North American Outlook
November 25, 2025 | 09:44
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 consumer spending likely expanding by more than 3% in Q3, propelled by a powerful wealth effect from the equity rally, we lifted our GDP growth call to 2.8%. The recently-ended federal government shutdown, the longest ever at 43 days, could bring growth to a near standstill in Q4, before rebounding in Q1. Growth will likely average almost 2% in 2026, as in 2025. 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. Monthly nonfarm payroll gains averaged just 62,000 in the third quarter, less than half the long-run norm. Other indicators, including ADP payrolls, suggest hiring remained weak in October. This may be 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. While Chair Powell says a December move is "far from a foregone conclusion", given sticky inflation and economic resiliency, we continue to lean toward a reduction and a combined 100 bps of rate relief in the year ahead. This view assumes continued soft job growth in the near term will lift the unemployment rate from 4.4% in September to 4.7% in 2026. 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. 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. While retail sales volumes have weakened recently, continued growth in services should propel overall consumer spending forward. Consumers will get some support from a recent rebound in employment. After shedding a net 106,000 positions in July and August, the labor market generated 127,000 new positions in September and October, pulling the unemployment rate back below 7%. The rebound likely reflects businesses adjusting to the trade war and trying to move forward. Still, we expect the jobless rate to drift to 7.2% by early next year, before embarking on a downward course as the economy strengthens. As in the U.S., Canada's housing market is a weak link 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 a modest recovery in the province 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% GDP growth in 2026, up from an estimated 1.2% in 2025. The earlier weakness in labor markets 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. However, with employment bouncing back and policy rates now "at about the right level to keep inflation close to 2 per cent while helping the economy ”, the Bank looks to move back to the sidelines in December. Still, assuming some renewed near-term softness in employment, we continue to eye a final rate cut in January. The main risk facing Canada's economy 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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