QUARTERLY ECONOMIC REPORT Second Quarter - April to June 2014

THE RECOVERY CONTINUES 





Weather-related weakness in Q1 reduced the outlook for 2014, as the consensus for the U.S. was cut to 1.6%, down from 2.2% in the June survey. Forecasters still anticipate improved economic performance for the rest of 2014 and 2015. Advance estimates for Q2 U.S. economic growth were positive (+4.0%), which bodes well for U.S. and global growth going forward.





Economic outlook largely on track Real GDP growth (annual % chg) 2.6

World

3.2

2.2 2.5

Canada 1.6

US 1.1

Eurozone

2014



3.0 2015

1.6

1.5 1.3

Japan

1.9

Latin America

2.7 6.0 6.1

Asia ex-Japan 0.0

1.0

2.0

3.0

Source: Consensus Forecasts, July 2014

4.0

5.0

6.0

7.0

The July Consensus Forecasts for global economic growth is 2.6% for 2014, and 3.2% for 2015, as the global economic recovery is expected to further gain traction going forward (see below chart). The Canadian outlook remains somewhat muted, partly due to weaker than expected foreign and domestic demand in the first quarter. European economic growth is expected to be weak in 2014, but this is a significant improvement over the recessions in the last few years. Unemployment, excess capacity and disinflation remain significant concerns for European policy makers. Developing Asian economic growth in is expected to do well. China is forecast to see economic growth on target, although concerns regarding the housing market and shadow banking remain. Latin American economies are challenged by high inflation, current account deficits and weak domestic demand.

Second Quarter - 2014

Inside This Issue*:

Economic Outlook

2

Canada

3

United States

5

Europe

6

Japan

7

China

8

Research & Risk Measurement Chris Lawless (778) 410-7331 Johann Kuntze (778) 410-7171

www.bcimc.com *This report incorporates information and data available through Aug. 8, 2014

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QUARTERLY ECONOMIC REPORT

Developed consumer inflation diverges

Inflation diverges Consumer price inflation (year/year % chg.)

China continues to lead the way



The latest readings on consumer inflation in Canada (+2.4%), the U.S. (+2.1%), and Japan (+3.6%) have jumped. In the case of Canada and the U.S., this was largely due to higher energy prices. Higher inflation in Japan is the result of a hike in the sales tax implemented April 1. In contrast, European inflation remains weak (+0.4%) and on a worrisome downward trend (see top chart).



In response to weak inflation and economic growth, the ECB announced a number of actions in June; however, it has yet to implement the more meaningful aspects of the plan.



Respective heads of the Canadian and U.S. central banks indicated that while inflation has picked up, they remain more concerned with weaker-than-expected economic growth and employment, and expect inflation will not accelerate.

Emerging markets continue to face challenges

Real GDP growth (annual % chg)



Chinese authorities have so far navigated the risks of a shadow-banking crisis and housing bubble, with economic growth still expected to be close to the government’s target of 7.0-7.5% (see bottom chart).



While recent economic growth in India has disappointed, a new pro-business government under prime minister Narendra Modi and a strong central bank governor are expected to provide better policy underpinnings for economic growth.

6.0 6.1

Asia ex-Japan

7.3 7.2

China 5.4

India

6.2 2014

3.6 3.7

South Korea

Risks

2015 5.3

Indonesia

5.7

0.0

ECONOMIC OUTLOOK

2.0

Source: Consensus Forecasts, July 2014

4.0

6.0

 8.0

Conflicts in the Ukraine and Middle East have escalated and have the potential to become much more serious. However, to date, this has not had a significant impact on oil prices, capital markets or global economic activity.

Second Quarter - 2014

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CANADA

QUARTERLY ECONOMIC REPORT

Economic growth remains moderate

Current inflation unlikely to persist



The Bank of Canada’s (BoC) July Monetary Policy Report examined the persistence of the components of inflation (see top chart). For example, clothing inflation (yellow bubble in bottom right quadrant) has exhibited above average level of inflation (right half), but tends to not be persistent and not likely to see continued increases in prices (bottom half). The majority of inflation components that tend to persist have been below trend, suggesting that inflation isn’t expected to creep higher.



With a weaker economic global outlook and Canadian labour market, the BoC now anticipates that the economy will not eliminate excess capacity until the middle of 2016, and inflation will remain close to 2% until then.

Relative persistence

The size of the bubbles in the chart refer to the relative weight in the index and the colour denotes the category.

Source: July 2014 Bank of Canada Monetary Policy Report

Low rates support house prices

Housing prices continue to rise 

An area of concern repeatedly identified by the Bank of Canada is the residential housing market, particularly in some major centres such as Calgary, Toronto and Vancouver. With mortgage rates at historic lows, households continue to be attracted to homeownership (see bottom chart), and prices have continued to rise faster than incomes.



CMHC insures the vast majority of residential mortgages. CMHC has taken steps to dampen demand, such as reducing the maximum amortization of mortgages to 25 years, evaluating mortgages based on posted 5 year fixed interest rates (typically higher than negotiated rates), and more recently, no longer insuring new mortgages on 2nd homes.



Nationally, new housing starts have rebounded from weatherrelated weakness in the first quarter, but remain in line with longer-term trends.

Second Quarter - 2014

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CANADA

QUARTERLY ECONOMIC REPORT Employment growth weak

Canada’s trade balance

Canada’s labour market is drifting 

Employment increased by 42,000 in July (data corrected by Statistics Canada August 15th). Employment growth over the last year has generally been weak (see top chart), with employment gains largely focused in part-time work. The unemployment rate was 7.0% in July, but this was largely due to people not looking for work.



Weakness in the labour market is reflective of overall weakness within the Canadian economy, along with a stronger Canadian dollar and weaker export markets. Other indicators such as retail sales and housing starts had been weak in the early part of the year, but have since rebounded.



With an increasingly indebted consumer, and hopes for a slowing housing sector, focus has shifted to increased business investment and trade to boost the economy.

Trade balance up as terms of trade improve 

Canada’s trade balance improved in recent months, as improved terms of trade (the ratio of export prices to import prices) and improved demand from the U.S. resulted in goods exports exceeding growth from imports (see bottom chart).



Despite the recent positive news, the Bank of Canada revised down its outlook for exports due to a weaker than expected foreign demand for Canadian goods and services. According to Consensus Forecasts’ latest outlook, Canada is still expected to maintain a trade deficit through 2015.



The significant drop since the recession in 2008 and 2009 can largely be attributed to the decline in foreign demand, which has not recovered fully, due in part to the high value of the Canadian dollar in recent years.

Second Quarter - 2014

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USA

QUARTERLY ECONOMIC REPORT US economy rebounds in Q2

Q2 GDP rebounds from weak 1st quarter 

The U.S. economy grew at an annualized rate of 4.0% in Q2, due to increases in inventories, business and residential investment, as well as stronger than expected consumer spending. This pleasant surprise comes on the heels of –2.1% annualized growth in Q1 (see top chart).



Most forecasters attributed the weak Q1 growth largely to one-time factors such as the severe winter weather and weak health-related spending related to the implementation of “Obamacare”. Oxford Economics forecasts stronger economic growth through the rest of 2014 and 2015.



U.S. Federal Reserve chair Janet Yellen indicated in recent testimony that the economic recovery remains on track, but that economic conditions continue to warrant extremely low interest rates. The Federal Reserve continues to taper its quantitative easing of monetary stimulus by U.S. $10B per meeting, currently targeted to level off by October 2014.

US labour market improving

U.S. labour market continuing to improve 

The U.S. labour market continues to show signs of steady improvement, adding an average of almost 230,000 jobs per month so far this year. The unemployment rose slightly in July to 6.2% as more people looked for work (see bottom chart).



Despite improvements in the labour market, there continue to be concerns regarding the employability of the long-term unemployed. If unemployment in this group becomes increasingly structural in nature, for example due to a deterioration in skills, this could reduce the potential output of the U.S. economy and the amount of slack remaining in the labour market.

Second Quarter - 2014

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QUARTERLY ECONOMIC REPORT Economic growth & inflation are weak

Industrial production falling in core

EUROPE

Economic growth and deflation are key risks 

While Europe has escaped recession, economic growth remains weak at best, while inflation is still trending downwards (see top chart).



This bad combination has led for further calls from the IMF’s head, Christine Lagarde, for greater monetary stimulus and quantitative easing. The ECB responded in June by announcing a stimulus package featuring minor cuts to interest and deposit rates. However, it left more significant measures, including additional quantitative easing, for the future.



With the ending of the ECB’s Long-Term Financing Operation (LTRO) to provide funding for financial institutions, it remains unclear how committed policy makers are to additional stimulus to boost growth and inflation.

Industrial production falling 

Recent industrial production data suggests that economic momentum is waning in the core countries of Europe. Notably, German industrial production has fallen sharply in recent months (see bottom chart).



In contrast, Spain has rebounded this year, after years of struggling with austerity, high unemployment and deleveraging from a housing market crash. Industrial production is up in 2014, led by a boost in exports.



Another bright spot is the U.K. economy, which grew at an annual rate of 3.5% in the second quarter, while June consumer inflation was 1.9%. The Bank of England has resisted calls to raise interest rates despite consistently positive recent economic data, citing slack high unemployment.

Second Quarter - 2014

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JAPAN

QUARTERLY ECONOMIC REPORT

Zig-zag growth pattern likely in near term

Contributions to Q1 GDP growth



As mentioned in the last report, consumers accelerated their spending in anticipation of the hike in the consumption tax that rose from 5% to 8% on April 1. As a result, consumption expenditures rose strongly in Q1.



Growth in residential investment remained strong business capital spending rose sharply in Q1 as well.



These factors more than offset weakness in net exports to result in the economy growing at a 6.7% annual rate in Q1 (see top chart).



Forecasters expect a zig-zag growth pattern in coming quarters as the one-time boost to consumer spending prior to the tax hike reverberates; the economy likely shrank in Q2 as retail sales fell (see bottom chart), but will expand again in Q3 as consumer activity gradually returns to normal.

Percentage point contributions Consumption

5.5

Government expenditure

0.1

Housing investment

0.4

Business investment

4.3

Public investment

-0.6

Inventories

-2

Net exports

-1.1

GDP

6.7

-4

-2

0

2

4

6

8

Source: Haver Analytics, Cabinet Office

Tax hike makes consumers, economy zig-zag

Abenomics—longer-term challenges continue 

One of the key elements of Abenomics, monetary stimulus, was successful initially, but its effects are wearing off.



The second element, making public finances sustainable, is creating headwinds for the economy as taxes rise and spending is restrained. Many observers believe the Bank of Japan will have to engage in further monetary stimulus to offset the drag on the economy from fiscal restraint.



The third challenge, structural reform, is the most difficult and some fear that the government lacks the political will to follow through in the face of opposition from key factions and supporters. The government has made many minor reforms, but has been reluctant to make radical changes that would boost female labour force participation and/or immigration in order to raise potential economic growth.

March 2014

April 2014

and

Second Quarter - 2014

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QUARTERLY ECONOMIC REPORT

CHINA

Economy grew faster in Q2

Spot the 2014 slowdown



Official data shows that in Q2, China’s economy grew 7.5% compared to the same period the prior year (see top chart), or 8.1% on an quarter-over-quarter annualized rate.



The government’s mini-stimulus measures and an export recovery have helped to support growth.



Looking ahead, weakness in the real estate market and problems in credit markets due to rapid expansion of shadow banking (green area in bottom chart) are likely to be a drag on growth later in 2014.



The government seems determined to let the credit and property excesses play out, bad for short-term economic growth, but beneficial for China’s longer-term health.

“Debt bubble”: one China-watcher’s perspective 

Credit bubble? issuance sheet credit

Source: UBS

Ray Dalio, founder and head of Bridgewater Associates, a long-time observer of China recently provided some perspective on China’s debt problems: “The most important things to know are that 1) the debt problems in China are manageable given their sizes, given that they are in local currency and given the government has enormous resources, 2) current economic leadership in China is very smart and has very strong character to deal with debt problems...These adjustments can be managed by smart open-minded people both in and out of China...Because policy makers have learned a lot and have become open-minded over the last 5 years or so, I believe that they will most likely handle these situations well.”

*RMB & FX: regular bank loans in domestic & foreign currency

Second Quarter - 2014

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