E-sight September 28: Adopting a recession call

This morning, we released an updated Deloitte Quarterly Economic Forecast. Recent events have led us to adopt the view that a recession is coming in Canada. After posting strong growth in the first half of this year of above 3% annualized, a sharp slowdown is underway, and a contraction could start as early as the fourth quarter of this year. he weakness is likely to persist through the first half of next year before economic growth regains any substantive momentum. 

The coming economic weakness reflects a variety of strong economic headwinds. 

First, high inflation is outpacing wage growth, reducing the purchasing power of worker incomes and with temper spending growth. Yes, inflation did retreat in August falling from 7.6% to 7.0%, but the inflation shock will take considerable time to abate.

Second, the Bank of Canada has aggressively raised interest rates to fight inflation, and this is triggering a residential real estate correction and depressing spending on housing-related items, like appliances and furniture. Last week’s news that retail sales fell 2.5% in July wasn’t just about lower gasoline prices. Excluding motor vehicle and parts and gasoline station sales, retail spending was down 0.9% in the month and the volume of those sales after removing prices were down 1.2%. Retail sales might edge up in August, but this holiday shopping season is looking increasingly challenging for retailers. It should be stressed that the impact of higher interest rates isn’t felt immediately. Indeed, the higher rates will raise debt service costs, but primarily when mortgages renew. Nevertheless, as inflation gradually comes down, debt service costs are likely to rise, meaning that consumers might not get much financial relief, and some may experience greater financial stress if their debt loads are excessive.

Third, the global economy is experiencing a broad-based slowdown as central banks rebalance monetary policy and this will dampen Canadian exports. Most important to Canada is the aggressive interest rate hikes by the US Federal Reserve. Last week, the Fed met our and financial market expectations by raising its benchmark fed funds target rate by 75 basis points to 3.00 to 3.25%. However, the real shock came from the Federal Open Market Committee (FOMC) members – the individuals who vote on interest rate changes – published expectations for where the fed funds rate is headed. The median of their views is 4.40% by year end and 4.60% by the end of 2023. This means that the most likely outcome is a peak in the fed funds rate of 4.50 to 4.75%. This is about one percentage point higher than their prior predications, and this is why global stock markets sank last week as market fears of a US recession increased. And, higher US interest rates tend to push global interest rates higher while a weaker US economy lowers global economic growth. Canada will import US weakness through its deep trade ties. Indeed, there is an old adage that if the US catches a cold, Canada get pneumonia – i.e. if the US has a recession, Canada will have one too and usually a worse one. 

Finally, the Canadian economy accumulated a record amount of inventories in the second quarter of 2022. Some of this inventory accumulation likely came from a reduction is supply chain disruptions, which is good news as it could help reduce supply-side inflation pressures. Some of the inventories likely reflected unanticipated accumulation from weakening foreign demand for Canadian exports. Finally, we know some of it was abnormal agriculture inventory accumulation. Regardless of the source, it is likely that efforts to reduce inventories in the second half of this year will act as a drag on the add up of real GDP growth. So, while other forecasters that have a recession call expect the timing to come at the start of next year, we think it could come as early as the fourth quarter of this year if the swing in inventories is pronounced. Its always hard to judge the timing of inventory swings.

The bottom line is that the Deloitte forecast had previously called for a soft-landing under the presumption that the peak in short-term interest rates in Canada and the US would be around 3.00%. We are now assuming the Bank of Canada will hike 50 basis points in October to 3.75%, but the guidance from the Fed suggests it will hike beyond that point and that creates challenges for the Bank of Canada. So, monetary policy is going to be very restrictive and depress economic activity. Add on the inventory swing, the volatility in financial markets, and increased recession speculation – and, we have a base case forecast that now has to accept that a recession seems the most likely path over the coming quarters. 

Many other economists are still in the soft-landing camp, and to be honest I hope they are right. However, if we do get a recession, I think we are looking at a more traditional business cycle than the last two economic contractions. The valley is likely two to three quarters, so leadership teams shouldn’t lose sight of medium- and longer-term objectives due to short-term economic volatility. And, there are key areas of economic support that should temper the coming weakness. The extreme tightness of labour markets and the pandemic savings of households are two factors that could limit the weakness on the consumer front. Similarly, the recent labour shortages could mean businesses still have reasons to invest in labour saving capital. And, high inflation has done wonders for creating additional tax revenues, so as inflation comes down, targeted fiscal stimulus might be deployed in response to an economic downturn. Compared to the pandemic, a normal business cycle is far less daunting. We got through the last contraction – we’ll get through this one too.