April 4, 2008

• Relative calm returns to financial markets, but for how long?
• U.S. consumer prospects become more gloomy
• Canadian and global economies closely tied to U.S. consumer

Although this morning’s weaker-than-expected U.S. jobs report represented a setback, the sentiment in financial markets has generally improved since the Fed-orchestrated rescue of Bear Sterns on March 16th. Equity markets, which received a lift this week from healthy demand for Lehman Brothers’ US$4 billion share offering, are up across the board globally. Even with today’s rally in government bonds, there has been a reversal of flows from this safe-haven area since mid-March, with yields on Canadian and U.S. 2-10 year maturities up 20-50 basis points. And with corporate borrowing rates (as measured by 3-month LIBOR) remaining relatively unchanged over the period, the hefty spreads have receded modestly. Lastly, commodity markets – which had been an attractive vehicle to hedge against the U.S. dollar – have pulled back as the greenback has strengthened modestly. Gold prices, in particular, have fallen from over US$1000 toward US$900.

While this relative calm has been encouraging, today’s moderate reversal of fortunes underscores the potholes that remain before credit spreads normalize and equity markets begin a full-fledged recovery. For one, the jury remains out on the total extent of credit losses in asset backed securities (ABS), with this week’s US$19 billion write down by UBS taking the total booked within the industry to about US$230 billion. Still, credit-loss problems continue to spread outside of the ABS market, notably high-yield bonds, where US$70 billion in distressed debt has already been written off. All-in estimates, including non-ABS, peg total losses at close to US$600 billion when it’s all said and done.

The other key risk relates to the growing macroeconomic impacts of the credit and U.S. housing market disruptions. And those risks were highlighted in the heavy plate of U.S. economic releases this week. On the plus side, gauges of business sector activity came in on the strong side of expectations. The surveys of manufacturing and non-manufacturing activity from the Institute of Supply Management (ISM) remained below the 50 contraction/expansion threshold – at 48.6 and 49.6, respectively – but registered higher out-turns than in the prior month. But while these indicators were consistent with a flat or slightly negative U.S. real GDP performance in the first quarter of 2008, the deteriorating consumer picture suggests the second quarter will be significantly weaker. In March, non-farm payrolls dropped for the third straight month, by 80,000 positions, while the jobless rate jumped to 5.1%. Most key sectors continued to register losses last month, as the softness spreads across the spectrum.

The extent of job losses hardly points to a free-fall, but taken together with the hit from slumping housing wealth, indicates that U.S. consumer spending will be well into negative territory in the second quarter – between 1-1.5% annualized. The tax stimulus will likely artificially inflate spending in the third quarter, before outlays revert back to a modest negative trend in late 2008 and early 2009. This path assumes that the pace of decline in employment doesn’t accelerate dramatically.

Global risks from U.S. consumer mounting

In our latest TD Economics’ Quarterly Forecast, we discuss the importance of the U.S. consumer to the health of the global economy. In recent years, the GDP share of U.S. consumer spending has surged from 67% to 72%, fuelling rapid growth in imports from across the globe. It is very unlikely that ongoing rapid expansion of domestic spending in countries such as China and India will be able to fully offset the headwinds from a weakening U.S. consumer appetite, leading to a substantial slowing in world GDP expansion.

This message was echoed in the latest IMF world forecast, which won’t be formally released until next week but was leaked to investors on Wednesday. The IMF marked down its U.S. growth forecast by a full percentage point in 2008, to only 0.5%, and scaled back its view for next year to only 0.6%. The global pace of expansion was also pared back substantially – to under 4% – with the organization citing a 25% risk of a world recession. Meanwhile, another high-profile economic assessment was delivered by Fed Chairman Bernanke in his usual testimony before Congress. He was quiet on any guidance on interest rates, but noted that real GDP is not expected to grow much, “if at all, over the first half of 2008 and could even contract slightly”.

How long can Canada’s job market hold up?

From a Canadian perspective, two of this country’s major export sectors – autos and forest products – are heavily tied to trends in U.S. consumption. So, the road will likely get only bumpier for these areas going forward. Yet, rather remarkably, the softening in exports recorded in recent quarters has not spread to any great extent to overall domestic spending or job market activity. And the latest economic releases indicate that this picture remained intact in the first quarter of 2008. January figures on real GDP showed that total output rebounded by 0.6% on the heels of a 0.7% decline in December. Although most sectors bounced back in the month, it was telling that manufacturing recouped only a fraction of its loss, while services and construction activity rose above November’s levels.

This morning’s numbers also told the all-too-familiar story. Despite a further 9,400 drop in factory jobs, overall Canadian employment rose by 15,000 in March, locking in a hefty gain of 86,000 in the first quarter as a whole. On a year-over-year basis, employment is up 2% in the nation as a whole, led by phenomenal growth in construction (9.3%) and in the public sector (5.8%). There remains quite a regional split, with the western region pulling up the average (2.5%). But, even in Canada’s industrial heartland of Ontario and Quebec, year-over-year job creation continues to run in the 1.5-1.8% range.

Although these recent results provide reassurance that any downturn in central Canada will be mild, the million-dollar question remains how much longer the domestic side can continue to expand robustly in the face of mounting weakness in their key export sector. And in our view, it’s only a matter of time before two key pillars of expansion – public administration and construction – gear down significantly. Government revenues, for one, are already feeling the bite from slowing incomes in the export sector.

Implications

Adding it all up, the period of calm is likely to be short-lived. A few key takeaways are: