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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
KrishenRangasamy(416)956-3219
Much is being banked on the notion thatimprovementsinenergyefficiencywillbetheanswertobothoildepletionandgreenhousegasemissions.Butis itarealisticeconomicpremise that technological change canreduceenergyusage,andbyimplication,itscarbontrail?
The OPEC oil shocks spawned hugeimprovementsinenergyefficiency,particularlyinsofar as oil was concerned. But threedecadeslater,wefindthattheneteffectofallofthoseefficiencyinitiativeshasbeentoincreasetheworld’sappetiteforcrude.WhileoilperunitofGDPhasfallenimpressivelyinlargeenergy-consumingeconomiesliketheUnited States, total oil consumption, andindeed,totalenergyconsumption,continuetogrowbyleapsandbounds.Theincreasein energy usage has dwarfed the gains ineconomic efficiency. Hence, instead ofcappingenergydemand,whatweobserveis that improvements in energy efficiencyleadtoeverandever-greaterlevelsofenergyusage.
FollowingtheOPECoilshocks,afewrenegadeeconomists argued that improvementsin energy efficiency would perverselylead to increases in energy demand. TheKhazzoom-Brookes postulate, as it hascometobeknown,isbasedonthestandardsubstitution and incomeeffects that resultfromanychangeinthepriceofagood.Thestandard theory of the consumer arguesthat a reduction in energy costs (due toimprovements in energy efficiency) canleadtoanincrease,notadecline,inenergydemand. Moreover, to the extent thatoveralleconomicgrowthwouldbenefitfromcheaperenergyprices,thereisanadditional
macroeconomicstimulustoenergydemand,allcontributingtoaverypowerfulreboundeffect. The postulate suggests that energyintensity targets, commonplace in mostcountries’ energy strategies, are effectivelyincapable of limiting future growth ineither energy-demand growth or carbonemissions.
To date, there has only been one sure-fireway of reducing energy consumption—shrink the economy. But even smallreductionsinthelevelofglobalGDPwouldlever huge increases in human hardship.But at the same time, reducing energyconsumptionperunitofGDPhasnotbeenaviablepolicyoption.Fromgasolinedemandto theenergy requirementsof theaverageAmerican home, the legacy of energy-efficiency improvements is ever-greaterenergyconsumption(seepages4-7).
In the past, the efficiency paradox hasbeen used as an argument against effortsto promote greater energy efficiency andconservation.Thatisnotourintentionhere.On the contrary, for a world facing thetwinchallengesofoildepletionandglobalclimate change, there has never been amoreurgentneedforboth.Butinorderfortotalefficiencytoactuallycurbtotalenergyusage, as opposed to energy intensity,consumersmustbekept from reaping thebenefits of those initiatives in ever-greaterenergy consumption. Otherwise, energyusage will be the beneficiary of our besteffortstowardsgreaterenergyefficiency.
The road to hell is paved with goodintentions.
“ . . . i n o r d e r f o r e f f i c i e n c y i m p r o v e m e n t s to actually curb e n e r g y u s a g e , consumers must be kept from reaping the benef i ts in ever-greater energy c o n s u m p t i o n . Otherwise, energy usage will be the b e n e f i c i a r y o f our best efforts towards greater energy efficiency.”
The Efficiency ParadoxbyJeffRubin
November 27, 2007
CIBC World Markets InC. StrategEcon- November 27, 2007
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MARKET CALL
INTEREST & FOREIGN EXCHANGE RATES
TheCanadiandollarhasgivenupground,butwithoilpricesremainingfirm,andtheUSdollarunpopular,thiswouldappeartobemerelyacorrectionfromoverdonelevels.We’reretainingourforecastforaparitytotheUS$1.05rangeforthecomingyear,stillverystrongbyhistoricalstandards.
Whileequitymarketshaveonlyseenatypicalcorrection,bothCanadianandUSbondmarketsarebehavingasifarecessionisunderway,pricinginaggressiveratecuts.OddsofatokenratecutbytheBanktocalmtheC$andnervouscreditmarketsaregrowing,butfornow,we’llstickwithourstand-patoutlook,expectingDodgetomerelychangethe“bias”towardsadovishtiltinDecember.TheFedclearlywouldprefertowaituntilQ1toeaseagain,butcouldbeforcedintoaQ4moveifcreditmarketconditionsdeterioratefurtherinthecomingweeks.
Bondmarketsareinforasharpcorrectionifarecessionisavoidedandcentralbankactionisthereforelimited.Whilethatoutcomemaynotbeentirelyclearforthenextmonthortwo,bynextsummer,weexpectasharpretreatinbothTreasuriesandCanadas.
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2007 2008
END OF PERIOD: 26-Nov Mar Jun Sep Dec
CDA Call loan (mid-point of range) 4.50 4.50 4.50 4.50 4.5098-Day Treasury Bills 3.93 4.30 4.40 4.40 4.45Chartered Bank Prime 6.25 6.25 6.25 6.25 6.252-Year Gov't Bond (4.25% 12/09) 3.50 3.95 4.30 4.45 4.5010-Year Gov't Bond (4% 06/17) 3.92 4.00 4.40 4.50 4.8030-Year Gov't Bond (5% 06/37) 4.13 4.20 4.40 4.65 4.90
U.S. Federal Funds Target 4.50 4.25 4.25 4.25 4.5091-Day Treasury Bills 3.10 3.45 4.05 4.20 4.402-Year Gov't Note (3.625% 10/09) 2.88 3.65 4.00 4.55 4.6010-Year Gov't Note (4.25% 11/17) 3.83 4.20 4.55 4.70 4.9530-Year Gov't Bond (5% 05/37) 4.27 4.50 4.80 4.95 5.00
Canada - US T-Bill Spread 0.83 0.85 0.35 0.20 0.05Canada - US 10-Year Bond Spread 0.09 -0.20 -0.15 -0.20 -0.15
Canada Yield Curve (30-Year — 2-Year) 0.63 0.25 0.10 0.20 0.40US Yield Curve (30-Year — 2-Year) 1.39 0.85 0.80 0.40 0.40
EXCHANGE RATES — (US¢/C$) 100.9 105.8 103.0 105.0 105.0— (C$/US$) 0.991 0.945 0.971 0.952 0.952— (Yen/US$) 107 110 113 112 110— (US$/euro) 1.49 1.45 1.42 1.40 1.40— (US$/pound) 2.07 2.00 1.89 1.94 1.94— (US¢/A$) 86.9 92.0 90.0 87.0 87.0
CIBC World Markets InC. StrategEcon - November 27, 2007
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STRATEGY AND EARNINGS OUTLOOK
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The TSX remains above August’s lows. The past month’s sell-off indicates, however, that it may takesomewhat longer than we had earlier expected for the downpull from mortgage and credit woes tosubside.Pointingtomorebadnewsfromhousingandhome-wealth-leveredconsumers,thepeakinUSmortgageresetsisstillaquarterorsooff.Overall,however,theTSXremainsmuchmoreaplayonastill-fairly-solidglobaleconomythanaweakeningUSone.Whilenearer-termvaluationsriskshaverisensome,ourunchanged16,200targetfortheendof2008reflectsourcontinuingbeliefthatCanadianstockswilloutperformbondsandcashinthenextyear.
Whilemaintainingouroverallexposure tofinancial stocks,weshiftedapercentage-pointofweightingfrombankstonon-bankfinancials.Thatsegmentislessvulnerabletofurtherwritedownsrelatedtothestill-implodingUSmortgagemarket,and isalso lessexposed to thespillover fromnegativebankstocksentimentsouthoftheborder.
Withgoldalready tradingabove theUS$800/oz leveland likely tohitUS$900by theendof2008onintensified dollar weakness, we added a half-percentage-point to our existing overweight of the goldmininggroup.Offsettingthat,weparedamatchingamountfromtheindustrialsector.ThatsegmentfacesheadwindsnotonlyfromthehigherdollarbutalsoasofterUSeconomythroughtheheavilyweightedrailsubgroup.
2005 2006 2007 2008 LatestEnergy 54.5 3.7 20.7 16.8 14.3Materials 21.3 93.3 19.4 9.4 18.4Industrials 23.6 6.6 13.4 13.7 13.8Consumer Discretionary 4.5 8.2 7.0 8.7 18.2Consumer Staples 1.3 -1.9 1.5 2.9 15.1Health Care -0.7 12.6 -31.3 -9.8 16.9Financials 12.8 18.3 13.4 9.4 11.9Info Tech 260.9 -52.1 25.2 26.2 41.0Telecom Svcs 2.1 34.7 12.7 14.8 14.7Utilities 10.4 15.2 -10.0 3.5 17.3
TSX Composite 31.2 17.6 15.0 13.0 14.8
Last 10 yrs.
TSX - Earnings Outlook & Forward PE
PE4-qtr Fw dOperating Earnings
(% ch)
13.027.515.618.6
34.713.9
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ASSET MIX (%) Benchmark Strategy Rec-ommendation
Stocks 56 68Bonds 38 29Cash 6 3GICS SECTOR EQUITIES (%)Consumer Discretionary 5.0 3.5Consumer Staples 2.6 1.6Energy 26.9 30.9Financials 29.8 30.3 -Banks 16.7 15.7 -Insur., REITs, oth. 13.1 14.6Healthcare 0.6 0.6Industrials 5.3 3.3Info Tech 4.9 2.9Materials 18.0 21.0 -Gold 6.6 8.1 -Other Metals 7.8 9.3Telecom 5.5 4.5Utilities 1.5 1.5Note: Bold indicates recommended overweight.
13,70016,200
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CIBC World Markets InC. StrategEcon - November 27, 2007
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In a disturbing assault on intuition and conventionalwisdom, the Khazzoom-Brookes postulate argues thatimprovementsinenergyefficiencycanworktoincrease,rather than decrease, energy consumption. Whileseeminglyperverse,itslogicfollowstheclassictheoryofdemand.Asimprovementsinenergyefficiencylowertheeffectivecostofenergyrelativetowhatotherwisewouldhave prevailed, the resulting substitution and incomeeffectsthatflowfromanypricechangeresultinmoreofthegoodbeingconsumed.
Energy conservation in the form of energy-efficiencyregulationshasbeenwidelyviewedasahighlydesirableroutetolimitingUSdependenceonforeignoilsuppliesandinreducingCO2emissionsintheAmericaneconomy.So much so that it has now become conventionalwisdom. Efficiency gains play a prominent, if notpreeminent,role inmostgovernmentplanstomanageenergyconsumptionincludingthelatestUSEnergyAct.ButiftheassertionsoftheKhazzoom-Brookespostulatehold,theeffectsofsuchprogramsmaybetheoppositeoftheirintentions.
While the so-called “rebound effect” on demand waspennedbyenergyeconomistDanielKhazzoomfollowingtheOPECoilshocks,theconceptdatesbackmuchearliertotheBritisheconomistJevons,whonotedtheparadoxthatimprovementsintheefficiencywithwhichanaturalresourceisused,isoftenassociatedwithanincreaseintheconsumptionofthatresource.Jevonsobservedthatafter thehugeefficiencygains followingtheadventofJames Watt’s steam engine, coal consumption, afterdropping initially, rose by tenfold between 1830 and1860.
The same story replayed with efficiencies gains insteel production in that era. The Bessemer process forproducing steel was one of the greatest fuel-savinginnovationsinthehistoryofmetallurgy,butitsultimateeffectwastoincrease,notreduce,thedemandforfuelduetothesubsequentsurge insteelproduction.Thus,while each ton of Bessemer steel or horsepower ofWatt’ssteamenginemightrequirelessfuelthanbefore,skyrocketingincreasesinthedemandforsteelandpoweroverwhelmedtheefficiencygains,leadingtosignificantlygreaterfuelconsumption.
DoesEnergyEfficiencySaveEnergy?JeffRubinandBenjaminTal
Khazzoom’s reboundeffect isnot likely toprove tobeanymorepopulartodaythanitwaswhenitfirstraisedcriticism of environmental initiatives after the two oilshocks.Nevertheless,withdepletionofconventionaloilsupplybecomingmoreandmoreevident,andgrowingconcernovergreenhousegasemissions,itsimplicationshave never seemed more important. Particularly nowthatonceagainthecallforconservationthroughgreaterenergyefficiencyiswidelyviewedasthesolutiontobothAmerica’soildependencyonpotentiallyhostilesuppliersand thepressingneed to limit carbonemissions in theatmosphere. TheKhazzoom-Brookespostulate suggeststhattheanswertobothchallengesmaylieelsewhere.
Americans Efficiently Consume Ever-IncreasingLevelsofEnergy
The problem is that energy efficiency is not the finalobjective—reducing totalenergyconsumptionmustbethefinalobjectivetoboththechallengesofconventionaloildepletionandtogreenhousegasemissions.Despitethe huge gains in energy efficiency, that is simply nothappening. Instead,energyconsumption isgrowingbyeverincreasingamounts.WhileenergyuseperunitofUSGDPhasfallenbyalmost50%since1975,totalenergyusageintheUSeconomyhasrisenbymorethan40%(Chart1).
Chart 1AmericansEfficientlyConsumeEver-IncreasingAmountsofEnergy
Source: EIA
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CIBC World Markets InC. StrategEcon - November 27, 2007
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Most government efforts to promote greater energyefficiency have been targetted at the transportationandresidentialsectors,whichtogetheraccountforhalfof total end-use energy consumption in the Americaneconomy. And they have largely been successful atpromotinglargeimprovementsinenergyefficiency—50%fasterthanthepaceintherestoftheeconomy(Chart2,left).Butparadoxically,energyusageinthetransportationandresidentialsectorshasalsorisenfasterthanintherestoftheeconomy(Chart2,right).Inshort,energyusagehasrisenfastestwhereenergyefficiencygainshavebeenthegreatest.
What holds for energy usage also holds for carbonemissions. CO2 emissions from the transportation andresidentialsectorshaverisenby40%,twicethepaceofemissionsgrowthintherestoftheUSeconomy.Infact,emissionsfromthesetwosectorscontributednolessthanthree-quartersofthetotalend-useemissionsgrowthintheUSeconomyoverthelastdecade(Chart3).
The transportation sector is perhaps the best exampleof the efficiency paradox. And it is one of the mostimportantsectorsintermsofenergyusage,accountingforalmost30%ofend-useenergyconsumption,andfor70%ofoilconsumptionintheformofgasoline,dieselandjetfuel.Thesectorhasseensteadyandsubstantialimprovements in energy efficiency since the OPEC oilshocks. Since 1980 the fuel rate, the average mileagepergallonforagiventypeofvehicle,has improvedbynolessthan30%.Onemightexpectthisimprovementto lower average fuel consumptionper vehicle, but as
is evident in Chart 4, fuel consumption per vehicle inthe US has remained remarkably constant despite theimpressiveimprovementinfueleconomyoverthelast25years.Why?
Because of the rebound effect. American driversconsumed all of the gains in fuel efficiency by drivingmore and by driving larger vehicles. Whereas in 1970theaverageAmericancarwasdriven9,500milesayear,todayit isdrivenover12,000milesayear(Chart5). Inpart,thisreflectsthegrowthofsuburbia,itselfafunctionofincreasingfuelefficiencyintransport.
Chart 2EnergyConsumptionRisingFastestWhereEfficiencyImprovedtheMost
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CIBC World Markets InC. StrategEcon - November 27, 2007
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NotonlyhaveAmericansconsumedfuelefficiencygainsbydrivingmore,buttheyhavealsoconsumedthosegainsbydrivingever-largervehicles.WhileinitiallythepursuitoffueleconomyinNorthAmericaledtothereplacementof gas-guzzling eight cylinder full-size cars with fourcylindersub-compacts,overtimesteadyimprovementsinfueleconomyencouragedAmericanstodrivelargerandlargervehicles.Thenumberoflighttrucks,whichincludesSUVs, vans and pick-ups, has risen by 45% between1995-2005, seven times faster than passenger cars. Infact, light trucksaccountedformore than80%of thegrowthinthenumberofvehiclesontheroadsince1985,becomingwithoutquestion,thevehicleofchoiceforyourstandardAmericanfamily.Onaverage,lighttruckshave25%worsefueleconomythanthestandardcar.
Butthestorydoesnotendthere.Improvementsinfueleconomyhaveallowedmorepeopletodrivecars.Todaythereare130millionmorevehiclesontheroadinAmericathantherewerein1970.Andoverthepastdecade,thenumberofcarsonAmericanroadsgrewattwicethepaceofhouseholdformation.ImprovedfuelefficiencythathasbroughtdowntheoperatingcostofrunningavehiclehasencouragedmoreandmoreAmericanhouseholdstoownmorethanonevehicle(Chart6).
Essentially the same rebound effect evident for motorvehiclesisfoundelsewhereinthetransportationsector.Takeaviationfuelforexample.Whilefuelconsumptionpermileflownhas improvedbymore than40%since1975, overall fuel consumption of aviation has risenby 150% over this time frame, due to the explosive
growthinthevolumeofairtravel.Gainsinusagehaveoutstrippedgainsinefficiencybyaratiooffourtoone(Chart7).
Thesamereboundeffectwasalsonotedseveraldecadesagowiththewideningofaircraft.Initiallywideraircraftwereexpectedtoreduceflightfrequencysinceeachflightwouldbeabletoaccommodatemorepassengers.Whatwasn’t foreseen was that wider aircraft lowered costsperpassengerandthusprices,whichinturn,inducedanincreaseinairtravel.Insteadofreducingthenumberofflights,thereboundeffectfromwideraircraftendedupincreasingthenumberofflights.
Chart 7FuelEfficiencyLagsConsumptioninAviation
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Chart �TheReboundEffect:MotorVehicleUsage
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Chart �EnergyConsumptionRisesWiththeSizeofVehicleFleet
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CIBC World Markets InC. StrategEcon - November 27, 2007
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Again, what holds for energy usage holds for carbonemissions.That’sevenmoresoforemissionsfromairlines,since their carbon trail is so disproportionately largecomparedtootherformsoftransport.
Gains in Usage Trump Those in Efficiency inResidentialSectorAsWell
The same patterns between improved efficiency andgrowing usage found in the transportation sector areamplyinevidenceintheresidentialsector,whichaccountsforroughly20%ofallend-useenergyconsumptionintheAmericaneconomy.Improvementsinthermalinsulationandintheenergyefficiencyofmajorappliancesincludingfurnaces and air conditioners, have all contributed tomajor gains in energy efficiency over the last threedecades. Virtually every major household appliance intheUSmustnowmeetsomeminimumenergyefficiencystandard.
But are these efficiency gains large enough to offsetincreased usage? Take refrigerators for example. Overthe last 15 years the energy efficiency of refrigeratorshas improved by just under 10%, but the number ofrefrigerators is up 20%, due largely to the increasedfrequency of a second refrigerator in the home. (Notethe tendency toward two-car households is the samefactordrivinguptheenergyusageinthetransportationsector.)Thenetresultisthatusagehasrisentwiceasfastasefficiency.
Evenmoresignificantfortotalresidentialenergyusageishowefficiencyversususagestacksupinairconditioningand heating systems. The energy efficiency of airconditioningsystemhasrisenby17%since1990butthenumberofairconditioningunitshasrisenby36%(Chart8,left).Thekeyreasonwhyusagehasgrownsomuchfaster thanefficiency is thenever-ending trend towardlargerandlargerAmericanhomesandhencelargerandlargerheatingandcoolingrequirements.Since1950,theaverageAmericanhomehasgrown from1000 squarefeettoalmost2500squarefeet(Chart8,right).Andthetrendtoeverlargerhousescontinues.Today,almostonethirdofallnewhomesintheUSareover2500squarefeet.
Add to that the ever-increasing number of powerconsuming appliances like computers found in today’sstandard American home and the trend toward rising,not falling, energy usage per household is very clear(Chart9).
Across a wide spectrum of activity throughout theAmerican economy, there seems ample evidence todebunkthenotionthatenergy-savingtechnologyreducesenergy consumption. Instead, energy consumptionhasgrownsteadilyasefficiencyimprovementshavesteadilyloweredthecostofconsumingenergy.
Chart 8EnergyUsageOutpacesEfficiencyinResidentialSector
Chart 9RisingEnergyUsageperHousehold
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CIBC World Markets InC. StrategEcon - November 27, 2007
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USInflation:NotDeadYetAveryShenfeld
TheFed’spriorfocusoncore inflationmadesense inaworldinwhichgasolineorfoodpriceswentupandthencamebackdown.TheconceptdatesfromapaperbytheeconomistRobertGordon in1975,written justafteraspectacularclimbandsubsequentcoolinginbothfoodandenergyinflationmeasures.
Butwhatiftoday’shigherfuelcostssimplygivewaytoevenhigherpricesinthefuture,orifglobalforcespushfoodpricesonapermanentlyfastertrend?Since2002,onacumulativebasis,headlineCPIhasoutpacedcoreby4.8%(Chart1),andmoreofthesameisinstorefor2008.WhilesomecoolingislikelyafterQ4,bondinvestorswillagainbestaringataUSCPIrateofroughly4%nextfall,makinginflation-linkedTIPSaninterestingplay.
OilInflationServedFourWays
GlobalenergymarketsarefuellingUSinflationinatleastfour ways. First, and most directly, rapid growth in oildemand from developing Asia, and from oil exportersthat typically subsidize their domestic consumers, hascrudepricesontherise.Globalsupplyisstilladvancing,butallofthemarginalbarrelsarecomingfromhighcostunconventionalsources—oilsandsanddeepwater.
Moreover,creatingroomforemerging-marketconsumersandindustrytoelbowtheirwayintothemarketrequiresever-risingpricestoinducethenecessaryconservationinthedevelopedworld,sothatoveralldemandisheldtothesluggishtrendgrowthinsupply.Wemay“only”belookingatUS$100/bbloilin2008,butareboundfromtheunusuallylowcrackspreadsthatprevailedinrecentmonthswillseegasolinepriceshandilytopandsustainUS$3.50/gallon(Chart2).
Naturalgashaslaggedwellbehindcrudeprices,butthereisa longer term relationship linked to fuel substitutionin some uses (Chart 3). Moreover, natural gas usagewillbeincreasedbyethanolproduction.Ifthiswinterisanythingclosetonormal,USHenryHubnat-gasshouldaverage US$9/Mbtu next year. Add it all up, and theenergycomponentoftheCPIisprojectedtoberunningindoubledigitsformuchofthecomingyear.
With risks to growth seen as paramount, US financialmarkets are shrugging off the recent upturn in CPIinflation.Sure,itsOctoberjumpto3.5%wasallabouta dip in gasoline prices in the prior year’s base forcomparison (i.e. October 2006), rather than a sharpmonthly upturn. And, of course, the 12-month pacewasallaboutfoodandenergy,withcoreinflationmuchtamer.
But when times get better, as they will further into2008, the Fed will no longer be willing to overlook apersistentlyhighertrendintotalCPIontheexcusethatfoodandenergydon’t count.Whilea rate cutor twoliesahead,don’tbetoosurprisedtoseetheFOMCdefymarkethopesformoreaggressiveeasing,andturntoare-tighteningassoonaslate2008iftheeconomyshowssignsofhealth.Afterall,wealleat,andeventhegreenestamongusstillconsumesomeenergy.
Bernanke and his team finally seem to be recognizingthatthe“core”inflationmeasureisnotthewholestory.TheFedwillnowpublishforecastsnotonlyforthecoremeasure, but also for all-in inflation (in this case, thePCE price index). In doing so, it’s moving more in linewith Europe’s ECB, which focuses more on total CPIratherthancore.InothercountrieswerecoreCPIplaysasignificantpolicyrole(Australia,Canada)foodsotherthanfreshproduceareincludedinthecoremeasure.
Chart 1USCoreCPIUnderstatesTrend
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CIBC World Markets InC. StrategEcon - November 27, 2007
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Chart 2FurtherPressuresonGasolinePrices
Chart �SinkingDollarBoostingImportPrices
been there,meaning thathigherpricesonsome itemssimplydepresshouseholdspendingpower,andthuspricepressures,elsewhere.Butthatcouldprovetobeamoremeaningfulthreatwhentheeconomypicksupbeyondthecurrentslowdown.
Finally, one policy response to high oil prices, andassociated fears of import dependency, has had muchto do with the recent inflation climb in food prices.The combination of subsidies for ethanol, and tariffbarriersonimportedethanol,hasseenarisingshareofUS agricultural land shifted to corngrown for ethanolproduction(seeCIBC World Markets, StrategEcondatedOctober2007).
Theresultingincreasesinfeedgrainpriceshavepushedup meat, dairy and egg prices, contributing to an
Second,energypricehikesareplayinganincreasingroleinAmerica’scurrentaccountandtradeimbalance.Whilethe weak dollar, and better demand growth overseas,are shrinking thenon-petroleum tradegap, agrowingoil importbill is standing in thewayofmoredramaticoverallprogress.TheresultingdownwardpressureontheUSdollar isservingtoraisepricesforotherUSimports(Chart4),withmoretocomeaftertheyen’slatestmove,andasChinaletsitscurrencyappreciateatafasterpace.Thelaggedimpactsofdollardepreciationwillalreadytackonabout0.5%-pointstonextyear’sCPI,accordingtotheFedmodel’selasticities.
Third,energycostsshowupinanumberofcoreprices—airlinetickets,goodsmovedbytruck,andpetrochemicalproductslikeplastics.Thusfar,thedamagetocorepriceshasbeencontainedasthenecessarywageinflationhasn’t
Chart �NatGastoClimb(L),Double-DigitEnergyCPI(R)
Chart �PayingtoEat:USFoodPricesClimb
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CIBC World Markets InC. StrategEcon - November 27, 2007
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Chart �CurrencyGainsShelterCdn,AussieFoodPrices
escalationinfoodinflationto4.4%inOctober,andthefurtherdiversionoflandforethanol-basedcornlookstoboostfoodpricesatanacceleratingpacenextyear(Chart5). Rising incomes in rapidly developing economies inAsiaandLatinAmericaarealso increasingpressureonglobalmeatandgrainprices.Droughtsinsomegrowingareas are also not helping, and at least some viewsuch arid conditions as a lasting feature tied toglobalwarming. Countries like Canada and Australia havebeentemporarilyinsulatedfromfoodinflationbysharplyappreciatingcurrencies.Butfoodcostshavebecometheissue for inflation in countries with lagging currencies,suchasChinaandMexico(Chart6).
CyclicalForcesonlyaTemporaryRespite
These secular inflation threats from food and energyarefornow,beingsetasidebytheFed,withtheFOMCmajority still focused on the threats to growth fromhousingandcreditconditions.Thebondmarketagrees,andhastakenTreasuryyieldssharplylowerinanticipationofFedratecuts.AslongascoreCPIisthefocus,inflationnumbersinthenextfewmonths,whichwillbeuglyonlyinthefoodandenergycomponents,won’tbeproblematicforbonds.CorepricesshouldseeatleastsomecyclicaldampeningemanatingfromtheUSslowdown.
Recessionstypically leavealowerinflationpathintheirwake.But if,asweexpect,thisprovestobenoworsethat a mid-cycle slowdown, the economy won’t openupenoughslacktomateriallychangethetrajectoryforinflation when better growth resumes in the secondhalfof2008. Indeed, inboth1987and1998, the lasttwotimestheFedeasedmid-cycletocounterafinancial
market shock, inflation accelerated in the subsequentsixquarters(Chart7).Byfallof2008,aneconomythatenteredaslowdownwithaheadlineinflationrateabove3%couldbefacingaheadlineratetakingaimat4%.
AHotTIPforFixedIncome
Asaresult,theFedmayberushingtore-tightenbeforeyear-end2008,asitdidnotlongafterthe1987and1998ratecuts.NotonlywillTreasuriesfeeltheheatofrisingshortrates,buttherewillbedoubtsabouttheefficacyoftherenewedtighteningintermsofitsabilitytoquellmoreingrainedinflationpressures.Today’sbondmarketrally will give way to a back-up in 10-year Treasuriestowards5%.
ThatcouldsideswipeCanadianbondsintheprocess,eventhoughneitherthebondmarketnortheBankofCanadawillbefrettingaboutinflationonthissideoftheborder.Thelaggedimpactsofthepastfewyears’C$appreciationinquellinggoodsinflationhasalreadyopenedupahugegapinCPI inflationrates(Chart8).Addinaone-pointcutintheGSTrate,andCanada’sall-itemsCPIwillholdbelow2½%through2008.
Stateside, inflation-linked bonds will be an interestingplay.UnliketheFed’sfocusoncoreCPIorPCE,thepayoffonUSTIPSistiedtoheadlineCPI.Rightnow,ona10-yearTIPS,theimpliedinflationrateasmeasuredbythespreadtonominalTreasuries,isroughly2½%.TIPSwilloutperformTreasuriestotheextentthatinflationexceedsthatimplicitprojectionoverthelifeofthebond,ortotheextent that thespreadwidensas inflationexpectationschange.
Chart 7InflationExperienceAfterMid-CycleFedEase
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CIBC World Markets InC. StrategEcon - November 27, 2007
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Chart 8
CanadianversusUSCPI
History shows that while a number of factors likelydrive thenominalbond-to-TIPSspread,actualheadlineinflationplaysarole.Notethattheimpliedinflationratewashigherattimesin2005-06,wheninflationwasalsorunningatahotterpace(Chart9).If,asweexpect,CPIinflationseessustainedperiodsabove3½%inthecomingyearonfoodandenergyprices,TIPSwilloutperformasinflationexpectationsrise.
Canadian Real Return Bonds (RRBs) might get somecontagion benefit by late 2008, but one likely to bemoremutedthanwhattheTIPSwillexperiencegiventheinflationdifferentialexpected.Evenifitwatchesonlycoreinflation,bytheCanadiandefinition,theBankofCanada
will be taking meat, packaged foods and other suchproductsintoaccount.AndtheimpliedinflationrateinRRBshasnotbeenaswellcorrelatedwithon-the-groundheadlineinflationinCanada.Still,withinflationfearsinCanada likelytoescalateastheUSeconomyreboundslaterin2008,RRBsshouldstilloutperformathreatenednominalGovernmentofCanadabondmarket.
At some point, if headline and core CPI continue todiverge, both the Fed and the Bank of Canada mighthavetotakeanevenharderlookattheassumptionthatcore is thebetter trackingmeasure.But in the interim,bondmarketsshouldexpectatoleranceforheadlinepricepressuresthatdon’tshowupinthecore.
Chart 9USCPIDrivesTIPSSpreads
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CIBC World Markets InC. StrategEcon - November 27, 2007
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CANADA
ECONOMIC UPDATE
UNITED STATES
CANADA 07Q2A 07Q3F 07Q4F 08Q1F 08Q2F 2006A 2007F 2008F
Real GDP Growth (AR) 3.4 2.2 1.9 2.1 3.0 2.8 2.5 2.6
Real Final Domestic Demand (AR) 4.3 4.2 3.5 3.5 3.4 4.7 3.6 3.6
All Items CPI Inflation (Y/Y) 2.2 2.1 2.4 1.6 1.5 2.0 2.1 1.8
Core CPI Ex Indirect Taxes (Y/Y) 2.4 2.2 1.9 1.6 1.5 1.9 2.2 1.5
Unemployment Rate (%) 6.1 6.0 5.9 5.9 6.0 6.3 6.0 6.0
Merchandise Trade Balance (C$ Bn) 65.7 42.6 53.8 56.4 57.4 51.3 55.2 58.8
U.S.
Real GDP Growth (AR) 3.8 3.9 0.8 1.2 2.0 2.9 2.1 2.0
Real Final Sales (AR) 3.6 3.5 1.1 1.2 2.1 2.8 2.4 2.0
All Items CPI Inflation (Y/Y) 2.7 2.4 3.7 3.6 2.7 3.2 2.8 3.4
Core CPI Inflation (Y/Y) 2.3 2.2 2.2 2.2 2.2 2.5 2.3 2.3
Unemployment Rate (%) 4.5 4.6 4.8 4.9 4.9 4.6 4.6 4.9
Wetrimmedourgrowthexpectationsforthenexttwoquarters,givensignsofahittotradefromtheUSdeceleration.ButourviewisnotasdownbeatassomearegoingtobeafterlookingatupcomingQ3results.Thatquartercouldshowalargebuildininventories,butalotofthatwillcomefromimports,ratherthandomesticsources.WecutourCPIforecastearlierthismonthduetotheimpactoftheGSTcut,whichwillnot,however,showupintheBankofCanada’scorerate.
Q3willlikelyberevisedupfromtheearlier-reportedfiguresthatareshowninthetable,butmomentumlookstobelackingforQ4.Butweseeenoughliftfromtradeandstill-positiveconsumerspendingtoescapeanoutrightrecession,anoutcomethatwouldbeasurpriseforinvestorswho,particularlyinthebondmarket,arebehavingasifarecessionisunderway.Weraisedour2008inflationoutlookduetomomentumfromfoodandenergy(seepages8-12).
