Softening "Policy-Induced" US GDP Growth. FOMC Members Are A Tad More Dovish.

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1 June 28, 2010 Softening "Policy-Induced" US GDP Growth. FOMC Members Are A Tad More Dovish. LBS Economic Research Carlos Leitao Chief Economist leitaoc@lb-securities.ca Sébastien Lavoie Assistant Chief Economist lavoies@lb-securities.ca Marie-Claude Guillotte Economist guillottemc@lb-securities.ca Emir Coskun coskune@lb-securities.ca Subscription: Martine Bérubé berubem@lb-securities.ca Stéphanie Fortin fortins@lb-securities.ca

2 Sébastien Lavoie Assistant Chief Economist The Monitor Softening "Policy-Induced" US GDP Growth The latest round of US data was disappointing. The plunge in existing and new home sales strongly indicates that real estate activity has been and will remain quite volatile in the post-tax credit environment. The number of mortgage applications in the US is near a 13-year low despite 30-year fixed-rate mortgages at 4.75%, an environment prone to soft prices and lofty inventories. All these developments occurred on the heels of a revised down 10Q1 real GDP figure originally from 3.5%, to 3.0%, to a final call of 2.7%. It is also troubling to find out that the inventory restocking contributes to two-thirds of the expansion in 10Q1. Typically a cornerstone of post-recession periods, growth in consumer expenditures was relatively soft, revised down from 3.5% to 3.0%. In fact, final sales have only advanced by 0.9% q/q saar in 10Q1 and by a mere 1.2% y/y. With such a sub-par performance, the inventory build-up will not be able to last for long US Real GDP (SAAR, Bil.Chn.2005$) US Real Final Sales (SAAR, Bil.Chn.2005$) Firstly, about the financial reform, G20s members simply said over the weekend in Toronto that "the amount of capital will be significantly higher and the quality of capital will be significantly improved when the new reforms are fully implemented... all members will adopt the new standards and these will be phased in over a timeframe that is consistent with sustained recovery and limits market disruption, with the aim of implementation by end " As for non-financial firms, especially small businesses, the lack of credit availability is a roadblock to massive private sector hiring we will get the June's payrolls numbers on Friday. New global rules on capital and liquidity will likely be announced in the next G20s meeting in Seoul, in November. Until then, at least, look for banks and non-financial firms to keep sitting on their huge pile of cash assets instead of lending money and hiring workers, respectively. Secondly, the 2.7% real GDP growth headline is disappointing amid the strong fiscal boost put in place by the White House, bringing back front and center two debates: the trade-off between public debt limitation and policy-induced growth; and the choice of cutting expenses or increasing taxes to clean up deficits down the road. On that front, G20s members in Toronto pledged to "at least halve deficits by 2013 and stabilize or reduce government debt-to-gdp ratios by 2016". Each country will have considerable flexibility to reach these minimum requirements. For example, should be able to meet these minimum thresholds without breaking a sweat, while the Obama administration may have to announce new policy measures down the road to achieve them. In turn, unsynchronized fiscal actions will contribute to keep the global expansion uneven as it is US Federal Deficit Sources: Bureau of Economic Analysis /Haver Analytics (CBO projections, fiscal year, $ millions) Despite consumer deleveraging supported by the 4% saving rate in May, cost-cutting US states, and a fragile housing sector, the US economy is not on the verge of a double-dip recession. Business investment is soaring, standing out from the pack. For example, new orders of nondefense capital goods ex. aircraft an excellent proxy for capex rose three times in the last four months, including by 2.1% m/m in May. US private investment in machinery and equipment is well on track to record double-digit growth in 10Q2 and 10Q3. Investors also hope that private employers will use a large part of their cash holdings to hire more workers in upcoming months. Job gains are starting to be critical at this sage to assure the transition between policy-induced growth and private-driven growth will go smoothly. That said, there is no such guarantee amid the lack of details surrounding financial regulation and the upcoming mid-term commitment to clean up fiscal houses Source: Office of Management and Budget /Haver Analytics Altogether, the pace of economic expansion is set to shift down one gear in the near term, and then remain there for a while. We forecast US real GDP growth to average close to 2.5% q/q saar in the second half of 2010, down from our estimate of 3.5% for 10Q2 (see our revised US outlook on page 10). 2

3 This is not particularly robust but hardly a disaster as the bears predict or as the bond market, and the credit market to a greater extent, start to price in. Put simply, the US has not experienced a V-shaped recovery in its initial stage, and is unlikely to continue in a L-shaped manner or dip in recession mode. FOMC Members Are A Tad More Dovish With economic growth tapering off slightly and fiscal tightening to take place in the mid-term, FOMC members were right to soften a little bit their tune in the June statement. It begins with: " Information received since the Federal Open Market Committee met in April suggests that the economic recovery is proceeding and that the labor market is improving gradually". This was slightly less but still positive than in late April. FOMC members did not sound extremely worried about external risks to financial stability either: "Financial conditions have become less supportive (instead of remain supportive) of economic growth on balance, largely reflecting developments abroad ". However, FOMC members show greater concerns about the absence of inflation: "Prices of energy and other commodities have declined somewhat in recent months, and underlying inflation has trended lower. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time". In our view, core inflation will stay near half a percent and dangerously close to zero in upcoming quarters. Nonetheless, outright deflation is not the most likely outcome in our view although the odds of such an eventuality are the highest since the deflation scare episode of There are more prices increasing than decreasing in the CPI basket, labour income is expanding (personal income up five times in the last six months, including a 0.4% m/m gain in May), and buoyant China is starting to export some inflation abroad Source: Bureau of Labor Statistics /Haver Analytics U.S. Core Inflation (y/y % change in core CPI) 85 All in all, the Fed is further away from a first hike than they were in late April; US GDP growth is softening; fiscal stimulus is ending; It is not inappropriate then to see US bonds rallying across the board. Such an environment led us to revise down our year-end forecasts for the US and Canadian yield curves (see page 3). In our view, the 10-year treasury yield should be closer to 3% than to 4% by the end of this year even if, in the near-term, it is entirely possible that receding risk aversion related to Europe could push yields back up temporarily. Then, in 2011, respectable GDP growth should support our scenario of a moderate and sustainable increase in yields

4 North American Forecasts This Week's Forecasts (%) This Week Next 4 Weeks In 3 Months 3-Month T-Bills Year Bond Year Bond Canadian Dollar (CAN$/US$) Month T-Bills Year Bond Year Bond Yen (Yen/US$) Euro (US$/Euro) /06/2010 Historical Data Forecasts* Q Q Q Q Q Q Q Q Q Q2 Overnight Rate Month Treasury Bills Year Bond Year Bond Year Bond Federal Funds Rate Month Treasury Bills Year Bond Year Bond Year Bond Canadian Dollar (US$/C$) Canadian Dollar (Euro/C$) Euro (US$/Euro) Yen (Yen/US$) Quarter-end data and annual averages June 28th, 2010 Interest-Rate and Exchange-Rate Forecasts 4

5 Market Review: Bonds and Currencies International 3-Month Rates Current Spreads (b.p.) against U.S. Yield Jun week -4 weeks -1 quarter - 1 year Jan U.S UK #N/A #N/A France International Bonds: Benchmark 10-Year Yield Current Spreads (b.p.) against U.S. Yield Jun week -4 weeks -1 quarter - 1 year Jan U.S UK France Germany Greece Portugal Spain Japan Provincial Bonds: Benchmark 10-Year Yield Current Spreads (b.p.) against Yield Jun week -4 weeks -1 quarter - 1 year Jan Alberta British Columbia Prince Edward Island Manitoba New Brunswick Nova Scotia Ontario Quebec Saskatchewan Newfoundland Currencies Currencies Jun week -4 weeks -1 quarter - 1 year Jan (%) (/US$) (US$/) Australia (Australia/US$) U.K. (US$/ ) Japan (US$/Yen) Euro (US$/Euro) Data updated as at: 28/06/2010 5

6 Market Review: Fixed Income Charts % U.S. Yield on 3-Month T-Bills % Yield on 10-Year Federal Bonds U.S Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 % Yield Curve 25-Jun-10-1 month -1 year 3m 6m 2y 5y 10y % U.S. - Yield Curve 25-Jun-10-1 month -1 year 3m 6m 2y 5y 10y 30y Yield Spreads in basis points ( minus U.S.) 25-Jun-10-1 month -1 year Spreads on 2-Year Federal Bonds (Can-U.S., base pts) m 6m 2y 5y 10y Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 6

7 Market Review: Stocks Exchange and Commodities Stock Market Summary Level Change (%) Jun w HI 52w LOW (-1W) (-4W) (-13W) (-52W) Jan S&P/TSX 11,708 12,281 9, S&P/TSX S&P/TSX Small Cap Index S&P 500 1,077 1, Dow Jones 10,144 11,205 8, Nasdaq 2,223 2,530 1, International U.K. - FTSE 100 5,047 5,825 4, Germany - DAX 6,071 6,332 4, France - CAC 40 3,520 4,066 2, Japan - Nikkei 225 9,737 11,339 9, Hong Kong - Hang Seng 20,691 22,944 17, Russia - RST 1,418 1, Australia - ASX All Ordinaries 4,439 5,024 3, Brazil - Bovespa 64,824 71,785 48, S&P/TSX Sector Summary Level Change (%) Jun w HI 52w LOW (-1W) (-4W) (-13W) (-52W) Jan S&P/TSX 11,708 12,281 9, Energy Materials Industrials Consumers Discretionary Consumers Staples Health Care Financials Information Technology Telecommunication Services Utilities Commodities Level Jun w HI 52w LOW (-1W) (-4W) (-13W) (-52W) Jan London -- Gold (US$/once) London -- Silver (US$/once) Copper (US$/LB) WTI Crude Oil (US$/barrel) Natural Gas (Henry Hub) (US$/MMBTU) Data updated as at: 28/06/2010 7

8 Calendar of Major Economic Indicators KEY ECONOMIC INDICATORS WEEK OF JUNE 28, 2010 Date Time Release Unit Data for: LBS * Consensus Previous Jun 29 8:30 Industrial Product Price M/M May % Jun 29 8:30 Raw Materials Price Index M/M May % Jun 30 8:30 Gross Domestic Product M/M April 0.1% 0.1% 0.6% * Laurentian Bank Securities Forecast Consensus from Bloomberg L.P. Date Time Release Unit Data for: LBS* Consensus Previous Jun 28 8:30 Personal Income M/M May - 0.5% 0.4% Jun 28 8:30 Personal Spending M/M May - 0.1% 0.0% Jun 28 8:30 PCE Core M/M May - 0.1% 0.1% Jun 28 8:30 PCE Core Y/Y May - 1.2% 1.2% Jun 29 10:00 Consumer Confidence - June Jul 1 8:30 Initial Jobless Claims Thousands June Jul 1 10:00 ISM Manufacturing - June Jul 1 10:00 Construction Spending M/M May % 2.7% Jul 1 17:00 Domestic Vehicle Sales Millions June Jul 1 17:00 Total Vehicle Sales Millions June Jul 2 8:30 Change in Nonfarm Payrolls Thousands June Jul 2 8:30 Average Hourly Earnings M/M June - 0.1% 0.3% Jul 2 8:30 Average Hourly Earnings Y/Y June - 2.0% 1.9% Jul 2 8:30 Unemployment Rate - June - 9.8% 9.7% Jul 2 10:00 Factory Orders M/M May % 1.2% 25/06/2010 8

9 North American Economic Indicators Period Monthly Chg. (% or Level) Cumulative change Current Previous - 3 Month - 1 Year Gross Domestic Product (GDP) March 0.6% 0.2% 1.5% 3.1% Manufacturing Shipments March 1.2% 0.0% 2.8% 10.2% Housing Starts ( ' 000) * April Retail Sales March #N/A #N/A #N/A #N/A Trade Balance (M$) * March ,373 Employment ( ' 000) * * May Unemployment Rate * May Wages (avg. hourly earnings) May 2.4% 2.0% 1.8% 3.5% Total CPI inflation April 1.9% 1.6% 1.9% -0.3% Inflation ex-food & energy April 1.9% 1.8% 2.1% 2.0% Industrial Product Price Index April 0.3% -0.4% 0.0% -0.4% Raw Materials Price Index April 1.7% 0.8% 2.9% 17.3% Period Monthly Chg. (% or Level) Cumulative change Current Previous - 3 Month - 1 Year ISM - manufacturing * April ISM - Non-manufacturing * April Industrial Production * April Capacity Utilization Rate * April Consumer Confidence Index * May Retail Sales April 0.6% 2.1% 3.3% 9.0% Trade Balance (M$) * March -40,047-40,148-37,132-28,445 Housing Starts ( ' 000) * April Existing home sales April 7.6% 7.0% 14.3% 22.8% Median price of ex. home sales April 2.1% 3.0% 5.0% 4.0% Non-Farm Payrolls ( ' 000) * * April Unemployment Rate * April Wages (avg. hourly earnings) April 2.3% 2.1% 2.6% 3.3% Total CPI inflation April 2.2% 2.4% 2.8% -0.6% Inflation ex-food & energy April 1.0% 1.2% 1.5% 1.9% Producer Price Index April -0.1% 0.7% 0.0% 5.4% - Ex-Food & Energy April 0.2% 0.1% 0.3% 1.0% * Level * * Change in level for the last month, 3 months and 1 year * * * Annual % change Data updated as at: 28/06/2010 9

10 North American Forecasts 2009Q4 2010Q1 2010Q2 2010Q3 2010Q4 2011Q1 2011Q2 2011Q Real GDP (%) Consumption Business investment Non-residential structures Machinery and equipment Residential construction Government spending Exports Imports Current account balance in % of GDP Inflation (%) Total CPI (y/y) Core CPI (y/y) Unemployment rate (%)* Employment Housing starts (000s) Before-tax Corp. Profits (y/y) *Average rate for the quarter or the year. Forecasts as of June 30th, 2010 Period-Over-Period Annualized Per Cent Change Unless Otherwise Indicated Annual Average 4th Qtr/4th Qtr Period-Over-Period Annualized Per Cent Change Unless Otherwise Indicated Annual Average 4th Qtr/4th Qtr 2009Q4 2010Q1 2010Q2 2010Q3 2010Q4 2011Q1 2011Q Real GDP (%) Consumption Private investment Machinery and equipment Residential construction Government spending Exports Imports Inflation (%) Total (y/y) Core (y/y) Unemployment rate (%)* Housing Starts (000s) Before-tax Corp. profits (%, y/y) * Average rate for the quarter or the year. Forecasts as of June 28th, 2010 This document is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author is an employee of Laurentian Bank Securities (LBS), a wholly owned subsidiary of the Laurentian Bank of. The author has taken all usual and reasonable precautions to determine that the information contained in this document has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze it are based on accepted practices and principles. However, the market forces underlying investment value are subject to evolve suddenly and dramatically. Consequently, neither the author nor LBS can make any warranty as to the accuracy or completeness of information, analysis or views contained in this document or their usefulness or suitability in any particular circumstance. You should not make any investment or undertake any portfolio assessment or other transaction on the basis of this document, but should first consult your Investment Advisor, who can assess the relevant factors of any proposed investment or transaction. LBS and the author accept no liability of whatsoever kind for any 10

11 damages incurred as a result of the use of this document or of its contents in contravention of this notice. This report, the information, opinions or conclusions, in whole or in part, may not be reproduced, distributed, published or referred to in any manner whatsoever without in each case the prior express written consent of Laurentian Bank Securities. 11