North American Outlook
September 11, 2023 | 14:28
Sticking the (Soft) Landing
We recently shifted to the soft-landing camp, as the broad strength shown in the Q2 GDP release convinced us that the U.S. economy is more durable than expected. Not only is it not slowing further, it might be picking up. Growth has held at or above long-run potential of around 2% for four straight quarters, and looks to have picked up further in Q3. Spending by consumers, governments and businesses is still motoring with minimal sign of fatigue. Although residential construction has continued to contract, it carries less weight in the economy (under 4%) and appears to have found a floor, with construction spending on new homes turning up recently. New home sales have also improved due to a dearth of listings in the resale market, which, along with the worst affordability in 37 years, is depressing existing home sales.
The labour market is also showing remarkable tenacity. Initial jobless claims are probing five-month lows, suggesting companies are unwilling to lay off staff after an earlier round of rationalizing in the technology sector. While growth in nonfarm payrolls slowed to 187,000 in August from an average of 242,000 in the first seven months of the year, that's pretty much in line with long-run norms. More jobs and rising real wages are giving consumers a fourth wind, with real personal spending running the fastest in July since soaring briefly at the start of the year.
Although we still expect the economy to downshift, we raised our growth forecast materially for the second half of the year and now see just one slight decline early next year. This lifted our annual growth call to 2.2% in 2023 and to 1.1% in 2024. The unemployment rate, at 3.8% in August, is expected to peak at 4.4% next spring, still low in a historical context.
If our outlook plays out, it would mark just the third soft landing for the U.S. economy in the past half century. The only two times the Fed managed to contain inflation without crunching the economy were in the middle of the 1980s and 1990s. But those tightening cycles didn't start with an overheated labour market and rampant inflation, implying that there is no guarantee the Fed can pull off this rare feat of skill and luck. Still, the odds of doing so might now be better than a coin flip.
The economy should continue to find support from several buffers, such as catch-up spending on travel and pent-up demand for autos, even if the bulk of excess savings appears to have been drawn down. Tax credits and subsidies provided by three large pieces of legislation—to refurbish the nation’s physical and electrical infrastructure and build facilities to increase production of electric vehicles, batteries and microchips—will provide a long tailwind. These winds are already picking up speed with private construction spending on manufacturing facilities up 80% in the past year, though it has faded recently. At the same time, state and local governments may continue to tap funds provided from earlier federal pandemic-related grants. In addition, two recent buffers include rising real wages, due to moderating inflation, and rising household wealth, due to the equity rally and firming house prices. The latter means looser financial conditions, even with the recent sharp backup in long-term Treasury yields to multi-decade highs, could provide less economic drag than anticipated.
However, even if a soft landing is achieved, we still look for considerably slower growth in the coming year. The Conference Board’s Leading Economic Index fell for a sixteenth straight month in July, the longest losing streak since the Great Recession. In addition, millions of households will resume student loan payments in October, which may carve annual GDP by about 0.2%. Curbs to federal nondefense discretionary spending mandated by the debt ceiling deal will clip GDP by another 0.2% next fiscal year. In addition, tighter lending conditions will reduce credit availability. For these reasons, and the lagged effect of higher interest rates, we still expect the economy to stall for one quarter early next year.
Attaining a soft landing will require further progress on inflation. The annual CPI rate is down to the 3%-to-4% zone compared with a 40-year high of 9.1% last summer, greased by tamer gasoline and food costs. Moreover, global supply chains are now running smoother than normal after three years of disruptions, according to the New York Fed. An upturn in productivity is also helping to offset wage gains and temper unit labour costs, an important driver of inflation. While core inflation is still running hot above 4%, it's at least decelerating with help from retreating used car prices and moderating rent increases. However, given ongoing pressure on services prices, firmer oil prices, and less helpful base effects, we don't see headline inflation returning to the 2% target until late next year. The last mile will feel especially long for the Fed to walk.
The FOMC resumed rate hikes in July to address the economy's resilience, though it was noncommittal on next moves. Chair Powell says that there still may be need for higher rates, and the decision will come down to upcoming data on growth and inflation, which we suspect will show enough signs of moderation to dissuade further action. Still, a move to lower the current target range of 5.25%-5.50% is unlikely to begin until about June 2024 given the expected sluggish path of inflation back to the target. The theme of 'high-for-longer' has pressured 10-year Treasury yields to 16-year highs. We suspect bond yields are close to plateauing, but it will take a weaker economy and lower inflation to convince investors.
Unlike the U.S., we have not changed our Canadian economic outlook materially, and believe that the landing may be a bit bumpier. A small drop in Q2 GDP for Canada, even as U.S. GDP rose by just over 2% in the quarter, highlighted the divergence between the two economies. Because of the surprising springtime softness, we have clipped our estimate for 2023 GDP growth to 1.1%, and have also slightly lowered next year's estimate further to 0.6%—both notably slower than the expected U.S. pace. Three months ago, we expected the two economies to grow roughly in sync. The Canadian growth estimates imply a continued decline in per capita GDP (and average living standards) given the fastest population growth in seven decades (3.1% y/y in Q2). The economy has been buffeted by labour strikes (federal workers in the spring, port and grocery workers more recently), as well as severe wildfires in many regions of the country. Even after a 0.2% dip in Q2 GDP, the early estimate for July was a flat reading, and we expect the economy to struggle to post any growth in Q3.
The rebound in housing activity after the central bank stopped raising rates early this year looks to have fizzled in the face of renewed tightening. Moreover, the unemployment rate rose to 5.5% in the summer, up a concerning 0.6 ppts from the multi-decade low registered last year. That, and higher interest rates, explain why retail sales are sagging and consumer confidence is the weakest since the start of the pandemic.
There are several reasons why Canada's economy is lagging the U.S., notably in per-capita terms. First, Canadian borrowers are more sensitive than their U.S. peers to higher interest rates as they hold more debt and shorter term mortgages. Second, U.S. households appear keener to spend excess savings, likely because of their lighter debt burden. Third, labour productivity continues to decline, in contrast with an upturn stateside. Fourth, though keeping a heavy foot on the gas, Canada's government is no longer putting the spending pedal to the metal as in the U.S., and isn't offering as generous subsidies or tax incentives to drive industrial policies. And finally, Canada is much more exposed to a weaker global economy, as goods exports account for 28% of GDP compared with just 8% for the U.S..
As in the U.S., further progress on inflation in Canada will be slow. After sliding to 2.8% in June from 8.1% last summer, the annual CPI rate has popped back above 3% amid tougher base effects and higher gasoline prices. Various core measures continue to track in the 3%-to-4% range, down from a peak of 5%-to-6%, though well above the 2% target.
Despite the backup in inflation, we suspect that waning momentum in the economy and labour markets will likely keep a data-dependent Bank of Canada on the sidelines after coming off the bench twice this summer. We expect no change in the current 5.0% policy rate until late next spring, at which time the Bank will likely gradually nurse rates toward more neutral levels of 2.5%-to-3.0% by late 2025. Canada's 10-year bond yield recently tested a 15-year high of 3.8%, though we still expect it to ease gradually as the economy weakens and inflation subsides.