Sunday, February 22, 2009

The Weekly Bottom Line

  • Inflation continues to decelerate in the U.S. and Canada
  • Details continue to emerge in U.S. recovery plans

While the Best Picture award will be decided this weekend, for financial markets and the global economy, the concern remains around the Big Picture. The data this week for the U.S. and Canada, and globally for that matter, was generally downbeat. The pace of U.S. housing starts reached a new post-war low in January, and early manufacturing indicators are pointing toward a lower reading for the February ISM report. Canadian wholesale sales in December fell the most since the August 2003 blackout, while the 8% m/m decline in manufacturing shipments was the largest decline on record. But, we already knew the pace of economic activity in North America was abysmal at the end of 2008 and the kickoff to 2009. That’s one of the reasons CPI data for January showed ongoing decelerations in the rate of headline and core inflation in both the U.S. and Canada. The big picture still revolves around U.S. plans to recapitalize the banking sector, provide economic stimulus through tax cuts and government spending, and forestall mortgage foreclosures. The extent to which these programs are successful will determine the extent to which U.S. consumers start spending and U.S. housing reaches a bottom and begins a sustainable recovery. And ultimately, no amount of government spending in Canada will replace the stimulative impact of a reinvigorated U.S. economy.

The Hottie and the Nottie

Unfortunately, the U.S. stimulus programs announced to date seem more likely to be candidates for a Razzie than an Oscar. We do expect the fiscal stimulus measures announced to date will have a positive impact on economic growth in the United States. But if the banking sector is not put back into order first, all this spending will be for naught. If you give a man a dollar, he spends it today. But if he can’t get a job or a loan, his spending will go away. (and the award for Worst Attempt at Poetry in an Economic Publication goes to…)

The banking sector plans announced by the Treasury are not bad, just short of details beyond the vague 3-step outline provided. First, they will determine which banks are illiquid but still solvent and which are both illiquid and insolvent. Many in the latter category will likely need major restructurings or bankruptcy, while the former can be helped through targeted capital injections. That brings the Treasury’s second part of the plan to try and use federal money as a teaser to bring in much more private sector financing. And this is crucial. Because without a substantial new appropriation from Congress, the Treasury is trying to fill a hole in the aggregate balance sheet of U.S. banks that is estimated at over $2 trillion with just $350 billion in remaining TARP money. But in the meanwhile, credit is needed to help finance new car purchases, student loans, mortgages, etc. This is why the current TALF program, in which government loans directly finance securitized products in these areas, was broadened. Credit needs to flow to these sectors now, and at least on the auto and credit card side, this effort has seemed to improve the spreads on these products.

Slumdog Thousandaire

No one is going to become a millionaire from the U.S. stimulus spending, but it will help. Nevertheless, there are still legitimate questions over the extent and timing of the stimulus spending signed into law this week by President Obama. While our expectations can be found in the TD Economics Special Report A Primer on Fiscal Stimulus, the big picture is this. The $787 billion dollar plan portends to spend $584 billion between the current fiscal year and the next, with about $245 billion in tax cuts and $339 billion in spending. However, included in those tax cuts are $85 billion in extension of the AMT (Alternative Minimum Tax) credit, something which Congress has provided every year. The AMT fix is not stimulus for the economy, but simply prevents more of a drag. Likewise on the spending side, there is about $150 billion of funding which either allow states to retain jobs or programs they already have in place or allow those already collecting unemployment or low-income medical benefits from reaching the proscribed time limit for receiving this assistance. All told, this means about 40% of both the tax cuts and spending provisions for the first two years are not new stimulus, but simply maintain the status quo.

The infrastructure spending will still be a significant positive boost for the economy, but most of this will come in 2010 and beyond. The tax cuts will still help, but a large percent of these will be saved, and much will not reach taxpayers until the end of this year and early into 2010. This is one reason we expect the stimulus to raise 2009 GDP growth by only 0.6 percentage points in 2009 but by 1.5 percentage points in 2010. However, the world of fiscal stimulus can be a tangled web. Take the new homebuyer tax credit, for example. Anyone who buys a home this year, who has not owned a home in the last three years, will receive an $8000 tax credit from the government. Several important questions when looking at this are what is the cost to the government, and will it help the housing market. On the cost, while the federal government will pay the $8,000 credit, each home bought will provide additional revenue to the states in the form of property taxes. The average national property tax in the U.S. is 1.1%, and the average home price is $200,000, so each government credit of $8,000 will on average bring in $2,200 in revenue for the state. Moreover, each one percentage point decline in U.S. home prices leads to a $2.5 billion loss in property tax revenues nationally (based on the existing U.S. housing stock). So any influence on moderating the decline in home prices will mean less lost revenue for the states. But, some of these homes would have been sold anyway, so the tax credit in these cases is free money for the home buyer.

The Curious Case of Mortgage Foreclosures

The most important point to keep in mind when it comes to the U.S. housing market is that income and interest rates are still important drivers in the decision to buy a home. U.S. mortgage rates are now at an all-time low, but some of this stimulus will be offset by the hit to incomes from lost jobs, slower wage growth, and more conservative buying habits. While the above homebuyer tax credit can help mitigate some of those short-term income concerns for a potential homebuyer, the big detractor in the housing market remains the large and increasing inventories of vacant and foreclosed homes that are driving down prices. Tax credits will not make the monthly payments of mortgages that have reset any cheaper. Nor, can the credits augment household income forever. Government money to help lower the principal or extend the term of otherwise unaffordable mortgages will help to reduce the pressure on home prices feeding back into the banking sector problems and lack of credit getting to businesses and consumers. And like the homebuyer tax credit, there will be leakages, as some mortgages will be renegotiated which would have otherwise still been paid, or will nevertheless still go into foreclosure. But, leakage is a two-way street since in those cases, you have more disposable income that can go to spending in the economy. Ultimately, job and income losses in recessions lead to rising foreclosures. In the current environment of banking sector fragility, to ignore this area of stress would be to invite more problems for U.S. banks and households. And that would certainly not be an Oscar-worthy performance.


Canadian Retail Sales - December

Release Date: February 23/09 November Result: total -2.4%% M/M; ex-autos -2.3% M/M TD Forecast: total -3.0% M/M; ex-autos -2.5% M/M Consensus: total -2.7% M/M; ex-autos -2.0% M/M

The wheels have clearly fallen off the Canadian retail trade sector as consumers tightened the grip on their pocketbooks in recent months, in the face of the worse global financial and economic crises since the Great Depression. Indeed, with the Canadian labour market turning bellyup in December and the economy appearing to have entered a rather deep recession in the last few months of 2008, it is no wonder why Canadian consumers are being increasingly cautious with their spending. For December, our call is for retail sales to fall by a further 3.0% M/M, following the 2.4% M/M drop the month before. Much of the decline will come from slumping auto sales and lower gasoline prices, while sales excluding autos are expected to fall by an equally disappointing 2.5% M/M. Real retail sales, however, are likely to perform slightly better as the aggressive discounting by retailers during the month should mean that the volume of sales will likely fall by less. In the months ahead, we expect retail sales to remain fairly soft, as Canadian consumers ease spending even further, though January may provide a brief positive interlude based on available data.

U.S. Durable Goods Orders - January

Release Date: February 26/09 November Result: total -3.0% M/M; ex-transportation -3.9% M/M TD Forecast: total -2.5% M/M; ex-transportation -2.0% M/M Consensus: total -2.3% M/M; ex-transportation -2.0% M/M

With the U.S. economy well into what is expected to be its longest lasting and most intense economic recession since the Great Depression, the continued retrenchment in capital expenditures by U.S. businesses in not entirely surprising. Indeed, new durable goods orders have declined in every month since August, and there is every indication that this trend will continue for more months to come as businesses scale back on big-ticket purchase in the face of softening consumer demand. For January, we expect the unprecedented decline in durable goods orders to continue for the sixth consecutive month, with a further 2.5% M/M drop. Excluding transportation equipment, the decline should be a more modest 2.0% M/M. In the coming months, we expect new orders to decline even further as the impact of the continuing U.S. economic recession gains traction.

TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.