U.S. outperformance continues but no sunshine yet for the Canadian economy

Resilience in the U.S. economy continued to buoy investors’ confidence, driving equities higher and narrowing credit spreads in February. Conditions also looked to have bottomed in the euro area and U.K. as purchasing manager indices pointed to a sustained rebound in services demand. In Canada, things are much less upbeat—output growth in Q4 2023 inched along but per-capita output continues to decline. Insolvencies among businesses and consumers are continuing to rise, sounding the alarm for downside economic risks ahead.

Highlights:

• Global central banks are reiterating that more progress is still needed on inflation before they can commit to cutting interest rates.
• We continue to expect the U.S. Federal Reserve to make its first cut to rates in its June meeting, and the Bank of Canada and European Central Bank in the week prior to the Fed (also in June), and a much more hawkish sounding Bank of England to follow suit later in August.
• Resurfacing inflation pressures in the U.S. over early 2024 means a more cautious Fed after the start of rate cuts. We expect them to go by a slower pace (once every other meeting) for the rest of 2024.
• The economic growth backdrop hasn’t significantly changed. The Canadian economy remains the worst of the bunch (on a per person basis). The U.K. and countries in the euro area meantime are already seeing early signs of a pickup in activity while the U.S. continues to show resilience.
• Topic in focus: Business insolvencies have surged in Canada in early 2024. Granted, the increase is from exceptionally low levels during the pandemic, and the January deadline for federal CEBA pandemic support loans is likely playing a role. But the trend looks concerning nonetheless and serves as a reminder that downside economic growth risks remain, and further deterioration in labour market conditions and household incomes are not entirely off the radar.

U.S. resilience stretching on but inflation risks also resurfacing

The outperformance of the U.S. economy persisted for another month. Personal spending on services was still running hot in January, and February’s payroll report extended the streak of solid employment gains. A strong macro backdrop won’t be problematic as long as inflation stays low. However, CPI data over early 2024 also showed price pressures reaccelerating. That’s likely to set the Federal Reserve back a step in its assessment of the sustainability of low inflation over the second half of last year. Markets have pared back pricing for rate cuts this year, moving towards a June starting point that is consistent with our forecast. Beyond then, we expect fewer cuts this year at a pace of every other meeting for the rest of 2024 (we had expected the Fed to cut in every meeting previously), leaving the Fed Funds range 50 bps higher than we previously expected, at 4.5% – 4.75% by the end of this year.

Economic conditions in Canada, euro area and the U.K. remain much softer. Gross domestic product growth in Canada trudged along in Q4 2023 with a surge in exports masking a large contraction in business investment. GDP growth in Q4 also came in weak in the euro area (barely changed from Q3) and the U.K. (a larger than expected -0.3% non-annualized decline.) Monthly PMI surveys did show a rebound in activities in both regions over the early months of 2024, primarily driven by stronger demand for services as the sub-indices are now within the expansion zone for both. The same cannot be said about Canada, where insolvencies are still rising and labour market conditions continue to soften.

Despite the divergence in economic growth backdrops, the messaging from global central banks has remained largely uniform—more progress is needed on inflation before they can commit to cutting interest rates. The BoC and ECB both reiterated that message last month while delivering widely expected holds on interest rates. U.S. economic outperformance has raised concerns that the Fed will need to be more cautious about easing than previously expected. But comments from policymakers, including chair Jerome Powell, have largely reinforced the central bank’s preference, which is to begin cutting interest rates this year. We continue to look for the BoC, Fed and the ECB to start to move rates lower in June, followed by BoE in August and the Reserve Bank of Australia later in December.

Central bank bias

Corporate bankruptcies are rising in Canada

Business insolvencies surged in Canada in early 2024 to levels not seen since the great financial crisis. What’s concerning is that most of the insolvencies were driven by actual bankruptcies that have more than doubled since last fall, instead of proposals for businesses to settle debt with creditors under conditions outside of the existing terms. Part of the increase may have been tied to the end of some government pandemic support programs. The repayment deadline for federal CEBA loans was in January. The rise also follows a period of exceptionally low business insolvencies during the pandemic.

Data from the Business Investment Survey also showed a large pickup in the Canadian non-financial corporate sector’s debt servicing ratio. Several factors likely contributed, including a more indebted non-financial corporate sector as a whole (debt-to-GDP ratio was the second highest among G7 just after France), and differences in term structures for business non-mortgage borrowing.

Consumer facing sectors harder hit

Many Canadian companies that survived the pandemic with the help of government support are now facing a triple whammy of slowing consumer demand, rising borrowing costs and deteriorating productivity. The conditions look worse for businesses in consumer-facing sectors such as retail, housing and accommodation, food, and recreation, which have seen the largest increase in insolvencies and the worst deterioration in credit access. Lenders have tightened standards in part due to anticipating softer demand in these areas, according to the Q4 2023 Bank of Canada Business Outlook Survey.

A high concentration of small businesses in these sectors also likely explains part of the underperformance, as small businesses tend to have less diverse financing sources. The deadline for small businesses to pay back CEBA loans without forgoing the forgivable portion likely further exacerbated the situation. We already saw an unusual increase in chartered banks’ business loans advanced towards the end of last year, likely driven by higher demand among small businesses to refinance debt to meet the CEBA January deadline.

Surging insolvencies pose risks to household income

It remains to be seen whether this recent rise in business insolvencies will be “transitory” (remember the last time that word was used to describe inflation?), or if it’s reflective of persistent underlying weakness in businesses operating conditions. Regardless, it will have a negative impact on the labour market.

As highlighted in the last Financial Market Monthly, the current cycle already counts as the longest where the unemployment rate has risen without the Bank of Canada cutting interest rates. The biggest reason behind that is rising inflation risks that have yet to fully subside. It also has to do with the fact that most of the deterioration in labour market conditions to date has not been coming from outright layoffs, implying less spillover to household income and credit conditions. That outlook will be put to the test in the coming quarters if the acceleration in business closures is followed by an acceleration in layoffs.

Loss of employment and income could be especially dangerous in an environment where households are highly indebted and expected to keep facing payment increases as fixed-rate mortgages get renewed at higher interest rates. Earlier analysis from the BoC highlighted continued income growth as key for households to be able to handle increasing mortgage payments. The expected increase in the mortgage debt servicing ratio could more than double or in some cases quintuple if households lose their income from layoffs.

We continue to expect a mild slowing in the Canadian economy (on a per capita basis) with some improvement over the second half thanks to strong population growth and expected easing from the BoC. But the rise in business bankruptcies is a reminder that downside risks remain.

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