Weekly Economic Letter

Canada – In July, the merchandise trade deficit did worse than expected by consensus (-C$1.5 billion), widening to -C$2.335 billion from a downwardly revised -C$1.9 billion the month before (initially -C$1.8 billion). This was the worst deficit on record since 1971. Exports fell 3.4% with declines in all the major subsectors save for industrial goods/materials. Auto exports, for their part, sank 5.3%. Imports sagged 2.2% with just a handful of sectors recording increases. In real terms, exports and imports both retreated 1.7%. Surprisingly, the rebound in commodity prices had little impact, with the energy trade surplus actually diminishing. The poor showing by auto exports was surprising as well in light of the good vehicle sales reported in the United States. Perhaps our auto exports will bounce back in the months ahead.
Nevertheless, overall trade, which was a huge drag on Canadian growth in Q2, seems to be worsening in synch with the tepid economic growth south of the border. In fact, with July's drop, real exports are tracking at -6.4% in Q3, versus 0.8% in Q2. The decrease in real imports of machinery and equipment suggests some headwind for business investment spending as well in Q3 after a decent Q2.

In August, housing starts soared to 225K, easily topping consensus, which was looking for a drop to 200K. The 8.1% increase was driven by multiples (+15.5%) while singles were roughly flat. In urban areas, starts were up in all regions except Quebec, where they fell instead 9.8%. Starts were up 20.4% in Ontario and 18.2% in B.C. However, the Atlantic Provinces registered the sharpest percent increase at 47.5%. The strength in August starts was surprising, although for the quarter as a whole, residential construction is moving as expected towards a deceleration. Based on two months of data, housing starts are tracking at an annualized -22% in Q3, with both multiples and singles down more than 20%. Hence, after contributing to Canadian GDP for six straight quarters, residential construction seems to be turning into a drag in Q3. Residential construction should soften even further through the rest of the year and early 2013 as the full impact of the new mortgage rules is felt.

Back in July, manufacturing shipments slipped 1.5% in nominal terms, flying in the teeth of consensus expectations. Worse still, the prior month’s figure was revised down four ticks to -0.8%. Sales were down in 11 of the 21 industries, with the other 10 generally posting minor gains. Weakness in the month was broad based, though transportation equipment stood out with a notable 6.4% drop in sales. In volume terms, shipments slid a sharp 2%. The real inventory-to-shipments ratio jumped to 1.38, its highest mark since February. The shipments data were very soft (the fifth monthly decline in the first seven months of 2012) and, with one month of data in, volumes growth is currently tracking at -6.6% annualized in Q3 (versus +8.7% in Q2).The rather high ratio of inventory to shipments suggests that production will be contained for the balance of Q3 after the significant inventory build-up in the prior quarter (remember the Q2 GDP report). The strong currency is not helping either. Indeed, in addition to the soft global economic picture, the highly stimulative monetary policy south of the border is pushing the loonie to multi-month highs, thus making matters worse for an already struggling export sector.

United States – In July, the trade deficit pegged in at $42 billion, little changed from an upwardly revised $41.9 billion in June. Exports fell 1% (or $1.9 billion) while imports dropped 0.8% (or $1.8 billion). Exports of food, feed and beverage rose on the back of higher prices while capital goods exports were lifted by aircraft exports. Excluding food and aircraft, exports showed broad-based weakness. In real terms, exports slumped 2.2%, while imports increased just 0.1%.

In August, retail sales rose 0.9%, near consensus expectations. However, the prior month was revised down two ticks to 0.6%. Auto and parts sales sprang 1.3%. Excluding these, sales were up 0.8%. Higher prices contributed to boost gasoline sales up 5.5% in the month. Sales of housing-related categories such as building materials and furniture continued to advance after a strong July. Discretionary spending (i.e., retail sales excluding gasoline, groceries, and health/personal care) swelled 0.4% after growing 0.6% the prior month.

Again in August, U.S. industrial production declined 1.2%, leagues below consensus expectations. Manufacturing output contracted 0.7%, pretty much in line with what the ISM, Empire and Philly indices were pointing towards.

Auto assemblies dropped 7.5%, likely the result of retooling that had been postponed in the past. Mining was very weak as well. Output fell 1.8% owing in part to precautionary shutdowns in the face of hurricane threats and reversing the gains of the previous three months. Utilities output, too, surprised to the downside with a 3.6% drop in the month. Capacity utilization ducked a full point to 78.2%. In sum, the industrial production report for August was very weak, although part of the weakness could be attributed to temporary factors. Mining output will likely rebound as plants resume normal operations after the weather-related shutdowns. Auto output, also, should bounce back as retooling nears completion and producers will try to keep up with strong demand for vehicles. Still, the month’s awful results will weigh down on Q3 GDP, likely translating into yet another sub-2% print. It should be noted that industrial output, which grew at an annualized pace of 2.6% in Q2, is now tracking at just +0.2% in Q3.

Auto assemblies, which grew at 15% annualized in Q2, are currently running at half that pace in Q3 In other news, the consumer price index (CPI) was up 0.6% in August buoyed by higher energy prices (gasoline accounted for 80% of the increase in the month). The annual inflation rate notched in at 1.7% in line with expectations. Excluding food and energy, prices edged just 0.1% higher, pulling the year-on-year core CPI down two ticks to 1.9%. On a 3-month annualized basis, core inflation was running at just 1.4%, its lowest level since December 2010.

At its September rate-setting meeting, the FOMC decided to extend by six months–"at least through mid-2015"–the period it expects to maintain its target rate in the range of 0% to 0.25%. Also and perhaps more eagerly awaited by markets, the FOMC announced it would embark on a new asset-purchase program, that is, the long-awaited QE3. Accordingly, the Fed plans to purchase agency MBS at the rate of $40 billion a month (no end date to the program was specified). Operation Twist, for its part, would continue as stated in June. This means that, with the addition of the latest measures, holdings of long-term securities should grow by $85 billion per month through to the end of the year.

The Fed made it clear that if the labour market did not improve substantially, it would continue to purchase MBS, undertake further asset purchases, and resort to other policy tools as well. Justifying its decision, the Fed explained that it was concerned that, without more stimulus, economic growth might not be strong enough to generate a sustained improvement in labour market conditions.

Euro zone – According to Eurostat, industrial production (s.a) increased 0.6% in the euro area in July. Annual inflation was 2.6% in August, up from 2.4% a month earlier.

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