Bank of Canada’s optimism questioned

By Mark Noble | July 21, 2009 | Last updated on July 21, 2009
5 min read

As promised months earlier, the Bank of Canada chose to stand pat on holding its current overnight lending rate at 0.25% until the second quarter of 2010. With this announcement came some of the rosiest economic predictions seen in months.

In the decision statement, the bank said the “dynamics of the recovery” in Canada remain essentially the same as were reflected in its April Monetary Policy Report (MPR), and added that the stimulative monetary and fiscal policies, improved financial conditions, firmer commodity prices, and a rebound in business and consumer confidence are spurring domestic demand growth.

However, a higher-than-anticipated Canadian dollar, compounded by the drive by Canadians to shore up their personal balance sheets, is “significantly moderating” the pace of overall growth.

The Bank projects the economy will contract by 2.3% in 2009 and then grow by 3.0% in 2010 and 3.5% in 2011, reaching production capacity by mid-2011.

The Bank also expects the consumer price index, which contracted 0.3% in June, to trough in the third quarter of this year before returning to the to the Bank’s 2% target in the second quarter of 2011. The Bank expects core inflation to diminish in the second half of this year before gradually returning to 2% in the second quarter of 2011. It held up at 1.9% in the second quarter of 2009.

Bank projections viewed as optimistic

While many private sector economists agree that we’re firmly on the road to recovery, they stress the challenges to get back to economic capacity are likely more difficult than the projections offered by the Bank would suggest.

“Today’s policy announcement didn’t change anything that [Bank governor] Carney is doing, but the central bank is clearly less worried about the downside risks to growth. That degree of optimism, however, may understate the structural challenges to brisk growth abroad, and the risks to Canada from an overvalued exchange rate,” says Avery Shenfeld, chief economist at CIBC World Markets. “The sunnier view for what remains of 2009 certainly has merit. The U.S. economy appears to be turning toward modestly positive growth in the third quarter. Judging by a flurry of home sales, Canadian households are also looking at the world through a rosier pair of glasses.”

“The Bank’s improved call for -2.3% growth in 2009 looks about right,” Shenfeld says. CIBC also predicts growth will resume in Canada in the coming quarter, rather than Q4 of this year. It’s in 2010 that CIBC’s forecast drastically departs from the Bank.

“A 3% real growth outlook for 2010 seems ambitious. Due to the differences between yearly averages and quarterly growth rates, meeting the Bank’s target would require the four quarters of 2010 to average roughly 4% annualized growth. That looks like quite a stretch with U.S. consumers hampered by weak balance sheets, and Canada’s exporters pinched by a firm loonie,” he adds. “We expect growth to run at roughly half the Bank’s call. That difference would be material for the interest rate outlook in 2010. Under the Bank view, monetary tightening might make sense in the last half of next year, but it wouldn’t if, as we expect, growth is too slow to make headway on the unemployment rate and the output gap.”

TD’s economists also have a much more muted forecast for 2010, says one its economists, Grant Bishop.

“Our forecast numbers were considerably weaker for the rebound in 2010. Their 2011 forecast, is roughly consistent with what we have — they have 3.5% and we have 3.3%. The 2010 growth rate does have the output gap. They see the Canadian economy [moving toward capacity] in 2009 we don’t see it closing the gap until the end of 2012,” Bishop notes. “[It won’t be until Thursday] until we see explicitly where the Bank sees that 3% growth coming from. Obviously exports are quite weak and we foresee them staying weak and contracting in 2010, and then slowly regaining some speed.”

As this lag in output continues it puts further downward pressure on prices and wages. Bishop suspects the Bank may be underestimating pressures on domestic demand and commodity prices. They well recover from their current levels, but they won’t be anywhere near where they were before the recession hit.

“There is an increased pressure for Canadians to save, and that diminishes consumption. So we are going to see some nominal rebound, in commodity prices but we are not expecting to see the heights that we did previously did in 2007/2008,” he says.

The bearish view

At the opposite end of the spectrum is iconic fund manager Eric Sprott, CEO and founder of Sprott Asset Management. Sprott believes investors are deluding themselves if they think things are getting substantially better. In his view, we are actually in early stages of a depression, according to his latest market commentary, entitled “It’s the real economy, stupid.”

“You wouldn’t know it by reading mainstream papers — they all focus on the relative decline in the slowdown’s intensity. Slowing down is not the same as growing, however, and doesn’t warrant excitement in our opinion,” Sprott says.

In his commentary, Sprott points out global economic data remains dismal. For example, the U.S. industry used only 68.3% of available capacity in May 2009, according to a monthly report from the Federal Reserve. Prior to the current recession, the lowest rate recorded since the Fed started this series of records in 1967 was 70.9% in December 1982.

Amongst other stats, Sprott also points out every state budget in the United States, except Vermont, will run a deficit — a collective $121 billion — and the federal government will see a more than a $1 trillion shortfall in spending to tax revenue for the 2009 fiscal year.

Unemployment remains at multi-decade highs. Sprott says the June 2009 jobless rate reached 9.5%, the highest since 1983. In addition, four million Americans have been looking for work for more than 26 weeks, representing 29% of the unemployed. That’s the highest figure since records began in 1948.

Sprott argues the real economic data doesn’t support the underlying stock valuations which seem to be fueling growing amounts of market optimism, since the earnings expectations for many stocks are not all that strong.

“There’s the real economy which generates the earnings, and then there’s the investor sentiment/perception which dictates the multiple they are willing to pay for those earnings. We already know that the real economy is in severe decline. What happens if investor sentiment changes?” Sprott says.

Sprott outlines three scenarios ranging from flat earnings which result in investor pullback to a “double trouble” scenario where earnings are halved and investor sentiment once again erodes.

“We find the similarity between the 2008 economic collapse and the 1929 economic collapse disturbing. Don’t get sucked in… the real economy is still struggling and the market has yet to reflect this. In 1932, the Dow Jones Industrial Average bottomed 90% below the September 1929 peak,” he writes. “The S&P 500 Index peaked in October 2007 at 1,576, and we can easily calculate a drop in the S&P 500 of as much as 88% from that peak using our ‘double trouble’ scenario. At the very least, under all our scenarios, it appears the S&P 500 Index will test the March 2009 low of 666. Judging by the continued declines we are seeing in the real economy, we expect that test to happen sooner rather than later.”


Mark Noble