Financial Markets Monthly - December 2010: Getting Ready for 2011
- The global recovery is staying on course even as the European sovereign-debt crisis continues.
- The U.S. economy grew at a faster than expected pace in the third quarter...
- ...and the momentum is forecasted to accelerate next year supported by very accommodative monetary policy and tax cuts.
- The Fed is watching the labour market and inflation, and it is unlikely to start the process toward rate normalization until both measures are more in line with its mandate.
- Canada's economy grew at a subdued pace in Q3/10...
- ...mainly due to a large drag coming from the trade sector.
- The economy is forecasted to pick up pace as the trade gap improves and business spending rises.
- The core inflation rate is running below the BoC's 2% target and is forecasted to stay below target until late 2012.
- This provides the Bank with time to assess the need for higher interest rates in the context of both domestic and external developments.
- Despite upbeat economic data, sovereigndebt concerns led the ECB to leave rates unchanged and extend liquidity provisions for a further three months.
- The second estimate confirmed the strong 0.8% non-annualized pace of growth in U.K. real GDP in Q3/10.
- Australian real GDP growth came in softer than expected in Q3/10 at a non-annualized 0.2%.
Getting ready for 2011
Financial markets are ready to ring in the New Year after 2010 was plagued with bouts of uncertainty as to whether the recovery would be sustained. Recently, there were hints of a change in sentiment with investors appearing to have embraced the idea that the global economy has built sufficient momentum to withstand the downward pressure emanating from Europe's sovereign- debt crisis. The global MSCI world stock index was 4.1% higher in November than October, on average, and the buying continued into the first week of December especially after the U.S. Government reached a tentative tax deal that would put money into the hands of U.S. consumers. Bond markets, conversely, lost ground with interest rates rising much more aggressively than we expected. The broad-based turnaround in the global purchasing managers' index in the October-November period suggests that even with many of the European countries experiencing draconian fiscal measures, demand in the global economy remains positive. Trade volumes have returned to pre-crisis levels and, although there is still a long way to go before the global economy is running smoothly, the risk of another dip into recession is no longer dominating market sentiment.
Deflation fears ebbing
During the summer months, U.S. investors battled their fears about deflation as the core inflation rate consistently decreased. Conversely, in China, investors were looking to see if the elevated level of inflation would induce the central bank to tighten policy. Last month, the Chinese central bank raised its policy rate for the first time since 2007. In the US, the Fed reacted to the declines in the core inflation rate by unveiling another round of quantitative easing and maintaining the ultra-low setting for the Federal Funds target. This course of action was followed in early December with the announcement of a fiscal stimulus package made up of various tax reductions. As we head into 2011, U.S. deflation prospects are likely to become less threatening with the core rate forecasted to reverse course slowly and grind higher during the year. In China, however, the strong pace of growth and tight capacity are consistent with inflation remaining elevated, which will likely result in the central bank continuing to tighten policy.
U.S. growth - prospects good for 2011
U.S. growth in the third quarter of 2010 was revised to a 2.5% annualized pace representing an improvement relative to the advanced estimate of 2.0% as well as the 1.7% gain recorded in the second quarter. Unexpectedly, an upward revision in consumer spending accounted for almost half of the upgrade to overall growth. We look for the U.S. economy to grow at a mildly slower rate in the fourth quarter and then accelerate sharply in 2011. Our forecast assumes that the recently announced tax package will be passed by lawmakers thereby lending support to consumer spending with the incentives contained therein also spurring a pickup in business investment. This tax cut package combined with very stimulative monetary policy and indications of improving consumer confidence are expected to result in the U.S. economy posting stronger quarterly growth rates in 2011. Stable conditions in the housing market means that this sector will no longer act as a drag on the economy; however, the inventory rebuilding that supported the economy in the early days of the recovery will fade away in 2011 although the tax reform package will prevent fiscal stimulus from turning negative. On balance, U.S. growth of 3.3% is forecast in 2011 with the pace accelerating to 3.6% in 2012.
Unemployment will remain an issue in 2011
Most of the recent data reports affirmed our belief that the U.S. economy has established sustainable growth momentum. The list includes readings on retail sales, the manufacturing and service sector purchasing managers' indices, and comments about activity levels contained in the Fed's Beige Book. The outlier in this trend of strengthening activity has been the monthly labour data, which so far failed to show a consistent improvement. To be sure, the number of employed in the private sector increased each month this year; however, the increases have fallen well short of previous recovery periods and resulted in just 14% of the jobs lost during the downturn being recovered. In 2011, we anticipate that the pace of job gains will accelerate as businesses are currently fully utilizing their labour forces given the lengthening in the average workweek and dramatic increase in the hiring of temporary workers. Unlike the consistent, though modest, gains in the number of employed, the unemployment rate has been volatile and remains elevated. The elevated unemployment rate reflects the fact the economy has been running well below its full-employment threshold. The U.S. output gap, which measures the difference between actual GDP output and the economy's potential, hit a whopping 7.8 percentage points during the recession. 2010's recovery cut this gap to 6.1 percentage points, and our forecast for a stronger gain in 2011 means that the gap will narrow further yet will likely remain wide by historical standards. Against this backdrop, we do not see any significant downward pressure being applied to the unemployment rate in the near term and forecast that the rate will fall to 9.0% in 2011 from 9.8% currently. The stronger growth pace in 2012 sets up for more rapid declines in the unemployment rate in the second half of that year.
Fed taking charge
The Federal Reserve faced down its critics regarding the decision to implement another round of quantitative easing in early November. The decision reflected the Fed's assessment that both the unemployment rate and inflation rate were at levels that were inconsistent with achieving its mandate of price stability and full employment. In anticipation of this announcement, investors and market-makers bought bonds, which drove interest rates to very low levels. Once the program was announced, however, the old adage that investors "buy the rumour and sell the fact" took hold thereby resulting in a sharp backup in interest rates. The rise in rates also coincided with an abrupt increase in the number of economic indicators that were reported as being stronger than expected. To our minds, interest rates are unlikely to fall back to the pre-announcement level on a sustained basis. Certainly, another round of risk aversion associated with concerns about the European sovereign-debt crisis may lead to U.S. Government bonds coming back into vogue and interest rates falling. We would look at this as a short-term phenomenon and expect that interest rates will gradually increase in 2011. With that said, given the elevated unemployment rate and low inflation backdrop, the upside for interest rates in the near term will also be limited. Our updated forecast takes into account the sharp sell-off in the Treasury market in recent weeks, and we now look for the 10-year bond to exit 2010 at 3.15% (compared to 2.6% in our November outlook). The thrust of our 2011 forecast remains the same, and we increased our year-end target for 10-year yields by 45 bps to 4.00%. We expect the Fed to hold the Funds target in its current range of 0.00% to 0.25% during 2011. Policy rate increases are likely to begin in 2012 when the economy is growing at a stronger 3.6% pace, the deleveraging process has been completed and financial market conditions are back to "normal". We forecast that the Fed will move the Funds target up to 2.25% by the end of 2012 and that the 10-year yield will rise to 4.50%.
Canada sprinted out of recession, economy takes a breather
The Canadian economy slowed in the third quarter of 2010 with annualized GDP growth dropping to 1.0% following gains of 2.3% in second quarter and 5.6% in the first quarter. Unlike the US, where the string of data reports have proven to be stronger than expected, Canadian data have been disappointing of late. With that said, the sharp slowing in GDP output in the third quarter was largely the result of big hit coming from the trade sector, which reduced real GDP growth by 3.5 percentage points. Domestic demand came in at a respectable pace due to stronger than expected consumer activity and a solid increase in business fixed investment. We expect the slowing in the pace of growth to be short lived with the economy forecasted to accelerate in the fourth quarter and throughout 2011. This view is primarily based on our assessment that the sizeable drag from net exports will not continue and that business investment will accelerate further. Any improvement in external trade is expected to be hampered by imports continuing to grow as the strong Canadian dollar supports investment spending on imported machinery and equipment. With exports forecasted to rebound in the face of accelerating growth in U.S. domestic demand, however, net exports will provide a small add to Canada's output in upcoming quarters. Consumers are expected to continue to spend in 2011 although the pace is likely to be slower than in 2010 because household debt levels have risen. The low interest rate environment will serve to limit the slowing in consumption activity and backstop the housing market, which is likely to experience slower activity. Our forecast is that the economy will grow by 3.2% in 2011 and 3.1% in 2012.
Bank of Canada - sitting back
The Bank of Canada temporarily called it quits on interest rate increases in October and December focusing on the downside risks to the global economy and financial markets emanating from the European debt crisis. The mid-year slowing in the U.S. economy also supported the Bank's decision that additional rate increases could pose a serious threat to the longevity of Canada's recovery. Furthermore, Canadian real GDP growth fell short of the Bank's forecast in the third quarter. Inflation, on the other hand, was deemed to be meeting expectations even though the core inflation rate jumped to 1.8% in October and the headline rate to 2.4%. The combination of disappointing growth and below-target core inflation will likely keep the Bank of Canada on the sidelines in the first quarter of 2011. Our expectation that Canada's economy will return to a faster growth track in the quarters ahead and that the U.S. economy will be able to sustain upward momentum should be sufficiently evident by the second quarter of 2011 at which time we look for the Bank to resume raising the policy rate. Our view that the core inflation rate will stay below the Bank of Canada's 2% target throughout 2011 suggests to us that the Bank will be in position to raise the overnight rate gradually. From today's 1.0%, we forecast that the overnight rate will rise to 2% at the end of 2011. The combination of sustained above-trend growth in Canada in 2012, and a steady acceleration in the U.S. economy will likely result in the Bank of Canada working to reduce policy accommodation in 2012. The overnight rate is forecasted at 3.5% by year-end 2012 with 10-year yields drifting higher during this horizon and ending 2011 at 3.80%.
Debt concerns complicating matters in the Eurozone
Economic data across the Euro zone continues to be fairly upbeat. The flash estimate of thirdquarter 2010 real GDP showed that the region expanded by a non-annualized 0.4% following the second quarter's exceptional strength (1.0% quarter-over-quarter). As well, November PMI indicated that activity accelerated and the Economic Sentiment measure jumped to its highest level in three years in November. In its December meeting, the European Central Bank viewed this as a confirmation that the, "positive underlying momentum of the economic recovery" remains in place and is consistent with continued real GDP growth in the fourth quarter. The Bank's inflation and growth forecasts saw minor changes in the details, although ranges narrowed and shifted toward the upper end of those seen in September. The Governing Council, however, assessed that risks to the outlook are "tilted to the downside, with uncertainty remaining elevated" due to the threat of "tensions in some segments of the financial markets" potentially spilling over to the real economy. In an effort to support financial stability in the region, the ECB extended its liquidity provision regime by three months, although the Bank disappointed by not announcing an expected increase in bond purchases. The Bank also left rates unchanged and reiterated that medium to longer-term inflation expectations "continue to be firmly anchored" in line the Council's target, leading us to maintain expectations of no changes during 2011.
Risk of further asset purchases in the UK diminishing
The strength seen in data in the past month suggests that the economic recovery is fairly well embedded in the UK. The second estimate of real GDP confirmed the surprisingly strong 0.8% non-annualized pace of growth in the third quarter. As well, activity indicators for the fourth quarter are consistent with continued expansion because retail sales volumes ticked up for the first time in three months in October and the composite PMI increased for the third consecutive month in November. On the monetary policy front, the November meeting minutes revealed that, contrary to expectations, a larger minority did not vote in favour of further easing, although the majority of members "stood ready to adjust policy in either direction as necessary" despite continued differences of opinions on the balance of risks to the inflation outlook. The Inflation Report essentially left the outlook for growth and inflation unchanged from August, but uncertainty was a major underlying theme because the range of forecasts was wider than usual. The recent confluence of events seems to suggest that while further asset purchases are not off the table just yet, the risk of such easing of policy in the near term has diminished. Accordingly, the Bank of England did not make any changes to monetary policy at its December meeting, and we expect the current stance to be maintained until late 2011.
Moderation in growth gives RBA cause for a pause
Most of the weakness in Australian third-quarter real GDP growth (non-annualized growth of just 0.2% following a downwardly revised 1.1% gain in the second quarter) can be attributed to a disruption-driven decline in bulk commodity exports, although household spending growth also slowed and private residential investment fell. Combined with large upward revisions to household savings rates and the sharp drop in October retail sales, this suggests that consumers are more cautious than expected in the face of the rapid normalization of interest rates. With these data points reflecting the period prior to the RBA's November rate hike, which translated in mortgage rates moving above past decade averages, there is little reason to expect spending to pick up until the end of 2010. The RBA left policy rates unchanged at this week's meeting with the statement taking a somewhat dovish tone in saying "inflation is expected to be little changed" in the next few quarters. We expect that the next rate increase will not come until the second quarter of 2011 unless data provide a compelling counter argument. The historically high terms of trade, an impending flood of investment spending (as indicated by the Australian Bureau of Statistic's recent survey of expected capital expenditure), shrinking capacity and increasing medium-term inflationary pressures, underline the need to move further into a restrictive monetary policy stance, so we continue to expect the cash rate to finish 2011 at 5.50% and 2012 at 5.75%.
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