Highlights
- Economic data suggest that the recession is coming to an end.
-
China’s economy powered along with output 8.9% higher than a year
earlier and the Reserve Bank of Australia has boosted its policy rate
twice.
- The U.S. economy grew at a stronger-than-expected 3.5% annualized rate in the third quarter.
- Fourth-quarter numbers are signalling a slower, but still positive, pace of growth.
-
The improvement in the economic news was not enough for the Fed to
change its commitment to keeping rates low for an "extended period”.
- Canada’s data have been a mixed bag with real GDP disappointing, but housing and employment posting gains.
- A positive print on September GDP is likely, although thirdquarter growth likely will turn out to be relatively weak.
-
The Bank of Canada looks for the economy to emerge from recession but
is worried that the strong currency will weigh on the economy’s export
performance.
- The currency lost ground against the U.S.
dollar in second half of October but still remains above model
estimates of fair value.
- The RBA raised its Cash Rate by 25 basis points in October and again in November...
- ... saying that "the downside risks to which the board was responding earlier have not materialized.”
- The RBNZ left rates at 2.50%, dropping its bias to ease further.
- Eurozone economic confidence hit a 13-month high in October.
- U.K. output defied expectations and declined in the third quarter.
-
The Bank of England has increased its quantitative easing program by
GBP 25 billion, bringing total asset purchases to GBP 200 billion.
The turning point
The tide has turned for the global economy with U.S. real GDP
posting a stronger-than-expected increase in the third quarter, the
Reserve Bank of Australia (RBA) citing Australia’s good economic
performance as a reason for raising the policy rate and China recording
a breathtaking 8.9% increase in third-quarter output. Canada, the
United Kingdom and the Eurozone have yet to produce clear indications
that their economies are out of recession, but conditions are improving
and we expect reports of positive growth soon. Central banks are
cautious, however, with only the RBA of the major central banks we
cover starting to unwind monetary policy stimulus. Given the deep hole
in economic activity, it is likely to be a long time before other banks
will be in a position to follow the RBA’s lead, with hikes expected to
come in the latter part of 2010 and continuing in 2011.
Nervousness creeps into financial markets
Investors got a bout of the jitters with global stock markets
reversing course in mid-October after a sustained upward run that
started in March of this year. The downdraft in stocks saw the MSCI
World Stock Index trim back its October gain to just 0.65% with most of
the 6.2% rise recorded in the first half of the month erased.
Government bond markets in Canada, the United States, the Eurozone and
the United Kingdom recouped some ground as investors shifted back to
the safety of government securities. The more certain growth momentum
in Australia saw yields rise with New Zealand rates going along for the
ride. All told, 10-year yields stand very close to their 2009 average
outside the Antipodeans. Looking forward, we expect the movement in
interest rates to be concentrated in the shorter-term maturities as the
timing of central bank tightening nears with longer-term maturities
staying range-bound until the spectre of inflation makes an appearance.
United States bounds out of recession
The U.S. economy grew at a 3.5% annualized pace in the third
quarter backed by a rebound in consumer spending and surging
residential investment. Consumer spending was largely powered by
durables consumption reflecting the impact of the cash-forclunkers
rebates, but spending also increased for non-durable goods and
services. In fact, these two consumption components increased at the
fastest pace since the third quarter of 2007, suggesting that U.S.
consumers are coming out of hiding. Residential investment also
surprised to the upside, ending 14 consecutive quarters of decline.
Business investment remained a weak spot as inventories were reduced
again and commercial real estate investment continued to collapse. On
the upside, the severe cuts to inventories set the stage for a pick-up
in production as demand continues to trend higher.
Data signals recovery is under way
Positive GDP growth after four quarters of decline likely signalled
the end of the recession for the U.S. economy. To be sure, the expiry
of the cash-for-clunkers program will cut into spending on durables in
the fourth quarter. Still, early reports on fourth-quarter activity
point to another increase in output, with the ISM manufacturing index
driving solidly into expansionary territory in October and housing
indicators pointing to firming sales against a shrinking inventory
overhang. The hitch was in the October consumer confidence reports,
which showed that households became less optimistic early in the fourth
quarter, thus raising alarm bells that they could retreat again. The
Fed worked to allay concerns about any tightening in monetary
conditions by committing again this week to their policy of
"exceptionally low levels of the federal funds rate for an extended
period.”
End of negative inflation rates
After falling for nine of the past 10 months, the U.S. headline
inflation rate is set to return to positive territory as the sharp
declines in energy prices in October through December of 2008 go
unmatched. We estimate that the headline CPI inflation rate will
average 1.3% in the fourth quarter, largely reflecting the movement in
energy prices. Excluding energy, the rate is likely to continue on its
downward trajectory. The widely-watched core measure, which removes
both energy and food price movements, is forecast to average just 1%
next year, the slowest pace of increase on record. The absence of
inflation pressures aside from energy, supports the case for the Fed to
hold the funds target in the 0.0% to 0.25% range to ensure that a more
vigorous economic recovery takes hold.
A mixed bag of Canadian data
Unlike the United States where the data point to the end of
recession, Canada’s numbers were less clear-cut. The third quarter
showed stronger-than-expected gains in employment and housing, but both
July and August’s GDP reports disappointed. The economy shrank by 0.1%
in August after posting no growth in July. Our estimate that the
economy expanded in September will skate GDP back into positive
territory, but the risks are that the rebound will fall short of the
consensus forecast for a 2% annualized gain. Our reckoning is that on
an expenditure basis, real GDP growth was 0.5% to 1% at an annual rate
in the third quarter.
The rebound in U.S. growth, low rates combined with government
spending augur well for an improving trend to emerge in quarterly
growth rates in the latter part of 2009 and into 2010. However, in its
October Monetary Policy Report, the Bank of Canada, alongside a list of
"favourable developments” for the economy, cautioned that "the current
strength in the dollar is expected, over time, to more than fully
offset the favourable developments since July.” The sharp drop in the
currency since this tough-talking statement has likely allayed some of
the Bank’s concerns. Still, currency movements affect the economy with
a lag, suggesting that the impact will be greatest in early 2010.
Canadian dollar — More aligned with fundamentals
The run-up in the Canadian dollar from mid-July to mid-October
resulted in the currency running ahead of model forecasts for its value
against the U.S. dollar. RBC Economics constructed a model similar to
the one Bank of Canada uses. Our model showed that the increase in the
Canadian-U.S. dollar exchange rate in the third quarter was about 5%
more than the model estimated. Recent comments by Bank officials
suggest a similar assessment. In their October statement, the Bank
characterized the loonie’s persistent strength as "working to slow
growth and subdue inflation pressures,” which contributed to
reaffirming their commitment to a 0.25% overnight rate target until the
end of the second quarter of 2010.
Look ahead to 2010 and 2011
While near-term indicators signal an end to the global recession,
markets remain worried about the durability of the upturn as fiscal and
monetary policy support subsides. In Canada, the recovery started with
a whimper rather than a bang, but we expect the momentum to build,
spurred by a strengthening U.S. economy, low interest rates and a
steady influx of government spending. Consumer confidence increased for
seven months and, although the index edged down in October, it remained
near the highest level since early 2008. With asset values recouping
part of their losses and interest rates extraordinarily low, we expect
consumer spending will recover in 2010, helped early in the year by
government programs like the Renovation Tax Credit. We forecast that
the economy will grow by 2.6% in 2010 with the unemployment rate
peaking early in the year and then drifting lower.
Against a backdrop of firming global growth and rising commodity
prices, Canada’s economy will pick up pace with real GDP growth of 3.9%
in 2011 even as both fiscal and monetary policy stimulus starts to
dissipate as long as credit conditions continue to improve. Inflation
pressures will remain muted in 2010 as the large output gap very slowly
starts to close. Price pressures will increase modestly in 2011,
however, with the headline rate forecast to average 2.2%, although this
largely reflects movements in energy prices, while the core measure
holds below the Bank’s 2% target until early 2012. For the Bank of
Canada, the road to the normalization of interest rates will be long
and we expect the tentative steps in the second half of 2010 to be
built upon in 2011. Our forecast is that the Bank will boost the
overnight rate to 1.25% by the end of 2010 with further increases in
2011, yielding a policy rate of 3.5% by year end.
U.S. recovery — Slow and steady
Emerging from the deepest recession since the Great Depression, the
U.S. economy remains fraught with uncertainty about the health of the
financial system and pockets of weakness outside of housing. In 2010,
fiscal and monetary policy stimulus will remain abundant, although the
Fed is likely to remove its quantitative and credit easing programs.
Growth will continue to be constrained by the deleveraging of household
balance sheets and a soft labour market. Real GDP is forecast to expand
by just 2.5%, a modest recovery by historical standards. Against this
backdrop inflation pressures will remain muted, giving the Fed leeway
to keep rates at very low levels until the recovery is more firmly
entrenched. Our forecast is that the first rate increase will come late
next year with the Funds target ending 2010 at 75 basis points. As the
financial system returns to health and the economy starts to generate
jobs, we expect the economy to pick up pace, growing by 3.4% in 2011.
However this will only manage to send the unemployment rate down to
8.9% by the end of that year. The return to trend growth and modest
firming in prices will see the Fed begin its program to return the
policy rate to a neutral stance. In 2011, this points to a steady drip
of rate increases with the funds target forecast to rise to 2.75% by
year-end and reach a more neutral setting in early 2012.
Australia is the first to begin tightening
The RBA beat our expectation by one month that it would be among
the first of the central banks to raise its policy rate when it raised
its Cash Rate by 25 basis points in October. The RBA explained that it
had earlier lowered rates based on its expectation of "very weak”
economic conditions but "that basis for such a low interest rate
setting has now passed.” Additionally, it expected growth to return
close to its trend rate (3%-3.5%) in 2010. In line with RBC’s
expectations, the RBA increased its Cash Rate by another 25 basis
points in November to 3.50%. The central bank cited global financial
market sentiment as being "much better” than earlier this year and
noted that the unemployment rate is likely to peak at a "considerably
lower level” than previously expected.
Not in a timid mood
While much of the developed world suffered deep recessions,
Australian growth dipped into negative territory for just one quarter
and the unemployment rate rose to only 5.7% as of September. The
strength enjoyed by Australia’s Asian trading partners helped its
foreign sector, while fiscal and monetary stimulus supported domestic
demand. After its first rate decision, Governor Stevens made a speech
counselling against being "too timid” in the removal of stimulus. The
end of October saw the quarterly inflation rate for the third quarter
accelerate to 1%, although base effects brought the year-over-year rate
down to 1.3%. The rise in the currency slowed inflation of tradables,
although this was more than offset by the increase in non-tradeables,
which gauges domestically generated costs. Recent events have prompted
us to add two additional rate hikes to our earlier forecast, putting
the Cash Rate at 5% by the end of 2010. In New Zealand, the RBNZ held
rates at 2.50% in October. It dropped its easing bias although pledged
not to increase rates before the second half of 2010. We expect the
RBNZ to begin raising rates in the second quarter of next year as the
pace of economic activity continues to firm.
Eurozone continues recovering, the ECB is on hold for now
Eurozone data have been pointing to a continuation of the recovery
into the fourth quarter. The region’s manufacturing PMI crossed the
50-mark in October, putting it in expansionary territory for the first
time since May of last year and its economic confidence survey hit a
13-month high. While acknowledging the improvement in growth, the
European Central Bank (ECB) continues to emphasize the high uncertainty
around its sustainability. However, it suggested that it may not extend
its 12-month refinancing operations into next year. By the third
quarter of next year, the ECB should have sufficient evidence of the
sturdiness of the recovery for it to begin raising its Refi rate. We
expect the ECB to raise rates to 1.75% by the end of 2010 as the
recovery takes hold.
United Kingdom remains the laggard
The 0.4% quarter-over-quarter drop in U.K. GDP in the third quarter
marked the sixth consecutive quarter of negative growth for the
country, the longest string of quarterly declines since the beginning
of modern records in 1955. At its November meeting, the Bank of England
increased its quantitative easing program by GBP 25 billion, bringing
total asset purchases to GBP 200 billion. The Bank of England stated
its expectations that, while a pick-up in economic activity may soon be
evident, the Committee believes "the prospect is for a slow recovery.”
We expect growth in the final quarter to bounce firmly into positive
territory, as households bring forward spending ahead of the VAT hike
scheduled for January. The PMI surveys for October were on the right
track, with both manufacturing and services posting their strongest
readings since August 2007. However, we expect growth to be weak in
2010, with the Bank of England keeping rates on hold until the final
quarter.
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RBC Financial Group
http://www.rbc.com
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