Summer 2024 economy and markets update

Sébastien: Hello and welcome to the “In Your Interest!” podcast. My name is Sébastien Mc Mahon. This week, I’ll be hosting the podcast on my own, while Ashley enjoys her vacation.

Markets were very volatile in August, against a backdrop of concerns about the resilience of the US economy. Is the era of “American exceptionalism” coming to an end? I’ll take a moment today to set the scene and share our views on what’s next for the world’s leading economy, on financial markets as well as on the Bank of Canada and our country’s interest rates.

Let’s start with the US economy. The US economy has outperformed most of its peers over the last few years, making the term “US exceptionalism” a carry-all term to support everything from the US government’s ability to inflate its public debt to the expensive valuation of its stock market. I mean, even the Olympics seem to confirm US exceptionalism this summer—with American athletes once again dominating the Summer Games. It seems, however, that the bond market is starting to express some doubts about how exceptional the US economy will remain over the coming years, leading to abrupt market moves in August that have temporarily pushed the “fear index”—the VIX—to crisis levels in August. So, as of late August, markets are pricing in four 25 basis points rate cuts in this year’s three remaining meetings, meaning that there’s a chance we’ll see a jumbo 50 basis points cut in September—a far cry from the two cuts that were priced in for the year, back in June.

If you were to ask us if we believe that the market is correct here, we would say that we won’t likely see a jumbo rate cut—or a panic cut, because it will really send a signal of panic from the Fed if they go through with this. But we have rallied with the markets. We used to think that we would see no cuts or one cut by the end of this year in the US, but after hearing what the Fed has been saying—they’ve changed their tune—and looking at the data, we’re thinking that it’s starting to make sense that there will be cuts beginning in September and we’ll likely see three cuts by the end of this year. But in Canada we should see five cuts total. More on that in a few minutes. So there’s still some divergence between the two monetary policies.

But what happened this summer? Did the US economy suddenly fall down the stairs? Is it merely a reflection of low liquidity in a market that was priced for perfection? Well, we’re inclined to say that it’s more the latter. And when you’re thinking about recession odds, you need to look at the labour market. This is the most important indicator to gauge the strength of an economy. And the US labour market continues to exhibit resilience when you look under the hood, even though there are still some lingering recession fears—and remember that in 2021/2022, our team was in the camp that US economic recession was a base case scenario. The economy was stronger than we expected, so we were wrong on that call. Now we’re looking at the economy and we’re seeing signs of strength and normalization. So it’s not an economy that’s falling into a recession, it’s an economy that’s simply normalizing after a bout of outperformance. And key indicators are making us comfortable in this view.

So, we’ll first look at job openings (the jobs that are open but not filled). What we see is that we’re still above pre-COVID levels and there are still more job openings than there are unemployed people. So, to be clear, if we gave a job to every unemployed person in the US, we would still have 1.4 million jobs that are open and unfilled. Of course, the gap was much wider a few months back, but we’re still seeing a labour market that is tight but is slowly normalizing. Also, the famous quit rate (the rate at which people are quitting their job without having another job lined up) is definitely falling, but it’s still at pre-COVID levels—so it’s not suggesting that the labour market is tumbling down the stairs, here. Same thing with wage growth: moderating—moderating quite rapidly, even—but still above pre-COVID levels, and it continues to support consumer spending. So, if you put everything together, you could look at this and say: “Well, why did everyone panic about the risks of a recession for a while there during the summer?

Well, there was this early recession indicator called the Sahm rule, named after Claudia Sahm, a well-known economist who created the rule. This rule basically suggests that when the unemployment rate is rising quickly, it usually signals a recession. But when we look at the unemployment rate in the US, we see that it has been pushed up by population growth—just like we’ve been seeing in Canada, where we have immigration that is pushing unemployment higher—and we are seeing people that were left out of the labour force during the pandemic continuing to come back. So, we’re seeing ‘unemployment rising for good reasons’ here. This makes us believe that it an economic downturn isn’t what’s being signalled, but rather a normalization of the labour market. So, we believe that the odds of a recession over the coming 12 months remain low, likely in the 25% to 35% range. It is, therefore, not the base case. And, again, we believe this is more a normalization than anything else.

Now, looking at the Canadian economy. We’re seeing evident progress on inflation. It’s now been seven consecutive months, if you count the month of July—the data was just published a few days ago—that inflation has been within the target band from the Bank of Canada, meaning it’s between 1 and 3%. We always say that the target is at 2%, but it’s a target band of 1–3%. It’s been seven consecutive months that we’ve been in this band and now inflation is falling too fast. So, we’ve moved from inflation being resilient to inflation falling too fast. And we’re not the only ones asking the question; the Bank of Canada itself asked this same question in the latest summary of deliberations. So, when the Governing Council convenes to make a decision on monetary policy, someone takes notes which you can read afterwards in the summary of deliberations. The latest decision was a rate cut in July, and in the summary of that meeting, you can read that some members of the Governing Council wondered if the pace wasn’t too quick and if there wasn’t now a risk of undershooting the rate of inflation.

And why are they asking themselves this question? Well, when you look at the Bank of Canada survey—they have their own surveys of businesses, which they call the Business Outlook survey—a few elements stick out, such as prospective sales: we’re seeing businesses being quite downbeat on the potential growth of sales over the next year. And very interestingly, labour scarcity seems to be over for now. We seem to have an inverted situation: labour was seen as being very scarce during the pandemic, but now it’s seen as being maybe too abundant. And if you ask businesses the question, ‘Would you be able to meet a sudden rise in demand for your product?’ The answer is an obvious, ‘Yes.’ So that means that businesses should hire less, wage growth should be less and all this should bring even more downward pressure on inflation over the coming months, quarters, maybe even a few years.

So, if you look at where we stand now: we started the year at 5% on the leading rate for the Bank of Canada, now we’re at 4.5% after a cut in June and a cut in July. Now, looking forward (we have data on market pricing all the way to January 2025 on the Bloomberg platform): all markets are pricing a rate cut on September 4, on October 23, on December 11, and on January 29 of 2025. And we would agree with this prognostic. That would bring us to 3.5% by late January of 2025, after starting at 5% in early 2024. But we would still be far from the neutral rate (the rate at which the bank is neither hitting the brakes nor the gas on the economy), which the Bank of Canada estimates is at 2.75%. So if we’re right and we have four more cuts until the end of January, that would lead us to 3.5% as of late January 2025. In that case, there would still be three more cuts to go before we’re neutral. That could happen somewhere late in 2025, because the bank could, at some point, skip a meeting or two to make sure that we have a clear view on how the data is behaving following those cuts. But the tone is set. The direction is pretty clear. The normalization of monetary policy is underway, and don’t expect it to slow down over the coming few decisions.

So, summing everything up, here. A lot of volatility in early August in the markets; equities have regained pretty much all their losses. Interest rates remain a bit lower than they were prior to the panic of early August. What pushed this? Of course, there are some liquidity aspects that I’m not getting into here, but there was this fear that maybe the US economy was losing some steam, risks of recession were rising. We think these were misguided.

When we look at the Canadian economy, we’re maybe seeing the inflation rate falling a bit too quickly. The Bank of Canada will, therefore, likely continue at a very steady pace to ease monetary policy. The Fed should also start cutting in September of this year, with three cuts by the end of 2024. So, the economy is not falling down the stairs, but interest rate cuts should be abundant in the US, in Europe and continue in Canada over the coming few months and quarters.

So, the idea here was just to paint a picture of where we stand at the end of August. We’re getting late into the summer, and we should have an eventful period in the fall with the US election that will occupy market psychology more and more.

Well, that ends this week’s episode. Many thanks to our listeners! Don’t hesitate to drop us a line if you have any questions, and we’ll see you again next week.

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