Capital Ideas^™ 
Investment insights from Capitals Express Investments

The global economy has managed to avoid a recession in recent months, thanks to resilient consumers, a surge in travel and leisure activities, and the reopening of China’s economy following pandemic-related lockdowns.

That’s likely to change in the second half of the year, says Capitals Express Investments economist Jared Franz, as the impact of high interest rates, inflation and a banking sector crisis combine to tip the world into a mild recession.

“Global economic growth is on track to decline by roughly 1% for the full year, in my view,” Franz explains. “That should be followed by fairly robust growth in 2024, driven by strong consumer spending and potentially lower interest rates in the U.S. and Europe.”

Many economic indicators are pointing to a recession in the United States, not the least of which is an inverted yield curve. That happens when yields on short-term U.S. Treasury bonds are higher than yields on long-term bonds, indicating that investors expect tough economic times ahead.

“The U.S. yield curve is more inverted now than it has been since the 1980s,” Franz notes. “Of all the recession indicators, it has been the most accurate one.”

The yield curve is also inverted in Canada with the averages of one- to three-year and three-to five-year short-term bonds markedly higher than the average long-term bond over ten years. And it’s been that way since the summer of 2022. 

Looking at the major economies around the world, the U.S. may decline by 1%, Europe should remain flat to slightly negative, and China could grow 2% to 3%, according to estimates from Capital Strategy Research (CSR), Capitals Express Investments’s macroeconomic research team. CSR estimates are slightly below consensus estimates, largely due to the view that inflation could remain at higher-than-expected levels.

It may not feel like it at the grocery store, but inflation is on a downward trajectory in the U.S., Europe and across many other markets, including Canada where the annual rate fell to 4.4% in April from a high of 8.1% last June. That’s largely due to lower energy prices, fewer supply chain disruptions and aggressive interest rate hikes by central banks, including the Bank of Canada (BoC). Interest rate-sensitive industries, such as housing, are already feeling the effects, with home prices falling in some formerly hot markets, although housing activity has picked up in Canada in 2023 after slumping last year.

U.S. rate hikes meant to fight inflation have also triggered a crisis in the banking sector south of the border. A sharp selloff in the bond market last year hammered the portfolios of numerous regional banks, contributing to the collapses of Silicon Valley Bank and Signature Bank. In Europe, contagion spread to Credit Suisse, which nearly collapsed before UBS agreed to buy it for more than US$3 billion.

The next shoe to drop could be commercial real estate. Office vacancy rates are on the rise as more companies embrace work-from-home business models. At the same time, it’s become more difficult to refinance commercial real estate (CRE) loans that were taken out when interest rates were much lower. That could be a growing threat to banks with a large exposure to CRE loans. 

“Office and retail properties look like the biggest concern,” says Ben Zhou, a Capitals Express Investments analyst who covers real estate investment trusts.

Although Canadian bank’s exposures to CRE are significantly smaller than their U.S. counterparts, the big banks did announce loan provision increases to cover potential defaults during their last earnings announcements at the end of May.

Interest rate outlook

Given these mounting risks, the U.S. interest rate outlook has changed dramatically since early March, when the banking crisis first hit. As shown in the chart below, investors no longer think the U.S. Federal Reserve will raise rates as far or as fast as previously expected, largely due to a tighter lending environment stemming from the banking turmoil.

“We knew there would be consequences to one of the most aggressive tightening campaigns in history,” says fixed income portfolio manager Pramod Atluri. “The dislocations we are seeing in the financial markets signal a painful new phase for the Fed. It has clearly exposed some vulnerabilities and, as a result, I believe we are nearing the end of this rate-hiking cycle.”

The European Central Bank has also slowed its rate-hiking campaign — from 50 basis-point increases previously to 25 basis points at its May 4 policy meeting. So far, ECB officials have not indicated a willingness to pause, given that inflation is running significantly higher in Europe than it is in the United States.

Even in the U.S., consumer price increases are well above the Fed’s 2% target. And there are growing signs that inflation in the range of 4% to 5% could be stickier than central bankers had thought it would be. On May 26, the U.S. government reported that core inflation rose 4.7% on a year-over-year basis in April, up from 4.6% the month before.

Canada also witnessed a rise after its most recent read as annual inflation ticked up to 4.4% in April from 4.3% in March. Stubborn inflation was one of the key reasons the BoC raised its benchmark interest rate by a quarter point to 4.75% on June 7, restarting its tightening campaign after pausing since January. 

A key question going forward is: Will the Fed and other central banks be willing to let inflation run hot for a while? Or will they decide — as the BoC did — that it’s more important to bring prices under control by keeping rates higher than market expectations?

“Central bankers find themselves in a tough spot and I don’t envy them at all,” Franz says. “In my view, the Fed is going to pause its rate-hiking campaign in order to assess the damage from the banking crisis, and they may even begin cutting rates by the end of the year.”