• Real GDP expanded at a 0.3% annualized pace in the second quarter, marking an improvement over the first-quarter’s 0.8% annualized drop, but indicating limited momentum in the pace of activity. June's GDP was up 0.1% after stumbling in May.
  
• Employment has surprised on the upside for most of this year, but this was quickly reversed with July's number showing a 55,000 drop in jobs, providing strong evidence that labour markets are starting to succumb to weakening GDP growth.
  
• The 0.4% drop in retail sales volumes in June is disappointing, but was largely concentrated in the auto component and more than offset by manufacturing sales and wholesale trade gains in the month. This reinforces our expectation that overall GDP likely rose 0.2% in June after stumbling in May and increases the likelihood that second-quarter economic growth will rebound at around 1% after the surprise 0.3% annualized drop in the first quarter.
  
• Housing starts sank 13.6% in July to an annualized 186,500 units from 215,900 in June. The drop was largely concentrated in Ontario. Housing activity is on a downward trend consistent with indications of deteriorating affordability through last year.
  
• The merchandise trade surplus improved to C$5.8 billion in June from a C$5.2 billion surplus in May. However, second-quarter net exports on a volumes basis deteriorated $10.7 billion as imports rose 3.9% while exports sank 5.5%. This will subtract about three percentage points from second-quarter GDP growth.
  
• The all-items year-over-year inflation rate was 3.4% in July, the fastest pace of increase since March 2003, up from 3.1% in June, largely reflecting a 28.6% rise in gasoline prices during the past 12 months.
  

Dawn Desjardins
dawn.desjardins@rbc.com

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Financial markets ...View full report (PDF)
Central banks plagued by inflation worries and fragile economies

Central bankers are surveying a landscape riddled with risks as the elevated level of energy prices pushes up headline inflation rates while the persistent U.S. housing market correction and financial market turbulence keep downside risks to economic growth alive. Faced with these opposing forces, we expect most central banks to remain on the sidelines in the near-term including the Bank of Canada and the Fed. Policymakers have pledged to monitor the economic data closely, suggesting that the next policy move will be determined by which risk becomes the most pressing — growth or inflation.

U.S. growth concerns resurrected

• Economic developments in the past month have resurrected worries about the U.S. economy with the housing market still undergoing a massive correction, the labour market sagging and the price of oil an hitting all-time high.
• Equity markets trended lower, denting the value of household assets. Financial market turbulence reared its head once more, with funding spreads widening, mortgage rates rising to their highest level in a year and long-term corporate bond rates climbing after a reprieve in April and May.
• The bright spot has been the U.S. consumer, with the strength in retail sales data supporting an increase in second-quarter spending growth of 1.5%, up from 0.9% in the first quarter. The increase in consumption boosted second-quarter GDP growth to 1.9%.
• The ramped-up pace of consumer spending in April and May probably borrowed strength in consumption from the third quarter, which means that the impact from the tax rebates will likely be short-lived and that growth in the second half of the year will be slower than in the first half.
• With the headline inflation rate running at its fastest pace in 17 years, the Fed is unlikely to alter the current policy rate. Most likely, the opposing risks of rising inflation and slowing growth will keep policymakers in data-watching mode with the Fed funds expected to hold steady at 2.00% until mid-2009.

Bank of Canada betting on moderate core rate to keep inflation expectations “anchored”

• Our tracking of the economy points to GDP growth returning to the positive column in the second quarter at an annualized quarterly rate of close to 1% after the 0.3% annualized decline in the first quarter.
• There are both upside and downside risks to the outlook for the economy, but our view is that it is likely to eke out modest real growth of 1.4% in 2008 overall.
• We look for the economy to continue to strengthen in the second half of the year, although the re-emergence of weakness in financial markets and attendant tightening in credit plus the forecasted slowing in the U.S. economy will keep downside risks to this forecast alive.
• The Bank of Canada forecasts the headline CPI inflation rate to average 4.3% in the first quarter of 2009 and then slow to 2.9% in the second quarter and the core rate (excludes the eight most volatile components) to remain below the mid-point of the Bank’s target band until mid-2009. Inflation expectations to expected to be “well anchored to the two per cent inflation target.”
• The Bank is also optimistic about the outlook for economic growth, with high commodity prices supporting a healthy labour market, firm income growth and strong domestic demand.
• We agree with the Bank of Canada’s assessment that Canada’s economy will continue to build momentum in early 2009 with growth rates returning to potential and the economy shifting back into balance, but we forecast that the core inflation measure will tip over the 2% mark early next year. This modest, yet important, difference makes a rate hike by the Bank of Canada likely in the first quarter of 2009.
  

Dawn Desjardins
dawn.desjardins@rbc.com

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• U.S. economy to remain weak, but market forecasters see reduced odds of a recession despite higher-than-expected energy prices.
• Economy continued to expand in the first quarter, but posted the weakest six-month growth rate since 2003.
• Consumer and business spending slowed as credit conditions tightened, but the cost of credit is starting to ease as greater stability is emerging in financial markets.
• Risks of a second-quarter contraction are lessening as the early wave of fiscal stimulus cheques may give consumer spending a boost and keep the economic growth numbers positive.
• The elevated inflation rate as a result of high energy and food prices threatens to boost inflation expectations.
• Oil prices are expected to trend lower through the forecast period.
• The Fed is likely the hold the policy rate steady for the remainder of this year.
• Canada's economy contracted in first quarter as special factors and inventories dragged the growth rate down, but domestic demand is holding up and will more than offset the significant drag from net exports this year.
• Import growth will remain robust, but flagging U.S. demand will weigh on export volumes.
• High commodity prices and the attendant rise in terms of trade will support real income growth and jobs.
• Consumer spending has slowed from its robust 2007 fourth-quarter pace but will still remain a key support for the economy in 2008.
• Business investment will continue to be a strong support to the economy as the high Canadian dollar lowers prices of imported machinery and equipment, and high commodity prices will warrant an increase in capacity.
• Canada's housing market is losing steam but is not headed for U.S.-style crash.
• The Bank of Canada is refocusing on the inflation outlook after easing 150 basis points since December 2007.

Paul Ferley
paul.ferley@rbc.com

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Developments so far this year continue to confirm the separate paths the resource-rich western provinces and manufacturing-heavy central Canada are taking. Record-high commodity prices and strong global demand for natural resources (with the significant exception of forest products) are sustaining unprecedented prosperity in western Canada, while the strong Canadian dollar, weak U.S. economy, high energy prices and delays in, or cessation of, major capital projects are causing hardship in provinces east of Manitoba.

• Saskatchewan is still projected to lead all other provinces in both 2008 and 2009, followed by Alberta. Newfoundland & Labrador and Ontario continue to appear at the bottom of the growth ranking this year, although both provinces should show some improvement next year.
• Our ranking of provincial economic growth is little changed from our April forecast; however, the gap between the highest and lowest has become more dispersed this year, with growth in Saskatchewan stronger than previously projected and that in Ontario and Newfoundland & Labrador slightly weaker.
• The stars so far appear to be perfectly aligned for Saskatchewan, with nearly all of its major export commodities benefiting from booming demand, generating rapid income growth in the province. The economic bonanza is likely to carry on through 2009, if not longer.
• Alberta is gearing down to slower, more sustainable growth as it economy faces increasing resource and price constraints.
• British Columbia and Manitoba are riding on strong capital investments that will sustain a solid pace of economic activity, albeit slower than in 2007.
• At the low end of the scale, Newfoundland & Labrador is taking a rest after a major burst of energy last year. Significant increases in oil production that occurred in 2007 are lacking a ready follow-up act this year.
• Ontario is labouring through its softest patch since the early-1990s recession. The provincial economy has likely contracted in the first quarter and should recover only gradually through the remainder of the year.
• Quebec also is stuck in the slow lane, although the export drag that is restraining its speed is not as severe as it is in Ontario. Good market conditions for mineral/metals and aerospace are providing a more powerful offset.
• Large capital projects will continue to be key growth engines in New Brunswick, Nova Scotia and Prince Edward Island. However, the probable delay of two major related projects in Nova Scotia has prompted us to notch our forecast for that province’s economy down in both 2008 and 2009.

Robert Hogue
robert.hogue@rbc.com

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Canada’s housing market is showing signs of coming off the boil after a period of unprecedented strength when resale home sales hit record highs, prices racked up double-digit gains and housing starts ran at a faster than 200,000-unit pace for six consecutive years. Recent reports showing that sales and prices are starting to slow have raised concerns that Canada’s housing market boom is set to bust, mirroring the slump in the United States. To be sure, conditions are softening, but there continue to be many factors that point to Canada’s housing market avoiding a U.S.-style crash landing.

Low speculative and sub-prime exposure leaves Canada in good shape
From a structural perspective, conditions in Canada’s housing market are markedly different from the U.S. market, with very limited sub-prime mortgage activity, a relatively small speculative sector and no significant supply overhang despite the robust construction activity. Additionally, affordability is forecast to improve this year with the Bank of Canada having cut the overnight rate by 150 basis points since December, mortgage rate spreads showing some signs of narrowing and the pace of house price gains slowing.

More conservative lending practices stand Canadian banks in good stead
Canada engaged in much more conservative lending practices during this past cycle compared to the United States. Mortgage credit was extended, on average, to more capable buyers, leaving household balance sheets in good shape with mortgage quality strong and delinquency rates well below past cyclical peaks. The sub-prime mortgage market in Canada accounts for about 5% of outstanding mortgages, while in the United States, sub-prime mortgages account for roughly 14% of the outstanding mortgage market. Speculative investing is also much tamer in Canada. Investor-owned mortgages account for roughly 2% of all mortgages in Canada compared to about 10% in the United States and the United Kingdom.

Outlook this year
Current conditions in Canada’s housing market point to a year of slower activity, although both starts and sales are likely to remain elevated by historical standards. Price gains are likely to slow but, with market conditions having shifted away from a seller’s market and into balance, we anticipate gains to average in the low single-digits, a far cry from the double-digit decline posted in the United States.

Dawn Desjardins
dawn.desjardins@rbc.com

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• Nationawide housing affordability deteriorated in every quarter throughout 2007 to end up at the worst level since the housing bubble peaked in 1990. Back then, soaring interest rates and a recession sparked much of the trouble. Today, however, a long upward trend in house prices, driven by sounder macroeconomic fundamentals such as job growth, is primarily responsible. Adding more fuel to this housing cycle is mortgage product innovation that has opened the market to more potential buyers since mortgage insurance liberalization began two years ago.
• During the fourth quarter, affordability for all four housing classes eroded across the country, with the exception of the cooling Alberta market where all housing segments experienced a drop in average price that resulted in improved affordability. Across the country, the standard condo remained the most affordable housing type, requiring about 30% of pre-tax household income. A standard townhouse was next at 34.5%, followed by a detached bungalow at 42.5%, while a standard two-storey home remained the least affordable housing type at 48%.
• The lagged effects of higher fixed mortgage rates continue to be a significant part of deteriorating affordability, but our forecast calls for the popular five-year mortgage rate to drop drop by a further 75 basis points by year-end. Going forward, falling mortgage rates, cooler house price gains and decent income growth should all lead to improved affordability across most markets.
• Alberta’s housing market is on watch for possible further negative developments. The average price of a standard two-storey home fell by 4.3% last quarter compared to the previous quarter. Bungalow prices fell by 7.3%, townhomes were off by 4% and condo prices fell by 5.3%, their second consecutive quarterly dip.
• The price of the benchmark two-storey home in Alberta is still 63% higher than two years ago. However, the year-over-year pace of price gains has gone from about 50% a year ago to only 11% today. Furthermore, the sales-to-listing ratios in Calgary and Edmonton remain at about 0.4, or about one-half the peak recorded during the past two years, which would point to the risk of further price cooling in a market with more slack.
• The onset of slipping house prices in Alberta and elsewhere in the country may well enhance a growing tendency to make comparisons between Canadian and U.S. household finances. Americans are still modestly richer, but much more heavily leveraged and further indebted with less liquidity. That, in turn, makes them more vulnerable than Canadians to ongoing credit market turmoil and risks associated with changes house price trends. In fact, the sharp depreciation in the U.S. dollar during the past six years has made Canadians relatively richer over time by raising the value of what their wealth will buy in world markets compared to that of their U.S. counterparts.

Derek Holt

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Special report ...View full report (PDF)
Evaluating the shocks hitting the U.S. consumer

Is the U.S. economy facing a consumer-led recession? Alhough financial markets have grossly overestimated downside risks facing the consumer on countless occasions during the consumer cycle of the past decade and a half, the list of shocks now hitting consumers is arguably the longest it has been in many years. That list includes deteriorating housing markets, mortgage market turmoil particularly via adjustable rate mortgage resets, tightening credit conditions, a potentially negative equity wealth effect, and high oil prices. We have quantified what we believe to be an overall set of stress-tested worst-case assumptions for each of these shocks.

All hopes now rest on continued income growth as an offset to the sum total potential hit coming from this array of negative shocks. A recession is not impossible, but is improbable even with only fairly modest shock-absorbing income growth assumptions compared to what we are actually forecasting. Our base-case scenario, therefore, still points to softer, but still positive, growth in consumer spending going forward. We believe that should a downturn prove to be sharper, it will be short-lived. Unlike past stress periods, however, there is no room for adding further serious unanticipated shocks to what is already a fairly long list.

There is one added insulating factor against a sustained downturn. We draw inferences from work done by economists at the Brookings Institution and the Federal Reserve that points to mass underestimation of the value of closely held equities on household balance sheets as reported by the U.S. Federal Reserve's Flow of Funds accounts. In turn, this work suggests that U.S. household net worth may well be materially higher than most analysts assume, while leverage is lower, and both act as greater supports to consumer activity than is commonly believed.

Derek Holt

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The Canadian economy is currently contending with a number of negative shocks. The most recent is the ongoing financial market turmoil that has emerged from a distressed U.S. housing market and is weighing on the U.S. expansion. In addition, the manufacturing sector is contending with the recent rapid appreciation of the Canadian dollar that is both making export goods more expensive in the U.S. market and making imports more competitive in the Canadian market. Yet, despite these seemingly negative factors, the Canadian economy reported an impressive 51,000 jump in employment in September and a staggering 20% jump in September housing starts to 278,200 units, the third highest annualized level on record. How can this happen given the strong headwinds currently confronting the Canadian economy? One possible explanation is that Canada's economy is also contending with a third shock - a rise in this economy's "terms of trade" - a shock of the positive kind that is much more supportive of growth.

"Terms of trade" shock
"Terms of trade" is simply defined as the ratio of export prices to import prices. Canada's terms of trade have shot up 20% since 2002 after displaying a relatively flat trend during the previous two decades. This recent surge is largely a reflection of the rapid rise in prices for a number of key commodity exports like oil, base metals and grains that have seen sharply rising demand, particularly from recently industrializing economies such as China.

New GDI measure captures the positive "terms of trade" effect
The benefit of rising terms of trade is that more goods can be purchased from export earnings. Unfortunately, this "trading gain" can often drop below the radar screen when doing a scan of the economy because the traditional measure of output - real GDP - fails to capture it for various reasons. In response, Statistics Canada has started to compile an alternative measure of output called real gross domestic income (GDI) that does capture this trading gain. From 2002 to the second quarter of 2007, real GDP indicates average annual growth of a respectable 2.9%, while the growth rate jumps to a more impressive 4.2% on a real GDI basis.

Not all provinces benefit equally
The positive terms of trade shock has a very disparate impact regionally in Canada depending on the degree of natural resource production compared to consumption. For example, Statistics Canada estimated that, on a real GDP basis, Alberta's economy grew by a relatively robust annual average 4.9% between 2002 and 2006. However, on a real GDI basis, the growth rate almost doubles to 9.5%, propelled higher by the strengthening in energy prices. A much weaker GDI performance is evident for Ontario where commodities such as oil are imported and consumed rather than produced and exported. All provinces showed stronger growth on a real GDI basis except PEI where the growth rate was unchanged. Thus, practically all provinces have benefitted from the terms of trade shock, although clearly some more than others.

Implications for Canada's economic outlook and the C$
An economy going through a positive terms of trade shock is likely to experience an appreciation of its currency. Most models of the Canadian dollar acknowledge the importance of commodity prices in determining the value of the loonie and have pointed to a strengthening currency in the face of rising oil and base metals prices. However, problems can emerge if too much momentum builds in a currency and it starts to overshoot levels warranted by the key economic drivers. In recent months, there has been growing concern that the Canadian dollar's appreciation may be in excess of that warranted by factors such as historically high commodity prices. Indications of an overvalued currency have resulted in RBC Economics moving towards a slowing in economic growth in 2008 relative to 2007. This reflects our view that the currency's value will hinder export demand and over-stimulate imports. The favourable terms of trade, however, will limit the slowing to a couple of tenths of a percentage point relative to the 2007 growth rate.

Paul Ferley
paul.ferley@rbc.com

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Commodity prices ...View full report (PDF)
Commodity Price Monitor

• RBC’s commodity price index gained 5% in February following January’s 5.2% increase. The early-year pause in energy price escalation has proven short-lived as oil broke records and natural gas’ momentum carried through February.
• Precious metals are currently breaking records as is likely in the context of U.S. dollar devaluation, but an increasing number of base metals prices are now also moving up because inventories remain scarce. Agricultural commodities haven’t paused, but the increase is mostly a result of grain prices, whereas other food prices such as meat are not as buoyant, at least not on North American markets.
• Much been said about emerging countries “decoupling” from the developed economies and fuelling a commodity boom, but the recent story highlights significant speculative play that will likely lead to great volatility. The resilience of developing countries to export shocks should not be overestimated (see the special focus on page 3) and talk of a widespread commodity super-cycle driven by decoupling emerging economies should be taken with a grain of salt.

Jimmy Jean
jimmy.jean@rbc.com

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