North American Outlook
June 08, 2023 | 12:25
R is for Resilience and Rising Rates
With the debt ceiling out of the way and the economy showing pockets of strength, we were again forced to delay our call for a mild economic slump. For every indicator fitting the recession mold of late, at least another is flashing resilience. Most importantly, consumer spending and labour markets jumped off to a solid start in Q2, with real spending popping 0.5% in April, job vacancies moving back above 10 million, and nonfarm payrolls soaring 339,000 in May. While new auto sales reversed course last month, they are trending higher this year due to more ample supply and pent-up demand. Existing home sales remain depressed due to poor affordability and limited listings, but last year's correction appears to have ended. More surprising is that nonresidential construction is firing back to life, with spending up 31% in the past year to April, led by manufacturing, lodging, and warehousing. The resurgence in new factories and plants reflects incentives from both the Inflation Reduction Act and the CHIPS and Science Act—a timely reminder that fiscal policy is still the gift that keeps on giving.
If two of the most interest-sensitive sectors—residential and non-residential construction—are weathering a 5-ppt hike in policy rates reasonably well, then the rest of the economy isn't likely to roll over that easily. In fact, the Fed's Beige Book reported little change in activity, citing resilience in consumer spending, labour markets, and leisure and hospitality. All three are reinforcing each other. Consumers are spending extra savings from the pandemic on deferred services such as travel, which is driving employment in leisure and hospitality, which is generating income and keeping the spending cycle churning.
Following modest 1.3% growth in Q1, the economy likely expanded further in Q2. We erased our prior call of a slight decline and have penciled in a 1.0% annualized increase. However, we still see the economy contracting slightly in the second half of the year, by just 0.5% annualized. That's hardly a recession—more akin to a shallow contraction and even milder than the 2001 mini-recession stemming from the dot-com bust. One potential (though moderate) headwind for consumer spending will emerge from the resumption of student debt payments in late August. Growth will resume next year, though some modest restraint from the debt ceiling deal may clip the annual rate by a couple tenths of a percentage point. We look for annual growth rates of 1.3% in 2023 and 1.0% in 2024, lifting the unemployment rate from 3.7% currently to 4.5% by early next year.
Consumer price inflation has fallen from above 9% last summer to just under 5% in April, largely due to cheaper gasoline, some moderation in food cost increases, and cooler goods prices. Helping out, global supply chain pressures have subsided after three years of disruptions and delays, according to the New York Fed. But core inflation is proving stubborn at 5.5%, raising fears that further progress will be tougher, especially since minimal slowing in wage growth is fanning services inflation. The CPI will likely continue to have a 3-handle at year-end, with the risks to the upside.
With inflation and job growth remaining sticky and stress in the banking sector subsiding, the Fed raised rates by 25 bps on May 3. However, it also signaled a potential pause in the rate cycle to assess the impact of 500 bps of past increases on the economy, with hopes of avoiding a hard landing. Recent comments suggest many FOMC members, including Powell, prefer to skip a meeting to better evaluate recent trends, suggesting a timeout is likely at the June 13-14 gathering. However, due to recent stronger data,we now expect one more 25 bp rate hike at the subsequent meeting in July. If the economy slumps as expected, rate cuts may still be on tap starting early next year, ultimately taking the policy rate to more neutral levels of around 2.6% in 2025. In this event, the current 10-year Treasury rate of 3.7% could drift down to 3.5% by year-end and settle around 3.0% in 2025.
The same fountain of resiliency (excess savings, revenge spending, labour hoarding) that the U.S. economy has been tapping is also watering Canada's economic landscape. In fact, Q1 real GDP actually grew faster than stateside, by 3.1% annualized. Growth was driven by a 5.7% surge in consumer spending, raising doubts about indebted households going into hibernation. Most mortgage holders have yet to face higher monthly payments, with the Bank of Canada estimating that refinancings will largely hit in two to three years, lifting monthly payments by 20%-to-40%. As well, a sharp drop in the personal savings rate to 2.9% in Q1, the lowest since the pandemic began, suggests some households may be drawing from a deep reservoir. Continued strong job growth and an unemployment rate stuck near half-century lows of 5.0% are also adding backbone to demand.
Perhaps the biggest surprise is that the year-long downturn in housing markets appears to have ended. Home sales rose for three straight months to April and preliminary data for several cities suggest further gains in May. While sales remain relatively low (down 20% y/y in April), an extreme shortage of new listings (at 20-year low) has benchmark prices rising for two straight months and likely again in May. Strong rates of immigration are keeping rental vacancy rates historically low and seemingly putting a floor under housing demand and prices, despite poor affordability in many regions.
Led by housing, the economy looks to have topped earlier expectations in the second quarter. Despite the public sector strike likely clipping at least a couple of tenths of a per cent from growth, April GDP rose 0.2% according to StatCan’s flash release, indicating positive momentum. Therefore, we flipped signs on our previous call and now see 0.8% annualized growth in the quarter. However, similar to the U.S., we continue to expect a mild contraction in the second half of the year, keeping annual growth rates subdued at 1.3% in 2023 and 1.0% in 2024. We still see the unemployment rate rising moderately to 5.8% by year-end.
Inflation is proving stubborn. The annual CPI rate edged up to 4.4% in April and sticky core metrics suggest further progress will be challenging unless the labour market loosens. However, given the expected rise in the jobless rate, we expect inflation to fall to 3% by year-end and approach 2% late next year.
The Bank of Canada held policy rates steady for nearly five months after signaling a "conditional" pause back in January, but it opted for a 25 bp increase on June 7. The press statement cited a resilient economy, tight labour markets, sticky core inflation, and an upturn in housing activity, all of which suggested that "monetary policy was not sufficiently restrictive to bring supply and demand back into balance and return inflation sustainably to the 2% target". We now expect an additional 25 bp rate increase on July 12, taking the overnight target rate to 5.0%, the highest in more than two decades. The Bank should then move back to the sidelines, before starting, in early 2024, the long path of returning policy rates to more neutral levels of 2.5% by late 2025.
Tighter central bank policy reinforces our view that the housing market is unlikely to see a V-shaped recovery this year. Sales and prices are expected to remain flat to modestly higher, before rate cuts set the stage for a stronger upturn next year. But if the Bank of Canada is forced to push rates well above 5% to restore price stability, the correction in home prices could resume.