September 15, 2023 | 12:56
The Economy That Didn’t Bark
Sherlock Holmes solves the mystery of the stolen racehorse by deducing that it was an inside job because of ‘the curious case of the dog that didn’t bark in the night’. Drawn from the story Silver Blaze, this is a classic example of a negative fact, where the famed detective had to crack the case with the help of something that didn’t happen. Markets are now deep in their own deduction process on the implications of something that hasn’t happened—the consumer has not cracked. Facing down 18 months of ferocious rate hikes, still-high inflation, fading excess savings, a renewed back-up in oil prices, and widespread calls that the economy was on the cusp of recession, households have just kept chugging along. The resilient consumer has plenty of ramifications, but equities mostly leaned to the positives this week, in that it supports the soft-landing story.
While overshadowed by the CPI release, U.S. retail sales yet again quietly exceeded expectations in August with a nifty 0.6% rise, after a revised 0.5% hike in July. No doubt, the gains are less impressive when stripping out the price-led bounce in gas station receipts, and volatile autos. And, true, overall sales are up a moderate 2.5% from year-ago levels, which actually trails the current headline inflation rate of 3.7%. But the simple fact is that the recession dog is not barking; if the economy were truly headed for trouble, we would not be seeing consistent moderate monthly sales gains of 0.5%-to-0.6%. And there’s also the small matter that retail sales mostly reflect spending on goods, which has been mild, and not services, which have been on a roll. More specifically, as per the July personal consumption data, goods spending is up 2.8% y/y (close to the retail figure), while services outlays have sizzled at +8.3% y/y (Chart 1).
China’s consumers even got into the act. Defying the recent gloom surrounding that economy, retail sales handily topped expectations last month with a sturdy 4.6% y/y rise. Coupled with that impressive gain, industrial production rose by a nearly identical 4.5% y/y, suggesting the signs of stability are broad. And note that these gains are mostly real, as China’s annual inflation rate is a mere 0.1% (up from -0.3% in July). While perhaps falling well short of full-blown stimulus, policymakers have been taking a series of steps to support growth, with this week’s 25 bp cut in reserve requirements but the latest move. We remain comfortable with our call of 5.0% GDP growth in China for all of 2023, then easing to 4.5% in 2024. That may be shy of some lofty post-opening hopes, but it’s not nearly as weak as some recent dire commentary on that economy.
The flip side of all this resiliency is higher-for-longer interest rates in the U.S., a somewhat less friendly tale for financial markets. The combination of generally solid economic data, a slight high-side miss on CPI, oil prices moving above $90 for the first time this year, and another wave of supply, drove bond yields a bit higher yet this week. Ten-year Treasuries pierced the 4.3% level with some conviction, while 2s pushed above the 5% threshold, with a mild bearish steepening move on net. While next week’s FOMC meeting is widely expected to see the second ‘skip’ of the year, the early November meeting is still up for some serious debate—the dot plot is likely to continue nodding toward one more hike this year. But, more importantly, the Fed is likely to signal convincingly that rates are going to stay at elevated levels for an extended period. The earliest we would look for rate relief would be next June, and consensus is gradually pushing out its views on the timing of the first rate cut—Q2 of next year is the new Q1.
Facing a different set of dynamics, the ECB sent a similar message alongside this week’s 25 bp rate hike. While it is dealing with higher inflation than stateside, it hinted that the current 4.5% refinancing rate may be enough to do the job, even at nearly a percentage point below U.S. short-term rates. The key difference is that growth concerns in Europe are whimpering, if not quite barking. We expect a mild contraction in Q3 GDP growth in the Euro Area, leaving output barely above year-ago levels. In contrast, our conservative call of 3.2% Q3 growth would leave U.S. GDP up 2.5% y/y.
Canada is somewhere in the middle, as is so often the case. While the Bank of Canada is talking a tough game on the possibility of further rate hikes, the case for them having done enough seems more straightforward than for the Fed. The jobless rate is up half a point since early this year (5.5% from 5.0%), the consumer is saddled with much higher debt loads (180% of income in Q2), and the economy contracted in Q2. Yes, there were special factors behind that negative print last quarter (strikes, fires), but early indications suggest that the economy will struggle to grow through the second half of the year. The autoworkers strike will quickly spill into Canada if not soon resolved, and could even be replicated by the domestic union, as its contracts are also up for renewal.
The headline act in the coming week for Canada will be the August CPI on Tuesday. It should echo the themes of the U.S. effort—a meaty headline, juiced by gas prices, and sticky core inflation. We expect the headline result to land just north of the U.S. at a yearly pace of almost 4%, an unhelpful result for taming inflation expectations. We’ll also hear directly from the BoC, as Deputy Governor Kozicki will speak the same day as CPI, and then the meeting deliberations from September 6 will be released just minutes before the FOMC decision. The latter may shine some light on how close a call the ‘skip’ decision was, and what is key for the next decision. Perhaps helping to solve the Canadian case, retail sales will be released on Friday, including a preliminary estimate for August. We suspect that sales saw moderate gains over the summer, despite consumer sentiment reportedly swooning. Even with unemployment rising, forest fires intruding, and gas prices reviving, it looks like the dog still wasn’t barking.
This space had initially been reserved for celebrating the Blue Jays locking up a playoff spot, but for factors beyond our control, we shall quickly morph to happier topics—like the Canadian housing market. The affordability crunch is dominating the conversation, between fast-rising rents, high borrowing costs, robust population growth, and never-say-die home prices. The CMHC chimed in this week with an estimate that the country will need 3.5 million new homes by 2030 to markedly improve affordability. A little arithmetic tells us that this means more than 500,000 new units per year. Ottawa is also now taking some steps to encourage construction, including removing the GST on the building of rental units.
Our key message on this front is that if we are counting on supply alone to fix the affordability issue, we are all going to be waiting a very long time indeed. As in, not going to happen. To be clear, we do not dispute the pressing need for plentiful new supply. But it takes years (and years) to build multiple-unit structures, and the industry is already operating almost flat out. The all-time record high for housing completions was 257,000 (in 1974!), or roughly half of what CMHC reckons we need per year for the next seven years. Finally, and perhaps most importantly, as long as investors are scooping up 30% (or more) of the supply, as the BoC now estimates, even torrid supply may simply fall into the bottomless pit of demand.