North American Outlook: Out of the Pandemic and Into the Fire

War on Several Fronts

• The Russian-Ukraine war is the second “black swan” event to hit the global economy in two years, coming hard on the heels of the fading pandemic. But this time, fiscal and monetary policymakers, saddled with already-high debts and inflation, are in a much weaker position to deal with the fallout. We can only hope the latest shock ends much sooner than the last one. Not that the pandemic is over, as per renewed lockdowns in parts of China, but it does appear to be shifting to the endemic stage, which should allow for a further easing of restrictions on business and social activity in North America.

• The war will have a stagflation-like effect on the economy, reducing growth while raising inflation. Surging commodity prices drove a sharp upward revision to our already-high inflation forecast. At the same time, the economy will suffer from new disruptions to global supply chains (notably in Europe's auto industry), reduced spending power and confidence, and lower exports (especially to hard-hit Europe). Meanwhile, sanctions on Russian companies will curb trade, and many North American companies have pulled back on operations in Russia. Most importantly, consumer and business spending will succumb to weaker financial conditions, notably, wider corporate credit spreads and lower equity values. The tech-heavy NASDAQ is in a bear market, though the TSX has been mostly insulated by the resource boom.

• With a powerful breeze already at its back, inflation will get another tailwind from the war. Russia is a major global producer of energy products and base metals, while both it and Ukraine are big exporters of grains and fertilizers. Consequently, resource prices have taken flight, with crude prices hitting the highest levels since 2008 and nickel, aluminum, and wheat all scaling record peaks. Natural gas has also bounced higher, though nowhere near as much as in Europe, which imports about 40% of supplies from Russia. Led by soaring energy and food costs, we raised our inflation forecast again, and now expect the U.S. CPI rate to rise from a 40-year high of 7.9% y/y in February to 8.6% in April, before retreating to under 6% in December and then to below 3% in late 2023. Likewise, Canada's inflation rate is expected to rise from 5.1% y/y in January to 6.0% in April, before falling back to 5% in December and below 3% late next year. While wage growth remains calm in Canada, rents are likely to chug higher due to surging house prices. Inflation in both countries will likely stay above pre-virus levels even at the end of next year, and this assumes resource prices retreat from current levels. We expect WTI oil prices to average $100 a barrel this year and $85 in 2023.

• Record high gasoline prices in both countries will drain purchasing power and slow spending. The more than $1 jump in U.S. regular fuel prices this year to record highs (a 32% gain) is estimated to carve real consumer spending by 0.7%, though high household savings will help soften the blow. North of the border, the jump in fuel prices this year could spur a somewhat larger hit for shoppers. Canadian drivers haven't been helped by the loonie's rare decoupling from oil prices due to strong safe-haven demand for greenbacks and expected faster Fed tightening.

• Thankfully, North America's economy showed decent resilience before the war, mostly weathering the record number of coronavirus infections at the turn of the year. The resilience reflects high household savings, inventory re-stocking, and still-low interest rates. In addition, Canada has posted a string of current account surpluses in the past year amid improved terms of trade, while the U.S. opted for no new measures to address Omicron. In the fourth quarter of 2021, real GDP grew 7.0% annualized in the U.S. and nearly as much (6.7%) in Canada. Surprisingly, Statistics Canada's initial estimate for January GDP showed a modest advance, despite capacity curbs on some businesses. The country is now rapidly easing restrictions, and should grow 2.5% annualized in the first quarter. Employment rebounded 336,600 in February, pushing further above pre-virus levels, while chopping the unemployment rate a full percentage point to 5.5%. That's the second lowest level in 50 years!

• Still, the fallout from the war drove a one-half percentage point markdown of our Canadian growth call to 3.5% this year and to 3.0% next year. This is still above potential growth (thought to be less than 2%), though subject to further downgrade if the war spreads beyond Ukraine's borders. Meantime, oil-heavy Alberta will lead the country with 5% growth this year, as it looks to use now gushing fiscal revenues and a return to budget surpluses to cushion the hit to consumers and businesses.

• We also cut our U.S. GDP forecast by one-half percentage point to 3.0% this year and trimmed next year's call to 2.3%.Following a hefty inventory build last quarter, the economy looks to expand less than 2% annualized in the first quarter, before picking up in the second half of the year, assuming no further damage from the war. Even with slower growth, the unemployment rate is expected to edge down to 3.4% later this year, the lowest since 1969. Businesses have been on a hiring binge, lifting nonfarm payrolls by 582,000 on average in the past three months, or three times the norm. The NFIB small business survey, however, suggests job growth will downshift due to the war's impact on confidence.

• Will the war chill Canada's overheated housing market? It should, so long as it doesn't derail the Bank of Canada from normalizing policy. A cool-down of current feverish conditions would be welcomed. Benchmark prices posted record gains on both a yearly (29.2%) and monthly (3.5%) basis in February. Even though prices are far detached from family income in many areas, bidding wars remain relentless, with the country posting the second-best February sales on record. Toronto's prices are up 36% y/y, and prices are rising even faster in some other areas, such as Brantford, where the benchmark house costs 47% more than a year ago (and 7% more than just last month). Higher interest rates will eventually take a toll, notably on investors who are now the fastest rising share of buyers. But the main threat is that prices could keep climbing at an unsustainable pace, before higher rates have a chance to pull the market gently down to earth. Solid job growth and a rebound in immigration will provide support, but demand is likely to weaken and price growth simmer down. The energy and resource producing provinces of Alberta, Saskatchewan, and Newfoundland and Labrador should outperform the national market. Not only have they mostly avoided the explosion in house prices in the past two years, and thus remain affordable, they stand to benefit from soaring prices of oil, wheat and potash. Calgary’s existing home sales hit a record for the month of February and prices accelerated 16% y/y.

Central Banks Gird For Battle

• Neither the Fed nor Bank of Canada imagined two years ago that inflation would overshoot their targets by such wide margins. And, neither likely thought two months ago that they would need to fight a war on inflation with one arm tied behind their back due to a real war and its uncertain effect on the economy. Both will need a “nimble” and “careful” approach to decision-making (and some luck) to get inflation under control without short-circuiting the expansion. So far, neither central bank believes the war will be an obstacle to tightening, as the Bank pulled the rate trigger on March 2, for the first time since 2018. Chair Powell, uncharacteristically ahead of a policy meeting, declared his preference to lift rates on March 16, by a quarter point. Both central banks intend to stick to the normalization path this year, and neither has ruled out 50-bp moves to quell inflation if required, even at the cost of a recession, according to Powell in congressional testimony. We expect the Bank to move six more times, taking the policy rate to 2.0% by next spring. The Fed is also expected to move in quarter-point steps, raising the fed funds target rate a total of 225 bps to 2.4% by late 2023. Both end-points are within a fairly wide range of neutrality, though the risk is that an overshoot will be needed to douse the inflation flames. Only if the war depresses growth more than it raises inflation will either central bank take an extended pause on the normalization trail. In any case, the coveted soft landing will be bumpy with plenty of turbulence along the way.

• As for quantitative tightening, we expect both central banks to start shrinking their balance sheets in the months ahead—the Bank in April and the Fed in July—with the latter gradually increasing the amount of maturing securities that won't be reinvested, while the former plans to go full-steam ahead with runoff. Neither bank intends, for now, to outright sell assets in the secondary market, which should alleviate the upward pressure on longer-term rates.

• As the policy screws tighten, we'll have a close eye on the slope of the yield curve, which is probably the single best predictor of a downturn. The current spread between 10- and 2-year rates has narrowed considerably, even as long-term rates have jumped to their highest level since 2019. The market continues to price in a series of central bank rate hikes to corral inflation, which is lifting the mid-section of the curve. If the Fed needs to move more aggressively than the market anticipates, the yield curve will invert, flagging a potential downturn.

• It's hard to end our discussion on a cheerful note. Perhaps the best we can say at the moment is that if inflation moderates as expected, the war ends soon, and the pandemic remains in check, the darkest clouds will begin to lift. While we will still see slower growth this year, at least the expansion should continue.

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