Monday, October 26, 2009

The Weekly Bottom Line


  • U.S. housing starts stall in September at 590 thousand but existing home sales continue to rise, jumping 9.4% in the month and helping to bring inventories of unsold homes down.
  • U.S. Beige Book shows a tepid recovery, with improvements in consumer sentiment and the housing market but continued weakness in labor markets and commercial real estate.
  • Federal Reserve Governor Benjamin Bernanke spoke on global imbalances and financial regulation this week, making the case for greater savings in the U.S. and greater domestic demand in emerging markets.
  • The Bank of England October Minutes reveal more optimistic outlook, but Q3 GDP later in the week was a big disappointment, showing the economy contracted for the sixth straight quarter.
  • Chinese economy grows by 8.9% y/y, with engines of growth expanding beyond just government stimulus.
  • Brazil places a 2% tax on investment inflows into the country in the hopes of controlling short-term inflows and avoiding an overheating equity market without putting further upward pressure on the currency.
  • The Bank of Canada kept rates at their effective lower bound of 0.25% and reiterated its conditional commitment to do so until mid-June 2009, however presented a slightly more pessimistic tone than its July Monetary policy report.
  • Canadian real retail sales were up 0.4% in August, making up for a 0.1% decline in July
  • Start to Canadian recovery may be slower than expected.


In a week focused once again on the fate of the U.S. dollar (not only in the U.S. but in global markets), economic indicators were tentative on the state of the U.S. recovery. As Christina Romer laid out in a speech this week, the early stages of economic rebound have been brought about largely thanks to policy actions ranging from the broad based liquidity provision and quantitative easing action of the Federal Reserve to the impact of specific government programs, such as the Car Allowance Rebate System (CARS) and the First-Time Home Buyer Tax Credit, which have been key factors behind the rebound in consumer spending and turnaround in the U.S. housing market.

With next week's release of the advanced estimate of third quarter U.S. real GDP growth, we will get a better picture of just how successful these measures have been in pulling the U.S. economy out of the Great Recession. We expect a greater than consensus result of 3.8% (annualized) growth, driven mainly by rebounding consumer spending, automotive production, and the housing market. Nonetheless, with the initial stages of recovery now in the rear view mirror and both fiscal and monetary stimulus starting to wind down, the key question now is how well is the U.S. economy prepared to stand on its own to feet?

The data flow this week continued to support our call for a gradual pace of economic recovery. While credit conditions have improved, the U.S. financial sector has not fully recovered and even as focus moves away from major systemic risks within the banking sector, the flow of credit will continue to be impaired by rising foreclosures and commercial real estate losses. The U.S. Beige Book, out this week, was similarly mixed in its reading on the recovery. While conditions in the housing market appear to have improved, continued deterioration in commercial real estate markets was noted across the country. Moreover, U.S. housing starts, after improving fairly dramatically earlier in the year, appear to have stalled in the third quarter and have been steady at just under 600 thousand since June. On the brighter side, existing home sales for September jumped a strong 9.4% and inventories of unsold homes fell to 7.8 months supply, from 9.3 in August. While these results are certainly positive, the impact of the first-time homebuyer incentive should not be underestimated, with first-time buyers accounting for 45% of the sales in the month. The success of the current program, which is set to expire at the end of November, has led to talk of prolonging the program beyond its deadline and expanding it to include all homebuyers.

Federal Reserve Chairman Benjamin Bernanke spoke twice this week. Early in the week his comments were of a global nature, focusing on the Asian experience with the current and past financial crises and also touching on global imbalances. In perhaps one of the more direct statements on the role of currency manipulation on the financial crisis, the Fed chief stated, “trade surpluses achieved through policies that artificially enhance incentives for domestic saving and the production of export goods distort the mix of domestic industries and the allocation of resources in an economy that is less able to meet the needs of its own citizens in the longer term.” With 70% of the U.S. economy directed towards consumption and only 35% of the Chinese economy, there is a lot of room for rebalancing.

Late in the week, Bernanke turned his attention once again to the Fed's role in U.S. financial regulation, making reference to one of the hot button topics of the day - compensation - by noting that compensation plans that encouraged excessive risk taking contributed to the financial crisis and efforts going forward should ensure that incentives are aligned with the long-run health of the organization and do not pose a threat to the soundness of the overall financial system.

All in all, it was a week with a lot of information to digest: U.S. growth is on the mend but the recovery still looks to be drawn out. Moreover, beyond the immediate recovery, issues in global rebalancing and financial regulation will continue to make headlines for weeks and likely years to come.

CANADA - Slowly but Surely

It would appear that the Canadian economy has headed down the road of recovery, but the take-off hasn't been as fast as originally hoped. Even the Bank of Canada provided a slightly more pessimistic tone in its monetary policy report than it had presented in July. However, there were no surprises on the direction of monetary policy. The Bank kept rates at their effective lower bound of 0.25% and reiterated its conditional commitment to do so until June 2010. The Bank stated that while the economic backdrop for final domestic demand has improved more “favourably” than expected, over the medium-term, the negative implication of a strong Canadian dollar will outweigh these positive developments. As such, the central bank has slightly downgraded its growth outlook for 2011 down to 3.3% from 3.5%.

It was not all that surprising that the Bank of Canada made the downward revision to the outlook, as many forecasters felt the Bank's outlook in July was much too rosy given what is widely believed to be a mild recovery in the U.S. and the negative implication of a strengthening Canadian dollar. The Bank's forecast of 3.0% growth in 2010 and 3.3% in 2011 is still slightly more optimistic than our own forecast for growth of 2.5% and 3.0% respectively. And in fact, the recent strength in the Canadian dollar, and an upward revision to our outlook on the currency does put some downside risk to our own forecast. As such, we believe that the Bank of Canada will stay put past its conditional commitment of June 2010, and the first rate hike will not come until the fourth quarter of next year.

What was surprising was that the Bank of Canada upgraded its estimate for growth in the second half of 2009, anticipating that the economy grew 2.0% (up from 1.3% in July's MPR) in the third quarter and will grow a further 3.3% in the fourth quarter. This was a bit notable given that this upgrade follows a month of poor economic data suggesting that the Canadian economy likely contracted in August. Following July's lackluster performance, this has led some to question whether the Canadian economy managed to record growth at all in the quarter. However, like the Bank of Canada we do believe that there are more signs pointing to a budding recovery in the Canadian economy in the third quarter. Unlike the Bank of Canada, we see that recovery coming with the risk of a slower pace than 2%.

Let's start with the good news. Both residential and business investment is tracking much stronger than we had originally thought, and is set to contribute significantly in the third quarter. The recent strength in building permits, and imports of machinery and equipment puts both residential investment and business investment on track for a 20% annualized gain. As such, both types of investment will contribute significantly to growth in the third quarter.

However, investment makes up only a small component of economic activity, and the other major components of growth - consumer spending and exports - are tracking weaker than our forecast. While real retail sales were up 0.4% in August, making up for a 0.1% decline in July, forward looking indicators suggest that sales likely fell again in September. This puts consumer spending on track for a 2.0% gain in the third quarter. The Canadian consumer is on the mend, albeit at a slightly slower pace than we had expected. Meanwhile, July strength in exports gave just enough boost to set exports up for their first gain in over two years; however, much of that gain will be wiped out by losses in August and September as an appreciating Canadian dollar put pressure on the export sector. As such, exports are set for a 13% gain in the third quarter. Putting it all together, our current tracking is that the Canadian economy may have grown at closer to the pace of 1.4% annualized, rather than the 2% the Bank of Canada is forecasting.


Monetary policy has never been easy. Interest rates must be set today based on expectations of how the economy will be doing 18 months in the future. So, decision making in the face of uncertainty is nothing new for central bankers. However, there was generally a belief that given the economic forecast, the choice of the appropriate level for interest rates was much less uncertain. Discretion was bad. Rules were good. That textbook is now in flux, and the sordid life of monetary policymakers has been on display recently in Australia, the U.K., Brazil, and China.

In spite of the volume of discussion over the decision by the Australian central bank to raise interest rates, that did not represent such a regime change. The near-term hit to inflation and the economy was less severe than elsewhere. Headline inflation fell to a positive 1.3% y/y pace as of September and Australian GDP contracted for only one quarter - avoiding a technical recession. So, the amount of spare capacity now bearing down on inflation is much less than elsewhere. But as insurance against the worst, the RBA had cut interest rates by 425 basis points, so textbook central bank policy mandated that interest rates should start to rise to reflect the better realities.

Textbook central bank policy also places inflation expectations on a pedestal, which may prove to be problematic for the Bank of England. The first reading on Q3 GDP came in at -1.6% (SAAR), vastly underperforming the expectations for +0.9%. This caps off a third quarter in which much of the hard data was rather anomalous, deviating fairly significantly from where forward-looking surveys of producers and consumers suggested economic activity would be. Our initial expectation is that we will see the fourth quarter make up some of this discrepancy, and the Bank of England has signaled they are likely to revise up their expectations for the economy in the medium-term, but they may also revise down the near-term ( boe_oct09.pdf).

This is important because the BoE's decision on how much government debt to purchase is based on the cumulative deviation of GDP, not just on expectations for growth. So less growth now and more in the future could actually translate into more government debt purchases now, but interest rates rising a bit more quickly in 2010. This is complicated by growing hawks on the Council. Inflation expectations are actually creeping up in the U.K., with our estimates suggesting that the current level of inflation priced into financial markets would be consistent with a 2.5% y/y headline inflation rate 12 months from now. Central banks take anchored inflation expectations seriously, and faced with rising inflation expectations now and an academic debate over how much slack there is in the economy and how that may or may not impact inflation down the road, persistently high inflation expectations will win every time. That is why the BoE could hike rates in the face of economic slack and why the Fed and Bank of Canada are still much more comfortable where they are.

For emerging markets, the tendency remains “Be like China.” Rather than moving to the more formulaic approach of central banks in the G-7, the idea is it's ok to manage your currency, take on huge currency reserves, and when necessary use the big stick of capital controls as opposed to the invisible hand of incentives. After all, it helped China reach their target of 8% GDP growth ( comment/rk102209_china.pdf). Brazil this week was not ready to raise interest rates. Even though the economy is making quick work of the 4% decline in GDP earlier this year, the currency has gone on a tear as investors piled back into Brazilian equities. Since fears of asset bubbles have taken on an elevated role in the brave new world of central banking, policymakers implemented a 2% tax on capital inflows. Just a few years ago, Brazilian markets would have likely been severely punished for this blunt force trauma, but this Tobin tax to discourage finicky speculative inflows comes right out of discussions from the G-20 in September (www. And, it certainly doesn't hurt that this tax will raise money from outside investors to finance domestic government spending. With the “Be like China” mantra among emerging markets, rather than directly preventing central banks from raising interest rates, this may be the more likely way that fiscal and monetary policy become intertwined in the post-subprime era.


U.S. Durable Goods Orders - September

  • Release Date: October 28/09
  • August Result: total -2.4% M/M; ex-transportation 0.0% M/M
  • TD Forecast: total 1.5% M/M; ex-transportation 1.0% M/M
  • Consensus: total 1.0% M/M; ex-transportation 0.7% M/M

With the recovery in the U.S. economy appearing to be gathering further traction, capital expenditures are slowly coming back on track as U.S. businesses prepare for the impending pick-up in demand for their products. Moreover, with the U.S. dollar nearing the cyclical lows of mid-2008, export demand is fast becoming a source of favourable support for U.S. manufacturing goods. As such, we expect U.S. durable goods orders to rise by a respectable 1.5% M/M in September, following the sharp drop the month before. The rebound should be mostly driven by a pick-up in transportation equipment orders, though other sub-components are also expected to post gains. Excluding transportation, orders should also rise, though by a more respectable 1.0% M/M. In the months ahead, we expect durable goods order to remain in positive territory and to perhaps gather further momentum, supported by the improving U.S. and global economies.

U.S. Real GDP - Q3/09

  • Release Date: October 29/09
  • Q2 Result: -0.7% Q/Q ann.
  • TD Forecast: 3.8% Q/Q
  • Consensus: 3.0% Q/Q

The third quarter of 2009 will in all likelihood mark the emergence of the U.S. economy from the longest and deepest recession in the post-war period. At 3.8% (annualized), the return to positive growth is expected to be substantial. The main pillars of growth will be a rebound in consumer spending, business inventory investment and residential construction investment. Aided by fiscal stimulus and cash-for-clunkers legislation, spending on automobiles skyrocketed in August, and while spending fell back in September on the expiration of the government program, other areas of consumer spending continued to hold up. The emergence of the U.S. automakers from bankruptcy was also important in returning growth to positive territory, and automobile production likely added close to 1.5 percentage points to growth in the quarter. Finally, the rebound in U.S. housing starts that took place mainly through the second quarter of this year implied more hammers and saws were put to work through the third quarter. On the negative side, fixed business investment (excluding inventories) continued to flounder in the quarter. Non-residential structures investment in particular saw another quarter of deep decline and is unlikely to rebound any time soon.

U.S. Personal Income & Spending - September

  • Release Date: October 30/09
  • August Result: income 0.2% M/M, spending 1.3% M/M; core PCE deflator 0.1% M/M, 1.3% Y/Y
  • TD Forecast: income -0.1% M/M; spending -0.4% M/M; core PCE deflator 0.1% M/M, 1.3% Y/Y
  • Consensus: income 0.1% M/M; spending -0.5% M/M; core PCE deflator 0.2% M/M, 1.3% Y/Y

With the support from the cash for clunkers program virtually washed out of the data in September, we expect to see a modest pullback in personal consumption expenditures during the month. The decline in motor vehicle spending, however, is likely to be partially offset by strength in expenditures in other categories as U.S. consumer spending continues to stabilise. As such, we expect personal consumption expenditure to fall by 0.4% M/M, undoing some of the 1.3% M/M surge in August. Income is also expected to be weaker, and after rising for two straight months, personal income should fall by a modest 0.1% M/M, reflecting in part the soft U.S. labour market conditions. On the inflation front, the core PCE deflator is expected to rise by a modest 0.1% M/M. The annual pace of core PCE inflation, however, is expected to remain unchanged at 1.3% Y/Y. In the months ahead, we expect the core PCE deflator to continue to ease as the growing economic slack in the U.S. economy dampens core consumer price pressures.


Canadian Real GDP - August

  • Release Date: October 30/09
  • July Result: 0.0% M/M
  • TD Forecast: -0.1% M/M
  • Consensus: 0.1% M/M

Even though the Canadian economic recession is now behind us, the path to economic recovery is likely to be uneven, as the favourable support from domestic demand (driven in large part by supportive fiscal and monetary policies) is partially offset by the drag from the strong currency. In August, we expect GDP to decline by 0.1% M/M, following the flat print in July. During the month, the positive momentum coming from the pick-up in domestic consumer spending and motor vehicle production should be offset by softer wholesale sales activity and the weakness in tourism-dependent sectors of the economy. The performance of the manufacturing sector, however, remains uncertain as even though real shipments were lower, actual production could possibly be positive. Overall, we expect both goodsproducing and service-producing sectors of the economy to be weak - or flat at best. In the coming months, the Canadian economic recovery should remain intact, as the significant monetary and fiscal policy stimulus administered to the Canadian economy gather traction, though the recovery is likely to both slow and fragile.

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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.

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