The pinch

Albert Einstein was not only the most extraordinary physicist of the 20th century, he also had interesting opinions on a variety of economic concepts. From those opinions came one of his famous quotes, “Compound interest is the eighth wonder of the world.?He who understands it, earns it. He who doesn't, pays it". Two years into one of the most aggressive US Federal Reserve (Fed) interest rate hike cycles in history, many economic agents are learning this undeniable truth the hard way.

Economic data

First to feel the pinch of higher borrowing costs are interest-rate sensitive sectors such as construction. US Housing starts were down 5.5% in May. This poor showing takes the Year-on-Year number to -19.3%. Building permits did not provide a brighter outlook at -3.8% for the month. Mortgage rates in the 7% area and high prices are enough to discourage the most enthusiastic buyers.

As rates stay higher for longer, the squeeze is felt in broader parts of the economy as consumers divert discretionary spending to service debt. Retail sales for the month of May disappointed with a meager increase of 0.1% after a revised -0.2% for April. The control group showed a healthier 0.4%, but it was still short of expectations and follows a weak -0.5% for the previous month. This number will put a dent in the early forecast of a 3.1% gross domestic product (GDP) growth from the Atlanta Fed. Although a weaker consumer is not something to celebrate, this data is consistent with the goal of a soft landing for the US economy.

Canadian retail sales looked better for the month of April, with an increase of 0.7%, the first positive number so far this year. However, deeper analysis also suggests that pressure from higher interest rates is driving consumer behavior. New car purchases, which have been a key driver of growth so far, were down 2.2% for the month. Here again, the cost of financing is forcing potential buyers to reconsider changing the old clunker for a new model. Building materials were lower by 0.4%. Gas station sales and food purchases, essentials for everyday living, kept the overall number on the positive side. Finally, the estimate for the month of May will temper hopes of a quick turnaround in sales, initially seeing a return to negative territory at -0.6%.

Bond market reaction: Mostly unchanged

Fixed income investors might not all be nuclear physicists, but they still can put two and two together. Lower than expected US payrolls, inflation and retail sales numbers so far this month increase the probability of central bank cuts. Therefore, rates remain at the lower end of the trading range we have seen so far this year. The 10-year Treasury bond finishing the week mostly unchanged at 4.25%. Yield curves remain stable as well on both sides of the border as markets will need more data to shift its current shape. Political turmoil emanating from Europe triggered a small move wider in corporate spreads, but overall levels remain very healthy and appetite for new issues is strong.

Stock market reaction: Mostly mixed

Global equity markets were mostly mixed this week across the different regions. In the US, ‘breadth’ of markets has been a topic of conversation over the past year as the large technology companies take leadership even within the S&P 500. This divergence has only gotten worse in 2024 with Nvidia’s outperformance vs. other index constituents. In fact, Nvidia is responsible for nearly a third of the S&P 500’s gains this year while other large tech companies account for another 25%. While fundamentals and earnings growth have been robust, ETF inflows have also exaggerated these moves.

In other news, the European Union (EU) announced a new round of tariffs on Chinese electric vehicle (EV) imports resulting in total tariffs of ~20%-40%, depending on the company. This doesn’t come as a major surprise given Chinese auto original equipment manufacturers (OEMs) are able to sell in Europe at a discount to domestic OEMs, despite additional freight costs. However, this raises the question over which areas China will target next. As a reminder, companies like Mercedes-Benz sell close to 30% of their total volumes into China.

What to watch in markets next week

The first week of summer will keep markets busy as the third estimate of US Q1 GDP will be released, along with new home sales, personal income and the personal consumption expenditures (PCE) deflator. Canadian data will include GDP for the month of April, Consumer Price Index (CPI) and the payroll employment number from the service of employment, payroll and hours (SEPH) which includes average weekly earnings.

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Authors: Adam Ditkofsky, Pablo Martinez, Sandor Polgar, Steven Lampert, Craig Jerusalim, Rahul Bhambhani and Diana Li

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