- U.S. home construction shows signs of life
- Global inflation and growth woes remain
Why so serious?
Remember April and May? The leaves were returning. The flowers were blooming. The credit crunch was over. Well, the spring fling is over and markets have come to the realization - which incidentally has been TD Economics base case scenario all along - that the credit crunch will continue to slowly bleed for some time. While the market roller coaster saw increasing optimism early this week, apparently markets forgot that the U.S. housing market remains in shambles. There is some light. For the first time since the spring of 2007, the 3-month trend in new home sales and starts is positive. New home construction is what is captured in GDP measures of residential investment, and this same signal preceded rebounds in U.S. residential investment in each of the last three downturns. Existing home sales, on the other hand, make up the majority of the U.S. housing stock and mortgage market, and sales there dropped another 2.6% M/M in June and are down over 15% over last year. Critically, at this current pace of sales, it would take over 11 months to sell the inventory of unsold homes already on the market. And this doesn't include other homes dumped on the market in coming months through foreclosure or voluntary sales. In the second quarter, one in every 171 U.S. households was foreclosed on - with Nevada showing a staggering one in 43 households and California one in every 65.
This is the heart of the liquidity famine. As more homes are dumped on the market, home prices fall further, driving further mortgages underwater, leading to further foreclosures, further homes dumped on the market, and further home price declines. Lather. Rinse. Repeat. At some point, lower prices will entice buyers into the market, but not until the expectation for further declines recedes. Why buy today when you can buy next year for 10% less? In the meantime, liquidity in the housing market is nonexistent. This feeds directly into the current dilemma for the financial sector. The smaller and more regional the bank, the more exposed to the mortgage market. Real estate loans account for 1/3 of all assets of U.S. commercial banks - over ½ of all assets for banks with total assets less than $1 billion - and nearly 2/3 of assets of savings and loans. This puts these institutions in a vise, and those like Fannie and Freddie that have bought or underwritten about half of all these mortgages in a bind. As a result, commercial banks' average daily borrowing of $16 billion from the Fed's emergency lending programs last week was the highest ever.
So the issue becomes what can be done to get that liquidity flowing again? In a perfect world, we'd let the market work itself out. Prices would fall to the point that buyers would move in, and larger banks would recapitalize by attracting investors. But current regulations limit the ability of buyout firms to move into the banking sector - an issue the Federal Reserve is reportedly trying to address - while large foreign investors that bought into large banks earlier have since lost money on their investments and may be once bitten, twice shy. The bill moving through the U.S. Congress right now hopes to help stop the self-fulfilling prophesies of doom, gloom, and liquidity vacuum. The government would increase its debt ceiling by about $800bn - about half of which could cover the expected 2008 federal deficit and the other half would be there just in case. This "just in case" would help cover, among other things, the federal government insuring approximately $300bn in mortgage debt belonging to 400,000 American households who will refinance their subprime loans into 30-year fixed-rate mortgages, $4bn in federal transfers to the states, and the ability of the U.S. Treasury to buy stock in Fannie and Freddie up to the federal debt ceiling. As banks continue to struggle, these two institutions are key to helping the U.S. mortgage market grind on. While not ideal, a government backstop may be just what is needed to avoid their failure and the vicious cycle in the mortgage market. Earlier this week, the Congressional Budget Office estimated the cost of the Fannie and Freddie rescue plan at $25bn. As with most of the estimates placed on the cost of credit crunch, this seems likely to creep higher, but is still much lower than the cost of doing nothing. In the worst case scenario - or even just the next incremental step because let's be honest, there isn't much of a difference between the first step off the cliff and the second - the costs to the Federal government could be ten times higher.
A horse with no name
The current U.S. predicament is core inflation and GDP growth both running at about a 2.5% pace over last year. For those unlucky few who need to buy gas and food on a regular basis, total inflation is running at twice that pace. Still, this is well short of the near 15% pace of core inflation and 1% Y/Y contraction in U.S. GDP in 1980 that saw the invention of the moniker "stagflation." Nor are there signs inflation will come unhinged in the U.S. to that extent so the "stag" part is much more likely than the "flation." Similarly in Canada, headline inflation is now running at twice the pace of core inflation (3.1% vs. 1.5%). In fact, on a global scale, the most likely scenario is further stagnation in advanced economies and further inflation for emerging markets, with very few of either seeing both on a sustained basis. The U.S. consumer is quickly running out of stimulus checks to spend. In Canada, retail sales for May showed an ongoing sharp deceleration in everything not being bought at a gas station. In Europe, surveys of the manufacturing and service sectors showed sharper than expected decelerations in Q2. The U.K. economy posted its weakest quarterly GDP growth rate in three years in 2008Q2 and is likely to contract before the year is out. And, the pace of exports from Japan and Hong Kong saw precipitous declines in June. So growth is likely to slow in these regions and exert a downward pressure on domestic inflation.
On the other hand, broad-based emerging market resilience and inflation worries remain. The pace of inflation-adjusted retail sales in China is the highest in 12 years. Korea's economic expansion stayed constant in Q2 while inflation remains at a 10-year high. And across the EM universe (or at least averaging 57 EMs), inflation has accelerated from a 5% pace in June 2007 to 12% in June 2008. So while Malaysia this week hiked interest rates for the first time since 2006, and Brazil surprised markets with a larger than expected rate hike, the average pace of inflation across EMs is rising faster than the average interest rate. This is pushing down real interest rates and helping to fuel both faster growth and inflation in these markets. The same is not occurring in advanced economies, with average real rates still above zero in the G-7.
So in the immortal words of the modern philosopher Axl Rose, "Where do we go now?" Sluggish economic growth in advanced economies is likely to keep a lid on growth prospects in EMs, but not unbearably so. Inflation in EMs is likely to place upward pressure on advanced economy inflation, but not uncontrollably so. And we are likely to see more mirages in the desert before we finally find paradise and bring balanced liquidity back to the global economy.
UPCOMING KEY ECONOMIC RELEASES
Canadian Real GDP - May
Release Date: July 31/08April Result: +0.4% M/M
TD Forecast: +0.2% M/M
Consensus: +0.2% M/M
The Canadian economy appears to have snapped back to life in Q2, following the disappointing 0.3% Q/Q ann. drop in domestic output in Q1. And we expect the economy to grow for a second consecutive month in May with a modest 0.2% M/M increase in output, coming on the heels of the fairly robust rise in GDP in April. The increase in overall economic activity should be on account of the strong performance in real exports and the fairly strong advance in real wholesale sales during the month. The manufacturing sector will also add favourably to economic activity during the month, given the modest increase in real manufacturing shipments. However, despite this cautious revival in economic activity, we expect Canadian GDP growth to remain soft in the coming months as the economy navigates against the challenges of a weakening U.S. economy, a slowing domestic housing sector and a sluggish labour market.
U.S. Real GDP - Q2/08
Release Date: July 31/08Q1 Result: +1.0% Q/Q ann.
TD Forecast: +2.2% Q/Q
Consensus: +2.0%
The story behind second quarter U.S. GDP was supposed to be the impact of the fiscal stimulus on consumer spending. However, the bump in spending has been somewhat anaemic, resulting in a quarterly number that is likely to disappoint expectations. Durable goods consumption is expected to contract for the second straight quarter, led by a sharp drop in motor-vehicle purchases. Instead, it will be the tremendous strength of exports that will steal the headlines when the advanced estimate for U.S. growth is released. Exports likely contributed close to half of the total growth in the quarter and combined with falling imports will be more than enough to offset weakness in domestic spending. Residential construction will continue to subtract from growth, offset partially by non-residential structures investment that continues to show resilience.
U.S. Nonfarm Payrolls - July
Release Date: August 1/08June Result: -62K; unemployment rate 5.5%
TD Forecast: -60K; unemployment rate 5.5%
Consensus: -75K; unemployment rate 5.6%
The U.S. economy has lost jobs for six straight months since January with a total of 438K positions being eliminated from the nonfarm payrolls, and the monthly revisions have been consistently downwards. We expect the deterioration in the U.S. labour market to continue at roughly the same pace in July, with a further 60K drop in the employment ranks (following the 62K fall in June). The unemployment rate should hold steady at 5.5%. Indeed, with the sluggishness in the domestic economy and higher input costs, employers are likely to continue economizing on their use of labour services as they contend with the challenge of reduced demand for their products. Needless to say, the weakness in the U.S. labour market continues to be highlighted by the elevated level of jobless claims, though it is important to bear in mind that predicting employment data in July has always been challenging, given the variability of seasonal factory layoffs. Our bias is for nonfarm payrolls to continue deteriorating in the coming months.
U.S. ISM Manufacturing Report - July
Release Date: August 1/08June Result: 50.2
TD Forecast: 49.0
Consensus: 49.2
We expect the recent surprising upswing in the ISM (in May and June) to be short-lived, with the diffusion index falling back marginally below the 50 threshold in July. Indeed, it is no secret that the U.S. manufacturing sector continues to struggle as it tackles the headwinds coming from the slowing domestic economy and high input costs. Moreover, notwithstanding the natural ebb and flow in this indicator, and the important offsets that have been coming from strong export demand, we expect the long-run general stagnation in the U.S. manufacturing sector to continue in the coming months. If there is a risk to this call it is to the upside, given the strong durable goods orders in June.
The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.
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