Forecasting an Acceleration
December 14, 2009
By Yilin Nie & David Cho
| New York
Revving Up the Growth Engine
After four quarters of contraction, Canada emerged from recession in 3Q. Growth eked out a small gain last quarter, but we look for GDP to accelerate going forward into 2010. Economic growth is shifting from being export-driven to relying more on domestic demand. In that regard, the Canadian consumer is well poised to carry the baton of growth.
From our perspective, both growth and inflation risks lie north of the Bank of Canada's current forecasts. We believe that the bank will need to hike before its conditional commitment to keep rates low until June 2010, and before the Fed. Our forecasts show the first BoC hike in April 2010, coincident with the release of the Monetary Policy Report. Below, we offer a more detailed discussion of the factors driving our fundamental outlook.
Consumer in Focus
3Q growth was something of a disappointment, but since then, we have seen consistent improvement in the domestic data that make us optimistic about the trajectory ahead. We look for a sharp pick-up in GDP in 4Q to give way to above-trend growth throughout 2010.
The composition is heavily weighted towards final domestic demand. In particular, three key factors make us increasingly constructive on the Canadian consumer. First, the labor market has shown signs of healing after the worst of the job losses earlier this year. Full-time employment is growing and hiring intentions are back on the rise (as reported in the BoC Business Outlook survey). We also illustrate that the unemployment rate is showing signs of peaking. As the labor market continues to improve and support wage growth, the consumer should see increased spending power in the months ahead. Second, the Canadian housing market is an important differentiating factor. Not only did Canadian real estate avoid the housing collapse seen across the border, but the latest prices, starts and permits data consistently point to renewed strength in the housing sector. Finally, echoing the trend of higher-beta assets, Canadian equities have also turned a corner. The performance of the financial sector has been especially noteworthy, with the major Canadian banks beating consensus expectations in last quarter's earnings. Foreign demand for Canadian securities and stocks has reached record-highs this year. Taking these factors into account, we believe that personal net wealth should continue to grow and drive final domestic demand higher in the coming months.
One of the Bank of Canada's key concerns is that net exports will detract heavily from growth, similar to what we saw in 3Q. Our forecasts reflect this effect in the coming quarters, but to a less severe degree than the bank forecasts. While the strong CAD is an important input in our forecasts, we believe that the pick-up in global demand and the recovery in the US will help to offset some of the negative impact. Notably, the revival of the US auto sector on the back of the cash-for-clunkers stimulus had positive spillover effects on the US's major trading partners. Canada's 3Q GDP report actually showed a notable upturn in export demand that was overshadowed by the growth in imports. We expect import growth to continue, but exports should catch up, particularly as the recovery in the US economy is positive for Canadian manufacturers and exporters. And if the global recovery continues along a reasonably strong path as Morgan Stanley Research expects next year, the open nature of the Canadian economy is well suited to benefit from the demand increase.
Finally, as the Canadian economy pulls out of the recession, inventories should shift from being a drag on growth to being a positive contributor. Inventories have been running lean through the growth slowdown, but the pick-up in domestic demand should prompt restocking in the coming quarters. The bounce-back in business investment in 3Q is also an encouraging indicator. As the growth cycle turns, businesses should respond positively to the rising consumer.
Mirroring the growth profile, we also see an upward trajectory for inflation. We forecast CPI to return to the 2.0% target by 3Q10, a faster normalization than what the bank forecasts. Canadian inflation took a sharp dive in late 2008 against the backdrop of the financial turmoil, decline in commodity prices and weakening of the CAD. But the majority of these factors have reversed, and we detect other price pressures building in the pipeline.
The trade-weighted CAD has appreciated nearly 20% from weak levels this year, alongside the run-up in energy prices. Meanwhile, wages are back on the uptick and home prices are rebounding sharply. This latter factor is significant as the recent price increases are not fully captured in the inflation data yet. Home prices tend to be reflected in CPI in a delayed manner, and the uptrend in those data suggests there are upside risks for inflation ahead.
We are already seeing a re-emergence of price pressures. In the latest CPI report, StatCan reported increases in six out of the eight components, with shelter being one of the two declines, which we expect to catch up to the other housing indicators. Another interesting trend that has persisted is the divergence between core and headline inflation. As we noted in our previous research, core CPI has proven much stickier than headline, suggesting that underlying price pressures may be greater than what the bank perceives. Indeed, StatCan revealed upside surprises in both the September and October core CPI, suggesting that 4Q inflation is likely to print above the bank's projections. Finally, the BoC Business Outlook survey also measures inflation expectations, which are shifting more in favor of higher price pressures ahead.
Based on our assessment of growth and inflation, we believe that the BoC will need to begin removing excessive monetary stimulus before June 2010. We expect a hike at the April 2010 meeting, which coincides with the release of the Monetary Policy Report that gives the bank an opportunity to justify a policy change. This is an out-of-consensus call, with the forwards curves only pricing in about a 30% probability of a hike in April. Following the first hike, we would expect the BoC to normalize rates rapidly to reach 2.25% by end-2010.
CPI will be the key guidepost to monitor. Although the bank continues to reiterate its commitment to low rates for now, the current stance is completely contingent on the inflation risks, which are shifting, in our view. If 4Q CPI ends up surprising above the bank's forecasts, the bank will need to revise its outlook and remove accommodative policy sooner (the next MPR Update is due on January 21, 2010).
On the growth front, the bank already acknowledges that the "main risks are stronger-than-projected global and domestic demand" (December 8 statement). Notably, our projections for both global growth and domestic demand are both higher than the bank's forecasts. If the growth trajectory unfolds as we expect, Canada will experience more upside than what the BoC is currently expecting.
Risks to Our Forecasts
There are a few risks to our forecasts stemming from global and domestic factors:
1. Slower global growth. Our forecasts assume that the global growth rebound will be robust next year (4.0%, see Global Forecast Snapshots, December 9, 2009, for more details). If global demand slows or remains sluggish next year, the Canadian economy will be sensitive to the slowdown.
2. Slower US growth. The US growth path is especially important, given Canada's strong trade exposure. Our economists are forecasting 2.5% growth in the US next year. If growth surprises to the downside and the US consumer retrenches, Canadian exporters will be disproportionately affected.
3. Commodities. Another macro risk factor is commodities, which present two-sided risks. Our commodities team is currently forecasting WTI crude to reach US$85/bbl by end-2010. This run-up should support Canada's terms of trade and, through the income effects, bolster domestic demand. However, excessive commodity price rises could stoke inflation concerns. Meanwhile, softer prices would present downside growth and inflation risks for Canada and give the BoC more room to stay on hold.
4. Productivity growth. On the domestic side, a risk stems from productivity growth, which has been persistently sluggish over the past decade. The low productivity could be problematic for Canada's long-term capacity use. Weaker productivity could also raise inflation concerns, even if growth disappoints.
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Noisy Details in 3Q09 CAD
December 14, 2009
By Michael Kafe, CFA & Andrea Masia
South Africa's current account deficit moderated further to R77.4 billion (3.2% of GDP) in 3Q09. This was higher than consensus expectations of R72.5 billion but much lower than our forecast of R97.1 billion, thanks to significant data revisions (including a ten-fold increase in inward transfers), a better-than-expected trade surplus and an unanticipated decline in interest payments to foreigners.
Trade Surplus Improves Further
The trade data show some interesting revisions. First, the 3Q09 trade surplus of R21.2 billion was not only higher than our expectation of a R15 billion print, but was also higher than the revised 2Q09 reading of R12.4 billion (from R26 billion previously), suggesting that the external trade balance actually improved between 2Q and 3Q of the year when all available monthly data pointed to the opposite. Once again, the confusing reading could well be a result of the seasonal and other adjustments that the SARB applies to the monthly data published by the South African Revenue Services.
Sharp Fall in Interest Payments to Foreigners
On the net invisible balance, service payments were in line with our R23 billion forecast and inward transfer payments were revised upwards by some R5 billion (0.2% of GDP); meanwhile, interest payments on non-direct investments (mainly portfolio inflows) posted a R5.4 billion decline that we did not anticipate. It appears that the latter reading may have been driven in part by a sharp fall in net bond purchases in September (latest official SARB data show net portfolio bond sales of a sizeable R11.3 billion, compared to the earlier flattish reading of some R1.4 billion published by the Bond Exchange of South Africa on Bloomberg). On the whole, our forecast on the net invisibles turned out to be too pessimistic.
Current Account Deficit May Have Bottomed
Looking forward, we believe that the current account deficit has now bottomed and is likely to rise again over the course of 2010, as consumer demand sets in and as private sector capital formation recovers in 2H10. We also believe that as commodity prices recover, dividend payments by commodity export companies are likely to soar again, putting further pressure on net invisibles. This is all likely to happen at a time where the presently strong inward momentum of capital flows over most of 2009 is likely to have slowed or even turned negative as global risk-love wanes. To be clear, we forecast the rand at 7.40 by end-2009, with a further appreciation to 7.00 by March 2010, before weakening to 8.70 by end-2010.
Swing in Other Investments Boosts Capital Account
With regards to the capital account, net other investments rose by R13 billion, thanks largely to the liquidation of foreign assets by the non-bank public. Foreign direct investment, although positive, was only R4.8 billion in 3Q09. This is a sharp fall from R100 billion in 2008 and an average of some R17 billion in the first two quarters of the year. However, portfolio inflows remain the dominant source of funding, with a net inflow of R23 billion - mainly equities, as risk-aversion towards emerging markets abated. The issuance of a US$500 million sovereign bond by the government also helped.
On the whole, the basic balance printed a R16.5 billion surplus that was only partially offset by a R10 billion (0.4% of GDP) outflow in unrecorded transactions, allowing the SARB to accumulate some R6.3 billion of reserves.
Demand-Side GDP: Significant Inventory Revisions
Significant revisions were made to demand-side GDP data too, the largest being in inventories, where the 2Q09 reading of -R52.9 billion was revised to -R38.7 billion. Again, contrary to anecdotal evidence in PMI surveys that an inventory rebuild was underway in 3Q, the national accounts data published by the SARB show that the inventory drawdown in 3Q09 (R50 billion) was actually worse than in 2Q09. According to the SARB Bulletin, "...inventory decumulation in the third quarter of 2009 was concentrated in the gold and platinum mining and manufacturing sectors, as well as the construction sector".
Further, large revisions were also made to the GDP residual term, which is a simple arithmetic measure of the deviation of demand-side GDP from the supply-side GDP aggregates published by Statistics South Africa. Previously, it appeared that the SARB had technically ‘overestimated' the country's GDP by some R12 billion over the past two years. This week's data, however, show a relative under-estimation of some R5 billion, after revisions were made to match demand-side data with the recently rebased and re-weighted supply-side GDP aggregates.
Consumption Likely Past its Worst Patch
Contrary to continuous claims of one million job losses in 2009, the Quarterly Bulletin reminds us that, at 366,000, the number of jobs lost in the formal non-agricultural sector of the economy is much less - some 4% of the total labor force at the height of the unemployment cycle. Most of the jobs lost have been in the informal sector, confirming that, as far as formal employment conditions are concerned, South Africa's labor laws are relatively inflexible. Even so, consumer confidence took a knock from the deterioration in employment conditions, with household consumption expenditure contracting by a further 2%Q in 3Q09, as expenditure on semi-durables (mainly clothing and footwear) fell to its lowest pace since 2Q03. Expenditures on non-durable goods also moderated sharply, although this was counteracted by a recovery in services and durable goods spend. It is worth noting that durable goods (mainly transport equipment, recreational and entertainment goods) have now posted their first positive reading since 1Q08.
Public Sector Investment Powers Ahead
Gross domestic capital formation fell 4.1%Q, thanks largely to a sharp fall in private investment activity. In line with our forecast of -14.8%Q, private sector capital spend fell by 14.1%Q, led by large contractions in capital formation by the agricultural, mining (-29%Q) and manufacturing (-33%Q) industries. According to the SARB, fixed investment in the private sector was held back by weak domestic demand conditions and poor prospects for a rapid recovery in export demand. On the other hand, public sector investment growth is simply not letting up. This sector continued to show resilient prints of 23.4%Q in 2Q09 and 18.7%Q in 3Q09 - after posting a sizeable 69%Q jump in 1Q09. We had expected a technical contraction in 3Q09. The strong growth here was driven by increased activity in public works, roads, transport and health sectors.
Finally, government consumption data rose at a strong 7.5%Q pace, thanks largely to increased expenditures on employee compensation, as well as the purchase of two military aircraft by general government.
On the whole, the Bulletin shows that consumption expenditures continued to contract in 3Q09, albeit at a less worrisome pace. We believe that the worst is over for the consumer and look for a return to positive growth as early as 1Q10. We also expect GDP to benefit from a deceleration in the pace of inventory drawdown in the coming quarters. With regards to the current account deficit, however, we believe that this reading marks the bottom in the cycle, and look for the deficit to rise in the coming quarters as consumer demand normalizes.
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