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North America Focus: Weak U.S. Data Spark 'Race to the Bottom'; Canada's Consumers Still Cool
By Prajakta Bhide, Tetiana Sears, Christian Menegatti and Rachel Ziemba
We kick off our look at North America with the U.S., where incoming data reveal the vulnerabilities in the housing sector, and unemployment insurance claims and the manufacturing slowdown in August cast a shadow over the month’s payrolls report. This week will reveal an ugly revision to the Q2 2010 GDP estimate, which, together with the continued string of weak data, points to a weaker-than-expected second half of the year, as headwinds against the economy gather pace. Moving north to Canada, we expect retail sales to show some strength in June, but the growth will be short lived, as a number of domestic and global factors constrain consumers. We expect consumer spending to remain in downshifting mode in H2 2010, weighing on Canadian growth.
Weaker U.S. Data Sparking “Race to the Bottom”
Prajakta Bhide and Christian Menegatti
We kick off with a look at the U.S., where we saw more negative signals emerging from new data last week, including the worsening pattern of unemployment claims in August, the deterioration in forward-looking indicators of regional manufacturing activity, the continued collapse of housing construction activity and builder confidence, and the third consecutive negative print in the weekly chain sales reports. This week, we will see the second estimate for Q2 2010 GDP, which we expect to represent an ugly downward revision given the deterioration in the trade data, lower inventory accumulation and softer-than-expected construction spending, with growth already below the 1.5% mark, which we did not expect before H2.
We have long maintained the view that “this time it’s different” and that we are in for a protracted sub-par recovery as the U.S. consumer continues to repair household balance sheets; the labor market remains in disarray; the support of fiscal stimulus and inventory restocking wanes; the housing sector re-enters deflation mode; and external demand weakens as the global economy slows down—among other headwinds. With the U.S. growth slowdown coming already in Q2 (even sooner than expected) we certainly cannot rule out a dip back into negative growth territory in the quarters ahead and we assign a probability of 40% to such a scenario. Regardless of whether there is another period of contraction in the near future, one can remain assured that “we’re still in one long Big Dipper,” as Robert Reich puts it.
After months and quarters of RGE expressing lower-than-consensus views on growth, the consensus (and forecasters who are usually on the bullish side) seems to be catching up with us. And the speed and frequency with which new information induces forecasters to revise down their numbers—closer to ours—looks increasingly like a race to the bottom. While we are certainly not trying to win that race, we now see our forecast of 1.5% in H2 2010 as the ceiling for real U.S. GDP growth, with risks significantly tilted to the downside. Stay tuned for updates to our point forecasts for U.S. growth in the next days.
Among last week’s data, the report on industrial production in July showed an uptick in manufacturing output, as we had expected, given the increase in the manufacturing workweek from the July payroll employment report. However, the first few manufacturing reports for August, the Empire State Manufacturing Index and the Philadelphia Fed Business Outlook Survey highlighted a sharp slowdown in activity. The forward-looking new orders component of the Empire State Index fell into outright contraction territory for the first time since June 2009. Meanwhile, the Philly Fed headline index showed contraction in business activity for the first time since July 2009, with new orders negative m/m for the second consecutive month and the index for future manufacturing activity showing the lowest expected pace of expansion in 17 months.
Since January, the manufacturing sector has created 183,000 jobs, emerging as a bright spot in an otherwise bleak labor market and this weakness in manufacturing activity casts a shadow on the upcoming payrolls report. While the employment gauges in the Empire State Manufacturing index showed a return to expansion in August, the Philly Fed employment indexes struck a decidedly gloomy note in August, falling sharply into negative territory. Meanwhile, the recent upturn in initial jobless claims is of great concern. In the week ending August 14, 2010, initial claims climbed to 500,000—their highest level since November 2009. While we would have liked to believe that the latest gain is a temporary blip, it represents the third rise in initial claims in a row, and does not bode well for the employment report in August.
Figure 1: Initial Claims Have Worsened in August
Source: U.S. Department of Labor
Meanwhile, data on the housing sector continued to reveal the extent of the collapse following the expiration of the first-time home buyers’ tax credit. Housing starts rose by 1.7% m/m, but single-family starts fell back by 4.2% m/m, the third consecutive month of decline. Meanwhile, the forward-looking data on building permits offered no fuel for near-term optimism—single-family building permits fell back for the fourth consecutive month in July, down by 1.2% m/m, suggesting ongoing weakness in August. The mood among builders only confirms this story. The National Association of Home Builders’ Housing Market Index (HMI) continued its collapse in August, and gauges for both present and future expected sales turned worse, revealing the lack of builder confidence in any near-term housing recovery.
Figure 2: Builder Confidence Signals a Further Decline in Starts in August
Source: U.S. Census Bureau, National Association of Home Builders (via Bloomberg)
This week, we will see data on new and existing home sales in July, where we expect to see confirmation of the extended slump in housing demand. The index of pending home sales, a gauge of future existing home sales based on contracts signed on homes, showed another drop in June after a sharp collapse in May. This signals a third consecutive correction in existing home sales (recorded as contracts closed on homes) in July, although the decline is expected to be cushioned slightly, given that the deadline for closing contracts to receive the first-time home buyers’ tax credit was extended through September 30. The Mortgage Bankers Association (MBA) mortgage applications survey offers no encouragement—the weekly purchase applications survey has been virtually flat—and the Conference Board Survey shows that consumers’ plans for buying a home are virtually on hold, with no sign of a near-term improvement.
Figure 3: Plans to Buy a Home
Source: The Conference Board (via Bloomberg)
The refinancing index in the MBA weekly applications survey has generated some interest of late. The steady decline in mortgage rates since April has taken rates to record-low levels in August. This has spurred an increase in refinancing activity. However, this increase is substantially below the refinancing boom witnessed in early 2009 and likely reflects the inability of many borrowers to meet refinancing requirements, including minimum required home equity and credit standards. While the Treasury has denied recent rumors that homeowners may receive some aid from the GSEs in addressing the impediments for refinancing, the FHA’s modified refinancing program will go into effect in September 2010, enabling borrowers who are current on their mortgages to qualify for an FHA refinance loan, contingent on a 10% principal reduction by the primary mortgage lender. Given that the program involves principal loan reduction by lenders, many analysts have expressed skepticism regarding the effectiveness of the program. (For more details on the effects of the programs, see the RGE Strategy Flash: Squeezing Stimulus Out of the MBS Market.)
Figure 4: Mortgage Refinancing Picking Up, But Well Below 2009 Levels
Source: Mortgage Bankers Association (via Bloomberg)
All in all, the housing data clearly reveal the beginning of a second decline for the sector following the withdrawal of government support, as we have been expecting all along. The weak data will leak into home prices over coming months, and home price indexes are expected to show negative readings. The first of the home price indexes for June—the CoreLogic home price index—indicated that national home prices were virtually flat m/m following two consecutive months of gains.
Canadian Consumer Spending: Still Cool
Tetiana Sears and Rachel Ziemba
Canadian retail sales for June are due on Tuesday this week, and RGE expects to see some growth in the monthly measure to offset weakness witnessed in April and May. In particular, we expect that some demand might have been brought forward to the end of Q2. We fear, however, that any strength in consumption will be temporary, given the slowdown in the domestic, U.S. and global economies. As such, Canadian consumption will be a much weaker contributor to growth than it was in late 2009 as it faces several headwinds.
Private consumption has been an important driver of final domestic demand, which has been part of the structural shift in Canada’s economy from exports and manufacturing. Supported by ample credit, household spending was also instrumental in pulling Canada’s economy out of recession in 2008-09 and expanding at a 4.4% q/q annualized rate in Q1 2010. However, we expect a moderation in the pace of growth as a number of domestic and global macro factors will constrain Canadian consumers. Primarily, consumption will be tempered by tepid income growth, even as debt levels continue to increase. The robust recovery in the labor market was mainly in terms of the number rather than the quality of created jobs; in particular, there was minimal growth in hourly compensation, barely exceeding the inflation trend. As growth in personal disposable income stagnates and borrowing costs increase, consumer spending will continue on its moderation path. As we argued in our most recent outlook, consumer expenditure is likely to hover around the mid-2% range in Q3 as Canadian consumption becomes more aligned with income growth and household debt levels.
Figure 5: Private Consumption Share of Output Climbing (Chained C$, Millions SAAR)
In fact, data for Q2 already show signs of pronounced weakness in personal consumption, suggesting that credit conditions and incentives like the home renovation tax credit have brought forward demand from the future. The most recent data for retail sales for May was surprisingly soft, falling by 0.2% m/m and extending the sharp 2.2% m/m drop in April. While some of the spring weakness reflected a cooling down from the overheated conditions at the turn of the year, it still represented an adjustment to a “new normal.” The details of May’s report underscore the underlying transition adjustments in Canada’s economy.
Broken down by component, the poorest sales performance was registered in building material and garden equipment stores purchases, which fell by 4.1% m/m in May, reflecting the cooling trends in the housing market and continued weakness from the expiry of past incentives. The most recent housing market data (homebuilding and existing home sales, which plunged 6.8% m/m in July) point to a notable moderation in national real estate trends, which will restrain housing-related consumption. The expiry of the home renovation tax credit also added to the distortion: After boosting renovation activity by an estimated C$4 billion, it has significantly exacerbated the diminishing trend in renovation investment for the rest of this year and into 2011. Thus, sales in furniture and home furnishing stores and building materials will weigh on overall retail sales activity going forward.
However, retail sales data for June are likely to turn positive in these categories as Canadians might still have brought forward some home-related purchases before the tax harmonization took effect on July 1 in Ontario and British Columbia.
June’s retail sales should also receive a boost from auto sales. New motor vehicle sales, a leading indicator for this category, were quite strong in volume terms in June. New auto sales grew solidly at 2.5% on the strength of truck sales, the growth of which has outpaced that of passenger cars over the past seven months. This latest trend is unlikely to be sustainable if the growth in passenger car sales does not pick up. Moreover, price discounting could also suggest weaker prices, even if volumes remain strong. Additionally, we expect the demand for new cars to remain weak as households will be more cautious in their spending habits, restrained by weak income and higher borrowing costs.
Retail sales ex-autos fell for two consecutive months in May, the latest soft patch in a period of volatility and uneven recovery. Despite the fact that sales volumes were 1.5% above their pre-recession levels, three-month-trend measures point to a slowing pace of growth in sales. While consumption will still be a significant growth driver, it needs to come back to reality. We believe that this moderation is a sign of an easing of Canadian consumption.
Given moderate income growth, greater global and U.S. uncertainties, Canadian consumption will remain in downshifting mode in H2 2010, weighing on growth rates. Canada’s Q2 real GDP growth is expected now to come in at a more modest annualized 2.4-2.6%, below the Bank of Canada’s estimate of 3%. The central bank also has fewer reasons to worry about the inflation trend, which appears to be well contained, according to the latest data release for July. Despite a 1.8% y/y hike in headline inflation due to the HST implementation in Ontario and British Columbia, the measure of core inflation, which excludes eight volatile items and indirect taxes, continues to remain mild—inflation slid to 1.6% y/y in July from 1.7% in June and 1.8% in May. Slowing domestic and global growth coupled with a softening trend in core CPI further support our view that the Bank of Canada will remain on hold at its September meeting. Moreover, further weakness in the U.S. economy would add to a more significant adjustment, prompting the Bank of Canada to take a longer pause in its tightening cycle than was previously anticipated.
Figure 6: Canada’s Retail Sales Trending Down