U.S. election upended

On the U.S. presidential election front, one is tempted to invoke Lenin’s famous line that “there are weeks where decades happen.” A lot has transpired lately.

With barely more than three months until the vote, President Biden succumbed to Democratic Party pressure and has decided not to contest the election. This, after trailing substantially in the polls, performing abysmally in the first debate, and given mounting concerns about his health.

Meanwhile, on the Republican side, former President Trump survived a shocking assassination attempt that very nearly killed him. He did so in sufficiently heroic fashion that his campaign enjoyed an initial surge of support.

Trump also selected his running mate, J. D. Vance, who shares the Republican candidate’s populist views and is perhaps even more isolationist from an economic and a geopolitical perspective. Vance is also anti-big business, anti-tax cuts for the wealthy, and in favour of collective bargaining. The Republican Party is no longer the party of Reagan. Of course, the Vice President doesn’t get to set policy.

Who will face Trump for the Democrats? Despite some initial uncertainty, the party has rapidly united around Vice President Kamala Harris. She is nationally known, already on the ticket and can directly access Biden’s election war chest. Betting markets assign a likelihood above 90% and rising that she will be the Democratic Party candidate. This is almost certainly too low, as nearly all of the party’s powerbrokers have lined up behind her, and she has already secured enough delegates for the nomination.

What is clear is that the election is now more uncertain than it was just a few weeks ago. And despite all of the gyrations, a Trump victory is now somewhat less likely than before. Betting markets assign a 54.5% chance that Trump will win, versus 45.5% for Harris.

The alternative is an open convention in which multiple candidates vie for votes among party members. This last occurred in 1968. But an open convention presents a number of drawbacks:

• It would risk fracturing the party along ideological linesand possibly lurch the party further to the left at a time when the political centre is unoccupied

• It would leave too little time for the victor to mount a proper challenge against Trump.

• It would occur too late to get the winner on the Ohio election ballot.

While Harris is herself viewed as occupying political space to the left of Biden, in practice she appears to have moved somewhat closer to the centre since her ill-fated attempt for the 2020 Democratic nomination. Furthermore, she will likely feel some obligation to demonstrate continuity with Biden’s policies. In practice, presidents are constrained by Congress from pursuing especially aggressive policies.

The bottom line is that Harris would be unlikely to govern in a manner that is materially further to the left than Biden.

Current polling argues that Trump is still the clear favourite in the election (see next chart). But Harris polls somewhat better than Biden, and she is now enjoying something of a popularity bump. Whether that bump lasts and how the public will like Harris as they get to know her better is unclear.

What is clear is that the election is now more uncertain than it was just a few weeks ago. And despite all of the gyrations, a Trump victory is now somewhat less likely than before. Betting markets assign a 54.5% chance that Trump will win, versus 45.5% for Harris.

Likelihood of a Republican president has waxed and waned in prediction markets

As of 07/24/2024. Based on prediction markets data and RBC GAM calculations. Sources: Predictit, Macrobond, RBC GAM

One might further posit that the Democratic Party, even if ultimately contesting a losing battle for the presidency, may fare somewhat better in down-ballot races with a more popular headliner. In turn, the odds of a Republican sweep have diminished somewhat. This had never been the base-case scenario but was viewed as an increasingly conceivable secondary scenario so long as Biden was in the race. Betting markets show that Democrats are currently expected to capture the House of Representatives, even as they are predicted to cede the Senate to the Republicans (see next chart).

The outlook for the 2024 U.S. elections is shifting

As of 07/24/2024. Probabilities for presidential election measured as the median probability of winning from oddschecker, Predictit and RealClearPolitics (RCP). Probabilities for Senate and House are crowd forecast from Good Judgment. Sources: oddschecker, Predictit, RCP, Macrobond, RBC GAM

From a financial market perspective, we’re now seeing what’s called the “Trump trade,” which is bringing a stronger dollar, higher yields and an enthusiastic stock market – especially non-mega cap stocks.  This phenomenon is driven by the Trump platform. Tariffs and economic stimulus both boost the dollar, stimulus and higher debt increase yields, and the stimulus also boosts the stock market. Furthermore, Trump and Vance have a particular skepticism toward large tech companies. This helps to explain why these firms have not participated as much as others in the current market rally.

This is not to say that the Trump trade will necessarily continue. Of late, it has been the reverse as Harris has enjoyed an initial honeymoon. But the odds are still skewed toward a Trump win, which would revive the Trump trade.

Executive powers shifting

U.S. executive power has been mounting in recent decades. Successive White House administrations have pushed the envelope in how they direct public bureaucrats to interpret and execute U.S. laws.

The wiggle room that permits this arises from two places:

1. There are almost always points of ambiguity within a law that permit a range of interpretations.

2. The executive branch gets to decide how many resources should be allocated toward the execution of each law – effectively determining how powerfully a law is enforced.

There are of course checks on the executive powers of a president. There is  capacity to clarify legislation via the legislative branch and via court challenges that then allow the judicial branch to opine on what constitutes overreach.

Still, there have been a lot of executive orders implemented by recent administrations. The raw number issued by Biden is not far behind the towering number Trump issued before him. Immigration has been a particular focus of successive presidents. The Biden administration has also focused on student loans and the environment, while the Trump administration previously emphasized international trade.

We mention all of this to set the stage for two major new developments that could alter how executive orders work going forward. The first would appear to modestly increase the power of the White House, while the second could profoundly reduce it.

1. On July 1, the Supreme Court ruled that presidents are immune from prosecution while they are carrying out “official acts.”  While the focus has been mostly on the protection this gives former President Trump in the context of his various legal challenges, it could also embolden future presidents to act more forcefully, knowing that even if their actions are later judged to have exceeded legal limits, they will not suffer prosecution for those actions. That represents at least a small increase in the power of the executive office, even if one would hope that future presidents will still endeavor to steer clear of legally questionable actions.

2. A different Supreme Court ruling on June 30 may arguably limit the power of the executive office. – This edict overruled “Chevron”, a landmark case from 1984 that had granted federal agencies “reasonable” flexibility over their interpretation of U.S. laws. Now that this is off the books, presidents may find themselves much more limited in terms of what they can accomplish via executive orders. At a minimum, executive orders and agency decisions will be more vulnerable to court challenges.

Some argue that this merely formalizes the increasingly activist role that lawsuits and courts have already taken in interpreting laws in recent years. So perhaps the change will not be so extreme. But some additional restrictions seem likely, especially in areas that are seeing particular presidential reach such as the environment, labour rules, the border and tariffs.

At the risk of generalizing too far, if presidents are incrementally limited in their ability to introduce new rules, then one might argue this constitutes a bit of deregulation – fewer restrictions, overall – with potentially positive implications for businesses and the stock market. Of course, it matters what specific rules are eventually challenged or rejected by the courts, as there are many executive orders that indirectly help certain businesses. This will probably be a slow-moving affair but could ultimately prove to be one of the more important developments of the year.

IT outage aftermath

The global CrowdStrike IT outage is being described as the Y2K-magnitude tech disruption that actually happened. What’s more, and unlike Y2K, it was completely unanticipated. On the other hand, a software patch has already been rolled out.

The bottom line is that most of the world’s businesses reliant on computer systems were either disrupted or scrambling for a day or two, with some lingering effects expected over a few weeks. For example:

• Many airlines had to ground flights altogether.

• Hospitals lost access to patient records.

• Banks and financial markets were unable to function completely normally.

• Hotels couldn’t access booking records.

• Border crossings had long delays.

This sort of short-term shock has the potential to subtract modestly from July economic output, but with the important counterpoint that the disruptions are already rapidly vanishing. There will also likely be some catch-up in the coming days that partially neutralizes any negative impact on GDP. This is all akin to the temporary economic distortions that frequently arise with natural disasters.

Longer-lasting repercussions could include a greater focus by businesses on the resilience of their IT systems – perhaps to the point of sacrificing a modicum of profitability at the altar of reliability.

Similarly, it seems reasonable to expect regulators, who already eye technology companies with suspicion, to further increase their scrutiny. This raises the risk of additional regulations potentially limiting the nimbleness of said tech companies.

Fiscal health reckoning?

In recent years, we have repeatedly bemoaned the yawning fiscal deficits (see next chart) and large public debt loads (see subsequent chart) that prevail around the world. We’ve flagged that markets may start to pay more attention to the problem once other pressing challenges such as inflation ease. We have also spoken ominously about the need for some sort of resolution or reckoning in the years ahead.

Fiscal deficits are quite large for a number of countries

Data for 2023. Sources: International Monetary Fund, Macrobond, RBC GAM

Many countries have high debt to GDP ratio

Data for 2023. Sources: International Monetary Fund, Macrobond, RBC GAM

The issue has become especially acute now that global interest rates are no longer as low as they were in the 2010s. Furthermore, large deficits were perhaps excusable during the worst moments of the pandemic, but those days are now long past. There is little justification for the sort of fiscal excesses that presently exist given that economies are by and large operating near their potential and inflation is still above target.  

Quantifying the problem

Rather than continue with broad generalizations, let us properly dig into the numbers (see next table). Our goal is to quantify the problem across countries and identify possible solutions.

Our latest fiscal health scorecard

2023 data for all indicators except interest payments (2022) and GDP growth (International Monetary Fund (IMF) forecast for 2020 used as proxy for ‘normal’). Fiscal adjustment refers to the necessary reduction in fiscal deficit to stabilize debt-to-GDP ratio. Sources: IMF, Macrobond, RBC GAM

We have constructed a fiscal health index for each of 27 countries, recognizing that fiscal health isn’t just a function of one single thing. Instead, it’s an amalgam of:

• The public debt load as a share of gross domestic product or GDP (fiscal metrics include all levels of government)

• The current-year fiscal balance as a share of GDP

• The fiscal adjustment – the necessary reduction in a country’s deficit as a share of GDP to stabilize its debt-to-GDP ratio

• Interest payments on the public debt as a share of GDP, which reflects how much of a country’s economic capacity is redirected toward servicing public debt obligations

• The steady-state economic growth rate, which speaks to how quickly a country can grow its way out of fiscal trouble

• The current account balance, which informs whether a country is a net saver or a net borrower on the aggregate when the private sector is also included

• Whether public debt is owed domestically or rather to foreigners (which speaks to the potential fickleness of a country’s bondholders and also vulnerability in the event of a depreciating currency)

• Whether a country controls its own currency (which provides additional flexibility for managing debt problems due to the ability to adjust one’s exchange rate and monetary policy).

Each variable assigns a score ranging from 1 to 5, wherein 1 is “Good” and 5 is “Extremely poor.” These are colour-coded in the table and the charts. The various variables are then weighted and combined to produce the fiscal health index for each country (see next chart).

Only a few countries demonstrate good fiscal health

Fiscal Health Index measures a country’s fiscal health on a scale of 1 (good) to 5 (extremely poor) and is constructed using a weighted average of various fiscal metrics. Sources: Macrobond, RBC GAM calculations.

To summarize the results, Denmark, Sweden and Ireland positively sparkle in the fiscal health index, with Russia, Australia, South Korea and the Netherlands not too far behind. Each has a relatively low public debt load, runs a surplus or small fiscal deficit, allocates little public funds toward servicing its debt, and doesn’t have to make any fiscal adjustment whatsoever to remain on a sustainable track.

At the opposite extreme is Italy, trailed at some distance by the U.S., U.K., Japan and Brazil. France and Belgium also merit mention. This group is a bit more varied in its characteristics. Italy fares poorly across nearly every metric, with an especially problematic debt load, deficit and necessary fiscal adjustment.

The U.S. fares even worse than Italy with regard to the deficit and is similarly positioned in its necessary fiscal adjustment, but a saving grace is that the U.S. is starting from a somewhat lower debt level and has a faster economic growth rate. The U.S. also enjoys a special privilege not directly captured by the fiscal health index: as the world’s reserve currency, it is less likely to suffer the sort of bond-buyer strike that other countries are more vulnerable to. But it is not completely immune to paying higher interest rates in response to a perceived fiscal risk, as demonstrated by the increase in the country’s term premium over the past few years.

While still poor, the U.K. has a smaller debt load, a lower deficit and a smaller current account deficit than the U.S., but it fares worse in its interest payments and economic growth rate.

Japan, of course, has its famously enormous public debt load (252% of GDP), a sizeable deficit and a slow GDP growth rate. But it has the advantage of paying very little in interest due to ultra-low interest rates. It must be conceded that Japan arguably fares better than it should in our fiscal health index since our system of bucketing assigns the same “Extremely poor” score for Japan and Italy’s debt, even though Japan has nearly twice as much as Italy.

Brazil doesn’t have an especially high public debt load, but its deficit is quite large, it suffers from very high interest rates, and critically – unlike many emerging market countries – its economic growth rate is quite meagre.

Some other countries rate especially poorly in one category, such as Greece’s sky-high debt to GDP of 169% and India’s deficit-to-GDP of 8.7%. But they make up for it with superior metrics elsewhere. Greece, for instance, now runs just a small deficit. India has such an extraordinary economic growth rate that it can sustain a deficit far higher than most countries.

Perhaps unsurprisingly, emerging market countries tend to have the highest interest payments given that they are usually subject to a larger risk premium in bond markets (see next chart). Of course, they also usually manage faster growth rates.

Some countries are more burdened by interest payments than others

Data from 2022. Sources: Public Finances in Modern History Database, IMF, RBC GAM

While Canada sports a high debt-to-GDP ratio, its deficit is sufficiently small that it is better positioned than many of its peers.

It is somewhat reassuring that most countries have previously experienced higher debt-to-GDP ratios than today (see next chart). However, we must not downplay the risk that currently exists. Some of the historical records were set during the pandemic or in the aftermath of the global financial crisis when the GDP denominator was artificially depressed. Other records were set during an era when the sustainable GDP growth rate was considerably greater (making it easier to later pay down the debt).

Debt-to-GDP ratios are high but not record-breaking

Data for 2023. Sources: IMF, Macrobond, RBC GAM

Seeking solutions

What do countries need to do to get back onto a sustainable footing? The bare minimum is to stabilize their debt-to-GDP ratios near current levels. The necessary fiscal adjustment in the chart below reflects how much a country’s deficit must shrink as a fraction of GDP to achieve this basic goal.

Some countries require significant fiscal adjustment

Data for 2023. Fiscal adjustment refers to the improvement needed in a country’s fiscal balance to stabilize the public debt-to-GDP ratio. Sources: IMF, Macrobond, RBC GAM

This isn’t a perfect metric, as it shows Norway as having the most work to do. That is technically accurate, but also not quite fair as Norway has a public debt-to-GDP of just 42% – one of the lowest among the 27 countries. Norway can afford to run a large deficit and let its debt load rise for longer than almost any other country.

The concept is more useful for countries with already-high debt levels. Italy, the U.S. and Japan exist within the Venn diagram intersection of high public debt and a large necessary fiscal adjustment. Not coincidentally, these are three of the four worst countries in our fiscal health index.

The added value of the fiscal adjustment metric is primarily in the fact that it gives a good numerical sense for how hard the job will be to stabilize debt-to-GDP ratios. The 4.5% for the U.S. means that the U.S. must reduce its deficit as a share of GDP by a whopping 4.5 percentage points. To be clear, this would still leave the U.S. with a deficit, but one that is small enough to be balanced out in the debt-to-GDP ratio with positive nominal economic growth.

How might the U.S. go about making the 4.5 percentage point adjustment?

Certainly, the most conventional and mechanical way would be to scale back government spending or increase government revenues. But that isn’t a political priority for either presidential candidate at present. What’s more, simplistically presuming a fiscal multiplier of one, doing so in a single year would guarantee a fairly deep recession. Doing so over two years would also very likely result in a recession. Thus, even optimistically, it would take four-plus years to resolve, and that’s only if the political will suddenly arises. This is why we talk about the likelihood of a medium-term economic malaise as fiscal excesses are addressed across a range of countries over a multi-year period.

The most likely scenario at present is that countries do very little in the near term, beyond perhaps nudging their deficits slightly lower. But it seems inevitable that something more forceful will be necessary later.

A preferable solution would be to increase the sustainable economic growth rate. There is a chance that rapid technological change juices productivity growth, or that some other exogenous shock allows economies to grow sustainably more quickly. But it can’t really be counted on – it merely represents an upside risk.

Countries might also opt to run a higher inflation rate. After all, it is the rate of nominal economic growth that matters for measuring debt-to-GDP ratios, not real growth. Inflation is a part of nominal growth. This is one of the reasons why people occasionally speculate that governments might opt to leave inflation somewhat higher than before the pandemic, perhaps in the high 2% range. This is possible, though at present central banks don’t appear inclined to stop until they get closer to 2%. That said, we do assume that long-term inflation runs a hair over 2%. This will help, but only a bit, and the assistance is only temporary because once the bond market figures out what’s going on, and once government debt has rolled into the new interest rate regime, the advantage is significantly lost.

The other option is to default on a portion of their debt. This usually isn’t an explicit “sorry we aren’t paying you back”, but instead usually involves an alteration to the terms of the debt, such as paying a smaller coupon or delaying the maturity date of the debt in a way that reduces its present value and saves the government money. This is what happened in Greece during its sovereign debt crisis. This would be an extreme last resort and doesn’t appear especially likely right now. But were Japanese bond yields to rise sharply, the country’s debt load might become unbearable and force an extreme outcome. Or if a deep recession were to arrive that pushes countries with deficit-to-GDP ratios already north of 6% past, say, 10%, debt loads could quickly become unsustainable. But, to be clear, defaulting remains a low probability outcome.

The most likely scenario at present is that countries do very little in the near term, beyond perhaps nudging their deficits slightly lower. But it seems inevitable that something more forceful will be necessary later. Perhaps technological change will come galloping to the rescue, and it seems reasonable to guess that inflation might run a hair hotter than otherwise. But the main force will have to be governments tightening their belts, likely after the bond market expresses its displeasure via a higher risk premium. Recall that the bond market screamed at the U.K. in the fall of 2022, pulling down the prime minister and altering the fiscal trajectory.

As noted above, the adjustment will have to occur over the span of multiple years and perhaps even multiple administrations, will be enormously unpopular as it happens, and is a strong argument for economic growth over 2025 through to the end of the decade being somewhat more muted than normal.

Critically, not all countries are affected equally, with some in a position to sail through largely unaffected while others – those with the worse fiscal health indexes – have some work to do and may suffer worse economic growth and larger bond market risk premiums.

A U.S.-specific danger is that the country might do nothing at all, given the utter disregard for fiscal finances at the political level and its special status in the global bond market. But this is highly dangerous. There is a very real scenario in which the U.S. debt-to-GDP ratio drifts ever higher until it more closely resembles that of Japan – minus the ultra-low interest rates. Even if the bond market never balks, the U.S. would find itself dedicating an ever-larger fraction of its productivity capacity to servicing debt as opposed to delivering services or leaving the money in the hands of taxpayers. Chronic economic problems could easily arise.

Admittedly, the math isn’t quite so simple given that every dollar of interest payments goes to a saver who might well deploy it productively themselves. But the work of Reinhart and Rogoff among others argues persuasively that higher debt loads are associated with worse economic outcomes. At a bare minimum that is something to avoid.

Improving inflation

Inflation fears continue to fade. The matter is hardly resolved altogether given still-elevated inflation readings and a variety of upward forces (shelter costs, shipping costs, wages) and risks (expansive fiscal policy, oil-relevant geopolitical turmoil) that persist. But the downward trend is clear, with a softer U.S. economy – discussed later – adding to the argument that further progress is possible on a trend basis. Lower inflation in turn opens the door for nearer-term rate cuts.

After the U.S. Consumer Price Index (CPI) improved modestly in April and then massively in May, it again delivered a big improvement with the June data. Headline prices actually fell slightly, while core inflation arrived at a mere +0.065% month-over-month (see next chart). The 3-month annualized rate of core inflation is now down to just 2.1%. That’s essentially in line with the Federal Reserve’s 2.0% target (see subsequent table).

U.S. Consumer Price Index monthly trend shows drop in inflation

As of June 2024. Shaded area represents recession. Sources: U.S. Bureau of Labor Statistics (BLS), Macrobond, RBC GAM

Inflation moving closer to the Federal Reserve’s 2% target

Note: As of Jun 2024 for CPI and PPI measures, May 2024 for PCE measures. Source: BEA, BLS, Federal Reserve Bank of Cleaveland, Federal Reserve Bank of Dallas, Macrobond, RBC GAM

Importantly, rent and owner’s equivalent rent both decelerated to +0.3% month-over-month for the first time since August 2021. Shelter costs have been by far the largest single driver of inflation, and while we have long known that the lags built into the index’s calculations should allow shelter inflation to retreat over time, it is nevertheless a relief that it is actually happening. There should be room for a further modest deceleration in the quarters ahead.

Elsewhere within the price basket, car prices continue their descent. On the service ex-shelter side, where inflation is still a heated +4.8% year-over-year, the 3-month trend has now ebbed to a quiet +1.3% annualized. Contributing to this, flight costs, education services and even insurance inflation (which had been a massive driver of inflation up until two months ago) were all soft in the latest month.

Be warned that even though we see further room for inflation improvement over the coming quarters, the initial July data suggests we could see a slight backup on a month-over-month basis (see next chart).

U.S. Daily Price Stats Inflation Index suggests a slight uptick in July

PriceStats Inflation Index as of 07/20/2024. CPI as of June 2024. Sources: State Street Global Markets Research, RBC GAM

Still, inflation has made major improvements and, in response, the market now prices in a near certainty of a September Federal Reserve (Fed) rate cut (97% of a cut is priced). We concur that September makes the most sense as a starting point, though it isn’t a complete certainty.

Interestingly, the market now debates whether there could be a total of two versus three 25 basis point rate cuts over the remainder of the year. That implies the Fed could cut in adjacent meetings.

What to fret about

As inflation concerns have eased, anxieties have pivoted toward the deteriorating growth environment.

• U.S. economic surprises have been persistently negative over the past three months.

• Global surprises recently turned south as well (see next chart). 

• The Institute for Supply Management (ISM) Manufacturing Index fell again in June, from 48.7 to 48.5. That’s consistent with a marginally contracting manufacturing sector. While not a new development – manufacturers have been complaining at approximately this volume since 2022 – it is most certainly news that the ISM Services Index has now also joined it with a sub-50 reading of its own of just 48.8. That’s the weakest reading since early pandemic and continues a slight downward trend (see subsequent chart).

• Making matters worse, the ISM Services new orders component fell from a healthy 54.1 to a weak 47.3, and the employment component fell from 47.1 to just 46.1.

• Small businesses are also continuing to complain, though incrementally less loudly than a few months ago.

It is still reasonable to expect an economic deceleration from here. The burning question is whether this will conveniently stabilize in soft-landing territory, or instead continue to descend into a much-feared hard landing. We continue to assign a 65% chance of a soft landing and a 35% risk of a hard landing.

Economic surprises turn negative

As of 07/23/2024. Sources: Citigroup, Bloomberg, RBC GAM

Both manufacturing and services sectors in U.S. are in contraction territory

As of June 2024. Shaded area represents recession. Sources: Institute for Supply Management, Macrobond, RBC GAM

• U.S. payrolls for June were also weak, at least once one probed beyond the respectable headline number of +206K. The combination of -111,000 in downward revisions to earlier months, hiring focused in non-economically sensitive sectors such as government, health care and social assistance, and an unemployment rate that ticked another notch higher from 4.0% to 4.1% gives the clear interpretation that the labour market continues to cool.

• Our Beige Book sentiment indicator – essentially, our quantification of a qualitative report – shows a slight downward movement in the latest release, partially reversing some nice earlier gains (see next chart).

Beige Book Sentiment Indicator shows slight shift downward

As of July 2024. The indicator quantifies the sentiment of local contacts by assigning different weights to a spectrum of positive and negative words used to describe the overall economic conditions in the Fed Beige Book. Sources: U.S. Federal Reserve, RBC GAM

• For all of that, U.S. second-quarter GDP is still tracking 2%-plus annualized growth, which is good. This is to say, a lot of businesses are complaining about the economy and are hiring fewer workers, but the economy itself seems to be holding on for the moment.

It is still reasonable to expect an economic deceleration from here. The burning question is whether this will conveniently stabilize in soft-landing territory, or instead continue to descend into a much-feared hard landing. We continue to assign a 65% chance of a soft landing and a 35% risk of a hard landing.

When we first alighted on those odds at the beginning of the year, our hope was to be in a position to steadily ratchet down the risk of a hard landing as time passed. That hasn’t happened. While inflation is falling and interest-rate cuts are coming into view, the degree of weakness visible in some economic figures keeps the risk of a hard landing very much alive.

The consolation prize is that if a recession were to transpire, inflation is now down to a sufficiently manageable level that central banks could cut rates sharply, ensuring that any recession is short and mild.

Canada check-up

The Bank of Canada cut its overnight rate by 25 basis points at a second consecutive meeting, bringing the rate down from a peak of 5.00% to 4.50% on July 24. Going into the summer, the debate had been whether the central bank would deliver a single cut in June versus July, but it has ultimately done both.

What is more, markets now price in a slightly greater than 50% chance of a September rate cut, and for a further reduction later in the year. Motivating this, Governor Macklem noted that “the downside risks are taking on increased weight in our monetary policy deliberations.”

Canada’s latest inflation print recently got the improving inflation narrative back on track. Headline prices were down 0.1% in June, allowing the annual figure to decline from 2.9% to 2.7% year-over-year (see next chart).

Canadian headline CPI and core CPI have declined

As of June 2024. Sources: Statistics Canada, Macrobond, RBC GAM

Shelter costs have been the main remaining inflation driver in Canada. But, of these, home prices have already settled and mortgage interest payments will improve as the Bank of Canada cuts rates. This leaves rent CPI the key remaining concern. Promisingly, Urbanation recently reported that June rents fell by 0.8%, the most substantial monthly decline since early 2021.

The Business Outlook Survey confirms a further slight deceleration in the Canadian economy (see next chart).

Business Outlook Survey indicator remains low

As of Q2 2024. Sources: Bank of Canada Business Outlook Survey, Macrobond, RBC GAM

On the employment side, Canada lost 1,400 jobs in June. This is a soft but not entirely remarkable number in isolation given the country’s history of employment data volatility. But two things were concerning.

1. First, because of the country’s enormous population growth, the unemployment rate continues to soar, up from 6.2% in in May to 6.4% in June, and from a low of 4.8% in July 2022. We are inclined to think that Canada’s natural unemployment rate is in the 6.0% to 6.5% range, meaning the country is perhaps a month or two away from opening up some definitive economic slack.

2. Curiously, despite this, the wage growth of permanent workers not only remained fast, up 5.6% from the year before, but also accelerated from a 5.2% year-over-year clip the month before. In the context of an inflation rate that is sub-3% and productivity growth that has been chronically negative, this represents a threat to price stability (see next chart). But wage growth should slow, given a cooling labour market (see next chart) and diminishing wage-hiking intentions (see subsequent chart).

Canadian labour market has cooled significantly

As of Q2 2024. Sources: Bank of Canada Business Outlook Survey, Macrobond, RBC GAM

Wage pressure in Canada has eased

As of Q2 2024. Sources: Bank of Canada Business Outlook Survey, Macrobond, RBC GAM

All of this is to say that the Canadian economy is softening, unemployment is rising and inflation is falling. This validates the Bank of Canada’s rate cutting decisions and argues that there is room for further easing in the months ahead. This is all the more likely given Canada’s status as a highly rate-sensitive economy with potentially painful mortgage rollovers set to take the stage over the next two years.

-With contributions from Vivien Lee, Vanita Maharaj and Aaron Ma