A Soft Landing May Still Be in Sight

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Avery Shenfeld

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Avery Shenfeld, chief economist at CIBC.

We at CIBC, were never in the official recession camp for 2023 in terms of our outlook. We were looking instead for more of a stall in growth, a period of three quarters where we might have a negative quarter here or there, but basically a period of zero growth. I think the one thing that’s changed in our forecast is the timing of that. We had expected to start seeing that in evidence in the first quarter numbers for 2023. It now looks more likely that it’s going to be a second to third and fourth quarter story, so a bit delayed, and that’s largely because the economies are proving a little more resilient to higher interest rates than we might have expected. But I think this is in total really more of a stay of execution than a full relief.

We’re still going to need to see that slow down or that stalling growth to get inflation under control, and the central banks are committed to getting interest rates to a level and leaving them at that level long enough to actually see that stall. So our forecast has changed mostly in the timing. We still expect that for both Canada and the U.S. we’re going to see this. You could call it a soft landing. In other words, a period of zero growth for a few quarters.

It certainly came as a bit of a shocker when we saw the numbers for January in both the U.S. and Canada and saw such strong employment growth. I think part of this is really the lagged impact of the demand for labour we saw last year. Demand that was in some sense frustrated as businesses couldn’t find the people they were looking for. So some of this is actually not so much a sign necessarily of a lot of economic strength in the first quarter of 2023, it’s a sign that businesses may be finally catching up and finding the workers they were looking for last year. If that’s the case, then we would expect that when we start to get numbers for January in terms of job vacancies, that in fact the hiring that took place at the start of this year was really filling some of those job vacancies and not necessarily a good omen of what’s to come.

I think we’re seeing enough signs of the slowing, particularly here in Canada. If you look at the fourth quarter, it doesn’t look that brisk, that in fact demand for labour will be slowing, but we are seeing this catch up hiring, which does create some income and of course some spending power, and that’s why we had to push back the start of that flat period for economic growth into the second quarter of this year. The good news is that the case that we had been making for why a soft landing might be sufficient to get inflation back to target, that case remains very much well-supported by the evidence. So remember that in neither the U.S. or Canada have we seen the labor market open up any slack. Unemployment is very, very low in both countries, and yet we have made some progress despite that in bringing inflation down. World commodity prices have softened. That’s helped us on the oil and gas front. We’ve seen even some world food commodity prices start to level off or come down that will show up eventually yet. We believe in a bit of a slowing in food inflation at the grocery store.

In the U.S. measures of what’s happening to rent inflation on the ground show that it’s easing off and that will show up in the CPI in the U.S. with a bit of a lag. And of course, we have some of the cost related to housing in Canada in terms of new home prices coming down. So we’ve made some progress on inflation already and that’s why we believe that a period of negligible growth as opposed to a deep recession might be sufficient to get inflation down the rest of the way towards the central bank’s 2% target.

So this isn’t going to be immaculate disinflation. We’re going to need some economic pain, but we don’t think we need to see a full-blown recession in North America in order to be at a 2% inflation environment when we get to 2024.

But you did see last year a lot of economists predicting a recession to hit even before the end of 2023. In fact, some people misread some of the signals from U.S. GDP figures and thought the U.S. had already fallen into recession in the first half of 2022. We certainly know that wasn’t the case when we look back on the year as a whole. The reality is that I think that economists who are predicting a recession have simply pushed out the timing of that, and it is fair to say that there’s still a substantial risk that we do end up in a recession, even though at CIBC, we don’t think that’s necessary to get inflation under control.

The largest risk is an overzealous central bank in the U.S. The Federal Reserve is clearly not done hiking rates. It sees the need to continue to push interest rates higher to get the slowing in growth and inflation that they’re looking for. And if we look back at past examples of when we’re in this position, sometimes the central banks have got it just right and we’ve just had this slowing in growth, and inflation has come down. But indeed, of course, there are historic cases where the central bank overdid it, sent interest rates too high, and caused a recession that maybe was deeper than they intended or they didn’t intend one at all.

I think the luxury we’ve had in Canada is having seen some reasonable progress on inflation and having a central bank that understands that Canadians are still renewing mortgages at higher rates and therefore we haven’t felt the full impact of the rate hikes they’ve already done.

The Bank of Canada has, I think, wisely chosen to take a pause. Not that they’re certain that rate hikes are done, but they want to give the economy some chance over the next several months to show its true colors and see whether or not we need to push on to higher interest rates before taking those additional steps. That’s the best assurance against that risk that the central bankers overdo it and send us into a full recession in the second half of this year. We’re hopeful that in Canada, the Bank of Canada has already taken interest rates to a level that will bring inflation to target by next year. So we think that rates hikes might be on hold for this year. Earlier hopes that financial markets had, I think they were quite false hopes, that having raised interest rates, the central banks and North America might quickly start cutting them in 2023. Those hopes have really gone out the window. I think that investors now understand that it takes a period of economic pain of higher interest rates in order to bring inflation down, and it would be self-defeating for the central banks to start cutting interest rates at the first sign of that sort of economic pain.

I think that’s what’s made it a challenging year for equity investors so far in the sense that there’s been this disappointment that interest rates may not climb further in Canada, but we’re not likely to see any interest rate cuts until we move perhaps a fair bit into 2024. In the U.S., we still have another 50 or 75 basis points of rate hikes to come, so still more pain ahead because we’re not getting the slowing that we need to see in the U.S. economy to bring inflation all the way down to 2%. But we’re quite confident that the central bank in the U.S., the Federal Reserve, is serious about hitting that inflation target, and we indeed believe that by 2024 in both Canada and the U.S., we’re going to be back to a 2% inflation world.

The challenge for equity markets this year is that while they have priced in this higher interest rate world, I don’t think they’re fully yet braced for what that means in terms of corporate earnings. The bottom line is that there’s no way you can even see a stall on economic growth without seeing a good chunk of the corporate sector in the US see negative year-on-year growth in earnings per share. That’s something that’s probably not yet fully priced into the equity market. Partly because we started the year with signs of economic resilience and maybe investors are forgetting that we’re going to need to see this period of economic pain to get inflation back to 2%, so could be still a challenging wobbly first half for the equity market.

We’re hopeful that by the latter part of the year as investors then focus more on 2024 earnings and start to see some further progress on getting inflation back to target, that relief will come at that point. That inflation is coming down. That we’re done with interest rate hikes at some point later this year, and that might allow the equity market to see a better second half than the first half could end up looking.