North American Outlook

October 05, 2021 | 16:07

Economy Hits Speed Bump Not Roadblock

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 and the Delta wave have slowed the North American economy, but they are more delaying than derailing the recovery, and we expect solid growth to resume soon

Seeing through the temporary downshift in growth and sensing a less transitory upshift in inflation, central banks are laying the groundwork for less stimulative policies

United States

Although supply shortages and the Delta wave have slowed activity, they are likely only delaying the U.S. recovery, and we continue to expect robust growth in the year ahead. The latest wave of infections, lack of product selection, higher prices, and fading support from rebate payments have clearly cooled consumers. Rising anxiety led to a pullback in travel and dining. At the same time, product shortages and output disruptions, in part due to an outbreak of infections in Asia, have held back supply. Nowhere is this one-two punch more apparent than in the auto industry, where the major producers have been forced to idle output due to a shortage of microchips (that now risks extending into next year) and with buyers forced to scrounge dealer lots for a limited selection. Despite a nice rebound in August, consumer spending likely downshifted to a 1% annualized rate in Q3. This led us to trim our GDP growth call to 4.5% annualized in the third quarter. But remember, the second quarter witnessed 12% annualized gains in both consumer spending and business equipment spending, and a 6.7% pop in GDP.
The good news is that the latest wave of infections appears to be cresting, setting the stage for a rebound in confidence and demand in the fourth quarter. Households have plenty of financial firepower due to a mix of high personal savings (much of it sitting in bank accounts and retail mutual funds), soaring net worth, and rising employment and wages. To boot, the expanded child tax credit has helped offset the end of emergency UI benefits. Meantime, rising factory orders for durable goods point to continued strength in business equipment spending. Commercial real estate is also on the mend, led by the thriving industrial sector and, to a lesser extent, multi-family residential amid low rental vacancy rates and climbing rents. The office space is grinding out a recovery as more workers return to their cubicles. Retail remains the laggard, though total returns turned positive in Q2 after five straight quarterly losses.

After fading earlier this year, the housing market has caught a second wind on strong job growth and a dip in mortgage rates. A spike in pending home sales to seven-month highs in August puts demand midway between the record peaks of last summer and the levels prevailing before the pandemic. So far, demand hasn't been chilled by record price increases, with two key measures (Case-Shiller and FHFA) running north of 19% y/y. While fading affordability suggests the housing market will moderate, rising employment will lend support.
Fiscal policy will likely remain a tailwind for some time, albeit far less than in the past year. Congress is still debating a roughly $1 trillion infrastructure plan and a $3.5 trillion social infrastructure and climate action plan. While the latter proposal is likely to get scaled back to appease some moderate Democrats, it will likely be pushed into law via the reconciliation process that requires just a simple majority in the Senate (which is all that it will get as no Republicans support it). The plan also comes with hefty tax increases on corporations and wealthy households, and the spending is spread over many years, suggesting that the economic impact, though positive (at the expense of a still-large budget deficit), will be limited.
After recently passing a stopgap measure to fund the government until December 3 and avert a partial shutdown, Congress' next hurdle is to raise or suspend the debt ceiling to avoid a payment default that Treasury Secretary Yellen warns could come around October 18. The debt ceiling issue has haunted markets roughly every two years for the past decade, so it's losing its ability to scare investors. However, failure to address the issue could ding the nation's credit rating (as in 2011), pushing interest rates higher and roiling markets. S&P has warned that the country would face "severe and extraordinary" consequences if it misses a debt payment, while Yellen says a default would be a "catastrophe". All the more reason for the issue to be addressed.
Each wave of the pandemic has brought less damage to the economy than the previous one. Assuming infections are contained this winter, supply disruptions begin to ebb, and inflation doesn’t get out of hand, consumer spending should rebound. We still see real GDP growing 5.8% this year and well above potential at 3.5% next year. Demand is strong, and will remain so when supply issues abate.
The robust expansion should drive the unemployment rate down from 5.2% in August toward pre-pandemic levels below 4% by late next year. Nonfarm payrolls have grown an average of 586,000 in the first eight months of the year, three times the quarter-century median. However, recovering the remaining 5.3 million jobs lost during the pandemic will require an upturn in the participation rate. Unfortunately, it has flat-lined in the past year, and the end of emergency UI benefits has yet to spur a significant upturn in job growth. Wage hikes, however, could provide a more powerful tonic.
After ramping to multi-decade highs above 5%, CPI inflation has steadied amid a cooling of some recent big drivers (used vehicle prices, airfares and hotel charges). However, we expect inflation to remain near or above current high levels through the turn of the year, as wage growth drifts higher, droughts pressure crop and food prices higher, surging natural gas prices (more than doubling this year) fans heating costs this winter, and new vehicle prices continue to climb in response to historic low inventories. While we expect inflation to moderate next year as supplies become more ample, the risk is to the upside given the potential for ballooning house prices to fan rents. As well, companies could continue to struggle to meet demand and might become more inclined to pass higher wages onto consumers.
Having made "sustained further progress" toward its goals on inflation and employment, the Federal Reserve recently signaled that tapering of asset purchases will begin "soon". Barring a weak jobs report, an announcement is likely at the next policy meeting in early November. Half of the FOMC members now see at least one rate hike in 2022. However, we doubt that the Chair Powell is among this group. Though admitting that inflation has run hotter for longer than expected, he still believes the upturn is transitory given that the economy is still "far away" from full employment. We still see an initial rate increase in early 2023, but now expect a faster pace of tightening with eight quarter-point hikes in the following two years.
After sinking below 1.2% in early August on global growth concerns, 10-year Treasury yields have popped above 1.5% recently as many central banks have either hinted at pulling back on stimulus or actually tightened policy (Brazil, Norway, Mexico). We expect yields to rise gradually to 1.6% at year-end and to 2.0% in late 2022 in response to fading pandemic fears, healthy economic growth, and elevated inflation. Long-term rates will climb further in 2023 amid tighter monetary policy.
Property developer China Evergrande's troubles spurred some brief safe-haven demand for Treasuries, but most analysts (including ourselves) believe the government will be able to ring-fence the damage to home buyers and stem broader contagion to financial markets. The country is also facing energy shortages that are impeding production and the global supply chain. We have trimmed half a point from our growth call for China's GDP to 8.0% this year and 5.5% next year.

Canada

After contracting moderately in the second quarter amid new restrictions and supply-related disruptions to auto exports, Canadian real GDP is expected to rebound 3.5% annualized in the third quarter amid support from expansionary fiscal policy, high household savings, and rising energy prices. Though slipping again in July, Statistics Canada expects a hearty 0.7% bounce in August GDP. Western Canada, and Alberta in particular, has struggled with the Delta variant, but Central Canada was less impacted. The auto industry continues to face supply shortages, with light vehicle sales down 20% in the past year to September, but other expenditures, such as on home furnishings and clothing, have picked up the slack. Business investment is also on an upswing. While small business confidence plunged in September, this was largely due to uncertainty about the federal election and vaccine passports, suggesting a rebound is likely. The country is now consistently recording merchandise trade surpluses for the first time in several years. We continue to expect stronger 6.0% GDP growth in the fourth quarter and 4.5% in 2022, well above long-run potential of under 2%.
The recent federal election delivered the status quo, with the Liberals maintaining a minority mandate and needing the support of other parties to pass legislation. While some (marginal) further spending is planned, as well as higher taxes on larger financial institutions, this hasn't altered our economic forecast. Wage and rent subsidies could be extended, but less clear is whether income-support programs for workers will continue beyond their scheduled expiration in the month ahead. Still, rising employment, with the household survey now showing net job losses of less than 1% since the pandemic started (amid plunging self-employment), should allay the adverse effects of fading fiscal support on consumer spending.
After spiraling to record highs earlier this year, existing home sales have settled down to above-normal levels. Benchmark prices, which had been decelerating, sped up in August, as new listings are not keeping pace with robust demand. Prices have surged 21% in the past year, near the top of the global charts. A smattering of demand and supply-lifting federal policies will provide some modest support to the market. But rapidly-eroding affordability across the country (though more in Central and Eastern Canada) will eventually cool demand and prices. Until then, correction risks will persist the longer that prices continue to leap-frog income.
Canada's CPI isn't as heated as south of the border, but it's still rising the fastest in 18 years at 4.1%. This is largely due to low base-year effects, as the two-year annualized rate is a more sedate 2.1%. However, surging house prices and producer food costs signal more pressure in the months ahead, before the pace begins to moderate. As in the U.S., the risk is that inflation stays high for longer, especially if wage pressures mount and the increases are passed along to consumers. While worker shortages in Canada are less severe than in the U.S., they are bound to worsen as the jobless rate slides from 7.1% in August to below 6% by late next year.
A cautiously optimistic Bank of Canada is likely teeing up another tapering of asset purchases at the October 27 policy meeting. Still, we expect it to hold off on raising policy rates for one more year to support a full recovery in the labour market. Like the Fed, we now expect a perkier tightening course, with four quarter-point moves in 2023.
Global growth concerns and diminished risk appetite have countered surging natural gas prices (more than double this year) and higher oil prices (7-year peak with OPEC+ sticking to its measured output increases amid rising global demand) to keep the Canadian dollar locked in a range around C$1.26 in the past two months. We still see the loonie strengthening moderately to C$1.20 (US$0.83) by late 2022 as the Bank of Canada lifts policy rates ahead of the Fed.