Economic Outlook

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Economic Outlook Capital Markets Investment
Counsel Association of Canada Montreal June
19th, 2008 Clément Gignac VP Chief Economist
Strategist
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Topics

• U.S. recession in the offing How long and deep?
• Emerging countries How long will the decoupling
  with the U.S. last?
• Canada Our reasons to remain cautiously
  optimistic
• Capital markets Where are we heading?

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Disclaimer
Parts of this presentation contain material that
may not be suitable for some viewers. National
Bank of Canada leaves it to the discretion of its
clients whether or not to accept the implications
of this scenario.
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A U.S. housing bubble pop and a halt to
securitization activity!

• Part 1
• The world has changed !

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Price of a single-family home as a ratio of
median family income
Ratio
Average 1980-2000
NBF Economic Research, Federal Reserve
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U.S. mortgage securitization activity suspended
From 4 of GDP
Quarterly change in value outstanding ( billion)
to -2.0 !
NBF Economy Strategy (data via Federal Reserve)
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A recipe for bubble creation by John Kenneth
Galbraith (1972)
Ingredients needed1- Wall Street Financial
Innovation (like CDOs now) 2- Easy access to
credit (ex subprime mortgages)3- Lack of
disclosure by participants (off balance sheet
items)
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U.S. Precautionary increase in loan-loss
provisions As of average assets, U.S.
FDIC-insured institutions
Source FDIC
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Credit crunchImplications on banks and
monetary policy
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Risk aversion is back ABCP are back on banks
balance sheets
Canada
U.S.
billions
billions
NBF Economy Strategy
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Now playing at a Wall Street theatreThe
Survivor
Citigroup share price
Dividend cut predicted
Dividend cut confirmed
Meredith Whitney, Oppenheimer analyst
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The Fed to the rescueSequence of
non-traditional actions

• Dec 12, introduces the Term Auction Facility
  (TAF) and arranges currency swaps with ECB and
  Swiss National Bank, BoE and BoC.
• Dec 21, announces that TAF will continue for as
  long as needed.
• March 7, again increases the size of TAF and
  initiates term repos with primary dealers.
• March 11, upgrade its Term Securities Lending
  Facility, up to 200 billion of Treasury
  securities for 28 days against agency debt
  (Fannie Mae and Freddie Mac) or AAA MBS.
  Increases currency swap with ECB and SNB.
• March 16, cuts the discount rate by 25 bps after
  a Sunday meeting. Create a lending facility to US
  primary dealers for the first time since the
  Great depression on a backdrop of Bear Stearns
  rescue by JP Morgan

and do not exclude additional bold moves from
the Fed
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US CRE concentration larger than ever
One third of institutions with CRE loans more
than 3 times equity

33.4
FDIC-insured institutions with commercial real
estate loans to total equity greater than
End of year
2008 As at March 31
Source FDIC
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Monetary Policy Broken transmission mechanism?
Spread Mortgage rate and government bonds
Fed funds et Mortgage rates

Basis points
Mortgage rate
Fed funds
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US Economic OutlookChoosing between 4 scenarios?

• Sub par GDP growth (1966, 1986 or 1995 episodes)
• Recession (7 times over the last 50 years)
• Stagflation (a 1973-75 commodities like the 70s)
• Depression (US in the 30s and Japan in the 90s)

PS As usual, we are trying to stay middle of the
Road!!!
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U.S. BUSINESS CYCLEThe real question is no
longer whether or not the U.S. will go through a
recession, but rather how long and deep it will
be
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U.S. Consumers feel miserable
Michigan sentiment survey and real wage bill
Financial obligations and spending on energy as
a of disposable income
(y/y)
index

Wage bill(left)
Michigan Sentiment(right)
Deflated with CPI inflation
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U.S. households Time to rebuild the savings
rate?
Home equity withdrawal as of disposable income
Rate of saving


NBF Economic Research
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US 1 increase in unemployment rate usually
heralds a recessionChange over 12 months

Global Insight
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U.S. Recessions could have different amplitude
and duration
Duration of GDP contraction
Rise in unemployment rate
Mean9 months
Mean 2.6 pp
Duration in Months
Percentage points
NBF Economy Strategy (data from Datastream)
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Any message of hope?
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US Unprecedented amount of rate cuts in a short
period of time

2-year Treasuries
Fed funds
NBF Economic Research, Datastream
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U.S. Economy Bottom line

• The ongoing rates cuts, falling dollar and
  upcoming fiscal stimulus should prevent a deep
  and prolonged US recession
• at least for now as we believe oil price will
  return to 80 over the next 12 months

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Risk factor Geopolitics in Middle East and
higher oil prices
OIL Price Nominal and real

Réel ( de 2006)

Nominal
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U.S. Risk factor Protectionism on the rise?
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The U.S. is no longer the powerhouse of the
global economy
Part II International

• The world has changed !

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World economy An ebbing of U.S. hegemony
of global GDP
BRIC
U.S.
NBF Economic Research, IMF (World Economic
Outlook, April 2008)
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BRIC and Middle East account for half of global
growth
Over half of the 3.7 increase in world GDP in
2008 to come from emerging markets !
, share of global GDP growth
Advanced economies
Emerging markets
NBF Economic Research, IMF (World Economic
Outlook, April 2008)
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China Industrializing very fast Percentage of
population living in cities China versus U.S.
of total population
U.S. urbanization since 1840
Forecast for 2011
2004
2000
Every year more than 25 million Chinese people
move to cities
1990
1978
NBF Economic Research, Census Bureau, China
Statistical Yearbook
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Commodities A new paradigm or history likely to
repeat itself
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Emerging countries theme

• Any risk factors?

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China Will authorities be too complacent on
growth?
CPI inflation Emerging Asia vs. G7 economies
Elasticity ratio of energy consumptionChina
vs. G7 economies
(y/y)
Ratio (3-yr moving average)
China
G7 economies
Emerging Asia
G7
Defined as the ratio of the growth rates in
energy consumption and real GDP
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Risk factor Food prices
world population living in urban area
CRB foodstuff
index

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Leading indicators Synchronized decline in
momentum!!!
BRICs
World
OECD
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World GDP Back to trend growth rate in
2008? Real world GDP growth
Average 1970 2006
NBF economic research, IMF
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Canadian Economy Why are we much more upbeat
about prospects in Canada than in the USA?
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Real estate Canada not at risk according to the
IMFIncrease in home prices over the period
1997-2007 not accounted by fundamentals
House price gap ()
International Monetary Fund (April 2008)
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Canada Strongest public finances in the G-7Net
government debt
of GDP
NBF Economic Research, Finance Canada
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Net exporter of resources Surging terms of
trade Ratio of export to import prices
NBF Economic Research
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External sector Canadian surplus, U.S. deficit
Current-account balance
Foreign-held debt
of GDP
of GDP
NBF Economic Research, Finance Canada
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CAD closely ties to commodities CAD vs. CRB
futures index
USD/CAD
CRB ijndec
CAD/USD(right)
CRB futures(left)
NBF Economy Strategy (data from Datastream)
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Warning Economics 101 Canada has great
fundamentals but our economy will not be immune
from a U.S. recession
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GDP growth Temporary soft-patch to be expected
in 2008 Real GDP, 2008 forecast

Canadian average 1.5
NBF Economic Research
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Bottom line BOC rate cuts not over yet in Canada

BoC overnight rate
Fed funds rate
NBF Economic Research, Datastream
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SPTSX
12,800
14,863
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Capital markets Volatility will remain for
some time
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Capital markets Volatility is back in stocks and
bonds!CBOE VIX and MOVE indexes, 40-week moving
averages
Index
Index
MOVE index (L)
VIX index (R)
Merrill Lynch trademark product
Source NBF Economic Research, Datastream
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SP 500 Volatility is back of trading days on
which the SP 500 has moved more than 1
First quarter 2008
NBF Economy Strategy (data via Datastream)
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Performance of equities in five U.S. recessions
SP 500 Composite and U.S. real GDP growth
-19
-49
q/q annualized
From pre-recession peak to trough
-20
SP 500 (R)
-27
-36
In recession periods, the SP 500 pulls back an
average 36 from peak to trough
-48
U.S. real GDP growth (L)
U.S. recessions in gray
NBF Economic Research, Datastream
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Sector rotation Any place to hide during
recessions?
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Capital markets currently on the
edge!!! Downside and upside risks about the
same?
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Equities valuation looks cheap at first
glance!!!
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but be aware that inflation is a headwind for
PE expansion
Trailing PEs on SP500 and headline CPI
inflation
Bottom-up consensus of equity analysts
PE
EPS
Projection
Tech bubble
equities will be vulnerable to earnings
downgrades
Given the limited scope for PE expansion in the
current environment
Current
Consensus sees EPS surging 78 between now and
Q4 2009 !
CPI inflation
NBF Economy Strategy (data via Datastream and
SP)
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US recessions More downward earnings
revisions???
Current year consensus earnings revisions, from
start to end of a given year

YTD -10.0
-24.2
-25.1
-29.3
Shaded for recessions
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Any message of hope?
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Stocks typically bottom 2/3 of the way through a
recession
Days
NBF Economy Strategy (data from Datastream)
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Credit crunch The worst behind us?
High-yield spreads
Investment grade spreads
RMBS spread
CMBS spread
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Our  cautious  view on oil price and SP/TSX
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SP/TSX Still heavily exposed to
resourcesSP/TSX and SP 500 sector weights
SP/TSX Resources weight 51
NBF Economic Research,Datastream
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SP/TSX Longest sequence of excess return in 45
yearsSP/TSX return minus SP 500 return in CAD
Longest winning streak in 45 years
2008 to date
NBF Economic Research, Datastream
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Stock markets How much longer can the SP/TSX
outperform the SP 500 ?SP/TSX and SP 500
5-year rolling return differential (in C)

Source NBF Economic Research, Datastream
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Commodity prices tend to slide when growth slows
for 2 years Deviation of global growth from
long-term trend (3.8) vs. Reuters/Jefferies CRB
Percentage points
Index
Shaded areas show two or more consecutive years
of below-trend global growth
?
Reuters/Jefferies CRB
World GDP growth minus 3.8
NBF Economy Strategy (data via Datastream,
IMF)NBF Economy Strategy forecast for 2009
3.5
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Slower GDP growth weaker oil demand lower oil
price Real world GDP growth and global oil
consumption
y/y
World GDP
Oil consumption
EIA
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Investment strategy

• Preference for
• Low debt companies
• Large capitalisations
• Dividend paying
• U.S. equities over SP/TSX

• Some sectors we currently favour Consumer
  staples, Utilities, Health care

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Summary Economic Outlook 2008-09

• International
• Continued expansion, but at a cooler pace
• U.S. A consumer led recession highly probable
• Fed and Capitol Hill will continue the rescues
  operation
• Canada
• Excellent fundamentals to cushion a U.S.
  slowdown
• Quebec and Ontario to face stiff headwinds
• BOC On the sidelines for some time
• Capital market
• Volatility likely to stay for some time
• U.S. equities Downsize risk less significant
  than a year ago
• SP/TSX Vulnerable to investors sentiment shift
  on commodities

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Thank you for your attention