Economics Insights CIBC Canada US

7/29/2019 Economics Insights CIBC Canada US

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Economicinsights

CIBC World Markets Inc. PO Box 500, 161 Bay Street, Brook iel d Place, Toronto, Canada M5J 2S8 Bl oomberg @ CI BC ( 416 ) 594-7 00

C I B C W o r l d M a r k e t s C o r p 3 0 0 M a d i s o n A v e n u e , N e w Y o r k , N Y 1 0 0 1 7 ( 2 1 2 ) 8 5 6 - 4 0 0 0 , ( 8 0 0 ) 9 9 9 - 6 7 2

Economics

Avery Sheneld(416) 594-7356

[email protected]

Benjamin Tal(416) 956-3698

[email protected]

Peter Buchanan(416) 594-7354

[email protected]

Warren Lovely(416) 594-8041

[email protected]

Emanuella Enenajor(416) 956-6527

[email protected]

Andrew Grantham(416) 956-3219

[email protected]

text text text

h t t p : / / r e s e a r c h .cibcwm.com/res/Eco/EcoResearch.html

Anyone taking a quick look at the mostclosely watched spot oil prices would assumethat or that key Canadian resource sector, allthe worries are behind us. Ater all, the hugegap between North Americas benchmarkprice, WTI and Europes Brent, has nearlydisappeared. And even though WTI typicallytraded through Brent, its absolute level, nowhandily clear o $100/bbl, seems generousenough to put the green light on some othe oil sands projects that had earlier been

postponed.

But massive investment decisions arent justbased on where things sit today, but on whatthe uture is thought to hold. On that score,we still have too many doubting Thomses.

While the utures market isnt inallibleas a orecaster or where oil prices areheaded, it does give a sense o what marketplayers are assuming. Instead o the typical

upward slope, the utures curve is in a steepbackwardation, with a barrel o WTI in mid-2016 etching only $85/bbl (Chart).

Add in concerns raised by a re-wideningo the discount on Canadian heavy crude,and worries about uture transportationbottlenecks, and were still waiting or morecertainty that rm prices are here to staybeore getting back into ull gear on capitalspending in the oil patch. That helps explainwhy Canadian oil stocks havent quite kept

pace with the bounce in crude.

Getting pipeline projects o the drawingboard and into the eld would help, andwere encouraged by new momentum on aproject to deliver Western Canadian crudeto Canadas east coast and beyond. Obamasannouncement on Keystone still lies ahead,

as do decisions on alternative proposals opipelines to the west coast, whose valuebecomes more apparent as US oil importdependency continues to shrink.

But in addition, the oil markets needs arentdissimilar to the needs o other parts oCanadas energy and industrial materialssectors: greater certainty on global growthI what were seeing in the US and Europe isa sign o things to come, we could be on the

verge o bringing those doubting Thomasesaround.

The US news hasnt been unambiguouslypositive signals rom total hours workedin July and real consumption in June were onthe disappointing side. But two key cyclicadrivers, new home sales and manuacturingcontinue to turn the corner. Overseas, Chinasstory is still hazy at best, but European datapoints to a return to positive growth or that

continent in Q3. Both the US and Europeshould benet rom a lighter scal drag come2014. I so, well have ewer doubts aboutCanadas oil and non-oil export prospectsand scope or Canadian equities to play somemuch needed catch up to whats happenedstateside.

Doubting Thomasesby Avery Sheneld

August 7, 2013

Were stillwaiting for morecertainty thatfrm prices arehere to stay.

Traders Doubt High Oil Prices Here to Stay

85

90

95

100

105

110

1 4 7 10 13 16 19 22 25 28 31 34

Curve today

Year ago

2 Years ago

NYMEX Light Sweet Crude

Contract, $/bbl

Months Until Delivery


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CIBC World Markets InC. Economic Insights - August 7, 2013

2

MARKET CALL

INTEREST & FOREIGN EXCHANGE RATES

Weve reached the targets we set or a bond market sell-o in 2013. Whether the Fed announces taperingin September, or as we slightly lean towards, in Q4, that story is essentially priced in. The Fed will time itsurther tapering steps, and its language on short rates, with an eye to steering a very gradual climb in yields.Thats one reason, but not the only one, we see 10-years in the US and Canada on such a path in 2014 (see

pages 6-8).

At the short end, were still targeting the rst quarter o 2015 or the rst hike by the Fed and a matchingmove by the Bank o Canada. Indeed, the earlier the bond market sells o, the more the Fed will be inclinedto wait, and our call implies that the hike will come at least a quarter ater the jobless rate rst hits 6.5%.

Encouraging European data has temporarily halted the US dollars general climb, but only because a comingUS growth turn hasnt shown its ull colours. That should come beore year-end, putting the dollar backinto avour. A Fed tapering announcement will be negative or the C$, but stronger global growth next yearpositions the loonie or a comeback.

2013 2014 2015

END OF PERIOD: 6-Aug Sep Dec Mar Jun Sep Dec Mar

CDA Overnight target rate 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.25

98-Day Treasury Bills 0.99 0.95 0.95 0.95 0.95 0.95 1.05 1.25

2-Year Gov't Bond 1.16 1.15 1.20 1.20 1.40 1.45 1.50 1.8510-Year Gov't Bond 2.53 2.50 2.60 2.70 2.70 2.80 2.85 2.95

30-Year Gov't Bond 3.04 2.90 3.00 3.05 3.05 3.10 3.15 3.25

U.S. Federal Funds Rate 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.25

91-Day Treasury Bills 0.05 0.08 0.08 0.08 0.15 0.15 0.15 0.20

2-Year Gov't Note 0.31 0.35 0.40 0.45 0.60 0.80 1.10 1.30

10-Year Gov't Note 2.65 2.60 2.75 2.80 2.80 2.85 2.90 3.00

30-Year Gov't Bond 3.74 3.60 3.70 3.70 3.75 3.80 3.90 4.00

Canada - US T-Bill Spread 0.95 0.87 0.87 0.87 0.80 0.80 0.90 1.05

Canada - US 10-Year Bond Spread -0.12 -0.10 -0.15 -0.10 -0.10 -0.05 -0.05 -0.05

Canada Yield Curve (30-Year 2-Year) 1.87 1.75 1.80 1.85 1.65 1.65 1.65 1.40

US Yield Curve (30-Year 2-Year) 3.44 3.25 3.30 3.25 3.15 3.00 2.80 2.70

EXCHANGE RATES CADUSD 0.96 0.95 0.94 0.96 0.97 0.98 0.99 0.99

USDCAD 1.04 1.05 1.06 1.04 1.03 1.02 1.01 1.01

USDJPY 98 100 102 102 103 100 98 98

EURUSD 1.33 1.29 1.24 1.23 1.22 1.23 1.25 1.27

GBPUSD 1.54 1.52 1.49 1.50 1.50 1.50 1.52 1.55

AUDUSD 0.90 0.90 0.88 0.87 0.85 0.88 0.90 0.99

USDCHF 0.93 0.95 0.99 1.00 1.01 1.01 1.02 1.01

USDBRL 2.30 2.10 2.05 2.05 2.06 2.09 2.08 2.05

USDMXN 12.65 12.60 12.50 12.50 12.52 12.53 12.62 12.75


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3

No Detroit Lurking in Canadian Muni MarketWarren Lovely

The largest municipal insolvency in US history is unoldingimmediately across the border, begging the question:

could a Detroit style bankruptcy happen here in Canada?Dont count on it. I Detroit isnt a harbinger o widescale US municipal deaultsand it doesnt appear tobeits even less the proverbial canary in the coal mineor Canadian municipalities.

Canadas municipal government sector is governeddierently than US munis, being subject to greater seniorgovernment oversight, characterized by traditionallyconservative iscal and debt management practices,generally possessing healthy socio-economic proles, and

endowed with strong credit ratings and healthy balancesheets. True, capital spending pressures exist, and in someselect cases, related debt accumulation could ultimatelythreaten credit ratings. But theres no equivalent toDetroit lurking in the shadows o Canadas municipalbond market. Debt burdens remain manageable andlimited net new bond supply should see municipal creditspreads continue to trade at the tight end o the rangeobserved in recent years.

Credit Ratings as Warning Signals

Detroits downall has been a long time coming. The citysdebt was downgraded to junk back in 2009 and a furryo subsequent downgrades in many cases pre-dated thebankruptcy ling by at least a year (Chart 1). Ratings or

other US munis have come under pressure, with Chicagodowngraded three notches by Moodys (to A3) one day

beore the Detroit bankruptcy announcement. But ratingagencies hardly envision a wave o downgrades settlingon the sector. Meanwhile, CDS spreads dont exactlybetray particularly elevated or broad based anxiety in theUS muni market.

Canadas local government sector remains solidlyinvestment grade. O the ty-odd entities rated by one oS&P, Moodys or DBRS, the vast majority are rated AA ohigher (Chart 2). Notwithstanding some isolated actionsthe average credit rating o Canadas large municipa

issuers is actually stronger today than it was beore theglobal nancial crisis.

Demographic Divergence and Other Dissimilarities

A mass exodus rom Detroit is commonly cited as akey catalyst or the citys inancial disaster. WhereasDetroits population topped 1.8 million in 1950, todaybarely 700,000 call it home. Once Americas th largesturban centre, Detroit barely cracks the top 20 today. Nomajor Canadian municipality has suered the same saddemographic ate (Chart 3).

Household ormation, alongside a more resilient jobsmarket, a more closely regulated mortgage market anda strong banking sector spared Canada rom a US-style

Chart 1

Detroit Credit Ratings Under Pressure or Years

Source: Moody's, S&P, CIBC

Chart 2

Canadian Munis are Solidly Investment Grade

Source: Moody's, S&P, CIBC

Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13

Detroit Average Credit Rating (S&P, Moody's)

A

BBB

BB

B

AA

AAA

CCC

CC 0

5

10

15

20

25

30

AAA AA+ AA AA- A+ A A- BBB+BBB BBB-

Distribution of Canadian Municipal

Credit Ratings


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housing contraction (Chart 4). This is an importantconsideration, given that property taxes generally accountor 40% o municipal revenue. As our upcoming MetroMonitor report will detail, the vast majority o Canadianmunicipalities continue to possess healthy economicmomentum. Nor do the large local economies northo the border suer rom the same degree o industryconcentration as Detroit.

Superior Fiscal Flexibility

Granted, a shrinking population and stagnating/unbalanced economy are hardly the sole precursors ormunicipal duress. A lack o scal fexibilityin particular,an inability to reely adjust revenue to better matchexpenseshas contributed to US municipal insolvenciesin the past (or example, in Orange County, Caliornia).

Fiscal fexibility is less a worry in Canada. In truth, itsoten deemed a credit strength. Keyed by a legislativerequirement to balance their operating budgets, andabsent US-style revenue constraints, Canadas locagovernment sector has a strong track record o matchingrevenue to spending (Chart 5). Its not always easy; to theextent tax measures are viewed as politically unpalatable,muted revenue growthan issue o latecan requirepainul spending restraint.

Still, provincial governments hold municipalities to

account, and wield the ultimate stick o provinciatrusteeship in the extreme case that a municipagovernment ails to live within its means. In Ontarioor example, provincial advisors remain in close contactwith municipal treasurers in order to monitor nanciahealth. More than mere oversightand a legal inability todeclare bankruptcynancial support rom upper levelso government provides a urther degree o comort tomunicipal investors, with meaningul long-term capitaunding rameworks and operational transers today morepredictable than in the 1990s.

Pension liabilities also tip the scale in Canadas avourDetroit carried a crushing pension burden into its Chapte9 ling and look across the US state/local governmentsector and youll ind plenty o other examples ostaggering pension shortalls. While there are challengesCanadian municipalities arent plagued to the samedegree by pension woes. In Ontario, or instancemunicipal employee pensions are jointly managed byOMERS. In recent years, contribution rates have beenincreased and benets reduced with a view to returning

Chart 3

Population Growing in Nearly All Major Canadian Cities

Source: Statistics Canada, US Census Bureau, CIBC

Detroit(MI)Saguenay(QC)

Thunder Bay(ON)Saint John(NB)

Sudbury(ON)Windsor(ON)

St.Cath.-Niagara(ON)Trois-Rivires(QC)

St.John's(NL)Qubec(QC)Kingston(ON)Peterborough(ON)Brantford(ON)

Winnipeg(MB)Montral(QC)

Victoria(BC)Regina(SK)London(ON)Sherbrooke(QC)Hamilton(ON)Moncton(NB)

Halifax(NS)Ottawa(ON)Guelph(ON)

Vancouver(BC)Kitchener(ON)Abbotsford(BC)

Gatineau(QC)Saskatoon(SK)

Kelowna(BC)Toronto(ON)

Barrie(ON)Oshawa(ON)

Edmonton(AB)Calgary(AB)

-30 -20 -10 0 10 20 30 40 50

% Change, 2000-2012

Chart

CDN Housing Has Supported Property Tax Revenue

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2000 02 04 06 08 10 12

Canada US

Resale Housing Price, Index: 2005=100

Source: Statistics Canada, NAR, CIBC


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Chart 6

Limited Debt at Local Government Level in Canada

Source: Statistics Canada, CIBC

the plan to ully unded status over the coming 10 to 15years. Granted, Canadian municipalities carry other post-retirement liabilities (including accumulated sick leave),but as weve seen more recently, benet reductions cansucceed in reducing these liabilities over time.

Capital Needs a Challenge

I theres a worry or Canadian municipalities, its long-term inrastructure needs. Despite extraordinary scalstimulus in the wake o the global recession, Canadian

cities still ace meaningul capital spending pressures. InEastern and Central Canada, these needs oten relateto the replacement o aging inrastructure. In WesternCanada, many cities are rushing to put in place theroads, sewers and other vital capital required to supporta burgeoning population and rapidly growing industrial

Source: CIBC

Chart 7

Recovery in Municipal Credit Spreads

base. Public transit needs are particularly pressing in thelargest urban centres.

Its worth noting that a growth-driven increase in debtdrove S&P to place the Region o Yorks AAA long-term rating on negative outlook. Still, the municipasector hasnt exactly abandoned conservative nancia

management in response to capital spending pressuresProvincial governments set down requirements or long-term borrowing and, as in Ontario, can cap the share orevenue consumed by debt servicing costs. In generala meaningul portion o capital spending continues tobe unded via development charges and other internasources, while sewer/water upgrades have generally beennanced by ratepayers. Nor have Canadian municipalitiesresorted to raiding debt/pension reserve unds to meetnancial pressuresan issue in some US jurisdictions.

All this has let local government net debt at a scant 2%

o GDP in Canadaa tiny raction o that carried at eithethe ederal or provincial levels o government (Chart 6)Across the border rom Detroit, or example, Windsorstax-supported debt burden is actually alling. And orCanadian municipal bond investors, supply undamentalslook constructive, with year-to-date gross supply holdingwell shy o the level digested in recent years. Little wondethen that municipal credit spreads are trading near thetight end o the range observed since the recovery tookhold (Chart 7).

With populations growing, economies reasonablydiversied, nancial management practices sound andprovincial oversight/support strong, investors in Canadasmunicipal government sector neednt ear a Detroit stylecrisis.

Chart

CDN Munis Have Successully Linked Revenue-Spending

Source: Statistics Canada, CIBC

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-2

0

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4

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1982 1987 1992 1997 2002 2007 2012

Revenue Spending

Year-over-Year Growth, %

0

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40

2005 06 07 08 09 10 11 12 13

Local Govt Federal Govt Provincial Govt

Net Debt-to-GDP, %

15

25

35

45

55

65

Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

AAA 10Y Muni Spread vs Ontario, bps


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6

Junes sudden bond market sell-o brought backmemories o 1994 or those o us o a certain age. It

seemed like virtually overnight, the spell that had beencast on the bond market, which had 10-year rates at1.6% as recently as late April, was broken (Chart 1). Themarket has it right rates were too low to be sustainedi an economic recovery truly takes hold in the US. But arewe looking at 2%, 3%, 4% or higher, and by when?

For that, its instructive to break down the actors thattook us to such incredibly low yields, how those will erodeover time, and what past sell-os can tell us, or not tellus, about how this time might dier. Collectively, theevidence suggests 3% yields will be with us in the next

six quarters or so, but that a our handle on 10-year ratesin the US and Canada will be much urther o.

How We Got There

QE or not QE, that is not the only question. Yields werealling long beore quantitative easing, and long beorethe Great Recession. That trend decline since the early1980s refected ading memories o the 1970s infationscare, a monetary policy commitment to price stability,and the resulting impacts on expectations or the mean

and potential variance o long term infation ahead.

That showed up in the two components that collectivelymake up the 10-year bond yield: the expected uture patho short term rates, and the term premium, dened asthe additional yield investors demand over and above the

One, Two, Three, Four, Where Are 10-Years Headed For?Avery Sheneld and Emanuella Enenajor

projected yield on rolling over short-term debt or the risko locking in. Lower infation implies that the central bank

will generally have to be less aggressive in hiking shortrates, given the trade-o that such hikes entail betweengiving up potential growth in the economy in exchangeor a dampening o infation. Moreover, since its the rearate o interest that matters, at lower expected infationrates, the same degree o economic braking is achievedat a lower nominal rate. That actor was the key driver othe steady decline in interest rates seen in the past ewdecades (Chart 2).

Low and stable infation also begets less uncertaintyabout the potential range o infation rates, thereby

reducing the term premium. That was the other, albeitless important, driver o the decline in 10-year yields since1981

1. Real rates (measured against expected infation

could be somewhat lower on 10-year debt becausemarkets, looking at the track record o central banksin recent decades, no longer assigned much risk thatinfation would end up well above the expected pathIt was much the same story in Canada, with the termpremium closely tracking that o the US (Chart 3) despitesome dierences in the path o central bank policy ratesduring this period.

And then, o course, we did have QE, which in its recentround, as well as in the twist operation that precededit, was directly aimed at reducing the term premium andfattening the yield curve. Estimates o its role vary andare necessarily imprecise, because we cant use a mode

Chart 2

Lower Short Rate Outlook Drives Drop in Yields

Source: Bauer and Diez de los Rios (2012), see endnote

Chart 1

The Cat is Out o the Bag: Bond Yields Trend up

Source: Bloomberg

1%

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Mar-200

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Jul-2

009

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US

fcst

10- ear interest


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7

to examine how QE has historically mattered, given thatthis is its rst incidence. Instead, models have looked at

equivalent changes in the stock o bonds outstanding,or at policy-change announcement day impacts on thecurve. Collectively, the various rounds o bond buying arethought to have pushed 10-year yields lower by roughly125 bps, carrying Canadian bonds and other substitutesalong or the ride.

Anatomy o the Sell-O

So whats changed? Mostly, the term premium, as marketsbrought orward estimates o when QE would be tapered

and then eliminated. The Fed has gone to great lengths,eventually i not initially successul, to reiterate that itsstatements on QE tapering need not imply that the pathor the ed unds rate had also become less dovish thanearlier envisaged.

To Ben Bernankes surprise, merely mentioning taperingreduced bond market expectations or uture supply onthe market enough to shed nearly hal the total benetso QE (Chart 4). So while there is still some normalizationrisk, likely to be seen when the Fed really does begin totaper and then end QE, more o that sell-o is behind usthan ahead o us.

Where are We Headed

Which brings us to the ultimate question: where are ratesultimately headed? History is actually not an easy guidebecause the results have been so variable. But i, as seemslogical, recent cycles will be more representative o thiscoming one than more distant cycles, there are reasonsor investors to be bearish, but not hyper bearish, on USand Canadian 10-years.

In the last cycle, during the period in which the US

economy hit its non-infationary potential, the real 10-year rate averaged roughly 1.6% (Chart 5). I, as weexpect, infation drits up to roughly 2% in 2014 andbeyond, that would be the equivalent to the nominal 10-year Treasury hitting 3.6% in ve years or so, given howlong it might take to close the currently yawning outpugap. Score one point, then, in avour o a airly gradualisttrend climb in bond yields.

Another angle is to look at the likely path or short rateswhich as we noted, is the other ingredient along with

the term premium that steers 10-year rates over timeImplied short rate expectations rom OIS, Eurodollar andsovereign bond markets also lean towards gradualismwith Canadas short rates and those o the US notconverging on 2% (a roughly zero real rate) until 2017(Chart 6).

Chart 3

Term Premium Falling Over Time

Source: Bauer and Diez de los Rios (2012), see endnote

Chart

Whoops! Bernanke QE Chatter Reverses Years oYield Repression

Source: US Federal Reserve, Bloomberg, CIBC

-150

-100

-50

0

50

100

QE: Impact on lowering

10-yr yield

Recent jump in 10-yr

term premium following

"tapering" talk

basis points

-2%

-1%

0%

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3%

4%

Jan-7

5

Dec-7

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Nov-8

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Oc

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Sep-8

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Term Premia Cda

Term Premia US

10-year term premium

Chart

US "Equilibrium" Rate Trends Lower

Source: CBO, BLS, Haver Analytics, CIBC

0%

2%

4%

6%

Q2-1988 Q2-1997 Q1-2005

10-yr real rate associated with US economy

reaching potential*

*avg interest rate in the 4-qtr period preceding a

historical closing in the output gap


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That makes sense on both sides o the border, or dierentreasons. In the US, the sheer scale o the output gapimplies that the Fed should be in no hurry to aggressivelypare back growth. In Canada, a record degree o leveragein the household sector means that any given bump inrates should entail a more meaningul drag on growth,due to the greater volume o debt being renanced. As

a result, the peak policy rate in the coming cycle couldend up being well below the 4.5% level achieved in theprior expansion.

Finally, in terms o where rates are headed through2014, we have Bernankes threat that he would pushback against an overly rapid run-up in yields that wouldthreaten the recovery, including the pledge to reinstitutemore QE to accomplish that. We have a clue to what sorto pace the Fed wouldnt see as excessive in a speech Benhimsel delivered back in March, in which he presented,as reasonable, a path that would take 10-year rates to

just over 3% by the end o next year (Chart 7). Thatsroughly in line with our projection, which has the 10-yearUS rate just a shade under 3% at that time.

How does the Canadian curve play out in that context?Two actors suggest that spreads will remain negativevs. Treasuries at the 10-year part o the curve, i onlymodestly so. First, given our aster orecast or US GDPnext year, America will make greater progress againstits output gap, helped by a more notable reduction inscal drag and its greater headroom or home building

gains. That is consistent with a slower climb in short ratesbeyond 2015.

Second, infation expectations might be better groundedon this side o the border, as seems to be the case inbreakeven rates implied by real return bonds (Chart 8).

The US might not see higher actual CPI rates in 2014 than

in Canada. But the uncertainties created by the mountaino earlier QE buying could have some earing lessprecision in containing infation thereater. Similarly, somewill argue that Americas greater government debt burdenprovides a greater temptation to infate it away. That tooleans to a lower risk premium or infation uncertaintiesat the 10-year horizon or Canadian bonds.

Add it all up, and its still a bear market or bonds aheadBut the panic o 1994 looks unlikely to be repeated, or atleast sustained, in the next two years.

Endnote Reference:(1) Bauer, G. and Diez de los Rios, A. (2012): An International DynamicTerm Structure Model with Economic Restrictions and UnspannedRisks, Bank of Canada Working Paper No. 2012-. We thank theauthors for providing us with their estimate of the term premium andexpecations components of Canadian and US 10-year rates.

Chart 6

Markets See US Playing Catch Up on Policy Rate

Source: Bloomberg, CIBC

0%

1%

2%

3%

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5%

2013 2015 2017 2019 2021

Canada

US

Market-Implied* Short Rate Path

*US: Fed funds & eurodollar

futures, Canada: OIS market,

yield curve

Chart 7

Sharp Jump in Rates Not a Part o FOMC Game Plan

Source: US Federal Reserve, Bloomberg, CIBC

1.5

1.7

1.9

2.1

2.3

2.5

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3.1

Jan-1

3

Jul-13

End-

2013F

End-

2014F

US 10Y Yield (%)

Forecasts From Bernanke's March

1st Speech

Chart

Markets See Greater US Ination Risk

Source: Bloomberg, CIBC

1.5%

2.0%

2.5%

3.0%

Aug-10 Nov-11 Jan-13

Canada US

Inflation expectations: long-term average


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Low Capital-Intensive Manuacturing in CanadaNot Necessarily a Bad Thing

Benjamin Tal

US manuacturing during the recovery. But it will be amistake to read too much into the impact o the potentiaenergy boom on US manuacturing. One would expectthe most energy-intensive manuacturing industriessuch as petroleum and coal, chemical, paper, printingand non-metallic minerals, to benet most rom recentdevelopments in US energy. However, the oppositehas been the case. Those energy-intensive industriesactually lagged the sector as a whole (Chart 2), in partrefecting the rapid improvement in energy eciency inUS manuacturing.

I the manuacturing recovery in the US was not led byenergy-intensive industries, it was certainly led by capital-intensive industries. Close to 75% o the improvement inmanuacturing activity since its trough was in industrieswith above-median readings o capital intensity (measuredas dollars o capital per worker) such as transportcomputers & electronics, primary metals and machinery(Chart 3). The shit rom labour-intensive to capital-intensive production is nothing new, but the trauma othe recession is working to accelerate this process. Duringthe past ve years, the ratio o production in high capital-intensive sectors to production in low capital-intensivesectors rose by more than 20%. Historically, it took eightyears to achieve an equivalent rise in this ratio.

The manuacturing sectors on both sides o the 49th

parallel recovered nicely rom the recession. But theimprovement in the US is not only stronger, it is also muchmore capital-intensive. However, beore you go long USmanuacturing, consider the act that capital intensitydoes not necessarily mean better prot or equity marketvaluation. In act, the dierent nature o the Canadianrecovery might give manuacturers here an edge as weenter the more mature stage o the recovery.

US Manuacturing RecoveryMore Capital-Intensive

The American manuacturing sector appears to beregaining momentum, ater sputtering earlier this year.But looking beyond the recent bumps, rom a cyclicalperspective, relative to other sectors o the economy, therebound in US manuacturing has been impressive. InCanada, while the recessionary pain was roughly in linewith that experienced in the US, the recovery has beenmuch less powerul (Chart 1). Since its cyclical trough,manuacturing activity has advanced by only 10% versusmore than 18% south o the border. As a result, thecurrent production level in Canada is still close to 8%below its pre-recession reading.

There is little doubt that the ongoing shale gas revolutionand the notable decline in natural gas prices did help

Chart 1

US Manuacturing Outperormed Duringthe Recovery

Source: Census Bureau, Statistics Canada, CIBC

Chart 2

Low Energy Prices Were Not Behind theImprovement in US Manuacturing Activity

Source: Census Bureau, CIBC

Manufacturing Production

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Canada

US

y/y % change

Production

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All manufacturing Energy intensive industries

Index 2005Q4=100

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08Q2-09Q2 09Q2-13Q1

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10

Naturally this led to a much more subdued improvementon the job ront, with the ratio o manuacturingproduction to manuacturing employment currently at arecord high and employment in the sector still almost16% below its pre-recession level (Chart 4).

In Canada the situation has been completely dierent.The more-muted manuacturing recovery was also lesscapital-intensive with the ratio o production in capital-intensive industries to non-capital-intensive industriesactually alling during the past cycle (Chart 5). Thistrajectory is working to widen an already wide 40%

gap between US and Canadian manuacturing capitalintensityrefecting not only the natural composition oCanadas manuacturing base, but also the act that inmany cases high capital-intensive sectors in Canada arenot as capital-intensive as their US counterparts1.

Is This a Good Thing or a Bad Thing?

Intuitively, the capital-intensive nature o the USmanuacturing recovery should be seen as good newsAter all, it means a more productive economy with all thepositive spin-os associated with it. While that might bethe case rom a long-term perspective, what does it meanor the here and now? Yes, capital-intensive industriestend to pay more but they account or only one-third oemployment (Chart 6), suggesting that higher pay doesnot ully compensate or the lack o job creation.

What about prot? Here again, reality is dierentthan perception. Despite the more capital-intensivemanuacturing trajectory during the past cycle, theoverall change in real operating prot in the US was notvery dierent than seen in Canada. In act, on average,

Chart 3

Capital-Intensive Industries Accounted For Most othe Improvement in US Manuacturing


Chart

US Manuacturing EmploymentStill Miles From Pre-Recession Level

Source: Census Bureau, BLS, Statistics Canada, CIBC

Contribution to

Production Growth

Since the Beginning

of Recovery (%)

Average

Capital

Intensity

$'000 per worke r

Transport 20.5Computers & Electronics 14.3

Primary metals 12.3

Machinery 11.2

Others 15.0

Fabricated metal prod. 8.5

Misc manufacturing 6.4

Plastics & rubber 6.0

Wood 4.9

Others 1.1

66.4

237.1

Chart

Relative to CDA, US Manuacturing Activity HasBeen Much More Capital-Intensive in Recent Cycle

Source: Census Bureau, Industry Canada, CIBC

Chart 6

Capital-Intensive Industries Pay Well,But Not Too Many Enjoy It

Source: Census Bureau, BLS, CIBC

Others

Employment

in capital

intensive

industries

Ratio of Production -

Capital Intensive to Non-capital Intensive

Industries

80

85

90

95

100

105

110

115120

125

130

07 08 09 10 11 12 13

Canada

USIndex 2007=100

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

0 100 200 300

Capital Intensity

AnnualMeanwage

$

($'000 per worker)

US DataProduction to Labour Ratio

90

95

100

105

110

115

120

06 07 08 09 10 11 12 13

Index 2006=100

% Below Pre-Recession

Level

-18%

-16%

-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

Production Employment


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11

prot in Canada rose aster than in the US during therecovery (Chart 7).

While that sounds surprising, the reality is that companiesthat depend largely on tangible assets or their competitiveadvantage are unlikely to earn superior returns on theirinvestment on capital. That is largely because those assetscan easily be replicated by competitorsa situation thatoten leads to excess capacity, price competition anderosion o returns on capital. In these businesses, growthrequires another plant, a distribution centre, a retail

outlet or capital to und growing accounts receivable orinventory.

Simply put, capital intensity is negatively correlated withprota act that is clearly illustrated in Chart 8. Overthe past twenty-ve years, return on equity on capital-intensive sectors was hal the return seen in non-capital-intensive sectors. The same goes or valuations, withnumerous studies nding that, on a consistent basis,low capital-intensive rms yield better returns than highcapital-intensive rms2.

Advantage Canada

The surge in capital-intensive manuacturing activitywas nanced largely by debt. Since 2010, borrowing bycapital-intensive rms has risen twice as ast as that amongnon-capital-intensive companies (Chart 9), bringing theirshare in total manuacturing debt to more than 80%.With debt interest payments already on the rise, the USmanuacturing sector is highly sensitive to any increasein interest rates. In contrast, the more labour-intensive

Chart

Borrowing by Capital Intensity in US Manuacturin


90

95

100

105

110

115

120

125

10 11 12 13

Capital intensive industries

Non-capital intensive industries

Index 2010=100

Chart 7

US Manuacturing Proft:Nothing to Write Home About

Source: Census Bureau, BEA, Statistics Canada, CIBC

Real Operating Profit

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

06 09 12

US

Canada

y/y change

5.0%

7.0%

9.0%

11.0%

13.0%

15.0%

17.0%

19.0%

21.0%

US Canada

Avg Y/Y Chg in Real OperatingProfit Since Trough

Chart

Capital Intensity Negatively Correlated with ROE

Source: Census Bureau, Statistics Canada, CIBC

Average ROE Since 1988

(Canada)

0

2

4

6

8

10

12

14

Capital

intensive

sectors

Non-capital

intensive

sectors

%

Capital Intensity vs. ROE

By Sector (Canada)

0

5

10

15

20

25

30

0 200 400 600

Capital Intensity

ROE(%)

($'000 per worker)

trajectory in the Canadian manuacturing sector suggeststhat Canadian manuacturers are not only more fexiblein adjusting to changes in demand, but also, given asimilar debt structure relative to their US counterparts, arenotably less sensitive to the eventual increase in interestrates. In addition to some improvement in commodityprices, that might add another actor in support o ourcall that corporate prots in Canada will outperorm thato the US in 2014.

Note:

(1) The gap might be overstated due to different depreciationassumptions utilized in the US and Canada.(2) See, for example, Elmasr Hassan Capital Intensity and StockReturns Journal of Investment Strategy Vol. 2 No. 1, or RaifeGiovinazzo Asset-Intensity and Cross-Section of Stock ReturnsUniversity of Chicago, 200.


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12

CANADA

ECONOMIC UPDATE

UNITED STATES

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Ater a surprisingly strong start to 2013, GDP growth likely decelerated to a 1.6% pace in Q2. That takes intoaccount both Alberta fooding and the Quebec construction strike and is somewhat rmer than the Banko Canadas ultra-cautious call. Although consumer spending acquired some speed, trade likely contributedlittle to growth in the quarter as a whole despite Junes solid numbers. Even with a second hal lit romreconstruction, real GDP o only 1.7% this year should help to keep infation under wraps, giving the Banklittle reason to begin tightening beore early 2015.

Revisions to US GDP data painted an even starker picture o sluggish growth toward the end o 2012 andat the start o this year. But strong June exports could see Q2 revised upward, and are another sign o lie inthe previously lackluster US manuacturing sector. Whether the Fed will taper as early as September remainsa close call. However, given our modest 2% orecast or Q3 GDP, and subdued core infation, we continueto lean towards a Q4 reduction in asset purchases. By that time growth should be starting to pick up moreappreciably ahead o a strong 2014.

CANADA 13Q1A 13Q2F 13Q3F 13Q4F 14Q1F 14Q2F 2012A 2013F 2014F

Real GDP Growth (AR) 2.5 1.6 1.8 2.2 2.4 2.5 1.7 1.7 2.3

Real Final Domestic Demand (AR) 0.6 1.4 1.3 1.6 1.7 1.5 2.3 1.4 1.6

All Items CPI Inflation (Y/Y) 0.9 0.8 1.3 1.9 1.7 2.0 1.5 1.2 2.1

Core CPI Ex Indirect Taxes (Y/Y) 1.3 1.2 1.5 1.7 1.5 1.6 1.7 1.4 1.7

Unemployment Rate (%) 7.1 7.1 7.1 7.1 7.0 6.8 7.3 7.1 6.8

U.S. 13Q1A 13Q2A 13Q3F 13Q4F 14Q1F 14Q2F 2012A 2013F 2014F

Real GDP Growth (AR) 1.1 1.7 2.0 3.1 3.8 3.8 2.8 1.5 3.3

Real Final Sales (AR) 0.2 1.3 2.5 2.9 3.8 3.8 2.6 1.6 3.3

All Items CPI Inflation (Y/Y) 1.7 1.4 1.8 2.0 2.1 2.2 2.1 1.7 2.3

Core CPI Inflation (Y/Y) 1.9 1.7 1.8 1.8 1.8 1.9 2.1 1.8 2.0

Unemployment Rate (%) 7.7 7.6 7.4 7.2 7.0 6.8 8.1 7.5 6.7

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