ECONOMIC & FIXED INCOME COMMENT- Navigating a Challenging Economic Landscape

While the global economy is gradually softening, concerns remain limited, with market consensus favouring a soft landing. Global GDP is projected to grow 3.1% in 2024, mainly driven by expansion in the U.S., improved growth prospects in emerging markets (excluding China), and a resilient Eurozone, particularly in France and Spain. Additionally, global monetary policy easing has become increasingly synchronized. The U.S. Federal Reserve’s (Fed) recent decision to cut interest rates by 50 basis points aligns the bank more closely with other developed central banks, including the European Union, U.K, Canada, New Zealand, Demark and Switzerland. The shift in Fed policy will allow other central banks greater flexibility in adjusting their monetary policies based on domestic economic conditions.

The Canadian economy grew by 2.1% (annualized) in Q2, fueled by government spending. However, signs of moderating growth emerged towards the end of the quarter. At the time of this writing, the Canadian economy is forecast to grow 1.3% in Q3, significantly lower than the Bank of Canada’s (BoC) initial estimate of 2.8%. For calendar year 2024, the Canadian economy is forecast to expand 1%.

With respect to Canadian inflation, the all-inclusive index further declined in August to 2% year-over-year (y/y), marking the slowest growth since February 2021. Furthermore, the overall slowdown was broad-based, with CPI excluding food and energy rising by 2.4% (y/y), down from 2.7%. The recent inflation figures demonstrate a persistent downward trend in domestic inflation. As inflation nears the 2% target, the BoC must increasingly guard against the risks of an economic slowdown and inflation falling below 2%.

Meanwhile, the Canadian labor market continues to weaken. The unemployment rate rose 0.2% to 6.6% in August, reaching a 7-year high outside of the COVID-19 pandemic. While the speed and magnitude of the current labor market softening resemble those seen in past recessions, the prevailing trends are unique. Notably, 80% of the rise in unemployment is among individuals aged 35 and under, particularly affecting students and recent graduates, who typically face longer job searches.

The BoC is set to make its next decision on October 23rd, where a further 25-basis point rate cut is expected, reducing the overnight bank rate to 4.00%. For the year, the BoC is expected to provide 125-150 basis points of rate relief, resulting in the overnight bank rate settling between 3.5% and 3.75% by yearend. In the medium-term, interest rate cuts are expected to continue through 2025 before settling at a neutral level of 2.75%-3% (see chart).

However, if Canada’s growth trends worsen or the unemployment rate continues to climb, more urgent measures may be warranted. If the unemployment rate reaches a psychologically important threshold of 7%, the bank could implement more substantial rate cuts, potentially by 50 basis points. Considering the BoC’s track record of decisive actions, this outcome is quite possible. For instance, in July 2022, the BoC increased its policy rate by 100 basis points in one meeting to tackle rising inflation.

The U.S. economy continues to demonstrate fundamental strength, despite ongoing concerns about the sustainability of growth and interest rate policies. After a slowdown in the first quarter, GDP rebounded impressively to 3.0% in Q2. However, as we look ahead, a further moderation is anticipated due to a softening in consumer demand. U.S. GDP is forecast to expand 2.4% for 2024.

With respect to the U.S. labour market, capital markets expressed concerns over July’s weaker-than-expected jobs report. Specifically, the unemployment rate climbed 0.2% to 4.3%, marking the highest level since October 2021. The increase in the unemployment rate triggered the Sahm Rule, a recession indicator signalling the start of a recession when the three-month moving average of the national unemployment rate rises by 0.5%. However, the creator of the Sahm Rule, Claudia Sahm indicated the July report was not a cause for immediate concern, and that the U.S. labor market remains relatively strong. Although the unemployment rate has moved higher from its lows of last year, it remains well below the long-term average unemployment rate of 5.7%. Moreover, the increase in unemployment has been driven largely by new entrants coming into the workforce, rather than large increases in job cuts or layoffs.

The Fed surprised market participants with a half-point rate cut on September 18^th, bringing the Fed Funds Rate to 5.00%.  The Fed’s new goal is to keep inflation stable while simultaneously ensuring the unemployment rate does not move materially higher. Furthermore, the Fed updated the Summary of Economic Projections (SEP) forecasting another 50 bps of rate relief by year end.  In the medium term, the Fed forecasts interest rates settling between 3.5%-3.75%. However, the pace and magnitude of further rate reductions will depend on the labour market and economic outlook.

In the third quarter, bond yields declined significantly, leading to strong returns. Notably, the yield curve—representing bond yields across various maturities started to normalize after two years of inversion. This shift is characterized by a "bull steepening," where both 10-year and 2-year bond yields dropped sharply from their peaks in May, primarily due to falling inflation. However, the decline has been more pronounced at the shorter end, creating a positive spread between 10-year and 2-year bonds (see chart). Such movements typically indicate that investors are anticipating an upcoming cycle of rate cuts. To capitalize on this shift in the yield curve, intermediate bonds offer a strategic balance between higher yields, potential for price appreciation, reduced reinvestment risk, and a hedge against market volatility.