Two-Sided Risks to US Soft Landing

We have spent much of the last two months defending our increasingly out-of-consensus call for three Fed rate cuts in 2025. A series of recent data disappointments has brought market pricing much closer to that view.

• US: Neither Invincible, Nor Broken
  
• Canada: Stronger Data 
  
• Australia: Downside Risks to Q4 Growth
• Spotlight on Next Week

Weekly Highlights

US: Neither Invincible, Nor Broken

We have spent much of the last two months (including in a recent piece here) defending our increasingly out-of-consensus call for three Fed rate cuts in 2025. A series of recent data disappointments has brought market pricing much closer to that view. This, of course, does not prove the point, but underscores what had been the core message all along: there are two-sided risks to our US soft landing forecast.

There had already been some worrying signs the week before: another drop in consumer sentiment and rise in inflation expectations in the University of Michigan survey, plus the first sub-50 reading in over two years for the S&P Global services PMI. This week, the theme of disappointments continued with a sharp retreat in the February Conference Board consumer confidence index and culminated with the outright decline in January consumer spending.

Within days, we seem to have swung from proclamations of apparent invincibility to worried questioning of whether the economy is somehow broken. Neither is true. We can’t help but be reminded of a similar situation in 2024, when the release of a softer-than-anticipated first-quarter GDP report also shifted macro assessments from “boom” to “stagflation” seemingly overnight.

It would be unwise to panic, just as it was unwise to look at the exceedingly strong growth in fourth-quarter consumer spending and assume it could be sustained. As we wrote at the time, the economy exhibited “a lot of peculiar dynamics that look likely to reverse in the coming quarter”. We are now in the midst of one of those reversals. For instance, we noted then in regard to motor-vehicle sales, that “having approached 17.0 million (annualized) in December, the scope for further material gains here seems limited”. Indeed, January brought a sharp pullback (15.6 million saar), which was one of the big drivers behind the 0.2% m/m decline in nominal consumer spending. Real personal spending plunged 0.5% m/m, which was the first monthly decline since January 2024. However, despite the sequential retreat, real personal consumption was 3.0% higher y/y, a solid print.

The January PCE (personal consumption expenditure) deflator data was largely as expected and provided what under normal circumstances (i.e., no impending tariffs) would likely be deemed by the FOMC as evidence that progress on the inflation front is resuming. The headline PCE deflator increased 0.2% m/m and the core PCE deflator rose 0.3%, lowering the two respective inflation measures by one and three tenths, respectively, to 2.5% y/y and 2.6% y/y.

This was the first improvement in the y/y core PCE inflation rate since June. There should be a little further progress near-term and then a plateau around 2.5% y/y for much of the second half. The retreat in January PCE inflation, plus likely signs of labor market erosion, support a June Fed cut. The federal employees who have accepted the DOGE buyout offer (roughly 75,000) will likely not show up in the data until November (i.e., the October payrolls) but enough is happening outside of that already between outright terminations and hiring delays at state level or even in the private sector amid uncertainty over funding and procurement. Hence, the labor market should loosen.

Canada: Stronger Data

Easing monetary policy and temporary fiscal stimulus have supported the Canadian economy recently. Still, new US tariffs, rising political uncertainty, and a declining population growth will likely weigh on economic activity by summer.

GDP rose 2.6% q/q saar in Q4, well above the 1.7% consensus, supported by strong domestic demand. Household consumption rose 5.6%, the strongest increase since Q2 2022. Business investment also rose solidly by 10.7%, with residential investment up 16.7%. Exports jumped 7.4% following two quarters of contraction. Meanwhile, widespread withdrawals from non-farm inventories and higher imports weighed on GDP growth. Q3 GDP was also revised substantially higher, from 1.0% to 2.2%, resulting in real GDP up by 1.5% y/y in 2024.

The Bank of Canada (BoC) has cut the overnight interest rate by 200bps since June 2024. Lower interest rates and changes in mortgage rules which allow for longer 30-year amortizations should continue to offer a small uplift to housing activity and consumer spending this year. The GST holiday and the Ontario Taxpayer Rebate will also give a temporary boost to spending in the first quarter. However, there are signs that trade policy uncertainty has already weighed on business investment and housing demand. In addition, the new curbs on immigration and temporary residents will drag on aggregate demand and supply. As the current stronger domestic demand likely reflects the effect of lower rates and some temporary factors, we think it will be short-lived. As such, while we continue to expect solid growth in Q1, we think that Q2 activity will be more muted, particularly as some activity could be front-loaded ahead of the potential tariff hit.

Overall, while stronger data has lowered the chance of a rate cut at the March meeting if tariffs are avoided, it is very likely that activity will weaken by mid-year. We continue to see the bank rate reach 2.25% this year.

Australia: Downside Risks to Q4 Growth

The monthly CPI indicator posted a 2.5% y/y rise in January, a tenth below consensus but in line with our pick. The core (trimmed mean) metric was a tenth higher at 2.8% y/y, the first print within the Reserve Bank of Australia’s (RBA) target band in four years and implying downside risks to the Bank’s Q1 forecast. Food prices rose strongly by 3.3% m/m, the fastest pace in a year, while holiday travel eased 6.0%, largely consistent with seasonal trends. The drop in the utilization of energy subsidies in Queensland as well as a soft print in household goods add the risk of a slightly larger subsequent prints, but overall, we think Q1 CPI will come within in the RBA’s target comfortably.

Separately, construction work done—an important input in GDP calculations—rose 0.5% q/q, but this was half the consensus expectation and driven by public work. Non-residential construction was especially weak at -5.4% q/q. In annual growth terms, private construction contracted for the first time since mid-2022 (-0.2% y/y).

Private capex declined -0.2% q/q against expectations of a modest rise (+0.5%), driven by a -0.8% fall in equipment and machinery. Worryingly, the first estimate of spending in FY 2026 (a forward looking measure) declined dramatically to 1.8% y/y, the lowest since 2016 outside Covid. At face value, this dims the outlook for capital expenditures, an important component of our optimistic growth projection this year.

In light of these developments, we lower our Q4 GDP estimate (data to be out on Wednesday) by a tenth to 0.4% q/q (1.2% y/y). However, we think inventories may pose an upside rise. Nonetheless, we see a risk to the RBA being behind the curve, and resultingly a dovish risk to our forecast of two more rate cuts this year. We continue expecting the next rate cut in May.

Spotlight on Next Week

1. US payrolls may disappoint.
2. Canada’s unemployment to remain steady.
3. The ECB to cut again.
4. Australia’s Q4 GDP to rise 0.4% q/q.