Monthly webcast
Our monthly economic webcast for August was recorded at the very end of July and still contains some valuable insights: The (economic and political) plot thickens.
Business cycle update
Our quarterly business cycle scorecard continues to argue that the U.S. is most likely occupying a mid-cycle or late-cycle moment, in line with last quarter (see next chart). This very loosely suggests that the economy might have another 2—5 years of growth left before succumbing to recession.
Our U.S. business scorecard points to mid-cycle or late-cycle
As of 08/09/2024. Calculated via scorecard technique by RBC GAM. Source: RBC GAM
While this happily aligns with our base-case forecast, we nevertheless place less confidence in the scorecard’s findings than usual right now. It simply isn’t communicating with much conviction.
The votes from the underlying variables are unusually dispersed. While mid-cycle and late-cycle are indeed the two most plausible readings, they barely outmuscle a wide range of other interpretations including end of cycle, recession and start of cycle. The only thing that can actually be said with much conviction is that it doesn’t look like the economy is at an early point in the cycle!
Fed rate cut nears
Rate cutting momentum continues to build across the developed world. Critically, the U.S. looks to be on the cusp of adding its heft to the effort. This has an outsized importance, not just because the U.S. economy is enormous and so relevant to investors and economic actors all by itself, but also because it has cascading implications for the rest of the world.
Falling U.S. rates also affect global exchange rates:
The U.S. dollar is already down 6% from July as markets prepare for the first rate cut.
The falling U.S. 10-year bond yield has a considerable influence on other markets.
Emerging markets significantly gauge their capacity to pare their own policy rates by the degree to which this would misalign with the U.S.
This has also been a key question in Canada.
Even before the first Fed rate cut, longer-term bond yields have fallen quite a lot as they have priced in that anticipated easing: the U.S. 10-year yield has plummeted from 4.70% in April to 3.80% now. The U.S. is, on the whole, less interest-rate sensitive than most countries. But it is arguably disproportionately sensitive to long-term rates and less directly sensitive to the policy rate itself.
This is because the American mortgage market has very few floating-rate or short-term mortgage terms. Most are on a 30-year schedule. Thus, the marginal American considering purchasing a home has already benefited significantly from the anticipated rate-cutting sequence.
We think the market is pricing in a bit too much U.S. easing in the near term. A 50-basis point rate cut is not strictly impossible on September 18, but absent a sudden decline into recession, it doesn’t seem likely. Yes, historical easing sequences frequently involved large rate cuts, but those were spurred by recessions that do not appear to be presently underway.
The market has already backed away from outright anticipating a 50-basis point cut for September, but we would put the odds at below the 33% assigned by the market. The recent Fed Minutes and Chair Powell’s Jackson Hole speech both point clearly toward imminent rate cuts, but not flecked with any panic.
Recall that the latest U.S. Consumer Price Index (CPI) print (for July) was fine and in line with expectations. However, it was not as profoundly soft as the prior two months and displayed some hesitancy in the all-important shelter data. Fortunately, real-time inflation appears to have slowed since then (see next chart), if not in a way that opens up aggressive rate cutting.
U.S. Daily PriceStats Inflation Index is slowing
U.S. Daily PriceStats Inflation Index
PriceStats Inflation Index as of 08/19/2024, CPI as of July 2024. Sources: State Street Global Markets Research, RBC GAM
From there, a rate cut is probable at every opportunity over the remainder of 2024, though the precise moves will depend on the inflation and economic data as it rolls in. Looking further out, it is not unreasonable to aspire to a low 3% fed funds rate by the end of next year as the U.S. economy opens up some slack (discussed later in this report) and as inflation ebbs.
International central banks
Outside of the U.S., the rate-cutting momentum also builds.
Sweden just delivered its second rate cut (with more signaled).
Canada is likely to deliver its third such move on September 4 (see next chart).
Monetary policy in Canada and U.S. sometimes deviates moderately
As of 08/22/2024. Shaded area represents U.S. recession. Sources: Macrobond, RBC GAM
The European Central Bank has waffled for what was arguably longer than necessary over the summer. However, it should deliver its own second rate cut on September 12. A further cut is expected by year-end.
The Bank of England only began its easing journey at the start of August and may pause in September. It should then move again in or around November.
The Reserve Bank of Australia (RBA) is worth a mention because for a moment it had appeared to be going in the opposite direction: markets priced in rate hikes as recently as late July. This made us nervous, because it cast some doubt on the universality of the declining inflation story. But all is well again, with the RBA seemingly back on track for rate cuts as its inflation concerns fade. Easing at the country’s September 24 meeting is unlikely, but a rate cut is probable by year-end.
U.S. election update
We wrote about how the U.S. election had been completely up-ended in July in an earlier MacroMemo. Since then, the changes have been more incremental, mostly revolving around the Democratic National Convention in Chicago.
Democratic Party candidate Kamala Harris chose her running mate – Minnesota Governor Tim Walz.
The Harris economic agenda has become clearer. She campaigned for the Democratic nomination in 2020 with quite a left-leaning platform that included a large corporate tax hike to 35%, universal basic income, Medicare for all, banning fracking and implementing the Green New Deal. However, she has since moderated her views and is displaying a fair amount of pragmatism.
Today, largely In line with Biden’s agenda, Harris has endorsed raising the corporate tax rate from 21% to 28% and increasing the top marginal tax rate for individuals regardless of income type. She also supports maintaining the Inflation Reduction Act and its environmental priorities, keeping Obamacare, and tightening the border as per legislation proposed by the White House earlier in the year.
New policy ideas specific to Harris include:
Enhance the child tax credit from $2,000 to as much as $6,000 per child.
Enhance the earned income tax credit to benefit middle- and lower-income Americans.
Expand the price cap on certain medications.
Ban “price gouging” at grocery stores (how this would work and how it would avoid the sort of economically damaging price controls that plagued the 1970s is unclear)
Help homebuyers with $25,000 down payment support and a $10,000 tax credit; eliminate tax breaks for large-scale apartment landlords; and encourage more home construction.
As with the Trump platform, it is difficult to imagine the U.S. fiscal deficit shrinking significantly given the cost of these new ideas. But in practice, Congress is reasonably likely to remain divided, limiting the ambitions of either candidate. However, a Congressional sweep cannot be ruled out if either of the candidates wins resoundingly and drags the rest of the ticket with them and so these policy ideas should be taken seriously.
More generally, while there remains an enormous partisan divide between Republicans and Democrats, the economic policies they propose have become remarkably inverted. Whereas tariffs were long the domain of the Democrats, it is now Republican candidate Trump who proposes them. Conversely, it is now Democratic candidate Harris who proposes supply-side solutions to U.S. housing woes, whereas supply-side solutions were long the domain of the Republicans.
The race remains close and has even tightened up again recently after Harris had surged to a considerable lead a few weeks ago. PredictIt data argues that Harris now has a 54% chance of winning (see next chart), though some other sources say the race remains closer than this. The election is still anyone’s race with just over two months left.
Leader of the U.S. presidential race flips back and forth
As of 08/26/2024. Based on prediction markets data and RBC GAM calculations. Sources: Predictit, Macrobond, RBC GAM
U.S. economic check-up
The broad economic narrative remains one of decelerating economic growth (see next chart).
Economic surprises turn negative
As of 08/02/2024. Sources: Citigroup, Bloomberg, RBC GAM
Reflecting this global slowdown, the volume of worldwide commercial flights is now in slight retreat after a long multi-year ascent (see next chart).
Global commercial flights tracked by Flightradar24
As of 08/21/2024. Include commercial passenger flights, cargo flights, charter flights and some business jet flights. Sources: Fightradar24 AM, RBC GAM
But, no less importantly, the most acute U.S.-centric economic fears are fading. After decent data a few weeks ago from the Institute for Supply Management (ISM) Services and Senior Loan Officer Survey, there is new evidence that the labour market isn’t weakening quite as problematically as previously feared, that the consumer is still OK, and that small businesses are becoming slightly less glum.
On the jobs front, weekly initial jobless claims have actually retreated somewhat in recent weeks. This has tentatively reversed the earlier worrying trend (see next chart). As it happens, last summer also experienced a brief deterioration that was then unwound in the fall, though there were auto strikes that explained at least part of the 2023 pattern.
U.S. jobless claims are stabilizing
As of the week ending 08/17/2024. Sources: U.S. Department of Labor, Macrobond, RBC GAM
Similarly, much has been made of the fact that the U.S. unemployment rate has risen significantly – to the point of triggering the Sahm’s Rule recession signal. However, this has more to do with rising labour force participation (a benign force) than the usual driver, which is an absence of hiring. Reflecting this, the gold line below shows that the actual fraction of the population that is employed has not fallen by nearly as much as unemployment has risen (see next chart and note inversion of the second Y-axis). In other words, the job market isn’t quite as soft as it first looks.
U.S. labour market isn’t quite as soft as it looks
U.S. labour market
As of July 2024. Sources: U.S. Bureau of Labor Statistics (BLS), Macrobond, RBC GAM
On the other hand, preliminary benchmark revisions to U.S. hiring between March 2023 and March 2024 reveal 818,000 fewer jobs may have been created than the 2.9 million net new positions originally reported. That’s a big miss, but it was broadly anticipated. The rate of monthly hiring was still pretty good (an average of +178,000 new jobs per month versus +246,000), and the revisions don’t apply to the past few months (which is when serious concerns about the pace hiring have arisen).
Furthermore, the final benchmark revision for the time period – to be released in February – will probably reverse some of the adjustment, as it has in each of the past four years. Additionally, the data fails to capture the large numbers of undocumented immigrants who have entered the workforce in recent years. All of this is to say that the original rosy hiring estimates could end up being not far from the truth after all.
Turning to the U.S. consumer, retail sales for July were quite strong, up 1.0% month-over-month. Granted, a fair chunk of that represented artificially surging motor vehicle sales after a cyberattack depressed that sector’s activity the month before. But even without autos, retail sales rose by a solid 0.4% for the month.
At the corporate level, Walmart reported “We aren’t experiencing a weaker consumer overall.” Target substantially exceeded expectations for its same-store sales in the latest quarter.
The University of Michigan’s Index of Consumer Confidence and especially its Current Economic Conditions Index remain low. However, it is notable that its Index of Consumer Expectations rose in the latest month and has been trending gradually higher for several years (see next chart). Consumers are not anticipating a near-term recession, anyway.
U.S. consumers’ view on current conditions deteriorates, but expectations improve
As of August 2024. Shaded area represents recession. Sources: University of Michigan Surveys of Consumers, Macrobond, RBC GAM
Finally, U.S. small businesses are no longer quite as depressed as before. The National Federation of Independent Business’ optimism index rose from 91.5 to 93.7. That’s the highest reading since February 2022 when rate hikes began. This is fitting, as declining interest rates are likely a big part of the interest rate-sensitive sector’s rising optimism.
The takeaway from all of this is that there doesn’t appear to be a U.S. recession forming at this exact moment, in contrast to fears to that effect just under a month ago.
Outside of the U.S., Japanese gross domestic product (GDP) staged a welcome rebound. It answered a -2.3% annualized first quarter with a +3.1% annualized second quarter. We never fully believed the weakness in the first quarter as it ran so contrary to what was happening in the Japanese labour market, with inflation and with the central bank.
The U.K. economy has been posting particularly solid economic data lately, an encouraging sign after the country had the worst economic performance among major developed world nations in 2023.
Is the U.S. economy still overheating?
For the longest time, the U.S. economy was moderately overheating, running beyond its potential due to a potent mix of monetary and fiscal stimulus, paired with natural momentum stemming from the post-pandemic rebound. This helped to explain why inflation overshot so badly, even if other powerful forces were also involved.
The economy has since slowed. Can we therefore say that the overheating is over? Nearly.
The idea behind an overheating or underperforming economy is that economies operate at their potential when demand equals the sustainable level of supply. When demand is too high, the economy is overheating and exceeding its sustainable potential. When it is too low, the economy is underperforming its potential. The gap between the economy and its potential is called the ‘output gap.’ A positive output gap means overheating and a negative output gap means underperformance.
How is it possible for the economy to exceed its potential? The idea is that it is temporarily possible to increase supply by recruiting more workers into the labour force or squeezing yet more activity from the existing capital stock. But this is inherently unsustainable because it forces wages and prices higher at an accelerating rate, eventually demanding higher interest rates that slow the economy back down.
A simple if rough way to observe the output gap is by examining the unemployment rate. We figure a normal unemployment rate in the U.S. is around 4.0—4.5%. Simply defining this is the “rough” part, as one would have argued it was closer to 5.0% a decade ago. The actual unemployment rate is now 4.3%. This argues that the U.S. economy was overheating until recently and is now operating around its potential. Realistically, the unemployment rate may continue to rise from here, which would push the economy into a slightly negative output gap.
There are more sophisticated ways to estimate the output gap, frequently invoking sophisticated smoothing calculations such as Hodrick-Prescott filters. The Congressional Budget Office, International Monetary Fund (IMF) and Organisation for Economic Co-operation and Development (OECD) each publish an output gap estimate for the U.S. We also maintain two of our own (see next chart).
U.S. economy versus potential shows gaps
Congressional Budget Office (CBO), GAM model 1 and 2 estimates as of Q2 2024. IMF estimates as of April 2024. OECD estimates as of May 2024. GAM model 1 estimated using CBO natural rate of unemployment; GAM model 2 estimated using HP filter trends. Shaded area represents recession. Sources: Macrobond, RBC GAM
Of the five metrics depicted, all five now show output gaps that are below their recent cyclical peak. Four of five are actively trending downward. This is consistent with a cooling economy.
But only one of the five output gap measures argues the U.S. economy is already below its potential. The other four are at or slightly above potential. Such metrics tend to use quarterly data and so can be slightly stale. We are reasonably confident that another one of the metrics will slip into a negative output gap within the next quarter. We further suspect that a few more could be there by the first half of 2025.
In other words, the U.S. economy is cooling off, but isn’t outright cool yet. It is still at or slightly above its potential, suggesting that a further modest economic deceleration should be welcome, and supporting our earlier assertion that 25 basis point rate cuts make sense rather than more aggressive munitions. Of course, the tricky part is then getting the economy to stabilize shortly thereafter.
Geopolitical tensions rise further
Geopolitical tensions have been elevated for many quarters but rose further over the past month.
In the Middle East, a series of military actions since late July have pitted Israel against Hezbollah and Iran, keeping the region at a high state of alert. Hezbollah indicated that its latest barrage of rocket attacks on August 25 constituted the conclusion of its response to earlier Israeli actions. But Iran may yet take further measures against Israel. There is the ever-present risk of further escalation.
Despite this, the appetite for a full-scale war seems limited on all sides. Thus, the most likely scenario is that this is avoided. But the risk of a war is not zero.
Meanwhile, in Ukraine, Russia continues to make incremental gains in Ukraine’s east. But Ukraine then surprised Russia on August 6 by invading Russian territory for the first time, capturing 1,200 square kilometres of Russian soil.
Ukraine’s motivation was presumably fourfold.
This was low-hanging fruit: Russia was only minimally defending its territory in the Kursk region, and so Ukraine was able to make major rapid gains.
Russia must now pull troops away from the main battlefield in eastern Ukraine to engage in Kursk and shore up their defenses elsewhere.
Ukraine is now in a better position should there eventually be a ceasefire, as it may be able to swap territory with Russia.
The military action has been a major morale booster for Ukraine.
In all of this, two main dangers exist for Ukraine. The first is that by invading Russia, Ukraine has crossed one of Russia’s (many!) ’red lines.’ The repercussions are unclear, and it should be noted that Russia’s response has so far been muted. But Russian President Putin has in the past threatened nuclear action in the event of an existential threat to Russia. One could debate whether the loss of territorial integrity is such a threat. The risk that Russia uses tactical nuclear weapons in response is low, but also not zero.
The second danger to Ukraine is the possibility of a Trump victory in the U.S. presidential election. The Republican candidate shows much less inclination to continue supporting Ukraine. It is not clear whether Europe would be in a position to sufficiently step up its support to keep Ukraine competitive in its war with Russia.
With both conflicts, it is difficult to draw a direct connection to major economies and financial markets. The most obvious channel remains through the price of oil, which could be materially affected by either conflict. Food prices and shipping routes are smaller geopolitical considerations.
So far, oil prices are sedate. The major producers presumably appreciate that a large, sustained disruption to the supply of oil at this point in history could represent a tipping point for electric vehicles and the green economy in a way that would be difficult to fully recover from later.
Despite this, a geopolitical misstep could send the price of oil significantly higher. This represents the main threat to the happy trend of declining inflation.
In such a scenario, central banks would be in a difficult position. Under normal circumstances, they might elect to look through an exogenous shock to the price of oil, as rate hikes can’t fix a war, the price level should settle over time, and the economic damage done by higher oil prices represents a counterpoint in favour of easing policy rather than tightening it. But coming on the heels of a major inflation shock and with bad memories of having erroneously judged the earlier inflationary episode to be ’transitory,’ they might not be so cavalier.
Canadian corner
The macro environment is both busy and challenging in Canada. Recent concerns include a brief rail strike, a softening economy, a high youth unemployment rate, new immigration rules and a wave of upcoming mortgage renewals. Let’s dig in.
Rail strike ends
Canada had a brief four-day freight rail work stoppage, spanning August 22 to 25. The stoppage ended not because management and the union reached an agreement, but because the federal government imposed binding arbitration on both parties.
The short duration of the lockout understates its impact. The work stoppage spanned Canada’s two major freight railway companies, CN and CPKC – which means that all Canadian rail shipments were effectively halted. Furthermore, the companies began winding down operations several days in advance of the stoppage. It will likely take many days to restore normal operations and clear the accumulated backlog.
About C$1 billion worth of goods is shipped by rail each day in Canada. That’s distinct from the economic damage inflicted when the shipments halted, as the transportation of goods does not generate the entirety of their value. But the point is that significant sums of money are involved.
Extrapolating from modelling done by the Conference Board of Canada and ratings agency Moody’s, one might estimate that the Canadian economy will suffer around C$1-2 billion in lost production, amounting to no more than 0.1% of annual economic output. As such, the work stoppage is certainly economically undesirable but it doesn’t change the broader narrative too much for 2024. The August trade and GDP data could well be visible affected, however.
Canada’s transportation woes are not necessarily over. Air Canada’s pilot union just voted 98% in favour of a strike that could begin on September 17. More generally, labour actions are likely to remain elevated over the next few years as unions with expiring contracts seek to reclaim lost purchasing power from the past several years.
Economic softness continues
The Canadian economy has certainly softened. Business conditions have begun to trend in a weaker direction as per Statistics Canada (see next chart).
Business conditions in Canada slipped below trend
As of the week of 08/12/2024. Equal-weighted average of Business Conditions Index of Calgary, Edmonton, Montreal, Ottawa-Gatineau, Toronto, Vancouver and Winnipeg. Sources: Statistics Canada, Macrobond, RBC GAM
GDP growth has also decelerated. Much of that was from an unsustainably fast pace associated with the post-pandemic recovery. However, the rate of deceleration now takes the economy down to an outright poor footing. And things are rather worse than they first appear.
When one subtracts (unnaturally fast) population growth, GDP per capita is in outright and rather serious decline (see next chart). The average person is producing less and consuming less in Canada.
Canadian growth has slowed markedly
As of Q1 2024. Sources: Statistics Canada, Macrobond, RBC GAM
Would it have been a recession without the fast immigration? It is hard to say. Part of the productivity damage appears to have come directly from the immigration itself. Furthermore, a number of countries have suffered mildly contracting economic activity without the labour market implosion that one would normally expect in a true recession. So perhaps the Canadian economy would have shrunk but the labour market would have held up. But it wouldn’t have been good, that’s for sure.
We believe the Canadian economy can continue to grow through 2025, but not at an especially fast rate. It does require a certain leap of faith that the period of collapsing productivity will come to an end.
Youth unemployment worsens
July brought a second straight month of small job losses to Canada. This is also worse than it looks because the country’s rapid population growth requires a lot of new jobs each month just to keep pace. Accordingly, the unemployment rate is now up to 6.4% – above our estimate for Canada’s neutral unemployment rate (5.75—6.25%).
Within the labour market, Canada’s youth unemployment rate is rightly attracting particular concern. It is now up to 14.2% – a sizeable 4.9 percentage points higher than the 9.3% cycle low.
As you might guess, a normal youth unemployment rate is considerable higher than for the labour market as a whole since young people have, on average, fewer skills and have had less opportunity to efficiently match with employers.
It is also normal for the youth unemployment rate to saw back and forth more sharply than the overall unemployment rate. This is because youth are often the last into an employer and so are the first out during economic busts. Also, they tend to be disproportionately employed in discretionary sectors like tourism and food services that dry up especially abruptly during recessions.
Still, even understanding that the youth unemployment rate should be higher and more volatile, it has performed especially poorly relative to the overall unemployment rate (see next chart).
Canadian youth unemployment rate is rising quickly
As of July 2024. Shaded area represents recession. Sources: Statistics Canada, Haver Analytics, Macrobond, RBC GAM
Why? The answer is almost certainly the massive rate of temporary immigration into Canada. Unskilled temporary foreign workers tend to be younger and so are in direct competition with Canadian youth. International students are also disproportionately young and have been allowed to work a significant number of hours in Canada. Thus, Canada’s youth unemployment rate is hit from both sides – by declining demand for labour as the economy weakens and by a rising supply of low-skilled labour.
Immigration changes likely
Hot off the presses, and no doubt significantly in response to Canada’s recent productivity, housing market and youth unemployment woes, major immigration changes appear to be coming to Canada in the near term. After a period of unprecedented immigration (see next chart), the federal government had already announced various tweaks earlier in the year. These actions included reducing the number of foreign student admissions by 35% and a broad commitment to reducing the number of overall temporary residents.
Canadian net immigration has peaked
Canadian net immigration
As of Q1 2024. Sources: Statistics Canada, Macrobond, RBC GAM
Now, with an August 26 pronouncement, the temporary foreign worker’s low-wage stream will mostly revert to its pre-pandemic settings:
No more than 10% of a company’s workforce can come from the program, down from 20%.
The limit will be 0% in parts of the country with an unemployment rate of 6% or higher (note the national average is already greater than 6%).
The temporary workers who do come can only stay for a single year instead of for two years.
Certain sectors such as agriculture enjoy exemptions.
Note that this latest change will not magically halt the rapid rate of immigration all by itself, as Canada admitted just 83,643 temporary foreign workers via the low-wage stream in 2023. This stream was responsible for less than 7% of Canada’s total net immigration in 2023.
The federal government also announced it will re-examine its target of 500,000 permanent residents per year for 2025 and 2026, presumably with an eye to reducing them so that a better balance can be struck in the housing and labour market.
A major unanswered question is the extent to which a lack of immigration enforcement will continue to allow a mounting number of people on expired temporary visas to remain within the country, undermining efforts to slow population growth.
The mortgage renewal wave may soon begin
Based on estimates tallied from Canada’s Big 6 banks, 2025 and 2026 should be colossal years for mortgage renewals. We figure that 23% of all existing mortgages will renew in 2025 and another 32% in 2026. That’s 55% of all mortgages renewing within a two-year period.
Part of this lumpiness is that a lot of people took out mortgages when rates were low and home prices were skyrocketing in 2020 and 2021. Those are coming due five years later. Another part is that many borrowers whose mortgages reset over the intervening years at unpleasant rates opted for shorter subsequent mortgage terms that also expire in the 2025 to 2026 period, in the hope that rates will be lower then.
That’s only half the story. The other half is that the financial impact will be quite large on most of the individuals within the cohort (really, anyone with an expiring five-year term). They locked in their mortgage rate in 2020 or 2021, when such rates were frequently below 2%. The equivalent rate today is two to three times higher. That constitutes an enormous coming financial adjustment, with mortgage payments set to rise by 20-40% according to the Bank of Canada.
This is just one of several motivations for the Bank of Canada to be cutting rates in 2024 with a little more haste than in other peer nations.
-With contributions from Vivien Lee and Aaron Ma
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