Focus
June 11, 2021 | 13:26
Supply Shock and Demand Awe: Will Price and Wage Pressures Linger?
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Supply Shock and Demand Awe: Will Price and Wage Pressures Linger? |
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The pandemic triggered supply and demand shocks of varying degrees across different sectors of the economy, and they continue to ripple today. In principle, a pure negative supply shock results in reduced output and higher inflation. But the pandemic outcome is not so simple; household behaviour, fiscal and monetary policy have all worked to create some massive, and often very different, disturbances depending on the area of the economy. This has impacted everything from real estate, the availability of workers, and the price of a 2x4 at your local lumber yard. |
The following is a look at some of the most notable pandemic supply/demand shocks, and how they might play out next (summarized in Table 1). Raw MaterialsDemand: Raw materials like lumber and steel have seen demand surge amid increased construction and sharp rebounds in many manufacturing industries. This has been especially acute in the lumber market, where residential investment in the U.S. and Canada surged above pre-COVID levels. In Canada, real construction and renovation investment sat 17% above pre-COVID levels in 2021Q1, a historically massive positive demand shock. Supply: Most raw material markets simply can’t respond as fast as demand, hence the shortages across many commodities. Canadian lumber production, for example, was already falling before the pandemic amid wildfires and sustainability measures, and the early response among producers was to cut output in anticipation of lower demand. Production has now moved somewhat above pre-COVID levels, but the market is still woefully under supplied (Chart 1). Impact: Sharp price spikes across various raw materials, many of which still haven’t turned around. Outlook: Construction-led demand for raw materials will remain elevated through the rest of this year and likely persist above prior trend levels in 2022. By 2023, demand should fade back to more normal levels, but the slow supply response in many raw materials sectors could lead to an outcome where prices settle into a level permanently higher than we were used to before the pandemic. Lumber, for example, is expected to average in the $600-to-$700 range versus $350 before COVID. |
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Consumer Goods |
Demand: The pandemic surge in demand for goods (electronics, appliances, recreational equipment, etc.) has been well documented, with U.S. real spending on goods running roughly 17% above baseline trend levels in 2021Q1. Even auto sales, which slumped early in the pandemic, have surged above 17 mln annualized units through the first five months of 2021. Supply: Supply chains in many industries have been disrupted, or bogged down by a lack of components. Shortages for things like semiconductors have spilled across industries like autos, where production has been unable to keep up with demand this year. Impact: Delays in bringing new component supplies to market, order lead times, and still-strong demand, lead to product shortages and consumer price increases. |
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In the post-war era, this is the first time we’ve seen a recession where order backlogs and supplier deliveries are major issues, with both pushing multi-decade highs in recent months in the U.S. (Chart 2). The result is that U.S. goods price inflation (excluding food & energy) hit 6.4% in May, the highest since 1982. Outlook: The torrid demand for goods should subside next year, easing the acute pressure. Here, price inflation might indeed be transitory, but there’s probably downward rigidity as well, and retailers might try to hold onto some of the increases. Residential Real Estate |
Demand: Housing demand has surged as households seek more space, adjust to expected future working conditions and look for vacation properties amid an absence of travel. Record-low mortgage rates have stoked the positive demand shock further. Make no mistake, this is an issue of extreme demand (Chart 3). Supply: Contrary to popular belief, resale market listings are actually running at a strong clip, or about 20% above the pre-pandemic run rate in Canada. Housing starts are also responding. While new construction tends to be 6-to-12 months behind demand, real estate is one market where the supply response can be relatively swift. Impact: Prices have surged (roughly 50% in some cases) across single-detached and vacation property markets, especially outside the core of the major cities. |
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Outlook: Markets will remain strong this year, and solid in 2022. Over the medium term, however, a lot of demand pulled forward to the pandemic could leave a void, and recreational property markets are especially at risk of a serious cooling. Tighter monetary policy by 2023 could bite, causing some of the froth to come out. Part of the relative adjustment in prices, however, will likely be permanent. Commercial Real EstateDemand: Office and retail demand weakened during the pandemic, but a massive wave of business insolvencies and vacancies was contained by government support measures. Supply: As firms downsize their footprint, more space is becoming available especially in downtown office markets. In Canada, there was 9.5 mln sqft of downtown sublet space on the market in 2021Q1, more than twice pre-COVID levels. Impact: Vacancy rates in impacted areas of commercial real estate are still on the rise. In Canada, the overall downtown class A office vacancy rate hit 11.9% in 2021Q1, up from 8.4% in late-2019. Rents have held up relatively well, likely with the aid of generous subsidy programs, but cap rates have backed up as investors have shied away from the asset class. Outlook: The adjustment in commercial real estate, especially the office market, will be ongoing in the years ahead. We believe that the major urban centres will come back strongly, but it will take time. In the meantime, rents and cap rates could continue to look soft until the market balances more substantially by 2023. Personal and Travel Services |
Demand: Many restaurants and personal services were disrupted by lockdowns, and travel activity was halted. In stark contrast to the goods side of the economy, the pandemic has been a historic negative demand shock for services and travel. In the U.S., real household services spending was still more than 6% below late-2019 levels in 2021Q1, unlike anything we’ve ever seen. Supply: Lockdowns and travel restrictions have cut supply. That is, there aren’t necessarily fewer barber shops, but in some regions you just can’t use them. The simultaneous nature of the demand- and supply-side shocks has temporarily ‘shut down’ industries, which is a much different outcome than we’ve seen on the goods side of the economy (Chart 4). |
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Impact: Since many of these industries are on hold rather than fundamentally weak, we haven’t seen a collapse in pricing. For example, airline fares are down 9% in the U.S., but they’re rebounding quickly upon re-opening (in Canada they have hardly budged). U.S. lodging prices are down 7%. In Canada, personal care prices have actually risen. Outlook: Personal services will tighten quickly upon re-opening, and the travel market could become extremely tight through 2023 as pent-up demand gets let out. The income support will be there, either through job gains or stockpiled savings, and the psychological demand could be historic. Indeed, although very early in the opening process (and with limited international flows), U.S. hotel occupancy rates are already back above 60%, or very near normal levels for this time of year. Combined with limited investment in capacity through the pandemic, shortages of good vacation accommodation could become a theme, perhaps lifting prices sharply. Labour Market and Wages |
Demand: The employment recovery in industries able to adapt to the pandemic was swift last year, leaving the remaining hole in the job market largely confined to those areas still dealing with restrictions. In Canada, for example, employment excluding accommodation, food, culture and recreational services was already back to pre-COVID levels in March. In the U.S., widespread re-opening has created strong demand for workers, with recent disappointing payroll prints held back not by a lack of demand, but not enough bodies to fill open positions. Supply: Indeed, U.S. job openings have surged to almost 9.3 mln as of April, the highest on record (by far) in both raw numbers and as a share of the job market. Meantime, almost half of small businesses have job openings that are hard to fill, according to NFIB, a record—previous cycles saw less than 40% reporting as such at the labour market’s tightest point. |
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Impact: Wages are ultimately the mechanism that draws workers back into the job market, and retains those that are currently there (the latter is not to be overlooked as the quit rate has risen to a record high as well). While year-over-year comparisons are currently wonky, there has been clear strength in wages in recent months, even as lower-paying industries have been driving job growth (i.e., likely biasing average wages down). In the near term, it’s hard not see further upward pressure on wages (Chart 5). Outlook: There are a number of factors likely holding back supply. Ongoing expanded/extended unemployment insurance benefits (U.S.) and support payments (Canada) are a disincentive to re-enter the job market, and could remain so through the end of the summer, assuming these programs get wound down. Pandemic-related risk aversion has also kept some out of the job market, and they might be slow to re-enter. Some young families that moved out of major cities with an eye on larger/more affordable homes might be better able to function on a single income. Finally, massive government transfers and reduced spending on services have padded household savings, allowing less urgency to re-enter the job market for some. All told, labour demand is coming back fast, but the supply response could be quite a bit slower, suggesting that pressures in the job market could intensify further in the years ahead. Bottom Line: The impact of major economic disruptions often tends to run stronger, and linger longer, than most think at the outset. Resource price pressures could persist, with some gains holding permanent. And, as pressures in the goods sector ease, those in services and the job market could intensify. The pandemic created massive supply and demand shocks, the impacts of which will still be with us for a while, and could call into question just how transitory they are. |