Monthly Economic Letter

December 2021
Feature article

Can households sustain Canada’s economic recovery?

Economic growth relies heavily on household spending. While household wealth has increased during the pandemic, there remains much uncertainty about how vulnerable consumers are to financial setbacks.

With inflation rising, the real estate market in a frenzy and interest rate hikes looming, how well positioned are Canadian households to support the economy in 2022?

Household savings could be a double-edged sword

If there was one positive economic outcome from the pandemic, it was probably the increase in household savings. In 2020, repeated lockdowns limited the ability of households to spend while government relief programs contributed to increased personal income.

The result is close to $300 billion in excess savings accumulated by Canadians since the beginning of the pandemic. This represents more than 10% of GDP, which is huge.

However, all this saving is not an unmitigated positive for the economy. The Bank of Canada has identified it as a potential source of higher inflation. With the supply of goods and services already under pressure from high consumer demand, even more spending could cause the economy to overheat.

Real estate: A source of wealth, debt and risk

It may seem odd, but despite sky-high savings levels, overall debt still increased during the pandemic because of higher mortgage debt.

Demand for homes has been stimulated by low interest rates and telecommuting during the pandemic. On the supply side, inventory in the resale market has continued to decline from already low levels. This has generated surging home prices and mortgage debt.

Anticipation of a strong economic recovery in early 2021 has pushed fixed mortgage rates ahead of variable rates, leading to more than half of mortgages originated in the third quarter of 2021 being variable rate. This makes households more vulnerable to changes in the Bank of Canada's rate than in the past, a situation that is exacerbated by a larger share of mortgages carrying high loan-to-value ratios due to the recent price spike.

Don’t underestimate the wealth effect

Presumably, Canadian households have taken advantage of their accumulated savings to pay down some debt and invest in the housing market. A good portion of the pot will also have been invested in the stock market.

Thanks to the good performance of the financial markets and higher home prices in 2021, household wealth has increased considerably—at least on paper. This wealth is not very liquid and can’t be readily spent to support economic activity directly. It would, therefore, be surprising if it fed a rapid increase in inflation.

On the other hand, the wealth effect suggests that consumer spending will continue to increase in the coming months, which is good news for the economy.

The impact for your business

  • The high level of household savings accumulated during the pandemic will continue to support growth, even though higher inflation will reduce the purchasing power of Canadians.
  • The wealth effect generated by the good performance of the real estate and stock markets should also contribute to maintaining solid demand.
  • Consumers appear cautious despite the reopening of service industries and borders. Demand should grow more gradually in coming months, in the context of rising interest rates.
Canadian economy at a glance

The ups and downs of the Canadian economic recovery

Surprisingly strong economic activity in the third quarter still wasn’t enough to propel the Canadian economy above its pre-pandemic level.

GDP growth reached an impressive 5.4% annualized in the quarter. Yet, GDP still stood at only 98.6% of the pre-pandemic level. This is because a contraction in the spring was worse than Statistics Canada had previously estimated. GDP actually fell by 3.2%, not 1.1%.

Despite this revision, there is no denying economic activity picked up strongly over the summer, thanks to reopenings and relaxed health restrictions. Household consumption and exports more than offset a decline in residential investment.

For the third quarter as a whole, the majority of sectors in Canada experienced positive growth (13 out of 20). The majority of the gains came from high-contact services, especially the accommodation and food services industry (+27.7% from Q2). The goods sector as a whole contracted by 0.9% during the period.

Manufacturing should improve slowly

A preliminary analysis by Statistics Canada suggests that economic activity grew by 0.8% in October. This growth appears to have been fairly widespread, but particularly strong in manufacturing.

The performance of the manufacturing sector has been rocky to say the least in recent months. A shortage of semiconductors has been a major contributor to its difficulties, including a 1.7% decline in September. As automotive and aircraft parts production picks up, the sector should begin to contribute positively to economic activity again.

Trouble in the residential sector

Rising real estate prices are both a cause and a consequence of the decline in residential investment (-31% in the third quarter). Stimulated by low interest rates and the need for more space due to the rise in telecommuting, strong demand pushed up real estate prices across Canada in 2021.

With very little inventory of homes for sale, prices have skyrocketed. Today, some buyers are discouraged by high prices while others simply can’t find what they need.

The decline in residential investment is also reflected in the construction industry (-3.9% in Q3). While housing starts remain high by historical standards, they continued to fall in October.

Demand for renovation projects is also slowing due to delivery delays caused by supply chain bottlenecks and the reallocation of household budgets to services. However, the residential real estate craze could pick up momentum again in the coming months as some households rush to finance their projects before interest rates rise.

More employment gains

In November, 154,000 jobs were created across the country. The pace of job creation has rebounded sharply from October. Since September, employment has fully recovered its pre-crisis level. November's impressive gains have propelled the employment level well above that February 2020 peak.

Many employers continue to have difficulty recruiting staff. In September, there were over one million jobs available in Canada. This suggests that the skills of potential workers do not match those needed by businesses. Despite all this, the unemployment rate at 6.0% remains above the pre-pandemic low.

The impact for your business

  • Despite the strong performance in the third quarter, there is still a long way to go before we return to pre-pandemic levels of economic activity. The supply side of the economy is still under pressure, but households are in a good position to support the economy. The evolution of the new Omicron variant could, however, cloud the economic outlook in the short term.
  • Employment continues to grow across the country and is making it increasingly difficult to recruit workers. Available workers may not be exactly what you are looking for. Consider developing an internal training program to adequately equip new employees.
  • Manufacturing and residential housing slowed in the face of the headwinds, but the latter could be headed for a rebound. Households and businesses should move ahead with their investment plans ahead of an expected 2022 interest rate hike.
U.S. economy at a glance

Economy is still on a solid footing

The U.S. economy entered the fourth quarter in a strong position. In addition to a marginal upward revision of third quarter GDP growth (from 2.0% to 2.1%), a number of economic indicators have turned green recently. Still, the pandemic continues to impact the economy and confidence.

A strong labour market supports demand

Inflation hit a 31-year high in October, reaching 6.2%. However, price increases don’t appear to have spooked consumers too much. Their spending rebounded by 1.3% in October after a poor performance in September. Household consumption is expected to remain strong thanks to a holiday season that’s less marred by the pandemic and strength in the labour market.

In November, U.S. employment continued to increase, adding 210,000 jobs and pushing the unemployment rate down to 4.2%.

The labour market is taking longer to recover from the pandemic than economic growth, which has already surpassed its pre-pandemic level.

Despite strong demand for workers lately, the economy is still 4 million workers short of its pre-pandemic level. Fiercer competition for workers has wages on an upward trend.

Ask and you shall receive? Not so fast...

Despite the dizzying pace of price increases in the U.S., demand for products and services remains strong. On the supply side, bottlenecks continue and delivery times are long.

Still, there are signs of improvement on the horizon. Transportation shipping costs have stopped rising and auto production has picked up, signalling that shortages are easing, though still present. The Purchasing Managers' Index fell, but optimism remains high.

Omicron infects the markets

While the wave of COVID infections from the Delta variant is receding, the Omicron variant is now causing uncertainty in the markets.

At the time of writing, there was still too little information about this variant to factor it into our forecasts. However, as the situation becomes clearer, the markets will take new developments concerning the variant into account, which will likely lead to episodes of volatility.

On the other hand, President Joe Biden favoured continuity when he reappointed Jerome Powell as Chairman of the U.S. Federal Reserve.

However, the Fed's view of rising inflation seems to have changed and could therefore surprise in the coming months. While some members of the policy committee already wanted to see the end of the asset purchase program brought forward from the latest schedule of mid-June, the reappointed chairman has done an about-face by adopting a more urgent tone regarding the tightening of its policy in order to control inflation. 

While job and wage growth have kept consumer confidence higher than it was at the beginning of the pandemic, the latest wave of infections and higher inflation have been reflected in a drop in confidence recently.

The impact for your business

  • U.S. demand remains robust. Despite a September growth slowdown and an October surge in inflation, the strong labour market should support consumption during the holiday season this year. Canadian exports should benefit.
  • Despite signs of improvement, production still faces significant challenges that will continue into next year.
  • Stability at the top of the Fed is positive for the markets, which are vulnerable to economic setbacks from the Omicron variant.
Oil market update

Tapping into strategic oil reserves: A good or bad idea?

In an effort to increase the supply of crude oil in order to lower prices and provide some relief to U.S. consumers as the holiday season approaches, President Joe Biden announced last month that he would tap into strategic reserves by adding 50 million barrels to the market.

The U.S action was supported by China, India, Japan, South Korea and the United Kingdom, which are all also set to dip into their strategic reserves.

What are strategic reserves?

Strategic reserves exist primarily to ensure the energy security of countries in the event of a major oil shortage. The use of these inventories is typically reserved for emergency support in the event of a natural disaster or war, which would lead to an energy crisis.

Member countries of the International Energy Agency are required to hold a quantity of oil equivalent to at least 90 days of the previous year's net imports. Countries that are net exporters of crude, including the United States, are not required to meet this requirement, although they do so anyway.

In response to the 1973 energy crisis, the U.S. created the world’s largest oil reserve in 1975. Today, it holds 609 million barrels of crude in reserve.

The impact on prices

Will this be enough to stabilize prices? Probably not. This is primarily a symbolic move.

Fifty million barrels to the market is too little to have an impact at the pump. Americans consume roughly 20 million barrels per day. Therefore, the measure announced by U.S. authorities represents little over two days of domestic demand.

The real objective behind the synchronized release of oil by major consuming countries is to put more pressure on the Organization of Petroleum Exporting Countries and its allies (OPEC+).

The oil market is currently under supplied because demand has picked up faster than expected, but the cartel refuses to deviate from its current timetable for increasing production, which is keeping prices high.

The major oil indices hit seven-year highs recently, hovering around US$85/bbl. Following President Biden's announcement, prices fell only slightly. It was the new Omicron variant that had a real impact on prices.

Omicron could be a game changer

At their latest meeting, OPEC+ members decided not to change their production policy, despite somewhat lower prices and the White House's call for higher production.

However, the cartel is monitoring developments very closely. Restrictions have already been reintroduced because of the new Omicron variant and the number of COVID cases are on the rise again in Europe, which could slow demand for oil in the coming weeks. The uncertainty of the new variant has already pulled prices towards a more sustainable level.

Bottom line

The increase in oil supply from the various strategic reserves will not be sufficient to rebalance the crude market in a sustainable manner. The coordination of the participating countries will only have a short-term effect on prices. OPEC and its allies have no interest in deviating from their current agreement to gradually increase supply, especially in the face of the uncertainty that the new COVID variant brings.

Other economic indicators

Bank of Canada to remain cautious

In October, the Bank of Canada announced the end of quantitative easing and suggested that the first interest rate hike could come as early as April 2022. The latest announcement on December 8 was not substantially different from the previous one. The Bank will likely be more cautious in tightening monetary policy as it expresses concern about mortgage debt in the country in the face of rising rates.

The Canadian dollar fell below US$0.78

The Canadian currency has hovered around US$0.79 in recent weeks, down from its 2021 annual average. More recently, in early December, the loonie slipped under US$0.78. Although the drop in oil prices is not unrelated to this depreciation, the uncertainty brought up by the Omicron variant in the markets has also contributed to the dollar's decline against its American counterpart.

Business confidence is slowly recovering

In November, the CFIB's business confidence index rose a few more points. Since falling sharply in September, the index has yet to return to the high levels experienced during the summer and stood at 62.2 in November. An indicator above 50 indicates that entrepreneurs expect the business environment to improve over the next 12 months. However, the short-term indicator (next three months), despite increasing to 49.8, shows that business owners see the reopenings as positive, although they are aware that challenges remain. In short, business owners are realistic about the economic challenges of the next few months but believe that the economy will recover in the longer term.

Key indicators—Canada