Friday, May 09, 2008

TD Canada Trust comments on Canadian and US economy and Rates


  • U.S. economy grew 0.6% in the first quarter
  • U.S. lost 20k jobs in April, less than expected
  • Fed cuts a quarter-point; sees risks balanced

As the Oracle of Omaha prepares to meet with shareholders, we are left to sift through this week's plethora of data in order to prophesize what is to come for the U.S. economy. We have dispensed with the crystal balls, have left our dark robes at home, and require no secret handshakes or Gregorian chants in order to attend. Consuming the eye of newt and toe of frog is optional.

A touch of GDP

The U.S. economy maintained its 0.6% pace from the last quarter of 2007 through the first quarter of 2008. On face value, one may say the U.S. economy got no worse. The details, however, were less than convincing. The pace of decline in residential construction accelerated further, and was joined by new contractions in both nonresidential construction and business investment. Were it not for an accumulation of inventories – businesses restocking shelves and producers resupplying inputs – the U.S. economy would have contracted by 0.2%. Increasing business capacity would be completely natural if there was an expectation the economy were about to turn a corner.

However, consumer spending growth slowed from 2.3% to just 1.0%, the slowest quarterly gain in over a decade. Perhaps consumers are waiting for their stimulus checks from the Treasury – the first of which were sent out this week and will continue through mid-July. Consumers are losing about $10bn per month in spending power just from the loss of mortgage wealth alone. The checks will add about $10-12bn per month in spending power – but will only last for the next three to four months. So retailers could be gearing up for a short-term spending spree.

In our chart above, we have broken out U.S. consumer spending between goods and services, as well as between wants (cars, televisions, etc.) and needs (food, energy, bills, etc.). All four categories are outperforming the typical start of a U.S. recession. Goods purchases are falling across the board, but only at about half the pace typically seen at the start of a recession. Even more impressively, service growth is expanding at more than twice its usual pace for wants and eight times the usual pace for needs.

Since spending on consumer services constitutes 40 per cent of the U.S. economy, the question is whether this can be sustained. Well, one-quarter of consumer services (one-tenth of the U.S. economy) is rent (and its equivalent for homeowners). One result of increasing home foreclosures and retrenchment in construction has been falling vacancy rates among rental units. So the worsening housing market has actually provided some support for this component of GDP. However, in the last two recessions, there was a lag of about 12 months between the worst declines in residential construction and initial declines in this rental component. In the 1980s housing crash, the lag was even shorter. Adding to these risks, one-in-ten dollars of consumer services spending is household operations – gas, electric, sewage, phone, etc. – and the generally close relationship between this component and residential construction has never been more strained. Year-over-year declines of over 20% in home construction typically translate into 5% declines in household operations spending, which is now posting 5% y/y gains. With the potential for further foreclosures, and with hefty demands for utilities likely to ease after a bad winter across much of the U.S., the risks for this component lie squarely on the downside.

A dash of jobs

But ultimately, as goes the labour market, so goes the consumer. The U.S. economy shed just 20k jobs in April - one-quarter of the market's expectation – and the unemployment rate fell from 5.1% to 5.0%. The chart across compares the job losses over the last four months with the average in the last three U.S. recessions. At the aggregate, we have been averaging just 65k lost jobs per month, less than the 100k that would be typical. Losses in construction and financial services have been ugly – no surprise given they are at the heart of the current problems. But weaknesses have leaked into the business services, trade (retail and wholesale) and transportation sectors leaving them just as bad as in past recessions. Manufacturing and mining (Other Goods) have seen just half the recessionary level of average monthly job losses, while the pace of job gains in other services (health, education, IT, hospitality, etc.) has been twice the usual pace.

In a typical recession, the total monthly job losses tend to double from this point forward. Moreover, while every sector covered here tends to worsen in the remaining months of the recession, manufacturing and business services tend to be the hardest hit. The ISM manufacturing survey pointed to further weakness to come in this sector, but the weak dollar – by boosting exports – is likely to continue to help mitigate job losses here to some extent. For business services, the losses of temporary workers, which have constituted all of the job losses to date in this sector, tend to be followed by even larger losses in full-time staff as economic weakness continues and may offer a hint of the economy's health as we move forward.

The blind-worm's sting

The Federal Reserve this week cut interest rates an additional quarter point, bringing the fed funds rate to 2.00%. Their statement generally left their descriptions unchanged for the economy (negative) and inflation (uncertain with a touch of hope). They did remove their mention of downside risks, which could imply they feel the level of interest rates is appropriate to balance the desire for moderate economic growth in the future with the risk of stoking inflation. In the near term, we may see the Fed pause to see how the economy reacts to 325bps of interest rate cuts over the last eight months – as well as $100bn in tax rebate checks. However, 325bps in interest rate cuts have translated into less than 75bps in cuts to 30-year mortgage rates and less than 25bps in cuts to rates on new car loans. We fear further economic weakness will warrant more easing, bringing the target rate to 1.25% by year-end. The Fed on Friday announced an expansion of liquidity operations aimed at increasing the pass-through into lower consumer loan rates, but they have yet to find the right mix of ingredients in their cauldron to cure what ails the economy.

The economic environment in the U.S. is as clear as mud. There are no clear precedents for when the financial market problems will dissipate and exactly how they will continue to bleed into the U.S. and global economy. For instance, the Canadian economy contracted for the second time in three months in February, with growing weakness in the trade and transportation sectors. As a testament to the U.S. spill-over effect, the predominant areas of weakness in the Canadian economy remain goods sectors dependant on U.S. demand. The worst still remains contained within the U.S.

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