Financial Markets Monthly - September 2009
- The global economy is emerging from recession.
- The U.S. economy is poised to post the first positive quarterly growth quarter in five quarters...
- ...with the cash-for-clunkers program supporting car sales and boosting production.
- Even as the economy returns to health, the output gap will be large and the unemployment rate won't peak until late this year.
Fed may take its foot cautiously off the accelerator by reducing its
non-traditional stimulus, but the Fed funds rate will remain
extraordinarily low until the recovery is well entrenched.
- Canada's economy contracted in the second quarter, but at a slower pace than in the prior six months.
- Real GDP increased by 0.1% in June, marking the first month in 10 that the economy grew.
- Increased U.S. demand for autos and inventory rebuilding will support a pop in real GDP growth in the third quarter.
- Core inflation pressures will continue to ease into year-end as the economy grows at a belowpotential pace.
- Asset purchases by the Bank of England were increased by £50 billion, although three members voted for a larger increase.
- The Bank of England's Inflation Report showed that the CPI is well below the Bank's 2.00% target.
- Weakness in second-quarter economic growth points to a wider output gap.
- Economic growth in France and Germany returns to positive territory in the second-quarter.
- The European Central Bank upgrades its growth forecasts.
- The RBA is poised to hike rates before the end of this year.
Upbeat economic data dominated in August especially in the United
States where the improvement in housing statistics and auto sales stole
the headlines. Globally, talk of the end of the recessions in Germany,
France and Canada and more positive news from Australia bolstered
expectations that the world economy is tracking a course for positive
growth in the second half of 2009. Investors piled into riskier assets
for most of August, although a healthy dose of caution was evident into
monthend as investors debate the relative strength of the recovery
Near-term growth prospects rosy...
We have made upward revisions to our near-term forecasts for Canada,
the United States and the Eurozone, taking into account the rise in
auto sales and production as government programs boosted activity. In
the United States, the pace of auto sales jumped by 16% in July and 26%
in August as the Car Allowance Rebate System known as
"cash-for-clunkers" motivated American consumers to purchase
automobiles. With the level of auto inventories in both Canada and the
United States having fallen to low levels, this pick-up in demand
spurred a sharp increase in production, leading us to boost our
third-quarter GDP forecast for both countries. In the Eurozone,
Germany's rendition of the cash-for-clunkers program pushed economic
growth up and supported a solid rise in French exports of motor
vehicles, which limited the decline in the Eurozone's secondquarter GDP
to 0.1% and sets up for a more vigorous third-quarter growth rate.
....but will this cannibalize growth in later quarters?
As the consensus ratcheted up third-quarter forecasts, the focus
turned to the trajectory for these economies once the boost from the
auto sector fades. While growth rates may ease up in late 2009 and
early 2010 causing markets to reassess the durability of the upturn, we
believe that there is enough stimulus in place to support a
full-fledged recovery in 2010.
U.S. economy emerging from worst recession in decades
We expect the current quarter to be the first in the past five to
show positive real GDP growth. The rise in auto sales, the auxiliary
pick-up in industrial production and receding drag from residential
construction have led us to revise up our forecast for third-quarter
growth to 2% from 1.3%. We look for growth to slow mildly in the fourth
quarter to 1.8% as consumer spending on durable goods eases. But, as
long as financial markets remain stable, the U.S. economy will remain
on a course for recovery. Looking forward, we look for the momentum to
build in 2010 as most of the fiscal stimulus hits, although the dismal
state of household balance sheets will likely restrain the pace of
growth compared to past recovery periods. This pick-up in demand, will
require inventory rebuilding after the drawdown that took place during
the recession. Furthermore, improved access to capital markets and
narrowing corporate bond spreads are expected to spur a pick-up in
fixed investment as the profit outlook turns around. Our forecast is
that real GDP will expand by an average 2.2% in 2010 following an
expected 2.7% drop in 2009.
Mind the gap - Modest recovery to keep unemployment rate high
The long and deep recession generated significant slack in the
economy with the capacity utilization rate falling to a record low in
June and the unemployment rate rising 4.8 percentage points since the
recession began. Even with the economy forecast to grow by 2.2% next
year, the output gap will remain wide, exerting only minimal downward
pressure on the unemployment rate. The high level of unemployment will
keep wages on a downward path and consumer price inflation muted. It is
only in 2011, when we expect a return to an above-potential growth rate
for the economy and a declining unemployment rate, that inflation
concerns will re-emerge.
Giving Fed little incentive to raise interest rates
Against the backdrop of below-potential growth, high unemployment
and easing prices, the Fed is likely to hold the Fed funds rate at the
current extraordinary low 0% to 0.25%. A rate increase is likely to
come but only when the economy is on the cusp of a sustained period of
above-potential growth and the unemployment rate is falling. Initial
steps by the Fed to reduce monetary policy stimulus are expected to
come through an end to the quantitative and credit easing programs. The
Fed slowed the pace of Treasury bond purchases in August, with some
policymakers hinting that there may be less need for the Fed to
implement the full amount of stimulus that is engendered in the
mortgage-backed securities purchase program if the economy and
financial markets continue to improve.
Interest rates to remain low
Our forecast for a modest recovery and unchanged Fed funds rate will
likely result in short-term rates staying low until late 2010.
Confidence that the recovery is durable and will be sustained will
likely see two-year rates rise to 1.85% by the end of next year.
Longer-term rates will be more influenced by concerns that the
third-quarter pop in economic activity will prove to be a false start
for the recovery and we forecast a move back to 3% in the final quarter
of the year. Similar to our forecast for short-term rates, we expect
10-year yields to rise in 2010, gravitating toward 4% by the end of
Canada's recession - Running its course
The hefty 3.4% decline in Canada's second-quarter GDP marked the
third consecutive quarter of contracting economic activity; but the
slump was more modest than the first quarter's record 6.1% drop and
output in June rose for the first time since July 2008.
Canadian consumer re-emerges
There were pockets of strength in Canada's economy from April to
June with consumers buying autos and houses. Residential construction
activity, which includes sales commissions and renovation spending,
posted a surprising gain. Spending on durable goods was also
firmer-than-expected mainly due to higher new and used vehicle
purchases, which rose at close to a 20% annualized rate. Better
functioning financial markets and low interest rates likely boosted
activity in these rate-sensitive sectors of the economy. Government
spending on goods, services and investment projects also boosted the
quarterly growth rate as the stimulus dollars filtered into the economy.
Weighing against these gains were weakness in business investment
with spending on machinery and equipment and structures falling. Even
with the pick-up in residential spending, the investment component
subtracted 1.8 percentage points from secondquarter growth.
Inventories, which lopped off 5.2 percentage points off the growth rate
in the previous two quarters, reduced output again in the second
quarter, but by a more modest amount. Exports plunged again in the
second quarter and imports recorded a smaller decline, meaning that net
trade trimmed back the quarterly gain.
Green shoots ready to bud
The sizeable decline in quarterly GDP in the past nine months has
generated significant slack in the economy, although the increase in
June real GDP suggests that Canada's recession is nearing an end. The
marked drawdown in inventories in recent quarters means that budding
demand will have to be met by new production. Rising homes sales during
the third quarter and a pick-up in the auto sector in line with the
jump in U.S. car sales point to a return to positive growth. We
forecast real GDP growth of 2% at an annualized pace in the third
quarter with a 2.4% gain expected in the fourth quarter and 2.6% in
Yawning output gap to keep unemployment rate high
Given that the anticipated gains in the economy in the second half
of the year will be modest, only a slight drop in the unemployment rate
is expected in 2010. The persistent slack in the system is expected to
exert continued, albeit easing, downward pressure on the inflation rate
and upward pressure on the unemployment rate into 2010. The Bank of
Canada has been worrying aloud about the implications of the Canadian
dollar's rise on the export outlook having highlighted this as a key
risk in their July outlook and in speeches by various Bank officials.
To our mind, the upswing in the currency since early May has been
largely supported by two factors - rising commodity prices, especially
crude oil, and rising risk appetite. Both of these factors reflect
growing optimism about the global economic outlook, which we expect
will mitigate the downside risks to Canada's recovery as long as the
global economy continues to pick up pace. Near-term, a fresh bout of
risk aversion will likely be accompanied by another bout of U.S. dollar
buying resulting in the Canadian dollar giving back some of its recent
No rate changes on the horizon
The moderate pace of growth and rising unemployment rate make it
likely that policymakers will honour the conditional commitment to keep
policy extremely accommodative until the second half of next year. The
risk to this view is that the economic rebound proves to be much more
vigorous than RBC or the Bank of Canada proposes as this would boost
the upside risk to the inflation outlook and likely lead to a
normalization of rates earlier than in our baseline forecast.
Short-term yields are forecast to hold around current levels until mid-
2010 when a rate increase looks imminent, with 10-year rates forecast
to take their lead from U.S. 10-year bonds given that moderate
recoveries are expected in both economies.
Bank of England's summertime surprises
The Bank of England's decision to expand quantitative easing took
markets by surprise as the Monetary Policy Committee (MPC) increased
its total asset purchases by £50 billion to £175 billion. With July PMI
survey data for both manufacturing and services in expansionary
territory, many had assumed that the MPC would stand pat. The initial
shock sent the yield on 10-year gilts down 31 basis points to 3.54%,
although they settled at 3.72% by the end of the day.
The Bank of England's quarterly Inflation Report forecasted that the
inflation rate will be 1.4% two years hence - well below the Bank's 2%
target. Governor King explained that inflation would likely undershoot
the target as weaker-than-expected second-quarter growth meant that the
output gap would be larger than initially thought.
In August, the services PMI rose to 54.1, but the manufacturing PMI
retreated below the 50-mark to 49.7. We expect third-quarter growth to
be 'less bad' with a decline of 0.1% quarter-over-quarter before rising
0.4% quarter-over-quarter in the final quarter of the year as Britons
bring forward purchases ahead of January's VAT hike. In 2010, as
consumers retrench and the savings rate rises, the United Kingdom will
experience an uneven quarterly growth profile, with annual growth
averaging just 0.3%. For monetary policy, this spells a prolonged
period of easy conditions with the Bank of England likely to hold the
policy rate steady until late 2010.
Eurozone growth surprises on the upside
The preliminary estimate for second-quarter Eurozone GDP showed a
0.1% quarterly decline, significantly less than the 0.5% decrease
expected by forecasters. Net trade made a positive contribution as
exports fell by less than imports. Geographically, the region's two
largest economies, France and Germany, led the upside surprise each
growing 0.3%. Germany's cash for clunkers program was largely
responsible pushing household spending up 0.2%, marking the first
positive print since the first quarter of last year. In light of this
stronger-than-expected number and improving survey data, the ECB
upgraded its staff forecast for GDP to a 4.1% decline in 2009 and 0.2%
rise in 2010 (from -4.6% and -0.3%, respectively). Its inflation
forecast was nudged up to a mid-point of 0.4% in 2009 and 1.2% in 2010
(from 0.3% and 1%, respectively). The ECB left the refi rate unchanged
at 1% and announced that the fixed rate for the second 12-months tender
would be held at 1% as well.
Australia's economy continues to outperform
The RBA left rates unchanged at 3% where they have been since early
April. The accompanying statement was optimistic and pointed to
strength in Chinese growth and upside surprises in domestic
consumption, confidence, investment and labour markets. In terms of
inflation, the statement observed, "the likelihood of inflation being
persistently below target now looks low."
Quarterly growth in Australia surprised on the upside for the second
quarter in a row, rising 0.6% quarter-over-quarter against the expected
0.2% rise. The strength was broadbased, with household consumption
posting the strongest gain since the final quarter of 2007. Business
investment also posted a healthy rise. Thus far, Australia has suffered
only one quarter of negative growth, giving it bragging rights to
escaping a technical recession. We now expect the RBA to begin hiking
rates by 25 basis points in November and again in December of this year
(rather than in the first quarter of 2010), although we still expect to
see the Cash Rate at 4.50% by the end of next year.
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RBC Financial Group