scotia capital points

8/9/2019 Scotia Capital Points

1/14

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

Global Economic Research

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

Derek Holt (416) [email protected]

Gorica Djeric (416) [email protected]

Not a Treasury Bubble But Go Cash If It IsTalk of a bond bubble heated up again this week as Treasury yields pushed tonew lows, and opinions came from far and wide. We still dont believe thebubble camp at this juncture. That said, if there is one, we believe the commonadvice to rotate out of bonds into equities in a broad asset allocation shift evenless.

If Treasuries are a Bubble, Then So Are the Risk TradesIf bonds are indeed in a bubble, however, then equities should not be favoured.To demonstrate this point, consider a simple Gordon model for valuing theexpected dividend stream on a stock. It says that a share price should equal nextperiods expected dividend payment divided by the spread between the expected

discount rate and the long-run expected growth rate in dividend payments. Its asimplifying approach for our purposes that assumes dividends grow at a constantrate over time in a perpetuity framework.

Now for the components, start by assuming that dividend pay-outs grow by theirlong-run average on the S&P500 over the past half century, which is about 5%.For the discount rate, use the yield on the Moodys BAA corporate benchmark asa proxy, which currently stands at about 5.5% and is at the lowest level in decades. Under this framework, onedollars worth of expected dividends that grows by 5% every year is worth $2 in present value terms becausediscount rates are so low.

Next, shock the discount rate applied to every one dollar of dividend income in accordance with higher yieldexpectations. If Treasuries get hit by capital losses, presumably corporates do as well. So shock the BAA yield bylets say 200bps. Now the present value sinks to $0.40. To negate the impact on equity prices, the average long rungrowth rate of the dividend income stream would itself have to rise by 200bps to 7% in order to still leave a presentvalue of $2. Finance 101 says that higher discount rates flowing out of a post bond bubble environment would hitthe whole spectrum of asset prices including equities.

This is just one approach, compared to many that can be used tovalue the earnings stream, but it flags the issue that earnings growthis unlikely to accelerate fast enough over a long-run average inorder to offset the impact of higher discount rates in a scenariomarked by a popping bond bubble. Further, while the average long-run divided growth rate may be skewed to the downside by thecrisis period, it was also skewed to the upside by past bouts of higher inflation which means that the expected dividend growth rategoing forward may well be lower than the long-run average. So

equities get pummeled in a Treasury bubble scenario, and so doesmuch of the credit landscape, as corporate bonds, MBS, agencies,provies, sub debt, deposit notes and much of the whole creditlandscape would be unlikely to fare well.

In the extreme scenario of a failed Treasury auction that serves asthe catalyst for bond bubble fears, the impact on the risk tradescould be potentially devastating.

Then consider the impact upon the financial system since guesswhat its US banks that have backed up the truck and sharplyraised the share of total assets held in Treasuries (chart 1) that would get sharply marked down in a popping bondbubble environment, not to mention the whole financial systems holdings of credit products. Sure, equities will do

Capital Points is available on: www.scotiabank.com, Bloomberg at SCOE and Reuters at SM1C

August 20, 2010

Commentary

Canadian Preview

U.S. Preview

International Preview

Canadian Macro Comment

Corporate Credit Markets

Emerging Markets

Fiscal Policy

Foreign Exchange Markets

U.S. Macro Comment

Indicator Preview Tables

1-2

3

3-4

4

5-7

8

8

9

10

11

12-13

Index


2/14

Capital Points

2

Global Economic Research August 20, 2010

wonderfully in a renewed environment of mark-downs at financial institutions. But then also trace through the generalequilibrium outcome in that, should a bond bubble pop and bring down the risk trades, a renewed safe haven effect wouldbe sparked that would bring flows back into government bonds although maybe not Treasuries in the longer run so much asother healthier government bonds (Canada, Australia, etc). The issue in the current context remains that equity andcorporate credit valuations are not coming from the weak starting point of March 2009, nor about to get a lift from anacceleration in short-run earnings growth as happened over the past year. Theyve come a long way from that, and arerichly valued and thus exposed to sharp swings in discount rates.

Thus, our view is that if one does believe Treasuries are a bubble, then it seems the asset allocation choice at hand entailsputting a higher weight on cash and near-cash instruments.

But Were Not in the Bubble Camp Because bonds have reflected expectations for deteriorating fundamentals better than equities, we think their value is

justified on the outlook for growth and inflation. Further, markets too often dont consider the crowding-in argument thatweve repeatedly emphasized throughout the crisis period as a credit flows way of justifying Treasury moves.

The issue in evaluating a bond bubble is to address where the competition for capital would arise. Right now, there isntany competition for that capital as the Feds flow of funds accounts continue to show economy-wide net debt being paiddown (chart 2). Further, the shadow products that are not well captured in the flow of funds figures also pose littlecompetition for capital, and they remain weak. Going forward, a gradual private sector credit recovery is eventuallypossible alongside gradually diminishing rates of annual Treasury issuance so as to still leave behind a mild environment foreconomy-wide debt growth and mild overall competition for capital that itself is likely to be supplied faster at the globallevel through higher saving rates. But in order for US 10s to get back to, say, 5% where they stood at the tail end of the lastexpansion just prior to the crisis, would require net debt issuance across all forms of private and public debt in the USeconomy to also push back to the peak north of $5 trillion a quarter at annualized rates from the current zero mark. We

judge that to be highly unlikely for a long time yet.

Further, next week won't offer much relief in terms of US fundamentals. On the one hand, durable goods orders(Wednesday, 8:30amET) are expected to post a sharp pop higher based on what we already know about a very strong gainin Boeing orders during July over June. Boeing orders have climbed from 5 planes in May to 49 in June and 130 in July.Core durable goods orders are more uncertain going forward, on evidence of a softening new order book. The take-back,however, arrives earlier in the week in that existing home sales (Tuesday, 10:00amET) will reflect the sharp plunge inpending home sales that had occurred following the April 30th expiration of homebuyer incentives. Resales are likely to seta new all-time low in the low 4 million range if not the high 3 million zone. Finally, GDP (Friday 8:30amET) is likely to be

revised about a full percentage point lower than the initial Q2 print of 2.4%. We think the markets are likely to be morefocused on the resale figures and GDP than durables.

Thats especially true in combination with our concerns about how Q3 GDP growth is shaping up (Is the US ConsumerNow Leading a Double Dip?, Capital Points , August 13 th page 1). Economic growth in Q2 was skewed to the front of thequarter as indicators trailed off later in the quarter, and that poses weak momentum and hand-offs to Q3. For instance, sincereal retail sales peaked in April at the beginning of Q2, its likely that the Q3 average will come in lower than the Q2average even with modest gains in monthly real retail sales in August and September. The start to the Q3 indicators isntany better on other fronts with initial claims during the nonfarm reference period potentially pointing toward renewed joblosses. Add in a softening new order book, and the factory sector has lost its momentum as a driver of GDP growth as perthe temporary V arguments weve made throughout the past year.

As a final observation, note that Japans experiences didnt follow a straight line over the years following the popping of thebubble on the Nikkei and in real estate markets (chart 3). Throughout years of debating whether JGBs were a bubble,oscillating patterns took the bias lower over a long period of time and stayed there.


3/14

Capital Points

3


Next Weeks Key Market Risks In Canada , this weeks highlight will be the June retail sales figures, which beg the question of whether June will mark thethird straight month of disappointing results. Leading indicators beg to differ. In the United States , markets prepare for anumber of top-tier releases, including the second round of revisions to Q2 GDP, and an update of durable goods orders andhousing sales figures with July data. The economy will remain the wild card, with the potential to pour some more coldwater on hopes of a smooth recovery. Should these releases disappoint, it could set a negative tone in the markets. On theinternational data front, services and manufacturing PMIs are likely to garner the most attention. There are no majorcentral bank meetings lined up for next week, but the Fed is scheduled to begin buying Treasuries .

CANADAThe volume-based retail sales gain of 0.4% m/m in May was not terribly impressive after theprior months sharp 2.1% m/m drop in price-adjusted sales, suggesting that some demand mayhave been frontloaded to the beginning of the year on the expiration of the Home RenovationTax Credit. For the quarter as a whole, Canada is tracking a 0.1% q/q decline in real retailsales, conservatively assuming that Junes reading comes in flat. Even should June surprisehigher, the second quarter will see a much weaker contribution to overall GDP growth fromretail sales, below the Q1 rise of 1.6% q/q (non-annualized). While both housing and retailsales are on the list of downsides to the Q2 GDP print, keep in mind that retail sales account foronly about 40% of total consumer spending in Canada, and that these numbers do notadequately capture services. Retail sales are expected to have reentered positive growth

territory in June, climbing 0.4% m/m at the headline level and 0.1% at the core level, on baseeffects, higher motor vehicle sales and frontloading of purchases ahead of the HSTimplementation on July 1 st; gasoline prices were virtually flat for the month. The risk lies in thecore reading. Looking ahead, solid reasons to expect healthy consumer gains include theredeployment of sidelined cash, combined with one of the strongest global job markets of thepast year. We think the balance of the readings through September 8 th when the Bank of Canada is scheduled to meet next will reverse some of the disappointing sentiment that had flowed from the last batch of reports for retail sales, jobs, and exports.

The Teranet Home Price Index (THPI) showed that home prices advanced 13.6% y/y in May, the fastest pace sinceSeptember 2006, and the third straight month of double-digit growth. The THPI is a relatively new index, with data goingback to April 2009. It is the Canadian equivalent of the U.S. S&P/Case-Shiller measure of resale, single-unit house prices,preferred to other measures because it does a much better job of controlling for the influence on average prices stemmingfrom compositional shifts. It is, however, lagged a month behind the Canadian Real Estate Associations measure of

average house prices. We expect home prices to have increased by 12.0% y/y (0.1% m/m), a slight moderation from May onbase effects; home prices bottomed in April 2009 such that Mays Teranet report is no longer being keyed off falling houseprices a year ago. The HST's more sizeable impact on the new-home segment may partly shield resale prices.

The Bank of Canada will auction 30-year real return bonds on Wednesday. Bank of Canada Deputy Governor Murraywill speak on Research and Renewal of Canadas Inflation Target at the Canadian Association of Business Economicsconference on Tuesday in Kingston.

UNITED STATES Data released to date suggest that the second round of revisions to Q2 real GDP growth will yield considerably lowerfigures. Our forecast predicts a gain of 1.4% q/q annualized, down from the original estimate of 2.4%. Most support is stilllikely to have come from household consumption, although less so than originally estimated. Trade and residentialinvestment will also act as a bigger drag, while government spending, inventory restocking and business investment in

machinery & equipment are expected to provide some offset.Durable goods orders are likely to have posted a solid headline gain in July, with our in-house forecast looking for anincrease of 3.5% m/m, and more modest growth of 0.6% at the core level. The top print is likely to be misleading, distortedby the sizeable and volatile transportation segment. Industry data suggest that the demand for both aircraft and vehicles washigher in July, with Boeing locking in 130 new orders as compared to 49 in June and only 5 in May. However, 62% of thoseorders were placed in the latter half of the month, and might not be captured by the survey period, as it ends at the mid-month point, but will be reflected in later revisions. According to the May ISM manufacturing index, growth in shipmentsand new orders continued to decelerate for the third straight month to a pace seen in the early second half of last year.Slightly higher commodity prices will gently lift nominal bookings for semi-processed durable goods. Watch for businessinvestment bookings for non-defense capital goods ex-aircraft act as a proxy for future business spending andmanufacturing inventories. The former is likely to have broadened further across most categories.

-4

-3

-2

-1

0

1

2

06 07 08 09 10

Canadian Retail Sales

Total

Total ex. Gas& Autos

m/m % change,3MMA

Source: Statistics Canada,Scotia Capital Economics.


4/14

Capital Points

4


We expect that both new and existing home sales will post declines in July, down to0.32 million annualized units from 0.33 million in the prior month remaining in thelow-300,000 and to 4.1 million from 5.37 million, respectively. Leading indicatorspoint to weak activity. Pending home sales have been retreating for two straight monthsnow, plunged a record-breaking 30% m/m in May, and another 2.6% in June. Given thelagging nature of existing home sales, these declines are likely to be heftily reflected inJuly results. Mortgage purchase applications may have increased during three of the five

weeks in July, but they are still 40% below their peak in the final week of April, when thefirst-time homebuyers tax credit expired. According to the National Association of HomeBuilders, traffic of prospective buyers has been falling for two months now, registering adecline of 18.8% m/m in June and 23.1% in July. Add to that increasingly cautiousconsumers intentions to buy a home have been declining since March lacklusterprivate-sector job gains and an excessive supply of on- and off-the-market homes, andyou get an environment that is not exactly conducive to improving home sales activity.

Next week we are due to get a handful of Fed speeches, most notably Fed Chairman Bernankes comments at Kansas CityFeds Jackson Hole Conference on Friday. Kansas City Fed president Hoenig a voting hawk, and so far the onlyFOMC dissenter is scheduled to testify at a field hearing on the House Subcommittee on Oversight and Investigations, tobe held on Monday in Kansas. Chicago Fed President Evans an alternate centrist will deliver a speech at theIndianapolis Neighborhood Housing Partnership Community Conference.

Multiple Treasury auctions are lined up for next week,including US$37 billion 2s, US$36 billion 5s, US$29billion 7s and a reopening of US$7 billion 30-yearTIPS. The Fed is scheduled to purchase Treasury notesand bonds next week. According to the New York Fed,across all operations in the schedule listed below, theDesk plans to purchase approximately US$18 billion.This is the amount of the principal payments fromagency debt and agency MBS expected to be received between mid-August and mid-September, adjusted for prior SOMAagency MBS purchases that have been allocated since August 4. The statement adds that the next release of the approximatepurchase amount and tentative outright Treasury operation schedule will be released at 2pmET on September 13, 2010.

INTERNATIONALAnother relatively quiet week on the international monetary policy front, with no major central bank meetings lined up. Policymakersin Hungary , Israel , Philippines , Poland and Thailand are scheduled to meet next week, and all save Thailand are expected tohold their overnight lending rates steady. Thailand is expected to start tightening monetary policy on Wednesday, with the consensuslooking for a rate hike of 50bps to 1.50%. Officials have remained on the sidelines since April 2009, and this would be their first rateincrease since August 2008. Second-quarter GDP figures for this export-reliant economy are due out next week. After expandingfive-fold in the first quarter, Thailands trade surplus doubled from April through June. In July, Thailand registered its first tradedeficit this year, as growth in imports outpaced that of exports, but both components signaled strength.

Looking ahead to key international fundamental releases, we see that they are relatively few in number, but that they are concentratedin the top tranche of economic data. In the euro-zone region, manufacturing and service PMIs for August will grab the limelight thisweek. Defying predictions for a further slowdown in economic growth, manufacturing and services activity in the euro zone regionpicked up pace in July to its highest reading in three months. Following two months of moderating growth, Julys increases came onthe back of solid gains in both output and new orders, suggesting a better-than-expected start to the second quarter. However,regionally, strength was concentrated in Germany, with the countrys composite PMI currently at the highest levels since early 2007.Consensus is looking for the pace of growth in both goods and services to moderate a touch in August, but remain well above the 50-point breakeven line. At the composite level, we will also get an advance estimate consumer confidence for August and newindustrial orders for June. Germany will update its IFO business sentiment survey and CPI data with August numbers, whileSpain will publish its July retail sales . The United Kingdom will publish the second round of revisions to its second-quarter GDP ,and the British Bankers Association will provide the July update on loan applications for house purchases. The consensus predicts norevisions to the second-quarter GDP, when the economy posted growth of 1.1% q/q (1.6% y/y), the fastest expansion in four years onimprovement in services, manufacturing and construction. The Bank of Englands latest Quarterly Inflation Report revealed scaled-back growth expectations to an annual rate of about 3% from 3.6% in May on shaky confidence, still-restrained lendingconditions and the impact of the fiscal austerity measures. From Asia, the only top-tier releases will come from Japan , a batch thatincludes July merchandise trade balance , household spending , unemployment rate and CPI .

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

06 07 08 09 100

5

10

15

20

25

30

35

40

45U.S. Homebuying Intentions

Plans to Buy Within6 Months, LHS

Traffic of ProspectiveBuyers, RHS

%

Source: The Conference Board,NAHB, Scotia Capital Economics.

index

Operation Date Settlement Date Operation Type Maturity RangeAug. 17, 2010 Aug. 18, 2010 Treasury Coupon Purchase 8/15/2014 - 7/31/2016Aug. 19, 2010 Aug. 20, 2010 Treasury Coupon Purchase 8/15/2016 - 8/15/2020Aug. 24, 2010 Aug. 25, 2010 Treasury Coupon Purchase 2/15/2013 - 7/31/2014Aug. 26, 2010 Aug. 27, 2010 Treasury Coupon Purchase 2/15/2021 - 8/15/2040Aug. 30, 2010 Aug. 31, 2010 TIPS Purchase 1/15/2011 - 2/15/2040Sept. 1, 2010 Sept. 2, 2010 Treasury Coupon Purchase 2/15/2012 - 1/31/2013Sept. 7, 2010 Sept. 8, 2010 Treasury Coupon Purchase 8/15/2014 - 7/31/2016Sept. 9, 2010 Sept. 10, 2010 Treasury Coupon Purchase 2/15/2013 - 7/31/2014Sept. 13, 2010 Sept. 14, 2010 Treasury Coupon Purchase 8/15/2016 - 8/15/2020Source: New York Federal Reserve, Scotia Economics.


5/14

Capital Points

5


Canadian Macro Comment Gorica Djeric(416) 862-3080 Derek Holt(416) 863-7707

[email protected] [email protected]

Do Canadians Borrow Like Americans? Paul Krugman said Canadians borrow like Americans in acolumn titled Uh-Oh Canada?, and that raised eyebrows

on this side of the border (go here: http:// krugman.blogs.nytimes.com/2010/08/16/uh-oh-canada/).He's mostly right, and we continue to believe that muchcommentary is overly sanguine with respect to the state of Canadian household finances. Canadian households arealready at all-time record highs on debt as a share of personal disposable income (chart 1), and debt as a shareof total assets. Leverage is indeed being amply utilized byCanadian households. Within six months, Canadianhousehold debt as a fraction of after-tax incomes willsurpass that of the US which is deleveraging while Canadaleverages higher. Household debt has risen by about fortypercentage points against incomes in the past decade.

Further, house price-to-rent, and house price-to-incomeratios are also at all-time highs, so that should be a cautionthat debt-to-asset ratios could well move higher if house prices keep correcting. Indeed, the Canadian equivalent to the US S&P CaseShiller repeat sales metric (chart 2) has roughly doubled in the past decade, just like the US measure did over 2000-06. Forgetaffordability ratios, as they only tell you where interest rates sit, and not much about the valuation of the underlying asset which is aseparate question that affordability ratios are not designed to measure. While the retail cycle has performed well in Canada comparedto the US over time, uncharted waters are represented by being at simultaneously record highs for house prices and leverage.

Yes, we've had a good run in Canada. Auto leases have been as favourableor more so as in the US. Mortgage innovation only arrived in 2007 to wakeup a sleepy market with longer amortizations, and insured investormortgages having arrived since alongside little-down financing options.Revolving credit with interest as the only obligation has exploded withpersonal lines of credit that have cannibalized fixed and variable rateinstallment loans as households go for the biggest short-run bang for thebuck via substituting away from products requiring regularly amortizedprincipal payments and toward just paying the interest ticket. Low rateshave also played a part in fueling debt, and so has the release of pent-updemand from the 1990s that had Canadians catching up to Americans whohad a decade-long jump start since Canadian households floundered formuch of the 1990s when the Canadian economy itself went throughdeleveraging on public and corporate balance sheets before job growthkicked in during 1997-98.

That said, there are also striking differences compared to the US debacle thatmake simple commentaries a touch dangerous. Strategic defaults don't existas an option outside of Alberta and Saskatchewan, owing to post-Great

Depression prairie populism against the eastern banks - a policy that costCalgarians deeply when they walked away and punted their house keys back to lenders in the early 1980s. Refinancing is tougherin Canada such that the one-way gravy train ridden by excessively leveraged US borrowers isnt quite as easy to ride in Canada.Canadians didn't borrow through foolish products like Ninja mortgages. Teaser rates dont represent the same time bomb on resetsas US option ARMs. Outside of leverage on the household balance sheet, leverage elsewhere in the Canadian system is not at allcomparable to what it was in the US because dealer gearing ratios within bank-owned structures were lower and because themortgages were not placed in off-balance sheet SIV and CDO structures. Further, unlike the US, any mortgage with less than 20-25% down (depending upon whether originated before or after the rule change) is required by law to have mortgage insurance andthat insurance is directly guaranteed by the state. Mortgage interest deductibility also doesnt exist in Canada, except for an array of sometimes real and sometimes not-so-real small businesses.

60

70

80

90

100

110

120

130

140

99 01 03 05 07 09

Index

Source: Teranet; Scotia Capital Economics

Canadian Teranet Resale Prices


6/14

Capital Points

6


Canadian Macro Comment (continued) Gorica Djeric(416) 862-3080 Derek Holt(416) 863-7707


But Krugman's view is on the mark in warning of complacency in a very low rate environment. The Canada advantage isn'timmutable as a permanent attribute to the country's economic and financial landscape.

As for Bank of Canada implications, they are two-fold. One is that we think the leverage cycle is one reason for taking away still-emergency rates with an overnight rate of 0.75% that over-stimulates credit channels. Two is that interest rate sensitivities of consumption and housing markets may have lessened through financial innovation now versus past cycles. By either extendingamortization, or further embracing interest-only lines of credit at the expense of products requiring some principal component toeach payment, and thus postponing principal payments, Canadian households have greater powers than ever to negate the influencesof a rising rate environment. That presents financial innovation and the credit cycle as added reason for BoC tightening.



Expect Temporarily Weaker Core CPI Readings in Canada Headline CPI spiked in July but core was soft. Expect more of thesame in evaluating the y/y trend at least temporarily, before the net

effects of the HST including tax credits work themselves outalongside the BoCs base view on other drivers. A return to the 2%target a year from now remains reasonable, in keeping with the needfor further policy tightening.

Yet again, look past the July figure for core CPI that flashed acrosstrading floors since it is not seasonally adjusted. Seasonally adjustedcore was up 0.1% m/m by the BoCs definition, in contrast to theunadjusted m/m print of -0.1%. Thats a repeat of exactly whathappened in the prior July report for June CPI. Discounting iscommon during the summer months and requires seasonaladjustments, but consensus polls ask economists for the non-seasonally adjusted prints. The difference isnt huge, but points to a mild pace of core inflation not falling core prices.Accordingly, the market reaction through a drop in 2-year yields was an exaggerated response to the distorted first impression.

While the y/y % change was softer than anticipated at 1.8% for headline and 1.6% for core, it is generally consistent with the BoCsguidance on the full effects of the HST over time. In its July Monetary Policy Report, the BoC noted the following in explainingthe direct and offsetting indirect effects of the HST over 2010H2-2011:

As in April, the Banks base-case projection for inflation incorporates estimates for the effect of the harmonized sales tax(HST) in Ontario and British Columbia. According to the Banks calculations, the direct impact will be a temporary rise of 0.6 percentage points in the year-over-year rate of increase in total CPI lasting from July 2010 to June 2011. As part of theshift to the HST, most taxes currently paid on business inputs will be refunded through tax credits. While this reduction inproduction costs should have some offsetting effect on consumer prices over time, the extent and the timing of this effectare difficult to assess. The Banks base-case projection assumes that these cost savings will be transmitted gradually duringthe second half of the year, eventually reducing core and total CPI by a cumulative 0.3 percentage points, all else beingequal. In addition, the Banks base case scenario now incorporates the announced increase in the provincial sales tax inQuebec, effective in January 2011, which is expected to add about 0.1 percentage points to total CPI inflation over 2011. Ashas been the case with previous changes in indirect taxes, for the purposes of monetary policy, the Bank will look throughthe first-round effect of these tax changes on prices.

Implications for the BoC? Core inflation is soft, but not terribly out of line with the BoCs expectations so far. The BoC hassignaled that they expect soft inflation readings through the Fall owing to the net effect of the HST, tax credits, incidence effects,and other factors influencing core before the effects wash out a year from now and bring readings back to the BoCs 2% inflationtarget. Nothing in the July CPI report changes that bias in fact, if anything, softer than expected near-term CPI points to aweaker base effect off of which to perhaps post a stronger gain a year from now. That still gives us reason to expect the BoC tohike on September 8th in keeping with a year-ahead look on inflation and in keeping with likely healthy prints for retail sales nextweek and monthly GDP at month-end.

The BoC's Inflation Forecast

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

10q1 10q2 10q3 10q4 11q1 11q2 11q3 11q4 12q1 12q2 12q3 12q4

Source: Mo netary Po licy Report, Bank o f Canada

y/y % change

Headline inflatio nCore inflation


7/14

Capital Points

7


Canadas Housing Imbalance

Canadian housing inventories are rising at an unusually rapid

pace, are likely to rise further yet to test prior highs, and thatcould well portend further house price weakness in the monthsahead.

The accompanying chart shows the months supply of inventories listed on the open market at current selling rates inboth seasonally adjusted (thick line) and unadjusted (thin line)terms. Note that in a typical year, the non-seasonally adjustedline shows inventories peaking by the very end of the year andinto the very beginning of the next year. Inventories aretypically low during the summer months after the Springmarket has settled down. But this time, the non-seasonallyadjusted stock of outstanding listings on the open market is

rising appreciably during the summer. More important is thatthe seasonally adjusted overhang that compensates for suchdistortions during the year has the overhang now pushing back up towards the range of late 2008 and early 2009. On aseasonally adjusted basis, it would take about eight months to clear out the total number of listings on the market at current sellingrates assuming selling activity remains unchanged.

Note, further, that since this measure is comparing the stock of outstanding listings on the open market to the flow of new monthlysales, should the denominator in the ratio of months supply soften further over the duration of the year as we think it will, then wecould wind up testing the previous highs in the inventory overhang in Canadian resale markets. That discounts the argument thatbecause new listings are now coming onto the market at a comparable pace to current monthly sales, the inventory overhangproblem may be peaking. The key is to compare the stock of outstanding listings not just new ones to expectations forweaker sales.

Canadas saving grace, however, is that listed product is a much more reliable indicator of housing resale inventories than in the USbecause the US has sidelined much of its excess housing stock acquired through foreclosures in what are commonly dubbed shadowinventories held off the market by lenders. The US inventory overhang including unlisted shadow product is about double theCanadian ratio of months supply where no real shadow product exists, so comparisons between the two housing markets remainway off base. That said, the supply-demand imbalance in Canadian housing is a clear downside risk to prices in sync with theviews we expressed last October that the Canadian housing market would see price declines after the Spring market.



Canada's Housing Imbalance

0

2

4

6

8

10

12

14

04 05 06 07 08 09 10

Source: Canadian Real Estate Association, Scotia Capital Economics.

Seasonally Adjuste d

months of inventory atcurrent selling rates

Non-Seasonally Adjuste d


8/14

Capital Points

8


Bank Regulators Float Trial Balloons on New Capital Requirements This week, the Bank of Canada released its paper Strengthening international capital and liquidity standards: a macroeconomic impactassessment for Canada , which models how new global bank capital and liquidity requirements might affect Canada. Their models show a

surprisingly large net benefit to the Canadian economy, to the tune of 13% of GDP, on an NPV basis. This is because higher capital standardsshould reduce the frequency and severity of future financial crises in all countries. For the capital markets, we find certain details of the Bank of Canadas analysis even more fascinating. Noting that carrying more capital and more liquidity is not costless to banks, the study assumesbanks employ some mix of: 1) generating more capital internally; 2) demanding higher lending rates (or increasing their fee income, ormanaging lower operating costs); or, 3) raising new equity capital. The Bank of Canada estimates that a 14 basis point increase in lendingspreads for each 1% more capital is found to cover these costs. Likewise, the anticipated extra liquidity requirements would be recouped withanother 14 bps of spread. No allowance is made for the private sector seeking alternatives to these higher borrowing costs, and in the longrun, the economy is assumed to adjust to such higher borrowing costs. The Bank of Canada also asserted that higher capital and liquidityrequirements should result in lower-risk banks, (so) investors may not require as-high returns on bank debt and equity there is plenty of scope for bank returns to decline over time. This possibility of lower returns is later justified by supposing new entrants into the bankingsector over time. We have observed before that, conceptually, higher capital and liquidity requirements could, all other things being equal,bring about lower borrowing costs for banks, i.e. lower bond spreads. However, we have to wonder if all other things will remain equal,following such a material change. Still, we find the scenarios raised in the paper and the Bank of Canadas analysis and assumptions form auseful basis for further discussion. As the paper points out, some kind of global accord on financial sector regulatory reforms is targeted forthe November G-20 leaders meeting in Seoul. The Basel Committee is expected to finalize its capital requirements proposal by the end of December (though it wont go into effect until some time later, to be determined). Change is on the way, and investors have to beginpreparing for the consequences. We see no immediate spread impact from the Bank of Canadas research. However, we think that bondmarket participants and issuers will have a busy time in the next several months critiquing the Bank of Canadas work to date, and coming toterms with the proposed new capital requirements, and some kind of change in the form of future Tier 1 capital instruments.

Yesterday, the Basel Committee released a paper for comment: Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability. The proposal is that regulatory capital instruments must include a mechanism that ensures (the holder) will take aloss (either a write-down, or conversion to common equity) when a bank has reached the point of non-viability. We think thatimplementation of such a mechanism would be enormously challenging, though the Basel Committee seems to recognize this, and isrequesting comments from market participants and issuers up to October 1 st. We think it would be very difficult to engineer a debt-likeinstrument which is exposed to downside risks that will be hard for the holder to foresee and monitor, with no upside opportunity (other thanthe issuer not defaulting), at an efficient price for the issuer. Indeed, the paper itself acknowledges that a triggering event brings about atransfer of wealth from the (regulatory capital) instrument holder to the common shareholder, something we dont think the bond market isready to buy.

Corporate Credit Markets Stephen Dafoe (416) 945-4982

[email protected]

Japanese GDP Still in Line to Expand in 2010 at Highest Rate in Five Years Japans GDP growth during April-June did not eliminate the possibility of a favourable outlook for the rest of 2010. Although the 0.1% quarterly gainwas disappointing in general, the details show that a favourable economicoutlook has yet to be eliminated. A flat consumer spending growth printwas balanced by a 0.5% q/q rise in non-residential investment; the secondsolid pickup after the previous quarters 0.6% gain. This is consistent witha persistent slight upward trend in leading indicators. The fall in thecontribution of net exports to growth resulted from the combination of rising imports and a slowdown of exports in June; both the logical result of

a strengthening currency trend that prevails into the third-quarter. A pickupin the demand for foreign goods speaks of a still favourable outlook forconsumers which remains supported by consumer confidence, growinglabour market participation and rising bank credit flows to individuals.Sales at large stores even recorded a slight (0.4% q/q) gain in the April-June period adding to the lukewarm economic recovery picture (consumerspending represents over 60% of GDP). The Japanese economys recordfirst-quarter gain (1.1%; the highest in a decade) is clearly unlikely to be repeated, however, save for the economy going back intorecession, output remains in line to expand at the highest yearly rate since 2004. Thus, even if the economic picture does not get muchbetter in the next two quarters, the country is still likely to grow by roughly 2.5% y/y in 2010. Part of this statistical result will be due tothe fact that the first-quarter expansion created a strong platform for the rest of the year, which compares favourably with last yearsdismal 5.3% output retrenchment.

Emerging Markets Oscar Snchez (416) 862-3174

[email protected]

1.00.5

-0.2

0.40.2

-0.5

-1.4

-2.6

-4.4

2.5

-0.3

1.0 1.1

0.

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

2007 2008 2009 2010

Japan Real GDP Growth

q/q% change, SA


9/14

Capital Points

9


Global Fossil Fuel Subsidies Another Aspect of Climate Change

One striking aspect of global energy forecasts over the next two decades, extrapolating current policy, is the worlds continued high

dependence on fossil fuels. According to the Reference Scenario in the most recent World Energy Outlook of the InternationalEnergy Agency (IEA), oil still represents 30% of primary global energy demand in 2030 (versus 34% in 2007, see first chart), whilecoals share rises from 26% to 29% as developing nations catch up in energy consumption. From their September 2009 meeting,the G-20 Leaders recommended phasing out through 2020 inefficient fossil fuel subsidies that encourage wasteful consumption,while at the same time limiting the impact on the poorest. The Leaders intent was to complement the efforts surrounding theCopenhagen Accord towards stabilizing global greenhouse gas (GHG) emissions.

Arguments for removing fossil fuel subsidies include the inefficient consumption and production trends they encourage, and the far-flung consequences of these trends, such as hindering new energy technology development. World Bank research indicates thatenergy price subsidies are regressive, with the bottom 40% of the global population by income receiving just 15%-20% of thesubsidies. Encouraging, therefore, is the progress since 2008 in reducing fossil fuel subsidies with a number of nations, includingChina, Russia, India, Iran and Indonesia, introducing reforms to bring their domestic energy prices closer in line with global prices.IEA modeling suggests that phasing out consumption-related fossil fuel subsidies between 2011and 2020 would cut primary globalenergy demand by close to 6.0%, equivalent to the current energy consumption of Japan, Korea and Australia, even with somerebound in consumption due to lower fuel prices. In turn, this drop in energy demand would be expected to trim carbon dioxideemissions by almost 7%, equivalent to current CO 2 emissions from the four largest euro zone countries and the UK. With the morelimited fiscal flexibility anticipated for many governments going forward, phasing out inefficient fossil fuel subsidies would openup significant room for other priorities, with the competitive issue of rising domestic production costs at least partially mitigated if the removal of fossil-fuel subsidies is pursued multilaterally.

Raising the availability and transparency of energy subsidy information is widely considered the critical first step in the requiredreform, and the research defining and quantifying fossil fuel subsidies across countries certainly underlines the extended complexityof energy-related subsidies built up around the world. In the second chart, the omission of subsidies to fossil-fuel producers inOECD countries reflects the ongoing research to determine consistent, credible estimates. Importantly with the current focus onfuture energy policy, research on energy subsidies also is highlighting the high relative expense of some of the new low-emissiontechnologies, such as biofuels, as well as the investment in nuclear power, where a range of studies indicate subsidies equal to one-third or more of the value of the power produced.

Fiscal Policy Mary Webb(416) 866-4202

[email protected]

0

2

4

6

FossilFuels 1

Nuclear

Biofuels 3Renewables 2US/kWh

Subsidies Related to Energy, 2007

0

1

2

3

4

5

6

Fossil Fuels Nuclear2 Renewable3

Other IEANationsG7+

CCS

Government R&DRelated to Energy

US$(2008),billions

FossilFuels

Nuclear 2 Renewable 3

1

0 10 20 30 40

2007

2030f

Coal (1.9%)

Oil (0.9%)

Natural Gas (1.5%)

Nuclear (1.3%)

Hydro (1.8%)

Biomass/Waste 2 (1.4%)

Other Renewables (7.3%)% share

of total

Primary Energy Demand,Current Policy 1

1 In brackets, average annual %change, 2007-2030; forecast annual

growth for total global primary energyis 1.5% . 2 Traditional & modern uses.Source: IEA, 2009.

1 Only consumer subsidies in non-OECD nations.

2 Excludes hydro.3 Based on Australia, U.S., Cda, EU,

Indonesia, Malaysia and Switzerland.Source: Preliminary Estimates,Global Subsidies Initiative.

1 G7 plus Korea and Turkey.2 Nuclear fusion and fission.3 Includes hydrogen and fuel cells.

Source: IEA, 2009.


10/14


11/14


12/14

Capital Points

1


Estimates for the week of August 23 27

Canada

United States

Date ET Indicator Period BNS Consensus Latest

08/24 (08:30) Retail Sales (m/m) Jun 0.4 0.3 -0.208/24 (08:30) Retail Sales ex. Autos (m/m) Jun 0.1 0.1 -0.108/24 BoC's Deputy Governor Murray Speaks in Kingston, Ontario (12:30)

08/25 (09:00) Teranet - National Bank HPI (y/y) Jun 12.0 -- 13.6


08/23 Hoenig Testifies at Congressional Hearing in Kansas (10:30)

08/24 (07:45) ICSC Chain Store Sales - Weekly (w/w) Aug. 21 -- -- -1.308/24 (10:00) Richmond Fed Manufacturing Index Aug -- 8.0 16.008/24 (10:00) Existing Home Sales (mn a.r.) Jul 4.10 4.60 5.3708/24 (17:00) ABC Consumer Confidence (index) Aug. 22 -- -46 -4508/24 Fed's Evans Speaks in Indianapolis (08:45)

08/25 (07:00) MBA Mortgage Applications (w/w) Aug. 20 -- -- 13.008/25 (08:30) Durable Goods Orders (m/m) Jul 3.5 3.0 -1.208/25 (08:30) Durable Goods Orders ex. Trans. (m/m) Jul 0.6 0.5 -0.908/25 (10:00) New Home Sales (mn a.r.) Jul 0.32 0.33 0.33

08/26 (08:30) Initial Jobless Claims (000s) Aug. 21 495 493 50008/26 (08:30) Continuing Claims (mn) Aug. 14 4.49 4.50 4.48

08/27 (08:30) GDP Deflator (q/q a.r.) Q2-S 1.8 1.8 1.808/27 (08:30) GDP (q/q a.r.) Q2-S 1.4 1.4 2.408/27 (09:55) U. of Michigan Consumer Sentiment Aug-F -- 69.6 69.608/27 Bernanke Speaks on Economic Outlook in Jackson Hole (10:00)


13/14

Capital Points

1


Estimates for the week of August 23 27

Europe

Asia/Oceania


08/23 (03:00) FR Services PMI (index) Aug -- 60.5 61.108/23 (03:00) FR Manufacturing PMI (index) Aug -- 53.4 53.908/23 (03:30) GE Services PMI (index) Aug -- 56.3 56.508/23 (03:30) GE Manufacturing PMI Aug -- 60.5 61.208/23 (10:00) EC Consumer Confidence Aug -- -14.0 -14.0

08/24 (02:00) GE GDP (q/q) Q2-F -- 2.2 2.208/24 (05:00) EC Industrial New Orders (m/m) Jun -- 1.5 3.208/24 (05:00) EC Industrial New Orders (y/y) Jun -- 24.0 22.9

08/25 (00:00) UK Nationwide House Prices (m/m) Aug -- -0.3 -0.508/25 (04:00) GE IFO Current Assessment Survey Aug -- 107.5 106.808/25 (04:00) GE IFO Business Climate Survey Aug -- 105.7 106.2

08/26 (04:00) EC M3 (3 mth avg.) Jul -- 0.1 0.0

08/27 (02:00) GE CPI (m/m) Aug -- 0.0 0.308/27 (02:00) GE CPI - EU Harmonized (m/m) Aug -- 0.1 0.308/27 (02:00) GE Retail Sales (m/m) Jul -- -- -0.308/27 (04:30) UK Business Investment (q/q) Q2-P -- 3.0 7.808/27 (04:30) UK GDP (q/q) Q2-P -- 1.1 1.1


08/24 (21:00) PHI Imports (y/y) Jun -- -- 31.408/24 (21:00) PHI Trade Balance (US$ mn) Jun -- -- -513.0

08/26 (00:00) VN Exports (y/y) Jul -- -- 17.508/26 (00:00) VN Imports (y/y) Jul -- -- 25.508/26 (04:30) HK Trade Balance (HK$ bn) Jul -- -23.3 -25.108/26 (04:30) HK Imports (y/y) Jul -- 37.5 31.008/26 (04:30) HK Exports (y/y) Jul -- 40.0 26.708/26 (19:30) JN Household Spending (y/y) Jul -- 1.5 0.508/26 (19:30) JN Jobless Rate (%) Jul -- 5.3 5.308/26 (19:30) JN National CPI (y/y) Jul -- -0.9 -0.708/26 (19:30) JN Tokyo CPI (y/y) Aug -- -1.1 -1.2


14/14

Capital Points


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

Tel: (416) 866-6253 Fax: (416) 866-2829 Email: scotia economics@scotiacapital com

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

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

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

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

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

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

Economics

Derek Holt , [email protected]

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

Gorica Djeric , Financial Markets [email protected]

Mary Webb , Senior Economist/[email protected]

Corporate Bonds

Robert Follis , Managing [email protected]

Stephen Dafoe , [email protected]

Francesco Sorbara , Associate [email protected]

Emerging Markets Strategy

Joe Kogan , Director [email protected]

Equity Markets

Vincent Delisle , Director, Portfolio Strategy [email protected]

Hugo Ste-Marie , Assistant Strategist [email protected]

Equity Research

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

Fixed Income

Roger Quick , Director [email protected]

Foreign Exchange

Camilla Sutton , Director [email protected]

Sacha Tihanyi , Associate Director [email protected]

ScotiaMcLeod Portfolio Advisory GroupPaul Danesi , [email protected]

Geoff Ho , [email protected]

Joey Mack , Director [email protected]

Steve Uzielli , [email protected]

Gareth Watson , [email protected]

ContactsContacts

scotia capital points

Documents