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JeffreyRubin AveryShenfeld BenjaminTal PeterBuchanan WarrenLovely DavidBezic (416)594-7357 (416594-7356 (416)956-3698 (416)594-7354 (416)594-7359 (416)956-3219
CIBC World Markets Inc. • PO Box 500, 161 Bay Street, BCE Place, Toronto, Canada M5J 2S8 • Bloomberg @ WGEC1 • (416) 594-7000C 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 Yo 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 6
Strategecon
Economics & Strategy
http://research.cibcwm.com/res/Eco/EcoResearch.html
JeffreyRubin(416)594-7357
AveryShenfeld(416)594-7356
BenjaminTal(416)956-3698
PeterBuchanan(416)594-7354
MenyGrauman(416)956-6527
KrishenRangasamy(416)956-3219
If the US economy is in recession, it’sremarkable how little impact that has hadonglobalcommoditymarkets.US$90crudepricesandUS$3.20copperpricesseemtobedefyingAmericaneconomicgravity.Infact,broadlybasedcommoditypriceindexesliketheCRBcontinuetopostnewrecordhighs.EithertheUSeconomyisnotnearlyasweakasfinancialmarketsperceiveittobe,ortheUS economy is not nearly as important totheglobaleconomyasitoncewas.
CertainlythereisanexaggeratedelementtofearsofUSweakness.Forexample,defaultrates on subprime mortgages will neverget anywhere close to the 50% rate thatthecreditdefaultswapmarkethasalreadydiscounted. And factory orders in the US,normally theepicentreof recessions, seemtoberising,notplunging(seepages10-11).
But an even bigger factor in the strengthof today’s commodity prices has been theUS economy’s loss of importance to theglobaleconomy.Whereasinthelate1990s,American economic growth accountedfor nearly 30% of global growth, todayit accounts foronly10%.And that loss ismuchgreaterwhen it comes to impactingresourcemarkets.
Takeoilforexample.WhiletheUSisstillbyfarthelargestoil-consumingeconomyintheworld,guzzling21millionbarrelsperday,itscontribution to global demand growth foroilover the last twoyearshasbeennil. Infact, oil consumption has fallen modestlyover thattimeframe,andthatwasduring
a period of reasonably robust economicgrowth. Recession or no recession, US oilconsumptionisgoingtocontinuetofalloverthe next five years and at an acceleratingrateaspumppricesheadhigherandhigher.By 2012, US$4.50 per gallon gasoline willhavechoppedover2millionbarrelsperdayout of daily American consumption (seepages4-7).Thatdeclinedwarfsanycyclicaladjustment in US crude consumption overanypastpost-warrecession.
Moreorlessthesamestorycanbetoldforbase metals. While bearish reports on theUS economy can still unnerve base metalmarkets,thereislittleinthepatternofrecentdemandgrowthtosubstantiatesuchfears.
Asisthecaseforcrudeoil,theUSeconomyhasmadenocontribution to the lasthalf-decade’s surge in global metal demand.Americanconsumptionofzincandcopperhas actually fallen over the last five yearsand consumption of aluminum and nickelhasbeenbasicallyflatoverthesameperiod.Contrastthatwith20%-plusannualgrowthrates in metals demand in China and it’ssuddenlyeasytoseewhypricesforkeybasemetalslikecopperremaininthestratosphereeven if the US economy is going into thetoilet.
Whether theUS isheading fora recessionor just a mid-cycle slowdown remains tobe seen.But themore importantquestionfor crude, base metals and other resourcemarkets, is whether it really mattersanymore.
“As is the case for crude oil, the US economy has made no contribution to the recent surge in global metal demand. ”
Does It Matter?byJeffRubin
January 18, 2008
CIBC World Markets InC. StrategEcon - January 18, 2008
2
MARKET CALL
INTEREST & FOREIGN EXCHANGE RATES
GreaterdownsiderisksontheUSeconomy,andBernanke’sapparentwillingnesstoignoreongoinginflationpressures,raisestheoddsofamoreaggressiverate-cuttingstance.WeseetheFedmoving50bpslaterthismonth,butholdingtoaquarter-pointcutinMarchassumingafiscalstimuluspackageisclosetopassageatthatpoint.TheBankofCanadahasagreenlighttocut50bpsinQ1ascoreinflationismuted,butahealthydomesticsectormakesmoreaggressiveactionlesslikely.
The bond market has already priced in extensive central bank cuts for 2008, and is vulnerable to adisappointmentastheUSavoidsrecession(seepages10-11).Butinthenearterm,bondplayerswon’tseeenoughevidencetochangetheirbearisheconomicview.Theroomforarally in2-years is limitediftheequitymarketfindsafloor,butthere’sbeenasignificantsteepening,leavingroomfor10-yearCanadastorallyabitfurther.
TheCanadiandollarwasleftoutoftheparadeasothermajorsgainedonthegreenbackinrecentweeks,reflectingconcernsthatanoutrightUSrecessionwouldspillovertheborderandalsodampencommodityprices.If,asweexpect,globalgrowthsurprisestotheupsideandoilpricesmarchonward(seepages4-7),theC$willbetradingstrongerthanparitylaterthisyear.
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2008
END OF PERIOD: 17-Jan Mar Jun Sep Dec
CDA Overnight target rate 4.25 3.75 3.75 3.75 3.7598-Day Treasury Bills 3.55 3.40 3.65 3.65 3.70Chartered Bank Prime 6.00 5.50 5.50 5.50 5.502-Year Gov't Bond (4.25% 12/09) 3.25 3.15 3.35 3.75 4.0010-Year Gov't Bond (4% 06/17) 3.78 3.60 3.75 3.95 4.1530-Year Gov't Bond (5% 06/37) 4.04 3.90 4.00 4.10 4.20
U.S. Federal Funds Target 4.25 3.50 3.50 3.50 3.5091-Day Treasury Bills 3.07 2.80 3.05 3.25 3.452-Year Gov't Note (3.25% 12/09) 2.44 2.40 2.75 3.35 3.7510-Year Gov't Note (4.25% 11/17) 3.64 3.55 3.65 3.90 4.2530-Year Gov't Bond (5% 05/37) 4.26 4.20 4.35 4.45 4.60
Canada - US T-Bill Spread 0.48 0.60 0.60 0.40 0.25Canada - US 10-Year Bond Spread 0.14 0.05 0.10 0.05 -0.10
Canada Yield Curve (30-Year — 2-Year) 0.79 0.75 0.65 0.35 0.20US Yield Curve (30-Year — 2-Year) 1.82 1.80 1.60 1.10 0.85
EXCHANGE RATES — (US¢/C$) 97.3 101.0 101.5 104.7 105.0— (C$/US$) 1.027 0.990 0.985 0.955 0.952— (Yen/US$) 107 106 109 110 110— (US$/euro) 1.47 1.49 1.45 1.43 1.40— (US$/pound) 1.97 1.92 1.91 1.91 1.89— (US¢/A$) 88.0 87.0 93.0 88.0 87.0
CIBC World Markets InC. StrategEcon - January 18, 2008
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STRATEGY AND EARNINGS OUTLOOK
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2005 2006 2007 2008 LatestEnergy 1.4 -2.5 9.9 9.9 13.6Materials 32.5 89.8 3.1 9.4 22.8Industrials 54.5 10.8 9.9 16.8 15.1Consumer Discretionary 1.4 10.4 -35.4 -9.8 15.9Consumer Staples 18.7 12.2 2.5 9.0 14.7Health Care 10.4 15.2 29.3 3.5 16.6Financials 12.8 17.3 14.4 9.4 11.1Info Tech 260.9 -47.6 25.2 26.2 26.3Telecom Svcs 31.1 7.5 14.2 15.2 8.8Utilities 5.7 7.6 -10.0 -10.0 14.9
TSX Composite 31.2 17.4 12.0 13.0 14.5
Last 10 yrs.
TSX - Earnings Outlook & Forward PE
PE4-qtr Fw dOperating Earnings
(% ch)
17.027.513.049.7
5.418.6
17.9
15.613.910.932.3
Witheconomicstrainsfromthesubprimecrisisclearlygrowing,theFedandBankarelikelytocutratesmoredeeplythanpreviouslyexpected.Weaccordinglyshiftedanadditional1%-pointsofweightingfromcashtobondstocapitalizeonthemoresupportivebackdropforfixedincomeassets.
In line with our expectation of at least one more Bank of Canada easing, we raised our exposure toutilitystocksbyapercentagepoint,astheirhighdividendyieldsarelikelytoappealtoinvestorsasasafealternativetodividend-payingfinancialstocks.Offsettingthatwehavereducedourexposuretotheconsumerdiscretionarygroup,particularlyautopartsproducers.Wealsoremainunderweightfinancialandindustrialstocks.AllthreeTSXsectorswillbeadverselyimpactedonewayoranotherbyUSeconomicweakness.
Continuingoverweightsinenergyandbasemetalsreflectbothprospectivesupportforoilpricesfromdelaysinaddingnewcapacity(seepages4-7),andastillquitefavourableoutlookforkeyoverseaseconomies.WiththeUSinstagflation,implyingtheFedwillcutrates(reducingtheopportunitycostofholdinggold)whileinflationremainsstubbornlyhigh,it’sanidealenvironmentforgoldbullion.Accordingly,weremainoverweightpreciousmetalsstocks.
ASSET MIX (%) Benchmark Strategy Rec-ommendation
Stocks 56 65Bonds 38 33Cash 6 2GICS SECTOR EQUITIES (%)Consumer Discretionary 5.0 2.5Consumer Staples 2.5 3.0Energy 27.9 31.9Financials 29.6 28.6 -Banks 15.9 14.9 -Insur., REITs, oth. 13.7 13.7Healthcare 0.5 0.5Industrials 5.4 3.4Info Tech 5.2 4.2Materials 16.8 18.8 -Gold 6.9 7.9 -Other Metals 4.9 5.9Telecom 5.5 4.5Utilities 1.6 2.6Note: Bold indicates recommended overweight.
620724
810916
0
200
400
600
800
1000
2005 2006 2007 2008
CIBCWM FcstTSX Index-Adj. Oper. Earnings
12%17%
31%
13%
Source: Thomson First Call, CIBC WM
0
5
10
15
20
25
30
35
80 85 90 95 00
TSX Composite Forward PE
Latest13.525-yr
average=16.2
07 05
CIBC World Markets InC. StrategEcon - January 18, 2008
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Despite healthy scheduled increases in world oilproduction, widespread project delays and soaring oilconsumption in many oil-producing countries point toawideningdemand-supplygapthatwillrequirefurtherpricerationinginworldcrudemarkets.
Thedelayswillsubtractover5millionbarrelsperdayfromglobal production growth over the 2008-2012 period.Factoring in the lossofnearly4millionbarrelsofdailyproductioneachyearduetodepletionatexistingfields,actualsupplywillfallasmuchas8millionbarrelsshortofestimatesbytheInternationalEnergyAgency(IEA)andUSDepartmentofEnergy,peakingatjustover88millionbarrelsperdayin2011.
Globally, only sub-1% annual demand growth canbe accommodated by expected supply gains. At thesame time, demand will be highly skewed towardsoil-producing countries themselves and to the rapidlydevelopingeconomies,leavingtheOECDmarketstobearmuchofthecomingsupplycrunchthroughsignificantlyhigherworldoilprices.
Because so much of the growth in global oil demandwilloccurincountriesthatmassivelysubsidizetheirownconsumers, prices will have to rise that much more incountrieswhereenergymarketsareallowedtowork.
ForOPEC that implies asmuchas ahalf-millionbarrel-per-daydecrease inexportsbetweennowand2012—adevelopmentthatwilldenymuchoftheworldtheoilsupplygrowththatitcurrentlyexpects.Little,ifany,gaincanbeexpected inRussianexportsbeyond2010,withdomesticconsumptionaccountingforallofthemodestproductiongainsexpectedthere.MeanwhileMexico’sexports,arelikelytocollapsewithinthenextfiveyears(Chart1).
In short, total global production gains will hugelyoverstateactualsupplyconditionsbecausefewofthoseprecious new barrels will ever see the light of worldexport markets. Excluding the fast-rising and generallyhighly subsidized consumption of major oil-producingcountriesthemselves,worldoilsupplieswillbeeffectivelyflat.ThatcomesamidsttheseeminglyinsatiableenergyneedsofrapidlyindustrializingeconomiesledbyChina.Price-insensitive demand in those countries will crowdoutOECDconsumption.
DelaysWillTightenGlobalOilMarketsJeffRubinandPeterBuchanan
Chart 1Exports:OPEC,Russia&Mexico(2005-12)
TheSupplyPicture:MajorDelaysonManyMega-Projects
Onthesurface,2008lookslikeabigyearforoilsupply,asdoesthecominghalf-decade.Accordingtothe IEA,global production will climb to as much as 96 millionbarrelsperdayby2012.Butthoseprojectionsignoretwofundamental forces thathave, in recentyears,broughtglobalproductiontoavirtualstandstill.
Thefirstisdepletion.Youhavetorunfastertostandstill.Depletionfromexistingfieldshasacceleratedtoover4%,effectivelycuttingnearly4millionbarrelsperdayoutofeachyear’sproduction (Chart2).Risingdepletionratesareat least, inpart,relatedtothegrowingimportanceof offshore and, in particular, deepwater fields,whosedepletionratesaretwicethatofconventionalfields.Cliff-likedepletionrateshavealreadybeeninevidenceintheNorthSeaandnowthehugeCantarellfieldoffMexico.
The second fundamental force blowing up supplyforecasts is the huge project delays and massive costoverrunsassociatedwithmanyoftheworld’slargestnewoil mega-projects. Heavy reliance on increasingly highcostandtechnicallychallengingfieldsliketheKashaganproject in Kazakhstan, Sakhalin II and Canadian andVenezuelan oil sands have left world supply growthvulnerable to seeminglynever-endingprojectdelays. Inmanycases,soaringdevelopmentcostshaveresultedintime-consumingre-negotiationswithhostcountries.
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05 06 07 08 09 10 11 12
Mn. Bbl/day
CIBC World Markets InC. StrategEcon - January 18, 2008
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Chart �ScheduledvsProbableNewGlobalProduction
Chart 2DepletionAddstoNeededCapacityGrowth
Of course, stagnant conventional world oil productionunderliestherecentproblemsassociatedwithharvestingunconventional supply. Virtually all of the increases inglobaloilproductionhaveoccurredfromdeepwaterfieldsoroilsands,withconventionalproductionseeminglystuckat2005levelsof67millionbarrelsperday(Chart3).
Ourreviewofnearly200newoilprojects(seeOccasional Report #6�, ”Delays Will Tighten Global Oil Markets”, January 10, 2008)slatedtostartoilflowoverthenextfiveyears,indicatesthatscheduledproductiontimelinesare far too optimistic, with project delays the norm,not the exception. Production delays in Kashagan, theworld’slargestoilproject,willtakeasmuchas200,000barrels from scheduled production increases by 2010andasmuchashalfamillionbarrelsperdayby2012.
DelaystooilsandsprojectsinVenezuelaandCanadawillshaveover700,000barrelsperdayfromprojected2012productioncapacityrelativetoearlierexpectations.AddinlikelydelaystootherprojectslikeNigeria’sBonga(NorthandAparo)andIran’sAzar2developmentandnewfieldproductionby2012willbeover5millionbarrelslowerthanofficialproductionschedulessuggest(Chart4).Ourmore realistic projections show a very different picturethan the “official production estimates”, with supplygrowing by only about 0.7% per year to just over 88millionbarrelsperdayby2012.
This year some 4.3 million barrels per day will comeintoproduction—1.5millionbarrels perday fromnewstart-upsand2.8millionbarrelsperdayfromscheduledproductionincreasesinalreadyoperatingfields(Table1).Butthat’s littleover700,000barrelsperdayabovethenearly3.6millionbarrelsperdaythatwillbelostthroughannualdepletion.Similarly,seeminglylargesupplygainsin2009and2010shrinktonetgainsoflessthan1millionbarrelsperdayafterdepletion.The result isnetglobalproductionlevelsthatappeartoplateauatjustover88millionbarrelsperdayby2011.
TheDemandPicture:MostofFuturePriceRationingWillOccurintheOECD
Withglobalinventoriesalreadylow,demandgrowthmustbroadly equal supply growth over a five-year horizon.While thatmustobviouslyholdat theaggregate level,demand is likely to be highly skewed towards certainregionsdue to the segmentationofglobal oilmarketsintothreedistincttypes,eachwithverydifferentmarketdynamics.
Chart �ConventionalOilProductionHasNotGrownSince2004
Total Supply
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Forecast
ConventionalCrude Oil
Source: CIBC WM, ASPO
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2000 2002 2004 2006 2008 2010 2012
Optimistic--No project delays
with delays in Kashagan, other projects
Mn bbl/day
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Falling Production from Current Fields
Global Oil Production
Depletion of Current
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Net New Supply
CIBC World Markets InC. StrategEcon - January 18, 2008
6
TheOECD,thelargestmarketsegmenttoday,isnotlikelytobesowithinthenextfiveyears.Thisisthemostprice-sensitive and mature market for oil where consumerspayfullworldoilprices.OECDoilconsumption,whichhasalreadyfallenoverthelasttwoyears,willdeclinebyalmost4millionbarrelsperdayoverthenextfiveyears(Chart 5) in response to steadily rising oil prices. Withcrudeprices risingtoUS$150/bbl in2012,USgasolinepriceswillreachashighasUS$4.50/gallon,cuttingdailycrudedemandby2millionbarrelsor10%.
AsecondmarketsegmentisChinaandthedevelopingworldwheremuchoftheworld’smostenergy-intensiveproductionismigratingtoandwherecarownershipratesareexplodingduetotheonslaughtoffirst-timebuyers.Demand for energy in these countries tends to be farmoreincome-sensitivethanprice-sensitive,incontrasttotheOECD.
Finally, a third segment, and themost rapidly growingpart of global oil demand is the soaring rates of ownconsumption found in most of the world’s largest oil-producing countries themselves. OPEC, together withnon-cartelproducersRussiaandMexico,accountsforover60%ofworldoilproduction.Butwhatincreasinglybearswatchingisnottheincreaseintheirproductionlevels,butthe rateofgrowthof theirown internal consumption.Russiangasolinedemandisgrowingat6%annually,asfastasinChina,thankstosoaringcarownershiplevels.
Soaring Consumption in Major Oil-ProducingCountriesThemselves
Tosomeextentstrongoil-producerdemandreflectstheincomeboostthathighoilpriceshavegiventheirpetro-basedeconomies.ButanevenmoreimportantfactorhasbeenmassivepricesubsidizationwithinOPEC,spurringextraordinarynear-double-digitgrowthinoildemandinmanycountries.
OilconsumptionlastyearinSaudiArabiagrewbyalmost10%,whileitsneighbourKuwaithassported6%annualgrowthinitsownoilconsumptionforoverthelasthalf-decade. Supercharged demand growth in many OPECcountries can be traced to gasoline prices as low as20centsagalloninVenezuelaand40-60centspergalloninSaudiArabiaandIran(Chart6).
This market is not only one of the fastest growing oilmarketsanywhereintheworldbutitisalsooneofthelargestmarkets.Collectively,OPECtogetherwithRussiaandMexicoconsumednearly13millionbarrelsperdaylast year, some 700,000 barrels more per day than all
Chart �RisingPricesWillHitOECDDemandHardest
-1.5-1.0-0.50.00.51.01.52.02.53.03.5
95 97 99 01 03 05 07 09 11
OECD Non-OECD
mn bbl. change in daily oil demand per year
Source: CIBC WM Global Oil Demand Model
Forecast
Table 1 WorldOilProduction*,DepletionandNewFieldCapacity2008-2012(millionsofbarrelsperday)
2008 2009 2010 2011 2012
85.30 86.06 86.98 87.85 88.411.49 1.15 0.80 0.54 0.962.84 3.38 3.73 3.70 2.753.58 3.61 3.65 3.69 3.71
86.06 86.98 87.85 88.41 88.40
* crude oil, condensate and natural gas liquids
Source: Oil Megaprojects Task Force/The Oil Drum, company, industry & govt. reports. Field start-updates have been adjusted by CIBC WM where appropriate to reflect expected delays due to political,technological and other factors.
ADD: Production of fields started this year
EQUALS: Current World Oil Production
ADD: Increased production from existing fields
Prior Year's World Oil Production
MINUS: Depletion
CIBC World Markets InC. StrategEcon - January 18, 2008
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of Western Europe and over 60% more than Chinaconsumed. By 2012, we estimate that OPEC togetherwithRussiaandMexicowillconsume16millionbarrelsperday,withthe3millionbarrel-per-dayincreaseoverthenext5yearstakingupthelion’sshareofallnewglobalproductioncapacitynetofdepletion.
Soaringratesofgrowthindomesticoilconsumptionwillsqueeze export capacity in many major oil-producingcountries.Individually,Mexicoislikelytoseethelargestdecline, with exports virtually collapsing to as little asseveralhundredthousandbarrelsperdayfromacurrentlevelofjustover1.5millionbarrelsperday.TheUSmarketwillbearmostofthisadjustment.ButevenOPECwillseeitsexportsdecline,particularlyifnewlyjoinedAngolaisexcluded.AndwhileRussianproduction isexpected togrowverymodestlyoverthenextfiveyears,allofthose
productiongainswillbegobbledupbydomesticdemandgrowth.
With virtually no growth in world exports, still-surgingcrude demand from developing countries will have tocomeattheexpenseofOECDconsumption.Sincecrudedemand in countries like China and India is far moreincome-elasticthanprice-elastic,thesecountriesarelikelyto outbid OECD markets for increasingly scarce globalsupply.
Furthermore, many of those energy-thirsty developingcountrieswillneedtodependmoreandmoreonworldmarkets.Forexample,China,theworld’ssecondlargestoil-consumingcountrywithconsumptionalreadytotalling7millionbarrelsperday, is likely toneed to importasmuchas70%ofitsoilneedsby2012comparedtoabout50%today.
It is in theworld’s still-largestoilmarket—theOECD—thatmostprice rationingwillultimately takeplace.Oilconsumption,havingalreadyfallenforthelasttwoyearsislikelytonowfallsteadilyoverthenexthalf-decadeinresponsetosoaringworldoilprices.
WeexpectthatOECDconsumptionwillfallby4millionbarrels per day between now and the end of 2012 inresponsetoafurther50%riseinworldoilprices.AriseinworldoilpricestotheUS$150/bblrange(Table2)overthenexthalf-decadeshouldincentamajordecarbonizationof those economies. Indeed by 2012, oil consumptionoutsideoftheOECDwillexceedconsumptionwithintheOECD(excludingMexico),adevelopmentthatwillposenewchallenges in theglobal taskofmanagingcarbonemissions.
Chart 6GasolinePricesAroundtheWorld
0 2 4 6 8 10
Venezuela
Iran
Saudi Arabia
Kuwait
Nigeria
Mexico
Russia
US
Canada
UK
Germany
Retail gasoline prices, US$/gal.
Table 2HigherOilPricesNeededtoRationFast-RisingGlobalDemand
1 Excluding Mexico
Mn barrels/day 2007 2008 2009 2010 2011 2012World Oil Demand 85.7 86.1 87.0 87.9 88.4 88.4 - % ch. 1.2 0.5 1.0 1.1 0.6 0.0OECD1 47.2 46.4 46.0 45.6 44.8 43.6 - % ch. -0.3 -1.6 -0.9 -0.9 -1.7 -2.6OPEC + Mexico + Russia 12.8 13.4 14.1 14.8 15.6 16.4 - % ch. 4.9 5.0 5.0 5.1 5.1 5.1China + Other Developing Countries 25.8 26.3 26.9 27.5 28.0 28.4 - % ch. 2.3 2.0 2.3 2.4 1.9 1.4
World Oil Supply 85.3 86.1 87.0 87.9 88.4 88.4
West Texas Crude ($/bbl.) 72 95 105 115 130 150
CIBC World Markets InC. StrategEcon - January 18, 2008
8
At first glance the severe correction in Canadian REITsvaluationssincemid-2007caneasilybejustifiedbycreditcrunch-related fears such as higher borrowing costs,reducedcreditavailabilityandfallingassetvalues.Butacloserlooksuggeststhatthosefearsarenotmaterializing.EffectiveborrowingcostsforREITsarefalling—notrising,asset values are still climbing and evidently, accessingcredit isnot reallyaproblem formostCanadianREITs.WhilereducedM&Aactivitysuggeststhatpricesmightnot return to their recent highs any time soon, withvaluationsatrecordlows,REITsarecheap.
TheCorrection
Sincemid-2007,CanadianREITpricesfellbyalmost25%(andbycloseto30%sincereachingtheirpeakinearlyFebruary).Thatis10%-pointsmorethanthedropinthefinancial indexand three times thedrop in theTSXasa whole (Chart 1). Note the high correlation betweenthe Canadian and American indexes, with CanadianREITsoutperformingAmericanREITsbyonly4%-pointsduringthatperiod.That’snotmuchifyouconsiderthattheactualhousingmeltdownishappeningsouthoftheborder—nothere.
What’smore,whenevaluatedinrelationtothenetvalueof their assets, Canadian REITs are now trading at an
AreCanadianREITsOversold?BenjaminTal
Chart 1REITs—TheCorrection
Chart �BondsandREITsareDiverging
Chart 2LargestDiscounttoAssetValueonRecord
unprecedented discount of almost 20%. That is threepoints deeper than the discount observed during thenear-recessionaryconditionsof2001(Chart2).
TheCostofBorrowingisFalling—NotRising
Keytotherecentsell-offofCanadianREITsisthefearthatthe current credit crunch is raisingborrowing costs—amajorpotentialnegativetothisinterest-sensitivesector.
Average REIT Unit Price Premium / Discount TO Estimated Net Asset Value
-20
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CIBC World Markets InC. StrategEcon - January 18, 2008
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thevacancyrateinAmericanshoppingcentresisnowatan11-yearhigh,inCanada,itisstillfalling.
Consequently, the fear that the credit crunch wouldresultinreducedassetvaluesandthusanotablyhighercaprate(netoperatingincomeasashareofassetprice)isnotsupportedbythedata.Theaveragecaprate,afterfallingbymorethanafullpercentagepointsincemid-2006hasnowstabilizedatjustover6%(Chart6).
Itwouldtakeafull-blownrecessioninCanadatojustifycurrentREITvaluations.Underanyotherscenario,REITsappeartobeoversold.
And indeed, this concern has resulted in a completebreakdownintherelationshipbetweenbondsandREITs,withlong-termbondpricesrisingbyalmost6%sincemid-2007,onlytoseeREITvaluationsplunging(Chart3).
Buttherealityisdifferent.Sincemid-2007,the10-yeargovernmentbondratefellbynolessthan80basispoints,andwhilethecreditcrunchdidnotspareCanadianREITs,itworkedtoraisetheiraveragespreadovergovernmentbondsbyonly50basispoints.Soeffectively,theaverageborrowingcostfacingREITsisnowroughly30basispointslowerthanitwasattheeveofthecrisis(Chart4).
And that’s precisely where we see the disconnect.Historically, REITs are extremely sensitive to swingsin interest rates. Not only are they three times moresensitive than the TSX average, but they are notablymoreresponsivetoratefluctuationsthanotherinterest-sensitive sectors such as banks and utilities (Chart 5).And interest rates will continue to fall in the comingmonthsduetocentralbankactionandagradualeasinginspreads.
Soit’snotacost-of-borrowingstory,norisitastoryofotherREIT fundamentals.CanadianREITshaveminimaldirectexposuretoUSdollarcashflowasmostpropertiesarelocatedinCanada.Yes,themanufacturingsectorisinrecession,butaccordingtoarecentsurveybytheDBRS,most industrialREITs inOntarioareexposedto tenantswhoare infactnet importers—afactthatexplainstheverylow6.4%nationalindustrialvacancyrate.Andwhile
Chart �EffectiveBorrowingCostisLower
Chart �SensitivitytoInterestRateCuts
Chart 6StableCapitalizationRate
10-Yr Canadian Gov't Bond
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6
7
8
05Q
2
05Q
4
06Q
2
06Q
4
07Q
2
07Q
4
%
By Segment
4
5
6
7
Office
Reta
il
Apar
tmen
ts
Indu
stria
l
%
Source: CIBC WM
CIBC World Markets InC. StrategEcon - January 18, 2008
10
IstheUSAlreadyinRecession?AveryShenfeldandMenyGrauman
Chart 1UnemploymentRateChange(Trough-to-Peak)
Chart �ISMNoWeakerThanPastMid-CycleSlowdowns
Chart 2NetChangeinNon-FarmPayrolls,3-monthMovingAverage
The“R”word is back. In the rush to judgment, someare saying that the US economy is in fact already inrecession.True,byonemeasure,the0.6%-pointriseintheunemploymentratefromitstrough,therewouldbesomemerittothatcall,aswe’veneverseenaslargearisethatwasn’tinconcertwithrecession(Chart1).Butthat’sasinglemeasureoutofdozensoftemperaturereadingsonDecemberandJanuaryactivity,andtakenasagroup,it’sevidentthattheUSisnotinrecessionaswewrite.
Payrollsemploymentalwaysfallssignificantlyinrecessions,sincegivenproductivitygrowth,ittakesanoutrightdropinstaffingtoproducetheoutputdeclinethatistheverydefinitionofrecession.Decemberpayrollsgainsweren’tpretty,but theyhadaplus sign, and themore reliablyestimatedthree-monthaveragepacewasnoweakerthaninwhatprovedtobeonlymid-cycleslowdowns(Chart2).It’smuchthesamefortheISMfactoryindex,whichwhilebelow50inJanuary,isagainnoweakerthaninpastmid-cycleslowdowns,andstillafewpointsabovethe30-40rangethathasspelledrecession(Chart3).
Andinanyevent,sinceit’sonlyasurvey,theISMcouldeasily be picking up gloomy sentiment rather than anactual decline in output. Indeed, industrial productiondata,thoughadmittedlyonlyforQ4,isn’tinthedecidedlydownwardtrendthatcharacterizesrecessions.
LookingpastthequalitativeISMsurvey,morequantitativeleading indictors for the factory sector don’t look allthat bad, likely capturing an improvement in globalcompetitiveness fromaweakUSdollar.Factoryorders,for example,havebeenclimbing (Chart4).And largermanufacturing retreatshave typicallybeenprecipitatedafter an unwanted inventory build-up. Instead, both
20
30
40
50
60
70
80
Jan-70 Jan-76 Jan-82 Jan-88 Jan-94 Jan-00 Jan-06
ISM Manufacturing Index
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Lowest Highest
Chg in Unemployment Rate During Last 6 U.S. Recessions
percentage points
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
Lowest Highest Current
Chg in Unemployment Rate During Last 6 U.S. Mid-Cycle
Slowdowns
percentage points
Shading denotes recessions
Shading denotes recessions
-600
-400
-200
0
200
400
600
800
Jan-68 Jan-74 Jan-80 Jan-86 Jan-92 Jan-98 Jan-04
000s new jobs
'86 slow-down
'95 slow-down
CIBC World Markets InC. StrategEcon - January 18, 2008
11
Chart �OrdersRising,BusinessInventoriesLean
factory and overall business inventory/sales ratios havebeenwellcontained,withNovember’sinventorytosalesratio at an all-time low. In the auto industry, often asourceofcyclicalweakness,inventoriesofdomestic(i.e.NorthAmericanmade)vehiclesareatthelowendofthepastdecade’srangerelativetosalesforthistimeofyear(Chart 5), suggesting no imminent further productioncutbackannouncements.
If theUS isn’t in recession in January, that needn’t, ofcourse,ruleoutaslideoverthatprecipiceinsubsequentmonths.Ourownforecastcalls foronlybarelypositivegrowthinQ1,whichforfinancialmarkets,willonsomedays,aftersomedatareleases,lookalotlikearecession.
For now, then, the Treasuries market will take solace,takingCanadasalongfortheride.
But odds still favour a turn to positive growth in Q2andbeyond.StilltocomearethelaggedimpactsofFedeasing, and theprotectivebenefitsof recentmeasurestoavoidtheworstcasescenariosforsubprimedefaults.Helping forestall recession is the lift to activity fromtrade, as American exporters reap the benefits of acheaperdollar.And inanelectionyear,bothCongressandtheWhiteHousearemovingtocobbletogetheraquickstimuluspackagetoputmoney intovoters’ (andconsumers’)pocketssoon.
If,then,the“R”wordprovesmisguided,whereareweintermsofthisFedeasingcycle?Nearlydone.Whilethemarketispricinginacuttoasub-3%fundsrate,theFedhasnevereasedthataggressivelyoutsideofarecession,withthesoleexceptionbeingtheextendedcomedownfroma lofty11½%funds rate in themid-1980s. Thatoutlieraside,assuminganother75bpsinQ1,thiseasingcycle will have significantly surpassed all other non-recessioneases(Chart6).Concernsoverfinancialsystemstabilitylikelyexplaintheunusuallyaggressiveresponsewe’veseen.Butevenso,thoseridingthebondmarketrallyinboththeUSandCanadashouldbereadytojumpoffthatbandwagonbeforenewsofpositivegrowth intheUSsecondquarterbecomestooapparent.
Chart �DomesticAutoInventoriesLeanforDecember
Chart 6Peak-to-TroughChangeinFedFundsRateDuringMid-CycleEases,MonthlyAverage
* Includes an additional �� bps in projected rate cuts40
50
60
70
80
90
100
Jan
Feb
Mar Apr
May Jun Ju
lAu
gSe
pOct
Nov
Dec
10-yr range 1997 - 2006
10-yr avg2007
days supply
1.20
1.25
1.30
1.35
1.40
1.45
1.50
1.55
Jan-96
Jan-99
Jan-02
Jan-05
Inventory/Sales Ratio, Business
Recession Begins
300
320
340
360
380
400
420
440
Jan-00
Jan-02
Jan-04
Jan-06
Factory Orders, $ bn
0 50 100 150 200 250 300
Sep.71 - Feb.72
Oct.87 - Mar.88
Mar.95 - Mar.96
Sep.98 - Jan.99
Jun.76 - Feb.77
Sep.75 - Mar.76
Current
Sep.84 - Sep.86
bps
550
*
CIBC World Markets InC. StrategEcon - January 18, 2008
12
CANADA
ECONOMIC UPDATE
UNITED STATES
ConflictsofInterest:CIBCWorldMarkets’analystsandeconomistsarecompensatedfromrevenuesgeneratedbyvariousCIBCWorldMarketsbusinesses,includingCIBCWorldMarkets’InvestmentBankingDepartment.CIBCWorldMarketsmayhavealongorshortpositionordealasprincipalinthesecuritiesdiscussedherein,relatedsecuritiesorinoptions,futuresorotherderivativeinstrumentsbasedthereon.Thereadershouldnotrelysolelyonthisreportinevaluatingwhetherornottobuyorsellthesecuritiesofthesubjectcompany.LegalMatters:Thisreportisissuedandapprovedfordistributionby(i)inCanadabyCIBCWorldMarketsInc.,amemberoftheIDAandCIPF,(ii)intheUK,CIBCWorldMarketsplc,whichisregulatedbytheFSA,and(iii)inAustralia,CIBCWorldMarketsAustraliaLimited,amemberoftheAustralianStockExchangeandregulatedbytheASIC(collectively,“CIBCWorldMarkets”).ThisreportisdistributedintheUnitesStatesbyCIBCWorldMarketsInc.andhasnotbeenreviewedorapprovedbyCIBCWorldMarketsCorp.,amemberoftheNewYorkStockExchange(“NYSE”),NASDandSIPC.ThisreportisintendedfordistributionintheUnitedStatesonlytoMajorInstitutionalInvestors(assuchtermisdefinedinSEC15a-6andSection15oftheSecuritiesExchangeActof1934,asamended)andisnotintendedfortheuseofanypersonorentitythatisnotamajorinstitutionalinvestor.MajorInstitutionalInvestorsreceivingthisreportshouldeffecttransactionsinsecuritiesdiscussedinthereportthroughCIBCWorldMarketsCorp.Thisreportisprovided,forinformationalpurposesonly,toinstitutionalinvestorandretailclientsofCIBCWorldMarketsinCanada,anddoesnotconstituteanofferorsolicitationtobuyorsellanysecuritiesdiscussedhereininanyjurisdictionwheresuchofferorsolicitationwouldbeprohibited.ThisdocumentandanyoftheproductsandinformationcontainedhereinarenotintendedfortheuseofprivateinvestorsintheUnitedKingdom.SuchinvestorswillnotbeabletoenterintoagreementsorpurchaseproductsmentionedhereinfromCIBCWorldMarketsplc.ThecommentsandviewsexpressedinthisdocumentaremeantforthegeneralinterestsofclientsofCIBCWorldMarketsAustraliaLimited.Thisreportdoesnottakeintoaccounttheinvestmentobjectives,financialsituationorspecificneedsofanyparticularclientofCIBCWorldMarketsInc.Beforemakinganinvestmentdecisiononthebasisofanyinformationcontainedinthisreport,therecipientshouldconsiderwhethersuchinformationisappropriategiventherecipient’sparticularinvestmentneeds,objectivesandfinancialcircumstances.CIBCWorldMarketsInc.suggeststhat,priortoactingonanyinformationcontainedherein,youcontactoneofourclientadvisersinyourjurisdictiontodiscussyourparticularcircumstances.Sincethelevelsandbasesoftaxationcanchange,anyreferenceinthisreporttotheimpactoftaxationshouldnotbeconstruedasofferingtaxadvice;aswithanytransactionhavingpotentialtaximplications,clientsshouldconsultwiththeirowntaxadvisors.Pastperformanceisnotaguaranteeoffutureresults.Theinformationandanystatisticaldatacontainedhereinwereobtainedfromsourcesthatwebelievetobereliable,butwedonotrepresentthattheyareaccurateorcomplete,andtheyshouldnotberelieduponassuch.Allestimatesandopinionsexpressedhereinconstitutejudgementsasofthedateofthisreportandaresubjecttochangewithoutnotice.AlthougheachcompanyissuingthisreportisawhollyownedsubsidiaryofCanadianImperialBankofCommerce(“CIBC”),eachissolelyresponsibleforitscontractualobligationsandcommitments,andanysecuritiesproductsofferedorrecommendedtoorpurchasedorsoldinanyclientaccounts(i)willnotbeinsuredbytheFederalDepositInsuranceCorporation(“FDIC”),theCanadaDepositInsuranceCorporationorothersimilardepositinsurance,(ii)willnotbedepositsorotherobligationsofCIBC,(iii)willnotbeendorsedorguaranteedbyCIBC,and(iv)willbesubjecttoinvestmentrisks,includingpossiblelossoftheprincipalinvested.TheCIBCtrademarkisusedunderlicense.(c)2008CIBCWorldMarketsInc.Allrightsreserved.Unauthorizeduse,distribution,duplicationordisclosurewithoutthepriorwrittenpermissionofCIBCWorldMarketsInc.isprohibitedbylawandmayresultinprosecution.
We’verevisedourQ4andQ1outlooksslightlydownward,theformerduetoalessfavourabletrendtorealnetexports,thelattercapturingthesoftertonetoUSprospects.Butwe’renotgivingtoomuchweighttoDecember’sone-offdropinemployment,givenhowstrongjobgainswerethepriortwomonths.Ongoingstimulus,ratecutsandaUSpick-upsuggestfastergrowthbythesecondhalf.
AfteraverystrongshowinginQ3,USrealGDPgrowthwilllikelycomeinslightlybelow1%q/qinQ4.Thisismainlyduetoanongoingdeclineinhousingactivity,aswellasweakerconsumerspendingandaone-timecomedownfromanunusuallystrongQ3realtradebalance.Lookingaheadto2008wedonotforeseeanoutrightrecession(seepages10-11),butrealeconomicgrowthshouldbeclosetoflatinthefirstquarter,beforebouncingbackinthesubsequentperiod.Headlineandcoreinflationshouldremainuncomfortablyhigh,butboththeFedandthemarketswillbefocusedontheongoingriskstogrowthforthefirstpartoftheyear.
CANADA 07Q3A 07Q4F 08Q1F 08Q2F 08Q3F 2006A 2007F 2008F
Real GDP Growth (AR) 2.9 1.9 1.7 2.7 2.7 2.8 2.6 2.4
Real Final Domestic Demand (AR) 4.6 5.0 3.3 3.2 3.1 4.7 3.9 3.8
All Items CPI Inflation (Y/Y) 2.1 2.4 1.7 1.6 2.3 2.0 2.1 2.0
Core CPI Ex Indirect Taxes (Y/Y) 2.2 1.7 1.5 1.3 1.3 1.9 2.1 1.5
Unemployment Rate (%) 6.0 5.9 6.0 6.1 6.2 6.3 6.0 6.1
Merchandise Trade Balance (C$ Bn) 42.8 42.2 43.4 47.2 55.2 51.3 51.7 49.1
U.S.
Real GDP Growth (AR) 4.9 0.9 0.2 2.0 2.2 2.9 2.2 2.0
Real Final Sales (AR) 3.9 1.7 0.3 2.1 1.5 2.8 2.5 2.1
All Items CPI Inflation (Y/Y) 2.4 4.0 3.9 3.1 3.9 3.2 2.9 3.7
Core CPI Inflation (Y/Y) 2.2 2.3 2.4 2.4 2.6 2.5 2.3 2.5
Unemployment Rate (%) 4.7 4.8 5.1 5.2 5.2 4.6 4.6 5.2
