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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
No one is saying that the Federal ReserveBoard shouldn’t have cut interest rates.After all, US payroll numbers have fallenfor four consecutivemonths andare likelyto continue todecline forat least anotherquarter, if not longer. But whether theFed isprepared to recognize itornot, thenewrealitythatitfacesisreflation.Andit’sthe type that isn’t likely tobe tamedbyaslowdownintheAmericaneconomy.
FoodandenergypricesmaynotcountintheFed’s inflationmetrics,but theysurecountin the lives of everyday Americans thesedays.Whilecoreinflationmaybebarelyover2%,that’sonlyofsolaceifyoudon’teatordrive.Headlineinflationisrunningatalmostdoublethatanditisn’tabouttobecomingdownanytimesoon(seepages8-11).Notwhen world oil prices are heading toward$200perbarrel,withgrainpricemovementsnotfarbehind.
Food inflation isn’tabout theUSeconomyanymorethantriple-digitoilpricesareaboutmotorists driving on interstate freeways.They’reinsteadabouthamburgersreplacingrice bowls and millions of new Tata andChery drivers on traffic-choked roads inChina, India and the rest of the emergingmarketworld.
But even more threatening to the outlookforpricestabilitythantheriseinoilprices,isthefactthatexplodingtransportcostsareremoving the single most important brakeon inflation over the last decade—wage
arbitrage with China. Not that Chinesemanufacturing wages won’t still warrantarbitrage. In and of themselves, they will.Butintoday’sworldoftriple-digitoilprices,distancecostsmoney.
The cost of shipping a standard 40-footcontainerfromEastAsiatotheUSeasternseaboardhasalreadytripledsince2000andwilldoubleagainasoilpricesheadtowards$200 per barrel (see pages 4-7). Unlessthat container is chock full of diamonds,shipping costs have suddenly inflated thecostofwhateverisinside.Andthoseinflatedcosts get passedonto theConsumer PriceIndexwhenyoubuythatgoodatyourlocalretailer.Asoilpriceskeeprising,prettysoonthosetransportcostsstartcancellingouttheEast Asian wage advantage. They alreadyhaveinsteel.Soaringtransportcosts,firstonimportingirontoChinaandthenexportingfinished steel overseas, have already morethan eroded the wage advantage andsuddenly rendered Chinese-made steeluncompetitiveintheUSmarket.
That’s great news if you are the UnitedSteelworkersofAmerica.Longlostjobswillsoonbecominghome.AndthemorethatoilpricesandtransportcostsriseforChinesesteelexporters,themorethatUSsteelwagescangrow.But if you’rea steelbuyer, yourcostsaregoingupregardlessofwhetheryouaresourcingitfromChinaorPittsburgh.
Andifyou’retheFederalReserveBoard,youwillsoonberaisingrates,andinahurry.
“ . . . e x p l o d i n g t ransport costs a r e r e m o v i n g the single most important brake on inflation over the last decade—wage a r b i t r a g e w i t h China.”
The New InflationbyJeffRubin
May 27, 2008
CIBC World Markets InC. StrategEcon - May 27, 2008
2
MARKET CALL
INTEREST & FOREIGN EXCHANGE RATES
TheFedseemssetontakingapauseoninterestratesinJune,andwenolongerexpectanyactionatthatmeeting.Afinalquarter-pointcutisstillapossibilityforQ3,givenourexpectationforadropinGDPinQ2andsomesteeperjoblossesinthenextfewmonths.Butthatwillbeonlyshort-livedcomfortfortheTreas-uriesmarket,whichatthelongendwillhaveitseyesfocusedonastubbornheadlineinflationrate,andamajordoseofFedtighteningcome2009.
TheCanadiancurvehasalreadypricedinourexpectationsforafurtherquarter-pointcutatthenextBankofCanadarate-settingdate.Butfurtheroutthecurve,marketswillbeincreasinglylookingathigherinflationrisksandtheprospectsforaretighteningbythecentralbankin2009.Wewouldsellgovernmentbondsintoanyminorrallythatdevelopsduringwhatlookstobeaquarterofstill-sluggishgrowthahead.
We’renearinganexpectedturningpointfortheUS$againstEuropeanmajors,withthelatterhavingonemorepushstrongeriftheFedreturnswithaneaseinQ3.FurtherdollardepreciationwillbefocusedonthePacificRimandoil-exportingcurrencieswherethetradedeficitnowlies.Thelooniewilljoininthatparade,butitsappreciationwillbecutshortastheFedoutdoestheBankofCanadainratehikesin2009.
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•
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2009
END OF PERIOD: 26-May Sep Dec Mar Jun Sept Dec
CDA Overnight target rate 3.00 2.75 2.75 2.75 3.00 3.25 3.7598-Day Treasury Bills 2.65 2.40 2.60 2.70 2.80 3.00 3.45Chartered Bank Prime 4.75 4.50 4.50 4.50 4.75 5.00 5.502-Year Gov't Bond (3.75% 6/10) 3.01 2.85 3.10 3.35 3.50 3.70 4.1510-Year Gov't Bond (4% 06/17) 3.65 3.60 3.75 3.80 4.00 4.10 4.2530-Year Gov't Bond (5% 06/37) 4.09 4.10 4.25 4.25 4.30 4.35 4.60
U.S. Federal Funds Target 2.00 1.75 1.75 1.75 2.25 3.00 3.7591-Day Treasury Bills 1.86 1.60 1.60 1.65 2.05 2.75 3.402-Year Gov't Note (2.125% 4/10) 2.44 2.25 2.50 2.85 3.40 3.85 4.0010-Year Gov't Note (3.875% 05/18) 3.85 3.80 3.95 4.10 4.35 4.45 4.6030-Year Gov't Bond (4.375% 02/38) 4.57 4.55 4.70 4.75 4.80 4.80 4.90
Canada - US T-Bill Spread 0.79 0.80 1.00 1.05 0.75 0.25 0.05Canada - US 10-Year Bond Spread -0.20 -0.20 -0.20 -0.30 -0.35 -0.35 -0.35
Canada Yield Curve (30-Year — 2-Year) 1.08 1.25 1.15 0.90 0.80 0.65 0.45US Yield Curve (30-Year — 2-Year) 2.13 2.30 2.20 1.90 1.40 0.95 0.90
EXCHANGE RATES — (US¢/C$) 100.8 104.7 105.0 103.1 102.0 102.0 101.5— (C$/US$) 0.992 0.955 0.952 0.970 0.980 0.980 0.985— (Yen/US$) 103 103 103 98 96 95 93— (US$/euro) 1.58 1.62 1.56 1.50 1.49 1.49 1.50— (US$/pound) 1.98 1.99 1.96 1.90 1.90 1.88 1.90— (US¢/A$) 96.1 96.5 93.0 92.5 91.0 92.0 93.0
CIBC World Markets InC. StrategEcon - May 27, 2008
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STRATEGY AND EARNINGS OUTLOOK
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WiththeCPIinflationratesettoalmostdoublenextyear,wetookoffouroverweightinbondsandshiftedfourpercentagepointsofweightingoutofthesector.WhiletheBankofCanadamaystilldeliveranotherratecut,reflationwillcompelittoraiseinterestratesbyatleast100bpsnextyearpromptinga60-bpback-upin10-yearbondyields.Assetsmovedoutofbondsweresplitequallybetweenstocksandcash.
WithTSXearningspoisedtosurge21%thisyearthankstoburgeoningresourcerents,wemovedtoaslightoverweightinequitiesbutremainwaryoffurthernear-termturbulencefromthefinancialsector.Withinourequityportfoliowehaveaddedapercentagepointofweightingtoouralreadysubstantiallyoverweightholdingsofenergystocks,aswellasaddinganotherhalf-pointofweightingtoouroverweightpositioninmaterialstocks.
Toaccommodateourgreaterweighting inenergyandmaterial stockswemovedapercentagepointofweightingoutofutilitystocksandahalfpercentagepointofweightingoutofconsumerstaples.Utilitystocks’renowneddividendsaregoingtobecomelessattractiveinanenvironmentofrisingbondyieldsthantheyhaveinthepastenvironmentoffallingbondyields.Keyconsumerstaplecomponentslikefoodretailersandprocessorsaregettingdecimatedbysoaringfoodcosts.
Source: Thomson First Call, CIBC WM
726817
9881107
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CIBCWM Fcst
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21%12%
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TSX Composite Forward PE
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May 23/0814.9
ASSET MIX (%) Benchmark Strategy Rec-ommendation
Stocks 53 55Bonds 38 38Cash 9 7GICS SECTOR EQUITIES (%)Consumer Discretionary 4.2 1.7Consumer Staples 2.2 2.2Energy 30.1 37.1Financials 28.2 25.7 -Banks 15.7 13.7 -Insur., REITs, oth. 12.5 12.0Healthcare 0.4 0.4Industrials 5.4 3.4Info Tech 4.9 3.9Materials 17.9 20.4 -Gold 6.9 7.9 -Other Metals 5.3 6.3Telecom 5.2 2.7Utilities 1.5 2.5Note: Bold indicates recommended overweight.
2005 2006 2007 2008 LatestEnergy 45.4 8.5 8.0 56.0 14.0Health Care 5.3 29.2 -38.8 8.2 14.7Industrials 27.9 13.0 38.5 -22.4 18.0Materials 40.7 79.9 -2.4 81.9 17.5Utilities 17.9 -6.2 56.2 6.9 15.2Consumer Staples 2.9 -1.2 -1.5 -0.9 14.5Financials 13.8 17.6 11.2 -5.3 13.1Info Tech -40.1 46.5 153.8 65.7 26.3Consumer Discretionary 2.3 18.0 12.8 2.7 14.5Telecom Services 5.9 30.8 28.4 -10.3 14.7
TSX Composite 31.2 12.1 11.8 20.9 14.9
15.729.8
16.1
17.415.712.044.5
12.022.014.928.9
Last 10 yrs.
TSX - Earnings Outlook & Forward PE
PE4-qtr Fw dOperating Earnings
(% ch)
CIBC World Markets InC. StrategEcon - May 27, 2008
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WillSoaringTransportCostsReverseGlobalization?JeffRubinandBenjaminTal
Chart 1TransportCostsHighlySensitivetoOilPrices
Source: RMT, CIBCWM
Globalization is reversible. Higher energy prices areimpactingtransportcostsatanunprecedentedrate.Somuch so, that the costofmovinggoods,not the costoftariffs, isthe largestbarriertoglobaltradetoday. Infact, in tariff-equivalent terms, the explosion in globaltransport costs has effectively offset all the tradeliberalizationeffortsofthelastthreedecades.Notonlydoes this suggest amajor slowdown in thegrowthofworldtrade,butalsoafundamentalrealignmentintradepatterns.
SoaringTransportCosts
Recentchanges intransportationhave ledto increasedsensitivitytohigherenergyprices.Mostnotableofthesechanges is the massive trend towards containerizationthateffectivelymakesshippingcostsmorevulnerabletoswings in fuel costs. Container ships can be unloadedmuchfasterthanbreakcargossotheyspendmuchmoretimeatseathaninports.
Anotherfactorisspeed.Theshifttocontainershipshasincreased the importanceof ship speed.Over thepasttwodecades,containershipswerebuilttogofasterthanbulkshipsandsincecontainershipsweresteadilygainingshare,theworld’sfleetspeedpickedup.Butgreaterspeedrequiresgreaterenergy,asitdoesinallothermodesoftransport.Inglobalshipping,theincreaseinshipspeedoverthelastfifteenyearshasdoubledfuelconsumptionperunitoffreight.
Withoilpricesnowaccountingforalmosthalfoftotalfreightcosts,itshouldcomeasnosurprisethatsoaringoilpriceshavetranslateddirectly intosoaringtransportcosts(Chart1).Overthelastthreeyears,everyonedollarriseinworldoilpriceshasfeddirectlyintoa1%riseintransportcosts.
TransportCostsandtheLinktoTrade
Thelastthirtyyearshaveseenanunprecedentedgrowthin world trade—a phenomenon widely credited withproviding the catalyst for the rapid industrialization ofeconomieslikeChinaandIndia.Inturn,thereductionintariffsandnon-tariffbarriersoverdecadesofmultilateraltradenegotiationswasfacilitatedbythesurgeinglobaltrade volumes. But in a world of triple-digit oil prices,soaring transport costs, not tariff barriers, pose thegreatestchallengetotrade.
Converting transport costs into tariff-equivalent ratesprovides a poignant perspective on just how trade-disruptingsoaringenergycostshavebecome.Evenbackata$100perbarreloilprice,transportcostsoutweightheimpactoftariffsforallofAmerica’stradingpartners,includingevenitsneighbours,CanadaandMexico.Backin2000,whenoilpriceswere$20perbarrel,transportcostsweretheequivalentofa3%UStariffrate.Currently,transportcostsareequivalenttoanaveragetariffrateofmorethan9%.At$150perbarrel,thetariff-equivalentrateis11%,goingbacktotheaveragetariffratesofthe1970s.Andat$200perbarrel,wearebackat“tariff”ratesnotseensincepriortotheKennedyRoundGATTnegotiationsofthemid-1960s.
Higherenergycoststranslatedirectlyintohighershippingcosts. At today’s oil prices, every 10% increase in tripdistance translates into a 4.5% increase in transportcosts.ThedurationofatypicalseavoyagefromChinatoNorthAmerica isfourweeks. Includinginlandcosts,shipping a standard 40-foot container from ShanghaitotheUSeasternseaboardnowcosts$8,000.In2000,whenoilpriceswere$20perbarrel,itcostonly$3,000toshipthesamecontainer.Butat$200perbarrel,itwillsooncost$15,000intransportcoststoshipfromChinatotheUSeasternseaboard(Chart2).
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CIBC World Markets InC. StrategEcon - May 27, 2008
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Soaring transport costs suggest trade should be bothdampened and diverted as markets seek shorter, andhence,lesscostlysupplylines.Andthat’spreciselywhatwehavewitnessedinresponsetopastOPECoilshocks.
Between1960and1973,exportsasashareofworldGDProsebyover50%,afunctionofbothfallingtradebarriersandcheaptransportcostswhenoilpricesaveragedlessthan$16perbarrel(intoday’sprices).Similarly1987-2002sawanotherquantumleapinworldtrade,spurrednotonlybya30%dropintariffsbutbystillrelativelycheaptransport costsgroundedbyanaverage$27 (constantdollars)perbarreloil.Insharpcontrast,exportsasashareofworldGDPwentabsolutelynowherebetweenthefirstOPECshockandtheaftermathofthesecond,despitea25%reductioninglobaltariffs(Chart3).
Nodoubtthe1974and1981/82recessionsdampenedtrade,buttradeshouldhavereboundedstronglyonthebackofhealthyrecoveriesfromthoserecessions.Annualworld GDP growth averaged 3.5%, roughly the samerateasfrom1987-2002whichsawworldtradegrowbyleapsandbounds.Tradefailedtorespondtoapick-upinglobalgrowthbecausetransportcostswereexplodingduetosoaringoilprices.
TradenotonlyfailedtogrowasashareofglobalGDPbutitalsodivertedalongincreasinglyregionallines.Withthe cost of trans-oceanic freight surging following the1973OPECshockandintotheearly1980s,theshareofnon-petroleumUSimportsfromEuropeandAsiafellbyastunning6percentagepointsinlittleoverahalfdecade,
whiletheshareofimportsfromtheCaribbeanandLatinAmericarosebyacomparableamount(Chart4).
It’srelativelyeasytoseewhyAmericanimportersshiftedtoregionaltrading.Trans-oceanictransportcostsliterallyexplodedduringthetwoOPECoilpriceshocks.Thecostofshippingastandardcargoloadoverseasalmosttripled,justasitdidoverthepastfewyears.Ultimatelysoaringtransportcostswerebornebyconsumers,andmarketsrespondedaccordingly,substitutinggoodsthatcouldbesourcedfromcloserlocationsthanhalf-wayaroundtheworldcarryinghugelyinflatedfreightcosts.
AdvantageUS
To what extent will astronomical increases in transportcosts alter the huge (but shrinking) wage differential
Chart 2TotalCostofTransportinga40'ContainerFromShanghaitoUSEastCoast
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Chart �TradeDiversionDuringtheOPECOilShocks
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CIBC World Markets InC. StrategEcon - May 27, 2008
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Chart �China'sSteelExportstoUSFallWhileUSSteelProductionRises
Source: US Census Bureau, CIBCWM
Chart �USSteelProducersNowHaveaCostAdvantageOverChina
Source: IRST, AISI, JP Morgan, CIBCWM
between Chinese labor and North American laborremains tobe seen.Butwearealready starting to seesome change in capital-intensive manufacturing whoseproductscarryahighratiooffreightcoststofinalsellingprices.
Takethesteelsectorforexample.Withlittleoveranhourandahalfoflabortimeembodiedintheproductionofatonofsteel,andrelativelyhighfreightcosts,theglobalcostcurveofthesteelsector ischangingrapidly.GiventhatmostpartsofChina(andAsiaingeneral)areshortironore,gettingtherawmaterialstothesteelmill(mainlyfromAustraliaandBrazil)addsanadditionalandgrowingcostnottypicallyincurredbyUSsteelproducers.Addtoitthe$90freightcostofshippingatonofhot-rolledsteelsheetfromChinatotheUS,andthetransportcomponentis large enough to turn the global steel cost curve onitshead.Evenattoday’soilprices,risingtransportcostshavealreadymorethanoffsetChina’sotherwiseslimcostadvantage,givingUSsteelacompetitiveadvantageinitsownmarketforthefirsttimeinoveradecade(Chart5).
The rapidly changing economics of steel is alreadyreflected in thetradestatistics.China’ssteelexports totheUSarenowfallingbymorethan20%onayear-over-yearbasis—theworstperformanceinalmostadecade.Whilemanymightattributethisdeclinetotheslowdownin the US economy, it is noteworthy that US domesticsteel production has risen by almost 10% during thesameperiod(Chart6).
Mexico—AnotherChanceatBat?
Exactlyhowmuch trade, soaring transport costsdivertfromChina(orforthatmatteranywhereelse)dependsultimately on how important those costs are in totalcosts.Goodsthathaveahighvaluetofreightratiocarryimplicitly small transport costs, while goods with lowvalue to freight ratios typically carry significantmovingcosts.
AsurprisinglyhighpercentageofChineseexportstotheUSfallinthelatercategory.Furnitureapparel,footwear,metal manufacturing, and industrial machinery—alltypical Chinese exports, incur relatively high transportcosts.
And there is already evidence that Chinese exports offreight-intensive goods are already beginning to slowunderthepressureofrapidlyrisingtransportcosts.
While there has been a general slowdown in exportgrowthtotheUSoverthepastyear,itisnotablethattheslowdown is farmorepronounced ingoods that carryrelativelyhigh freightcosts compared to those thatdonot.Onayear-overyearbasis,thiscategoryisnowfallingfor thefirst time inmore than10years (Chart7, left).Freight-sensitiveChineseexportstotheUSnowaccountfor 42% of total exports—down from 52% in 2004.Infact,weestimatethatifitwerenotforthedramaticincreaseintransportcosts,growthinChineseexportstotheUSsince2004wouldhavebeen30%strongerthantheactualtally(Chart7,right).
China's Steel Exports to the US
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CIBC World Markets InC. StrategEcon - May 27, 2008
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Chart 8RelativeShippingCoststotheUSEastCoast:MexicoversusEastAsia
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Chart 7ElevatedFreightRatesAreAlreadyImpactingChina'sTradewithUS
Source: US Census Bureau, Golisticsmgnt, De 2007, CIBCWM
Freight-Intenstive Exports to US
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Chart 9Mexico'sNon-EnergyExportstotheUS
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HowmuchofChinesemanufacturingproductionwillbecominghomeremainstobeseen.Butthereiscertainlyno reason why we should not expect to see at leastcomparable ifnotgreater tradediversionthanwesawduringtheOPECoilshocksofthe1970s.
While there remains a strong imperative in the worldeconomy to arbitrage wage costs, the arbitrage willincreasinglytakeplacewithintheconstraintsimposedbysoaring transport costs. Instead of finding cheap laborhalf-wayaround theworld, thekeywillbe tofind thecheapestlaborforcewithinreasonableshippingdistancetoyourmarket.
Inthattypeofworld,lookforMexico’smaquiladoraplantstogetanotherchanceatbatwhenitcomestosupplyingthe North American market. In a world where oil willsooncostover$200perbarrel,Mexico’sproximitytotherestofNorthAmericagivesitscostsahugeadvantage.
Compare,forexample,howrelativetransportcostshaverecentlychangedbetweenthePacificRimandMexico.If in2000American importerspaid90%more to shipgoodsfromEastAsiatotheUSeastcoast,todaytheypay150%more,andwhenoilpricesreach$200perbarrel,theywillpaythreetimestheamountitcoststoshipthesamecontainerfromMexico(Chart8).Toputthingsinperspective, today’s extra shipping cost from East Asiaistheequivalentofimposinga9%tariffonEastAsiangoods entering theUS.And at oil prices of $200, thetariff-equivalentratewillriseto15%.
ItseemsthatAmericanimportersarestartingtodothemathandalreadyshiftingsomebusinessfromChinatoMexico.WhilethepaceofshipmentsfromChinatotheUSisslowing—mainlyamongfreight-intensivegoods,evennon-energyMexicanexportstotheUSarestillrisingatahealthyannualrateofmorethan7%.Andinterestingly,thegoodsthathaveseenthefastestgrowtharetheonesthat,onaverage,aremorefreight-intensiveanddirectlycompetewithChina, such as furniture, iron and steel,rubberandpaperproducts(Chart9).
Inaworldoftriple-digitoilprices,distancecostsmoney.Andwhiletradeliberalizationandtechnologymayhaveflattenedtheworld,risingtransportpriceswillonceagainmakeitrounder.
CIBC World Markets InC. StrategEcon - May 27, 2008
8
America’sbeenignoringit,andCanadahasyettoreallyseeit,butforthoselookingbeyondthenextquarterortwo,inflationispoisedtobethenextbigstoryforNorthAmericanmarkets.Bernankecan’taffordtofightpricehikeswhilehe’sfendingoffaglobalfinancialcrisisanda mild US recession, but he will have to confront thissimmering battle once the economy begins to recovertowards the endof the year.Meanwhile, northof theborder,inflationisasleepinggiant,butissettoreawaken.Inbothcases,thesafetyofgovernmentbondsispoisedtoevaporateasratesbegintocreepuplaterthisyear,andrisesharplyin2009.
MisleadingtotheCore
IntheUS,inflationhasbeenlowonlyforthosepreparedto ignore what is staring them in the face—sharplyrisingenergyandfoodcosts.Ofcourse,theconvenient“core” CPI index does just that, but the rationale forfocusing on core price measures no longer exists.Foodandenergypricesarenotseeingshort-termvolatilityanymore. They are simply trending consistently higher.As a result, the headline CPI rate has steadily driftedfurther and further away from core CPI, to a total of6.7%onacumulativebasissince2002(Chart1).Coreinflationisdead.Itwon’tbelongbeforetheFedandthebondmarketbothhavetopaymuchmoreattentiontoheadlineratherthancoreprices.
Inflation:RisingUpin2009AveryShenfeldandMenyGrauman
Chart 1"Core"MissesUSInflationTrend
Arapidlygrowingdevelopingworldcontinues topressupagainst limitedworldsupplyofbothfoodandfuel,providingastrongfundamentaljustificationforsteadilyrisingcommodityprices.Stripoutgasliquidsthatcan’tbeeasilyusedforvehicletransport,andcrudeoilsupplywill grow by only 0.7% per year over the next twoyears.Withgrowingenergydemand in thedevelopingworld and in oil-exporting countries themselves, crudeoilshouldaverageasmuchasUS$140/Bblnextyear inordertorationdemandgrowthdowntothatpace,(seeStrategEconApril24,2008:“How Much Higher Will Oil Prices Go”).Naturalgaspricesarealsoclimbing,asoilbecomestooexpensivefor industrialuseandascoal isdeemed too dirty for new electricity generation. LNG,once thought to be a safety valve, is now in shortersupplyasotherglobalmarketsbidforit.
Washington’s plan to shift 30% of the corn crop intoheavily subsidized ethanol production was touted as akeypartofthe“solution”toAmerica’sdependenceonimportedoil.Butwhateverminorimpactithadonenergyinflation,hasbeenswampedbyitsimpactonfoodprices.Thepremiumearnedby cornoverother cropshas cutbackproductionandliftedpricesofimportantstapleslikesoybeansandwheat. Thishasalsoboostedworldwidefertilizer prices, making it too expensive for many lowincomedeveloping-worldfarmerstoafford.That,inturn,hascutintocropyieldsatexactlythetimewhendemandisswelling.
Tobesure, largespeculativepositionshaveheightenedthe volatility in grain prices lately, but the longer-termgrowthincaloricconsumptioninthedevelopingworld,and particularly increased meat demand, is providingfundamentalsupport for theobservablepricechanges.Meat consumption requires far more grain and landuse than less protein-intensive diets, and as economicdevelopmentcontinuestosweepthroughAsia,demandfor meat will also continue to head higher. At thesametime,droughtconditionshaveleftstoresofgrainperilouslylow,whichhaspushedupfeedcosts,andwilleventuallyalsoshowupinmeatprices.USfoodinflationisalreadyrunningat5.1%year-over-yearandbasedonthesetrendsshouldaccelerateto6%nextyear.
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Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
All Items CPI Core CPI
Index, Jan. 02 = 100
cumulative 6.7% gap
CIBC World Markets InC. StrategEcon - May 27, 2008
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someofthosegainswillbepassedonatthefactorydoor.Furthermore,sharplyrisingshippingcostsaregivingpricetagsforimportedgoodsanunwelcomeaddedboost.
MildRecessionNoCure-All
Fornow,inflationistakingabackseattoworriesabouta US recession and the economic impact of a shakyglobal financial system. With Q2 GDP likely to showa decline, inflation doves are already arguing that thecurrent economic slump will take the heat off futurepricepressures,butthehistoricalevidencedoesnotbearthisout.Moreimportantly,therearegrowingsignsthatthe bond market is also having trouble accepting that
Foodandenergycostsarenotbeingoffsetbydisinflationin the core CPI basket. Of course US home prices aredroppinglikeastoneandshouldbedownbyacumulative25-30%fromtheirpeakbeforethemarketstabilizesin2009. But because the CPI calculates price growth inowner-occupiedhousingbylookingatthecostofrentinganequivalenthouse,rapidlydecliningrealestatevalueswillfailtomoderatemeasuredinflationbyverymuch.ItisworthnotingthatsoaringhousepricesneverfedintotheCPIearlierinthisdecade(Chart2),andtheyshouldn’thaveamaterialimpactontheirwaydowneither.
Theonlyvisiblecorrelationwiththe“owners’equivalentrent” component of the CPI is its artificial negativerelationshiptoutilityprices(Chart3).ThatarisesbecausetheBLSdeductsanestimateforutilitycoststocalculateapurerentmeasure,andsincerentalratesarenotresetmonthly, the pure rent figure goes down when utilitypricesrise.Therecentdisinflationinowners’equivalentrent is therefore capturing rising gas and electricitybills,andwillvanishoncerentsthatincludeutilitiesareadjustedtothesenewcosts.
ElsewhereinthecoreCPIbasket,manyconsumergoodsareno longer falling inpriceas theywere in2007.Asinthecaseoffoodandenergy,globalforcesarepartlyto blame, with non-petroleum import prices movingsharplyhigheroverthepastfewmonths(Chart4).That’safunctionoftheUSdollar’songoingweakness,butalsoreflectsrisinginflationratesinmanyforeigneconomiesthatsellintotheUSmarket.Wagesandpricesarerisingin China, India and other developing economies, and
Chart �Owner'sRentInverselyTracksUtilityPrices
Chart �ImportPricesThreatenCoreGoodsInflation
Chart 2HousePricesDon'tAffectOwner'sEquivalentRent
-6
-4
-2
0
2
4
6
Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
CPI: Core Goods Non-Petroleum Import Prices
y/y % chg
-20%
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-10%
-5%
0%
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10%
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Dec-95 Dec-98 Dec-01 Dec-04 Dec-07
S&P/CaseShiller 10-City Home Price Index
CPI: OER
y/y % chg
-2%
-1%
0%
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Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07
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Owners's Equiv. Rent/primary Res. (LHS)
Fuels & Utilities, inverse (RHS)
y/y % chg y/y % chg
CIBC World Markets InC. StrategEcon - May 27, 2008
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line. Over the last five US recessions headline inflationhas actually risen slightly six months after the start ofthe economic downturn and has remained essentiallyunchangedoneyearout(Chart5).Future price pressure is also expected to come fromwages.TheUSeconomyenteredtheyearwitha labormarket beyond its non-inflationary unemploymentrate. Productivity gains have delayed the pass-throughto unit labor costs, but slower capital spending couldeat into productivity growth in the coming year. Theunemployment rate will almost certainly head higher,butthecurrentslowdownmightnotlastlongenoughtothrowcoldwateronpayscales,particularlysinceaweakUSdollarmeansthatthereisslightlylesscompetitionforAmerican workers from abroad. Tighter borders after9-11 may also stem the inflows of lower cost illegalworkers.
USinflationshouldnotbeanyhigherin2009thanwearealreadyseeingthisyear.Afterall,energyinflationwillalreadybeoff thechartsonayear-on-yearbasiscomethis June. But the CPI’s failure to come back to earth—stillrunninginthe4%rangenextyear—willbeabigdisappointment for both policy makers and the bondmarket,bothofwhicharecurrentlycountingonrecessiontowipeinflationoffthemap.Instead,theFederalReserveisgoingtohavetoleaninwithratehikesandconstrainthepaceof2009’seconomicreboundasitbeginstogetmoreworriedaboutheadlineinflation.
CanadaLosesitsInflationImmunity
Canadaappearstostandasastunningexceptiontotherisingglobalinflationtrend.However,ifnotforahugerun-up in the Canadian dollar, inflation on the northside of the 49th parallel would also be climbing wellabovetarget.Afterall,Canadianservicesprices,largelyuncheckedbyimports,arealreadyadvancingata3.3%pace (Chart 6), even with the benefit of a one-pointGST cut. Wage growth has also accelerated, and theslowdowninGDPgrowthhasfailedtoopenupmaterialslackinthelabormarketbecauseofsofterproductivitygains.
Canadiancoregoodspricesaredroppingby3%year-on-year,whichisitslargestdivergencefromthecomparableUSmeasuresince1994.However,muchofthatgapliesinfoodprices,whicharesoaringintheentiredevelopedworldexceptforCanada(Chart7).
Three factors account for that temporary shelter fromthestorm.First,a12%riseintheC$intheyeartoApril2008had fruitandvegetableprices fallingata similaryear-on-year pace. Currency moves tend to be quicklytranslated into these high-turnover goods, but theimpactcouldbegoneasearlyasAugust,whendomesticproducetakesover.Second,foodcostswereheldbackbyagrocerystorepricewarthatmightalreadybecoolingoffafteraperiodofprofit-destroyingmargincuts.Thirdly,marketingboardpricingfordairy,poultryandeggstendstosmoothoutadjustmentstocostincreases,buthigher
Chart �USInflationTrendsinPastRecessions
Chart �Canada'sInflationTameOnlyinCoreGoods
-0.4%
-0.2%
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
CPI Core CPI6 months after start of recession
12 months after start of recession
Core CPI CPI -4%
-2%
0%
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4%
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08
CPI: Core Goods CPI: Services
y/y % chg
CIBC World Markets InC. StrategEcon - May 27, 2008
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Chart 7Canada'sFoodPricesanUnsustainableException
feedandenergycostspoint to largepricehikesaheadforfluidmilk,eggsandpoultrynextyear.Pricesforotherfoodproductsarealsopoisedtoclimbasgrocerystorebillshavenotkeptpacewiththepriceschargedbyfoodmanufacturers(Chart8).
Ourabove-consensusforecastforthelooniecallsforonlymodestyear-on-yearcurrencyappreciationoverthenext12-monthsandshouldthereforeonlyhaveaverysmallmoderatinginfluenceoninflation.Asaresult,CanadianCPIshouldaccelerateoverthenextsixquarters,reaching3½%year-over-yearbytheendof2009,andcatchingtheeyeofacentralbankthataimstokeepthismeasure
Chart 8CdnWholesaleMinusRetailFoodInflation
at2%(Chart9,left).Thesedevelopmentsshouldboostadministeredratesby100bpshigherin2009,andsend10-yearCanadayieldssharplyhigher(Chart9,right).
Theupcomingimplicationsforfinancialmarketsareclear.Governmentbonds,whichseemedlikethesafeplacetobeearlierin2008whencreditmarketscrashed,willbeanythingbutsafeintheyearahead.Atthesametime,stockswhosebottomlinesbenefitfromrisingcommodityprices will outperform those sectors that traditionallyget hit by rising rates like banks, REITs and utilities(Chart10).
Chart 9CanadianCPIandInterestRatesSettoClimb
Chart 10EquitiesMostSensitivetoInterestRateHit
-8%
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Jul-04 Jul-05 Jul-06 Jul-07
Difference between food manufacturing
prices and consumer food prices
y/y % chg, 3m ma
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REITS BankStocks
10-YearGOC
UtilityStocks
AverageTSX Stock
% sensitivity to a 100-bp hike in 10-yr interest
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Cana
da
Japa
n US
Fran
ce UK
German
y
Food Inflation, y/y % chg
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Jan-07 Jan-08 Jan-09
GoC 10 YR YieldBoC Overnight Target Rate
%
Forecast
0.0%
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Jan-07 Jan-08 Jan-09
CPI Core CPI
Forecasty/y % chg
CIBC World Markets InC. StrategEcon - May 27, 2008
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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.
USfirst-quarter realGDPgrowthsurprisedtotheupside,buttheoutlookfor thesecondquarter ismuchlessfavourable.TheAmericanconsumercontinuestoexhibitphenomenalresiliencyinthefaceofmountingeconomicchallenges,butcracksareshowing.Wecontinuetoexpectamildandshort-livedrecessionintheUnitedStates,butthisshouldnothaveamaterialimpactoninflation,whichislikelytoremainatroughly4%year-over-year.AlthoughtheFedhassignaledapauseinitscurrenteasingcampaign,weseeanotherquarter-pointcutinthecardsbeforepolicymakersstartratchetingupratestowardstheendoftheyear.
First-quartergrowthlookstohavebeennegligible,despitethedragfromnetexportseasingoffrelativetoQ4.Reducedproductionforinventoriesandaninevitableslowdownfromthepriorquarter’storrentconsumerspendingpacearetoblameforQ1weakness,andanotherexportdropinQ2willkeepthatquartertame.Butthisyear’sbrushwithnear-recessionwillgivewaytoacommodities-linkedspiketoinflationin2009.
CANADA 07Q4A 08Q1A/F 08Q2F 08Q3F 08Q4F 2007 2008F 2009F
Real GDP Growth (AR) 0.8 0.2 0.7 1.2 3.0 2.7 1.3 2.7
Real Final Domestic Demand (AR) 6.9 2.7 3.5 2.7 3.0 4.3 4.1 3.3
All Items CPI Inflation (Y/Y) 2.4 1.8 1.9 2.6 3.0 2.1 2.3 3.0
Core CPI Ex Indirect Taxes (Y/Y) 1.6 1.4 1.2 1.4 2.0 2.1 1.5 2.0
Unemployment Rate (%) 5.9 5.8 6.2 6.5 6.4 6.0 6.2 6.3
Merchandise Trade Balance (C$ Bn) 37.1 50.9 49.7 43.5 43.5 49.4 46.9 49.5
U.S.
Real GDP Growth (AR) 0.6 0.6 -0.8 -0.5 2.8 2.2 1.1 2.2
Real Final Sales (AR) 2.4 -0.2 -1.0 -0.5 2.2 2.5 1.0 2.1
All Items CPI Inflation (Y/Y) 4.0 4.1 3.9 4.3 4.2 2.9 4.1 4.0
Core CPI Inflation (Y/Y) 2.3 2.4 2.3 2.2 2.3 2.3 2.3 2.8
Unemployment Rate (%) 4.8 4.9 5.2 5.5 5.5 4.6 5.3 5.3
