Financial Markets Monthly - September 2009

Highlights

• 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.
• The 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.

Recovery watch

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 trend.

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 next year.

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 2010.

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 gains.

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
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