• Real GDP rose a solid 0.4% in April following two months of decline. The solid rise in April GDP reinforces the view that the 0.3% annualized contraction in first-quarter GDP reflected largely transitory negative factors, which augurs well for a postive second-quarter growth rate.
• After a string of upside surprises for Canada’s labour market, the pace slowed down in May with 8,400 jobs created. Despite, the modest slowing in job creation in May, the economy has still generated 132,000 jobs so far this year, running at a 26,000 monthly average rate.
  
• Retail sales rebounded 0.6% in April from a flat reading in March and grew a solid 0.5% on a volumes basis. The volume of retail sales is up an annualized 2% over the first quarter, which augurs well for second-quarter consumer spending coming close to matching the first-quarter’s 3.2% gain.
  
• Housing starts rose 3.5% in May to an annualized 221,300 units. The level of housing activity is slowing from its first-quarter average of 234,300, although it still remains above the 200,000-mark that is indicative of robust housing market activity.
  
• The merchandise trade surplus deteriorated in April to C$5.1 billion from C$5.7 billion in March. Exports rose by a relatively modest 0.8% (C$0.3 billion), which was more than offset by an even greater 2.6% (C$0.9 billion) jump in imports. The strength in the Canadian dollar and weakness in the U.S. economy are expected to result in net exports being a drag on growth through the remainder of this year and next.
  
• The all-items annual inflation rate jumped to 2.2% in May largely as a result of a 15% spike in gasoline prices in the past 12 months. The inflation outlook has been marred by the steady rise in energy prices, which have pushed the all-items inflation rate from a recent low of 1.4% in March to 2.2% in May.
  

Dawn Desjardins
dawn.desjardins@rbc.com

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Financial markets ...View full report (PDF)
Inflation concerns rising, while downside risks to growth persist

It’s a tough time to be a central banker because the upside risks to the inflation outlook and signs of a pick-up in inflation expectations are presenting a strong case for policy to become less accommodative at a time when such a move would risk choking off economic growth. The Fed and the Bank of Canada have become more vocal in the past month about worrying signs of a pick-up in inflation, pointing to the persistent rise in energy prices. However, worries about the economy persist, with the U.S. housing recession in full swing, consumer confidence deteriorating and the unemployment rate at its highest level in 3-1/2 years. The housing market slump and financial market turbulence are keeping the U.S. economy vulnerable to slipping into recession. In Canada, second-quarter data are suggesting that the contraction in first-quarter real GDP was an one-off event, although the weak state of the U.S economy is keeping the downside risks to the export outlook intact.

Fed talks tough but likely to keep policy steady

• The Fed has become more vocal regarding their concerns about the inflation outlook and has stated that while downside risks to the economy still exist, they are starting to diminish somewhat.
• The Fed’s even-handed statement accompanying its June rate announcement dampened expectations of a near-term rate hike.
• Our view is that the strong headwinds facing the economy will be enough to keep the Fed on the sidelines for the remainder of this year, especially if energy prices start to decline, as we expect, and take some of the heat off headline inflation rates.

Bank of Canada on hold until early 2009

• The Bank of Canada unexpectedly left the policy rate at 3% in early June and focussed attention on the upside risks to the inflation outlook.
• With energy prices staying high, the headline inflation rate is likely to rise to the top of the Bank of Canada’s target band.
• The economy is set to rebound in the second quarter after the modest contraction in real GDP in the first quarter but will still post only moderate growth this year, thus increasing the amount of spare capacity in the economy and alleviating some of the upward pressure on prices.
• The next move by the Bank of Canada is likely to be a rate hike in early 2009 as the economy’s growth momentum builds going into 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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After yet another blockbuster year for Canada’s housing markets in 2007, the much-anticipated housing market slowdown in Canada has arrived. The delayed arrival of softer housing markets can be partly attributed to recent mortgage innovation that has seeped into the Canadian market during the last two years. Higher loan-to-value ratios and longer amortization periods (now extending up to 40-years) prolonged the housing cycle by opening up the market to a wider range of prospective homeowners.The effects of mortgage innovation will cushion, but not prevent, Canada’s housing markets from cooling off as the current housing cycle gears down.

Tide turns in 2008

• Last year, major markets delivered a sixth consecutive year of 10% house price gains, sales-to-listings ratios held firmly in seller’s territory, and housing starts held above 220,000 units for a fourth year running as excess demand in the resale market spilled over into the new home market. But, housing markets are now on a clear cooling path.
• Calgary and Edmonton have moved from chart-toppers to bottom-of-the heap in only a matter of months on a range of key housing market indicators, including house prices and sales.
• Regina and Saskatoon continue to clock year-over-year price gains that are several multiples above the pace of their local wage growth. This lends evidence that current momentum is unsustainable, with a fate similar to Alberta’s housing market likely for both of these cities in a year’s time.
• Many of the middle-of-the-pack markets — like Toronto, Ottawa and Montreal — are maintaining their slow and steady cruising speed. House prices across much of central and eastern Canada are growing between 5% and 10% year-over-year.

No U.S. style correction

• Canada’s housing market is on much firmer footing compared to the U.S. market. The recent softening in house prices is part of a natural end-of-cycle slowdown that is expected to take hold through 2008.
• Several factors support our view that Canada’s market is simmering down but is still in healthy shape, including Canada’s more conservative lending practices, healthy household finances, tight labour markets and a manageable inventory situation.

More conservative lending practices

• Canada engaged in much more conservative lending practices in this past cycle compared to the United States. Mortgage credit was extended, on average, to more capable buyers in Canada, leaving household balance sheets in better shape with mortgage quality strong and delinquency rates well below past cyclical peaks.
• Also, while U.S. sub-prime mortgages account for roughly 14% of the market, Canada’s sub-prime mortgage market is negligible, with the highest estimates showing a moderate 5% share.
• Speculative investing is also much tamer in Canada as investor-owned mortgages account for roughly 2% of the market compared to about 10% in the United States and the United Kingdom.

Labour markets are tight

• A strong labour market is a critical underpinning to healthy housing markets. Canada’s unemployment rate is holding at a 33-year low and average wages are outpacing inflation, meaning that homeowners are still realizing real increases in their monthly wages.
• Some slack in labour markets is expected as the economy cools, but outright job declines are unlikely as service sector gains are more than offsetting manufacturing sector losses.

Inventory overhang manageable

• The inventory situation is largely in check, with the exception of outliers like Edmonton, with unabsorbed inventories inching up but still comfortably below levels hit in the late 1980s housing market bubble.

Amy Goldbloom
amy.goldbloom@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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