North American Outlook
November 08, 2023 | 09:51
The U.S. economy just had its strongest quarter in nearly two years. Led by consumer and government spending, real GDP growth accelerated to 4.9% annualized in Q3, more than double the prior quarter's rate. That's not the speed one would expect after the most aggressive Fed policy in four decades. Growth of 2.9% in the past year is the most since rates started rising in early 2022. A pickup in hiring and real wages pumped consumer spending 4.0% annualized in the quarter. A mid-year bounce in confidence, partly due to lower gas prices, also padded the spending spree. Meantime, fiscal policy remains stimulative, with government spending jumping 4.6% last quarter. In contrast, growth was tempered by some cooling in business spending on equipment and commercial structures. The latter had been juiced by fiscal incentives aimed at refurbishing the nation’s physical and electrical infrastructure and reshoring microchip and electric vehicle battery production.
However, growth is expected to decelerate sharply to around 1% annualized in Q4 and stall early next year. For all of 2024, real GDP looks to expand just 1.3%, down from an estimated 2.4% in 2023. Demand will succumb to the over 500 bps of Fed rate hikes and resulting tighter financial conditions, as well as stricter lending standards. The rate-sensitive housing market is sagging anew, with existing home sales testing 13-year lows as 30-year mortgage rates approach 8%. The latter is also to blame for lean resale listings, as over half of mortgaged households are paying a rate of less than 4% and, so, are reluctant to move. The tight supply, in turn, has sent prices to record highs and affordability to the worst level in nearly four decades.
Meantime, households have lost their appetite for dining and travel, likely due to diminished excess savings. A sharp drop in the saving rate supported spending in Q3, but that’s unlikely to persist as many lower and middle income households appear to have depleted pandemic stockpiles, according to two Fed studies. In addition, consumer confidence has dipped amid a pullback in equity markets and with the Middle East conflict threatening to fuel another rise in energy prices. While improved inventories are supporting auto sales, high borrowing costs and prices will keep them in the centre lane.
The economy still faces the threat of a government shutdown after November 17. A five-week closure could carve more than half a percentage point from Q4 annualized growth. But the economy appears to have dodged two other bullets. The recently-settled strike between the UAW and Detroit automakers now looks to clip just two tenths of a percentage point from Q4 annualized growth, a far cry from the nearly 3-ppt hit that was feared had the strike escalated to include all workers and lasted through year-end. In addition, the resumption of student loan payments might now have a much more modest impact of, say, one-quarter percentage point instead of more than one percentage point, as the Administration's Saving on a Valuable Education plan gives many lower-income borrowers the opportunity to reduce or even defer payments.
A soft economic landing is likely the minimum needed to restore price stability. Consumer price growth has fallen from a four-decade peak of 9.1% y/y in mid-2022 to 3.7% in September, while the core rate has eased more gradually from 6.6% to a two-year low of 4.1% y/y. Smoother-running global supply chains and some moderation in wage growth have helped. However, services inflation remains sticky due to robust demand and ongoing tightness in labour markets, suggesting a full retreat to the 2% target is unlikely before 2025.
Despite peppy growth, the Fed held its fire at the last two policy meetings amid tighter financial conditions stemming from the sharp rise in bond yields. With the full effect of past rate hikes still to come, Powell said the Fed will "proceed carefully", though some further loosening in labour markets and easing in inflation will likely be needed to forgo future rate hikes. The modest upturn in the unemployment rate to 3.9% in October should keep the Fed on hold in December. As well, a timely pickup in labour productivity has held back unit labour costs, a key inflation driver. Assuming the jobless rate rises to around 4-1/2% by next summer, the Fed could be done raising rates. Still, given stubborn services inflation, rate cuts are likely off the table until September 2024.
After punching through 5% for the first time in 16 years, 10-year Treasury yields have slipped back to around 4.6% amid speculation the federal funds rate has peaked. We expect the benchmark yield to decline almost half a percentage point by late next year.
Unlike the U.S., Canada's economy has stalled, at best. Real GDP contracted slightly in Q2 and Statistics Canada's initial read is for a slight decline in Q3, meeting one (though not the most accurate) definition of recession. Special factors such as wildfires and strikes by public sector and port workers haven't helped, but there is more behind Canada's underperformance. Households are struggling with larger debts and shorter-term mortgages than U.S. consumers. Past rate hikes will increasingly bear down on spending, as less than half of mortgages have reset at higher rates since early 2022, according to the central bank's Financial System Review. While Canadian households still appear to have substantial excess savings, they are likely to use them to pay down debt and ease the burden of rising loan payments. The divergence with the U.S. also reflects less heated fiscal spending, greater exposure to the weak global economy, and sagging labour productivity. The latter partly explains why the economy isn't growing despite 3% annual population growth, causing living standards to shrink.
We expect real GDP to contract 1.0% annualized in Q4 and remain flat early next year. Not helping is a housing market heading south once again as a result of high mortgage rates and the worst affordability in over three decades. Benchmark prices could sag about 5% by next summer, taking total losses to around 15% since early 2022. Apart from a still-rapidly expanding public sector, Canada's economy is also getting some lift from auto sales, which zoomed 20% y/y in October amid more ample supplies and pent-up demand. Still, real GDP is expected to grow just 0.5% in 2024 after an estimated 1.0% rate in 2023, a far cry from 3.4% in 2022. At 5.7% in October, the unemployment rate is up 0.8 ppts from its half-century low of mid-2022, and will likely reach 6.5% by next summer. Although employment has risen by one-half million in the past year, with nearly a quarter of the gains landing in the past three months, it can't keep up with torrid labour force growth. And, with job vacancies sliding 26% y/y in August, hiring could weaken soon.
A looser labour market will ease pressure on unit labour costs, which are still running hot due to fast-rising wages and declining productivity. It should also support a further slowing in consumer inflation, which has fallen from 8.1% in mid-2022 to 3.8% in September. Most core CPI metrics are now below 4%, though sticky services prices (notably rents) suggest that inflation could still take until late next year to return to the 2% target.
With the economy on the cusp of recession, the Bank of Canada is likely done raising rates. It kept the policy rate unchanged at 5.0% in the latest two meetings, but retains a tightening bias given elevated inflation. We suspect the next move in policy rates is a cut, likely beginning in July 2024, and eventually settling at a more neutral level of around 2.75% in 2026. A friendlier rate environment should see 10-year Canada yields ease modestly from current levels of around 3.8%.