North American Economic Update
In the US, stronger-than-expected growth in domestic demand in the latter part of 2004 has implied stronger momentum into the first half of 2005, thereby countering some of the negative influence from energy prices and the flatter yield curve. This does not guarantee that growth will hold up above 3 per cent going forward. Growth in real consumption during the second half of 2004 averaged more than 5.5 per cent per quarter, which exceeded even the spending surge seen in the second half of 2003. The performance is incredible considering that employment growth was anaemic relative to past cycles. While interest rates pushed higher in October and November 2004, it is now clear that the relief in longer-term rates, at least from June 2004 highs, saw some pent-up demand from the first half of 2004 translate into stronger purchases in the second half.
The relief in energy prices after the October 2004 highs was also instrumental in spurring growth in spending, as was the dissipation of uncertainty once the US presidential election was over. Again, those recent stimulants are now gone and already there has been a deterioration in some of the key consumer metrics, such as the weekly confidence numbers. Consumers, as well as businesses, now face two major headwinds – energy and rates.
Crude oil prices have spiked beyond expectations since the early part of February 2005, reaching close to US$54/barrel (at the time of writing), or a 33 per cent increase over the low seen on 13 December 2004. Since the start of 2005, oil has risen by roughly 22 per cent versus the 12 per cent year-to-date gain experienced this time last year in 2004. The trend increase in oil coming into this quarter, however, has not been as dramatic.
Compared to the start of the fourth quarter of 2004, crude oil prices are up over 5 per cent today, whereas prices had climbed by almost 25 per cent over the comparable period in 2003. Still, with prices one and a half times higher than 2004, oil represents a major headwind for the global economy in 2005. In 2004, the consequence from higher crude oil prices was deterioration in business and market sentiment, though the impact on actual economic growth was not as noticeable. This time around, the escalation in costs is likely to affect both psychology and behaviour, meaning reduced growth, weaker profits and slower job growth.
As for offsets to higher energy costs, there are none. In the case of the US, administered interest rates are 150 basis points above where they were this time in 2004 and 10-year government yields are roughly 30 points higher, though still below the peak for yields witnessed in the second quarter of 2004. We have argued that a similar snap back in yields could easily occur again, especially considering the threat of reduced foreign participation in upcoming US Treasury auctions and how flat the US curve has become. Indeed, a modest back-up in 10-year yields has already begun following the bounce off 4 per cent in early February 2005. Keep in mind that this correction is starting from a higher base and if bears are able to achieve a break of 4.5 per cent, then there is an increased risk that 10-year yields in the US will be up at 5 per cent or higher by summer 2005.
On the manufacturing front, sentiment has also eroded following a brief improvement in December 2004, although the pace of shipments growth remained firm into January 2005 on the back of stronger orders in 2004. Some of that strength in orders stemmed from corporate investment decisions made in relation to tax incentives, or more specifically the view that tax incentives would expire as scheduled at the end of 2004. To the extent that orders growth in the final quarter of 2004 ‘stole’ from subsequent quarters, the pipeline fueling future shipments growth could be drying up already. Keep in mind that the US also experienced a substantial acceleration in inventories in 2004 and running those stocks down to more manageable levels may keep shipments growth firm – but at the expense of production and therefore jobs. This does not paint a positive picture for overall business investment, or at least the prospects for continued GDP growth leadership from this sector.
During the last seven quarters, real investment growth has averaged more than 14.5 per cent per quarter on an annualized basis and while we have knocked down our estimates for 2005, the outlook still calls for no minuses. If longer-term interest rates do spike higher in the coming months, alongside further tightening by the Federal Reserve, housing demand will also weaken and drag overall construction spending growth down.
Of course, the focus will remain on US trade performance and whether the dollar’s devaluation to date has benefited this sector, which so far has not happened. The current account deficit continues to hit new record highs as growth fades in developed industrial countries. Even if net real exports do improve, the degree of improvement will be too small to make any material difference to the nominal trade deficit or the current account deficit. Add in a $400bn federal government deficit in 2005 and possibly in 2006, and it becomes hard to make a case for why the US dollar should not continue to slide against the major currencies. It also makes the argument for lower bond yields tougher to make.
In this environment, the Federal Reserve will most likely live up to its guidance and tighten rates once or twice more before taking a break and observing the economic landscape. Most analysts expect the tightening cycle to continue; however, with growth falling back below 3 per cent and one or more sectors of the economy showing more significant signs of strain, we are comfortable with the view that the Federal Reserve stays on hold for a “considerable” period of time.
Aside from the headwinds facing the US economy in 2005, time may also be a potential enemy. Since the Second World War, there have been 15 episodes of expansion in the US economy (GDP growth lasting at least two quarters). Not including the current expansion, the average expansion duration was 12 quarters. The longest stretch of uninterrupted growth was the 1991 to 2000 expansion (37 quarters), followed by a 35-quarter growth string from 1961 to 1969. Assuming positive growth in the current quarter, this expansion has now lasted 14 quarters, and average quarterly growth (annualized) has been 3.4 per cent, compared with 3.7 per cent during the 1990s expansion. The two growth spurts prior to this one were both in excess of 30 quarters (1982 to 1990 counted for 32 quarters), supporting the view that perhaps the glass is even better than half-full. These periods followed a declining trend in expansion durations from the mid-1970s (10 quarters) to 1980 (two quarters). Keep in mind, however, that the ability to achieve above-average expansion duration since the early 1980s has been augmented by some key stimulants – first, a secular downtrend in oil prices from the early-1980s and, secondly, a secular downtrend in interest rates. Considering the growth in non-G7 energy demand and explosion in US deficits this decade, neither of these stimulants will be available.
Canada’s economic fundamentals have deteriorated not only in an absolute sense, but relative to the US as well, as a result of the general appreciation in the Canadian dollar (C$) since 2002 – especially the run-up seen in 2004. GDP growth in the fourth quarter of 2004 sank to 1.7 per cent – the weakest performance since the third quarter 2003. Growth in the third quarter of 2004 was also revised down to 2.9 per cent; however, the true underlying picture of Canada’s economy is only found after lifting off the recent inventory upswing. In the second half of 2004, inventory accumulation amounted to over C$40bn in volume terms – the largest on record. If we exclude this contribution, GDP contracted by 3 per cent in the third quarter and grew by a meagre 0.2 per cent in the fourth quarter of 2004. In other words, without the help of inventory restocking, Canada was technically in recession in the second half of 2004. Unless demand growth abroad remains solid, it will be necessary to see some of 2004’s surge in inventories run off at the expense of production growth and that will eat into GDP growth in 2005. Based on the fourth quarter numbers of 2004, we have already shaved 0.2 per cent off growth for 2005 to 2.3 per cent and there could be more to come.
The two major risks facing Canada remain the currency and a potential hiccup in the US economy. With respect to the Canadian dollar, our call for 90 US cents by the end of the third quarter of 2004 is still intact, despite the five-cent correction since late November 2004. Several factors have influenced this retracement in the currency, including the weaker economic picture and a shift in the Bank of Canada’s policy from a tightened stance to a more neutral one at the tail-end of 2004. That said, the currency has effectively held above the 80 US cent mark (thanks mainly to higher oil prices), but the key driver behind the Canadian dollar’s pullback has been a consolidation and recovery in the value of the US greenback. We continue to see this recovery as having a very short shelf life, and the next down-wave in the dollar will be significant enough to carry Canada’s exchange rate up towards 90 US cents over a relatively short time period. This will put further pressure on exports, while the negative effects on corporate profitability (outside energy) will cause employment growth to slide as well. If export growth remains negative at the same time that consumption growth is unable to compensate for whatever inventory run-off we get, then the headline GDP growth numbers in Canada could start looking more like the ex-inventory figures in the second half of 2004.
Throughout this period, the Bank of Canada will have no choice but to maintain the current level of interest rates, and if conditions deteriorate sufficiently, the Bank will at some point lower rates. At a minimum, we would expect the Bank to remove the 50 basis points worth of tightening that it implemented during September and October 2004. Such a shift in policy would naturally cool off a rally in the Canadian dollar, but the effects of the currency appreciation will continue for several more months after.