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Financial Markets Monthly - November 2009

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The tide has turned for the global economy with U.S. real GDP posting a stronger-than-expected increase in the third quarter, the Reserve Bank of Australia (RBA) citing Australia’s good economic performance as a reason for raising the policy rate and China recording a breathtaking 8.9% increase in third-quarter output. Canada, the United Kingdom and the Eurozone have yet to produce clear indications that their economies are out of recession, but conditions are improving and we expect reports of positive growth soon. Central banks are cautious, however, with only the RBA of the major central banks we cover starting to unwind monetary policy stimulus. Given the deep hole in economic activity, it is likely to be a long time before other banks will be in a position to follow the RBA’s lead, with hikes expected to come in the latter part of 2010 and continuing in 2011.

Investors got a bout of the jitters with global stock markets reversing course in mid-October after a sustained upward run that started in March of this year. The downdraft in stocks saw the MSCI World Stock Index trim back its October gain to just 0.65% with most of the 6.2% rise recorded in the first half of the month erased. Government bond markets in Canada, the United States, the Eurozone and the United Kingdom recouped some ground as investors shifted back to the safety of government securities. The more certain growth momentum in Australia saw yields rise with New Zealand rates going along for the ride. All told, 10-year yields stand very close to their 2009 average outside the Antipodeans. Looking forward, we expect the movement in interest rates to be concentrated in the shorter-term maturities as the timing of central bank tightening nears with longer-term maturities staying range-bound until the spectre of inflation makes an appearance.

The U.S. economy grew at a 3.5% annualized pace in the third quarter backed by a rebound in consumer spending and surging residential investment. Consumer spending was largely powered by durables consumption reflecting the impact of the cash-forclunkers rebates, but spending also increased for non-durable goods and services. In fact, these two consumption components increased at the fastest pace since the third quarter of 2007, suggesting that U.S. consumers are coming out of hiding. Residential investment also surprised to the upside, ending 14 consecutive quarters of decline. Business investment remained a weak spot as inventories were reduced again and commercial real estate investment continued to collapse. On the upside, the severe cuts to inventories set the stage for a pick-up in production as demand continues to trend higher.

Positive GDP growth after four quarters of decline likely signalled the end of the recession for the U.S. economy. To be sure, the expiry of the cash-for-clunkers program will cut into spending on durables in the fourth quarter. Still, early reports on fourth-quarter activity point to another increase in output, with the ISM manufacturing index driving solidly into expansionary territory in October and housing indicators pointing to firming sales against a shrinking inventory overhang. The hitch was in the October consumer confidence reports, which showed that households became less optimistic early in the fourth quarter, thus raising alarm bells that they could retreat again. The Fed worked to allay concerns about any tightening in monetary conditions by committing again this week to their policy of “exceptionally low levels of the federal funds rate for an extended period.”

After falling for nine of the past 10 months, the U.S. headline inflation rate is set to return to positive territory as the sharp declines in energy prices in October through December of 2008 go unmatched. We estimate that the headline CPI inflation rate will average 1.3% in the fourth quarter, largely reflecting the movement in energy prices. Excluding energy, the rate is likely to continue on its downward trajectory. The widely-watched core measure, which removes both energy and food price movements, is forecast to average just 1% next year, the slowest pace of increase on record. The absence of inflation pressures aside from energy, supports the case for the Fed to hold the funds target in the 0.0% to 0.25% range to ensure that a more vigorous economic recovery takes hold.

Unlike the United States where the data point to the end of recession, Canada’s numbers were less clear-cut. The third quarter showed stronger-than-expected gains in employment and housing, but both July and August’s GDP reports disappointed. The economy shrank by 0.1% in August after posting no growth in July. Our estimate that the economy expanded in September will skate GDP back into positive territory, but the risks are that the rebound will fall short of the consensus forecast for a 2% annualized gain. Our reckoning is that on an expenditure basis, real GDP growth was 0.5% to 1% at an annual rate in the third quarter.

The rebound in U.S. growth, low rates combined with government spending augur well for an improving trend to emerge in quarterly growth rates in the latter part of 2009 and into 2010. However, in its October Monetary Policy Report, the Bank of Canada, alongside a list of “favourable developments” for the economy, cautioned that “the current strength in the dollar is expected, over time, to more than fully offset the favourable developments since July.” The sharp drop in the currency since this tough-talking statement has likely allayed some of the Bank’s concerns. Still, currency movements affect the economy with a lag, suggesting that the impact will be greatest in early 2010.

The run-up in the Canadian dollar from mid-July to mid-October resulted in the currency running ahead of model forecasts for its value against the U.S. dollar. RBC Economics constructed a model similar to the one Bank of Canada uses. Our model showed that the increase in the Canadian-U.S. dollar exchange rate in the third quarter was about 5% more than the model estimated. Recent comments by Bank officials suggest a similar assessment. In their October statement, the Bank characterized the loonie’s persistent strength as “working to slow growth and subdue inflation pressures,” which contributed to reaffirming their commitment to a 0.25% overnight rate target until the end of the second quarter of 2010.

While near-term indicators signal an end to the global recession, markets remain worried about the durability of the upturn as fiscal and monetary policy support subsides. In Canada, the recovery started with a whimper rather than a bang, but we expect the momentum to build, spurred by a strengthening U.S. economy, low interest rates and a steady influx of government spending. Consumer confidence increased for seven months and, although the index edged down in October, it remained near the highest level since early 2008. With asset values recouping part of their losses and interest rates extraordinarily low, we expect consumer spending will recover in 2010, helped early in the year by government programs like the Renovation Tax Credit. We forecast that the economy will grow by 2.6% in 2010 with the unemployment rate peaking early in the year and then drifting lower.

Against a backdrop of firming global growth and rising commodity prices, Canada’s economy will pick up pace with real GDP growth of 3.9% in 2011 even as both fiscal and monetary policy stimulus starts to dissipate as long as credit conditions continue to improve. Inflation pressures will remain muted in 2010 as the large output gap very slowly starts to close. Price pressures will increase modestly in 2011, however, with the headline rate forecast to average 2.2%, although this largely reflects movements in energy prices, while the core measure holds below the Bank’s 2% target until early 2012. For the Bank of Canada, the road to the normalization of interest rates will be long and we expect the tentative steps in the second half of 2010 to be built upon in 2011. Our forecast is that the Bank will boost the overnight rate to 1.25% by the end of 2010 with further increases in 2011, yielding a policy rate of 3.5% by year end.

Emerging from the deepest recession since the Great Depression, the U.S. economy remains fraught with uncertainty about the health of the financial system and pockets of weakness outside of housing. In 2010, fiscal and monetary policy stimulus will remain abundant, although the Fed is likely to remove its quantitative and credit easing programs. Growth will continue to be constrained by the deleveraging of household balance sheets and a soft labour market. Real GDP is forecast to expand by just 2.5%, a modest recovery by historical standards. Against this backdrop inflation pressures will remain muted, giving the Fed leeway to keep rates at very low levels until the recovery is more firmly entrenched. Our forecast is that the first rate increase will come late next year with the Funds target ending 2010 at 75 basis points. As the financial system returns to health and the economy starts to generate jobs, we expect the economy to pick up pace, growing by 3.4% in 2011. However this will only manage to send the unemployment rate down to 8.9% by the end of that year. The return to trend growth and modest firming in prices will see the Fed begin its program to return the policy rate to a neutral stance. In 2011, this points to a steady drip of rate increases with the funds target forecast to rise to 2.75% by year-end and reach a more neutral setting in early 2012.

The RBA beat our expectation by one month that it would be among the first of the central banks to raise its policy rate when it raised its Cash Rate by 25 basis points in October. The RBA explained that it had earlier lowered rates based on its expectation of “very weak” economic conditions but “that basis for such a low interest rate setting has now passed.” Additionally, it expected growth to return close to its trend rate (3%-3.5%) in 2010. In line with RBC’s expectations, the RBA increased its Cash Rate by another 25 basis points in November to 3.50%. The central bank cited global financial market sentiment as being “much better” than earlier this year and noted that the unemployment rate is likely to peak at a “considerably lower level” than previously expected.

While much of the developed world suffered deep recessions, Australian growth dipped into negative territory for just one quarter and the unemployment rate rose to only 5.7% as of September. The strength enjoyed by Australia’s Asian trading partners helped its foreign sector, while fiscal and monetary stimulus supported domestic demand. After its first rate decision, Governor Stevens made a speech counselling against being “too timid” in the removal of stimulus. The end of October saw the quarterly inflation rate for the third quarter accelerate to 1%, although base effects brought the year-over-year rate down to 1.3%. The rise in the currency slowed inflation of tradables, although this was more than offset by the increase in non-tradeables, which gauges domestically generated costs. Recent events have prompted us to add two additional rate hikes to our earlier forecast, putting the Cash Rate at 5% by the end of 2010. In New Zealand, the RBNZ held rates at 2.50% in October. It dropped its easing bias although pledged not to increase rates before the second half of 2010. We expect the RBNZ to begin raising rates in the second quarter of next year as the pace of economic activity continues to firm.

Eurozone data have been pointing to a continuation of the recovery into the fourth quarter. The region’s manufacturing PMI crossed the 50-mark in October, putting it in expansionary territory for the first time since May of last year and its economic confidence survey hit a 13-month high. While acknowledging the improvement in growth, the European Central Bank (ECB) continues to emphasize the high uncertainty around its sustainability. However, it suggested that it may not extend its 12-month refinancing operations into next year. By the third quarter of next year, the ECB should have sufficient evidence of the sturdiness of the recovery for it to begin raising its Refi rate. We expect the ECB to raise rates to 1.75% by the end of 2010 as the recovery takes hold.

The 0.4% quarter-over-quarter drop in U.K. GDP in the third quarter marked the sixth consecutive quarter of negative growth for the country, the longest string of quarterly declines since the beginning of modern records in 1955. At its November meeting, the Bank of England increased its quantitative easing program by GBP 25 billion, bringing total asset purchases to GBP 200 billion. The Bank of England stated its expectations that, while a pick-up in economic activity may soon be evident, the Committee believes “the prospect is for a slow recovery.” We expect growth in the final quarter to bounce firmly into positive territory, as households bring forward spending ahead of the VAT hike scheduled for January. The PMI surveys for October were on the right track, with both manufacturing and services posting their strongest readings since August 2007. However, we expect growth to be weak in 2010, with the Bank of England keeping rates on hold until the final quarter.

RBC Financial Group

The statements and statistics contained herein have been prepared by the Economics Department of RBC Financial Group based on information from sources considered to be reliable. We make no representation or warranty, express or implied, as to its accuracy or completeness. This report is for the information of investors and business persons and does not constitute an offer to sell or a solicitation to buy securities.


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