North American Outlook
October 16, 2023 | 10:38
Eye of the Storm
The U.S. economy remains sturdy. Led by consumers, real GDP appears to have picked up to a 4.5% annualized rate in Q3 from 2.1% in Q2. That's not the speed one would expect after the most aggressive course of monetary tightening in four decades. But some lingering pent-up demand from the pandemic, still healthy job creation, and rising real wages are buttressing demand. Moreover, fiscal policy remains stimulative, with the budget deficit clocking in at around 7% of GDP in the past year. Also supportive are tax credits and subsidies provided by earlier legislation to help refurbish the nation’s physical and electrical infrastructure and reshore production of EVs, batteries and microchips.
Still, the economy looks set to decelerate to a sub-1% rate in Q4 before stalling early next year. Demand is now bucking against the lagged impact of the 75-bp grenades the Fed launched last year. The interest-sensitive housing market is taking the full brunt of the assault. With 30-year mortgage rates at 23-year highs above 7%, existing home sales are testing 13-year lows. High borrowing costs, together with still-rising home prices amid lean listings, have sent affordability spiraling to the worst levels in nearly four decades. Bank lending standards continue to tighten even as earlier stress in the regional banking sector has subsided. Households are losing their appetite for dining and travel. According to the Fed, apart from some high-income earners, most people have depleted their pandemic savings. In addition, tens of millions of student loan borrowers have now resumed repayments after a 3 1/2-year hiatus. While many can reduce or even defer payments under the Administration's Saving on a Valuable Education plan, growth in spending could still take a roughly 2% annualized hit in Q4. This could carve more than a percentage point from quarterly GDP growth, while full-year growth could get dinged by 0.3%.
Thankfully, Congress' last-minute stopgap bill to fund the government has averted a partial shutdown until at least November 17. We estimate that a 5-week shutdown, as per the last one in early 2019, could slice over half a percentage point from quarterly annualized growth. Meantime, a full-scale escalation of the autoworkers' strike could chop quarterly growth by about 3 percentage points. Suffice it to say, some combination of these shocks could seriously throw the U.S. expansion into reverse. For now, we see growth of just 1.2% in 2024 after an estimated 2.3% rate in 2023.
Though still qualifying as a soft landing, a deceleration in the economy is precisely what Doctor Powell ordered to cure inflation. Alas, resurgent oil prices to around $90 a barrel have stemmed the steady decline in inflation from its four-decade peak of 9.1% y/y in the summer of 2022 to 3.0% in June, lifting it to 3.7% in September. Still, core inflation (ex-food and energy) is behaving well at two-year lows of 4.1% y/y, down from 6.6% last fall. Smoother-running global supply chains and moderating wage growth have helped. But services inflation remains sticky, suggesting a full retreat to the 2% target is unlikely until early 2025.
The Fed held its fire at the last meeting, but many policymakers believe further rate hike(s) may be needed. Continued evidence that core inflation is easing and labour markets are loosening is likely needed to prevent them from pulling the trigger on November 1. Though still low, the unemployment rate has risen modestly to 3.8% in September, and we see it rising to around 4-1/2% by next summer. That could more permanently sideline the Fed. Still, with policymakers expecting fewer rate cuts next year (just 50 bps), we pushed out the timing of the inaugural easing pivot next year to September from July.
The theme of 'higher-for-longer' has propelled 10-year Treasury yields 120 bps higher in the past five months to a 16-year peak of 4.7%. While we expect yields to drift down to 4.5% at year-end and to 3.8% in late 2024, it will take a weaker economy, looser labour market, and lower inflation to convince investors.
Unlike the U.S., Canada's economy has already stalled. This is partly due to households having larger and shorter-term debts (notably mortgages) than U.S. consumers. The impact of past rate hikes is now bearing down more heavily as maturing mortgages reset higher. While Canadian households still appear to have substantial excess savings, they are likely using some funds to pay down debt and ease the burden of rising loan payments. Considering that the population is growing the fastest in almost seven decades (3.0% y/y on July 1), one would expect real GDP to have grown strongly rather than contract slightly in Q2 and expand just 1.1% in the past year. The latter is less than half the U.S. rate of 2.4%.
The wildfires and public-sector workers' strike didn't help this spring, but monthly GDP data suggest the economy was still flat on its back this summer. And no wonder, with productivity sliding downhill, home sales sagging again amid the worst affordability in more than three decades, and with a quarter of economic activity dependent on selling goods to a soggy global economy. No doubt, the landing will be a bit bumpier than in the U.S., though it should still qualify for a soft one. We expect essentially no growth until next spring, with real GDP expanding just 0.6% in 2024 after an estimated 1.1% rate in 2023, down from 3.4% in 2022. Alberta is expected to lead the country in both years with growth of 1.7% and 1.2%, benefiting from high oil prices, a less expensive housing market, and a surging population (4.1% y/y) led by record in-migration from other provinces.
A stalled economy has loosened the labour market. Job vacancies, though still high in health care and construction, are well off their peak. While employment continues to expand, it's not keeping up with meteoric population growth. The unemployment rate has jumped from a half-century low of 4.9% in July 2022 to 5.5% in August, approaching the kind of increase typically seen at the start of a recession, and we see it reaching 6.0% next year.
Given the usual inertia in wages and prices, it will take time for easing worker shortages to calm inflation. Most wage measures are still clocking in at around 4%-to-5% and key core CPI measures are still running north of 3 1/2%. After plunging to 2.8% in June from 8.1% in the summer of 2022, the annual CPI rate leaped to 4.0% in August (above the U.S. rate) amid higher fuel costs. With wage settlements running hot, the last mile for controlling inflation will be the longest, and we don't see it reaching the 2% target until late next year.
Despite the latest inflation setback, the Bank of Canada will likely think twice before resuming rate hikes given the economy's soft patch. Like the Fed, the Bank was lobbing hefty rate bombs a year ago (of the 100 bps and 75 bps variety), which are about to land with full force. While the odds of a rate hike on October 25 are far from low (futures are around 40%), we expect the next change in policy will be a rate cut, albeit not until July 2024. At that time, the Bank should begin to gradually nurse rates down from 5.0% currently to more neutral levels of 2.5%-to-3.0% in late 2025. Still, the risk of another rate increase has 10-year Canada yields punching above 4.0% for the first time in 16 years. As the economy weakens and inflation subsides, yields could drift back to 3.9% at year-end and to 3.4% by late next year, assuming inflation behaves better.