Highlights

  • Global monetary policy firmed another notch in February as surprisingly vigorous growth in China and Japan prodded their central banks to tightened credit.
  • After a sequence of strong reports, U.S. economic indicators have been much softer than expected in the last few weeks. Homebuilding in particular has weakened anew as lenders introduce tighter credit standards for residential mortgages
  • It’s been a good month for Canada. Employment, housing, exports and manufacturing shipments shattered expectations. The economy is finally firing on all cylinders. However, we are skeptical of the sustainability of this spurt, especially in exports

World: China accelerates

While most of the OECD economies continue to show moderate expansion, growth in China and Japan was surprisingly vigorous in the fourth quarter. Their central banks have responded by tightening credit.

China continues to exceed expectations. Real GDP grew robustly again in Q4, bringing its expansion over the year as a whole to 10.7%. That was the strongest in more than a decade, overshooting the government’s 8% target by a very wide margin. The government was probably also frustrated by the growth mix, in which investment and trade again accounted for the lion’s share. From the latest numbers, we estimate that the share of consumption in Chinese GDP fell to just below 50% in 2006, down from 62% in 2000 (top chart). In our view, this development will likely prod Beijing to further action favouring domestic demand over exportled growth and investment in the coming quarters.

Such action is imposed by signals of even more acceleration ahead. The OECD leading indicator for China rose 0.24% in December, the fifth consecutive monthly increase. As our middle chart shows, the sixmonth rate of change in the leading indicator has shot to the highest since April 2004.

Meanwhile, the six-month change in the international composite indicator was virtually unchanged in December as a result of mixed signals from the larger economies. The U.S. and Japan were up and the euro zone was down. At this point the overall message remains one of continued expansion of the industrialized economies in 2007 at a cooler pace than in 2006, in marked contrast to the red-hot outlook for China.

An acceleration of growth when China is already expanding at a rate well in excess of government guidelines will further test Beijing’s resolve. The central bank, concerned with growing inflationary pressures, has yet again raised the reserve requirements for banks, to 10% of deposits effective February 25. This increase, the fifth since last June, is aimed at curbing the growth of renminbi-denominated loans, currently up 16% from a year ago. The central bank has also continued to let the currency appreciate. In February the renminbi hit a new high against the U.S. dollar, for a cumulative rise of almost 7% since the end of the dollar peg in July 2005. Appreciation against the USD has averaged 0.5% monthly since last fall, more than three times the pace of the previous year. For 2007 we continue to anticipate a rise of 7% to 10% against the USD.

Japan’s central bank has also reacted to better-thanexpected indicators. Real GDP grew in the fourth quarter at an annual rate of 4.8%, the strongest in three years. Nominal GDP was even better at 5%, a six-year high. This is an important development as it suggests that Japan has emerged from a long period of deflation. The Q4 national accounts also showed a better balance of growth, with a stronger domestic economy reflecting improvement in the labour market. Against this backdrop the Bank of Japan raised its overnight call rate from 0.25% to 0.5% on February 21, the second rise in seven months. It could be argued, however, that monetary conditions in Japan have not tightened at all since last July because of depreciation of the yen. In other words, more rate hikes are in store for 2007. How fast and how long the BoJ stays on the path of interest-rate normalization will depend on incoming economic reports and the movement of the exchange rate. For now, the most likely outcome is a very slow rise of Japanese interest rates in 2007.

U.S.: Banks tighten lending standards

After a sequence of strong reports, U.S. economic indicators have been much softer than expected in the last few weeks. Homebuilding in particular has weakened anew as lenders introduce tighter credit standards for residential mortgages.

The advance estimate of the Bureau of Economic Analysis for the fourth quarter shows U.S. real growth of 3.5% annualized, the best in three quarters. Consumer spending rose at 4.4%, accounting for almost 90% of the overall growth. At the other end of the spectrum, residential investment fell 19.2% annualized, the largest drop since 1991 Q1, and subtracted 1.2 percentage points from overall growth.

Inventories and business investment were also drags, and recent reports showing a slower pace of business inventory accumulation are highly suggestive of a downward revision of Q4 growth in the report to be released February 28. In the first quarter we expect the U.S. to expand at 2%. It is important to keep in mind that the very robust real growth of the fourth quarter was spearheaded by a jump in volume spending on durable and non-durable goods, up 6% and 6.9% respectively. Volumes were boosted by deep discounting and energy relief. As our middle chart shows, the price index for personal consumption expenditures fell an annualized 0.8% in Q4, the largest decline since 1954. Nominal spending grew at only 3.6%, the slowest in four years. The temporary nature of Q4 price declines implies that volume consumption will slow in the coming months to half the current pace of growth.

A January relapse in factory output suggests that inventories are not contributing to growth in Q1. As our bottom chart shows, the ISM index of U.S. manufacturing activity dropped to 49.3 in January. This reading, the weakest in almost four years, indicates a contraction of industrial output. The most surprising item in the report was an outsized decline in the inventory component, which fell to a five-year low. We would have thought that the strength of real GDP growth in Q4 would prompt a rebuilding of inventories.

Instead it appears that stockpiles are on track to again subtract a significant chunk from growth in Q1. They could of course rebound in Q2, but for that to happen, new orders will have to pick up.

Homebuilding is still the biggest drag on U.S. growth, and banks have taken a cautious turn on mortgage lending. According to the just-released survey of senior loan officers on bank lending practices, the net percentage of domestic banks tightening credit standards for residential mortgages rose significantly in January to the highest in 17 years (top chart).

Mortgage rates remain well below those of the early 1990s, but easy lending conditions have played a key role in the rise of the U.S. homeownership rate to historic highs. With banks now pulling in their horns on residential real estate – the proportion of lenders anticipating a deterioration in credit quality for residential mortgages has increased markedly over the past year – we believe the housing market is likely to weaken in the coming months. There were more than 2 million vacant housing units on the market at year end. Under current conditions, we think starts will need to drop below demographic requirements to bring the market into balance. Household formation has averaged 1.3 million annually over the past five years, according to the Census Bureau.

Housing weakness notwithstanding, the U.S. economy remains well-supported by the labour market – the key to a soft landing. Payroll employment rose 110,000 in January, a somewhat disappointing figure since it included the return of 12,700 striking workers. Is the U.S. job creation machine sputtering? To be fair, it could take at least one more report to get a good grasp of the underlying trend in the U.S. labour market. After all, upward revisions to monthly payroll gains have been the norm recently – a cumulative 103,000 for the last three months. That said, there were elements in the January jobs report that are consistent with a cooling of growth. Total hours worked fell for the first time in five months, service-producing employment expanded the least in eight months, household employment declined the most in two years (122,000 after adjusting for population controls) and the percentage of people leaving their jobs voluntarily was the lowest in 1½ years. Though the U.S. labour market is undoubtedly still very tight, we see these developments as consistent with some loosening in the coming months. For that reason we still think the Federal Reserve will ease early this summer (more in our Fixed Income Monitor).

We have made no changes to our U.S. forecast this month.

Canada: Will this reprieve have legs?

It’s been a good month for Canada. Employment, housing, exports and manufacturing shipments shattered expectations. The economy is finally firing on all cylinders. However, we are skeptical of the sustainability of this spurt, especially in exports.

Real GDP at factor cost rose 0.2% in November, the first significant increase in three months. That outcome was driven mostly by a 7.1% surge in automotive output, the largest monthly increase since August 1998. Motor vehicle production carried the economy again in December as the merchandise trade surplus expanded to a 10-month high of $5.0 billion. More than half the monthly improvement in the trade balance was due to automotive exports, whose 8.4% rise was the largest since August 2005. This report confirms our projection last month that trade will make a large contribution to real GDP growth in Q4 for the first time in more than two years. However, we do not expect a repeat performance in Q1. First, the December trade balance was down, not up, when adjusted for inflation, providing a poor handoff to Q1. Second, a very sharp January decline in U.S. auto production implies a negative contribution to Canadian exports from that sector. Third, continued softness in the U.S. housing market bodes ill for shipments of Canadian forest products. All in all, trade seems likely to revert to subtracting from growth in Q1, or at best to make no contribution.

However, the Canadian economy remains extremely well-supported by domestic forces. The employment market began the year on a very strong note with a net addition of 88,900 jobs. It was the best January since 2002. The two-month gain of 141,400 is the strongest on record and has propelled the employment rate to a new high. Of course the latest report continues to show a strong regional divide, with most of the growth in the two westernmost provinces. But the rest of Canada appears to be enjoying spillover effects (Ontario and Quebec are, after all, still adding jobs). A strong labour market is also reflected in the housing market. Starts shot up 17% in January to the fastest pace since the summer of 2004.

But how can Canada generate so many new jobs from so little GDP growth? The answer is enough of a mystery that Statistics Canada set up an analytical group to look at past relationship between the numbers for job creation and for real GDP growth.

In our opinion, several factors suggest that strong employment growth is not a statistical artifact. First, governments continue to report solid intakes from income taxes withheld at source. Second, the Canadian version of the U.S. payroll survey – the Survey of Employment, Payrolls and Hours, or SEPH, which is released about two months after the labour force survey – confirms the vigorous job growth reported in the latter (middle chart). Could it be that real GDP is understated? In our opinion, the rapid contraction of Canadian manufacturing employment since 2003 coupled with strong growth in service employment may have exacerbated problems inherent in measuring services output. The downtrend of wage inflation despite a very low unemployment rate is evidence against overheating of the economy, implying that productivity growth may also be understated.

However, even if some caveats with current methodologies were to be acknowledged by Statcan, they would take time to correct. At this writing, we doubt very much that GDP growth will be revised unless a mistake is discovered.

Given the circumstances, we think that as long as wage pressures remain tame and CPI inflation is under control, the Bank of Canada is unlikely to raise interest rates even with a very low unemployment rate. This is all the more true now that housing inflation appears to be receding. The price of new homes including land failed to grow in December for the first time in 6½ years. The house-only component, which normally accounts for two-thirds of the price of a new home and which feeds directly into calculation of CPI, was actually down for the first time since August 1998.

Interestingly, the deflation was confined to Alberta, where prices fell 0.9% on the month. It was the largest decline in 11 years (though it left prices up a whopping 38% from a year earlier). This development is significant because Alberta housing has been a major source of inflation in Canada. A cooling of the Alberta housing market will go far to keeping Canada’s inflation backdrop very tame.

We have not made any significant changes to our Canadian outlook this month and continue to anticipate the Bank of Canada to lower interest rates in H2 2007.

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