fascinating conversation. I’ll ask you one more question. Over the long term, and I’m thinking like five, 10 years, that sort of time timeframe, are you feeling optimistic about Canada’s economy and growth prospects, or pessimistic, and why or why not?
Craig Alexander:
I think we’re going to have a recession in North America. It could start before the end of the year, but it’s certainly going to be in the first half of next year. But I don’t think it is going to last very long. I think it’s going to be more of a typical business cycle, which lasts two to three quarters. I firmly believe that once you have a contraction in demand, inflation will disappear very quickly. When you have a contraction in demand, businesses won’t be raising prices, they’ll be cutting prices, and the inflation will disappear fast. That will then set the stage for a reversal of monetary policy. Interest rates will come down and we will then start the next leg up. We’ll get a recovery and then we’ll get stronger economic growth.
I think the big challenge is, I’m optimistic that if we look out beyond the next three to four quarters, I’m optimistic that we’re going to see growth and we’ll be starting a new business cycle, which is a positive. That should have some longevity to it. From a Canadian point of view, our big challenges are going to be around productivity, innovation, and competitiveness. Canada has some really fundamental challenges when it comes to projections for long term growth. Canada really needs to improve its game in terms of becoming more competitive, being more innovative. We need to see more investment in productivity enhancing machinery equipment, and we need government programs and policies that focus less on redistribution and put more emphasis on actually driving long-term productivity and growth.
Peter Tertzakian:
On that note, thanks for all your insights, Craig. I mean, this whole issue of the economy and recession is obviously unsettling, but also something that we need to understand more about. I think you’ve certainly helped our audience get a deeper insight into some of the issues. So, thank you very much, Craig Alexander.
Craig Alexander:
It’s been a pleasure. Thanks for having me.
Jackie Forrest:
Thank you, Craig, and thanks to our listeners. If you enjoyed this podcast, please rate us on the app that you listen to and tell someone else about us.
Announcer:
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