The Weekly Bottom Line

HIGHLIGHTS OF THE WEEK

• A slew of positive macroeconomic data across Europe lifted market sentiment, underpinning the euro
• European financial stocks were up sharply and sovereign debt spreads narrowed significantly
• U.S. second quarter real GDP came in to the downside of expectations at 2.4% (annualized). Downward revisions to past growth show a deeper recession than previously thought with a peak-to-trough decline of -4.1%.
• Real consumer spending comes in weak at 1.6% (annualized) in Q2. Consumer spending growth is also up a meager 1.6% from its trough a year ago.
• St. Louis Federal Reserve President James Bullard says the U.S. is as close to a deflationary threat that it has even been and recommends the Fed do more to anchor inflation expectations.
• Canadian economic activity improves marginally in May, with real GDP growing by 0.1%.
• Goods-producing sectors, as in the past, are driving the recovery; however, these were also the sectors responsible for much of the decline in economic output.
• In particular, manufacturing, mining, oil, and gas extraction, transportation & warehousing, wholesale trade and retail trade have accounted for most of the peak-to-trough decline in overall real GDP, and the subsequent growth thereafter.
• If the 1980's recession and recovery was a capital 'V', then undoubtedly the 2008-2009 recession would be a lower-case 'v'.
• Overall, the current recovery will continue to be driven by goods-producing sectors such as manufacturing, construction, and mining, oil, & gas extraction due mainly to capacity underutilization.

INTERNATIONAL - EUROPE'S SOVEREIGN DEBT WOES, GONE WITH THE WIND?

This week Europe caught some wind in its sails, with good news blowing from several quadrants. Indicators showing better than expected results began to accumulate a week ago with the release of strong second quarter GDP data for the United Kingdom -up by 1.6% Y/Y- well ahead of market expectations, and the stress test results on 91 European banks. Granted, the design of the stress scenarios was seen as too lenient (for instance, they ignored the possibility of a Greek debt restructuring), and the resulting low failing rate and small recapitalization needs were received with some skepticism by analysts. Nonetheless, the market took some comfort on the detailed disclosure of information regarding the exposure of European banks to sovereign debt. Investor sentiment continued to build with strong second quarter earnings and the publication of some new regulation details by the Basel Committee on Banking Supervision that looked to be less stringent than previously anticipated. As a result, financial stock prices rose during the week, while the spread on credit default swaps of financial institutions also came down. The euro also benefited from this bout of positive sentiment, and was trading up by roughly 9.7% from its June lows vis-à-vis the US dollar.

Near-term economic momentum is building broadly across Europe. For instance, in Germany an increase in industrial orders, both from domestic and external buyers, and a rebound in construction have proved supportive of overall activity. Unemployment has been trending down and part-time jobs have also shifted to full time in many sectors. Indeed, the unemployment rate fell to 7.6% in July, the lowest since November 2008. In turn, German business confidence surged this month, according to the Ifo Business Climate index. Sizeable improvements regarding both the current situation and the outlook for the second half of the year were observed among a swath of firms in manufacturing, construction, wholesale, and retail.

Other surveys compiled by the European Commission also showed a lift in consumer and businesses sentiment across broader Europe. And to top it all off, the European Central Bank reported credit data for June, which showed strong household credit expansion across the euro area driven mainly by mortgages, but also stemming from consumption credit. A slower decline in credit to non-financial corporations could also be regarded as a positive note.

In response to all this upbeat news, yield spreads on 10-year Spanish, Irish, Portuguese, and Greek bonds to German bunds edged down by as much as 45 basis points as of Thursday, although at the time of writing they appeared to have turned back up slightly. Moreover, both Spain and Greece had successful sovereign bond placements, which highlighted the shift in risk perception towards European peripherals.

Although the recent slew of macroeconomic data has been refreshing, the underlying fundamentals of most European economies have not changed dramatically. Within the euro area, Germany is pretty much on its own when it comes to driving the region's recovery, as its main euro partners will face much tougher fiscal consolidation efforts. The other countries also stand to benefit less from the boost to exports stemming from the weaker euro and resilient external demand from emerging markets. Moreover, the German economy is unlikely to maintain its recent robustness for much longer. Collective wage negotiations sought to safeguard jobs in Germany, causing many industries to agree to freeze basic pay until 2011. These arrangements, combined with flexible working hour schemes avoided a sharp increase in unemployment throughout the recession. The flipside to this is that income growth will remain sluggish, restraining consumption growth. In addition, a decline in public investment projects due to the withdrawal of fiscal stimulus will pose a drag on economic activity. As such, the German economy will continue to rely heavily on exports to sustain its upturn; but, as we highlighted in our latest Quarterly Economic Forecast, a slight slowdown in economic activity in emerging markets will prevent German external sales from climbing at the fast pace that emerged during the early stage of the recovery.

Outside of Germany, muted job gains will keep pressure on private consumption across the euro zone. So far, France, Italy, Ireland, Portugal and Spain have not seen improvements in their labor markets. Fiscal retrenchment will also carry a detrimental impact on households' disposable income next year, when most of the proposed tightening efforts will be implemented in these countries.

In all, the recent slew of macroeconomic data has been refreshing, but the underlying economic fundamentals for most European economies have not changed. In the coming quarters they will continue to face headwinds, and progress will be secured very slowly.

UNITED STATES - HIGH UNEMPLOYMENT IS STAYING FOR CHRISTMAS

It doesn't matter what daily rag you read in the morning, the economy is bound to be front page news. With the release of second quarter real GDP today, another page has been written in the story of the economic recovery. Deleveraging is a dominant theme, playing out in a shell-shocked consumer sector where spending has grown at half the pace of the overall economy thus far in the recovery.

Another key element to the slow pace of growth is labor market conditions. In fact, perhaps the main question faced by policy makers on both the fiscal and monetary front is how to get America hiring again.

The Great Recession ravaged payrolls, cutting over 8 million jobs and leaving the number of employed at a level not seen in more than a decade. Next week we get data on job growth for the month of July. As a result of the continuing unwind of census hiring, total employment will likely decline by more than 100,000 and the unemployment rate will likely increase. In the run up to this important report, it is worth examining recent trends in job growth and unemployment, and what we might expect over the remainder of this year.

From December 2009 - when employment reached a nadir - to June 2010, the U.S. economy created 882,000 jobs. Of these, 593,000 were private-sector jobs, and 324,000 were census related jobs. (Government employment outside of the census fell by 35,000 over this period). On average, private job growth in 2010 has amounted to 99,000 jobs a month.

While it is certainly a positive development that job growth has turned upward, it is important to place these numbers in context. In order to bring down the rate of unemployment (currently sitting at 9.5%), the increase in jobs must be greater than the increase in entrants to the labor force. In normal times, the labor force expands by around 130,000 persons a month. However, discouraged by the likelihood of finding employment during the recession, many job searchers gave up the ghost and left the workforce altogether. As a result, the labor force participation rate has fallen from a pre-recession level of 66% to its current level of 64.7%. While the labor force has grown by an average of 113,000 per month thus far in 2010, the total labor force is still 1.2 million workers below its peak level. As the economy improves, history tells us that many of these discouraged workers will continue to re-enter the labor force. So, even as job growth turns positive it will have to compete with even stronger growth in the labor force.

An expanding economy should mean more employment, but this is not a foregone conclusion. Indeed, jobs continued to be shed through the second half of 2009, even while the economy was improving. The discrepancy is explained for the most part by rising labor force productivity, which grew by whopping 7.3% (annualized). In addition, employers also cut the average hours worked during the recession. While this has improved in 2010, as of June, the average work week was still 1.7% below its level before the recession began.

So, with real GDP growth of around 2.5%, what does this mean for job growth in the second half of this year? After several quarters of raucous growth, productivity is likely to slow over the remainder of 2010. At the same time, employers are likely to move average weekly hours closer to their pre-recession level. Presuming modest gains in average hours and a slowdown in productivity to around 1.0% (annualized), a reasonable estimate for employment is for growth of somewhere between 100,000 to 150,000 jobs per month. At this rate, with workers beginning to make their way back into the labor force, the unemployment rate is likely to remain at or close to its current level of 9.5% for the remainder of 2010. The bottom line is that in order to see any noticeable improvement in the unemployment rate, economic growth is going to have to be a whole lot better

CANADA - A SEMI-THROWBACK TO THE 80'S

Real GDP data for May 2010 released this morning indicated that Canadian economic activity increased by 0.1%. More importantly, May marked the end of the first full year of recovery following the recession of 2008-2009. As is common knowledge by now, the Canadian economy experienced a robust recovery that outpaced most of its advanced international counterparts around the world, including the U.S. and Western Europe. But what drove the pace of expansion?

Unfortunately, comparing Canadian recessions and recoveries is, in fact, quite troublesome in that we simply do not have very much history to rely on. Unlike our friends to the South who have no less than 8 recessions since 1960, we in the Great White North thankfully have only three - 1981-1982, 1991-1992, and 2008-2009.

In all three recessions, much of the loss in economic output came from a few key sectors: manufacturing, wholesale and retail trade, mining, oil & gas, construction, and transportation & warehousing. However, these same sectors are also responsible for much of the economic recovery, which is intuitive given that pent-up demand builds over the course of the recession and is then released when the economy goes into recovery-mode, resulting in outsized gains in the areas worst hit. When the aforementioned five sectors are taken as a whole, they contributed 75-125% of the peak-to-trough declines in total output and 65-100% of subsequent growth in the following year across all three recessions.

Over the past year, the Canadian economy has undoubtedly benefited from a robust recovery in these particular sectors; but, things are a little different this time around. The current recovery has been much more dramatic than in the 1990's, where it was a long drawn-out affair. The 1990's housing crash occurred contemporaneously with the Bank of Canada building its credibility as an inflation fighter; thus, monetary policy failed to have the stimulative impact felt in the 80's and latest recovery. In addition, the federal government was also in the process of combating fiscal deficits through widespread spending cuts, resulting in the exact opposite response that has occurred recently. Indeed, the current pace of recovery appears more akin to the rebound that occurred in the 1980's, but in a much less pronounced way. If the 80's was a capital 'V', then certainly 2008 and 2009 would be considered a lower-case 'v'.

Though there are differences. In particular, services are playing a much larger role than they once did which tends to smooth out the business cycle. As such, though the declines in, say, manufacturing output are almost identical between the two recessions, the overall recovery this time around is much more muted than in the 1980's. So although the economic recovery in Canada is still being driven by certain goods-producing sectors, a wider range of services are increasingly becoming an integral part of that process.

So where does the economic recovery go from here? The discussion so far has focused only on the year following the trough in activity, but the length of time it takes any given sector to fully recover can vary widely. For example, manufacturing yet sits some 10% from its level at the end of 2007, while the construction and mining, oil & gas sectors are still 5-6% away from theirs. Many services either showed no discernible decline in activity or have already recovered to their pre-recession levels. In other words, the major goods-producing sectors will continue to drive the Canadian economic recovery for the time being. While the majority of services should persist in their consistently moderate growth, the bulk of real GDP growth will likely be accounted for by manufacturing, construction, and mining, oil, & gas extraction, mainly due to the underutilized capacity yet present in those sectors.

U.S.: UPCOMING KEY ECONOMIC RELEASES

U.S. ISM Manufacturing Report - July*

• Release Date: August 2/10
• June Result: 56.2
• TD Forecast: 54.8
• Consensus: 54.5

The ISM manufacturing index is expected to post a modest decline in July falling from 56.2 to 54.8, the third decline in as many months. The index continues to point to solid economic activity but some of the froth from its recent peak of 60.4 in April (also the highest since January 2004) had been reduced by weakening new orders, inventories, and to a lesser extent production. The manufacturing sector has been extremely strong over this recovery period, certainly more so than the service sector, in part on the positive contribution from the external sector. Over 80% of exports are manufactures of some type. The export component of the ISM, not reflected in the headline calculation, had risen from its recent low of 35.5 in December 2008 to a recent high of 62 in May. Last month those orders fell to 56, a six month low, and further deterioration will provide clues as to the depth of the recent fallout from the Euro Crisis during Q2.

U.S. Nonfarm Payrolls - July*

• Release Date: August 6/10
• June Result: -125K; unemployment rate 9.5%
• TD Forecast: -160K ; unemployment rate 9.7%
• Consensus: -95K; unemployment rate 9.6%

The July employment report is expected to demonstrate a lack of follow through in private job growth that had averaged almost 145k per month during Q2. Private payrolls are forecast to rise only 45k in July, half the pace in June, while headline jobs decline by 160k owing to another round of census worker fires. Job growth in July is facing several headwinds. The high frequency labour indicators have been fair, and in the case of the monster index very strong. However, birth death adjustments will be negative and a slowdown in hiring for leisure and hospitality, construction, and professional business services indicate a subpar performance on the month. The unemployment rate is forecast to rise to 9.7% as some of the recent weakness in the labour force is unwound relative to employment.

One strain of thought over the current recovery is that surging profits have not translated into a commensurate rise in labour demand. Some have argued that this reflects a less rosy state for small businesses that have struggled more to obtain bank financing. We lean against both assertions because labour demand has increased substantially and in a fashion generally consistent with prior profit recoveries. It doesn't feel that way because the last labour recession was the worst in 80 years. Private jobs were falling by 600k per month and are now rising by approximately 100k a month over the past six months. That level of job creation may be insufficient to chew up much excess slack in the labour market, but it still represents a heroic turnaround. Moreover, there does not appear to be any notable lag in hiring by small businesses, at least not according to the ADP data. It may be wishful thinking that job creation will now accelerate as the economy approaches the peak in the earnings cycle. We know productivity will slow as the output equation is reduced, but firms are not yet at the point that requires a surge in hiring given a workweek that has further room to run. In July, the workweek is expected to remain edge modestly higher to 34.2.

CANADA: UPCOMING KEY ECONOMIC RELEASES

Canadian Employment - July*

• Release Date: August 6/10
• June Result: 93.2K; unemployment rate 7.9%
• TD Forecast: +20K; unemployment rate 7.9%
• Consensus: +10K; unemployment rate 7.9%

The Canadian labour market continues to expand at a truly remarkable rate, adding an average of 75K jobs over the past three months. In fact, one has to look back to 1976 to find as rapid of a pace of hiring over a three month period. While it is tempting to conclude that some of this hiring has been pulled forward, which would justify a forecast for an outright contraction in employment, history shows that there is a tremendous amount of persistence in the labour market. So even after the outsized gains observed in recent months, employment in July is forecast to increase by 20K jobs. As in recent months, the composition of job growth is expected to be tilted towards the services sector. Furthermore, there is little anticipated impact from special factors, since both the impact from the G8/G20 Summit and the lockout at the Port of Montreal fall outside the reference week used in the survey. The steady increase in the participation rate over the last three months is expected to subside in July, which when paired with the modest forecast for job growth, will keep the unemployment rate unchanged at 7.9%. Elsewhere in the survey, we anticipate that hours worked will slow for the second consecutive month, mirroring the deceleration observed in other economic indicators. The expectation for slower economic growth in the second half of the year will limit the rate at which additional jobs will be added to an otherwise healthy labour market.

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