The recovery is not off to a good start

A few weeks ago Canadian forecasters convinced themselves that growth in the 3rd Quarter was going to be much better than expected. Unfortunately, the data doesn't seem to be cooperating. Retail Sales for July actually fell 0.6%, and real GDP growth in July was flat, with the retail and construction industries posting declines. This may be a concern given that personal consumption expenditures and residential construction tend to be early indicators of recovery - as shown in this chart from Calculated Risk:



We should get a better idea of the shape of the recovery this week with data for Q3 housing starts, building permits, jobs, and the increasingly important BoC Senior Loan offers Survey all being released in the next few days.

My own forecast for Q3 growth is still somewhere around 1-1.5%. Consensus from Bay Street seems to be around 2-2.5%, though I notice that BMO has, again (aside: I think BMO revises every week, it's really something) revised their forecast to 1.3%.

TSX hits my target! Now what?

All the way back in May I made the bold prognostication (read: wild guess) that the TSX should be valued at between 11,400 and 11,500 - up from about 10,200 at the time. I hazarded a guess that the TSX might get to that level by the end of 2009, however it decided not to wait until the end of the year, closing at 11,496 today.

In my previous post I suggested that the market was undervalued and would be pricing in 2009 TSX earnings of about $575 per share. I then applied a long-run average PE multiple of about 20 to arrive at my call of 11,400-11,500.

Current estimates for 2010 corporate profits are in a range of 5-10% growth. My own model of corporate profits is spitting out growth of 30% (which I don't quite believe) - so lets say TSX EPS of around $630-$750. Since so much depends on the multiple applied to these profits, i've made a quick and dirty attempt at incorporating a PE equation based on short and long-term interest rates and nominal GDP growth into my Canadian economy model. The model derived PE suggests an average multiple of between 17-18 over the next year. Applying this multiple to the above range of forward earnings gives a fair value for the TSX of between 11,400 and 13,500, suggesting a market going sideways or a market about to pop by about 20%. A big range to be sure, but perhaps that is consistent with the amount of uncertainty in stock prices.

Could I have arrived at this range by pulling numbers randomly out of a hat? Probably, but what fun would that be?

The Training Wheels Economy

Looking at the most recent National Accounts data from Statistics Canada provides a sense that the Canadian economy can’t quite stay upright on its own. Luckily, the Government and the Bank of Canada have committed to stabilizing the economy until it can, sort of like a set of training wheels on a bike.

For its part, the Bank of Canada has committed to keeping its target rate at an effective lower bound of 25bps until the second quarter of 2010. The fiscal stimulus proposed by the Federal Government is projected by the Bank of Canada to contribute about 2.3% to GDP over the next year and a half, including close to half of the Bank’s projected growth for 2010.

So how long might the economy need training wheels? Well, personal consumption and residential investment seem to have turned, which is normally the case at the end of a recession. However, if this recession is anything like the past, private sector investment in non-residential structures and machinery and equipment may not recover for a while, particularly if bank lending remains tight.





Non-residential investment in structures and M&E contributed an average of about 1% to annual real GDP growth from 2003-2007 before subtracting growth in 2008 and 2009. The fiscal stimulus should go a long way in replacing that growth in 2010, but if consumption growth stalls or the loonie creates a larger than expected drag on exports, we could be looking at keeping the training wheels on for an extended period. If not, a 1980-1982 style double-dip recession is a real possibility.

Hey I got one right! .......but so did everyone else.

Real GDP (quarter-over-quarter annualized) came in at -3.4% for the second quarter, just a shade better than my forecast of -3.5% (I've been having problems with my forecast link not working so I've taken it down until I can figure out a better way to link to it -you'll have to just trust me on this one.)

For whatever reason there was quite a bit of (correct) consensus on the growth prospects for the 2nd quarter:

Actual: - 3.4
WCI (Stephen Gordon): -3.4%
BoC: -3.5
SMC (Me): -3.5
BMO: -3.3
RBC: -3.2
CIBC: -3.1
TD: -2.2
Scotia: -2.0

The one thing the above list ignores is vintage (which I'm too lazy to dig up right now). The last time I made a forecast was sometime in early July, while others like RBC and TD were mid-June.

Congrats to Stephen Gordon for nailing the number right on the head (I know yours was more of a preliminary estimate based on available 2nd quarter data, but still, kudos.)

WTF Econo-Journalism: CBC Edition

Okay, this is a minor complaint, but those are my specialty. While watching the news (CBC Vancouver) this evening, I overheard the anchor-woman say the following:

"Another sign that the economy is on the road to recovery - inflation in
July fell to its lowest level in years"

I've asked this before, and I'll keep asking, are there any editors anymore? I assume someone wrote the above for the teleprompter and someone else signed off on it. And yet, there is some blonde news anchor on my TV making an elementary mistake while projecting absolute confidence, leaving me no recourse but to scream obscenities at the ceiling.

Reconciling the Bank of Canada's forecast or the Importance of Exchange Rate Assumptions

In its most recent MPR, the Bank of Canada produced a growth forecast for 2010 that seems rather optimistic compared to some private sector forecasts:

Bank of Canada 3%
Merrill Lynch 2.7%
Bank of Nova Scotia 2.5%
Royal Bank of Canada 2.5%
Shock Minus Control 2.5%
Bank of Montreal 1.8%
CIBC 1.5%
Toronto-Dominion Bank 1.4%

One probable reason for the variance between my forecast and the Bank’s is the Bank's assumption of an 87 cent US/CAD exchange rate versus my model range of 87 to 95 cents. Indeed, I can account for quite a bit of the variance between my own forecast and the Bank's simply by tweaking the exchange rate assumption.

Of course, there any number or assumptions that could be driving this difference, particularly within a complex model such as TOTEM, the Bank’s primary forecasting model. However, the low exchange rate assumption does seem to be a pretty important one.

Canadian Economic Forecast 2009-2010

The Canadian economy will contract significantly in the first half of 2009 before giving way to a modest recovery in the third quarter. I anticipate that growth in 2010 will be given a boost from combined fiscal and monetary stimulus, but that overall economic growth in 2010 will be sluggish. Overall, I expect the Canadian economy to contract by 2.5% in 2009 before returning to positive growth of 2.4% in 2010. It is important to note that although I've forecast a strong rebound in quarterly real GDP growth in 2010, much of this growth will come from temporary sources such as government stimulus and the rebuilding of depleted inventories by Canadian businesses. Therefore, despite a return to positive quarterly growth, I expect that the economy will remain fundamentally weak, characterized by sluggish employment growth and an over reliance on government stimulus.

I expect the unemployment rate to peak around 9.2% before declining at a measured pace as the economy begins a slow recovery. The enormous amount of slack in the economy should keep core inflation well below the Bank of Canada’s 2% target for all of 2009 and 2010. Low inflation, along with a strong Canadian dollar, will allow the Bank of Canada to keep its conditional promise of holding its overnight rate at 25bps until the second quarter of 2010. However, if core inflation remains near target, the Bank may be eager to bring rates back to pre-crisis levels. The forecast suggest that the second half of 2010 could see the Bank increasing its overnight target by 100 basis points with the first increases announced in June or July.

I should note that this forecast assumes that the normalization of credit markets currently underway continues without further disruption and that GDP growth in the United States turns positive by the end of 2009 and remains positive but below trend growth in 2010. The forecast also assumes that the Canadian dollar stays within a range of 87-95 cents.