SEPTEMBER 30, 2011
July GDP reads in line with expectations. Economists excited. Credit markets, not so much...
Expectations were for a 0.3% month-over-month gain in July GDP. That's exactly what we got, as Stats Canada released the latest figures earlier today. Final Q2 GDP came in slightly negative, which means another consecutive quarter of declining GDP would be a technical recession. July is only the first month of the third quarter, but the growth in GDP certainly suggests that we may avoid the 'R' word for now.
Manufacturing finally found its footing and was responsible for the bulk of the heavy lifting, posting a 1.4% gain over June after declining for three straight months. The major drag came from retail sales, which should be no surprise to anyone watching the credit markets. With the year-over-year change in credit running at lows not seen in two decades, it's no surprise that consumers have closed their purse strings:
In our modern, consumer debt-driven society, you can't have strong consumption without credit growth. God forbid people actually save for stuff they want!
Credit market reaction to the news shows that traders are still seeing significant economic weakness despite July's reading. The Overnight Interest Swap (OIS) promptly priced in a rising likelihood of a rate cut despite the GDP growth. Remember that when OIS rates are below the Bank of Canada overnight rate, it means that a rate cut is expected to be the next move. When OIS rates are above the overnight rate, a rate hike is expected to be the next move. Of course, a rate cut is one of the first tools the Bank of Canada will use to counter a weakening economy and falling inflation.
Meanwhile, the yield on the 5 year bond continues to plunge, now sitting at 1.4%, which is even lower than during the depths of the financial crisis. If a sustained rebound in economic activity was expected, the bond market would price in a greater chance of rising inflation and an interest rate hike. There is no sustained rebound in economic growth or inflation being priced in at present. In fact, if one were to take the cue from the credit markets, it looks like the markets expect things to get ugly.
All the big banks weighed in on today's GDP reading, but I think BMO summed it up best:
Overall, this is a nice report, but it’s seemingly drawn from the Pleistocene era, given the recent sharp drop in confidence. Growth looks poised to slow notably as we head into year‐end.
Indeed. July seems like years ago. Since that time, we've seen stocks sell off, leading indicators tank, business and consumer confidence fall hard, and credit demand wither. July has given some hope that we may sidestep a technical recession, but we're far from being out of the woods.
China starting to buckle?
It's hard to overstate the importance that the Chinese economic miracle has been to commodity markets. Canada has benefited from this boom, as has the commodity-heavy TSX. I have long maintained that a hard landing in China is a far greater threat to Canadian markets than the ongoing weakness in the US, despite the fact that no one is watching it. I'll remind my readers once again that TD recently estimated that a slowdown in GDP in China from 10% to 5% (more than double our own GDP rate, I might add), would strip at least a full percentage from global GDP, crush commodities to the tune of 40%, and very likely trigger (or exacerbate) an outright global recession.
Last year, while economists were predicting another double-digit GDP growth reading out of China, I suggested they were likely to slow, leading to copper being the worst performing commodity in 2011. We'll have to see at year end just how this turns out, but I like my chances, particularly with the new data coming out of China. I don't mind saying that I believe that China is a bubble no different than the tech bubble or Japan bubble. I think we'll look back at some point in the next 10 years and marvel that we could ever believe that such a dysfunctional economy could ever grow at double digit rates ad infinitum. The problem is that centrally-planned economies are exceptionally resilient in the short term and can maintain a facade of prosperity. But when the end game comes, it comes swiftly.
One great site that follows economic trends in China is Also Sprach Analyst. I recommend it as a daily read. The main author, who goes by the name of Zarathustra, is among the best China analysts anywhere. His (her?) views are well worth reading as (s)he has a view of emerging trends in China from the ground level.
There are many, many concerning signs coming out of China of late, perhaps the most significant being rapidly rising credit default swap premiums on a variety of Chinese debt obligations. The credit markets are starting to question the Chinese growth miracle, and that alone ought to cause us concern. These 'insurance' policies which are taken out as protection in the event of a debt default by an entity, have been rising particularly quickly for a couple of Chinese banks. China Development Bank Corp and Bank of China Ltd have both seen CDS premiums double since August:
In addition, the HSBC purchasing managers' index (PMI), a measure of manufacturing activity, has been easing for three months, signaling a slowdown in factory activity. OECD's leading indicators have been signaling a slowdown in China for months now, so this is not a shock.
Finally, consider this gem of an article from Also Sprach Analyst. It nicely outlines the case for a cooling Chinese economy via a whole slew of hyperlinks. Follow them and read up on it. If China is, in fact, set for a hard landing, it will be felt worse in Canada than just about anywhere else on earth. Brace yourself!
ECRI says US heading back to recession:
I recently discussed the ECRI's weekly leading indicators, which have been signaling a major slowdown in the US for the past couple months. In that article, I noted the following:
The Economic Cycle Research Institute (ECRI) publishes weekly leading indicators (WLIs) for the US economy. They have proven to be remarkably good indicators of economic weakness in the US. In the past 50 years, the WLI has registered 'dips' of -6% or more only 9 times. Six of those times have preceded the recessions that the US has experienced in that time. One recession was not predicted by the WLI. One preceded the Wall Street crash of 1987. One was a false reading in 2010. The last is right now. The correlation between the WLI and economic growth is evident.
Now, the ECRI has formally acknowledged what has been obvious to anyone watching their own index: The US is heading into another recession. In a formal press release issued today, they had this to say:
Early last week, ECRI notified clients that the U.S. economy is indeed tipping into a new recession. And there’s nothing that policy makers can do to head it off.
ECRI’s recession call isn’t based on just one or two leading indexes, but on dozens of specialized leading indexes, including the U.S. Long Leading Index, which was the first to turn down – before the Arab Spring and Japanese earthquake – to be followed by downturns in the Weekly Leading Index and other shorter-leading indexes. In fact, the most reliable forward-looking indicators are now collectively behaving as they did on the cusp of full-blown recessions, not “soft landings.”
Last year, amid the double-dip hysteria, we definitively ruled out an imminent recession based on leading indexes that began to turn up before QE2 was announced. Today, the key is that cyclical weakness is spreading widely from economic indicator to indicator in a telltale recessionary fashion.
And just to drive the point home, the director of the ECRI gave this nice little interview in which he delivered the following excellent sound bites:
"It's a done deal. We are going back into recession."
"There is a contagion among those leading indicators that we only see at the start of a business cycle recession."
"It's a deadly combination. We won't escape this."
If the US can't escape a recession, it's hard to see robust growth coming out of Canada.