North American Outlook

November 23, 2021 | 10:23

Skid Game

Economist

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Key Summary

Supply shortages have left the auto industry reeling and many companies scrambling for parts. Combined with the Delta wave, a drought that walloped the agriculture sector, and now the B.C. floods, the supply challenges have slowed North America's expansion. But, growth is set to rebound as virus cases and supply issues abate, even if the latter could linger into next year.

Stubbornly high Inflation has spread to more goods and services, and now rising wages risk fanning the flames.

By ending QE, the Bank of Canada has removed its foot from the accelerator, while warning of possible earlier rate hikes. The Fed continues to cling to the transitory inflation mantra, but has at least taken a toe off the gas pedal by beginning to taper its asset purchases.

United States

The Delta wave, a dearth of new vehicles, and declining purchasing power cooled American consumers in the third quarter, as real spending slowed to just 1.6% annualized from the stimulus-fueled 12% pace of the second quarter. The pullback, alongside weaker exports, construction, and business spending, trimmed GDP growth to just 2.0% from 6.7% in Q2. Absent a skidding auto industry, GDP would have risen a firmer 3.5% in the quarter.
Underlying demand is far from weak. In fact, consumption of services jumped nearly 8% last quarter, led by a 17% spike in recreation that suggests ample discretionary spending. The main force holding back demand isn't lack of income or desire, it's a lack of supply arising from jammed ports, product shortages, and continued global supply-chain disruptions. The microchip deficit, which is also starting to crimp output of electronic items such as iPhones, now looks to extend into next year. Stalled auto production has left buyers scrambling for hard-to-find models, sending many scampering back to used-car lots where prices are re-heating.
Growth looks to pick up to 4.5% in the fourth quarter, which is off to a great start. The ISM service index hit record highs in October, while auto sales snapped a five-month losing streak and nonfarm payrolls jumped more than half a million. The Delta wave has retreated, spurring an increase in air travel, hotel occupancy, and indoor dining. While the saving rate has returned to pre-pandemic norms, households are still sitting on a considerable cache of extra savings, estimated at well over $2 trillion or 9% of GDP. Couple this with soaring net worth from record equity values and near 20% annual house-price gains, and the holiday shopping season could be the merriest in decades, though some items might be hard to find. While expiring emergency UI programs held back personal income last quarter, it should rebound on strong job and wage growth, with an assist from the expanded child tax credit. (This credit is set to expire at year-end, though Democrats aim to extend it for one year in current budget talks.)
Rising capital goods orders suggest the dip in business equipment spending last quarter won't last. Residential construction is also poised to rebound, as housing markets have caught a second wind. Commercial real estate is on the mend, led by thriving industrial and multi-family residential sectors, the latter supported by low rental vacancy rates and rising rent. Construction of offices and malls, however, will take longer to recuperate, given long-run challenges stemming from remote work and online sales.

Fiscal policy is still providing a tailwind, albeit a fast-fading one. State and local spending jumped more than 4% annualized in the third quarter, stoked by $360 billion in funds from the American Rescue Plan Act of 2021. Congress recently passed the $1 trillion infrastructure bill, which repurposes existing funds and includes $550 billion in new spending to support infrastructure projects over five years. Given the lengthy planning process, shovels may not hit the ground until well into next year. Revenue raising measures will also keep the economic impact small, but attendant gains in productivity could provide some marginal lift to long-run potential growth. Meantime, the nearly $2 trillion Build Back Better plan for education, healthcare and climate control has cleared the House but will have a tougher ride in the Senate. With zero support from Republicans, it needs to be shoehorned into law using the reconciliation process, and the Democrats can’t afford to lose a single vote. Spending in this plan will be spread over many years and the fiscal lift will be partly offset by revenue measures, meaning it will add only moderately to growth in the years ahead. However, the economy will face a lighter corporate-tax hike, as the original proposal to raise the rate from 21% to 28% has been replaced by a 15% minimum tax on domestic firms and a 15% minimum tax on foreign earnings of U.S.-based multinational companies.
Despite slower growth, the unemployment rate has fallen by more than one percentage point in just four months to 4.6% in October. This reflects strong job gains, with payrolls expanding by more than 3 million in the past five months. But, it also stems from a depressed participation rate due to early retirements and virus-related anxieties and challenges. This means worker shortages will likely worsen as the recovery progresses, with the unemployment rate expected to return to pre-virus levels (and half-century lows) of 3.5% by late next year, or possibly much sooner if the part rate remains flat. Most wage measures are already heating up, with the quarterly employment cost index rising the fastest in 17 years (3.7%) in the past year, and unit labour costs climbing the most in 38 years (4.1%) on a two-year annualized basis.
Despite some cooling-off in items that rebounded quickly during the reopening, such as airfares and hotel rates, CPI inflation has popped to a three-decade high of 6.2% in October and could take a crack at 7% in the new year. Energy prices have steadied but remain elevated, while the severe drought across the North American Plains has sent crop prices to multi-year highs. Vehicle prices have been turbo-charged by production cuts and thin inventories. Rents are rising as many prospective buyers get priced out of the housing market. While no clear signs of broad wage pass-through are evident, a shift here would likely keep inflation high for longer. Half of small businesses say they can't fill openings, forcing many to either pay more or stay small.
Our forecast for solid 3.5% GDP growth in 2022 assumes the shackles will start to come off supply chains by early next year, and that stubbornly high inflation will begin to recede at that time, too. We also assume no missteps on the fiscal front, such as a partial shutdown after the current stopgap funding measure expires on December 3 or, worse, a payment default if the debt ceiling isn't addressed in the coming month.
Starting in November, the Fed will reduce the size of its $120 billion monthly debt purchase program by $15 billion per month, suggesting the program could wind down by mid-2022, barring higher inflation or weaker growth. This should set the stage for an increase in the funds rate in September, with a series of quarterly moves taking it above 2% by mid-2024. Chair Powell believes inflation will recede by the second or third quarter of 2022. If not, or should wages accelerate and inflation expectations deteriorate, policy could be tightened sooner and more aggressively.
After rising on higher inflation and the looming Fed taper, the 10-year Treasury rate has steadied in the 1.5%-to-1.7% range. We still expect it to reach 2.0% by late next year on tighter Fed policy.

Canada

After shrinking in the second quarter due to virus-led restrictions and supply-related disruptions (which hammered auto exports), real GDP is expected to rebound 3.5% annualized in the third quarter. The risk, however, is to the downside, as GDP fell slightly in July, rebounded less than expected (0.4%) in August, and stalled in September according to StatCan's initial call. Along with the usual suspects (a fourth virus wave and supply-chain woes), agriculture was slammed by the severe drought in Western Canada. Still, growth will get a boost from a sharp rise in Canada's goods trade surplus, as export volumes surged in September.
Despite strong gains in retail sales and manufacturing shipments in October (according to StatCan's flash estimates), we were forced to slash our Q4 GDP growth call by 3 percentage points to 3.0% due to the devastating floods in British Columbia. While efforts to reopen roads, railways and pipelines are progressing well, it's clear that supplies to and from the Port of Vancouver and the entire region will be severely disrupted for some time. Lost trade and delayed production will likely shrink GDP in November.
Rebuilding efforts in the province and the fading of supply-chain bottlenecks should support brisk 4.3% GDP growth in 2022. Households are sitting on a mountain of excess savings, while also benefiting from powerful wealth effects. Rising energy prices (though painful at the pump) are good for the economy, flipping Canada's trade balance to a steady surplus. The housing market is heating up again as buyers rush to use pre-approved mortgages in anticipation of higher borrowing costs. Existing home sales remain well above normal, while benchmark prices are up 23% in the past year to October. Low interest rates, steady demand from millennials, and the return of immigration are supporting the market. But the longer that prices outrun family income, the greater the risk of a correction when interest rates normalize.
One factor that will temper the recovery is the end of federal income-support programs for most businesses and many unemployed people. Wage and rent subsidies will be targeted at the hardest-hit companies in the leisure and hospitality sectors. Most of the over 800,000 persons receiving $300 a week in Canada Recovery Benefits saw their payments end in late October. The program was delivering roughly $1 billion per month, or 0.5% of monthly GDP, though the adverse impact on growth will be limited if many can find work in a now healthier labour market.
Canada's economy marked a milestone in September, recovering the last of the 3 million jobs that were shed during the shutdowns. Another 31,000 positions were added in October, taking the unemployment rate down to 6.7%, which is less than half the recession peak and just one percentage point above pre-pandemic levels, similar to the U.S. situation. However, labour shortages are less severe in Canada because the participation rate has nearly fully retraced its decline. Unlike the U.S., the number of unemployed (1.4 million) far exceeds the number of job vacancies (732,000 in Q2). Accordingly, wage growth is tame in Canada, with the annual average hourly measure up just 2.0%, less than half the inflation rate.
Due to a firmer loonie, inflation is also less heated than in the U.S., though that doesn't mean it's running cold. Annual CPI inflation of 4.7% in October is the highest in 18 years. The two-year annualized rate of 2.6%, which filters out weak prices a year ago, is more moderate but tracking upwards, as are most core measures. Surging house prices and wholesale food costs are likely to keep inflation near 5% at the turn of the year, before slipping below 2.5% by late next year as reopening pressures and supply issues ease.
The Bank of Canada expressed more concern about the inflation outlook at its October 27 meeting when it abruptly announced an end to its QE program. It also warned of the possible need to raise rates as early as next spring. With the pandemic clamping down on supply and potential growth, the Bank sees the output gap closing sooner, in either Q2 or Q3 of 2022, when rate hikes would be expected to begin. As a result, we advanced the timing of the expected initial rate hike by several months to July 2022. A series of quarterly rate hikes should return the current 0.25% policy rate to a more neutral 1.75% by late 2023. The 10-year Canada rate is now consistently tracking above its U.S. peer, a rare feat in the past eight years.
The central bank's hawkish pivot put some wind under the Canadian dollar's wings, though it has since weakened on a modest pullback in energy prices. We see the loonie cruising moderately higher to C$1.20 (US$0.83) by late 2022 as the Bank hikes rates ahead of the Fed.