The weekly overview (ZT 8.12)

TD Weekly Bottom Line

August 12, 2005

HIGHLIGHTS

• Crude oil climbs above US$66 …
• … driving S&P TSX even higher
• Canadian dollar moves to 8-week highs

It may be the dog days of summer, but you wouldn’t know it judging by the strong buying activity taking place in Canadian equity and foreign exchange markets. Although a number of factors continued to underpin the strength in Canadian markets – including further evidence of buoyant housing-market activity, healthy growth turned out by the country’s major trading partner Stateside, and better-than-expected corporate earnings reports – the surging price of crude oil led the charge.

Crude oil prices remain in the spotlight

This week, the price of crude oil surged by some 6 per cent, reaching a new record level of nearly US$67 per barrel for West Texas Intermediate. As has been the case of late, this week’s gain occurred despite news of rising crude inventories in the United States, which continued to advance over the previous week, and now sit a comfortable 10 per cent above their year-earlier levels. Rather, oil markets remained focused on the risk of supply disruptions and inadequate supplies of refined products. And, while figures on net buying activity of speculators are released with a lag, it would appear that speculative activity – which has been rising in recent months – remained a major force pulling up prices again this week.

High oil prices driving investor interest in Canada

Undeniably, the rally in oil markets is not leading to celebrations in all walks of Canadian life. Almost generating as many headlines as crude oil prices are those of gasoline, which have broken through $1.00 per litre in many parts of Canada, imposing a tax on households and certain businesses. Nor are the impacts well distributed geographically, with the west and Newfoundland & Labrador the big winners. However, for a country boasting the second highest oil reserves in the world – after Saudi Arabia – prices at current levels are generating a significant net benefit here at home.

These positive knock-on effects were evident in spades this week. Consistent with the improved outlook for both oilpatch-related revenues and government coffers, there were reports this week that private-sector estimates of the federal surplus have been raised to about $8 billion for the past fiscal year, more than double the official budget estimates. And, data on international trade for May revealed that a 4.5-per-cent gain in crude petroleum exports in the month – towed along by a combination of both higher prices and volumes – helped to vault Canada’s overall trade surplus to $4.9 billion from $4.4 billion in April.

Canadian export side starting to turn the corner

The June trade report carried even more significance, however. In recent months, rising exports of primary commodities such as crude oil have only partially offset declines in manufacturing exports, with the latter being sideswiped by the 35-per-cent surge in the value of the loonie since early 2003. However, with virtually every export category recording a rise in shipments in June, today’s news was the clearest sign yet that the worst from the currency-related adjustments is in the rearview mirror. Meanwhile, domestic activity in Canada remains robust. Tuesday’s report of housing starts for July revealed that a flurry of condo activity underpinned a total turnout of 242,300 units at seasonally-adjusted annual rates, one the best monthly showings of the current cycle.

U.S. continues to grow briskly

Supporting optimism in Canada this week were further signs that spending in the United States – the destination of the vast majority of Canadian exports – continues to chug along. Retail sales shot up by 1.8 per cent in July, reinforcing expectations that real consumer spending growth will run at a brisk 4-per-cent rate in the third quarter of 2005. The fact that spending appears to have strengthened since the end of 2004 was a major factor cited by the U.S. Federal Reserve in its decision to raise short-term interest rates by a further 25 basis points on Tuesday, to 3.50 per cent. But, while we remain of the view that the U.S. central bank’s efforts to slow the economy and stave off inflation pressures down the road will eventually pay dividends by mid-2006, the economic momentum in the U.S. looks unbreakable over the next couple of quarters. As such, the Fed will likely push up its bellwether rate to 4.50 per cent over the next half year.

Softwood lumber dispute back in the news

The likelihood of continued strong U.S. growth is good news for Canada’s recently-battered trade sector, and add further credence to the view that the Bank of Canada will itself begin to raise rates at its next fixed-announcement date on September 7th. At the same time, however, uncertainty about the future trade relationship between the two countries rose this week following Wednesday’s decision by the NAFTA trade panel to uphold an earlier ruling that had rejected the U.S. claim that Canadian softwood lumber exports posed a threat to the U.S. lumber industry. U.S. officials have indicated that they will ignore the decision, and hence, continue to collect a 20-per-cent duty on Canadian lumber shipments. In reaction, Canada has suggested that it might consider retaliatory actions. Hopefully, the two sides – which intend to resume talks in an attempt to end the dispute before the end of the month – will reach a negotiated settlement soon. There is simply too much at stake.

Overall, a very good week for Canada

Still, with much of the focus remaining on crude oil and Canada’s strong economic fundamentals, this heightened uncertainty merely put a dent in the Canadian market rally. The Canadian dollar – increasingly labeled the petro-currency in investor circles – neared in on an eight-month high of 84 U.S. cents. Despite a modest pull back this morning, the TSX will end the week up roughly 6 per cent, lifting its year-to-date return to 15 per cent. In contrast, bond yields traded at close to their week-earlier levels this morning.

Derek Burleton, AVP & Senior Economist
416-982-2514

 

BMO Weekly overview

August 12, 2005
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Indicators

The bond market managed to claw back a portion of its recent sharp losses as oil prices hit record highs of US$66 per barrel this week, threatening to derail the US expansion. Bonds were further supported by weaker-than-expected data and sanguine comments on inflation by the Fed.

Retail sales rose 1.8% in July, topping the 1.7% advance of June. However, excluding an incentive-driven jump in auto sales, total spending climbed a more subdued 0.3% following a 0.9% spurt in the previous month. Nonetheless, the numbers continue to flag personal consumption growth of 4¼% annualized in the third quarter, up from 3.3% in the second quarter. This should anchor a 4½% advance in GDP in Q3.

Supported by rising house prices and wealth, consumers appear to be shrugging off the impact of rising energy costs. But the lofty oil prices continue to inflate imports and the trade deficit. Imports rose 2.1% in June, widening the trade deficit to US$58.8 billion from $55.4 billion in June.

The softer data should not discourage the Fed from tightening again. After raising rates for the tenth straight time to 3.50% on Tuesday, the Fed noted that "policy remains accommodative" and the economy had "strengthened." This likely means further rate increases at the next two policy meetings. That said, with inflation expectations "well contained," the pace of tightening should remain "measured," i.e.; limited to increments of 25 basis points.

The higher oil prices and softer data, together with ongoing speculation that foreign central banks will begin selling their large US-dollar assets to diversify reserves, weighed on the dollar. The greenback’s decline against sterling was abetted by speculation that the Bank of England will refrain from cutting rates further after an upbeat description of the economy by Governor King.

The Canadian dollar was supported by rising oil prices and solid data. Driven by a boom in condo construction, housing starts unexpectedly rose to an annualized 242,300 units in July from an already-high level in June. In addition, the merchandise trade surplus jumped to $4.9 billion in June from $4.4 billion in May on the back of a sizeable (1.8%) and broad-based gain in exports. The trade report removes a downside risk to our estimate of 2.8% growth in the second quarter. It also provides further evidence that the economic impact of the high loonie is starting to wane, so the Bank of Canada will likely raise interest rates at the September 7 fixed announcement date.

Sal Guatieri, Senior Economist, 416-867-5258
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