Sunday, May 31, 2009

The Weekly Bottom Line


  • Equity markets extend rally and bonds sell off as U.S. consumer sentiment improves.
  • U.S. durable goods orders improve by 1.9% in April, but core capital goods orders fell 1.5%, and the decline in overall orders for March was revised sharply downwards to -2.1% from -0.8%.
  • Even though U.S. existing home sales have stabilized since November, unsold inventories remain lofty and prices show no sign of stabilization yet.
  • GM on the edge of bankruptcy as initial debt-for-equity swap proposal falls through. Meanwhile, Magna looks poised for an acquisition of Opel.
  • Canada's latest federal deficit estimate for current fiscal year tops $50 billion, or 3.2% of GDP.


How much longer can equity markets and consumer confidence echo each other to feed the ongoing rally? From an absolute rock bottom level of 25.3 in February, the Conference Board consumer confidence index improved to 54.9 in May. Most of the improvement occurred in that last month, in households' expectations rather than current situation. As of close yesterday, both a reflection and cause of the alleviation in consumer anxiety, the S&P500 stood 32% higher than its most recent low of early March. Consumer sentiment itself, while much improved from its low and climbing towards levels that were typical coming out of previous recessions, is by no stretch of the imagination 'good'. Hence, without any underlying improvement in economic fundamentals, there is little doubt that overextending this shift in sentiment would be premature. Part of the sentiment shift seems quite legitimate, however, the bar having been set so low in the Fall as a state of absolute fear gripped markets in the aftermath of the Lehman and AIG downfalls. However, the signals generated by the economic data continue to be mixed with some pointing to a recovery later this year, while others show no signs of improvement whatsoever.

For example, wage growth (net of inflation), which tends to lead consumer spending out of recessions, was, as of April, the highest since the early 1970s. As such, it suggests consumer spending is bound to pick up in upcoming quarters, although the surge in savings currently under way is more than a passing fad. Meanwhile, the inventory of unsold existing homes remains lofty even though sales have stabilized since late last year. As a result, home prices, which tend to turn 3 to12 months after sales bottom, will remain under pressure in the medium-term.

In the absence of a consensus as to the timing and strength of an eventual economic recovery, all one can expect in the meantime is for markets to remain quite choppy. Irrespective of the cloudy considerations surrounding economic recovery, what is clearer is that foreign exchange market sentiment has signalled a clear turn against the U.S. dollar. As the accompanying chart highlights, the dollar has depreciated by about 9% on a broad basis since March, just as equities started rallying. As the global financial system heals itself, the dollar's safe heaven position is not sought after as much as it was in the midst of the crisis, and structural issues have come to the forefront. Funds are finding their way towards riskier asset classes, many of which are denominated in foreign currencies. Furthermore, concerns over the level of deficits, the necessary U.S. Treasury bond issuance that follows, the level of public debt, tied-in to longer-term concerns over inflation all figure prominently in a turn of sentiment against the dollar. It is also in this context that a lack of strong appetite for U.S. Treasuries for maturities 5-years out and longer, when measured against a large pipeline of supply, has meant yields have backed up substantially over the last two months. With little movement in yields for shorter term maturities as China has substantially upped its portfolio's share of Tbills, the result has been a sharply steeper yield curve. While yields remain low in historical terms, the worry is that the Fed's purchases of Treasuries will have to be ramped up to lean against this wind. Legitimate or not, worries about the Fed's exit strategy and potential inflation could fuel further sell offs and blank the Fed's ammunition if it were to be deployed. And so the paradox continues for the world's reserve currency. Just as the financial market crisis helped boost the dollar, talk of 'green shoots', rallying U.S. equities, and mixed economic data have not helped the currency - quite the contrary. Meanwhile, foreign central banks are worried that the dollar's decline will result in a further blow to their exports, the latter having already taking a beating over the last two quarters. No one ever suggested the path to recovery was going to be smooth sailing.


The Canadian dollar (CAD), up past 0.91 USD as of writing, has certainly been on a tear of late. Remember when it was at 0.77 USD just three months ago? Is this 2007 all over again? Not quite. The drivers behind this latest move differ from those that drove the CAD above parity against the USD in mid-2007. First off, Canada is not alone in this move, far from it. It has also not recorded the largest appreciation against the USD by any means, but rather lies in the middle of a pack in this regard, as the accompanying chart highlights. Most major currencies have appreciated substantially against the USD in the last three months. Sure enough, oil prices have rallied and contributed to lifting the CAD, but broader commodity prices that would be needed to ground the currency move in fundamentals, in particular natural gas, have moved mostly sideways during the same period. Our TD commodity price index has been roughly flat since the beginning of the year, and most sub-components, with the exception of precious metals, have had a similarly dull profile. Most notably, the CAD appreciation isn't far off from that recorded by the Euro over the same period. So this is not, for the most part, a made-in -Canada story, regardless of its relatively better fundamentals (e.g. financial, fiscal) when compared to other advanced economies. Even in light of the federal government's announcement that its latest estimate of the deficit for the curent fiscal year was nearly 50% higher than budgeted and would top $50 billion, it would still weigh in at 3.2% of GDP, which is much lower than other advanced economies.

After benefiting from its safe-heaven position in a context of extreme fear in the midst of the financial crisis, the USD has retraced its steps, and is off by 9% since early March on a broad trade-weighted basis. As a result of this quick shift in foreign exchange market sentiment - more on this in our U.S. section commentary on the previous page - we've adjusted our forecast, and are now calling for a further 10% appreciation in the CAD which would bring it within parity against the USD by year's end. Such a large shift in the currency over a short period of time begs the question of its impact on the economic outlook. It is here that the driving force behind the currency move matters most, in particular in terms of monetary policy response. Our analysis of the recent surge in the CAD suggests it is more than two-thirds due to factors such as financial flows, risk aversion, and bond supply concerns, that would suggest a more accommodative monetary policy than otherwise, a so-called 'Type-II' move. Less than a third of the CAD move can be associated with factors, such as fundamental economic developments or shifting commodity prices, or so-called 'Type-I' move, that would suggest a tighter monetary policy. Fair-value models of the currency also corroborate this view. How much can the CAD appreciation be expected to dull our or the Bank of Canada's economic outlook? Fortunately, not that much. There is a slight downside tilt to economic growth, but the impact would be transitory as parity is unsustainable given current fundamentals. We expect the CAD to head back towards fair value of 0.87 USD by the end of 2010. Our sensitivity analysis suggests the breakdown between Type-I and Type- II factors nets out as largely a wash in terms of economic impact and monetary policy response. The bottom line impact would likely be on the order of only -0.1 percentage points or so in terms of annual real GDP growth per year in 2009 and 2010. In the current environment where other, more qualitative factors also argue in disfavour of the Bank of Canada deploying a quantitative easing policy, we still deem the current monetary policy stance as appropriate.


U.S. Personal Income & Spending - April

  • Release Date: June 1/09
  • March Result: income -0.3% M/M, spending -0.2% M/M; core PCE deflator 0.2% M/M, 1.8% Y/Y
  • TD Forecast: income -0.1% M/M; spending -0.1% M/M; core PCE deflator 0.2% M/M, 1.8% Y/Y
  • Consensus: income -0.2% M/M; spending -0.2% M/M; core PCE deflator 0.2% M/M, 1.9% Y/Y

The weak U.S. economic condition has continued to wreak havoc on households' balance sheets, as the combination of falling home prices, deteriorating labour market conditions and tight lending conditions have conspired to erode household wealth and access to credit. The weak economic backdrop is expected to remain well entrenched in April, and our call is for personal income to fall for the third consecutive month, declining by a further 0.1% M/ M. And despite the noticeable rebound in consumer confidence in recent months, personal consumption expenditures are expected to soften even further, falling by 0.1% M/M. Moreover, with the backdrop for U.S. consumers continuing to be grim, we expect both personal income and spending to weaken in the near term, though the massive fiscal stimulus is likely to bolster both indicators later this year. On the inflation front, despite the underlying economic weakness, the core PCE deflator is expected to rise for the fourth straight month, gaining a further 0.2% M/M in April. The annual pace of core PCE inflation, however, is expected remain flat at 1.8% Y/Y. In the months ahead, we expect the core PCE deflator to start easing as the growing economic slack dampens core price pressures.

U.S. ISM Manufacturing Report - May

  • Release Date: June 1/09
  • April Result: 40.1
  • TD Forecast: 41.0; Consensus: 42.0

The upward momentum in the U.S. ISM manufacturing sector index appears set to continue for the fifth straight month in May, underscoring the growing sense of a moderation in the pace of deterioration in U.S. manufacturing sector activity. Evidence of this can be seen in the numerous regional manufacturing sector surveys, which have improved markedly on the month. The only exception to this trend has been the Chicago Fed index, which worsened on the month, and this was sufficient to cause us to temper the extent of the anticipated bounce in May. As such, our call is for the ISM index to climb to 41.0, leaving it just shy of the 41.2 level which would be historically consistent with an end to the U.S. economic recession. Adding to the upward momentum in the index are the recent strong gains in new orders, which are now only marginally below the 50 threshold. Notwithstanding this improvement, with the economic backdrop for U.S. goods producers remaining very dire, we expect manufacturing sector activity to remain weak for some time, even though the pace of decline should continue to ease.

U.S. Nonfarm Payrolls - May

  • Release Date: June 5/09
  • April Result: -663K; unemployment rate 8.9%
  • TD Forecast: -475K; unemployment rate 9.2%
  • Consensus: -530K; unemployment rate 9.2%

The U.S. economy remains in dire straits, and the continued weakness in consumer demand will remain a key factor forcing employers to reduce their workforce even more, adding to the 5.7 million jobs that have already being lost. Even so, the recent flow of employment related surveys have shown some moderation in the pace of labour market deterioration, and we expect this to be reflected in the official employment report in April. As such, our call is for nonfarm payrolls to decline by a further 475K in April, following the 539K drop seen in the prior month. As has been the case in the past, the losses are likely to be split among the goods-producing and servicesproducing sectors. However, further 2010 census hiring during the month is expected to bolster the payroll of the public sector. In terms of the unemployment rate, with the pace of job destruction continuing to outpace job creation, the unemployment rate should rise even further, climbing to 9.2%. In the months ahead, we expect the pace of contraction in U.S payrolls to remain relatively brisk, though further easing in the pace of layoffs is expected.


Canadian Real GDP - Q1/09

  • Release Date: June 1/09
  • Q4 Result: -3.4% Q/Q ann.
  • TD Forecast: -5.8% Q/Q
  • Consensus: -6.5% Q/Q

The dice have now been thrown, and the lot of the Canadian economy decided. Indeed, with the global economy crumbling in the face of the intense financial and economic crises, and the U.S. economy (Canada's main trading partner) continuing to languish in the depth of its most profound economic recession since the Great Depression, it is now clear that Canadian economic activity has taken a dramatic turn for the worse in Q1. During the quarter, we expect Canadian GDP to plunge a staggering 5.8% Q/Q ann., which will almost match the worst quarterly performance of the Canadian economy on record (going back to 1961). Nominal GDP is expected to fair far worse, plunging at a double-digit clip for the second straight quarter. The weakness in Q1 economic activity should be fairly broadly based, with both domestic consumption expenditure and external trade providing significant drag on the domestic economy. Business investment should also be weak. Government expenditure is expected to be the only component adding favourably to output, given the significant fiscal stimulus administered to the Canadian economy. If there are any risks to this call, they are clearly to the downside. The contraction in Canadian economic activity should continue for the next two quarters, with economic activity expected to stabilise later in the year.

Bank of Canada Interest Rate Decision

Release Date: June 4/09

  • Current Rate: 0.25%
  • TD Forecast: 0.25%
  • Consensus: 0.25%

Given the BoC's transparency in the last communiqué that it would leave the overnight rate unchanged at 0.25% until June 2010, there is little reason to believe that it will be swayed from the sidelines. The economic environment has certainly deteriorated, and inflation has remained soft but not significantly so as to prompt the Bank into changing its stance. Given that the Bank has so clearly stated its intention that rates will remain on hold, the focus then turns to the statement. On that front, there may be only a few subtle nuances to watch for. First, the Bank might steer away from its view that the risks to inflation are to the downside. While inflation has moderated, prices simply have not retrenched as much as would be expected with this serious a recession. Moreover, the market will be looking for any further clues as to whether the Bank will follow a path of QE. We still think that it will keep this bullet in its arsenal, but it will not be implemented immediately and only if conditions deteriorate significantly.

Canadian Employment - May

  • Release Date: June 5/09
  • April Result: 35.9K; unemployment rate 8.0%
  • TD Forecast: -50.0K; unemployment rate 8.3%
  • Consensus: -42.5K; unemployment rate 8.3%

The April labour force survey was a bit of a headscratcher as the Canadian economy was reported to have added a massive 35.9K jobs in what can only be described as the worst economic environment since the Great Depression. This went against the grain of what was widely expected, and we are unlikely to see a repeat performance in May. In fact, with the Canadian economy appearing to have declined further in recent months our call is for the ranks of the employed to decline by 50.0K in May. Much of the loss is likely to occur in the goods producing sector, where the continued restructuring in the auto sector and the adverse impact of the strengthening Canadian dollar on activity is expected to show up in lower employment. The service producing sector, which added all of the jobs last month, is also expected to post losses on the month. Moreover, with the weak economy continuing to limit the ability of displaced workers to find new jobs, the unemployment rate is expected to rise to 8.3%, after holding steady at 8.0% the month before. Looking ahead, given the very weak economic backdrop for the Canadian economy, we expect the negative labour market dynamics to remain entrenched, and the pace of job losses to be brisk in the coming months

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.