Andrew Pyle
August 10, 2023
Will the Canadian consumer tap out?
Last week, we discussed the validity of the soft-landing view of the U.S. economy and the fade in equities this past week suggests some are re-thinking that view. The same holds true for Canada, though there are indications that things are weaker north of the border, from the latest employment figures to negative results out of Canadian Tire. The question now is how much of a drag consumer spending will be on overall economic activity during the second half and whether a revival can take place before the holiday season?
The chart below shows the Citi Economic Surprise Index for Canada, which measures whether economic data releases have come in above or below consensus, on net. A reading above zero shows indicators beating expectations and vice versa. As you can see, there was a deterioration in the index in the first quarter, followed by a bit of a rebound later in May. This coincided with the Bank of Canada’s surprise decision to resume tightening; however, a weakening pattern has followed this quarter and the index is back into negative territory for the first time since May.
Even though employment and housing activity was strong in June, the latest figures are pointing to a moderation in July, though not a massive one. On the jobs front, all of the weakness has been in part-time staff, while full-time employment rose by a couple of thousand in July after a strong 110,000 increase in June. Wage growth has also been robust this summer, with average hourly wages up 5% in July compared with the same month last year. That was an acceleration from the 3.9% increase in June and not far from the post-pandemic peaks (5.4%) seen last November and this past February. We will get July housing starts figures next week and economists expect a pullback after the sharp jump in June. That said, building permits continued to push higher in July, so any decline may not be that severe.
Finally, consumer confidence is still hanging in there. The Nanos-Bloomberg Economic Mood index hit a record high in 2021 as the nation rebounded from the pandemic and money was “free”. As inflation took hold and the threat of higher interest rates grew, we saw a deterioration in sentiment all the way through 2022 and, by October, the nation’s mood was getting close to the low we saw at the start of Covid. Fueled by strong employment gains, sentiment recovered in the first half of this year and, while we have seen a retracement since June, it has been minor. Hence, the traditional fundamental indicators would suggest that the wheels are not coming off the Canadian consumer cart just yet. That doesn’t mean the resilience is infinite.
There has been a lot of push back against the market’s notion that central banks will quickly lower interest rates as inflation continues to moderate and you are hearing more economists and market participants talking about “higher for longer”. True, yesterday’s U.S. CPI numbers came in as expected, but core inflation rose a tenth of a point to 4.8% - even though the monthly rise in the core CPI held at just a hair under 0.2% (the slowest pace in two years). If we assume that core prices continue to nudge along at this rate, then in a year’s time core inflation would approach 2%. That’s still a big assumption and one that the Federal Reserve seems unwilling to make. Therefore, barring an outright recession this half, official rates are likely to stay up where they are.
Ally and I have been advising clients that we are at or close to the end of the rate hiking cycle and some infer that an end to rate increases means somehow that the pressure on households is going to diminish. One look at what is happening to the cost of servicing existing debt runs counter to that inference. The above chart comes from Statistics Canada and measures the interest paid on consumer debt on a seasonally adjusted annualized basis. As you can see, there has been an explosion since the Bank of Canada started to raise rates in 2022. As of the first quarter, total interest amounted to just over $146 billion, representing a 60% increase from recent low set back in 2021. In annualized terms, this is a 37% increase or 7 times the pace of wage growth.
There are a couple of factors at play here. First, consumer debt has expanded at a significant clip due to higher home prices and, for non-homeowners, increased expenditures on rent, food and other necessities. Personal deposits in Canada have also followed the same trajectory as in the U.S., with households drawing down inflated balances created by pandemic stimulus. As of May, the Bank of Canada’s M2 personal deposits were down close to 12% from the peak reached in March of last year. This is intuitive given that significantly larger share of household income is going to paying debt interest and in some extreme cases, families may be tapping into revolving credit to pay interest on fixed debt (like mortgages and car loans).
At some point, the drag from higher debt servicing costs is going to show up in spending and the May retail sales report suggested that the wallet books might already be closing. With monthly gains in sales falling back to near zero, the year-over-year increase in sales fell to only 0.5% in May – the lowest since the pandemic. Chances are we will see this turn negative in the months to come and that is going to push overall GDP growth lower, given that consumer spending accounts for more than 50% of national GDP.
And this brings us back to the Canadian Tire results. In the quarter ended July 1st, the retailer reported that revenue had dropped by 3% from the same period last year and that net income also edged lower. Management attributed the weakness to inflation and higher interest rates, which impacted non-discretionary spending. Outside of the move in the stock price, which gapped lower by more than $8 yesterday, the message is that consumers might already be tapping out.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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https://www.bls.gov/cpi/
https://www.statcan.gc.ca/en/subjects-start/labour_