Questions? We've Got Answers 

Addressing Issues Impacting the Economic and Financial Outlook

Date Published: August 16, 2023


Print Version

Share this:


Optimism that the U.S. Federal Reserve will achieve a soft landing has increased among forecasters and financial markets. A welcomed cooling in some inflation metrics has been met with economic resilience, alleviating the worst fears among some analysts that a recession is at hand. But, the journey is not over. Core inflation is far off the desired 2% mark, leaving the door open that the Fed may not yet be done on the rate hike cycle. We explore these themes in our latest list of questions, while tackling topics on the Chinese economy, commodities, the U.S. Dollar, and housing markets.

Q1. What's the implication of China's abrupt slowdown to the global outlook and inflation? 

Chart 1 shows the share of U.S. manufactured goods imports coming from China through 2023 for five categories of products: Chemicals, Machinery ex electrical products, computer and electronic products, transportation equipment and all other products excluding petroleum. The chart show that for all five categories the share of imports coming from China is currently below the maximum share achieved during the period 2002 to 2023.

China's disappointing growth performance in the second quarter doesn’t move the needle on our global outlook for the second half of the year. A slowdown was already embedded in the outlook, as the post-lockdown burst of activity gave way to persistent structural drags, such as the effects from the government’s determination to reduce leverage in the real estate sector. The only aspect of surprise was that the fillip to growth petered out faster than expected, and combined with downward revisions to 2022 data, caused an 80-basis point downgrade to China’s 2023 GDP growth or equivalent to a global hit of 15 basis points.  

This downgrade could yet be challenged if policymakers move to stimulate the economy. In July, the Politburo showed some wavering in prior commitments. A debate has emerged towards firming up consumer spending, supporting critical industries, and cleaning up local government debts. Markets have responded positively, but the implementation leaves a bit to be desired. Policies are being rolled out in a piecemeal fashion. At the time of writing, tax cuts for small businesses and an extension of tax breaks for EV purchases had been announced. In a conciliatory effort towards the real estate sector, looser rules for first time buyers have been floated, with one provincial capital already taking steps independently. These moves are likely insufficient to meaningfully buoy consumer confidence, which has been cut to the bone.  

When it comes to China’s influence on global inflation, it looks to be more diminished. This is partly due to its slower growth trajectory, but also a reflection of geopolitical tensions that have deliberately diversified manufactured goods supply chains away from China (Chart 1). In fact, geopolitical factors will maintain a wide reach on global price pressures in the coming year, such as OPEC’s ongoing supply restriction of crude oil, and Russia’s renewed blockage of Ukrainian grain exports on downstream food prices. China’s poor economic performance relative to market expectations has, for now, mitigated a proliferation of broader global price pressures

Q2. Is the commodity market oversold and are the risks shifting to a rebound? 

Chart 2 shows historical WTI prices and the supply-demand balance in oil markets since 2015. As of June 2023, the oil market balance flipped to a deficit of 1.1 million/bpd with the projected deficit deepening to 2.1 million/bpd in August 2023. In June 2017, the deficit reached 4 million/bpd and in June 2021, it reached 4.1 million/bpd. Over the time horizon, oil prices hit a low of US$17/bbl in April 2020 and a high of US$115/bbl in June 2022. We forecast oil prices to increase from current levels, averaging US84/bbl in Q4-2023 and US$78/bbl in Q4-2024.

The short answer is yes. Commodity prices are building some tailwinds, after struggling to find direction over the first half of the year. Previously, commodity prices were restrained as recession risks in major advanced economies dominated hopes of a robust recovery in Chinese activity. Now, risks are tilting slightly to the upside, as the worst of those recession fears fade, combined with some tightening in supply-side factors for a select group of commodities. Bloomberg's Commodity Price Index has risen for two consecutive months and is up 6% since the broad selloff late last year.  

A shift in sentiment has been notable in crude oil markets. As of June, crude oil balances flipped into deficit territory, which is expected to deepen over the remainder of the year. On the supply side, Saudi Arabia extended its unilateral production cut, adding to other voluntary curtailments by some OPEC members that will remain in place until the end of 2024. On the demand side, global demand is faring much better than previously expected. This combination of events has caused global oil inventories to decline, and we expect WTI prices to embark on a further modest rally over the remainder of the year before moderating into next year as markets return to better balance (Chart 2). 

Elsewhere, wheat prices have been volatile. Recent estimates point to ample supply from major producers, but Russia's decision to terminate the Black Sea grain deal last month has reinfected uncertainty on global supply. Moreover, future production yield may face difficulties from sustained above-average temperatures and a lack of precipitation. On demand, attention will shift to China, which is the world's largest wheat importer.  

China also still carries a high influence on industrial metals, where its manufacturing decline and property sector woes have led to mixed results on prices. China’s surging imports of aluminum amid domestic supply shortages and depleted inventories should provide a lift to prices. Copper and nickel markets, usually the most sensitive to Chinese developments, face a more uncertain path forward as concerns around near-term Chinese consumption collide with brighter longer-term prospects around the global energy transition.

Q3. Is the recent U.S. dollar weakness the start of a larger trend? 

Chart 3 depicts the recent performance of the U.S. dollar against the euro, pound, and Canadian dollar. The recent weakness has been driven by potential interest rate differentials as global central banks are expected to remain in tightening mode longer than the Fed. Despite the recent weakness, the greenback is poised to strengthen in the near-term due to its safe-haven status.

The U.S. dollar has backtracked to its lowest level since April 2022 (Chart 3), as a deceleration in employment and inflation trends boost confidence that the Fed is nearing the end of its rate hiking cycle. At the same time, central banks in Europe are expected to remain in tightening mode due to less progress on curtailing inflation. A marginal compression in interest rate differentials has manifested in a lower dollar. However, we don't think the recent weakness is the start of a longer-term trend. The greenback should maintain support given its likely economic outperformance to peer countries and its safe-haven status.  

For instance, the economic challenges in Europe are mounting. An economic slowdown has been underscored by plummeting business loan demand which is already at an all-time low despite the passthrough of the interest rate hike cycle still in its early stages. Weaker economic growth prospects relative to the U.S. should spell near-term downside risk for the euro against the dollar.

Q4. With inflation easing in the U.S., how long will peak interest rates remain? 

Chart 4 shows the policy rates in terms of % for the Fed, BoC, BoE, and ECB for year-end 2023 and 2024. The bars show our current forecast for 2023 as higher than our prior forecast and the markers show the same for 2024.

If we told you a year ago that U.S. headline inflation would go from 9% year-on-year (y/y) to 3% y/y today without any net job losses, you'd probably expect the Fed to be cheering that result. Even though that's exactly what happened, the central bank has kept its pom-poms locked away. This is because the drop in headline inflation isn’t likely to persist. While the headline reading has fallen on the back of falling energy prices, underlying core measures signal that future inflation will be stuck above 3% for some time. U.S. core PCE inflation has already remained above 4% y/y for almost two years!  

What's a central bank to do? Raise interest rates higher than previously expected and commit to keeping them elevated for longer. On the first part, the Fed raised rates to new heights in July (Chart 4), testing what the economy can bear to sustain a downtrend in inflation. It was only five months ago that the Federal Reserve thought the peak policy rate would be 50 basis points lower. One year ago, a peak rate of 4.6% was believed to do the trick. So, it’s certainly possible we’re not yet at the end of the road, but can at least see where the pavement ends.  

This next step requires “tough talk” to ensure yields don’t prematurely decline and re-inject demand into the economy before core inflation sustains a downtrend. Our research (see Dollars & Sense) shows that the peak in interest rates typically coincides with fading consumer spending momentum. As we show in our economic forecast, this is more of a late 2023/early 2024 story, which means that the opportunity to start cutting interest rate cuts is most likely to occur in the spring of next year. However, when that moment arrives, it’s unlikely that the speed of the rate hike cycle that saw 50- to 75-basis point jumps will be paralleled on the way down. The central bank will likely move in a more cautious, measured fashion.  

Q5. Is it true that contracting U.S. gross domestic income predicts a recession, even though GDP is expanding?  

Chart 5 shows real Gross Domestic Product (GDP) and Gross Domestic Income (GDI) in year-over-year % change terms dating back to 1980 through to 2023:Q1. While the two measures historically have moved together, there have been several instances where they have diverged (2006). As of Q1-2023, GDP rose by 1.8% y/y while GDI contracted by 0.8% y/y – leading to the widest difference in history. Data is sourced from the Bureau of Economic Analysis.

Resilience has been commonly used to describe the U.S. economy over the past year – and for good reason. Despite being over a year into the most aggressive Fed tightening cycle in multiple decades, the economy still grew by 2.2% (annualized) over the first half of this year, which is a few ticks above trend growth. And based on more recent data, Q3 is again tracking close to 2%. At this rate, even if Q4 were to flatline, the economy would produce a 2023 growth rate that matched last year’s gain of 2.1%!  

However, the parallels between this year and last end there. 2022 got off to a rocky start, with GDP contracting in each of the first two quarters. This was the initial catalyst that ignited market jitters that the U.S. economy was already in a recession, despite the Fed being very early into its tightening cycle and inflation continuing to reach new multidecade highs. At the time, we had argued that GDP was likely overstating the degree of weakness in the economy, particularly given that alternative measures of economic output such as Gross Domestic Income (GDI) were still pointing to a modest expansion. Today, the story has flipped. Despite GDP recording a string of solid gains, GDI has contracted for two consecutive quarters. The exclamation mark comes when we compare GDP and GDI on a year-on-year basis, which showed the gap between the two widening to the largest margin on record in Q1 (Chart 5).  

Chart 6 shows the quarterly change in U.S. domestic corporate profits by in industry (non-financial, financial ex. Federal Reserve and Federal Reserve) dating back to Q1-2022 through Q1-2023. The chart shows that nearly all of the decline in Q4-2022 corporate profits was the result of Federal Reserve, whereas both profits at the Fed and non-financial corporations fell in Q1-2023. Data is sourced from the Bureau of Economic Analysis.

The last time a large gap occurred was immediately prior to the global financial crisis and subsequent recession. Some economists argued that GDI was a better bellwether for an impending downturn. However, this time the sources creating that divergence differ. GDI is declining due to corporate profits, but a hefty amount of that is due to the Federal Reserve incurring massive losses on its QE bond holdings as interest rates move sharply higher (Chart 6). Excluding the Fed, corporate profits would have printed positive in the final quarter of last year and fallen by less than half the amount in Q1. That decline reflected a $103B drop in non-financial corporate profits, which shouldn’t be shrugged off. But here too context matters. Profit margins had been running at an unsustainable level over the past two-years and some pullback was inevitable, as the headwinds from softening demand, elevated wages costs and less ability to raise prices intensified. Even after accounting for the Q1 compression in profit margins, they are still hovering slightly above pre-pandemic levels, which likely suggests there's still room to fall.  

So what's the takeaway? Neither GDP nor GDI are perfect measures of economic activity, with each having outperformed the other at various points in previous economic cycles. An average of the two is likely our best gauge on the crosswinds of economic activity. That measure shows that growth has been virtually flat in recent quarters, which is a more realistic depiction of where GDP growth is likely headed towards year-end and H1 2024.

Q6. Why is U.S. investment showing unusual resilience in a high rate environment?  

With interest rates at a 22-year high, businesses should be decreasing their exposure to capital good outlays. However, broadly speaking, this does not appear to be the case. After adjusting for inflation, non-residential fixed investment rose by an impressive 4.6% above year-ago levels in the second quarter. 

This resilience reflects direct and indirect forces related to federal subsidies for green technology, in addition to delayed post-pandemic recovery trends in the transportation sector. Both influences have persistence that help shield a broader and deeper contraction despite a high interest rate environment.  

There are three main aspects to this logic: 

  1. The automotive sector is out of sync with the business cycle. Pandemic-related supply chain disruptions prevented automakers from boosting production in response to the exceedingly strong demand in the first half of 2021. Jumping forward to 2023, supply chain disruptions have eased and auto production appears to have normalized, allowing the backlog of business orders to be filled. In the second quarter, investments in light trucks rose 75% quarter-on-quarter (annualized), adding 0.4 percentage points (ppts) to real GDP growth. However, the recovery process remains incomplete. Investments in light trucks are roughly 26% below pre-pandemic levels, suggesting that the recent outsized gains boosting investment growth are likely to continue in the near term. 

  2. Like autos, aircraft investments are experiencing delayed and outsized post-pandemic growth. The long-term outlook for travel and commercial aviation was highly uncertain during the pandemic, as lockdowns and lingering health concerns weighed on the industry. However, with 2023 travel demand back at pre-pandemic levels, aircraft investments have expanded by 69% year-on-year in the second quarter. This alone contributed 30 basis points to real GDP growth. 

  3. Chart 7 shows total construction expenditures on manufacturing facilities, construction spending on computer/electronic/electrical (CEE) manufacturing facilities, and CEE's share of total construction expenditures on manufacturing facilities. The trends for both total and CEE construction spending on manufacturing facilities were fairly stable from 1995 to 2021, with some slight fluctuations around the 2008 recession and a gradual uptick during the subsequent recovery period in the early 2010's. However, starting in 2022 the trends in both total and CEE became exponential, with the former rising by over 100% and the latter rising by over 300% between January 2022 and June 2023. CEE's share of total construction expenditures rose from 11% pre-pandemic to 56% in June 2023.
  4. Federal legislation, notably the Inflation Reduction Act and the CHIPS & Science Act, is providing targeted support. There are numerous provisions that are supportive of the current economic expansion, but the largest investments are related to manufacturing facilities for clean energy, semiconductors, and electric vehicles. Investment in manufacturing structures was up a massive 54% y/y in the second quarter, with most of this strength stemming from new semiconductor and EV battery production facilities. The computer, electronic, & electrical subcategory has seen its share of total manufacturing construction spending grow from 11% in the decade leading up to the pandemic, to 56% in June 2023 (Chart 7). The combined federal and state level subsidies being offered to firms are sufficient in most cases to offset most, if not all, of the rise in financing costs over the past year. The boost to economic activity won’t end once the facilities are constructed. Investment will then get a boost through equipment, which usually occurs with a 4-5 quarter lag. In other words, this investment impulse will exist over the medium-term through an increase in manufacturing capacity.

Q7. Are higher rates having any effect on U.S. consumers yet?  

There are three primary elements which have combined to blunt the impact to consumers of the higher rate environment. First, American households deleveraged after the Global Financial Crisis and now have relatively low debt service burdens to weather rising rates (Chart 8). Second, the prevalence of longer-term fixed-rate debt is also dampening the impact of the central bank’s rate hikes. Consumers have locked in lower rates on many existing debts (primarily mortgages and auto loans), so the impact of rising rates will only feed through gradually via new debt or as existing debts are renewed. Finally, households also have higher net worth coming out of the pandemic, which can help cushion the impact from higher borrowing costs.  

Chart 8 is a line graph showing the U.S. household debt service ratio. It shows that household debt service payments as a percentage of disposable personal income, fell notably during the pandemic but has since recovered back to pre-pandemic levels. Even so, at 9.6% the metric remains significantly below previous highs, such as the 13.1% reached in March 2008, during the height of the global financial crisis.
    Chart 9 contains three line graphs showing the delinquency rates for three consumer loan categories over the period January 2015 to July 2023. The categories are car loans, credit cards and consumer finance loans. The delinquency rate for all three fell during the pandemic but have been rising since bottoming out in mid-2021. All three delinquency rates are now back to or above where they were just prior to the pandemic.

That said, there is evidence that higher interest rates are starting to leave a mark. Delinquency rates on consumer loans have been trending up in the last few months. This is reflected in both rising credit card delinquencies and other loan categories, such as installment and single payment plans. Total delinquent balances for auto loans at 3.6% also reflect a 50-basis point increase since the start of the year (Chart 9). At the same time, loan demand is declining, as some would-be auto buyers step back from the market. Although the level of delinquency rates is not ringing any alarm bells, it must be true that household financial strain is taking hold on the margin given it’s occurring alongside strength in wages and jobs. A more telling picture will emerge after October, as the restart of student loan payments will add additional pressures to borrowers and may cause delinquency rates to rise further. 

It’ll become increasingly more difficult to withstand the forces of higher interest rates as "excess savings" dwindle. The nest egg that consumers built up through the pandemic is now lower than TDE's previous estimate. From a peak of just over $2.2 trillion in 2021 Q3 (previously calculated at $2.7 trillion peaking in 2021 Q4), we estimate that households have just under $800 billion worth of excess savings as of 2023 Q2, which is forecast to be exhausted by H2 2024.  

Chart 10 shows U.S. single-family permits and multifamily permits, with the data stretching back to year 2012. The multifamily series has been smoothed using a three-month moving average. The chart shows a clear divergence between the two segments over the last few months, with single-family permits trending up and multifamily permits trending down.

One interesting phenomenon is how the housing market is reacting to a crippling mortgage rate environment. This market was the first to bow down to higher financing costs, but now counter-influences are propping it back up. For the most part, existing homeowners' mortgage rates sit well below today's prevailing rates of near 7%. This disincentive to move and take out a new mortgage at a higher rate is contributing to a lack of churn in resale inventory, which is keeping a floor on prices.  

More buyers have pushed into the new home market, manifesting in improved homebuilder confidence, although optimism has been confined to the single-family segment. Multifamily permits have been trending down since the autumn of 2022 (Chart 10). This is consistent with a rise in the multifamily vacancy rate and a record-setting number of units under construction. In essence, the U.S. has a bifurcated market in housing demand, which is expected to persist even under a cooling job market.  

Q8. Are we seeing a turn in the U.S. labor market?

Chart 11 shows the U.S. core working age participation rate for both men and women. More recently, the male participation rate has returned to its pre-pandemic level of 89.4% while the female equivalent has surged to 77.5%. This is 0.5%-pts above its pre-pandemic level and also just off its June all-time of 77.8%. Data is sourced from the Bureau of Labor Statistics.

U.S. job growth continues to moderate on a trend basis, but is still averaging 218k over the last three-months ending in July. This remains above the roughly 100k jobs per month needed to keep the unemployment rate flat in a steady participation environment.  

Job openings are also coming off the boil, but here to remain historically elevated with roughly 2.5 million more openings relative to the average of the two-years prior to the pandemic. Initial jobless claims are showing even more stubbornness, trending lower over the past month after having steadily moved higher through H1 2023. Little wonder why the unemployment rate sits only a tick above its 53-year low.  

At this point, the major constraint on future job growth is labor supply. Up until now, employers have had the benefit of a surge in the core working age (25-54 years) participation rate, which rose by 1.1%-pts between November 2022 and July 2023. Gains have been seen across both men and women, though the headliner has been the female participation rate reaching an all-time high (Chart 11). Whether or not further inroads can be made remains to be seen.  

American women between the ages of 25-54 participate in the labor force at a rate 8%-pts below Canadian women. This suggests significant upside potential for female labor force growth. (There is also a gap for men, although relatively smaller at 3%-pts). Differences in parental leave policies explain a large part of the gap, and that hasn't changed. But the increased shift to hybrid work arrangements has likely been a factor drawing more women into the paid labor force. If the female participation rate moved up by just 2%-pts, that would add 1.3 million workers, or roughly half the 'excess' job openings seen today. However, this would mark a milestone for the U.S. and certainly wouldn’t happen in short order. Nor is there any reason to think it will happen, but it does illustrate the possibility for the labor market to come back into better balance without as large an increase in the unemployment rate, as history would suggest.   

Contributing Authors

  • Beata Caranci, Chief Economist | 416-982-8067

  • Derek Burleton, Deputy Chief Economist | 416-982-2514

  • James Orlando, CFA, Director | 416- 413-3180

  • Leslie Preston, Managing Director | 416-983-7053

  • Thomas Feltmate, Director | 416- 944-5730

  • Andrew Hencic, Senior Economist | 416-944-5307