03.2011 CIBC Economic Insights

8/6/2019 03.2011 CIBC Economic Insights

1/12

Economicinsights

CIBC World Markets Inc. PO Box 500, 161 Bay Street, Brookie ld Place, Toronto, Can ada M5J 2S8 Bl oomberg @ WG EC1 (4 16) 594- 700

C 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 Y o 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

March 31, 2011

Economics

Avery Sheneld(416) 594-7356

[email protected]

Benjamin Tal(416) 956-3698

[email protected]

Peter Buchanan(416) 594-7354

[email protected]

Warren Lovely(416) 594-8041

[email protected]

Krishen Rangasamy(416) 956-3219

[email protected]

Emanuella Enenajor(416) 956-6527

[email protected]

text text text

h t t p : / / r e s e a r c h .cibcwm.com/res/Eco/EcoResearch.html

It seems like only yesterday that investorswere shaking in ear o deation, but itspolar opposite is now the rising concern.Across the globe, ination readings haveescalated as improving global demand andnegative supply shocks combined to pushoil, ood and some industrial commoditiesthrough the roo.

While inlation has already broken outstrongly to the upside in emerging markets,

most Western industrialized economieshave seen more limited pressure. Wherethe CPI goes rom here will, o course,depend on the nearly unpredictable courseo geopolitical events in North Arica andthe Middle East. But assuming these dontget any worse, the ination story will rest onthe transmission rom a one-time ood andenergy shock to broader price levels.

Central bankers and investors around the

world are coming to dierent conclusions onthat ront. In Europe, the ECB appears poisedor a couple o rate hikes to demonstrate itsresolve, a move that replays its ill-advised2008 hike. The now elevated euro, fscalrestraint and a shaky banking system willlikely send the ECB back to the sidelines ater50 bps o hikes. The Bank o England is in acivil war, with hawks voting to hike now, andKings majority camp trying to hold o in theknowledge that the ballooning ination rateis all about oil and sales taxes, not excess

demand.

In North America, some benchmarks oination expectations are heating up (Chart).Stateside, the University o Michigan surveysfve-year ination outlook is at the top o

its typical range, and fxed income investorshave also lited the breakeven ination rateimplied by the TIPS market.

But in wage rates, the key to any broadeningin ination rom oil/ood to core, theresbeen absolutely dead calm. Indeed, USconsumption spending is being squeezed bythe ailure o wages to keep up with CPI, atrend that will put downward pressure onretail prices in the core basket. Theres no

deation risk to prompt a QE3, but neitheris there any threat o a Fed rate hike.

Canadas real return bonds are pricing in aneven greater ination threat, with the 10year breakeven ination rate topping 2.5%.That seems overdone. Not only does theBank o Canada deserve credit or managingination to its 2% target over the past 15years, but wages on this side o the borderare also becalmed. Remember, the last core

ination reading was only 0.9%. I energyprices atten out, so too will CPI. Anyoneholding RRBs should think about cashing innow.

Infated Fearsby Avery Sheneld

Anyone holdingRRBs should thinkabout cashing innow.

1 1.5 2 2.5 3 3.5

U-Mich 5-yr

Infl Exp

Cdn 10 yr

RRB

Breakeven

Inf

US 10 Yr

TIPS

Breakeven

Inf

US Hourly

Earn yr/yr

Latest

Sep-2010

%


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CIBC World Markets InC. Economic Insights - March 31, 2011

2

MARKET CALL

INTEREST & FOREIGN EXCHANGE RATES

Weve extended the time period or oil to stay at loty levels associated with geopolitical events. That willkeep the C$ trading stronger than parity or the next month or two, and we now see only a modest andtemporary dip to weaker levels i oil comes o the boil towards mid-year. The euro has climbed on theprospect o ECB hikes ahead, but we see it giving back gains once the frst hike is in the rear view mirror and

attention turns to lingering fscal woes.

Bonds reversed the ight to saety rally seen ater Japans quake. The ront end o the US curve remainsgrounded by a stand pat Fed, but the long end could weaken as we approach the end o support romQE2.

Earlier this month, we pushed back the frst Bank o Canada rate hike to July (rom May), with surprisinglytame core ination and a stall in progress on the unemployment rate suggesting a higher estimate or theeconomys non-inationary potential. That also lowered our bond yield targets or June. Still, Q1 growthwill be well above the Banks last outlook, and we still see upward pressure on yields as the Bank hikes theovernight rate to 2% by year end.

2011 2012

END OF PERIOD: 30-Mar Jun Sep Dec Mar Jun Sep Dec

CDA Overnight target rate 1.00 1.00 1.50 2.00 2.00 2.00 2.00 2.25

98-Day Treasury Bills 0.93 1.00 1.55 1.90 1.85 1.85 1.85 1.902-Year Gov't Bond 1.78 2.00 2.15 2.50 2.40 2.75 2.85 3.00

10-Year Gov't Bond 3.32 3.50 3.55 3.50 3.60 3.85 3.95 4.00

30-Year Gov't Bond 3.75 3.80 3.90 3.85 4.00 4.10 4.25 4.25

U.S. Federal Funds Rate 0.15 0.20 0.20 0.20 0.20 0.20 0.20 0.20

91-Day Treasury Bills 0.10 0.15 0.15 0.15 0.15 0.15 0.15 0.20

2-Year Gov't Note 0.80 0.75 0.65 0.65 0.85 0.90 0.90 1.00

10-Year Gov't Note 3.47 3.55 3.50 3.40 3.50 3.80 3.85 3.95

30-Year Gov't Bond 4.54 4.60 4.55 4.40 4.65 4.75 4.80 4.80

Canada - US T-Bill Spread 0.83 0.85 1.40 1.75 1.70 1.70 1.70 1.70

Canada - US 10-Year Bond Spread -0.15 -0.05 0.05 0.10 0.10 0.05 0.10 0.05

Canada Yield Curve (30-Year 2-Year) 1.97 1.80 1.75 1.35 1.60 1.35 1.40 1.25

US Yield Curve (30-Year 2-Year) 3.74 3.85 3.90 3.75 3.80 3.85 3.90 3.80

EXCHANGE RATES CADUSD 1.03 0.98 1.00 1.01 1.01 1.02 1.02 1.03

USDCAD 0.97 1.02 1.00 0.99 0.99 0.98 0.98 0.97

USDJPY 83 84 86 89 88 90 92 94

EURUSD 1.41 1.35 1.32 1.33 1.34 1.35 1.34 1.32

GBPUSD 1.60 1.57 1.58 1.62 1.65 1.67 1.65 1.65

AUDUSD 1.03 0.96 0.95 0.98 1.01 1.03 1.01 1.00

USDCHF 0.93 0.94 0.96 0.98 0.99 1.01 1.03 1.06

USDBRL 1.64 1.67 1.65 1.63 1.62 1.62 1.61 1.62

USDMXN 11.99 11.85 11.90 12.00 12.00 11.85 11.75 11.50


3/12


3

COMMODITIES OUTLOOK

Oil prices equal demand-supply dynamics plus geopolitical risk. The clear and present risk rom a potentiallyprotracted Libyan conict and a volatile Middle East political map have led us to hike our 2011 WTI price targeturther to an average $97/bbl. Replacing shuttered nuclear generation in Japan will also provide a modest near-term lit to demand. As reected in our unchanged $90 target or 2012, undamentals still point to a declining

path o least resistance or prices i and when Middle East tensions ease. OPEC has more spare capacity todaythan during oils record-setting mid-2008 run. Eorts to contain ination and trim budgetary gaps will slowgrowth and oil demand in the worlds two largest markets, the US and China.

While de-emphasizing nuclear could provide support or natural gas prices down the road, transportationconstraints and ample shale gas supplies are likely to weigh on North American prices or now. Our target pricesor 2011 and 2012 imply that the uel will continue to trade cheaply relative to oil in BTU terms.

Base metals prices have regained some or all o thelosses seen on the ight to quality ater the disasterin Japan. Re-construction eorts there should help to

support prices and demand or steel and many basemetals over the next ew years (see Chart). Rebuildingwill also require a range o orestry products, romlumber and panelboards, to structural and oriented-strand products.

Various unresolved crisesrom the fghting in Libyato eurozone sovereign and US budgetary and debtwoesare constructive or gold. China has seen thestrongest growth in investment demand in recent years.Ination ears are likely to support hedging demand inthat country and other ast-growing markets like India.

While QE3 looks like a non-starter, continued ultra-lowUS rates are also constructive, with the Fed unlikelyto start liting its target beore 2013. These actorscontinue to suggest a peak o around $1600/oz in thenext 12-18 months.

Construction Demand or Base Metals

Source: Handbook of Commodity Investing

0

10

20

30

40

50

60

Copper Zinc Aluminum

% of total use

Spot Commodity Prices29-Mar 2008 2009 2010 2011 (f) 2012 (f)

Oil (WTI) $/bbl 105 100 62 80 97 90

Natural Gas (Henry) $/Mn Btu 4.28 8.89 3.82 4.37 4.50 5.00

Gold $/troy oz 1418 870* 1088* 1406* 1600* 1600*

Copper $/lb 4.35 3.16 2.35 3.43 4.40 4.00

Aluminum $/lb 1.19 1.17 0.76 0.99 1.05 0.90

Nickel $/lb 12.08 9.57 6.69 9.91 12.50 10.00

Zinc $/lb 1.07 0.85 0.76 0.98 1.05 1.00

Lumber** $/'000 bd ft 280 252 221 245 270 300

* end of period **1st Futures

Average


4/12


Canada Goes to the Polls: What's at Stake?Avery Sheneld and Warren Lovely

Canadians will be trudging to the polls in early May,casting their votes in the ourth ederal election in seven

years. Party platorms are still taking shape, so we dontyet know all o whats at stake or the economy orfnancial markets. But its still worth examining potentialperormance in the lead up to the vote, and what theimplications might be o alternative political outcomes.

No Jitters

Thus ar, markets have taken the election call in stride,with no response in the exchange rate, the bond marketor equity perormance that could be attributed to theevents that led to the deeat o the Conservative minority

in the House. In part, thats due to the act that recentpolls show the Conservatives headed or nothing worsethan another minority government (Chart 1), with asteady-as-she-goes policy outlook as a result.

Although the clich is that markets abhor uncertainty,elections in the past ew decades have not typicallyshaken market conidence. In contrast, sovereigntyreerendums have produced heightened volatility, evenas the ballots were counted in the case o the 1995 vote.But or elections, its generally been calmer waters.

I anything, the period rom the dissolution o parliamentto the day ater the vote has been one in which Canadianequities have ared well and outpaced those statesideCanadian bond spreads have narrowed to Treasuriesand the Canadian dollar has gained modestly. Thatsparticularly evident i one strips out the 2008 electionwhich had the misortune o coinciding with the heightso the US inancial crisis (Table 1). While electionsmight not actually be good or markets, the governing

party tries to time the vote to match up with decenteconomic trends. Nor is there evidence o a post-electionhangover, as judged by currency, bond and equity marketperormance in the weeks ollowing a vote.

Chart 1

Polls Put Conservatives Out in Front

Source: Various polling agencies, CIBC

Table 1

Market Perormance During Past Elections

Election Winning Party / US$/C$ 10-Year Yields (Chg, bps)1 Equities (Chg, %)2

Date Type of Government (Chg, %) Goc UST Spread S&P TSX S&P500 Diff

8 -Jul-74 Libe ra l M ajority -0.9 71 17 54 -10.8 -14.6 3.8

22-M ay -79 P C M inority 0.9 -14 -6 -8 1.5 -1.1 2.6

18-F eb-80 Libe ra l M ajority 1.2 172 232 -60 20.1 5.2 14.9

4-S ep-84 P C M ajority 1.9 -91 -81 -10 7.1 7.1 0.0

21-N ov-88 P C M ajority 1.2 -14 8 -22 -0.8 -1.7 1.0

25-O c t-93 Libe ra l M ajority 0.2 -18 17 -35 5.9 1.7 4.3

2-Jun-97 Libe ra l M ajority 1.6 -44 -32 -12 10.2 10.5 -0.2

27-N ov-00 Libe ra l M ajority -1.7 -3 -5 2 -14.9 -4.4 -10.5

28-Ju n-0 4 Libe ra l M inority 2.2 17 -7 24 3.5 3.9 -0.4

23-Ja n-0 6 Cons ervat ive M inority 1.5 6 -8 15 6.9 0.7 6.1

14-O c t-08 Cons ervat ive Minority -10.8 -3 25 -28 -27.3 -26.9 -0.3

Average -0.3 7 14 -7 0.1 -1.8 1.9

Excluding 2008 Election3

0.8 8 13 -5 2.9 0.7 2.1

Notes: Table shows change in key financial market variables FROM start of election (day Parliament dissolved) TO one day after election

1. For 1974 to 1988 elections, bond market yields based on weekly data

2. For 1974 election, equity market returns based on month-end data

3. Figures for 2008 election reflect financial market fallout from Lehman Brothers bankruptcy, which occurred in midst of campaign (15-Sep-08)

20

25

30

35

40

45

50

Dec-08 Sep-09 Jun-10 Mar-11

Conservative Liberal

Popular Support, % (3-Poll Moving Average)

Conservative Support (2008 Election)

Liberal Support (2008 Election)


5/12


Source: Haver Analytics, CIBC

Chart 2

Current Path or Federal Decit Reduction

Is Decit Reduction at Risk?

For the bond market, the most important issue is whether

the election result could take Canada o its deicitelimination track. The 2011 budget, which was nevervoted on, hewed close to earlier plans to eliminate thedefcit by 2015/16 (Chart 2).

Note that fscal policy in recent years has reected thegive-and-take associated with a minority government.That was most evident in what transpired two yearsago. In the all o 2008, with evidence o a recessionmounting, the Conservative government initially plannedto trim spending in order to stay in balance. Opposition

threats to topple the government on that plan produceda dramatic U-turn, with a major fscal stimulus packageand a souring economic outlook dramatically increasingthe defcit in the 2009 budget (Chart 3).

But that reected a Keynesian stimulus program thatvirtually all other major western economies oered tosome degree. The Liberals can claim that in good times,back in the 1990s, they too took dead aim against defcitsby running a tight fscal ship. Two relatively costly itemson the Conservative agendafghter jets and prisonsrequired under a get-tough-on-crime programare

likely to be reconsidered under the Liberals, although theparties will debate about whether the cost or fghter jetswill end up any lower. Any savings on such items mightalso be reallocated to other spending priorities in a Liberalgovernment, rather than to defcit reduction.

Does the budget balance really hinge on the numbero seats a government holds? History does not showany consistent turns in fscal directionas measured bythe cyclically-adjusted budget balanceater changes

Chart 3

Opposition orced Chg o Course in 2008-09

between Liberal and Conservative parties, or betweenminority and majority governments (Chart 4). Moreoveropposition parties havent come out strongly against

defcit reduction as an objective, with platorms diverginglargely on where the available fscal room should beallocated (e.g., tax cuts vs. spending).

Whats less clear is whether there would be a dierencein fscal direction in a coalition government, as opposedto a minority that did not include other parties in itscabinet. Theres been only one ormal Canadian coalitiongovernment, way back during WWI. Still, in the UK,a tight fscal line has been taken by an equally rarecoalition.

The bond market might note that the Bloc Qubecoismade some airly expensive demands regarding supportor its home province as a pre-condition or supportingthe 2011 budget. These summed to $5 bn, comprisingcompensation or earlier HST harmonization, richer

Chart

Budget Balances and Political Parties

-4

-3

-2

-1

0

1

2

3

FY00 02 04 06 08 10 12 14

Federal Budget Balance, % of GDP

Fcst

(2011 Budget,

not passed)

-40

-30

-20

-10

0

10

FY07 08 09 10 11 12 13

2008 Fall Update

2009 Budget

Federal Budget Balance, $bn

-6

-4

-2

0

2

4

6

8

1975 80 85 90 95 00 05

Federal Cyclically-Adjusted Balance, % of GDP

Lib

Major

PC

Majority

Liberal

Majority

Cons

Minority

Lib

Major

PC

Minor

Lib

Minority

'09


6/12


equalization and university unding, and other items. TheNDP was seeking more health care unding in addition tothe increases in support or the aged-poor and energyretrofts that were included in the budget, although itopposed using fscal room or corporate tax cuts.

Still, both the Conservatives and Liberals have pledged

not to seek a ormal coalition. Best bets are that Canadawill stay on a course o defcit reduction similar to thefgures presented in the latest budget, regardless o theelection outcome. The Conservatives have pledged toachieve balance while still cutting corporate taxes, whileLiberal plans or a higher corporate rate would appearto be devoted to unding health care spending andeducation tax cuts, rather than a aster track or defcitreduction. That approach might help relieve pressureon provincial governments that bear responsibility orhealth/education.

Once balance is achieved, its unlikely that Canadawould aim or a return o large surpluses, given that thedebt/GDP ratio will already be alling sharply even with abalanced budget. Indeed, the Conservatives have alreadypledged to deliver a personal income tax cut or amilieswhen the budget reaches balance.

Monetary Policy: Above the Fray

Monetary policy, the other underpinning or the bondmarket and the Canadian dollar, is also not likely to be

signifcantly aected by the election result. The Bank oCanada is not wholly divorced rom the government,with its governor being a political appointee. And theBanks 2% ination target is up or renewal this year, withconsideration having been given to a lower target, or aswitch to price-level targeting, under which a period ohigher than target ination would have to be made upwith a below target period.

But odds are that the Bank is on course or simplyreairming the existing policy arrangement. Thegoverning party o the day is likely to resist a lower target,

given that it would entail a more stringent interest rateregime, and one not matched by the US Fed. Carney hassounded unenthusiastic about price-level targeting giventhat the current system has worked well.

Nonetheless, the election may well aect the timing othe next BoC hike. O late, the Bank has typically signaleda change in direction one rate-setting-date ahead. WereCarney thinking o a May hike, that would require him towarn o it in Aprilsquarely in the midst o the election

campaign. Moreover, surprisingly-low core ination givesthe Bank exibility to delay a warning on rate hikesuntil May, with the next round o tightening looking tocommence with a quarter point hike in July.

Issues or Equity Markets

With the bond and currency markets largely sidelinedthe greater ocus on the election could come rom equityinvestors. Here the most notable divergence in platormsthus ar is the Conservative pledge to carry on withcorporate tax cuts (to 15% by 2012), against a Liberaplan to return the rate to 18% (where it was in 2010)(Chart 5). Companies that might beneft rom a quickapproval o the militarys jet program also have issues atstake.

Environmental policies that could aect the energy sectomight also come into play. The Liberals are no longe

advocating the carbon tax that ormed part o theirplatorm in 2008, and when in power, did not stringentlyadhere to the Kyoto Accord despite signing on to it. Stilldebates during the campaign may draw out dierencesamong the parties on this ront.

More Votes to Come

At the end o the day, i current polling holds up, thiselection could prove uneventul or fnancial marketsBut keep tuned to the political channel. Five provinces are

scheduled to hold general elections this year. For the bondmarket, the greater concerns these days lie in defcits andfnancing requirements at that level o government. Itstoo early to get a read on opposition platorms or thesevotes, but the debates over this weeks Ontario budgetwill provide some clues on that ront or the countryslargest province.

Chart

Corporate Tax Cuts at Stake

15

16.5

18

1919.5

22.12*

12

14

16

18

20

22

24

2007 08 09 10 11 12

Legislated Path (Conservatives) Liberal Plan

Federal Corporate Income Tax Rate, %

* Includes 1.12%

federal surtax


7/12


An old and amiliar spectre is haunting the globaleconomy these daystriple-digit oil prices. The recent

run-up comes nearly three years ater oils last moon shot,which saw the price hit a record $147/bbl in the aceo ast-rising emerging-market demand. Oil prices havebasically been on a gradual upswing since early 2009,when the frst green shoots o global recovery emerged.

Crude prices can rise or a variety o reasons. Somelike demand gains due to a stronger global economyare essentially positive rom an economic standpoint,others like the OPEC disruptions that plunged the globaleconomy into recession in the 1970s and 1980s are aclear negative. The Middle East and North Arica produce

nearly hal o the worlds oil, and ears that anotherproducer could be poised to ollow Libya into strie havehelped turn a not-so-disturbing demand-driven run-upinto a worrisome supply shockwave.

Although Libyas output is approximately hal as largeas Canadas, its oil is prized or its high quality, and isparticularly well-suited or European diesel markets. Theprospects or a drawn out conict there and risks in otherproducers have led us to upgrade our WTI orecast to anaverage $97/bbl this year, although we still expect prices

to settle back to $90/bbl in 2012 (see page 3), as supplyand demand undamentals reassert themselves. Estimatesrom a variety o sources suggest OPEC spare capacitywas ample beore the crisis, and easing growth in Chinawill help to cool demand growth there.

Not Yet as Large as Recession-Inducing Shocks o1970s and 1980s

Oil prices did surge ahead o ive o the last six USrecessions. Most observers would argue, though, thatpricey oil was not the main reason growth oundered in a

number o these cases. The 2001 recession was arguablyar more about the shock rom dot-com implosion, than$1.60/gal gasoline, and oils gyrations certainly didntblow up the US mortgage market later in the decade.

The back-to-back recessions o the mid-1970s and early1980s were clearly much more an oil story. Both o thoseepisodes, however, involved a much harder blow to theindustrial economies, based on the rise in costs to thosenations as a percentage o GDP. Thats a good way o

Oil Prices and the North American EconomyPeter Buchanan

Chart 1

Oil Supply Shocks

looking at things, allowing or the global economysdeclining oil intensity as well as the act that the level o

oil prices beore the shock matters. A doubling in pricesis more painul, in other words, rom $50/bbl than whenthe starting point is $10, a distinction that is lost whenlooking only at percentage price changes.

Oil consumption costs rose by the equivalent o nearly3% o GDP in the frst 1973-75 supply shock, which cameater an OPEC embargo, and more than 4% in the second(Chart 1) which came on the heels o the overthrow othe government o Iran, the largest Middle Eastern crudeproducer at the time.

Given declining levels o oil intensity and other actors, oiprices would have to reach $160/bbl to match the frst othose two knockout punches and nearly $200 to matchthe second. The Feds uber-hawkish stance, moreoverhelped accentuate the US economys troubles in the early1980s. Thats not to say that the impact o the recentprice run-up has been inconsequential. In the US, the risein ood and gasoline prices since the start o the year haseectively oset most o the beneft to consumers romthe recent tax stimulus.

Lit to Canadian GDP Modest and Transitory

Canada is divided between an oi-consuming east anda producing west, and the provincial implications o

0.0

0.5

1.0

1.5

2.0

2.53.0

3.5

4.0

4.5

Iranian

Revolution

1973 OPEC

Embargo

Iraq's Kuwait

Invasion

Since Start of

Recent

Turmoil

Rise in OECD countries' oil costs, % of GDP

Source: US DOE, CIB


8/12


oil prices have typically overshadowed the nationalmacroeconomic ones. All signs are that the relationshipbetween growth and oil prices is a non-linear onemeaning simply that some is good, a lot bad. In 2008,the C$ ollowed crude only until prices hit $100/bbl. Thecrossover point or Canadawhere the negative eectso pricier oil like weaker growth in the US and auto sales

increasingly predominatemay not consequently be toomuch above that level.

We used a standard statistical modeling approach1 toget a better handle on the impact o oil price changeson the Canadian and US economies, and key variableslike the currency and rates. Our analysis suggests thatit takes about a year or the US economy to eel the ullpinch rom an oil price shock (Chart 2). That suggestsone shouldnt take too much comort rom the recentresilience o energy-sensitive categories o demand likeauto sales.

Canada is one o the worlds top dozen net exporters o oiland oil products (Chart 3). Higher prices are nonethelesssomething o a double-edge sword in that the countrytrades heavily with an increasingly oil-import-dependentUS. Long transportation distances, a sizable auto sectorand high levels o energy consumption in many o thecountrys traditional industrial mainstays (Table 1) alsomean that higher oil prices are not the unambiguousbeneft some might imagine. While Canada leads the G7in per capita oil production, it is also the most intensive

user (Chart 4).

Our analysis implies that in the very near term, higher oilprices result in a modest improvement in macroeconomic

perormance at the national level. A 25% rise in wellheadprices, approximating the recent increase, ordinarilylits real GDP growth by a tick or two in each o thetwo ollowing quarters. Beyond a couple o quartersthe negative eects (Chart 5), including the drag onkey trading partners and auto sales, begin to outweighthe positive, hurting GDP growth. Beyond our to fvequarters, the bad more than cancels the good, and thelevel o GDP is actually lower than it would otherwisehave been. A urther negative is the increasing drag rominduced C$ appreciation on the countrys non-energyexports.

Chart 2

Impact o 25% Oil Price Shock on US GDP

Chart 3

Top Net Oil Exporters, 2009

Source: Canadian Energy End-Use Data & Analysis CentreSource: CIBC

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

0.1

1 2 3 4 5 6 7 8 9 10

99.3

99.4

99.5

99.6

99.7

99.8

99.9

100.0

Growth (L)

Level (R )

% chg, SAAR

Quarters from start of shock

Pre-shock = 100

0 2 4 6 8

Canada

Mexico

Qatar

Kazakhstan

Algeria

VenezuelaKuwait

Norway

United Arab Emirates

Iran

Saudi Arabia

Russian Federation

MM Bbl/day

Table 1

Petroleum Use Per Unit o Output, 2009

Ele ctric ity Ge n e ra tio n 6 9 .7 8Pa p e r Ma n u fa ctu rin g 1 9 .8 8Prim a ry Me ta l Ma n u f. 1 7 .4 2Min in g (n o t O il, Ga s a n d C o a l) 1 0 .6 9Pe tro le u m an d C o a l P ro d u cts Ma n u fa ctu rin g 1 0 .2 1

N o n Me ta llic Min e ra l P ro d u ct Ma n u fa ctu rin g 8 .3 1C h e m ica l Ma n u fa ctu rin g 6 .3 6W o o d Pro d u ct Ma n u fa ctu rin g 4 .8 9To ta l a l l In d u s trie s In c lu d in g Min in g 4 .4 7Total A l l Manufactur ing Indus t ries 4.32

Te xti le Mil ls 1 .9 0P la s tics an d R u b b e r P ro d u cts Ma n u fa ctu rin g 1 .6 8Fo o d Ma n u fa ctu rin g 1 .4 5Fa b rica te d Me ta l P ro d u ct Ma n u fa ctu rin g 1 .3 4Fu rn itu re a n d R e la te d P ro d u ct Ma n u fa ctu rin g 1 .0 0Prin tin g a n d R e la te d Su p p o rt Activitie s 0 .9 9Mis ce lla n e o u s Ma n u fa ctu rin g 0 .9 7Be ve ra g e a n d To b a cco P ro d u ct Ma n u fa ctu rin g 0 .8 7E le ctrica l Eq uip , Ap pli & Co m po ne nt Ma nu fa ctu rin g 0 .6 9Ma ch in e ry Ma n u fa ctu rin g 0 .6 8C lo th in g Ma n u fa ctu rin g 0 .5 3Tra n s p o rta tio n E q u ip m e n t Ma n u fa ctu rin g 0 .4 9C o n s tru ctio n , All s e cto rs 0 .2 8C om pu te r a n d Ele ctro n ic P ro d u ct Ma n u fa ctu rin g 0 .2 2

TJ/$2002

mn.INDUSTRY SECTOR

Source: BP, CIBC


9/12


Equity Market Ramications o Higher Oil Prices

Oil production is much more heavily weighted in the TSXthan in the Canadian economy. Estimates by the CanadianEnergy Research Institute suggest that the petroleumsector accounts or about 11% o Canadian GDP. Incomparison, the energy sector, which is dominated by themajor oil and gas producers, accounts or over 27% othe TSXs market cap. That segment has also accountedor as much as a fth o index earnings in recent years,second only to the fnancial group. While that arguably

suggests a larger upside or market perormance romrising oil prices than the economy, it is worth noting that

higher prices have historically had a widely varying eecton a sector-by-sector basis. Ater the obvious example othe energy sector, the TSX material group has traditionallybeen the largest benefciary o costlier oil. Producers ogold, whose price moves generally track oil, account ohal o the market cap o that sector. The sectors mostat risk rom rising oil prices historically have been the

consumer groups, given the drag on spending powerom higher prices. The industrial sector, which containsheavy users like the airlines and is closely tied to theenergy-dependent US economy, is another traditionaloser (Chart 6).

Oil prices have risen dramatically recently. Although therun-up is causing pain or some sectors and will aecthe strength o growth and equity market perormanceprices would in all probability have to rise urther to kilthe recovery on their own. While not yet at recessioninducing levels, the situation bears close watching giventhe evolving picture in the Middle East. Looking at thedomestic implications, rising oil prices beneit somesectors o Canadas economy and regions, but are not theunequivocal plus that is sometimes made out.

1 The approach is known formally as a vector autoregression, andinvolves regressing each of a number of variables (Canadian and USreal GDP growth, CAD and 10-year government of Canada yields) onlagged values of each other. Our model is thus able to capture howa rise in oil prices impacts Canadian GDP directly and via induced

changes in the US economys performance, and the exchange andinterest rates.

Chart

Impact o 25% Oil Price Shock on Canadian GDP

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

1 2 3 4 5 6 7 8 9 10

99.6

99.7

99.8

99.9

100.0

100.1

Growth (L)

Level (R )

% chg, SAAR

Quarters from start of shock

Pre-shock = 100

Chart

Canada a Heavy Oil User as Well as a Producer

0

100

200300

400

500

600

Cana

da

Unite

dStates

Japa

n

Germ

any

Italy

Unite

dKing

dom

Fran

ce

bbls of oil/Mn $ of GDP, 2010

Chart

Impact o Oil Price Changes on TSX Groups

-60

-40

-20

0

20

40

60

Energy

Materials

Info

Tech

Utilitie

s

Fina

ncials

Health

Telecoms

Industria

ls

Cons

Discr

Cons

Stap

Outperform when oil strong or rising

Underperform market when oil strong

Note: chart shows correlation between sector's relative strength

and WTI price, based on weekly data from 2002 - 11

Source: IMF, IEA

Source: CIBC Source: CIBC, Bloomberg


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10

Chart 1

Oil and C$ Positively Correlated Ater 1982

Oiling the Canadian Dollar SwingsKrishen Rangasamy

While its no secret that the Canadian dollar generallytends to beneit rom higher oil prices, whats less

obvious is the mechanism through which that relationshipholds. The benefts to the currency o the associatedimprovement in oil export receipts are well understood,but less so are non-trade actors which are oten morecrucial in determining the loonies trajectory. Thoseactors have worked to keep the Canadian dollar inovervalued territory over the last couple o years. Butthe recent run-up in oil prices past US$100/barrel hasallowed or a better alignment between the loonie andits undamentals.

Amplier Eects on the C$

What is now conventional wisdom, namely the positiverelationship between oil to C$, hasnt always been so.The correlation between the currency and oil prices wasin act negative beore 1983, when Canada was still a netimporter o oil. It was only when Canada began runningpetroleum trade surpluses on a sustained basis that tradeows started to work in the loonies avour (Chart 1).

In recent years, the elasticity o the C$/US$ exchangerate to oil price movements seems to have risen (Chart 2,

let). While part o that increased responsiveness can beexplained by the much larger inuence o oil in Canadasexport revenues (Chart 2, right), there are actors otherthan trade ows that are at least as important. For one,US dollar weakness has gained momentum in recentyears with enhanced concerns about US fscal and debt

problems, and that has been a major actor in keepingboth oil prices and the C$/US$ exchange rate at lotylevels.

Capital Flows Trump Trade Flows

Also, while trade ows are important, ows o capitaare becoming even more important in inuencing theCanadian dollar. According to the Bank o InternationaSettlements, the Canadian dollars share o the currencymarket was around 5.3% in April 2010, which isequivalent to volumes o around $2,500 bn/month. Thacontrasts with total Canadian goods and services tradeo under $82 bn/month last year. In short, the bulk oC$ trading can be impacted by perceptions rather thanundamentals. And conventional wisdom tends toaect perceptions, with investors pouring cash into aperceived petrocurrency like the Canadian dollar whenoil prices rise and vice-versa. Speculative holdings havetended to ampliy the impacts o oil price movements inthe Canadian dollar. In March 2011, speculative longwere at their highest since October/November 2007.

Inows o oreign cash related to oil prices havent beenlimited to trade. The run-up in oil prices in recent yearhas also encouraged oreign direct investments (FDIin the Canadian energy sector. So much so, that theenergy sector now accounts or a disproportionately high

Chart 2

C$ Now More Responsive to Oil (L), Oil Now

Main Driver in Canada's Energy Trade (R)

20

30

40

50

60

70

1983 1992 2001 2010

Oil/Petroleum products

trade surplus as a % of

total Canadian energy

trade surplus

1983-

2007

avg.



-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

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1973-1982 1983-2010

C$ correlation with WTI oil price

0.00

0.05

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0.15

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0.25

1983-2007 2008-2010

C$ elasticity

(% chg. in US$/C$ when

oil price chgs 1%)


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11

to the heady levels o the actual C$/US$ exchange rate(Chart 5). Simply put, the C$ had overshot undamentalsseveral years ago and the recent run-up in oil prices hasallowed undamentals to now catch up to the currency.

While the Canadian dollar is now reecting resource andinterest rate undamentals, thats scant consolation onon-resource producers, many o whom are eeling theeects o the Dutch disease, particularly those who ailedto make signifcant headway in improving productivityWhile we expect oil to cool rom current heights later this

year, it will remain elevated by historic standards, withurther gains over the long term. The resulting persistentstrength o the Canadian dollar, while not precludinggrowth in manuacturing, will continue to put pressure onCanadas share o oreign markets in that sector.

percentage o incoming FDI inows. And the upwardtrend there hasnt been interrupted despite the slump inoil prices during the 2008-2009 recession, suggesting thatoreigners are investing in the resource sector or the longhaul (Chart 3). Those inows serve to urther ampliy oilsimpact on the currency.

Oil prices generally tend to aect prices o other non-energy Canadian exports, perhaps because oil is otenused as an input, either directly or indirectly, in producinga range o products. Agricultural product prices soared

in 2008 and again this year, not just because o higheroperating costs (e.g. higher uel bills) but also partlybecause o uel substitution, with corn (a key input inood production) being diverted away rom the oodsupply chain to produce oil-competing uels like ethanol.The positive correlation between oil prices and ex-energycommodity prices isnt just contemporaneous but lingersor several months (Chart 4), which somewhat enhancesthe eect o oil prices on trade ows and hence the C$.

Has the Canadian Dollar Overshot Fundamentals?

With the Canadian dollar hitting 0.97 C$/US$ in March,an obvious concern is whether the currency has overshotits undamentals. A model similar to the Bank o Canadaserror-correction model, taking into account interest ratedierentials between Canada and the US, and commodityprices, has been showing a loonie straying in overvaluedterritory over the last couple o years. But the sharp run-up in oil prices in the frst quarter this year means thatthe Canadian dollars air value has now caught up

Chart

Oil Price Correlated With ex-EnergyCommodity Prices

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

ex-Energy Metals Agriculture

Contemporanous correlation

Correlation with oil lagged 9 months

Correlation coefficient:

BoC commodity price index vs. WTI oil price


Chart 3

More Inbound FDI Going to Energy Sector

0

20

40

60

80

100

120

1987 1998 2009

10

12

14

16

18

20

22

24

WTI oil price (L)

Energy sector's share of Direct Investment (R)

US$/barrel %


Chart

C$ Now Fairly Valued Thanks to Oil's Ascent

Source: CIBC

0.95

1.00

1.05

1.10

1.15

1.20

1.25

1.30

1.35

09Q1 10Q1 11Q1F

C$/US$

Fair value

as per ECM

Actual


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CANADA

ECONOMIC UPDATE

UNITED STATES

Conficts o Interest: CIBC World Markets analysts and economists are compensated rom revenues generated by various CIBC World Markets businesses, including CIBC World Markets Investment BankingDepartment. CIBC World Markets may have a long or short position or deal as principal in the securities discussed herein, related securities or in options, utures or other derivative instruments based thereon. Threader should not rely solely on this report in evaluating whether or not to buy or sell the securities o the subject company.Legal Matters: This report is issued and approved or distribution by (i) in Canada by CIBC World Markets Inc., a member o the IIROC and CIPF, (ii) in the UK, CIBC World Markets plc, which is regulated bythe FSA, and (iii) in Australia, CIBC World Markets Australia Limited, a member o the Australian Stock Exchange and regulated by the ASIC (collectively, CIBC World Markets). This report is distributed in thUnites States by CIBC World Markets Inc. and has not been reviewed or approved by CIBC World Markets Corp., a member o the New York Stock Exchange (NYSE), NASD and SIPC. This report is intended o

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With energy prices set to stay loty or longer, weve revised up our 2011 CPI call by three ticks to 2.5%,although core should come in at a slightly tamer 1.6%, given its recent weakness. Growth is still on trackto hit 2.8% or 2011, helped by a strong start, as rebounding manuacturing activity looks to take the Q1growth rate to 4%. But with fscal drag and rate hikes on their way in the second hal o the year, economicgrowth should revert to a lower gear.

Weve slashed our US frst quarter growth rate to 2.8%, ater having expected growth to top 4% a month ago,prior to the deepening supply shock to oil prices. The downward revision is centred on consumption, whereweakness in wage gains, alling house prices and costly gasoline has put the squeeze on spending. Businesscapital spending also looks to be coming up short. We expect even slower growth in the second hal, in partallowing or fscal restraint that Republicans are pushing or. Our CPI targets are higher in the near term dueto the shock to gasoline.

CANADA 10Q4A 11Q1F 11Q2F 11Q3F 11Q4F 12Q1F 12Q2F 2010A 2011F 2012F

Real GDP Growth (AR) 3.3 4.0 2.5 2.0 1.9 2.3 3.1 3.1 2.8 2.8

Real Final Domestic Demand (AR) 4.7 2.5 2.5 1.9 1.8 2.3 3.0 4.4 3.0 2.7

All Items CPI Inflation (Y/Y) 2.3 2.4 2.8 2.6 2.2 1.7 1.5 1.8 2.5 1.8

Core CPI Ex Indirect Taxes (Y/Y) 1.6 1.2 1.4 1.8 1.9 1.9 1.8 1.7 1.6 2.0

Unemployment Rate (%) 7.7 7.7 7.5 7.6 7.8 7.7 7.5 8.0 7.6 7.4

U.S. 10Q4A 11Q1F 11Q2F 11Q3F 11Q4F 12Q1F 12Q2F 2010A 2011F 2012F

Real GDP Growth (AR) 3.1 2.8 3.0 2.3 1.9 2.4 2.5 2.9 2.7 2.4

Real Final Sales (AR) 6.7 1.6 3.3 2.7 2.3 2.2 2.5 1.4 2.9 2.5

All Items CPI Inflation (Y/Y) 1.3 2.0 2.4 2.8 2.5 1.9 1.6 1.6 2.4 1.8

Core CPI Inflation (Y/Y) 0.7 1.1 1.2 1.3 1.4 1.6 1.6 1.0 1.3 1.7

Unemployment Rate (%) 9.6 9.0 9.0 9.2 9.3 9.3 9.1 9.6 9.1 8.9

Documents

03.2011 CIBC Economic Insights