It was another volatile week in financial markets as fears around slowing global growth were exacerbated by worries over Brexit. This, as the cabinet minister in charge of negotiating a Brexit deal with the European Union resigned over the direction of the proposed deal. The S&P 500 finished the week down 2.1% as of writing.

Financial market jitters are not a reflection of any newfound weakness in U.S. economic data, which continues to point to solid growth and limited inflation. This week, consumer price index (CPI) data for October showed headline inflation rise to 2.5%, mainly due to rising energy prices. Core inflation, on the other hand, edged down to 2.1% (from 2.2%). Over the past three months, core prices have risen an average of just 1.6% (annualized), suggesting little cause for alarm on the price front. What’s more, the recent pullback in the price of oil is likely to push headline inflation lower in the months ahead, with the Fed’s preferred metric – the personal consumption expenditure price index – likely to drift back below the 2% mark.

A relatively soft inflation environment is giving support to the more dovish voices on the FOMC. In comments made this week, Chair Powell struck a balanced tone, but gave a nod to some of these more dovish elements. In particular, he noted the conditions that could lead the Federal Reserve to slow its pace of rate hikes over the next year. Slowing global economic growth, fading fiscal stimulus, and the lagged impact of past rate hikes are three factors that the Fed is monitoring. Despite these risks, the Chairman also noted the relative strength in the American economy, and notably that with press conferences scheduled after every Fed announcement in 2019 (instead of just once a quarter), every meeting is “live” – that is, has the potential for a change in policy.

Between the midterm elections and a Fed rate decision there was plenty of news this week. But after the dust settled there was very little new information. As was widely expected, the Democrats gained a majority in the House of Representatives, and Republicans tightened their grip on the Senate. A divided Congress will temper Trump’s agenda, but much depends on the Democrats’ strategy for working with the GOP. Even less surprising was the Federal Reserve’s decision to hold the funds rate steady, after hiking in September. Equity markets seemed pleased with these largely as expected results.

Congress is now gridlocked through 2020, which raises risks on a variety of fronts. A few tests loom on the near-term horizon. Currently 25% of discretionary spending for the 2019 fiscal year is under a temporary funding agreement until December 7th. The current Congress will likely kick the can into early 2019, which sets up a potential funding battle and the risk of a partial government shutdown in the New Year. Government shutdowns are a risk with a divided government, but typically these do not have a meaningful impact on economic activity (as they have not proved long lasting).

In a job market that just won’t quit, U.S. workers are finally hitting pay dirt. Job growth shows little sign of slowing with nonfarm employment growing by 250k in October. The labor force participation rate also edged up to 62.9% and the unemployment rate continued at its cycle low of 3.7% - the lowest since 1969. With workers getting scarcer, companies either have to pay up, or scale down expectations.

The tight labor market is indeed forcing many to compete for workers by boosting paychecks. Both the employment cost index, which captures wages and benefits, as well as average hourly earnings show upticks in workers’ compensation. Wages broke through the 3% growth ceiling that has stood for nearly a decade, coming in at 3.1% y/y. Wages haven’t exceeded 3% growth since April 2009 (Chart 1).

Going in the opposite direction, home-price gains decelerated for the fifth consecutive month in August. The S&P Case-Shiller Home Price Index grew 5.8% y/y, falling below 6% for the first time in a year. After more than five years of solid home price growth, this is the latest indication of a slowdown in the housing market, which is likely to persist as interest rates edge higher. Despite slowing, house price inflation remains well above wage growth, contributing to the affordability crunch prospective buyers have grappled with of late (Chart 2).

Rounding out the week were data on ISM manufacturing and personal income and spending. Manufacturing activity eased in October, though it remained in growth territory as manufacturers continued to struggle with capacity constraints and tariff pressures. Though consumer spending momentum remained strong through the end of Q3 and should result in a solid Q4 handoff, the stimulus from tax cuts likely plateaued in Q3 and could be a harbinger of slower consumer spending. Year-on-year, core PCE inflation remained at 2.0% for a fifth straight month.

One potential development that could raise inflation (and further reduce the stimulative impact of tax cuts) are higher tariffs. On that front, tensions with China continue to simmer. This week, the Commerce Department barred U.S. companies from engaging in business with a state-owned Chinese chip maker after it was accused of stealing trade secrets from an American firm. The news left China’s chip industry on edge, feeling vulnerable to the escalating China-U.S. trade standoff. Subsequently, a spark of hope emerged Thursday when President Trump signaled progress on trade talks. This followed a phone call, initiated by the White House, to President Xi. The two countries are now more likely to resume talks at the G-20 summit in Buenos Aires later this month. As things stand, however, the jury is still out on whether there will be a cease fire in the trade fight following the summit.

All told, the U.S. economy is currently enjoying the sweet-spot of low inflation and unemployment. Only time will tell for how long.

Shernette McLeod, Economist | 416-415-0413

This was a tough week for financial markets. All major indexes fell precipitously, set to end the week deeply in the red. As it stands, markets’ downturn in October has erased all the gains from the start of the year. While domestic economy remains on solid footing and Q3 corporate earnings have so far exceeded expectations, investors’ conviction that corporate profits may have peaked is growing. Forward-looking investors are increasingly worried about slowing global growth, mounting trade tariffs, rising interest rates and a fading boost from fiscal stimulus.

International developments didn’t help to lift investors’ spirits. It seems that the U.S. – China trade negotiations have hit a stalemate. This threatens to undermine a scheduled meeting between the two presidents in November, and raises the probability of further tariffs.  Also, in an unprecedented (even if widely expected) step, the European Commission has rejected Italy’s budget.

Domestically, there was relatively little on the economic radar this week, with the advance estimate of Q3 GDP the only major data release.  As anticipated, after an impressive 4.2% print in Q2, the U.S. economy has downshifted slightly in Q3, but at 3.5% (annualized), growth nonetheless remained very hot and well above potential (Chart 1). Looking under the hood, consumer and government spending were both exceptionally strong, advancing by 4% and 3.3% in the quarter. Coming on the heels of a similarly robust 3.8% gain in Q2, this marks strongest two-quarter pace for consumer spending in over three years courtesy of a tight labor market and income tax cuts.

Even as consumers are hitting malls in masses, the housing market remains unloved due to deteriorating affordability and lack of supply. Sales of new and existing homes are down by 11% and 6%, respectively, since December (Chart 2). With both homebuilders and prospective buyers facing a number of hurdles, residential investment has been contracting for three consecutive quarters.

Business investment was another fly in an ointment in today’s GDP report. After setting a blistering pace in the first half of the year, spending took a breather in the third quarter, up only 0.8%. While one quarter does not make a trend, given the tensions on trade front this is where the risks lie going forward. Tariffs have already dented business confidence and could lead to further delays in investment in the coming quarters. If investment spending continues to be soft, dampening economic growth, the Fed would likely temper the pace of rate hikes.

All in all, with trade risks percolating and the boost from fiscal stimulus expected to fade, performance over the last two quarters likely represents the high water mark for the U.S. economy. So far though, despite President Trump taking yet another jab at the Fed this week, it certainly looks like current economic fundamentals warrant another interest rate hike in December, bringing the upper end of the target range to 2.5%.

Ksenia Bushmeneva, Economist | 416-308-7392

Equity markets stopped the hemorrhaging and partially recovered from last week’s downturn. A cocktail of information, which included FOMC minutes, domestic data and thorny international developments, resulted in bouts of volatility. Domestic data was predominantly underwhelming, but did little to change the status quo of a solidly-growing U.S. economy. Retail sales edged up by only 0.1% (m/m) in September – well below market expectations. While disappointing, the report did not raise any red flags. The headline print was likely swayed by Hurricane Florence, given a steep drop in spending at bars and restaurants. More importantly, core sales still rose at a healthy pace of 0.5%, pointing to continued robust momentum in consumption. With September retail sales in the bag, consumer spending in the third quarter likely rose at solid pace of around 3% annualized.

Despite a strong consumer backdrop, the housing market continues to struggle. Existing home sales fell 3.4% in September, marking the sixth straight monthly decline. Housing starts didn’t do any better, falling 5.3% to 1.20 million. Again, part of the weakness can be chalked up to weather-related disruptions, with both existing home sales and starts in the South recording the sharpest drops since late 2015. Going forward, tight inventories of homes for sale should help support moderate gains in new homebuilding. Still, limited supply will keep upward pressure on prices and weigh on demand, especially in the near-term. Rising interest rates, which appear to be behind some of the recent malaise, will be an added headwind (Chart 1).

The FOMC minutes released this week reinforced the view of higher interest rates ahead. The key message here is that as long as the economy continues to expand at a solid pace and inflation remains close to target, the Fed will continue to hike rates, likely by 25 basis points a quarter. In addition, a number of participants believe that it will be necessary to raise rates above neutral temporarily, in order to avoid overshooting inflation or contributing to financial imbalances. For a deeper dive on how high rates can go, see here.

While the data remain supportive of ongoing rate hikes, there is no shortage of potholes in the path ahead, particularly on the international front. Across the pond,  Brexit remains a source of uncertainty, while recent developments in Italy have also become a major cause of concern. The EU Commission has determined that Italy’s draft budget is in serious breach of EU budget rules, and may reject it. The Rome-Brussels rift, which has sent Italian bond yields skyward (Chart 2), will bear close watching next week with Italy expected to reply to the commission by Monday. Chinese economic growth is slowing and policymakers there have a tough balancing act between deleveraging and maintaining adequate growth. A sour exchange between trade representatives of the EU and U.S. this week also reminds us that the Trans-Atlantic trade truce rests on feeble foundations. All told, plenty of risks remain and it won’t be an easy path to navigate.

Admir Kolaj, Economist | 416-944-6318

The headline story this week has been the downturn in global equity markets. The S&P500 has fallen about 6% this past week, the biggest five-day loss since February. A bond market rout was the cause then, and it was behind the move in recent days too, as equities re-price to reflect the higher yield environment (Chart 1). This is not a bear market, which is a 20% drop for at least two months, or even a correction, which the market did experience back in February.

For its part, the U.S. economy continues to do well. Indeed, stocks have weakened in part because the economy is doing well. The Fed has clearly signaled they expect strong economic growth to continue, and expect to continue raising rates over the coming year. Bond markets are increasingly taking them at their word, and investors now require a higher yield to hold bonds. When analysts value equities, they discount the expected future cash flow or dividends, and with higher rates those discounted cash flows are looking less valuable, resulting in a repricing of stocks.

There are plenty of downside risks lurking around corners for the U.S. economy: negative impacts from increased tariffs; higher government deficits could lead to a further move up in Treasury yields; and the risk of a Fed policy error. But, at the moment it must be acknowledged that the U.S. economy is growing strongly, a healthy labor market is increasing the share of people with jobs, and wage gains are occurring. At the same time, inflation pressures remain very well behaved. That helps ensure the Fed can remain patient as it raises policy rates.

Further evidence was received this week that inflation pressures remained contained in September. The Consumer Price Index rose only 0.1% on the month both for the headline and core. Core inflation held steady at 2.2% year/year, within the range it has maintained since March. The story of core services inflation running around 3%, being offset by deflation in core goods remained unchanged (Chart 2). But, the cast of characters holding goods prices down on a month-to-month basis changed; in August it was apparel, in September, used cars. Still, the bottom line is that core goods have been firmly in deflationary territory for five years now. We had been expecting this to change, as the effects of past dollar appreciation wear off, but the more recent strength in the dollar will likely delay this. And, we haven’t seen much evidence yet of tariff impact at the consumer level.

Meanwhile, services inflation has picked up from its 2017 soft patch, but it hasn’t really broken new ground. We continue to expect a tight labor market, and increased wage pressures to lead core inflation higher over the next year. But, September’s inflation numbers provide reassurance that an undesirable sharper upturn is not occurring. We expect the Fed to continue raising rates a quarter point at every other meeting over the next year. It would take a much more severe tightening in financial conditions than recently observed to put this pace at risk.

Leslie Preston, Senior Economist | 416-983-7053

The September FOMC meeting was the highlight of this week’s economic calendar. The Fed did not disappoint, hiking the Fed Funds rate by 25 bps as widely expected. This lifted the upper bound target to 2¼ % – the highest level since 2008 (Chart 1). The policy path ahead remained broadly unchanged as per the Fed dot plot. What’s more, the funds rate is now projected to remain above the longer-run neutral level through 2021.

Market focus however, gravitated more toward what was not in the Fed statement, rather than what was in it. The communiqué dropped the reference to policy remaining “accommodative”. This received a dovish interpretation initially under the premise that the Fed may be getting close to the end of the hiking cycle, leading to volatility in bond yields and equities.

The debate around textual changes in the Fed communiqué appears to detract from the main point – the Fed remains committed to further gradual tightening given its conviction for well-anchored inflation expectations and a positive view of the economy. Economic data in the week remained broadly in line with this narrative. The Fed’s preferred measure of inflation held right on target for the fourth straight month in August. Meanwhile, real personal spending was up 0.2% in the same month. While this marks a slight moderation in the monthly pace of spending, it’s sufficient to keep our tracking for third quarter consumption growth north of 3% annualized. A solid rise in wholesale and retail inventories added to the positive tally.

Not all of the data was positive though, with soft pockets including trade and housing. The goods trade deficit widened more than expected in August. The first two months of the quarter reaffirm the notion that, unlike the second-quarter experience, net trade will be a drag on growth this time around. Pending home sales, a leading indicator of sales activity, also fell 1.8% in August (Chart 2). This marks the fourth decline in five months, suggesting that sales will continue to languish in the near-term.

Putting all the pieces together, the economy is still on solid footing, with over 3% growth expected in the third quarter. With price pressures holding near target, this should indeed be sufficient for one more hike before the end of the year. Beyond this point, however, there is significantly more uncertainty, as trade disputes pose significant downside risk to the economic outlook.

The U.S.-China trade conflict saga continued to play out in the background, given other more salacious domestic political developments. China scrapped talks with the U.S. as tariffs on $200 bn of Chinese goods came into effect. Meanwhile, President Trump accused China of attempting to interfere in the upcoming midterm elections, given his stance on trade. With the two economic heavy-weights on a hard-to-avoid collision course, we see this dispute as a key risk to growth. Tariffs in effect and those threatened could knock off up to 1 p.p. from U.S. and 0.3 p.p. from global economic growth (see here).

Admir Kolaj, Economist | 416-944-6318

Neither escalating trade wars, devastating hurricanes, rising interest rates, nor tumultuous emerging markets prevented the S&P500 from attaining new heights this week. Strong corporate earnings growth is playing a key role, as is a 50% increase in share buybacks over the first half of 2018. Thanks to tax cuts, corporations are awash with cash, and have managed to increase capital expenditures and return money to shareholders.

Strength in equity markets is backed up by a very healthy U.S. economy. Our latest Quarterly Forecast outlines how fiscal stimulus is helping to boost real GDP growth to 2.9% this year. Growth well above potential is expected to push the unemployment rate to the lowest level since Woodstock (Chart 1). With the economic party raging, the Federal Reserve is widely expected to drain some more punch from the bowl next Wednesday. A 25 basis-point rate hike will raise the fed funds rate to 2.00-2.25%, marking the eighth rate hike since 2015. We expect the Fed to hike four more times over the next year, placing the fed funds target at a peak level of 3.25% in 2019.

Next week’s decision looks like a done deal, but the Fed’s economic forecast will still be closely watched. Now that another tranche of tariffs on Chinese imports and China’s retaliatory measures are on the books, it will be interesting to see how FOMC members adjust their outlook, if at all. Our forecast calls for growth on a quarterly basis to slow from roughly 3% in the second half of 2018 to below 2% by 2020. Those numbers do not include the impact from the latest round of tit for tat tariffs.

If the 10% tariff on roughly $200bn in Chinese imports run their stated course, and rise to 25% on January 1st, we estimate that U.S. real GDP growth could be knocked back by roughly 0.4 percentage points over a 4-6 quarter period. The peak impact would occur at roughly the same time as the waning impact of fiscal stimulus measures exerts a drag on growth. Those two headwinds could hold the economy back to a very anemic 1.5% pace by early 2020.

In the event of full escalation of the U.S.-China trade war, where the administration follows through on its threat of tariffs on a further $267bn in Chinese imports, the economic hit would double to 0.8 percentage points in total. That could push US growth closer to 1%. For now, it seems financial markets do not think that this outcome is too likely, but forecasters are becoming increasingly concerned about the risks to growth in 2019. The OECD lowered its targets for global growth slightly in its outlook published this week. It now expects the global economy to grow by 3.7% next year, down two ticks from its 3.9% forecast back in May citing downside risks from trade.

We also expect global growth to moderate next year to 3.6%, due to weakening emerging market momentum, without the impact from escalating China-U.S. trade tensions. The path forward on tariffs is not written in stone, and hopefully if the political rhetoric cools down after the U.S. mid-term elections in November, cooler heads might also prevail at the trade negotiation table.

Leslie Preston, Senior Economist | 416-983-7053

Trade developments and payrolls stole the limelight in this busy, holiday-shortened week. Concerns about emerging markets continued to weigh on investor sentiment with the selloff in EM assets and currencies spreading further beyond Turkey and Argentina. Meanwhile, the increased risk of another round of economic sanctions has sent the Russian ruble lower. While selling pressure eased somewhat by the week’s end, headwinds battering emerging markets are unlikely to dissipate soon. U.S. expansionary fiscal policy is buoying domestic growth, putting upward pressure on the dollar, inflation, and interest rates. At the same time, trade spats with China and other U.S. trade partners are weighing on overseas currencies and global growth. As a result, dollar strength coupled with worries about trade should continue to fuel investor flight from emerging markets.

Meanwhile, if cracks are appearing in U.S. business confidence, they were nowhere to be found in the August data. ISM indices for both manufacturing and services sectors rose handsomely (Chart 1), suggesting that U.S. industries remain at the top of their game. Even as tariffs continue to raise costs and play havoc with supply chains, companies report rising new orders and expanded production on the back of solid domestic demand that offers a deep cushion against potential tariff impacts.

Strong sentiment and economic momentum is boosting hiring, as evidenced by today’s payroll report, which showed that 201k new jobs were created in August. With the jobless rate hovering at historic lows, it is becoming increasingly difficult to find workers to fill positions. This continues to draw in workers from the sidelines (Chart 2) and also motivating firms to raise wages. As a result, the closely watched average hourly earnings measure rose 0.4% in August, accelerating to 2.9% on a year-over-year basis. This is the fastest pace of wage growth of the recovery, and may prove to be the start of the long-awaited sustained pickup in wage growth. 

Clearly the U.S. economy is barreling full steam ahead, and the estimated impact of tariffs has so far been quite small. The $50 bn in import tariffs on China and the steel and aluminum tariffs may shave roughly 0.2 ppts off U.S. real GDP growth in about years’ time, and add two tenths of a point to inflation. However, as we note in our report, the tariffs in place are only the tip of the iceberg relative to those under review or threatened. So far the U.S. has levied tariffs on $107 bn of imports into the U.S., but the total tariff action under consideration amounts to $715 bn. If implemented, they could place about 1.2 ppts of U.S. and 0.4 ppts of global growth at risk.

All told, an escalation in the trade spat with China and waning global demand may yet test the durability of the current expansion. However, for now the U.S. economy continues to boom with little reason for the Fed to alter its interest rate normalization plans that include another quarter point increase on September 26th.

Ksenia Bushemenva, Economist

The U.S.-Mexico trade agreement was welcomed by markets this week. Coupled with positive data flow, U.S. equities made further gains midweek. The agreement included augmented rules of origin for autos, strengthened intellectual property protections, and enhanced protections for labor and the environment (for a complete list see here). Details still need to be finalized, including Canada’s position. Today’s deadline for a tri-party agreement looks unachievable. An updated NAFTA agreement would allow the U.S. to shift focus back to resolving its trade dispute with China. News reports anticipate that President Trump will impose tariffs on an additional $200 bn of Chinese imports next week, helping pare back equity gains by week’s end.

Looking past shifting trade headlines, there was plenty to digest on the data front. Aside from pending home sales, which retreated for the 7th straight month in July and underscored the fact that housing remains a sore spot, data were broadly positive. Second quarter GDP was revised up slightly to 4.2%, beating expectations for a slight downgrade. Corporate profit data, released on the same day, added to the upbeat tone. Corporate taxes fell 33% from a year earlier, boosting after-tax profits 16% in Q2 – marking the best y/y gain since 2012. Tax cuts have indeed been bearing fruit, and they have been far more beneficial to businesses than households (Chart 1).

Personal income and spending data for July also proved positive. Nominal income (+0.3% m/m) and spending (+0.4%) recorded solid gains that were in line with prior months. On an inflation-adjusted basis, spending rose 0.2% m/m, extending the streak in real gains to five months and marking a good start to the third quarter. Last quarter’s 3.8% rebound in consumption will be hard to repeat. Nevertheless, upbeat consumer confidence, which is sitting at an 18-year high, along with continued employment gains and rising incomes all point to healthy consumer spending growth in the 2½ to 3% range for the rest of the year.

On prices,  it was encouraging to see the Fed’s preferred measure of inflation holding at target. Core PCE rose 2% y/y in July, and has been in the 1.9% to 2% range since March (Chart 2). Inflation is not too hot, not too cold – it’s just right. This should allow the Fed to continue its gradual reduction in stimulus. As such, an almost certain September hike will likely be followed by another one in December.

Although the U.S. economy is experiencing a goldilocks moment, the same cannot be said for many of its international counterparts. Financial troubles in Turkey and Argentina have policymakers there battling plunging currencies and surging inflation. Argentina’s central bank hiked its policy rate to 60% this week – the highest in the world. All told, although the impact of trade policy uncertainty and turmoil in some emerging markets has been limited thus far, they remain clear downside risks to the domestic, and global, economic outlook.

Admir Kolaj, Economist | 416-944-6318