The weekly ovewview (ZT 8.21)

TD Weekly Bottom Line

August 18, 2005

HIGHLIGHTS

• Crude oil prices pull back from last week’s peak
• Canadian data mixed
• U.S. data solid, but downside risk to growth in 2006

The extreme volatility of crude oil prices remained the top headline grabber this week, as financial markets continued to gauge the potential impact of high energy costs on the economy. Data released this week provided further evidence that crude oil prices are not dampening consumer spending significantly or leading to a broad pickup in prices on both sides of the border. The U.S. data was particularly encouraging on this front. In contrast, economic reports released in Canada showed further signs of solid domestic activity alongside a struggling export-oriented manufacturing industry.

High volatility in crude oil prices continue

Early in the week, crude oil prices for West Texas Intermediate retreated close to US$63 per barrel from its US$67-peak reached last Friday. However, news of production disruptions in Ecuador and Nigeria, caused by residents and workers’ manifestations, drove oil prices back above US$64 in early Friday trading. Despite these daily fluctuations, the bottom line is that oil prices remain unsustainably high – above the US$60 mark for a third consecutive week – fuelled by persistent concerns of the tight supply-demand balance of crude oil and inadequate refining capacity. The Canadian dollar, powered by its growing status as a “petrocurrency”, fell in lockstep with the price of oil, ending the week slightly above 82 cents relative to the U.S. dollar.

High energy costs do not spread to U.S. core inflation

U.S. CPI data continued to reveal that the ripple-through of high crude oil prices to most goods and services prices is limited. In particular, rising gasoline prices boosted headline inflation to 3.2 per cent, but the rate of core inflation remained benign at 2.1 per cent. Also, low initial jobless claims in August supported the view that the U.S. labour market is tight. Lastly, two surveys conducted in August by the Federal Reserve Bank revealed strengthen activity for manufacturers located in the region of New York and Philadelphia. The combination of subdued inflation and solid economic momentum will keep the Federal Reserve Bank raising rates at a “measured-pace” to 4.50 per cent by early 2006.

Retail, wholesale and resale housing activities are very strong in Canada

On this side of the border, high energy costs have not stopped Canadians from buying more goods and motor vehicles so far this summer. First, incentives by dealers helped to boost new motor vehicles sales by 7.4 per cent in June. Despite the fact that gas pump prices are close to a dollar a litre, there are few signs that consumers are switching to fuel-efficient motor vehicles. In fact, sales of new trucks (3.9 per cent) were higher than cars (1.6 per cent) on a year-to-date basis. Second, sales at large retailers jumped by 1.2 per cent in June and were broad-based, increasing in seven out of eight commodity groups. Mirroring this strong showing, wholesalers saw total sales rise by a healthy 0.5 per cent during the same month, led by sales of computers, electronic equipment, personal and household goods.

Figures released by the Canadian Real Estate Association showed that the Canadian housing resale market remains on a roll. Sales of existing homes shot up by 1.5 per cent in the January-July 2005 period compared to the same time last year, as homebuyers continued to take advantage of low mortgage rates. So far this year, home prices averaged $263,400 in Canada, up a hefty 8.7 per cent from the January-July 2004 period. For comparison purposes, the Canadian S&P/TSX composite climbed by 13 per cent and the S&P 500 rose by 6.0 per cent over the same period. The fact that the overall return of the TSX is above the home price appreciation recently is largely attributable to the skyrocketing energy component of the TSX, which has jumped 39 per cent in 2004 and a further 58 per cent so far this year. All together, wealth gains coming from both the stock markets and housing prices have been key factors offsetting the negative impact of the energy price shock on consumer spending.

Energy shaped manufacturing sector’s performance

To a large extent, manufacturing shipments data for June reflected to a large extent the rise in energy prices and the previously-released figures on trade. Indeed, the 0.5-per-cent rise observed in the value of manufacturing shipments was driven by higher petroleum and coal prices. On the positive side, inventories were lower and unfilled orders were higher in June, two key ingredients that will help manufacturing production to gradually strengthen down the road. However, higher factory input costs due to energy prices coupled with the likelihood of a slowdown in the U.S. expansion remain the sector’s key challenges over the next two years.

U.S. expansion will lose steam in 2006

A new report by TD Economics entitled U.S. Expansion on ‘Borrowed’ Time highlighted the risk of a significant slowdown in U.S. growth next year, most notably through the channel of weaker consumer spending. An extended period of low interest rates explains largely why real home prices have risen at an annual pace of 9.4 per cent since 2001, which, in turn, has been a key driver to consumer spending. In a scenario where real housing price growth tapered off, the wealth effect will wane and shave 0.7 percentage points to personal consumer expenditures next year and hold back U.S. real GDP growth to a less than 3 per cent at an annual rate in the second half of 2006.

The absence of key economic data in the Unites States should make for a quiet week while retail trade and CPI data will be potential market movers in Canada on Monday and Friday, respectively. In particular, financial markets will focus at the possible impact of rising energy costs on core inflation and consumer wallets.

Sébastien Lavoie, Economist
416-944-5730

For the full report in PDF format - including all charts and tables click here.

BMO WEEKLY OVERVIEW

August 19, 2005
Click here to Dowload the PDF version
Indicators

There was a raft of US economic data out this week which prompted divergent reactions within financial markets. While the US dollar was generally stronger against most of the major currencies, long bond yields fell. The rally in fixed income markets was also a reflection of some retracement after an almost steady deterioration since the end of June.

The bond market reacted largely to some benign inflation measures that were released this week. Key in this regard was the negligible 0.1% rise in core consumer prices in July. This kept the year-over-year rate moderate at 2.1% thought this was up slightly from 2.0% in June. The overall measure was up a more sizeable 0.5% in the month and 3.2% over the year, largely reflecting a surge in energy prices.

Some of the declines in long bond yields were retraced mid-week with the release of the July producer price report which showed greater price pressure. Energy prices were a factor sending the overall measure up a hefty 1.0% in the month though the core measure was also up a larger-than-expected 0.4%. However, most of the pressure on a core basis was concentrated in a 1.5% surge in the motor vehicle component. By week’s end fixed income markets had put a greater weight on prices at the consumer level and thus held on to most of the initial gains.

By contrast, foreign exchange markets put greater weight on indications that economic growth remains robust. This strength was most evident in July housing starts where activity remained very high at an annualized 2.042 million units down only marginally from June’s upwardly revised level of 2.045 million. Permits in July rose to an even higher 2.167 million units, which augurs well for strength in starts continuing near term. Encouragement was also taken from the jump in the August Philadelphia Fed business conditions index to 17.5 from 9.6 in July, indicating strong economic growth.

The depreciation of the Canadian dollar was abetted by sagging oil prices this week. Prices on a WTI basis dropped from almost $67/barrel the end of last week to under $65/barrel by Friday midday. The loonie is increasingly being traded as a "petro-currency" on indications of rising investment in, and thus future oil production from, Canada’s vast tar sands reserves in Alberta. This production will result in Canada becoming a more significant net oil exporter than is currently the case.

There was minimal impact from the Canadian economic data this week. June manufacturers’ shipments rose 0.5% in the month though this followed a 0.3% decline in May. As well, all of the increase was attributable to higher prices. With volumes flat in the month, the report suggests some modest downside risk to our current estimated GDP growth rate for Q2 of 2.8%. However, the pace of activity remains sufficiently strong that we expect that the Bank of Canada will return to tightening mode at the September 7 fixed announcement date. At this meeting we expect the overnight rate to rise to 2.75% from 2.50% currently.

Paul Ferley, Assistant Chief Economist, 416-867-7842
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