United States
The risk of running off the fiscal cliff will become a reality in a couple of weeks if a middle ground is not found by December 20th.
Financial markets may be acting too complacent. As of early Friday, the S&P500 index was up 4.5% in three weeks, even though there is already evidence that excess cautious behavior from policy uncertainty is taking a toll and creating distortions in the real economy.
Our Q4 real GDP tracking is less than 1%, showing an economy already on thin ice.
The Fed has a 2-day meeting on December 11th and 12th. Monetary policy can not single-handedly push against the fiscal headwind, but we doubt the Fed will stand by idly. Operation Twist terminates at year-end and in its place may come an extension of QE3 with open-ended Treasury purchases.
Canada
To no one's surprise the Bank of Canada left interest rates unchanged this past week, as Canadian economic growth continues to be soft, hurt by weak foreign demand. But, the Bank retained its hawkish bias.
November's very healthy job growth would seem to support that hawkish stance by the Bank. However, some of the details in the report reveal the soft underbelly of the Canadian economy, namely a slowing goods sector.
In addition to weaker external demand, Canada faces competitiveness challenges seen clearly in Canada's poor productivity performance in Q3. These reasons underscore why November's healthy job gain is unlikely to be sustained in the months ahead.
UNITED STATES - TIME'S A TICKIN' ON FISCAL POLICY RESOLUTION
Tick tock tick tock. With the risk of running off the fiscal cliff soon to become a reality if a deal isn't brokered in Congress, Republicans and Democrats are stepping up efforts to table plans. Both sides acknowledge it will be necessary to achieve a bipartisan plan with a combination of spending cuts, revenue increases and entitlement reforms. But, they are miles apart on the characteristics of the right policy mix. Last week, a White House proposal laid out a two-stage plan, of which the most contentious part for Republicans was a $1.6 trillion increase in tax revenues over the next decade. House Speaker John Boehner and company fired back this week with a letter that emphasized structural reforms in entitlement programs and about half the increase in revenue, achieved only in the absence of higher tax rates. If a middle ground cannot be found by December 20th (at the latest), hope of getting a bill passed through both chambers of Congress will turn into despair. And, let's not forget that the debt ceiling limit will once again be hit in late February or early March, adding yet another dimension that needs resolution within Congress.
The S&P500 index is up 4.5% in the past three weeks, making us wonder whether investors have complete confidence in politicians or are being too complacent of the risks. There is already evidence that excessive cautious behavior due to policy uncertainty is taking a toll and creating distortions in the real economy. Take business investment as an example. It's been well documented (including by ourselves) that businesses are under investing relative to the health of their balance sheets. This is true regardless of the metric, be it the financing gap, profits as a share of GDP, or liquidity ratios. Yet, investment in equipment and software contracted in Q3 and has only slightly improved in Q4. By all counts, it should be expanding in a 6-8% annualized quarterly range and be a key driver of economic growth. Now consider that Q3 federal defense spending grew at the fastest pace in four years and was to credit for almost one-quarter of real economic growth. With defense spending on the sequester chopping block, no doubt the Pentagon took the precaution to accelerate spending ahead of potential budget cuts. Thus, this economic boost is no guide of underlying economic momentum and presages a decline.
This is just the tip of the iceberg of potential market distortions if a deal in Congress is not struck soon. Capital gains and dividend taxes will reset in 2013, and the latter, in particular, could induce tax avoidance strategies. Before the year is out, equities could come under intensified downward pressure as investors move to realize capital gains. For instance, the Tax Reform Act of 1986 raised the maximum tax rate on long-term capital gains from 20% to 28%. When compared to prior years, this resulted in abnormally high trading volumes in the December prior to the policy taking effect, followed by abnormally low volumes in January. With a 5 percentage point tax swing on deck for capital gains, investor jitters can kick up without a moment's notice. Remember the 25% drop in the S&P500 Index in 2008 when Congress voted down TARP legislation, only to scramble for a second vote two weeks later? Volatility in markets and confidence is the last thing the economy needs. Our Q4 real GDP estimate is tracking less than 1%. The economy is already skating on thin ice in the absence of any additional shocks.
Enter the Federal Reserve. A timely 2-day meeting is set for December 11th and 12th. Fed members have repeatedly articulated that monetary policy can not single-handedly push against the fiscal headwind. Yet, we doubt they will stand by idly. Operation Twist is terminating at year-end, and with more to lose in doing nothing than something to shore up market confidence, we could see an announcement towards further Treasury purchases. It would likely not be a full scale QE4 program. Rather, it may be an extension of QE3 with open-ended purchases for a short period of time (i.e. a few months) to help us through the fiscal policy hump and the persistence in political discord. Tick tock tick tock.
CANADA - ECONOMY FACES CHALLENGES DESPITE JOB GAINS
Markets in Canada were treated to two marquee economic events this week; an interest rate announcement and an employment report. Economic growth in Canada continues to be sub-par, keeping the Bank of Canada on the sidelines. But, November's strong employment report underscored the reason the Bank's bias is that the next move in interest rates is still more likely to be up, rather than down.
As was universally expected, the Bank of Canada left the overnight rate unchanged this past week, and more importantly left its forward-looking language on the path of monetary policy untouched. Canada's economic growth has been sub-2% for three quarters now; not fast enough to absorb the excess slack in the economy and increase inflationary pressures. While many might be frustrated by the continual warnings of higher rates that never materialize, the economic fundamentals in Canada do not yet warrant rate hikes.
The Bank remains optimistic that economic growth will pick up through 2013 and that "some modest withdrawal of monetary policy stimulus will likely be required". It expects that growth will be driven mainly by domestic sources - consumption and business investment - as exports pick up only gradually. Canada's exports "continue to be restrained by weak foreign demand and ongoing competitiveness challenges", which include the strong Canadian dollar.
Evidence of these competitive challenges was seen in the Q3 productivity report, which showed business sector productivity declined for the second-straight quarter. Canada's poor productivity performance is sadly nothing new, but the third quarter data showed that compensation growth continues to outpace productivity, therefore increasing our unit labour costs. Add in a strong Canadian dollar, and unit labour cost growth is outpacing that in the United States.
Competitive challenges aside, we still expect stronger demand from the United States, particularly in areas like auto sales and residential construction to help lift Canadian exports. That's why even though the U.S. fiscal cliff talks in Washington may only be the second most closely watched negotiation in Canada after the NHL lockout, the outcome is more important for our economy. It is still unclear what mix of tax increases and spending cuts will be negotiated to avoid the worst of the fiscal cliff in 2013 (see page 2), but we believe an agreement will be reached, although potentially at the eleventh hour.
Friday's employment report highlighted Canada's domestic strength in the face of weak external demand. Canada's economy created a healthy 59 000 new jobs in November, taking the unemployment rate down two ticks to 7.2%. There is also little to quibble about in the number's overall strength. Gains were concentrated in full-time jobs, posted by men, women and youth, and seen in seven out of ten provinces.
But, we wouldn't be economists if we didn't throw some cold water on this seemingly good news employment report. On an industry basis, job losses were posted in construction, which is not surprising as the housing sector slows. Manufacturing also shed 20 000 jobs in November. Employment is up a healthy 4.1% year-on-year, but the sector has been losing jobs over the past six months. In fact, the same can be said for the goods-producing side of the economy as a whole, which has above-average job growth over the past year, but has been losing momentum more recently (see chart), illustrating the impact of a slower global growth backdrop.
In recent months, the services side of the economy has been more than picking up the slack for a slowing goods sector. However, the trouble is that November's job gain is hard to square with a decelerating growth backdrop, and falling levels of business confidence. Add in rising unit labour costs and we don't expect these strong job gains to be sustained heading into next year. Job growth should slow to a pace more in line with economic growth, with the unemployment rate failing to make much further progress over the next couple of quarters.
U.S.: UPCOMING KEY ECONOMIC RELEASES
U.S. FOMC Interest Rate Decision
Release Date: December 12, 2012
Current Rate: 0.0 0% to 0.25%
TD Forecast: 0.0 0% to 0.25%
Consensus: 0.0 0% to 0.25%
The December FOMC will affirm that financial repression is alive and kicking. The two principal issues are whether the Fed will adopt numerical economic targets (unlikely at this meeting) and the size and contours of the next leg of QE3. The Fed will outline a 3-month buying agenda equivalent in size to the current program, one that is set to expire. That means $40B in MBS and approximately $45B in Treasuries. Distribution of Treasury purchases will differ relative to Operation Twist. Buying in the 4-6 year sector to be reintroduced at the expense of purchases in 20-30 year bonds. Buying distribution is a detail, but size and program length are not. Our operating assumptions are that there is little to gain and everything to lose by underwhelming a market expecting more QE and, in a time of uncertainty the Fed will lean toward the status quo. That suggests a total QE program of approximately $85B. Since QE is open-ended the Fed does not need to outline QE intentions beyond the next 3 months. We know QE will now be used in a fashion similar to the policy rate, adjusting it accordingly relative to the tone of emerging risks and data. If it errs, it will be on the side of more, not less.
U.S. Retail Sales - November
Release Date: December 13, 2012
October Result: Total -0.3% M/M; Ex-autos 0.0% M/M
TD Forecast: Total 0.1% M/M; Ex-autos 0.3% M/M
Consensus: Total 0.4% M/M; Ex-autos 0.0% M/M
The strong rebound in motor vehicle sales should more than compensate for falling gasoline sales in November. During the month, we expect total retail sales to rise at a modest 0.3% m/m pace, reversing some of the weakness the month before. Excluding autos, however, sales should decline by 0.3% m/m mostly on account of reduced expenditures at the pump. Core spending activity (which excludes spending on autos, gas and building material, and is a useful gauge on the tone of real spending) should post a more respectable 0.4% m/m gain adding to a similar gain the month before. In the months ahead, we expect the pace of core consumption spending activity to be relatively tepid, reflecting in part the impact of the Hurricane and the headwinds from weak employment growth.
U.S. CPI - November
Release Date: December 14, 2012
October Result: All-items 0.1% M/M; Core 0.2% M/M
TD Forecast: All-items -0.1% M/M; Core 0.2% M/M
Consensus: All-items -0.2% M/M; Core 0.2% M/M
Falling gasoline prices in November should more than compensate for rising food prices, with the headline CPI index expected to post its first decline since May with a 0.1% m/m drop. With the decline, the annual pace of consumer price inflation should moderate to 2.0% y/y, down from 2.2% y/y the month before. Core inflation, on the other hand, should remain quite firm, advancing at a further 0.2% m/m pace, though the annual rate pace of core consumer price inflation should remain unchanged at 2.0% y/y. Higher vehicle prices should be one key driver for the up-tick, adding to the gains in apparel and lodging costs. In the coming months, we expect inflation momentum to remain relatively subdued as the weak labor market performance and subdued economic recovery continue to temper inflation momentum.
U.S. Industrial Production - November
Release Date: December 14, 2012
October Result: Industrial Production -0.4% m/m; Capacity Utilization 77.8%
TD Forecast: Industrial Production -1.1% m/m; Capacity Utilization 77.0%
Consensus: Industrial Production 0.2% m/m; Capacity Utilization 78.0%
US industrial output is expected to decline for the second straight month in November as the impact of Hurricane Sandy continues to show up in the data. In particular, with a large swathe of the Northeast without power for the better part of two weeks and a large number of factories idle for a few days, we expect the pace of industrial production to decline by a further 1.1% m/m. Utility production should fall sharply, declining by 2.5% m/m, adding to the 1.0% m/m drop in manufacturing sector output. However, with the impact of the Hurricane expected to reverse meaning- U.S. CPI - November* Release Date: December 14, 2012 October Result: All-items 0.1% M/M; Core 0.2% M/M TD Forecast: All-items -0.1% M/M; Core 0.2% M/M Consensus: All-items -0.2% M/M; Core 0.2% M/M fully in December, we expect overall industrial production activity to bounce back next month. Capacity utilization should also decline on the month, falling to 77.0%.
CANADA: UPCOMING KEY ECONOMIC RELEASES
Canadian Housing Starts - November
Release Date: December 10, 2012
October Result: 204.1K
TD Forecast: 198.0K
Consensus: 202.0K
Housing starts are forecast to decline for a third consecutive month to an annualized level of 198k units in November. While single unit starts are expected to stabilize around 60k annualized units following a sharp decline in October, multiple units should remain under pressure in keeping with the sharp retrenchment in building permits through September. The impact of tighter mortgage regulations has already weighed on home sales and we expect that new construction projects will also be curtailed. This weakness should be especially pronounced in multiple unit projects which cater to first time home buyers who have borne the brunt of the tighter mortgage regulations. In seeing through the monthly wiggles, our November forecast will leave the 6-month trend in starts at a healthy 215k clip.
IMOH, Patrick E.
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