ScotiaBank JUL 16 Capital Points Weekly

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Capital Points A weekly look ahead at Canadian and U.S. financial market

Global Economic Research

Capital Points is available on: Bloomberg at SCOE and Reuters at SM1C

Derek Holt (416) [email protected]

Gorica Djeric (416) [email protected]

Is the US Facing a Debt Spiral Like Canada Once Did?Is the US facing a debt spiral like Canada did from the mid-1970s through to themid-1990s? Mary Webb and Nathan Joshua join Gorica and me in examining thepotential for this to come true.

The crux of the issue is whether the US creates such a mountain of public debtthat interest payments become a practically insurmountable burden, crowding outother elements of the federal budget, while also making it very difficult to everrein in budgetary deficits. That would therefore result in a constantly rising debt-to-gdp ratio which would in turn make credit rating agencies and marketsincreasingly nervous over the long haul. Indeed, for sovereign governments,inherent in market discipline is the interest burden of rising public-sector debt as akey variable used in assessing country risk. Increasing interest charges inevitablyrestrain other spending plans, a critical concern as the spending requirements of aging populations force tough trade-offs. This should sound very familiar to aCanadian audience, and it's not at all inconceivable that the US faces the roadCanada went down from the mid-1970s through to the mid-1990s.

Canadas Experiences Recall that this was the period in which decades of large deficits financedspending that became the politically accepted norm and did indeed resultin punitively high interest payments that hardwired deficits into theCanadian fiscal landscape. Gross public debt charges started off aroundthe 2% of GDP range in the early 1970s. Throughout the 1980s and1990s, Canada had faced a rise in gross public debt charges on the Federal

debt alone that was equal to 4-6% of the economy with little difference asto whether we consider interest payments in gross or net terms to accountfor the return on government assets. That far surpassed the US over thatperiod (chart 1), though there are definitional differences. After federaldeficits averaging 5% of GDP at nearly $33 billion from fiscal 82-83(FY83) to FY96, Canada witnessed just such a punitive rise in interestcosts from the $447 billion ramp-up in the net federal debt. In absoluteterms, Canadas federal gross debt charges peaked in FY96 at $49.4billion, representing almost 41% of program spending.

The ensuing rise in the mountain of debt then took over as the dominantdriver of federal deficits through the interest bill such that in order to reinin out -of-control deficits by the late 1980s through to the mid-1990s, program spending had to be cut and tax

revenues raised at a faster pace and for longer than would have otherwise been the case if interest payments had nottaken the driver's seat in Ottawa. By the mid-1990s, the gig was up and heavy fiscal drag was being imposed uponthe economy in what in several respects was the better part of a lost decade for the Canadian economy (including itshousing markets).

US Prospects The US quite possibly faces similar dynamics with structural, very long -lived deficits. Right now, net interestpayments on federal debt equal about 1% of the economy. Thats fairly modest, but still significant. Yet fastforward to the end of this decade and interest payments are more than double as a share of the economy through thePresidents own projections and under what we think are fairly optimistic assumptions on medium-term growth(chart 2). Move forward another decade yet into the 2030s with the CBO's base case and alternative scenarioprojections and interest payments rise to represent up to 8% of the economy. That is akin to what Canada wentthrough by way of deficits being hard wired into the economy just by virtue of the interest bill. Without sharp fiscal

Capital Points is available on: Bloomberg at SCOE and Reuters at SM1C

July 16, 2010

Commentary

Canadian Preview

U.S. Preview

International Preview

U.S. Macro Comment

Canadian Monetary Policy

Foreign Exchange Markets

Equity Markets

Indicator Preview Tables

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FY70 75 80 85 90 95 00 05

% of GDP

Federal Debt Service

Data to FY09. Source: OMB, Finance Canada.

Canada:Gross Debt

Charges

U.S. NetInterest

Net Debt

Charges


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Global Economic Research July 16, 2010

drag or an alteration in the social contract between the federal government and thepopulation, U.S. federal deficits will last much longer than that on Canadian styleparallels. By corollary, what is not a bond and USD bubble now could well becomeone for long-term accounts, and eventually welcome relief through higher discountingof future obligations for pensions and life cos. Todays appetite for safehaven flowsmay be facilitating complacency toward this very real long-term challenge that can beexceptionally difficult to turn.

The key is what happens to the long-run debt position of the US economy in whatamounts to a partial feedback loop with higher interest payments causing more debtand vice versa. In the U.S., the February 2010 federal Budget projected a steep run-up in publicly held debt from 40% of GDP in September 2008 to 69% by September2011 from three years of deficits wider than US$1 trillion. From FY13 through FY20,the Budget forecast a string of deficits equal to about 4% of GDP, that by FY20 againwidens the shortfall beyond US$1 trillion. In the U.S., about a third of Washingtonstotal debt is presently held by government accounts, most notably Social Security. Asthe federal deficit widened beyond the accounts average annual take-up of roughlyUS$250 billion, the proportion financed from public borrowing escalated.Consequently, the Budget projects the debt held by the public climbing steadilyhigher over the next decade, topping 75% of GDP by FY20, while total debt rises

from 69% of GDP in FY08 to more than 100% by FY20 (chart 3).

Growth and Rate Assumptions Could Worsen For how long the debt-to-gdp ratio spirals upward depends partly on the spreadbetween interest rates and growth, but also on the scale of the primary deficits and theextent to which this invokes positive hysteresis effects of the sort weve pointed to viathe interest bill. But now we focus on assumptions surrounding the role played by thespread between rates and growth since, in the Canadian context, that added to the woesof the 1980s and 1990s by pushing the interest bill upward at a faster pace than theeconomy was able to grow revenues (chart 4).

In the U.S. context, the spread between rates and growth cannot be expressed simplyin current terms that entail pointing to the current free pass being given by markets tothe U.S. Treasury to issue as much debt as it wants in an environment marked bycrowding in of Treasury issuance behind a void of net economy-wide private debtissuance of on- and off-balance products including the shadow sector. What if growthslows appreciably and then faces renewed retrenchment by 2012 as per our beliefs,and the appetite for Treasuries and the USD wanes as it did for some Europeangovernment bonds while the US stumbles upon European-style fiscal exit woes andtheir harsh effects on growth over 2011-13? The spread between rates and growthcould well rise appreciably at the same time that deficits remain stubbornly very highand public debt keeps rising. This is not a risk to be dismissed in a cursory fashionparticularly as the US faces long-tailed social security obligations that weresignificantly addressed in Canada with CPP reforms in the late 1990s.

Mildly Encouraging Near-Term Deficit WorriesIn the near-term, the news on the U.S. deficit is actually encouraging and that merits amention. The FY10 deficit, instead of exceeding the FY09 US$1.4 billion deficit byalmost US$150 billion as the Budget projected, will likely be about US$150 billionnarrower. In fact a small decline in program spending is anticipated given the sizablereduction in outlays relative to last year related to TARP, the Treasury payments forFannie Mae and Freddie Mac, and the net outflows for federal deposit insurance.

...Give Way to Long-Run U.S. Fiscal Challenges Yet the challenges to reining in the deficit to significantly less than US$1 trillion byFY12, as the President forecast, remain formidable, including the promised withdrawalfrom the Iraq and Afghanistan conflicts by the end of 2011, the cost of continued tax

Chart 2

Chart 3

Chart 4

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500600

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FY90 94 98 02 06 10e 14f 18f0.0

0.5

1.0

1.5

2.0

2.53.0

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4.0

4.5% of GDP

Forecast Surge in U.S.Federal Net Interest

Source: OMB, Scotia Economics (adjustments for year improvements).

U.S. NetInterest / GDP, RHS

US $ billions

U.S. Net Interest,LHS

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Growth and Interest Rates -Canada's Experience

Source: Finance Canada, Statistics Canada.

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FY90 94 98 02 06 10e 14f 18f

US $ trillions

U.S. Total Federal Debt

Held by Gov't Accts

Held by Public

Source: OMB, Scotia Economics (adjustments for current-year improvements).


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relief for lower- and middle-income citizens and pressure for further assistance for state governments and the long-termunemployed. Under the Pay-As-You-Go legislation adopted in February, key items, such as the tax relief, are subject tospecial treatment. A further concern is the robust real growth assumed in the Administrations Budget estimates. Real GDPgrowth of 3.8% is built in for 2011, with annual gains for the following three years averaging over 4%, whereas ScotiaEconomics looks for real growth to average less than 2 from 2011 to 2014. A bi-partisan Fiscal Commission has beenappointed to identify medium-term policies, with the goal, as laid out in the February Budget, to balance the books,excluding interest payments, by 2015, moving towards a stable debt-to-GDP ratio if nominal GDP growth remains

relatively strong.

Why the 2015 milestone? Washington is well aware of its rising net interest bill, and the escalating costs of its Medicare,Medicaid and Social Security programs with an aging baby boom generation, shadowed by the major health care reform.Net interest, even with narrower-than-expected deficits in FY10 and F11, is still expected to quadruple from FY09 to FY20,surging from 1.3% of GDP to 3 of GDP. Interest charges amply illustrate the restricted fiscal flexibility stemming from astring of oversized deficits and the advantages of embarking sooner rather than later on substantive fiscal consolidation.


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Next Weeks Key Market Risks

The Bank of Canadas rate announcement on Tuesday and the subsequent release of the BoCs Monetary Policy Reportwill be front and centre this week. The fundamental docket is fairly light, but the updates on consumer spending and pricepressures are likely to garner market attention. South of the border, a handful of top-tier U.S. housing market indicatorswill give a key update on recent developments in the residential real estate market in the aftermath of the April-30th expiryof the first-time homebuyers tax credit. Out of Europe, the highlight will be the release of the bank stress test results , dueout on Friday. The Reserve Bank of Australia and the Bank of England are scheduled to publish the minutes from theirrespective July-6 and July-8 monetary policy meetings. And, advanced results from June PMI manufacturing andservices surveys for the euro zone will be the main macro feature; both are expected to expand further, although at a slightlymore moderate pace. Given the lags of the austerity measures introduced in the region, the jury is still out on howmanufacturing and services industries will be affected.

CANADA

Next week will overwhelmingly focus on the BoC interest rate announcement (Tuesday, 9amET) and the release of theBoC Monetary Policy Report (Thursday, 10:30amET). Canadian retail sales disappointed in April, but a month does notmake a trend. Declines were partly attributable to a strong base effect and weaker auto sales. In fact, Canadian retail salesare expected to remain on an upward trend in the months ahead, on positive momentum in underlying fundamentals. Retailsales (Thursday, 8:30amET) are expected to have climbed higher in May, up 0.4% m/m at both the headline and core level,

compared to respective declines of 2.0% and 1.2% in the previous month, on base effects and a touch higher motor vehiclesales volumes (and prices) in May. Solid reasons to expect healthy consumer gains include redeployment of enormousbalances of sidelined cash, combined with one of the strongest global job markets of the past year, alongside those inAustralia and South Korea. May wholesale trade numbers will kick off the week in Canada on Wednesday (8:30amET) trends in wholesale will give guidance for May retail sales numbers.

Canadian headline CPI (Friday, 7:00amET) is likely to have moderated a touch in June we are looking for a 0.1% m/mdecline marking its second straight month of retreat. Over the course of the month, The Thomson Reuters/JefferiesCommodity Research Bureau (CRB) Index increased by 1.5% m/m, reversing only partly the 8.25% drop experienced inApril, the biggest since November 2008. However, retail gasoline prices remained virtually flat (% m/m). The three-monthmoving average suggests that core consumer prices continue to edge higher, but at a moderating pace, a trend we expect tohave extended into June (0.1% m/m). Last weeks release of the new housing price index used as a proxy forhomeowners replacement costs reaffirms this view. Overall, the underlying macro data both on growth and prices

remain supportive of continued rate hikes by the BoC.

The latest BoC Business Outlook Survey indicated that input and output prices are expected to rise over the next 12 months,on forecasts for higher prices of commodities and related inputs as well as improving demand, with many of the firms citingtheir intention to pass along higher input costs to restore or protect profit margins. However, CPI is expected to remainwell-anchored over the next two years, with nearly all firms anticipating that inflation will be within the Banksinflation-control range of 1 to 3%.

UNITED STATES

The data calendar is headed by a series of housing market releases, including July NAHB housing market index, Junehousing starts & building permits, June existing home sales and May FHFA house price index.

NAHB homebuilder sentiment survey (Monday, 10:00amET) will give us an early sense of how the housing market isdoing, once the echo effect of the first-time homebuyers tax credit has dissipated. We expect the headline index tomoderate further in July, down to 16. Since bottoming in early 2009, homebuilder sentiment recovered modestly, but hasbeen trending sideways mostly. The headline index remains at historically depressed levels. Last months results weresharply worse than expected, sending homebuilder confidence back to where it stood in late winter, and the detailssuggested worse to come. Prospective traffic through model homes slipped in June, in line with declining mortgagepurchase applications ever since the tax incentives expired on April 30th, and is likely to fall again in July.

A June update on housing starts & building permits is due out on Tuesday (8:30amET). We expect that housing startsand building permits continued to retreat, down 2.2% m/m and 1.3% m/m, respectively. Homebuilders reacted much fasterto the expiration of homebuyer incentives on April 30th than had been expected, as singles took all of the hit in May,


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declining 17.2% m/m. Single-family unit construction is almost four times larger than multis, placing housing as a source of drag on the economy after gently lifting it so far this year. This is in part why we see U.S. economic growth moderatingover the duration of this year. Future months will likely aggravate the downward trend further yet, as building permits fell5.9% m/m in May, after a steep 10.9% drop in April. The hit, here too, was concentrated in single family homes (-9.9%m/m). While the multi-family segment is showing signs of stabilization, it will be a gradual process, as the inventoryremains high by historic standards and availability of financing is still restrained for both homebuilders and potentialbuyers.

Pending and new home sales count the number of signed contracts, but existing home sales measure closed deals, therebylagging the former by one to two months. Existing home sales (Thursday, 10:00amET) are predicted to have contracted8.0% m/m in June, as pending home sales plunged a record-breaking 30% m/m in May. Given the lagging nature of existing home sales, this decline will be reflected in both June and July results. While resale activity unexpectedly declinedin May, it remained at solid levels; sales figures have yet to fully reflect the state of the underlying demand following theexpiry of the tax credit. Though below this cycle's high of 11 months, listed supply on hand currently sits at 8.3 months,well above the long-run average of under 6 months. Whats more, the official number does not reflect the shadowinventory, which, if included, would roughly double the official months supply.

In the years ahead, we expect generally flat house prices to result from the gradual release of shadow inventories. Basel IIIwill amplify this risk, as a greater emphasis gets placed on capital preservation.

On the speech front, Fed Governor Duke a voting centrist will give welcoming remarks at a hearing on theCommunity Reinvestment Act on Monday (9:00amET). Fed Board Governor Tarullo also a voting centrist willtestify at a Senate Banking Committee hearing on Continuing Oversight on International Cooperation to ModernizeFinancial Regulation on Tuesday (10:00amET). Fed Chairman Bernanke wraps up the week with two testimonies. TheChairman will deliver the semi-annual monetary policy report to the Senate Banking Committee on Wednesday(10:00amET) and to the House Financial Services Committee on Thursday (9:30amET).

There are no government bond auctions scheduled for next week in the United States.

INTERNATIONAL

The highlight on the international front will be the release of the bank stress test results , due out on Friday. A EuropeanCommission spokesperson said the results will be published on a bank-by-bank basis, and that these individual results willbe done on a consolidated basis, i.e. at group level, including the foreign branches and subsidiaries. The statement alsoindicated that in order not to mix the different exercises, it was agreed that the supervisory authorities wishing to disclose theresults of stress tests done on foreign subsidiaries will not do so before two weeks from the release of the results of the CEBSexercise. For more information, refer to page 13 of our July 9, 2010 issue of Capital Points , where Tuuli McCully examinesthe key features of the forthcoming European banking-sector stress tests.

While it will be a relatively quiet week in Asia and Oceania, there will be a slate full of top-line releases in the euro zoneregion. From Australia , we get the minutes from the RBA July-6 meeting. The minutes of its June monetary policymeeting singled CPI as a potential hurdle. Those from the July 6 meeting to be published on Monday could providemore insight on recent developments in price dynamics. The RBA expects core inflation to trend around 2.75% through2010 and 2011, before climbing a touch higher to 3.0%. Hong Kong will publish its June unemployment rate and CPI,while Japan is to release its leading economic indicators index for May. From the euro zone region , we get preliminaryaggregate and regional (France, Germany) manufacturing and services PMIs for July, alongside May construction output,May industrial new orders and July consumer confidence. Germany will make June producer prices available and circulateresults of the IFO business climate survey for July. France will issue an update on its consumer and business confidencenumbers for July as well as consumer spending figures for June. Italy the regions third biggest economy will printits May industrial orders and retail sales, as well as July consumer confidence. The U.K. has a handful of top-line releaseson the docket, including the advance Q2 GDP, the BoEs July-8 meeting minutes, June retail sales and June public finances.With exception of the Bank of Canada, there are no major central bank monetary policy meetings next week.


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Walls Street Slowly Turning On the Lending Tap, But Commercial Banks Remain Reluctant

The Feds inaugural quarterly Senior Credit Officer

Opinion Survey (SCOOS) on dealer financing terms released on Tuesday, July 13 revealed that financialmarkets remain fragile, but that lending conditions atdealers are gradually improving on increased competitionand improved liquidity, revived by low interest rates andThe Feds emergency liquidity programs.

The SCOOS was modeled after the Senior Loan OfficerSurvey, which tracks commercial-bank lending tohouseholds and businesses. The SCOOS collects qualitativeinformation from a panel of 20 financial institutions thatrepresent most of the dealer financing activity on changesin credit terms and conditions in securities financing andover-the-counter derivatives markets. Special questionsasked participants to compare current conditions to those inlate 2006, before the crisis began.

Over the past three months, financing appetite improvedfor high-grade corporate bonds, stocks, and residentialmortgage-backed securities issued by Fannie Mae andFreddie Mac as well as other asset-backed securities.Dealers provided somewhat more favourable terms tohedge funds, private equity firms, insurance companiesand other major institutional investors. Some offeredlower borrowing rates, while others loosened financingterms (documentation requirements, haircuts, maximummaturity), but efforts by clients hedge funds inparticular to negotiate more favourable terms had alsointensified. However, little change was reported in theUS$615 trillion OTC derivatives market for both plainvanilla and more exotic derivatives and overalllending conditions remain uniformly more stringent than in late 2006.

While lending conditions for businesses and households have improved since bottoming in late 2008, they remain restrictively tight.The most recent Senior Loan Officer Survey showed that most commercial banks kept the bar high for borrowers (chart 1). Theonly exceptions were large banks, where a small fraction of respondents reported having eased somewhat their lending policies,and mostly so for large- and medium-size businesses. In a speech on Monday, Fed Chairman Bernanke called for financialinstitutions to step-up lending efforts to support economic recovery and boost employment. Commercial banks remain cautious,with the decline in lending more than offset by increases in cash reserves which continue to hover near record highs establishedduring this cycle and Treasury holdings (Chart 2).

Loans to individual residential borrowers and small businesses are particularly challenging to secure. Small businesses account forabout half of GDP and over two-thirds of U.S. employment, with start-up businesses of less than two years the ones that rely themost on loans estimated to contribute about one quarter of job growth. The June survey from The National Federation of Independent Businesses revealed that the Small Business Optimism Index has come in below a reading of 90 in 23 of past 30months June included an unprecedented result, as the index has tended to break above the 100-point mark within a quarter ortwo of the trough in economic activity.

As this weeks new Fed survey showed, financial institutions are gradually regaining confidence, testing the waters with larger,safer borrowers, cautiously spreading out a broader client base. Basel III and the U.S. Financial Reforms Bill which will specifyboth the level and quality of the minimum capital and liquidity requirements to be put aside as a safeguard against financial andoperational risk will, at least in the near term, have banks erring on the side of caution.

U.S. Macro Comment Gorica Djeric(416) 862-3080 Derek Holt(416) 863-7707

[email protected] [email protected]

Household & Business Lending

-40

-20

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96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Source: The Federal Reserve, Scotia Economics

net percentage of domestic respondentsw ho continue to tighten lending standards

ConsumerLoans

Business Loans:Small Firm s

Business Loans: Largeand Medium Firms

Chart 1

Chart 2Banking Sector Balance Sheet

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8,000

Source: The Federal Reserve, Scotia Economics

billions of dollars, SA billions of dollars, SA

Cash Rese rves (RHS)

House hold andBusiness Loans

(LHS)

Treas ury Holdings(LHS)


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Bank of Canada Expected To Hike by 25bps Next Week, Maintain Neutral Bias

We have previously provided our in-depth Bank of Canada, Fed and overall curve views (Treasury Supply to Restrain the Bear

Flattener, pages 1-4, Capital Points, July 9, 2010). The consensus is unanimous on the near-term call with every economist in theBloomberg and Reuters polls expecting a 25bps rise. We would also anticipate the maintenance of a neutral bias for reasons wereviewed in that previous article but that are summarized in terms of a central bank that wishes to avoid being handicapped bymarkets that too aggressively price in a full tightening cycle through CAD and the short-end of the curve. Canadian growth andleading indicators remain strong, and future prospectspoint toward slower growth in a non-emergencysetting for growth that no longer requires emergencyrates.

The greater debate is what would motivate the BoC tobegin hitting rates harder than expected. To thateffect, this week saw considerable debate over whetherinternal views at the BoC are concerned about

inflation-overshooting as brought forward by a formeradvisor to the BoC through a C.D. Howe Institutepaper (go here: http://www.cdhowe.org/pdf/ ebrief_102.pdf).

The second debate we offer concerns evidence of transmission mechanisms of record-high house pricesinto distorted credit decisions by Canadian householdborrowers. While Canadian home equity remainsexceptionally higher than in the US (chart 1), a correction to house prices that appears underway may close some of this gap.Further, what is not included in these home equity figures in Canada but is in the U.S. is explosive growth in lines of credit. Thatsbecause the U.S. includes secured Home Equity Lines of Credit (HELOCs) in mortgage figures that are deducted from housingassets to compute home equity, but Canada records HELOCs and unsecured lines of credit not in mortgage figures but in consumerloan tallies.

Since Lehman blew up in September 2008, drawn balances on Canadian personal lines of credit have risen by about $50 billion.That extra $50 billion in total secured and unsecured lines of credit is a further dent in Canadian home equity, and much of it iseither secured directly against home equity or, even if not, benefits from a wealth-effect induced upward bias to borrowing appetite.While refinancing may be more punitive and difficult in Canada than the U.S., dont take that to mean that wealth-effect inducedcash-outs are not occurring here in a manner that is transmitting the effects of low rates into distorted borrowing patterns. We think they reflect Canadian-style equity cash-outs that should be of concern to Canadian monetary policy as it should have been in theU.S. several years ago.

Canadian Monetary Policy Gorica Djeric(416) 862-3080 Derek Holt(416) 863-7707


Chart 1


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Reserve Diversification Amongst Emerging Markets Favours New Alternatives

Over the past year, the market has experienced severe bouts of weakness in both the USD and EUR, to the extent that their positions

as reserve currency vehicles has been challenged. While it is not under any doubt that both currencies will continue to account forthe largest proportion of global reserves in the decade to come, due to their liquidity and economic importance, other currencies areincreasingly being viewed as viable reserve vehicles. This bodes particularly well for CAD and AUD. While liquidity will be lessthan that found in the USD and EUR, the benefits of diversification serve to outweigh the liquidity constraints. This begs thequestion as to whether there has been concrete evidence of movement into non-traditional reserve currencies. We refer to therecently released IMF Currency Composition of Official Foreign Exchange Reserves data (covering up to the end of Q1 2010) forevidence.

Looking at the total allocated reserves amongst all emerging/developing and developed economies, we can observe an interestingtrend unfold over the past few quarters. It is not surprising that the pattern of reserve allocation in the EUR and the USD mirroreach other to the extent that gains in the EUR allocation generally occur coincidentally with decreases in the USD reserveallocation. We note a general downtrend in the proportion of reserves allocated to the USD and a concurrent uptrend in theproportion of reserves allocated to the EUR (see Chart 1). Another interesting pattern appears when looking at the proportion of

reserves allocated to GBP, JPY and the other category, which captures all other currencies excluding CHF (see Chart 2). It seemsthat this category, which has been fairly stable at around 1.7% of total reserves in the decade before 2009, has suddenly increasedrapidly to 3.7% of all reserves. While small in comparison with the proportion of reserves allocated to the USD and EUR, thepotential impact is much larger. Currency trades involving these other pairs (according to BIS statistics) in aggregate only makeup 20% of daily global foreign exchange turnover. Thus, shifts in reserves into these other less liquid currencies, though smallrelative to all FX reserves, can have a large impact on valuations due to lower liquidity levels. A $10bn shift into CAD from USDcan have a much more significant impact on USDCAD than a $10bn shift into EUR from USD has on EURUSD.

Today, the most important reserve managers are those in the emerging/developing economy category, considering that they hold66% of total global currency reserves (up from 50% in 2005 and 37% in 2004). The proportion of emerging market reservesallocated to the other currency category had averaged 1.5% in the decade before 1999, though this proportion has increased evenmore rapidly than in the all-country measure. Reserves allocated to other currencies have essentially doubled over the past threequarters, from around 2% to 4.4% (see Chart 4), indicating that non-standard reserve currencies are becoming more sought after byemerging market managers. This seems to have come at the expense of the USD, though EUR reserves have also fallen, as theproportion of reserves lost to EUR and USD combined essential equals that gained by other currencies. This trend will likelycontinue to develop and be borne out by future IMF data, particularly considering how precipitously EUR fell in the second quarterof 2010. We believe that commodity currencies are likely to be the most popular recipients of reserve diversification, though wehave also seen a recent increase in GBP and JPY holdings.

Foreign Exchange Markets Camilla Sutton(416) 866-5470 Sacha Tihanyi(416) 862-3154



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Beat the Street

Q2 Earnings Could Positively Surprise

Although economic worries hit equity markets last quarter, we would expect another solid earnings season for the S&P 500. We seefour reasons why the upcoming Q2 earnings season could once again surprise on the upside:

Economic figures published so far in Q2 have, on average, been firmer than in Q1. Recent earnings revisions have been only mildly negative. Negative to Positive (N/P) preannouncement ratio is below average. S&P 500 earnings sensitivity to Europe is relatively low.

S&P/TSX Q2/10 Earnings Season PreviewEarnings. Based on bottom-up consensus forecasts, quarterly EPS should expand 7% year over year (YOY) to $182 in Q2. On asequential basis (Q2/10 vs. Q1/10), TSX earnings are expected to grow 3% (see Exhibit 1). At $182, the TSX is en route to postingits best quarterly earnings performance since the $273 registered in Q3/08. TSX quarterly EPS troughed at $122 in Q1/09. TSXtrailing EPS is expected to hit $681 in Q2.

Top line: TSX quarterly revenues are expected to rise 2% on a sequential basis, the second straight increase. Eight of 10 sectorsshould grow their top line in Q2, with Materials (+27% quarter over quarter) and Consumer Staples (+23%) expected to rank in thetop two spots. Financials (-12%) and Utilities (-8%) should experience declining revenue in Q2.

Sectors: Breadth is improving, with seven of TSX GICS sectors expected to deliver sequential earnings growth in Q2 comparedwith five sectors in Q1/10 and six in Q4/09. Cyclicals should stay in the drivers seat, with Materials (+38%), Discretionary(+33%), and Industrials (+31%) expected to post solid earnings growth in Q2. Consumer Staples should, however, deliver thestrongest sequential earnings improvement with bottom-up forecasts calling for a 51% increase. Amongst the laggards, Utilities(-48%), Energy (-13%), and Financials (-6%) are expected to report earnings declines on a sequential basis.

From an industry standpoint, Banks earnings areexpected to grow 6% sequentially in Q2 while

Insurance earnings should tumble 34% afterhaving posted a strong scorecard in Q1.Insurance earnings could be hit by volatileinterest rates and equity markets as well asdeterioration in credit spreads. Materials EPSshould bounce 38% QOQ in Q2 as Mining andFertilizers are expected to report strongscorecards. Earnings expectations are low for theGold sector (+2% QOQ) despite the 7.8%quarterly increase in the average gold price.

Beat or Miss: We believe TSX Energy andGolds Q2 EPS could surprise on the upside, andwe see little upside for Financials, while Miningcould disappoint once again.

S&P 500 Q2/10 Earnings Season PreviewEarnings: Quarterly EPS is expected to reachUS$19.61 in Q2/10, according to S&P data,which translates into a 1% sequentialimprovement and a 42% YOY increase. Yearlycomparisons are still impressive, given a verylow earnings base last year, but that couldchange as soon as Q1/11. Although the bar has

Equity Markets Vincent Delisle(514) 287-3628 Hugo Ste-Marie(514) 287-4992


Contribution to Sector$ QoQ YoY to TSX Earnings Weighting (%)S&P/TSX 182 3% 7% 100% 100%

Energy 29 -13% 32% 26% 27%Materials 41 38% 47% 12% 21%

Divers. M/Mining 166 92% 74% 3% 3% Gold 27 2% 20% 6% 13%

Fertilizers 73 62% 51% 2% 3% Industrials 18 31% 9% 4% 6%

Transportation 47 30% 23% 3% 3% Capital Goods 8 34% -5% 1% 2%

Cons. Discretionary 19 33% 48% 4% 5%Cons. Staples 31 51% 1% 2% 3%Health Care 5 13% 20% 0% 1%Financials 30 -6% -17% 39% 30%

Banks 40 6% 3% 25% 20% Insurance 17 -34% -53% 11% 6%

Technology 5 9% 21% 4% 3%Telecom 16 3% 10% 6% 5%Utilities 19 -48% 12% 2% 2%TSX 60 11 1% 0% 82% n/aTSX Completion 10 16% 55% 18% n/a

Q2/10 E

Exhibit 1: S&P/TSX Q2/10 Earnings Expectations (as at June 30, 2010)

Q2/10 estimates include companies with quarter ending in May, June, and July.

Source: Scotia Capital; Thomson Financial; Bloomberg.


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1


been set higher than in Q1 (the consensus was set at US$17.16) and investors remain worried over the global economic prospects,we believe the upcoming earnings season could once again surprise on the upside. The beat ratio should remain above its 10-yearaverage of 64% for a sixth consecutive quarter, but it will most likely come off from the 75%-80% range seen in the past few

quarters. S&P 500 trailing EPS is expected to hit US$72 in Q2.

Top line: Should continue to gain traction in Q2 as companies benefit from the global economic recovery. S&P 500 quarterlyrevenues are expected to grow 1.4% QOQ, posting their fifth straight sequential improvement.

Sectors: On a sequential basis, five sectors are expected to post positive EPS growth in Q2. That is similar to the breadth observedin the past two quarters. In terms of earnings improvement, Industrials (+7%), Consumer Staples (+7%), and Technology (+6%)should be the top performers on a sequential basis, while Consumer Discretionary (-2%), Financials (-3%), and Utilities (-22%)should deliver the weakest results. Note that YOY comparisons are not very meaningful, as they are still distorted, given a very lowbase effect.

Scotias Top-Down View on Earnings

Taking Our 2011 Numbers DownWe continue to believe the global recovery remains on track, but the pace of growth will slow down in the coming quarters. Thecurrent consensus is looking for U.S. GDP growth of 3.2% this year and 2.9% in 2011. For China, growth forecasts stand at 10.1%in 2010 and 9.3% in 2011. In our opinion, these forecasts will be revised lower. In fact, the momentum in the global leadingindicator has already started to weaken, which is pointing towards a slower pace of global economic expansion. A deceleration inthe global economy would not derail the earnings recovery, but it would most likely slow the healing process.

The current flattening U.S. yield curve is also calling for a slower pace of earnings growth over the next 12 to 18 months. Hence,we expect low single-digit EPS growth in fiscal 2011.

We have recently taken our EPS forecasts lower. Our 2010figures are relatively unchanged, but we have reduced our2011 estimates by about 3% for both the TSX and S&P 500.We forecast S&P 500 earnings of US$78 (+37% YOY) in2010 and US$82 (+5% YOY) in 2011. TSX earningsestimates are reduced to $750 in 2010 and to $825 in 2011.

2011 Bottom-Up Forecasts Too OptimisticRecent economic figures have been disappointing and therecovery is clearly losing momentum. If this trend persists incoming months, bottom-up earnings forecasts will have to bemarked down. 2011E EPS figures appear more at risk as theyare calling for 15%+ earnings growth in Canada and the U.S.,which appears optimistic at this point. As pointed out inExhibit 2, S&P 500 quarterly EPS forecasts are rising fast in2011. Moreover, the Q3/11 consensus figure of US$24.31would even set a new record high in terms of quarterly

earnings, beating the previous US$24.07 record registered inQ2/07.

The pace of positive earnings revisions has already started to slow and this trend should extend over the coming months. Thepositive-to-total earnings revisions ratio has turned lower recently for both the TSX and S&P 500. If this ratio falls in the 40% rangeor below, negative earnings revisions will take centre stage. As this deceleration process plays out over the coming months, wewould expect a different earnings leadership to emerge in favour of more defensive assets/sectors.

Equity Markets (continued) Vincent Delisle(514) 287-3628 Hugo Ste-Marie(514) 287-4992


20.72

22.03 22.01

23.22

24.31

25.48

19.68

19.38

16

17

18

19

20

21

22

23

24

25

26

27

M a r - 1 0

J u n - 1

0

S e p - 1

0

D e c - 1

0

M a r - 1 1

J u n - 1

1

S e p - 1

1

D e c - 1 1

EPS forecasts calling for steep

increase in profitability, especiallyafter Q3/10

Exhibit 2: S&P 500 Quarterly EPS Forecasts Rising Fast in 2011

Source: Scotia Capital; S&P.


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Estimates for the week of July 19 23

Canada

United States

Date ET Indicator Period BNS Consensus Latest

07/19 (10:00) NAHB Housing Market Index Jul 16 16 1707/19 (09:00) Fed's Duke Gives Welcoming Remarks at CRA Hearing

07/20 (07:45) ICSC Chain Store Sales - Weekly (w/w) Jul. 17 -- -- -1.507/20 (08:30) Housing Starts (mn a.r.) Jun 0.580 0.577 0.59307/20 (08:30) Building Permits (mn a.r.) Jun 0.567 0.570 0.57407/20 (10:00) Fed's Tarullo Testifies on Financial Regulation in Senate

07/21 (07:00) MBA Mortgage Applications (w/w) Jul. 16 -- -- --

07/21 (10:00) Bernanke Gives Monetary Policy Report to Senate Banking Panel07/22 (08:30) Initial Jobless Claims (000s) Jul. 17 440 450 42907/22 (08:30) Continuing Claims (mn) Jul. 10 -- 4.59 4.6807/22 (10:00) Existing Home Sales (mn a.r.) Jun 5.15 5.20 5.6607/22 (10:00) Leading Indicators (m/m) Jun -0.4 -0.3 0.407/22 (09:30) Bernanke Gives Monetary Policy Report to House Panel


07/19 (08:30) Int'l C$ Securities Transactions (C$ bn) May -- -- 12.407/20 (09:00) BoC Interest Rate Announcement (%) 0.75 0.75 0.50

07/21 (08:30) Wholesale Trade (m/m) May 0.3 0.3 -0.3

07/22 (08:30) Retail Sales (m/m) May 0.4 0.5 -2.007/22 (08:30) Retail Sales ex. Autos (m/m) May 0.4 0.5 -1.207/22 (10:30) Bank of Canada Monetary Policy Report and Press Conference

07/23 (07:00) CPI, All items (m/m) Jun -0.1 -0.2 0.307/23 (07:00) CPI, All items (y/y) Jun -- 0.9 1.407/23 (07:00) Core X8 CPI (m/m) Jun 0.1 0.1 0.307/23 (07:00) Core X8 CPI (y/y) Jun -- 1.9 1.8


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Estimates for the week of July 19 23

Europe

Asia/Oceania


07/19 (04:00) EC Current Account (EUR bn) May -- -- -5.107/19 AU Reserve Bank's Board July Minutes (21:30)

07/20 (02:00) GE Producer Prices (m/m) Jun -- 0.2 0.307/20 (04:30) UK M4 Money Supply (m/m) Jun -- -0.1 0.007/20 UK CBI Quarterly Industrial Trends Survey

07/21 UK BoE Minutes July 7-8

07/22 (02:45) FR Consumer Confidence Jul -- -40.0 -39.007/22 (02:45) FR Business Confidence Jul -- 95.0 95.007/22 (03:30) GE Services PMI (index) Jul -- 54.5 54.807/22 (03:30) GE Manufacturing PMI Jul -- 58.0 58.407/22 (03:50) FR Services PMI (index) Jul -- 60.0 60.807/22 (03:50) FR Manufacturing PMI (index) Jul -- 54.1 54.807/22 (04:30) UK Retail Sales (m/m) Jun -- 0.6 0.507/22 (05:00) EC Industrial New Orders (m/m) May -- -- 0.607/22 (05:00) EC Industrial New Orders (y/y) May -- -- 21.807/22 (10:00) EC Consumer Confidence Jul -- -- -17.0

07/23 (02:45) FR Consumer Spending (m/m) May -- -- 0.707/23 (04:00) GE IFO Current Assessment Survey Jul -- 101.8 101.107/23 (04:00) GE IFO Business Climate Survey Jul -- 101.6 101.807/23 (04:30) UK GDP (q/q) Q1-F -- 0.6 0.3

Date ET Indicator Period BNS Consensus Latest07/20 (01:00) JN New Composite Leading Economic Index May -- -- 98.707/20 (01:00) JN Coincident Index CI (index) May -- -- 101.207/20 (21:30) BOJ Deputy Governor Yamaguchi to Speak in Toyama City

07/21 JN BoJ Minutes June 14-1507/22 (00:30) JN All Industry Activity Index (m/m) May -- -- 1.8


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Capital Points


Scotia EconomicsScotia Plaza, 40 King Street West, 63rd Floor Toronto, Ontario Canada M5H 1H1

Tel: (416) 866-6253 Fax: (416) 866-2829 Email: [email protected]

This report has been prepared by SCOTIA CAPITAL INC. Opinions, estimates and projections contained herein are our own as of the date hereofand are subject to change without notice. The information and opinions contained herein have been compiled or arrived at from sources believedreliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. Neither Scotia Capital Inc., nor itsaffiliates accept liability whatsoever for any loss arising from any use of this report or its contents. This report is not, and is not to be construed as,an offer to sell or solicitation of an offer to buy any securities and/or commodity futures contracts. Scotia Capital Inc., its affiliates and/or theirrespective officers, directors or employees may from time to time acquire, hold or sell securities and/or commodities and/or commodity futurescontracts mentioned herein as principal or agent. This report may not be reproduced in whole or in part, or referred to in any manner whatsoever,nor may the information, opinions, and conclusions contained in it be referred to without in each case the prior express consent of Scotia Capital.SCI is authorized and regulated by The Financial Services Authority. U.S. residents: Scotia Capital (USA) Inc., a wholly owned subsidiary of ScotiaCapital Inc., accepts responsibility for the contents herein, subject to the terms and limitations set out above. Any U.S. person wishing furtherinformation or to effect transactions in any security discussed herein should contact Scotia Capital (USA) Inc. at 212-225-6500.

Each research analyst named in this report or any subsection of this report certifies that (1) the views expressed in this report in connection withsecurities or issuers that he or she analyzes accurately reflect his or her personal views; and (2) no part of his or her compensation was, is, or will

be directly or indirectly, related to the specific recommendations or views expressed by him or her in this report.

The Research Analyst's compensation is based on various performance and market criteria and is charged as an expense to certain departmentsof Scotia Capital Inc., including investment banking.

Scotia Capital Inc. and/or its affiliates: expects to receive or intends to seek compensation for investment banking services from issuers covered inthis report within the next three months; and has or seeks a business relationship with the issuers referred to herein which involves providingservices, other than securities underwriting or advisory services, for which compensation is or may be received. These may include servicesrelating to lending, cash management, foreign exchange, securities trading, derivatives, structured finance or precious metals.

For Scotia Capital Research Analyst standards and disclosure policies, please visit www.scotiacapital.com/disclosures

Economics

Derek Holt , [email protected]

Karen Cordes Woods , Financial Markets Economist(Currently on maternity leave)

Gorica Djeric , Financial Markets [email protected]

Mary Webb , Senior Economist/[email protected]

Corporate Bonds

Robert Follis , Managing [email protected]

Stephen Dafoe , [email protected]

Francesco Sorbara , Associate [email protected]

Emerging Markets Strategy

Joe Kogan , Director [email protected]

Equity Markets

Vincent Delisle , Director, Portfolio Strategy [email protected]

Hugo Ste-Marie , Assistant Strategist [email protected]

Equity Research

John Henderson , Managing Director, Head of Equity Research [email protected]

Fixed Income

Roger Quick , Director [email protected]

Foreign Exchange

Camilla Sutton , Director [email protected]

Sacha Tihanyi , Associate Director [email protected]

ScotiaMcLeod Portfolio Advisory GroupPaul Danesi , [email protected]

Geoff Ho , [email protected]

Joey Mack , Director [email protected]

Steve Uzielli , [email protected]

Gareth Watson , [email protected]

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