Wednesday, March 07, 2007

Equity Sell-off but Canada and US poised to accelerate

- Equity sell-off will have fleeting economic impact
- 2007 GDP growth in Canada and the U.S. poised to accelerate

This is certainly a good week to take a step back and
regain perspective. Nothing that happened in financial
markets this week has caused us to change our outlook
for Canada, the U.S., or the global economy. The
carnage in equity markets appeared to key off of a
nasty game of whisper down the lane in China on
Tuesday. The first person in line said “Beijing is the
capital of China,” and the last person in line swears
they heard “Beijing is implementing a capital tax on
equity gains of 20 per cent in China.” The government
did announce on Wednesday this wasn’t true, but in
general, Chinese authorities remain keen to reign in
liquidity and prevent overheating. This is why they
made moves this week to shore up the stock market and
will continue to do so in the future. As in any
emerging market, Chinese equities will continue to be
subject to growing pains and higher volatility
correlated more with regulatory changes than any
connection with economic performance or prospects (See
TD Economics special report on China earlier this

Because of this disconnect and its relatively small
size, the Chinese stock market is not systemically
important on a global scale. Rather, what we saw was a
reflection of the fractious debate regarding the
future path of the global economy. Sixty per cent of
China’s exports are foreign firms listed in exchanges
outside of China and 40% of the earnings of companies
listed on the S&P 500 originate from outside of the
United States. For these reasons, evidence of
entrenched economic weakness in either economy would
be systemically important. While we continue to
believe the U.S. and Canadian economies will coast
through the current mid-cycle slowdown – and on this
account we are in the majority – there is still a
vocal minority of doomsayers. We do not discount the
weaknesses these individuals point to. We simply don’t
think the outcomes they subscribe to are likely to

The Least Likely Outcomes

The Recessioniks are the largest minority. They
believe that the correction in the U.S. housing market
will spread through to the rest of the American
economy. Data on new home sales for January showed
further weakness in the U.S. housing market, but
existing home sales – the larger market by far –
unexpectedly improved. Concerns over sub-prime lending
are tied to the weak housing market. The sub-prime
market is a small percentage of total lending,
however, and because interest rates are on hold at
moderate levels and there has yet to be any
significant pullback in lending to prime borrowers,
fears of contagion seem unwarranted. Taken at face
value, larger than expected weakness in U.S. durable
goods and core capital goods orders would help to
support the case for recession, as well. Both are a
sign that manufacturing activity may be slowing.
Additionally, core capital goods orders serve as a
forward indicator of firms’ investment plans. But
whether you are in a recession or mid-cycle slowdown,
investment always slows. In both cases, residential
investment tends to be the first to fall, followed by
non-residential investment. It is impossible to
distinguish a recession from a fleeting economic
softpatch looking only at investment data.

But the Recessioniks also point to Q4 GDP, which was
revised down this week from an initial estimate of
3.5% to 2.3%. The earlier figure certainly emboldened
markets to think the slowdown was over, but the lower
figure dashed that perception. In fact, output growth
is now in the range we thought we’d see at this stage
given a mid-cycle slowdown. Moreover, the revisions
were the result of firms slowing their accumulation of
inventories. While this drawdown may continue in the
first quarter, its implication for growth in the
second half of the year is positive for production and
investment once firms start to reload.

The Stagflationiks are the next minority. They share
the Recessioniks concerns, but feel that a contraction
in economic activity will be coupled with inflationary
pressures ala the oil crises of the 1970’s. This would
force central banks like the Bank of Canada (who meet
next week but aren’t expected to make any changes) and
the Federal Reserve to raise interest rates in order
to maintain stable prices. The core PCE deflator
showed consumer prices in the U.S. rose by 2.3%
year-over-year since January. Prices are hovering just
above the Fed’s implicit range of 1.5-2%. But given
the current global climate, any substantial economic
weakness is much more likely to be coupled with
deflationary pressures, not inflationary ones. Ample
global liquidity has been fueling rapid investment
growth internationally, especially in China where it
accounts for nearly half of GDP. This is a lot of
productive capacity which, if not needed, would lead
to softening prices as producers try to move

The Most Likely Outcome

So this leaves TD Economics in the most likely camp –
the Likeliniks. The most probable scenario given all
the information we have received to date is that U.S.
GDP will continue to grow at a pace below 3% – but
well above the 0% and worse needed for a recession –
and will accelerate into 2008 as housing, investment,
and inventory weaknesses unwind. What is key for this
story is consumer spending, which makes up two-thirds
of the economy. Consumer spending continues to track
the path of a mid-cycle slowdown and is nearly a full
two percentage points above where it would be given a
recessionary path (see graph). January’s U.S. personal
income and spending data showed consumer income was up
1.0% while spending was up 0.5%. U.S. consumers
continue to have the income to spend, they continue to
have the desire to spend, and with spending growing
slower than income, consumers have even managed to cut
back on borrowing.

The Canadian economy appears similarly poised to
accelerate. Although GDP growth for the fourth quarter
of 2006 came in at a meager 1.4%, this was slightly
higher than expected, and Q3 GDP growth was revised up
from 1.7% to 2.0%. Moreover, monthly GDP growth for
December of 0.4% points to a strong hand-off to the
first quarter. Like in the U.S., inventories were a
large part of the story and represented a drag on GDP
growth of nearly four percentage points. With a strong
handoff from December and the inventory overhang
largely unwound, Canadian GDP could come in for a
showing at or above 3% in the first quarter of 2007.

Alan Greenspan earlier this week said it is possible
the U.S. economy could slip into a recession at some
point in the future without any qualification of what
he meant. Saying the U.S. or Canadian economies could
slip into a recession is like saying an Olympic
swimmer could drown in the deep-end of the pool. Is it
possible? Yes. Is it more likely than if he or she was
standing in the shallow end? Of course. Is it the most
likely outcome? No.

Article courtesy of R.Paul Chadwick, Manager of Residential Mortgages,TD Canada Trust

Read about the real estate market

For more information please contact A. Mark Argentino
Toronto Real Estate Board (TREB) Average Prices and Graph
A. Mark Argentino, Broker, P.Eng.,
Specializing in Residential & Investment Real Estate
RE/MAX Realty Specialists Inc., Brokerage
2691 Credit Valley Road, Suite 101, Mississauga, Ontario L5M 7A1

BUS. 905-828-3434
FAX. 905-828-2829

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