Friday, February 15, 2008

Weekly Bottom Line in Economics TD Canada Trust

The Weekly Bottom Line in economics courtesy of TD/Canada Trust


Non-manufacturing ISM spurs more recession talk in the U.S.
TD Economics revises U.S. growth projections
Canadian jobs data a shocker

This week, investors continued to seek the relative safety of bonds at the expense of equities. Notably, U.S. 2-year government bond yields fell below 2% for the first time since April of 2004. Canadian 2-year government bond yields declined as well, though they still remain above 3%. Despite the 125 basis points in interest rate cuts by the Fed over the past 3 weeks, equity markets recorded losses across the board, led by the tech-heavy Nasdaq (-5%). Declines in the S&P 500 and Toronto's S&P/TSX were 4% and 3%, respectively.

U.S. economic news disappoints

In addition to being served up with a number of disappointing fourth quarter earnings reports, investors continued to fret about the rising risks of a U.S. recession. Following poor January employment numbers last week, the ISM non-manufacturing reading for the same month was even worse, plummeting from 53.2 to 44.6. The sizable drop in January was not only the largest monthly decline on record, but also the lowest level since the series was created in 1997. The culprits behind the weak performance were substantial losses in the business activity, new orders and employment sub-indices. While these figures certainly paint a dismal picture for the U.S. economy, they can be quite volatile on a month-to-month basis. Still, even if February records a moderate reversal, these data build the case that no growth was being recorded in the U.S. economy as the year kicked off.

Adding to concerns was Thursday's report on initial jobless claims, which came in above expectations at 356,000. On a 4-week moving average basis, jobless claims continued to edge higher. This report has proven to be a good leading indicator of recessions in the past. At this stage, the trend is not sounding off alarm bells, even though the January payrolls report increases the risks that the trend in claims could continue to worsen.

Worries about economic growth were also echoed in Fed speeches this week. Richmond Fed President Lacker acknowledged the possibility of a mild recession, similar to the last one experienced in 2001. He noted that business investment will likely slow this year, but still remain in positive territory, and that job growth will likely be lethargic for the better part of the year. Lacker also signaled upside risks to inflation, thereby making rate decisions even more difficult. Philadelphia Fed President Plosser also raised concerns about economic growth, but he too sounded a word of caution about inflation, arguing that "ignoring price stability during times of economic weakness risks undermining our ability to achieve economic growth over the long run."

In light of the latest signs as to the direction of the U.S. economy, we have downgraded our U.S. economic growth forecast. We are now projecting Q4/Q4 growth of 1.4% in 2008 (previously 1.9%) and 2.5% in 2009 (3.1%). For details, see TD Economics Special Report: Economic Stimulus and the U.S. Outlook available on our website. The volatility in equity markets, weakness in employment, and continued erosion of the housing market are likely to curb consumer spending during the first half of 2008, leading to virtually no growth during each of the first two quarters. The fiscal stimulus package expected to be implemented by the U.S. government will support growth during the second half of this year. However, this will provide only a temporary boost, and as such, a sub-par expansion is likely to carry into 2009 (see chart). The prominence of downside risks to growth has prompted us to revise our Fed rate call as well, from a cut of 25 bps to 50 bps in March. However, due to the inflationary pressures weighing on the economy, we expect the next cut to be the last.

Canada's job market remarkable

As signs of U.S. weakness were further manifested, the Canadian economy continued to show remarkable resilience. Employment numbers released this morning showed that 46,000 jobs were created in January, bouncing back with a vengeance from December's revised 3,000 loss. The gain boosted the employment rate to a new record of 63.8%, and drove the unemployment rate back down to the 33-year low of 5.8% reached last October. January saw a reversal in recent trends, as growth in the private sector far outweighed declines in both the public sector and the self-employed, and the goods-producing sector outperformed the service-producing sector, which was relatively flat for the month. Perhaps the biggest surprise was the 18,000 jump in export-oriented manufacturing jobs. Still, employment in the sector over the past year is down 5.4%, dampened in part by the slowing U.S. economy. Elsewhere, job creation in other areas continued to be supported by domestic strength, with particularly large gains in professional, scientific and technical services as well as financial services.

Another key job generator in Canada was the construction sector. Today, we received news that Canadian housing starts also beat expectations in January, rising 21% from December to 223,000. While single-unit housing starts recorded a modest decline, multi-unit housing starts rose by a whopping 64% month-over-month. The largest gains stemmed from Ontario (44%) and Quebec (22%), while the Atlantic region (-17%) was the only area to weigh down the total number of starts.

While this week's data are likely to spur further talk of decoupling between Canada and U.S., our view is that January's surge in Canadian economic activity represents more of a blip than a sign of renewed strength. Hence, look for both indicators to cool in the coming months. With the risks of knock-on effects from the deteriorating U.S. economy growing since the Bank of Canada's last fixed announcement data and Canadian core inflation remaining below trend, we expect that the central bank will remain forward looking and cut interest rates by 50 bps points in March and 25 bps in April.

BOE cuts rates, ECB to follow

Similarly, the U.S. is not alone in its economic woes, as the Bank of England cut rates by 25 basis points this week, and the Eurpoean central bank has signaled that it may cut rates going forward. The increasing recognition that central banks around the world will be required to jump on the rate-cutting bandwagon is likely to be instrumental in spurring a moderate recovery in the U.S. dollar later this year.

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