The Weekly Bottom Line : UNITED STATES - 2010 STATE OF THE UNION AND STATE OF THE ECONOMY

HIGHLIGHTS OF THE WEEK

• U.S. real GDP grows by 5.7% annualized in Q4 2009. Inventory investment leads the way with a 3.4 percentage point contribution. Net exports also add to growth, while final domestic demand growth decelerates. For the year as a whole, real GDP contracted by 2.4% in 2009, its largest annual decline in over sixty years.
• U.S. home sales finish 2009 on a low note, with existing home sales down 16% and new home sales down 8% from November. Month's supply of unsold homes moves up from 6.5 to 7.2 months for the existing market and from 7.6 to 8.1 months for the new.
• FOMC meeting turns slightly more optimistic about state of U.S. recovery, but - reflecting low inflationary prospects - statement restates policy to keep fed funds rate at low levels for an extended period of time. Fed President Hoenig dissents.
• Canadian economic activity advanced 0.4% in November, putting fourth quarter real GDP on track for a 4% gain.
• Toyota's announced production stoppages to impact both plants in Canada and about 15% of total Canadian auto output.

What a busy week it was - we heard from both the Federal Reserve and the U.S. President, while economic data reminded us just how fragile an economic recovery built on government stimulus can be.
First the bad news: 2009 was the worst year for the U.S. economy in more than half a century - U.S. real GDP contracted by 2.4%, its largest annual decline in the post-war period. Now, the good news: the year ended a whole lot better than it started. Real GDP in the fourth quarter expanded by 5.7% (annualized) - the second quarter to see positive growth and the first to see anything resembling a typical post-recession bounce. Similar to past business cycles, growth was predominantly due to a slower pace of inventory liquidation, which contributed 3.4 percentage points to the rise in real GDP.

With 2009 now in the rear-view mirror, we move our attention to 2010. The country began the year with the highest unemployment rate in 27 years at 10%, and the largest federal budget deficit in more than half a century, also at 10% (of GDP that is). Neither of these two facts were lost on President Obama as he delivered his first State of the Union address. While jobs played a key role in the President's speech, the need to balance the near-term recovery with fiscal prudence thereafter was also a strong undercurrent.

We have long said that the U.S. recovery will depend on how the private sector takes over where public stimulus has left off. Fiscal stimulus may have helped start the ball rolling, but it can not last forever, and has not come cheap. The housing tax credit is a very good example of this. Through much of 2009, we witnessed a rebound in U.S. home sales. From a low of 4.5 million (at an annualized rate), existing home sales rose 46% to 6.5 million in November. But, home sales fell by 16% in December, the month after the original tax credit was set to expire. While the credit has been extended to the end of April - sales pulled forward by the tax credit still mean lower sales later on. Of course, the tax credit could be extended once again, but this is not a costless proposition. Indeed, the cost of the tax credit is likely to be more than $15 billion, which based on reasonable assumptions on the amount of new home sales due to the credit, implies a cost per each additional sale of over $50,000. With a gross debt-to-GDP ratio that is likely to reach close to 100% of GDP as soon as next year, the need for restraint becomes more and more pressing by the day.

On Wednesday, the Federal Reserve made its 8th interest rate announcement since reaching their effective lower bound in December of 2008. While relaying an economic outlook that was slightly more upbeat than in the past, the policy statement remained relatively consistent with past statements, specifically in its commitment to keep the fed funds rate 'exceptionally low' for an 'extended period.' The interesting development was actually less in the wording of the statement and more in that, unlike past statements, the decision was not unanimous. Fed President Hoenig objected to the 'extended period' mantra, signaling to markets that like fiscal stimulus, monetary stimulus will need to be unwound in the not too distant future

CANADA - Q4 ON TRACK FOR STRONG REBOUND

With not much else on the economic calendar in Canada this week, much of the focus was on this morning's GDP report, as markets looked for further evidence that the economic recovery is still on track. And indeed, that's what markets got! After kicking off the fourth quarter with an upwardly revised 0.3% (M/M) pace, economic output continued to expand in November, growing by a faster-than-expected rate of 0.4% (M/M). Wholesale trade, and mining and oil and gas, were the top performers on the month, though 15 of the 18 industries managed to increase activity. November's advance puts real GDP on track for a robust 4% (annualized) growth rate in the final quarter of the year - a much more convincing rebound than the 0.4% (annualized) pace recorded during the prior quarter.

While the gains over the past few months have been fairly widespread, one area that has grown consistently is the construction sector. This comes as no surprise given the remarkable strength seen in the Canadian housing market. But, it's not just new homebuilding activity that has given output in the sector a boost. Home renovations and repairs have also been accelerating in recent months, thanks in part to the federal Home Renovation Tax Credit. While the stimulus program has been in place since last January, it appears as though homeowners ramped up renovation activity in the final quarter of 2009 in order to take advantage of the tax credit before it expires on February 1st, 2010. As a result, residential investment will be a key source of strength for overall economic growth in the fourth quarter. January data is also likely to reflect this impact; however, there is potential for some payback in the months thereafter, once the tax credit has expired.
Another sector that looks to have given Canadian economic activity a lift in the final quarter of last year is auto and parts. Since August, automakers have ramped up production in order to replace inventories in the U.S. that were run down by the Cash for Clunkers stimulus program. But while the fourth quarter GDP should get a nice boost from auto output, some of those gains could be retraced in February, given Toyota's recent announcement of production stoppages.

This week, the automaker announced that it will temporarily suspend sales of eight models - including the Corolla and Camry, which are top selling models in Canada and the U.S. - due to safety issues regarding faulty accelerators. Consequently, the automaker will also halt production of these vehicles beginning February 1st, to prevent inventories from accumulating. Both Toyota plants in Canada will be affected, given that the Rav4 is produced in Woodstock and the Corolla and Matrix are made in Cambridge. Production of the Lexus RX350 in Cambridge is the only line in Canada that will continue to run. Toyota has stated that production will be stopped for one week. But depending on how quickly a solution is found, that shutdown could last longer. The three vehicles alone accounted for about 15% of all vehicles produced in Canada last year, so even a 1-week halt in production will weigh on the sector's total output during the month. Moreover, while it's still too early to tell, should Toyota's sales suffer from this incident, the fallout on auto production in Canada could last even longer

U.S.: UPCOMING KEY ECONOMIC RELEASES

U.S. Personal Income & Spending - December

• Release Date: February 1/10
• November Result: income 0.4% M/M, spending 0.5% M/M; core PCE deflator 0.0% M/M, 1.4% Y/Y
• TD Forecast: income 0.3% M/M; spending 0.4% M/M; core PCE deflator 0.1% M/M, 1.5% Y/Y
• Consensus: income 0.3% M/M; spending 0.3% M/M; core PCE deflator 0.1% M/M, 1.5% Y/Y

With the U.S. economic recovery gaining further traction, there are encouraging signs that the U.S. households are themselves beginning to slowly regain their appetite for spending, buoyed in large part by the improving economic outlook and the recovery in housing and labour market conditions. We expect this positive momentum in spending to continue, with personal consumption expenditures expected to advance for the third straight month with a 0.4% M/M gain. Evidence of the strength in personal consumption expenditures has been seen in the corresponding retail sales report, which rose by 1.3% M/M in December, providing an upside risk to this call. Personal income is also expected to grow, posting its sixth consecutive rise with a 0.3% M/M print. On the inflation front, the core PCE deflator is expected to rise by a modest 0.1% M/M, with the annual pace of core PCE inflation rising to 1.5% Y/Y, from 1.4% Y/Y in November. In the coming months, we expect the core PCE deflator to ease as the growing economic slack in the U.S. economy dampens core consumer price pressures

U.S. ISM Manufacturing Report - January

• Release Date: February 1/10
• December Result: 54.9
• TD Forecast: 56.0
• Consensus: 55.6

As positive momentum continues to build in the U.S. economy, the rebound in manufacturing sector activity also appears to be gaining further traction, with the headline ISM manufacturing sector index remaining above the all-important 50-threshold for the past five consecutive months. Much of the support for the recovery in manufacturing activity has come from export demand, which has been bolstered in large part by the soft dollar and the recovery in global demand. These factors are expected to remain largely in place in January, and we expect the ISM manufacturing index to rise slightly to 56.0, suggesting further gains in manufacturing sector activity. The new orders, production, employment and new export orders sub-indices are all expected to remain well above 50.0, underscoring the breadth of the strength in the report. Moreover, with the new orders to inventory spread, a useful proxy for the future direction of manufacturing sector activity, widening to its highest level since August, there appears to be further upside momentum for U.S. manufacturing sector activity. In the coming months, we expect the ISM headline index to sustain its above-50 momentum as the global economic recovery gathers steam.

U.S. Nonfarm Payrolls - January

• Release Date: February 5/10
• December Result: -85.0K; unemployment rate 10.0%
• TD Forecast: 25.0K; unemployment rate 10.0%
• Consensus: 27.0K; unemployment rate 10.0%

After almost two full years of job losses, with over 7 million jobs being lost, the U.S. economy appears to be on the verge of reversing the tide and beginning to create jobs on a consistent basis. This effort is likely to be bolstered in the first quarter of the year by the surge in 2010 Census related hiring, when as many as 1.2 million additional temporary jobs will be added to payrolls. Given that most of this hiring will likely occur in the latter part Q1, with mass canvassing to begin in May, we expect nonfarm payrolls to rise by only 25K jobs in January. The slow pace of rebound in labour market conditions has become evident in recent weeks, with the level of jobless claims accelerating slightly in the past few weeks. The job gains are likely to be concentrated in the services-producing sector, while the goods-producing sector should shed jobs for the 25th straight month. The rate of joblessness should remain unchanged at 10.0%. Note also that the final benchmark revisions to last year's estimates will also be published in this report, and these are could be somewhat worse than the preliminary estimate of -824K. In the coming months, we expect the pace of job creation to gather steam, particularly on account of the 2010 Census hiring

CANADA: UPCOMING KEY ECONOMIC RELEASES

Canadian Employment - January

• Release Date: February 5/10
• December Result: -2.6K; unemployment rate 8.5%
• TD Forecast: 10.0K; unemployment rate 8.5%
• Consensus: 15.0K; unemployment rate 8.5

Even though the Canadian economy has moved well past the economic recession, the pace of recovery has been less than stellar, and this has been reflected in the slow rebound in labour market activity. The recovery in the labour market itself has not been smooth, as it has seesawed between job growth and job losses on a fairly regular basis. In January, we expect this pattern to continue, with the economy adding a modest 10.0K jobs. Most of the job gains are expected to come from the service-producing sector, while the goods-producing sector should shed job. The unemployment rate is expected to remain unchanged at 8.5%. In the months ahead, we expect the stabilization in the labour market to continue as the economic recovery takes root.

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