Connor Hare

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

The holiday-shortened week was a very busy one for investors in Canada, with global political developments and economic data to digest. Equities faded late in the week on oil prices, pushed lower on higher Saudi production and trade tensions, but a broad-based recovery took hold, with a positive end to the week looking like at the time of writing. The U.S. implemented additional $34bn in tariffs on Chinese exports taking relations to a new low and weighing on the greenback – down 0.5% on Friday vis-à-vis most majors.

Escalating tensions between Canada’s two most important trade partners weighted on sentiment, but economic data has so far remained intact. Hiring resumed in June with the Canadian economy adding 32k jobs last month. Gains were led by construction and manufacturing, while services disappointed, losing jobs on net for the first time in five months. Despite the job creation, unemployment ticked higher by 20bps to 6.0% as more than 75k people entered the labour force – a six year high. Average wages decelerated, down some 30bps, but at 3.6% y/y remains near a decade-high (Chart 1).

Canadian trade figures were less inspiring with the deficit in May widening to $2.8bn. Imports were up 1.7% and 1.2% in nominal and real terms, respectively. They were somewhat boosted by airliner and gasoline imports, but strength was broad-based across categories, indicative of healthy domestic demand. Exports, on the other hand were weak, remaining flat in nominal terms while volumes fell 1.0%. While much of the weakness was related to transitory factors including supply disruptions in automotive parts and work stoppages in iron mines, exports are unlikely to surge going forward. Alongside ongoing NAFTA uncertainty, the imposition of tariffs in June will have a severe impact on the Canadian metals industry, with potential for downstream effects a real risk.

Another risk central to the Canadian economy is the housing market. This week we got June real estate board data for the two most closely watched markets in Canada. Figures from TREB suggested the recovery in the GTA market has begun in earnest. Sales rose for the first time this year (Chart 2), surging by nearly 18% in June according to TREB figures, but remaining well below historical norms. New listings, meanwhile, pulled back, helping rebalance the market. The tighter conditions led prices higher, with the HPI up about 0.2% while average prices rose over 3% - on account of increased activity in the most expensive single-detached segment. The GVA by contrast, saw both activity and new listings pull back around 10% apiece in June, according to REBGV figures. The decline in sales was the fifth in six months, with the softness manifesting in prices. The HPI was down 0.5% in June, the third consecutive decline and the weakest performance since late-2016, which also followed a provincial policy change.

Risks related to trade and housing will surely be top of mind for the Governing Council when it meets next week to discuss monetary policy. But, until they are seen as likely to materialize they will not drive monetary policy. This is set on incoming data and the outlook, which are relatively sanguine. From that standpoint, another 25 basis point hike next week is the most appropriate move.

Michael Dolega, Senior Economist | 416-983-0500

The U.S. economy slowed more than previously believed in the first quarter of 2018, with growth coming in at 2% ann. according to the BEA’s third estimate, down 0.2 percentage points from the second estimate. The downward revision was largely due to weaker consumer spending, while softer inventory investment also played a part. New data out this morning on personal income and outlays reinforce the notion that the soft start to the year was temporary. Supported by a healthy 0.4% m/m gain in nominal personal incomes, nominal spending rose a respectable 0.2% in May. But given inflation, consumption was flat in real terms. Strength in March and April still set Q2 consumer spending – currently tracking just shy of 3%, slightly below our forecast (Chart 1) – up for a rebound. We continue to expect the economy to grow by some 4% in Q2 given widespread strength in other components.

Consumer spending should continue to follow a decent 2.5% growth path in the second half of 2018, bolstered by a tight labor market and tax cuts, which will continue to support incomes. The latter will feature favorably for housing demand, even as interest rates rise. But a lack of inventory will constrict the sales pace. On this front, pending home sales – a solid gauge of near-term activity – retreated in May, marking the second consecutive monthly decline and weakening a previously improving trend.

Perhaps the most striking element from this morning’s report was inflation data. The headline PCE index ticked higher to 2.3% y/y, while core PCE (the Fed’s preferred measure of inflation) hit the bullseye of 2% for the first time in six years (Chart 2). These developments support our view for the Fed to continue raising rates gradually, with two more hikes expected for 2018. The focus now shifts from below-target-inflation to containing the upside risks.

With little else in the way of primary data, shifting headlines on trade remained an important driver of stock market activity. Markets opened lower on Monday after indications that the U.S. planned new curbs on Chinese investment in U.S. tech firms. Foreign policy also got in on the action, with crude prices surging on the anticipation of tougher U.S. sanctions on Iran. The rollercoaster ride in equities continued, with the President seemingly taking a softer stance on Chinese tech investment, but then hinting at the possibility of protectionist action on autos.

Ultimately, trade spats with a number of important trading partners risks siphoning away much of the economic boost from fiscal stimulus by way of higher consumer prices, reduced exports, supply chain disruptions, and by denting consumer and business confidence. Under the presumption that the tougher trade rhetoric is simply a negotiating tactic, there is still hope that common sense will prevail, and tensions will de-escalate. The risk, however, is that once the wheels have been set in motion, tensions can quickly escalate to a full-out trade war. China, Mexico and the EU have already retaliated to some degree, while Canada is announcing a detailed list of U.S. products to be slapped with retaliatory tariffs at the time of writing, which will take effect over the weekend. The U.S. may up the ante, further reinforcing the negative feedback loop.

Admir Kolaj, Economist | 416-944-6318

Our new quarterly forecast is titled Full Steam Ahead, which is an accurate description of our forecast. The American economy is barreling ahead with more momentum than we had expected. Real GDP growth is tracking 3.0% in 2018, revised up from 2.7% in our March forecast. This is a notable improvement from 2.3% in 2017, thanks in large part to fiscal stimulus.

A healthy economy is set to push the unemployment rate even lower over the coming quarters. This in turn will add to inflation pressures. Stronger economic momentum and firming inflation have prompted us to edge up our rate-hike expectation by an additional 25 basis points for this year, taking the upper end of the policy range to 2.5% by year end (see Financial Outlook).

At the risk of sounding like a broken record, 3% growth is difficult to sustain beyond a near-term cyclical updraft. The boost from tax cuts and government spending increases will start to fade next year. Add to that the reduced lift from monetary policy. The Fed has raised its policy rate 150 basis points over the past 18 months, and is expected to raise it 125 more over the next 18 months (Chart 1). Higher oil prices than in our previous forecast will also nip at consumer and businesses’ purchasing power. These cyclical concerns add to the underlying structural dynamics of the US economy. Even with an expected improvement in productivity growth, an aging population holds potential growth in the economy to roughly 2%.

All of these factors mean that on a quarterly basis growth is set to slow over the course of 2019, to 2.1% by the end of the year (Chart 2). Still, this should be kept in perspective. Even as the U.S. slows, it is expected to outpace all other G7 economies (see Global Outlook). And, when an economy is already running at 3%, the only real direction for it is to slow.

Now is the time in the economic cycle where so –called “animal spirits” can lead to excess risk taking, and sow the seeds of the next recession. For the U.S. it is as yet unclear what these unknowns might be. Indeed the factors that cause the next recession may come from outside the U.S.’s borders. But one potential risk is self-inflicted. An escalating trade war is a clear downside risk, particularly for the U.S.’s key trading partners (see impacts of auto tariffs on Canada), which would have knock on impacts at home. Even so, with the economy doing so well, it has sufficient economic cushion to absorb some negative shocks.

In an otherwise quiet week for economic data, we did get an update on the trigger of the last recession – the housing market. There a few signs of froth there. Housing starts continued their gradual upward trend in May. Residential construction has been on a stronger footing this year after weakness in multi-unit structures drove a lull in 2017. The existing home market, on the other hand, was a bit disappointing in May. Sales have trended down recently, as the market struggles with a lack of listings. Forward looking indicators suggests activity should improve in the months ahead. In time, construction of new homes should help, but improvement is expected to be gradual as affordability constrains demand.

Leslie Preston, Senior Economist | 416-983-7053

This was a busy week for soccer fans and investors alike. The former got treated to a kickoff of a month-long FIFA World Cup extravaganza in Russia, while the latter had a full docket of policy decisions from the Fed and the European Central Bank, as well as readings on inflation and retail sales and to close off the week an announcement of 25% tariffs on $50 billion of goods imported from China.

Tuesday’s inflation report got the ball rolling ahead of the FOMC rate announcement. As widely expected, inflation continued to gain traction in May. The headline and core consumer price indexes rose by 0.2pp (m/m) apiece to 2.8% and 2.2% (year over year), respectively. A strong economy, wage pressures and (now) tariffs will continue to push inflation measures higher in the coming months, particularly as businesses become more comfortable with passing higher costs to consumers (see Chart 1).

The Fed’s June rate hike looked like a done deal even before the inflation report, and indeed the FOMC raised the federal funds rate target by 25 basis points to a range between 1.75% and 2.0%. Details of the statement and  the accompanying economic projections were insightful. Notably, the statement removed its forward guidance that the “federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”  With committee member projections showing the federal funds rate rising above its anticipated “longer run” rate by 2019, this made sense. The Fed’s increased confidence in its rate hiking path was also illustrated in an edging up of the median expectation for the fed funds rate to 2.4% (from 2.1%) this year, implying two more rate hikes this year (one more than previously). During the press conference, Chairmen Powell also said that starting next year he will be holding a press conference following every FOMC meeting, a move likely aimed at freeing up Fed’s hands somewhat with respect to future rate changes.

The Fed’s view that economic growth is revving up was corroborated Thursday’s retail sales report. Spurred by tax cuts, job gains and rising incomes, American consumers have been on a tear for the last three months, and in May retail sales surged by 0.8% – double the expectations and the biggest jump in half a year. Helped along by a pickup in consumer spending, GDP growth is currently expected to surpass 4% (annualized) in the second quarter, and average 3% for the year as whole – the best result since 2005.

While the U.S. economy may be sizzling, there are risks on the horizon. As with tariffs on steel and aluminum, the recent tariff announcement on Chinese goods sparked a retaliatory action by China. Taken alone these tariffs are likely to present a modest drag on U.S. growth and modest lift to inflation (please see our recent report on U.S.-China tariffs). However, while direct impacts are modest, the hit to business confidence and supply chain disruptions could result in a more deleterious effect on growth, So far, financial markets have taken these skirmishes in stride, but a further escalation or full out trade war could bring this assumption into question.

Ksenia Bushmeneva, Economist | 416-308-7392

Next week the Federal Open Market Committee (FOMC) will meet for the fourth time this year to discuss whether the current level of stimulus is appropriate for the U.S. economy. During their discussions they will evaluate the health of the economy, wage and price pressures, and emerging risks before deciding on revisions to their outlook for economic activity, inflation, and the future path of the fed funds rate.

The U.S. economy is firing on all cylinders at the moment. Growth in the second quarter is currently tracking a blistering 4.0% annualized pace, helped along by a strong rebound in household spending, firm business investment, and surprising strength in net exports. What’s more, growth is expected to continue at a 3.0% annualized pace on average for the remainder of the year, with fiscal stimulus contributing about half a point.

Strong economic activity is working to absorb any remaining spare capacity. The unemployment rate is at an eighteen year low, and as of April there were more job openings than there were job seekers (Chart 1). Wage growth is healthy by historical standards, but should move even higher as skilled labor becomes scarce. But, wages typically keep up with productivity growth, and on that front the U.S. economy continues to perform below historical trends (Chart 2).

Consumer price inflation is above 2.0%, a sign that the U.S. economy is bumping up against capacity constraints. Add higher fuel prices, higher import prices due to increased tariffs, and strong wage growth, and it’s just a matter of time before profit margins get pinched enough for firms to pass on rising costs to consumers. All told, headline consumer price inflation is likely to peak at 2.7% this year, with the Fed’s preferred measure, the core personal consumer expenditure deflator, holding near its target of 2.0% through the end of this year.

Altogether, this solid outlook should be more than enough to convince the FOMC that the U.S. economy does not require the amount of monetary stimulus currently on offer. As a result, the fed funds rate is likely to move up by 25 bps next week, with another hike or even two embedded in the updated dot plot summary for this year.

That said, although further rate hikes are certain, their exact timing is still open for debate. Geopolitical risks remain elevated, and a policy misstep or two may be just enough to send financial markets, business confidence, and global trade into a tailspin. Trade skirmishes could easily escalate into trade wars, particularly if talks fail to make progress between the U.S. and its major trading partners. Although much better prepared than in past tightening cycles, emerging markets remain at the mercy of nervous investors who are more concerned with capital retention than returns in such an uncertain environment. Argentina and Turkey were the first victims of speculative attacks, but they surely will not be the last during this tightening cycle. All told, in light of these and other risks, the FOMC is likely to stay on its current path of gradual rate hikes.

Fotios Raptis, Senior Economist | 416-982-2556

The theatrical twists and turns of this week’s events are worthy on an opera, with the opening act set in Italy. Political turmoil and fears that new elections in Europe’s fourth largest economy could strengthen the grip of Eurosceptic parties spooked investors, who began to unload Italian assets. This sent yields on short-term government debt skyrocketing (Chart 1). Investors also steered clear of other southern European debt, with short-term Spanish, Greek and Portuguese bonds also selling off. Concerns regarding new elections subsided as the week wore on, and these moves began to reverse course. By the end of the week the populist coalition was allowed to form a government. Still, the fact that the new Italian government – which favors tax cuts and spending increases – is likely to clash with the E.U. on a number of issues, suggests that this is merely a new chapter which may further tests the bloc’s stability. The sheer size of Italy’s economy – roughly ten times that of Greece – will warrant special attention.

Markets were thrown another curve ball when the White House announced that it would be pushing ahead with tariffs on $50B of Chinese goods and end the exemption on steel and aluminum tariffs for the E.U., Canada and Mexico. These normally close allies pledged to challenge the tariffs through the WTO and NAFTA channels and levy retaliatory tariffs. At around $12.6B and $7.7B of U.S. products targeted by Canada and the E.U. respectively, and an estimated $4B in trade with Mexico, the amount of affected trade is still quite small. But the wide list of products marked for tariffs, which stretch from agricultural products to motorcycles, are sure to strike a sour cord with the U.S. Ultimately, the tariffs will make goods more expensive for the American consumer. In a prior analysis, in which we expected the exemptions for the allies to stay, we estimated that the tariffs would have a muted direct impact on U.S. economic activity and inflation. The recent events make us more confident that while the impact on U.S. economic activity is still expected to be limited, the tariffs are likely to boost consumer price inflation by at least 0.1 percentage points this year and next.

Behind the curtain of the unfolding Italian and trade sagas, U.S. economic data was broadly positive. American consumers were back in full force in April, with personal spending rising by a robust 0.4% in real terms, building on a solid March print. The back-to-back gains point to a 3.5% rebound in second quarter consumer spending after a soft first-quarter print (1% Q/Q ann.). This narrative is further reinforced by a strong labor market. In May, payrolls gains (223k) beat expectations, the unemployment rate fell to an 18-year low (3.8%) and wage growth accelerated to 2.7% y/y (Chart 2). Rounding out the good economic news was an above-consensus print in the ISM manufacturing index, which pointed to manufacturing activity accelerating in May.

The latest data cement the case for a Fed rate hike on June 13th. But this is no time to fall asleep, with further policy rate normalization also requiring a watchful eye on developments out of Europe and the potential fallout from heightened trade tensions. For now, Nessun Dorma.

Admir Kolaj, Economist | 416-944-6318

The FOMC minutes, renewed trade tensions and a cancellation of the June summit with North Korea made the week anything but boring for investors. It was also a politically-charged week across the Atlantic. U.K. negotiations with the EU soured over U.K.’s participation in the Galileo satellite project, while the new Italian Eurosceptic government appointed Giuseppe Conte as prime minister.

Financial markets rallied on Monday on the news of positive weekend developments in the U.S.-China trade dispute. Details of the agreement were vague and largely unquantifiable as far as trade deficit reduction targets are concerned. In the follow-up statement China agreed to  “meaningfully” increase imports of U.S. agricultural and energy products, and lowered tariffs on imports of autos and parts. These relatively limited concessions were sufficient to put the proposed tariffs on $50 billion worth of Chinese goods set to take effect on May 21 on hold.

Although U.S. trade tensions with China have eased for now, they have flared up elsewhere, weighing on market sentiment later in the week. On Wednesday President Trump ordered a review of automotive imports, citing national security concerns. The decision drew sharp international criticism and warnings of retaliatory tariffs, but was also opposed domestically. Automakers as well as Republican lawmakers expressed concerns that, if imposed, auto tariffs will raise auto prices for consumers, disrupt supply chains, start trade wars and alienate U.S. allies.

Worries about trade also showed up in the FOMC minutes. Specifically, the FOMC members acknowledged that trade uncertainty could hurt business sentiment and investment intentions. As for the monetary policy discussion, the FOMC members agreed that they would soon need to “take another step” in removing monetary accommodation, with a June rate hike looking like a done deal. At the same time they stressed that the Fed’s inflation objective is “symmetric”, suggesting they will allow inflation to temporarily overshoot 2%. All told, we remain of the view that a total of three rate hikes this year the is most likely outcome.

Higher interest rates will certainly have an impact on the housing market. After declining by 6% in the first quarter, existing home sales have started the second quarter on a weak footing as activity fell 2.5% in April. Sales of new homes also took a break in April, declining by 1.5%. Since the start of the year, the average rate on a 30-year mortgage rose by 70 basis points. Rising rates alongside brisk growth in home prices have dented affordability; however, this is only part of the story behind relatively tepid home sales. Low inventory of houses on the market has  been the most important factor restraining resale activity (Chart 1), but the pace of construction remains modest and will likely be contained by labor shortages and rising input costs. The price of American steel rose 40% this year, while lumber prices are up 34%. Some relief to the housing shortage may come as more existing homeowners, with fully rebuilt home equity (Chart 2), become encouraged to list their homes. However, the overall pace of activity in the housing market will likely once again remain modest this year.

Ksenia Bushmeneva, Economist | 416-308-7392