Resilience or Recession?

We still lean toward "resilience" in the title question but with waning conviction. High energy and food costs are eating into consumer spending power and confidence. Fast-rising interest rates are cooling the previous fire-breathing housing market. Even after several upward revisions, we still see upside risks for both inflation and policy rates. Any further bumps higher would almost surely lead to a hard landing. Still, we give the expansion just over even odds to continue, albeit at a slowing pace. Support stems from high household savings and pent-up demand for travel, in-person services, and automobiles. Businesses need to invest to expand capacity. But a lot of things must start going right, notably for inflation and the war in Ukraine. Falling lumber prices and easing restrictions in China are a start, but these are relatively small wins with oil prices near $120 a barrel and natural gas prices more than doubling this year to 14-year highs.

Canada's economy is outperforming most major countries due to its heavy resource exposure. While real GDP grew less than expected in Q1 at 3.1% annualized, this followed 6.6% growth in Q4 and was still above long-run potential. The slowdown reflected a big reversal in exports and a weak start to the quarter owing to pandemic-related restrictions. However, domestic demand was healthy, led by big gains in residential construction (18.1%) and business investment (9.0%). In addition, consumer spending was solid (3.4%), supported by nearly $300 billion of extra savings piled up during the pandemic, equal to 19% of disposable income. That will cushion the pain of rising energy and food costs for most households, at least for now. Solid monthly GDP figures point to even stronger 4.5% growth in Q2. But that could mark the high point for a while, as interest rates will begin to bite, as is already the case for housing. The cost of servicing record household debt could eventually consume more than 15% of disposable income, up from 13.8% in Q4. Due to more aggressive monetary tightening and weaker global demand, we cut our growth forecast to 3.5% this year and to 2.3% next year.

U.S. real GDP shrank 1.5% annualized in Q1 after surging 6.9% in Q4. A record trade deficit and government spending cuts did most of the damage. However, accelerating business investment and sturdy consumer spending indicated underlying strength. A strong bounce in April consumer spending suggests GDP rebounded 3.0% in Q2. However, growth is expected to slow to 2.4% this year and to a below-consensus 1.5% in 2023. Monetary policy is quickly tightening. Record gasoline prices are siphoning money from consumer pockets. On the plus side, there is still some remaining inventory rebuilding and business investment looks solid so far. Most importantly, households are mining an extraordinary cache of extra savings, about $2.3 trillion or 13% of disposable income, to sustain spending in the face of rising fuel and foods costs. Even if just a third of the excess savings is used for purchases, it will support demand well into next year. There is also pent-up demand for autos, once supply improves.

Solid growth led to the best labour market conditions in decades. Canada now has 457,000 more jobs than at the start of the pandemic and the 5.2% jobless rate is the lowest in at least 45 years. Meantime, U.S. payrolls rose 390,000 in May, down from earlier months but still more than double the long-run norm. There are nearly two job openings for every jobless worker in the U.S., and one opening in Canada, which is still a record. Despite rapid hiring, the U.S. jobless rate has held at 3.6% for three months due to a welcome upturn in the participation rate. The expected slowdown will likely push the jobless rate above 4% next year, helping to relieve inflation pressures.

Fast-rising mortgage rates are rapidly dialing down the heat in housing markets. Earlier this year, house prices in Canada and the U.S. rose at record rates of 29% y/y and 21%, respectively, mostly in response to above-normal demand juiced by too-low interest rates. However, more recent data show sales are sliding fast due to poor affordability. Mortgage service costs are approaching 1989 levels in Canada and 2006 levels in the U.S. (recall, neither episode ended well). Sales in Canada are likely to slide below pre-pandemic levels once support from pre-approved mortgages dries up. We expect prices in Canada to retrace a good portion of their past year surge, before resuming a more modest upward course with support from strong immigration. Prices in the somewhat less-frothy U.S. market should level off later this year. Alas, the harder that central banks need to fight inflation, the greater the risk of a deeper correction in housing markets.

Inflation risks remain tilted to the high side, even for our above consensus view. Annual CPI rates are expected to peak above 8% in the U.S. and above 7% in Canada, before declining slowly to 3% at the end of 2023, still above the 2% target. While wage growth remains calm in Canada at just over 3% y/y, U.S. compensation gains are running about 2 ppts faster. Dismal productivity growth in the U.S. and an outright decline in Canada are also stoking unit labour costs. Energy and food costs show no sign of fading. The high cost of owning a house is pushing rents higher. Falling lumber prices and freight costs are small wins on the inflation front, while the New York Fed's global supply chain pressure gauge remains sky-high, though off its peak.

The Fed and Bank of Canada are on a speedy track to rate neutrality, or beyond. The Bank isn't ruling out a 75-bps hike in July, saying it is "prepared to act more forcefully if needed" to prevent high inflation from becoming entrenched in expectations, as the economy is "clearly operating in excess demand". Deputy Governor Beaudry mused about possibly taking policy rates "to the top end or above the neutral range". We now expect the Bank to raise rates 50 bps at the next three policy meetings to 3.0% in October. The Fed has even more catching up to do, and we see it moving in 50-bp steps at the next four meetings and a final 25-bp move in December, taking rates to 3.13%. Both forecasts are 25 bps higher than we previously thought. The peak Fed funds rate is now somewhat above a neutral range (of 2% to 3%). Any further upgrades would raise the odds of a hard landing.

The possible need for aggressive monetary tightening is the single biggest threat to the expansion. The risk of a downturn will rise especially next year depending on how far central banks need to take rates above neutral to restore price stability. Recession odds could be as high as 45% given that the Fed has never achieved a soft landing in at least six decades when inflation was this high and the unemployment rate and policy rates this low at the start of a tightening cycle. Other things could go wrong as well, such as the war spreading beyond Ukraine's borders, lockdowns returning to China, and a more severe strain of the virus. One thing is clear: the economy's resilience will be sorely tested unless a lot more things start to go right than wrong in the year ahead.