North American Outlook
January 05, 2026 | 11:38
2026 Outlook: Resilience and Risks
Economics
Economics
|
United States: Despite accelerating 4.3% annualized in the third quarter, U.S. real GDP growth likely moderated to an estimated 2.2% rate in 2025 from 2.8% in 2024. The effects of the trade war, federal government cuts, and immigration curbs more than offset rapid AI-driven business spending, record equity values, and stimulative fiscal, regulatory, and monetary policies. Still, the economy outperformed expectations last year and growth looks to hold roughly steady at around 2.3% in 2026 as tailwinds persist while headwinds subside. On the tariff front, the second half of 2025 brought some relative stability, though little clarity on policy direction. The Supreme Court could rule that the international emergency duties that account for the majority of new tariffs are illegal. This would only partially curb the Administration, likely resulting in new duties under other trade acts. The USMCA will be reviewed this year and we assume talks will extend at least into next year. While Canada and Mexico have more to lose if the U.S. withdraws (after giving six months' notice), the economy would slow moderately amid disrupted supply chains and new counter-duties. We also assume the U.S. will extend a one-year trade truce with China, averting a sharp rise in tariffs between the two countries. Cuts to federal government spending and jobs peaked last year, suggesting a diminished drag in 2026. The same applies for immigration curbs, even as deportations continue. We also assume the federal government will remain open beyond January 30, when the current continuing resolution expires. The previous closure, the longest on record, likely shaved at least one percentage point from Q4 GDP growth, though the subsequent reopening will support a Q1 rebound. |
Easing headwinds will allow prevailing tailwinds to dominate in 2026. Big Tech plans to boost spending on AI infrastructure (data centres, chip plants, and even energy sources to run it all), while other businesses are investing heavily in AI systems to drive productivity. The latter will weigh on employment, though evidence of a material effect to date remains mixed (our research suggests it's too early to tell). Whether AI spending can deliver a meaningful productivity payoff will likely determine whether the equity rally continues or corrects. An equity correction—with ten mostly AI-related companies accounting for over 40% of the S&P 500 market cap—would partially reverse the wealth effect that's driving upper-income household spending. OBBBA's full impact will be felt in 2026 amid increased spending on defense and border security and lower taxes stemming from a modest rise in the child tax credit, an increase in the State and Local Tax deduction and the standard claim for seniors, no taxes on most overtime pay and tips, and an accelerated deduction allowance for businesses. On net, tax breaks could moderately lift consumer spending this year, partly offset by reduced subsidies for private health insurance and Medicaid, student loans, and food stamps. Total fiscal support could add half a percentage point to economic growth this year. In addition, the Fed probably isn't done easing after trimming the funds rate another 75 bps in 2025. True, with the policy rate close to a neutral range, divisions are hardening within the FOMC over whether more cuts are needed to address labour market weakness or whether to pause and assess progress toward the inflation goal. While annual CPI inflation fell sharply to 2.7% in November and the core rate dipped to a near five-year trough of 2.6%, shutdown-related distortions (especially in calculating rents) likely aided the moderation. Barring an exceptionally weak December jobs report (on January 9), we believe the FOMC will pass on lowering rates at the January 27-28 meeting. However, it should resume trimming in March. Hiring slowed sharply last year with nonfarm payroll gains running at about a third of 2024's pace. The jobless rate, now at a four-year high of 4.6%, is expected to average 4.7% this year, above the FOMC's neutral estimate (4.2%). Chair Powell's replacement in May is widely expected to lean dovish, even as the incoming voter rotation skews hawkish, setting the stage for more policy dissents. Subsequent rate cuts in June and September would take the mid-point of the policy rate range down to 2.875% by the fall. However, questions about the Fed's independence, alongside firm economic growth and a large federal budget deficit, could keep the 10-year Treasury yield at or slightly above 4% this year. Canada: The best that can be said about Canada's economy in 2025 is that it likely skirted a recession, thanks to the duty-free status of USMCA-compliant goods, supportive fiscal and monetary policies, and the TSX's blistering 28% rally. Still, real GDP growth likely slowed to 1.7% from 2.0% in 2024. Moreover, the annual average figure likely understates the true deceleration in activity, with GDP likely rising just 0.8% on a Q4/Q4 basis after surging 3.1% in 2024. We expect stronger 1.9% growth in 2026 (Q4/Q4, or 1.4% annual), assuming no nasty surprises on the trade front. Our critical assumption for 2026 is that the USMCA review will extend beyond this year, keeping the U.S. in the Agreement and preserving the compliance exemption on most Canadian goods. Potential issues for discussion include supply management and the Online Streaming and News Acts. The review could lead to a reduction of some sectoral duties, notably the 50% import tax on steel, aluminum, and some copper products, trimming the U.S. average tariff on Canadian imports from its current level of around 7%. Apart from a few hard-hit industries, the economy will largely adjust to the lower level of exports. Ongoing uncertainty, however, could cast a longer shadow on business confidence and investment. The impact of a USMCA breakdown would be far worse, potentially spiking the average tariff rate and triggering a moderate recession in Canada, even with significant policy support. Manufacturing industries that depend heavily on U.S. sales, including automobiles, electrical equipment, machinery, computers, and chemicals, would face dire consequences. Stimulative fiscal policies at both the federal and provincial level should continue to cushion tariff effects in 2026. Combined deficits are projected at near 4% of GDP this fiscal year, or more than 2 percentage points above FY2024/24. Federal initiatives aim to jump-start investment by accelerating infrastructure, mining and energy projects, while reinstating full and immediate capital expense deductions and supporting tariff-impacted industries. The economy will also benefit from last year's 100 bps of rate cuts from the Bank of Canada. However, with rates now at the low end of neutral and inflation still moderately above target, the easing cycle is probably over. Nevertheless, we don't see the Bank reversing gears this year. Although employment, as measured in the household survey, has rebounded strongly after contracting last summer, ongoing weakness depicted in the establishment survey likely better reflects reality. It may be no coincidence that both industry payrolls and real GDP have grown a mere 0.4% in the past year to October. Home price risks remain contained to Ontario and British Columbia, where affordability (though improving) remains poor. The Toronto area faces extra price risks from a glut of unsold condos and a surge in purpose-built rental construction, made worse by meaningful immigration curbs. However, as long as mortgage rates remain near neutral levels and the jobless rate holds relatively still—we see the current 6.5% rate peaking at 6.8% before declining—home prices in the two provinces should stabilize this year. Elsewhere, prices could climb modestly, with regions currently seeing outsized gains, such as Quebec City, St. John's, and Moncton, reverting to more normal increases. After rising moderately against a weak greenback in 2025, the Canadian dollar is expected to appreciate further to |
|
|
|
