RGE North America Weekly

By Prajakta Bhide and Tetiana Sears
Sep 19, 2011 4:00:00 PM | Last Updated
Read this analysis on Roubini.com

• September FOMC Meeting: A Twist Won’t Cut It
• U.S. Economic Data Show Deterioration: August Retail Sales Weak; Inflation Adjusted Spending Looks Even Weaker
• Consumer Sentiment Recovers Marginally, But Expectations Dip
• Manufacturing Activity Continues Sliding In Early September, August Small Business Sentiment Sharply Lower
• Initial Claims See Upward Pressure
• Uptrend in Core CPI Remained Intact in August
• Canadian Household Balance Sheets Deteriorate in Q2
• August CPI: Modest Inflationary Pressures
• July Retail Sales: Cautious Spending Ahead

UNITED STATES

By Prajakta Bhide

September FOMC Meeting: A Twist Won’t Cut It

The key event for the U.S. this week is the Federal Open Market Committee (FOMC) meeting for September. RGE, along with most market participants, expect the Fed to expand monetary accommodation by announcing a program along the lines of the Operation Twist endeavor of 1961. The Fed will likely to announce purchases of long-term Treasurys in an effort to lengthen the average maturity of its balance sheet, without increasing the size of the balance sheet. This could be achieved by reinvesting the runoff on the Fed’s holdings of short-term securities into longer maturity securities, or actively selling shorter maturity securities; the latter option is more likely. Research indicates that the effects of a policy like Operation Twist can be expected to be modest. (A 2010 paper by Eric Swanson of the San Francisco Fed notes that the original Operation Twist lowered the yield on long-term Treasurys by about 15 bps and corporate bond yields were lower by only a few basis points.)  Also, the size of the program and the pace of purchases would be limited by a decision to keep the balance sheet constant. We expect that the size of purchases under such an endeavor could amount to around US$400 billion. As a share of total outstanding securities, this would be roughly similar to the original Operation Twist but smaller than QE2. Attempting to increase the average maturity of the Fed’s balance sheet would address the key criticism of QE2, that QE2 purchases were of intermediate-term bonds and did little to counter the lengthening maturity of new bond issuance by the Treasury. However, it is important to note that the 1961 endeavor involved coordination between the Fed and Treasury regarding the maturity of new security issuance, in order to ensure the program’s effectiveness—a step not expected in the upcoming endeavor.

Our baseline forecasts now envision a recession in the U.S. (probability 60%) and the deterioration in recent economic data is in line with this view. As a result, we expect that by the November meeting, the Fed will be pushed to engage in easing beyond the Operation Twist-like program. Indeed some members within the Fed favored additional easing at the August meeting itself (rightfully so, in our view). However, recent data show that measures of core inflation are showing some resistance to a downward correction; this will cause the hawkish FOMC members to pressure against a stronger move at the September meeting. Nevertheless, at the September meeting, we can expect the Fed to discuss a range of options of further easing, including lowering the interest on excess reserves (which could be ushered in September itself, though in our view the effect would be limited). Other options include QE2-like large-scale asset purchases (LSAP), changes to the Fed’s communication around both the inflation and employment mandates (as recently outlined by Chicago Fed President Charles Evans), or more unconventional policies like price-level or nominal GDP targeting. One potentially effective policy option is also the least likely to occur: large-scale purchases of other assets, including mortgage-backed securities (MBS). A large scale Treasurys-only purchase program may have been appropriate for QE2 amid a downtrend in inflation expectations; in that sense, the program was effective. However, a “plain vanilla” large-scale asset purchase program may have only modest effects this time around, even if the purchases are concentrated in longer maturity securities. Unless substantially larger than QE2, another LSAP would have little impact on asset reflation. As the 2010 Swanson study noted about QE2, “If the goal of quantitative programs such as QE2 is to reduce private sector borrowing rates, purchases of Treasury securities may not be the most effective means of attaining that goal. Instead, purchases of mortgage-backed securities, or other securities with more similarity to private borrowing instruments, may reduce private sector borrowing rates more substantially and ultimately have a greater effect on macroeconomic variables.”

 U.S. Economic Data Show Deterioration

Last week’s U.S. economic data showed deterioration consistent with our baseline view of a recession in the U.S. (to which we assign a probability of 60%).

August Retail Sales Weak; Inflation Adjusted Spending Looks Even Weaker

Seasonally adjusted nominal retail sales in August 2011 were virtually flat m/m at US$389.5 billion after a downward-revision to sales in July. Core retail sales—excluding autos, gasoline and building supplies—were flat m/m in August after rising 0.3% m/m in July; the three-month average eased to 0.2% in August from 0.3% m/m.  Nominal retail sales of autos fell 0.2%, apparel sales fell 0.7% m/m in August, restaurant sales fell 0.3% after a 0.4% dip in July, and furniture sales fell 0.1% m/m after a 0.4% gain in July.  Among positive components were electronics, online sales, building supplies and healthcare. Gasoline sales also increased, up 0.3% after a 0.9% gain in July; retail gas prices were about 0.5% lower m/m. The August retail sales weakness comes as no surprise, given early readings from unit auto sales and chain store sales reports. The data point to a dip in inflation-adjusted personal consumption expenditures (PCE) in August after an uptick in July, and our tracking estimate for Q3 PCE growth remains unchanged at 1.6% q/q seasonally adjusted annual rate (SAAR)—a weak reading considering the quarter was expected to benefit from a technical rebound from the shocks of Q2.

Consumer Sentiment Recovers Marginally, But Expectations Dip

The Reuters/University of Michigan Consumer Sentiment index rose in mid-September to 57.8 from 55.7 in August, when the gauge touched the lowest level since 2008, at which time the economy was still in recession. The gain was led entirely by a gain in the sentiment gauge for current conditions, up six points to 74.5; on a negative note, the gauge for consumer expectations dipped to 47.0 from 47.4.  Survey director Richard Curtin noted, “Overall, the data indicate that a renewed downturn in consumer spending is as likely as not in the year ahead."

Clearly, the dip in consumer sentiment (to some extent affected by political uncertainty early in the month) and the substantial net worth erosion and continued labor market weakness (both wages and hours of work fell in August) appear to be restraining spending. Looking ahead, heightened economic uncertainty and continued weakness in gauges of confidence, the specter of further losses in net worth (net worth is historically highly correlated with growth in spending) and ongoing labor market weakness indicate a risk of further slowdown in Q4 spending, in line with our view of renewed downturn in economic activity.

Manufacturing Activity Continues Sliding In Early September, August Small Business Sentiment Sharply Lower

The Empire State Manufacturing Survey showed manufacturing conditions worsened further in September for the fourth consecutive month, the gauge for business conditions down 1.1 points to -8.8 (positive values indicate growth, negative values show contraction). The forward-looking new orders index fell to 8.0 from -7.8, the shipments index collapsed to -12.9 from 3.0 in August and the employment index fell into contraction territory at -5.4 from 3.3 in August. On the other hand, the September 2011 Philadelphia Fed manufacturing index remained in contraction territory, but showed a softer pace of decline. The headline index rose slightly to -17.5 from -30.7 in September. New orders continued to contract, albeit at a slower pace, at -11.3 from -26.8 in August, while shipments fell faster. The index for employees rose back into positive territory with a reading of 5.8 from -5.2 in August, though the average workweek showed continued deterioration.

The persistent weakness of the manufacturing sector into September points toward a further dip in the September ISM PMI, into contraction. Particularly noteworthy are the outright contractions in new orders in both the Empire state and Philly Fed indexes. Also noteworthy are the implications for hiring: The Empire index showed a contraction in hiring and no growth in expected hiring, and although the Philly Fed showed improvement in these gauges over the prior month, the levels are extremely weak. 

The National Federation of Independent Business (NFIB) Index of Small Business Optimism dipped for the sixth consecutive month in August, sharply lower at 88.1 from 89.9 in July. Sales remained the key problem for small businesses, and the net number of firms reporting higher current sales dipped, while expectations of higher sales over the next three months also dipped to a net negative 12% of firms. On a positive note, plans to increase employment improved, to a net positive 12% of all firms in August, though current reported job creation was marginally negative on net.

Initial Claims See Upward Pressure

Initial unemployment claims rose 11,000 in the week ending September 10 to 428,000, from an upward-revised level of 417,000 in the prior week. The four-week average of claims rose for the fourth consecutive week, up to 419,500 and has now been above 400,000 for 21 weeks.

Uptrend in Core CPI Remained Intact in August

Headline CPI rose 0.4% m/m in August after rising 0.5% m/m in July, while the seasonally unadjusted (NSA) annual growth pace reached 3.8% from 3.6% in July. The data showed that the recent uptrend in underlying inflation remained in place in August. Core CPI, excluding food and energy components, rose 0.2% m/m, while the NSA annual growth pace touched 2.0%, from 1.8% in July. The key drivers of the core inflation index included the index for shelter, up 0.2% m/m in August. This was driven by a 0.4% jump in the index for rent of primary residence and a 0.2% gain in owners’ equivalent rent, while the index for lodging dropped sharply. Another contributor was apparel, the index up a strong 1.1% m/m after a gain of 1.2% in July. (The price sensitivity of consumers is apparent with the drop in nominal apparel retail sales for August.) The index for new cars remained unchanged for the second month in a row, after significant upward pressure on CPI in prior months.

CANADA

By Tetiana Sears

Canadian Household Balance Sheets Deteriorate in Q2

National accounts data for Q2 2011, released last week, showed further deterioration in the overall state of household balance sheets, which bodes ill for the consumer spending outlook. Canadian households’ net worth fell 0.3% q/q in Q2 following three quarters of growth as debt accumulation rose 1.4% q/q and  asset growth flatlined (+0%). A reacceleration of household credit and especially mortgage borrowing drove the increase in debt in Q2, after a moderation in Q1, resulting in further deterioration in household balance sheets. Given the asset market moves in Q3, household balance sheets most likely deteriorated further in Q3, reinforcing the erosion in consumer confidence going forward.

In Q2 2011, growth in total household assets stalled as modest growth in real estate assets failed to offset the decline in the financial assets. Financial assets fell 0.9% q/q, reflecting the 5.9% q/q decline in the S&P/TSX composite, which reduced the value of household holdings of equities and pension assets. Canadian equities continue to slide in Q3 amid extreme global uncertainty about the pace of economic recovery and the ongoing European debt crisis, suggesting financial assets will again slide in Q3. Meanwhile, growth in real estate assets improved to 1.3% q/q in Q2 from 0.6% in Q1, however, growth continued to moderate on a yearly basis. Continued strength in the resale market could support residential assets, yet the upside will be limited by rising households’ debt levels and new regulations.

Figure 1: Financial Assets Decline in Q2 (%, q/q)

Source: Statistics Canada

Liabilities continued to grow at 1.40% q/q (6.0% y/y) in Q2, though the pace of growth has been easing since Q2 2010 on a sequential basis.

In Q2, the pace of household credit almost tripled to 1.6% q/q from 0.5% in Q1, as mortgage borrowing advanced 2.2% q/q, the strongest pace in 12 months, and continued to outpace overall consumer credit. Meanwhile, compared to the robust pace of credit growth a year ago, consumer credit eased to 5.0% y/y in Q2 from 5.3% in Q1, and mortgages slowed to 6.8% y/y from 7.1% in Q1. The increase in mortgage debt reflected the continued strength in housing market activity in Q2, coupled with still-attractive borrowing costs.

Figure 2: Credit Growth Slows on a Yearly Basis (%, y/y)

Source: Statistics Canada

Growth in personal disposable income slowed further to 0.5% q/q in Q2 from 0.8% q/q in Q1. As such, the household balance sheet deteriorated in Q2 as indicated by various ratios. The conventional measure of indebtedness—the debt-to-income ratio— rose further in Q2 to 150.8 from 149.5 in Q1 as mortgage debt outpaced disposable income. Leverage ratios (debt to total assets and debt to net worth) also slightly deteriorated in Q2, erasing some of the previous improvements. Homeowners’ equity as a percentage of real estate further declined to 67.2% in Q2, remaining on a downward trend since 2009.

However, low interest rates cushion households with high debt levels, as the interest costs of carrying debt as a share of income remain low. In fact, the household debt service ratio remained unchanged at 7.5% in Q2, slowly climbing from the post-recession low of 7.1%, but still well below the 30-year average of 8.1%. Moreover, the mortgage part of the debt service ratio inched down from 3.9% in Q1 to 3.8% in Q2 ; well below the 4.7% average since 1990. As interest rates remain historically low, there is a risk that households will continue to take on additional debt, reinforcing long-term vulnerabilities when interest rates begin to rise modestly in early 2013.

Recent turmoil in financial markets, combined with weaker domestic and U.S. growth, suggests that growth in assets will be limited in 2011. Meanwhile, despite the attractive borrowing costs, households have limited room to increase debt levels in light of an already historically high debt-to-income ratio, tepid income growth and high homeownership rates.

Figure 3: Households Remain Heavily Leveraged 

Source: Statistics Canada

August CPI: Modest Inflationary Pressures

The August Canadian CPI report released on September 21 should show mild inflationary pressures across most categories, while gasoline prices continued to ease in August. On balance, we expect headline inflation to rise a modest 0.1% m/m on a non-seasonally adjusted basis. On a yearly basis, total inflation should increase modestly to 2.8% from the 2.7% seen in July, after jumping to a 3.7% y/y pace in May. Meanwhile, core inflation should remain muted, close to the 1.6% y/y pace seen in July. We expect core inflation to remain well anchored below the 2% mid-target in the medium-term as moderating economic activity adds to the persistent excess capacity in the economy.

Headline inflation peaked at 3.4% y/y in Q2 and will likely ease in Q3 to average 2.7% y/y as the HST effect falls out of calculations and easing commodity prices soften overall inflationary pressures. These dynamics are set to continue into Q4 with the quarterly inflation tracking 2.0%, bringing the annual inflation rate to 2.7% in 2011.

In August, we expect monthly gains in food and gasoline prices to subside. However, low base effects will support food prices on a yearly basis. On average, we expect food CPI to advance by 3.8% y/y in 2011, further constraining discretionary consumer spending, as it hits low-income families particularly hard.

After peaking at 29.5% y/y in May, gasoline prices should continue easing due to base effects. In fact, the average monthly retail price at the pump slid a further 2.3% m/m in August; on a downward trend since May. On a yearly basis, prices eased to 23.5% in August from 24.9% in July. The slowing in oil prices bodes well for gasoline prices, which tend to follow, usually with a one-to-two month lag. However, despite some slowing in gasoline prices and, consequently, in the transportation component in the CPI, inflationary pressures should edge up in August on balance.

Figure 4:  CPI Largest Contributors, up to 75% (NSA, %, y/y) 

Source: Statistics Canada

July Retail Sales: Cautious Spending Ahead

The release of Canadian July retail sales figures on September 22 will provide us with the last important data point for the monthly real GDP number. In July, we expect a modest decline in total sales as the decline in monthly auto sales is likely to be more pronounced than gains in other sales. The new motor vehicles sales report for July, released earlier by Statistics Canada, showed a sharp 6.2% m/m seasonally adjusted (SA) drop in auto volumes, partly offsetting the outsized gain of 10.4% (revised down from the previous estimate of 10.8%) in June. As such, auto sales are most likely to dip in July.

We do not expect other categories to provide a strong offset, as consumers’ confidence dropped further in July to 81.3 from 83.1 in June, according to the Canadian Conference Board, amid intensified economic worries. Faltering growth, weaker balance sheets as noted above and heightened external headwinds in Q3 should further undermine consumer confidence, suggesting personal consumption will be even more subdued than previously estimated in the coming quarters. We discuss growth dynamics and policy implications in more detail in our latest Outlook Update.

Figure 5: Core Retail Sales Weakening (SA, %, m/m) 

Source: Statistics Canada