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

Aside from the political storm in Washington, this was a relatively quiet week. Data-wise, new and existing home sales and durable goods orders were on the docket. On the policy front, highlights included minutes of the FOMC meeting and the central bankers’ conference in Jackson Hole. On the trade front, new China-U.S. trade talks failed to produce any meaningful results, while the latest batch of tariffs targeting $16 billion of each other’s goods came into effect. Despite the deepening trade spat with China, U.S. business investment has remained upbeat in July, with new orders of capital goods (ex. aircraft) rising 1.4% m/m, up 8.5% from a year ago.

Financial markets’ jitters eased somewhat this week as concerns about emerging countries have temporality subsided. This was helped by the lower U.S. dollar, which has reversed some of its recent strength following president Trump’s comments that he was “not thrilled” about the Fed’s interest rate increases.

Like it or not, the latest FOMC meeting minutes have signaled that the committee continues to view gradual interest rate increases as appropriate, so long as the economy evolves in line with its expectations. For now this continues to be the case. The committee noted the recent strength in economic growth and expressed confidence in the outlook, despite downside risks stemming from trade tensions. Taken together, these comments signal another 25 bp rate hike in September, and likely one more in December. At Jackson Hole, Chair Powell reiterated his support for the gradual pace of monetary policy normalization and defended the Fed’s current approach.

Concerns about Turkey drove volatility in global financial markets this week, but U.S. equity markets rebounded as contagion fears diminished. A key factor driving emerging market concerns is the strong U.S. economy. Robust economic growth and rising interest rates favor U.S. assets, and the safe haven flows driven by emerging market fears drives dollar strength (Chart 1). This week, we received further affirmation that the U.S. economy is on course to post another strong showing this quarter. Retail sales, a key indicator of consumer spending, expanded 0.5% in July, well above expectations (Chart 2). Moreover, despite trade policy uncertainty and ever more acute labor shortages, small business optimism remains at a historical high. Although housing starts in July were somewhat disappointing, the combination of strong permits and rising wages should support a gradual uptick in construction in upcoming months.

As the U.S. economy hums along nicely, other economies are not faring so well. Turkey experienced a large selloff of assets and the lira as it failed to take action to calm debt fears. Last quarter, concerns about the financial outlook for Argentina drove a dramatic depreciation in the peso, forcing the central bank to raise domestic policy interest rates to 40% in an attempt to slow capital outflows. Like Argentina, Turkey depends heavily on foreign capital to finance domestic spending. Moreover, President Erdogan has weakened Turkey’s political institutions and refused to allow domestic interest rates to rise. This has amplified concerns that Turkey is headed for a debt crisis.

Like Argentina, Turkey is too small in the scope of the global economy to trigger a broader global crisis. Turkey’s economy is responsible for about 1.7% of global annual output (2016 purchasing power parity), a little more than Canada at 1.4%. Contagion risk via trade linkages is low, although Europe is most exposed. Similarly, financial contagion is limited, with Spanish, Italian, and French banks at risk to lose a tiny proportion of foreign loans.

That said, contagion to other economies can still occur through confidence and sentiment channels. That was evident this week with the turmoil in global financial markets that drove a selloff in risk assets and emerging market currencies, and a bid for developed market bonds. Further bouts of volatility are likely as emerging market economies with large imbalances are targeted one-by-one by increasingly discerning investors.

Although concerns eased by week’s end, Turkey is not out of the woods yet. It remains in the early stages of a balance of payments crisis. A sudden stop to capital inflows has occurred, and the next step for Turkey involves spending cuts and an emphasis on boosting exports to help generate foreign currency required to pay for its large external obligations. The medicine will be bitter, but the sooner Turkish authorities follow through with interest rate increases, capital controls, and fiscal spending cuts, the more likely they can mitigate the economic fallout.

Fotios Raptis, Senior Economist | 416-982-2556

For the second week in a row, action on Chinese import tariffs dominated the economic news, in what was a relatively quiet week for data. Markets remained positive overall, despite the headlines, likely reflecting relief that oil prices have come off their recent highs.

President Trump had previously threatened that if China retaliated to the first tranche of U.S. tariffs, he would order further 10% tariffs on $200 bn worth of Chinese imports. China indeed retaliated, and so this week the U.S. Trade Representative (USTR) started the process of making good on this threat by publishing a list of goods which would be subject to a 10% tariff. To be clear, these tariffs are not immediate; they need to go through a two-month process before being enacted. The USTR will hold a public consultation period ending on August 30th.

So far, China has held off on announcing knee-jerk retaliatory tariffs. It remains to be seen what steps China might take. In the meantime, this creates uncertainty for businesses, and likely further volatility in the trade data, as businesses attempt to ramp up shipments ahead of the potential tariffs. In this way, and in prices for many commodities, even potential tariffs have an impact on real economic activity.

These tariffs will raise input prices for many American businesses, but the extent to which they are passed on to consumer prices will depend on the competitive environment of the industry. If businesses can’t pass on price increases to their customers (for fear of losing too much market share), they may have to cut costs by reducing staff or planned investments. Both of these actions will crimp growth in the overall economy. If tariffs are fully passed on to consumers you get higher inflation, and slower growth by a different channel. The federal government may mitigate the negative impact by funneling the tax revenues back into the economy.

In a perfect world, the Fed will look through one-time price increases caused by tariffs. However, if tariffs are placed on a wide variety of goods further up the supply chain, it makes it difficult to disentangle how much inflation is due to a hot economy, and how much is the result of tariffs. That raises the risk the Fed misinterprets the inflation signal.

This suggests the Fed is likely to be very cautious. This week’s June CPI data was too early to pick out evidence of import tariffs. Overall the data showed yr/yr inflation continued to rise as expected, reaching 2.9% (Chart 1). Core inflation was 2.3% yr/yr, having risen steadily for the past year. The upswing in annual inflation in part reflects comparisons to low readings last year. Monthly increases look steadier (Chart 2), with little acceleration in June.

Next week Chair Powell testifies before Congress on the economy. It should have been a straightforward good news story of a strong economy, with inflation rising in a non-threatening way and gradual increases in interest rates. Now, he is likely to face questions on the impacts of tariffs, which are both uncertain and hard to forecast.

Leslie Preston, Senior Economist | 416-983-7053