North American Outlook
November 05, 2025 | 09:11
Resilience and Recovery
Economics
Economics
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United StatesU.S.-China trade tensions de-escalated in late October. The earlier threat of an additional 100% tariff on China was suspended for a year after a meeting between the two leaders produced a temporary truce. In fact, China’s pledge to ease restrictions on the export of rare earth minerals and increase U.S. soybean purchases was rewarded with a halving of the 20% ‘fentanyl’ duty. This slightly reduced the U.S. average effective tariff rate on all countries to around 17%—still the highest in nearly a century, but not so high as to cause a recession. So far, tariffs have led to some 'stag' and a little 'flation', but less of both than feared. Make no mistake, growth has slowed this year. Real GDP grew at an average annualized rate of 1.6% in the first half, down from 2.8% in 2024. Consumer spending averaged just 1.5%, half of last year's rate. Still, overall growth remains near the economy's long-run potential rate of about 1.8%. Private domestic demand has provided the backbone, advancing 2.4%. Technology companies are spending massive sums to build AI infrastructure, notably data centers, while other firms are investing heavily to adopt AI systems. Even after rebounding 3.8% annualized in the second quarter, real GDP has a stiff wind at its back. With personal spending likely accelerating to over 3% in Q3, we lifted our GDP growth call to 2.8%. This puts the economy on track for near-2% growth for all of 2025, a big step up from the darkest days of the trade war in early April. Propelling consumers (at least upper-income ones) is a powerful wealth effect from the equity rally. Aside from ongoing federal government cutbacks, there are two soft spots in the U.S. economy. The first is the housing market, where activity has struggled ever since the Fed first tightened policy in 2022, pushing mortgage rates to multi-decade highs. However, some easing in borrowing costs seems to have put a floor under the market. |
The second, and more worrisome, source of weakness is the labour market. Nonfarm payroll gains averaged just 64,000 in the six months to August, about a third of the rate in the previous half-year. Private-sector sources and state jobless claims data suggest hiring remained weak in recent months. This is partly due to uncertain trade policies. But it also stems from two other forces: deportations, which are slowing growth in the workforce; and AI, which is making more companies think twice about hiring. Walmart, the country's largest private-sector employer, plans to keep staff levels roughly flat over the next three years as AI eliminates and transforms "literally every job". This will pressure other retailers to follow suit to remain competitive. To address downside risks to employment, the FOMC resumed lowering policy rates in September and followed up with another cut in late October. With the federal funds target rate still modestly restrictive at just below 4%, more easing is likely. However, Chair Powell says a December move is "far from a foregone conclusion", given sticky inflation and economic resiliency. Nonetheless, provided the job market remains soft, we expect a cut and a combined 100 bps of rate relief in the year ahead. Apart from an escalation of the trade war, the biggest risk to the U.S. expansion stems from a prolonged shutdown of the federal government. Now in its fifth week and exceeding the longest on record (in 2018-19), the closure could cause real GDP to contract in Q4 should it last a few more weeks. However, if Congress can pass a continuing resolution relatively soon to restore funding and repayments to federal workers, the reopening should support growth in Q1 and leave little lasting effect on the economy. CanadaUnfortunately, trade relations between the U.S. and Canada have taken a wrong turn. Taking exception to a provincial advertisement, the White House suspended trade talks with Canada (which were aimed at reducing some sector-specific duties) and threatened to lift the posted tariff rate by 10 ppts to 45%. This follows recent new tariffs on softwood lumber, furniture, pharmaceuticals (brand name only) and heavy trucks. Still, thanks to the compliance exemption on USMCA goods, the U.S. average effective tariff rate on Canada is only around 7%, with the pain concentrated in three industries (autos, steel, and aluminum). Due to this exemption, the economy should avoid a technical recession. After contracting in the second quarter due to pandemic-like declines in goods exports to the U.S. and in machinery investment, monthly data suggest real GDP is on track to meet our current estimate of 0.5% annualized growth in Q3. Barring an escalation of the trade war, both exports and investment spending should stabilize. Households are doing their utmost to defend the economy from tariffs. After nearly stalling early this year due to trade-war concerns, consumer spending rebounded almost 5% annualized in Q2. Moreover, retail sales have advanced further this summer. With Canadian southbound visits down 30% y/y in August, billions of dollars have been redirected toward domestic tourism, which accounts for over 1% of GDP. A rising TSX is also greasing the spending wheels. As in the U.S., Canada's housing and labour markets are two weak links in the economic chain. While national existing home sales are trending higher, demand remains weak in Ontario, the province at the epicentre of the correction. However, improving affordability amid falling prices should lead to some near-term stability in Ontario's sales and a modest recovery next year. Meanwhile, only 22,000 jobs have been created nationwide, on net, in the first eight months of the trade war—about what the economy would typically create in a single month. The unemployment rate has edged above 7% and will likely rise slightly further before retreating next year. With substantial fiscal stimulus in the pipeline, the economy is expected to gain some momentum in the quarters ahead. The recent federal budget tabled numerous measures to support growth, including billions of dollars allocated to infrastructure, defense, and industries affected by tariffs. The reinstatement of the accelerated capital cost allowance for a broad range of business assets will help revive private-sector investment after a decade-long slump. Despite efforts to improve government efficiency, the new spending initiatives and tax relief measures will nearly double the budget deficit to $78 billion in the current fiscal year, or 2.5% of GDP. This could add roughly half a percentage point to annual economic growth. However, many of the measures were previously announced and factored into our forecast of 1.4% growth in 2026, up from an estimated 1.2% in 2025. Labour market weakness caught the Bank of Canada's attention. Despite underlying inflation still hovering above the 2.0% target, the Bank resumed policy easing in September and trimmed rates again, to 2.25%, in October. With rates now "at about the right level to keep inflation close to 2 per cent while helping the economy ”, the Bank could take a pass in December. Still, assuming further softness in employment, we continue to eye a final rate cut in January. The main risk facing Canada is if the U.S. withdraws from the USMCA and exporters lose the compliance exemption. In this event, the economy would likely face a recession. Consultations between the U.S. government and businesses have begun and hopefully will underscore that re-signing the free trade agreement, even with modifications, is in the best interests of all three countries. |
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