North American Outlook
September 03, 2024 | 14:38
Sticking the Landing
Economics
Economics
United StatesThe U.S. economy keeps chugging along. Real GDP growth picked up in the second quarter to 3.0% annualized, offsetting the slow start to the year. Spending by the big three engines—consumers, businesses, governments—was solid. Household purchases were supported by rising equity and home prices. The sole soft spot was construction, both residential and commercial, with the former groaning under the weight of a generational slide in housing affordability and the latter held back by a struggling office market. Weaker employment, manufacturing and service sector activity in July suggests the third quarter is off to a soft start, with growth likely to downshift to 2.0%. However, consumers still have something left in the tank, boosting real spending 0.4% in July, so overall growth should remain close to potential. Labour market conditions are cooling. Nonfarm payroll gains slowed to an average of 170,000 in the three months to July from 218,000 in the prior three months. Though reasonably healthy, job creation hasn't kept pace with an expanding labour force, resulting in the unemployment rate rising 0.9 ppts from last year's low, an increase normally seen only in recessions. The current level of 4.3% is slightly above the FOMC's estimate of the 'natural rate' consistent with stable inflation. As Chair Powell said recently, the job market is likely no longer a source of inflation pressure. Moreover, it looks to loosen further before growth improves next year. |
A looser labour market was required to break the back of stubborn services inflation. Providing an assist was stronger productivity, up 2.7% in the year to Q2, a full percentage point faster than the half-century norm. As a result, unit labour costs are up just 0.5% y/y, the smallest increase in nearly five years. If sustained, this low pace could help businesses expand profit margins and lead to inflation undershooting the target. After a brief upturn earlier this year,inflation has resumed its downward course. The Fed's preferred measure, the price index for personal expenditures, is up just 2.5% in the past year to July, while the core rate is a tick higher. Inflation is within reach of the target, though tougher base effects will slow its descent this year. In late July, the Fed signalled that rate cuts were coming into view. With the jobless rate exceeding expectations, the FOMC would need to be "attentive to the risks to both sides of its dual mandate". Reducing inflation was no longer the prime focus; preventing the jobless rate from rising further would garner equal attenion. Then, on August 23, Chair Powell went a step further, declaring that "the time has come for policy to adjust", cementing expectations for a rate cut on September 18. The only remaining question was: by how much? Powell was less forthcoming here, but by saying that "we do not seek or welcome further cooling in labor market conditions," he left little doubt that another bad employment report would likely warrant a forceful start to the easing cycle. For now, we continue to lean toward quarter-point moves at each of the next five policy meetings, with the fed funds target rate eventually settling just above 3.0% by early 2026. With the policy debate revolving around the pace of easing, Treasury markets have rallied hard, driving the 10-year yield below 3.9% for the first time in six months. We expect the yield to trough at 3.5% in 2025, a half percentage point lower than previously thought. Thirty-year mortgage rates have fallen more than one percentage point since October 2023, but, at 6.5%, remain around two percentage points above the two-decade norm. As borrowing costs fall further, green shoots should appear in the beaten-down housing market. CanadaCanada's economy has underperformed the U.S. and its potential. Although growth improved slightly more than expected in the second quarter to 2.1% annualized, the yearly rate of 0.9% pales against the U.S.'s 3.1% expansion and the population's 3.2% spurt. Business investment rose strongly last quarter, but overall growth was mostly flattered by a surge in government spending. Despite increased energy shipments through an expanded Trans Mountain pipeline, overall exports fell in the quarter. Consumer spending slowed to a crawl as households faced rising mortgage payments. The housing market also remains in the doldrums. Sales in Ontario and B.C., the two most expensive regions, remain depressed due to poor affordability. In Toronto, a glut of investor-owned condos has led to the highest resale inventories since the financial crisis, driving benchmark prices 5% below year-ago levels. By contrast, other regions in the country are benefiting from an inflow of migrants in search of less expensive properties, and prices continue to rise in places like Calgary and Halifax. With June and July GDP results coming in on the flat side, growth looks to downshift to 1.3% in the third quarter. The recent short-lived rail strike won't help. While binding arbitration put a quick end to the lockout, the disruptions to supply chains and trade will have an adverse effect on activity. Moreover, other labour disruptions loom, including at Air Canada. For all of 2024, Canada's economy looks to grow just 1.1%, slightly below last year's sluggish pace, before interest rate relief spurs a moderate pickup to 1.8% in 2025. Businesses aren't in a hiring mood. Employment has weakened rapidly outside the public sector. Payroll growth eased to just 0.6% y/y in June, the slowest rate in nearly a decade apart from the pandemic. In fact, without strong gains in education, health care and public administration, employment would have contracted in the past year. And with still-strong immigration fanning the labour force, the unemployment rate has spiked 1.6 ppts in the past two years to 6.4% in July. A further rise to 7.0% is expected this year before a firmer economy and slower population growth stem the tide. With more details to come, the federal government has already announced plans to slash the number of international students and temporary foreign workers, and it is even considering a reduction in the target for new permanent residents (which was expected to rise to 500,000 next year). Depending on implementation, annual population growth could drop to 1% or less, which will cut into economic growth and housing market activity even as it relieves pressure on the jobless rate. The only good to come from a rising jobless rate is that annual CPI inflation has fallen to 2.5% in July, the lowest in three years, and the Bank of Canada has delivered additional interest-rate relief while pledging more to come. Governor Macklem says "downside risks are taking on increased weight" in policy decisions, to the point that "we need growth to pick up so inflation does not fall too much". We expect a further 75 bps of rate reductions this year and a similar-sized decline next year, returning the policy rate to a more neutral 3.0% by mid-2025. Imminent Fed easing has provided a respite for the beleaguered Canadian dollar, which was facing its darkest days since the 2020 shutdowns. Unfortunately, the outlook for the loonie remains lacklustre given persistent weak productivity and other competitiveness issues, as well as negative rate spreads with the U.S. We expect the loonie to weaken modestly before year-end, possibly testing |
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