The Weekly Bottom Line

HIGHLIGHTS OF THE WEEK

United States

Negotiations between Greece and its international lenders kept financial markets switching the risk button on and off throughout the week. A parliament vote on further austerity measures has been scheduled for Sunday; if it fails, Greece could default in March.In the U.S. initial jobless claims declined, bringing total claims down to levels not seen since September 2008.A $25 billion deal between the White House and five leading commercial lenders was announced on Thursday. It will help underwater homeowners to refinance their loans. It is a positive step, but arguably one with limited macroeconomic impact.

Canada

Canada's trade surplus more than doubled in December, on the back of a sharp 4.9% gain in exports. The trade surplus is now the highest since the recession began in 2008. The real trade balance puts some upside risk to our forecast of 2.0% real GDP growth in Q4.Over 2012, the Canadian export sector will likely benefit from a cyclical rebound in U.S. demand for manufactured goods such as autos and machinery and equipment. Nonetheless, Canadian exporters will likely continue to face significant competitive challenges, such as a lofty loonie and poor productivity growth, in the U.S. market. A long-term strategy on export growth should involve diversifying trade into other non-U.S. economies.

Greek debt talks dominated headlines once again this week. Negotiations between Greek political leaders and EU/IMF officials led to a tentative agreement on further austerity measures that would enable the latter to sign off on the second Greek bailout program. The initial positive reaction faded late on Thursday when European officials made clear the program will not be finalized until the Greek parliament passes the new austerity measures. The vote is scheduled on Sunday. At the time of writing, the S&P 500 was down 0.8% on the week, and European stocks were in the red by an even larger margin.

In the U.S. there were some positive developments both in the labor and credit markets. A drop in initial jobless claims brought total jobless claims below 3.89 million, a figure comparable to levels last seen in September 2008. Jobless claims resumed a declining trend after hitting a plateau during the third quarter last year. As such, their recent performance is encouraging because it adds to the momentum shown by other indicators signaling improvement in the labor market. In the credit market, consumer loans rose for the third month in a row during December 2011. Sustained improvement in employment should reinforce that trend going forward, lending support to households' consumption.

Another relevant piece of news this week was the announcement of a $25 billion deal brokered between the Obama administration and five leading commercial banks, which will bring some relief to mortgage borrowers. The deal was the result of a yearlong negotiation involving the lenders and the attorney generals of several states. In principle, this initiative will only reach homeowners with mortgage loans held by the five lenders involved. The banks have agreed, among other things, to reduce the principal owed on the loan in those cases in which the market value of the property is significantly less than the remaining balance on the loan. This is an important step in the process of healing the housing market.

However, when measured against the size of the challenge, the program appears to be small, despite of the $25-billion headline figure. The negative equity - the excess loan balance over the house market price - is estimated to be around $700 billion. Moreover, commercial banks hold around $2.13 trillion in outstanding family residential mortgage loans, while the equivalent amount held by all lenders is around $10 trillion. Therefore, from a macroeconomic perspective, the deal will have a limited direct impact. Nevertheless, it is important because it could contribute to a more normal functioning of foreclosure procedures. Although this might have an initial dampening impact on prices, it is an unavoidable step in order to stabilize the housing market.

Indeed, anything that would temper some of the domestic economic headwinds is most welcomed, given that the U.S. economy will struggle to gather any strength from abroad due to the modest global outlook. December's trade balance figures released today pay testimony to this claim: the deficit widened by 3.6% on the month to reach $48.8 billion. On net, the external sector will likely subtract from overall growth during 2012. Thus, it will be up to domestic demand to generate the thrust needed to keep moving the labor and housing markets in the right direction.

The most pleasant Canadian economic surprise this week emerged from the international merchandise trade report. Exports surged 4.9% in December, pushing the trade surplus to $2.7 billion - the highest level since the recession began in 2008. The improvement in the real trade balance poses an upside risk to our current forecast of 2.0% real GDP growth in the fourth quarter.

Canada appears to be benefiting from a cyclical rebound in U.S. demand for key manufactured goods such as autos and machinery and equipment. Some of the Q4 momentum is likely to carry forward into 2012 as the recovery in U.S. employment and consumer credit has made modest improvements over the last few months. Indeed, exports are likely to grow at a pace that is twice as strong as overall real GDP growth in 2012. Canadian economic growth led by exports is exactly what the doctor ordered, especially with domestic demand burdened by high household debt loads.

Despite the cyclical snap-back in U.S. demand, Canadian exports are expected to continue to face long-term challenges in the U.S. market. In fact, in real terms, Canada exported fewer goods in 2011 than was the case in 2000 as a lofty loonie and poor productivity performance has eroded the competitiveness of Canadian-made goods. The competitive challenge has been and will remain a major headwind for the nation's manufacturing sector. In contrast, exports of resources such as energy and agricultural products have climbed to record highs and continue to enjoy strong demand from emerging markets, as well as high prices.

Canadian exporters are going to have to increasingly turn their attention to diversifying trade away from U.S. markets. For one, the U.S. recovery remains fraught with risks that could derail growth, such as the large fiscal imbalance. Looking beyond the near term, real GDP growth in the U.S. will likely run at to an average annual pace of around 2 %, compared to an average of 5.0-6.0% in major emerging markets like China, India and Brazil. We expect that the Canadian economic contribution from exports to the U.S. will likely average 0.8% over the next decade, almost a third of the contribution experienced at the height of the U.S.-Canada trade relationship during the 1980s and 1990s. As such, Canadian exporters should be looking for ways to take advantage of the growing demand for world goods and commodities from other non-U.S. economies.

Canadian exporters have already made significant headway in reducing their reliance on trade with the United States. The U.S. now only accounts for 72% of Canadian exports compared to 84% in 2000. Exports to the U.S. are down 14% from decade ago levels, while trade with other countries like emerging Asia and Europe has more than doubled over the last decade. The shift towards expanding trade with other non-U.S. economies will likely be supported by a slew of Free Trade Agreements already signed or under negation by the federal government. Among the most important include a Canadian-Europe Comprehensive Economic and Trade agreement, which the government of Canada estimates will boost Canadian exports to Europe by 20% once signed and sealed - an event expected to occur sometime in 2012. Progress has been good, but building trade bonds with other non-U.S. economies should remain a key initiative for Canadian policy makers.

Release Date: February 14, 2012December Result: Retail Sales 0.1% M/M; ex-autos -0.2% M/M; ex-autos & gas 0.0% M/MTD Forecast: Retail Sales 0.8% M/M; ex-autos 0.5% M/M; ex-autos & gas 0.3% M/MConsensus: Retail Sales 0.7% M/M; ex-autos 0.5% M/M; ex-autos & gas 0.4% M/M

After the disappointing performance in December, we expect consumer spending to rebound nicely in January, with retail spending activity advancing at a respectable 0.8% M/M pace. This will mark the biggest rise in this indicator since September and will be consistent with the better tone in labour market activity in recent months and the rebound seen in consumer confidence more generally. Much of the improvement should come from gains in auto sales, while higher gasoline prices should more than compensate for the drop in gasoline volumes. Excluding transportation, sales should rise at a decent 0.5% M/M pace, while core sales should advance at a 0.3% M/M pace, following the flat print the month before reflecting. In the coming months, with the economy regaining its footing and labour market activity continuing to show signs of positive momentum, we expect the gains in spending to be sustained and should continue to provide a favourable backdrop for economic activity going forward.

Release Date: February 15, 2012December Result: Industrial Production 0.4% M/M; Capacity Utilization 78.1%TD Forecast: Industrial Production 0.5% M/M; Capacity Utilization 78.5%Consensus: Industrial Production 0.6% M/M; Capacity Utilization 78.6%

With the economic recovery appearing to be gathering steam, we expect strong manufacturing sector activity to continue to provide a source of positive momentum for overall industrial production activity. In January we expect strong automobile production will further underpin improvements in overall activity, with headline production advancing at a very brisk 0.5% M/M pace. This will mark the 8th monthly gain in this indicator in the past nine months, underscoring that the strong rebound in manufacturing activity from the supply-chain induced slowdown last year is being sustained. Given the unusually warm weather, we expect utility production to decline for the sixth straight month, partially offsetting the positive momentum in manufacturing activity, while mining production should be higher. Moreover, with the global economic recovery appearing to be regaining traction, we expect the gains in manufacturing to be sustained. In terms of factory usage, we expect the pace of capacity utilization to hit a new cyclical high, rising to 78.5% up from 78.1% the month before.

Release Date: February 17, 2012December Result: CPI 0.0% M/M; Core CPI 0.1% M/MTD Forecast: CPI 0.3% M/M; Core CPI 0.2% M/MConsensus: CPI 0.3% M/M; Core CPI 0.2% M/M

After remaining largely unchanged for two straight months, we expect the pace of headline inflation to accelerate to 0.3% M/M in January, marking the fastest pace of consumer inflation since September. Higher energy, driven mostly by gains in gasoline prices and gains in food prices should be the key catalysts for the gains in the headline number. Excluding these items, core price inflation should advance at a slightly more modest 0.2% M/M pace (+0.173% M/M at 3-decimal places), as gains in OER and new vehicle prices are expected to offset further declines in used vehicle and apparel prices. On an annual basis, core inflation should remain unchanged at 2.2% Y/Y, though the pace of headline consumer price inflation should continue its downward trajectory, falling to 2.7% Y/Y from 3.0% Y/Y the month before. Looking ahead, with the economic recovery still weak and commodity prices moving sideways, we expect headline consumer price inflation to moderate further, though core inflation should remain firm around the 2.0% Y/Y mark.

Release Date: February 16, 2012November Result: 2.0% M/MTD Forecast: 2.0% M/MConsensus: 1.0% M/M

Manufacturing sales are expected to rise for a second consecutive month by 2.0% M/M in December, the same pace as the month before. While weaker producer prices will weigh on total nominal sales, this will be offset by strong exports. Indeed, the recent release of the international trade report revealed universally strong export growth both in nominal and real terms. Auto exports, improved US demand and the build up of new and unfilled orders will provide a boost to sales. After adjusting for the impact of changing prices, sales are poised to post a robust gain in the month, which will bode well for industry level real GDP. Heading forward, we are cautious towards the outlook in light of the uncertainties on the global front, but should US economic momentum be sustained, manufacturing sales will benefit.

Release Date: February 17, 2012December Result: CPI -0.6% M/M; Core CPI -0.5% M/MTD Forecast: CPI 0.3% M/M; Core CPI 0.2% M/MConsensus: CPI 0.3% M/M; Core CPI 0.0% M/M

The non-seasonally adjusted all-items index is expected to rise by +0.3% M/M in January, following the sharp 0.6% decline in December. While seasonal factors are expected to be at play (we expect the seasonally adjusted price series to rise by 0.4%) - including the typical discounting effect in both the clothing and recreation sub-components of the CPI - the bias for the other sub-categories is up. One of the most pronounced increases is expected to come from transportation, largely driven by higher gasoline prices. Moreover, the increase in the Quebec Sales Tax (QST) is expected to contribute to a temporary +0.1% pop to headline CPI and will remain a factor in pushing the year-ago rate of inflation higher for the next 12 months. Measured on a year-ago basis, headline inflation is forecast to remain unchanged at 2.3%.

The non-seasonally adjusted core index is forecast to rise by +0.2% M/M, bringing the year-ago measure to 2.1%. After stripping out the impact of the seasonality, the seasonally-adjusted core price index should increase by 0.3%. All told, inflation is likely to stay toasty before a slower growth trajectory will help core prices decelerate below the 2.0% target by the middle of the year.