HIGHLIGHTS OF THE WEEK

• The FOMC reflects recent economic weakness with a dovish statement. “To help support the economic recovery,” the Fed also announces a plan to rollover asset purchases and maintain the size of its balance sheet.
• U.S. international trade data show a surprising jump in the trade deficit in July as exports fall 1.3% and imports jump 3.0%.
• Consumer prices beat expectations with a 0.3% M/M gain. Consumer price inflation (Y/Y) moves up to 1.3% from 1.1% previously. Core consumer prices edge up 0.1% M/M leaving the core inflation rate steady at 0.9%
• Retail sales rise by 0.4% on strong auto and gasoline sales. Core retail sales (excluding autos and gas) fall slightly by 0.1%.
• The dreaded ‘D’ word (deflation) is once again making the rounds. We join the discussion in our U.S. commentary this week.
• Canadian housing starts in July subsided to 189,200 units, ahead of market expectations but a decline of 1.6% from June. With starts having declined for three months, homebuilding appears to be easing in sync with cooling resale housing markets.
• Canada’s trade deficit widened to $1.1 billion in June from $0.7 billion in May, owing to a contraction in export volumes and a fall in export prices that outstripped the pull-back in import values.

UNITED STATES – DEFLATION ON THE BRAIN BUT PROBABLY NOT ON THE HORIZON

It was another volatile week for financial markets as a dovish sounding Fed came up against disappointing economic indicators that, once again, raised fears about the sustainability of the U.S. economic recovery. By the time of writing, equity markets were down over 3.0% from their previous week’s close and the yield on U.S. 10 year treasuries had fallen 0.1 percentage points – reachings its lowest level since March of 2009. With the economic recovery slowing, and the job market showing little signs of joining in what economic recovery there is, the deflation boogeyman is once again popping up and keeping investors from a good night’s sleep. We have written in the past about the risks of deflation (see U.S. Consumer Prices to Drift Awefully Close To Deflationary Danger Zone). Given the turn in economic indicators, and in light of the move by the Federal Reserve to take baby steps towards more, rather than less, monetary stimulus, it is worth considering these risks again.

First, let’s go over why deflation is such a scary word. On the face of it, falling prices might be considered a good thing. You certainly don’t hear many people complaining when it costs less to fill up their gas tank. However, while by definition, deflation means a general fall in prices, it is what deflation signals about the state of the economy and about the effectiveness of monetary policy that is really frightening.

A key factor to the relatively sluggish pace of economic recovery (see chart) is that households and businesses are reluctant to take on additional debt and financial institutions reluctant to lend it out. The primary downside of deflation is that it exacerbates this debt-deleveraging cycle by increasing the real cost of debt. Further, the real risk to deflation is that this could lead to a vicious spiral where faced by a greater debt burden, households are even less reluctant to go out and spend, and businesses, facing poor demand, less willing to invest – thereby initiating a renewed downturn.

While in theory, the Federal Reserve has an infinite ability to create money, in reality it must rely on the financial system to get this money circulating in the economy. With short-term interest rates effectively at zero, the Fed has in fact been creating a vast amount of money in order to purchase financial assets. There are two intended effects of these purchases. The first is to raise their price, thereby lowering yield (and the cost of credit), and the second to put more money into the economy. However, as can be observed in aggregate money supply measures, the second part of this mission is difficult since the extra cash has remained in the excess reserves of commercial banks. Put simply, the difficulty faced by the Fed in raising the aggregate money supply is the same on they face in putting upward pressure on the price level.

The final part of this story, which has been hinted at throughout, is that sentiment and expectations matter. Prices are inherently forward looking, responding to anticipating changes in demand and supply. At the macro level, if expectations of deflation and/or recession become entrenched, this can soon become a self-fulfilling prophesy. Once again the role of the Federal Reserve is important. While signaling to markets that short-term interest rates will remain low for an extended period is a useful tool to bring down longer-term interest rates, it also has the potential to signal that the Fed also expects to see price growth continue to dissapoint their expectations. If this signal is strong enough it could actually push the economy towards the type of equilibrium the Fed is trying to avoid – one where deflationary (and recessionary) expectations rule the day.

Fortunately, financial markets received some respite at the close of the week in a consumer price report that showed stabilization in the core rate of inflation. Moreover, recent upward movement in the one key component – Owners Equivalent Rent – that has been exerting the most negative pressure on the index, makes a dip into negative territory any time soon increasingly less likely. The bottom line is that while in the words of Chairman Bernanke, the current economic outlook is “unusually uncertain,” the most likely outcome remains a gradual improvement in activity and the slow removal of economic slack. As a result, while the chattering classes will continue to mention the ‘D’ word, the risks of an actually deflationary experience should remain remote.

CANADA – ABOUNDING RISKS FROM ABROAD

In financial markets and economic data, this past week highlighted the external risks to Canada’s maturing recovery. The optimism of the global rebound’s initial boost has now faded and, with investors increasingly uncertain about global prospects, the concern has buffeted markets.

This week, markets were beset by the downgrade of the Federal Reserve’s outlook, as well as ongoing murmurs of slowdown in China, as policy-makers combat emergent inflation and a possible property price bubble. With commodity demand closely tracking global output, prices for energy and minerals in particular were walloped, with oil again falling below $80/barrel. On heightened risk perceptions, equity markets were driven significantly lower mid-week and had failed to mount a recovery by early Friday. With government bond prices bid up, interest rates in the “belly” (i.e. 5-10 year range) of the yield curve subsided. Even as 3-month T-bill yields have steadily climbed, the yield on a Government of Canada 5-year bond has declined from a peak of 3.2% in late April to 2.14% as of August 11th. The fall in bond yields even as the Bank of Canada commenced hiking overnight rates demonstrates the renewed move towards risk-free assets witnessed during a volatile summer.

The S&P/TSX cleaved around 300 points over the week. Although we expect an ongoing recovery in corporate profits, the profit resurgence will slow in-line with the easing pace of overall economic activity. Compared to forecasted corporate profit growth of 20% in 2010, we anticipate around 10% growth in 2011.

As well, Canada’s trade data for June, showing a widening trade deficit, underscored the impact of uncertainties in the global economy on our own recovery. The synchronous rebound in global trade and in the U.S. manufacturing sector had benefited Canada, but that boost now appears to be subsiding. After six consecutive months of gains, exports volumes fell by 1.3% in June and, coupled with declining export prices, the value of exports fell by 2.5%. With the pace of U.S. rebound tepid and stateside consumer demand shaky, the recent boost to certain of Canada’s export categories – in particular, auto exports – was not sustainable. A widening Q2/2010 trade deficit detracted from growth sizably and we expect this trend to persist into the third quarter.

As well, giving some pause to anticipated rebound in investment, imports of machinery and equipment slowed in June. From a surge in these imports during April and May, investment in M&E is expected to add robustly to second quarter growth. However, the push from business investment in the third quarter looks more muted, with M&E import growth easing and the Bank of Canada’s Business Outlook Survey pointing to cooler investment intentions.

Canada’s performance in the first quarters of recovery has relied on the push from residential investment and household consumption spending. We expect these contributions to fade, and anticipate that investment will propel domestic demand. However, with the global recovery appearing shaky, Canadian firms are understandably cautious in undertaking major new investments, constraining future strength on this front. With demand from abroad wobbly, there is a significant downside risk to Canada’s exports. These factors point to a moderation in Canada’s economic growth in future quarters. Indeed, Canada’s fortunes are inexorably linked with events beyond our borders.

U.S.: UPCOMING KEY ECONOMIC RELEASES

U.S. Housing Starts – July

• Release Date: August 17/10
• February Result: 549K
• TD Forecast: 545K
• Consensus: 560K

The artificial boost to housing activity from the first-time homebuyers’ tax credit is now behind us, and accordingly the sugar-high in the housing market has now run its course. Since then, housing activity has been in a downward spiral as both new and existing home sales and residential building activity have all come off their recent peaks. The downturn in new residential construction activity is expected to stretch into July, with starts falling modestly to 545K, which will be the lowest print on this indicator since October last year. This soft outlook for July is reflected in the continued decline in the NAHB housing market index, which has also now fallen to its lowest level since April last year. Permits approvals have also been quite weak, pointing to further weakness in upcoming construction. If there are any risks to this forecast, they are to the downside. All of the declines are expected to be in the single-family units segment, while multi-unit construction is expected to rebound from the 22% M/M decline the month before. In the coming months, we expect new residential construction to remain fairly subdued, mostly on account of weak demand (despite the very favourable buying conditions) and the drag from the huge overhang of unsold homes.

CANADA: UPCOMING KEY ECONOMIC RELEASES

Canadian Manufacturing Shipments – June

• Release Date: August 17/10
• May Result: 0.4% M/M
• TD Forecast: -0.9% M/M; Consensus: N/A

The Canadian manufacturing sector is straddling the gulf between a reasonably robust domestic economy and the pronounced deceleration in global economic activity. We expect the latter influence will play a larger role in the coming months, starting with a forecasted 0.9% decline shipments in June. Both hours worked and employment in the manufacturing sector declined in June, which augurs for a slowdown in shipments. The weakness is expected to be shared by both the durables and non-durables sector. In particular, weaker automotive trade is forecast to have weighed on the transport sector while lower energy prices will hamper manufacturing activity in the energy complex. By contrast, shipments of machinery and equipment are expected to remain on an upwards trajectory, thereby preventing a more outsized decline in the headline. The silver lining of the release is that industrial prices were generally weaker during June, which will dull the impact that the decline in nominal shipments will have on both real manufacturing shipments and real monthly GDP growth.

Canadian CPI – July

• Release Date: August 20/10
• June Result: core 0.1% M/M, 1.7% Y/Y; all-items -0.2% M/M, 1.0% Y/Y
• TD Forecast: core 0.1% M/M, 1.8% Y/Y; all-items 0.5% M/M, 1.8% Y/Y
• Consensus: N/A

After the modest retreat in Canadian consumer prices in June, the introduction of the Harmonized Sales Tax (HST) in Ontario and British Columbia will provide a sizable jolt to Canadian inflation in July. During the month, we expect headline CPI to rise by 0.5% M/M, both on a seasonally and non-seasonally adjusted basis. This would represent the largest monthly increase since November of last year and is expected to be broadly based across a wide range of components (including those goods and services now subject to the HST). Higher energy and food prices should also contribute to the uptick in prices. On an annual basis, headline inflation is expected to accelerate to 1.8% Y/Y from 1.0% Y/Y in July, though 0.4 to 0.6 percentage points of this increase can be traced to the HST and will fall out of the data next July. By design, the Bank of Canada’s core inflation measure should be unaffected by the introduction of the HST and it is expected to rise by a slightly more modest 0.1% M/M, with the seasonally-adjusted indicator gaining 0.2% M/M. Annual core inflation should also accelerate on the month, rising by 1.8% Y/Y, up marginally from 1.7% Y/Y previously. In the coming months, we expect core inflation to remain relatively elevated for this stage of the business cycle, though it will likely continue to remain below the Bank of Canada’s 2% target.

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