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Economic Insights

August 7, 2013

Doubting Thomases
by Avery Shenfeld

Avery Shenfeld (416) 594-7356 Benjamin Tal (416) 956-3698 Peter Buchanan (416) 594-7354 Warren Lovely (416) 594-8041 Emanuella Enenajor (416) 956-6527 Andrew Grantham (416) 956-3219

Anyone taking a quick look at the most closely watched spot oil prices would assume that for that key Canadian resource sector, all the worries are behind us. After all, the huge gap between North Americas benchmark price, WTI and Europes Brent, has nearly disappeared. And even though WTI typically traded through Brent, its absolute level, now handily clear of $100/bbl, seems generous enough to put the green light on some of the oil sands projects that had earlier been postponed. But massive investment decisions arent just based on where things sit today, but on what the future is thought to hold. On that score, we still have too many doubting Thomses. While the futures market isnt infallible as a forecaster for where oil prices are headed, it does give a sense of what market players are assuming. Instead of the typical upward slope, the futures curve is in a steep backwardation, with a barrel of WTI in mid2016 fetching only $85/bbl (Chart). Add in concerns raised by a re-widening of the discount on Canadian heavy crude, and worries about future transportation bottlenecks, and were still waiting for more certainty that firm prices are here to stay before getting back into full gear on capital spending in the oil patch. That helps explain why Canadian oil stocks havent quite kept pace with the bounce in crude. Getting pipeline projects off the drawing board and into the field would help, and were encouraged by new momentum on a project to deliver Western Canadian crude to Canadas east coast and beyond. Obamas announcement on Keystone still lies ahead,

as do decisions on alternative proposals for pipelines to the west coast, whose value becomes more apparent as US oil import dependency continues to shrink. But in addition, the oil markets needs arent dissimilar to the needs of other parts of Canadas energy and industrial materials sectors: greater certainty on global growth. If what were seeing in the US and Europe is a sign of things to come, we could be on the verge of bringing those doubting Thomases around. The US news hasnt been unambiguously positive signals from total hours worked in July and real consumption in June were on the disappointing side. But two key cyclical drivers, new home sales and manufacturing continue to turn the corner. Overseas, Chinas story is still hazy at best, but European data points to a return to positive growth for that continent in Q3. Both the US and Europe should benefit from a lighter fiscal drag come 2014. If so, well have fewer doubts about Canadas oil and non-oil export prospects, and scope for Canadian equities to play some much needed catch up to whats happened stateside.
Traders Doubt High Oil Prices Here to Stay
110 105 100 95 90 85 1 4 7 10 13 16 19 22 25 28 31 34 Months Until Delivery NYMEX Light Sweet C rude C ontract, $/bbl C urve today Year ago 2 Years ago

Were still waiting for more certainty that firm prices are text text text here to stay.

http://research. EcoResearch.html

CIBC World Markets Inc. PO Box 500, 161 Bay Street, Brookfield Place, Toronto, Canada M5J 2S8 Bloomberg @ CIBC (416) 594-7000 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 Yo r k , N Y 1 0 0 1 7 ( 2 1 2 ) 8 5 6 - 4 0 0 0 , ( 8 0 0 ) 9 9 9 - 6 7 2 6

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Economic Insights - August 7, 2013

Weve reached the targets we set for a bond market sell-off in 2013. Whether the Fed announces tapering in September, or as we slightly lean towards, in Q4, that story is essentially priced in. The Fed will time its further tapering steps, and its language on short rates, with an eye to steering a very gradual climb in yields. Thats one reason, but not the only one, we see 10-years in the US and Canada on such a path in 2014 (see pages 6-8). At the short end, were still targeting the first quarter of 2015 for the first hike by the Fed and a matching move by the Bank of Canada. Indeed, the earlier the bond market sells off, the more the Fed will be inclined to wait, and our call implies that the hike will come at least a quarter after the jobless rate first hits 6.5%. Encouraging European data has temporarily halted the US dollars general climb, but only because a coming US growth turn hasnt shown its full colours. That should come before year-end, putting the dollar back into favour. A Fed tapering announcement will be negative for the C$, but stronger global growth next year positions the loonie for a comeback.


2013 END OF PERIOD: CDA Overnight target rate 98-Day Treasury Bills 2-Year Gov't Bond 10-Year Gov't Bond 30-Year Gov't Bond U.S. Federal Funds Rate 91-Day Treasury Bills 2-Year Gov't Note 10-Year Gov't Note 30-Year Gov't Bond Canada - US T-Bill Spread Canada - US 10-Year Bond Spread Canada Yield Curve (30-Year 2-Year) US Yield Curve (30-Year 2-Year) EXCHANGE RATES CADUSD USDCAD USDJPY EURUSD GBPUSD AUDUSD USDCHF USDBRL USDMXN 6-Aug 1.00 0.99 1.16 2.53 3.04 0.10 0.05 0.31 2.65 3.74 0.95 -0.12 1.87 3.44 0.96 1.04 98 1.33 1.54 0.90 0.93 2.30 12.65 Sep 1.00 0.95 1.15 2.50 2.90 0.10 0.08 0.35 2.60 3.60 0.87 -0.10 1.75 3.25 0.95 1.05 100 1.29 1.52 0.90 0.95 2.10 12.60 Dec 1.00 0.95 1.20 2.60 3.00 0.10 0.08 0.40 2.75 3.70 0.87 -0.15 1.80 3.30 0.94 1.06 102 1.24 1.49 0.88 0.99 2.05 12.50 2014 Mar 1.00 0.95 1.20 2.70 3.05 0.10 0.08 0.45 2.80 3.70 0.87 -0.10 1.85 3.25 0.96 1.04 102 1.23 1.50 0.87 1.00 2.05 12.50 Jun 1.00 0.95 1.40 2.70 3.05 0.10 0.15 0.60 2.80 3.75 0.80 -0.10 1.65 3.15 0.97 1.03 103 1.22 1.50 0.85 1.01 2.06 12.52 Sep 1.00 0.95 1.45 2.80 3.10 0.10 0.15 0.80 2.85 3.80 0.80 -0.05 1.65 3.00 0.98 1.02 100 1.23 1.50 0.88 1.01 2.09 12.53 Dec 1.00 1.05 1.50 2.85 3.15 0.10 0.15 1.10 2.90 3.90 0.90 -0.05 1.65 2.80 0.99 1.01 98 1.25 1.52 0.90 1.02 2.08 12.62 2015 Mar 1.25 1.25 1.85 2.95 3.25 0.25 0.20 1.30 3.00 4.00 1.05 -0.05 1.40 2.70 0.99 1.01 98 1.27 1.55 0.99 1.01 2.05 12.75

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Economic Insights - August 7, 2013

No Detroit Lurking in Canadian Muni Market

Warren Lovely
The largest municipal insolvency in US history is unfolding immediately across the border, begging the question: could a Detroit style bankruptcy happen here in Canada? Dont count on it. If Detroit isnt a harbinger of wide scale US municipal defaultsand it doesnt appear to beits even less the proverbial canary in the coal mine for Canadian municipalities. Canadas municipal government sector is governed differently than US munis, being subject to greater senior government oversight, characterized by traditionally conservative fiscal and debt management practices, generally possessing healthy socio-economic profiles, and endowed with strong credit ratings and healthy balance sheets. True, capital spending pressures exist, and in some select cases, related debt accumulation could ultimately threaten credit ratings. But theres no equivalent to Detroit lurking in the shadows of Canadas municipal bond market. Debt burdens remain manageable and limited net new bond supply should see municipal credit spreads continue to trade at the tight end of the range observed in recent years. Credit Ratings as Warning Signals Detroits downfall has been a long time coming. The citys debt was downgraded to junk back in 2009 and a flurry of subsequent downgrades in many cases pre-dated the bankruptcy filing by at least a year (Chart 1). Ratings for
Chart 1

other US munis have come under pressure, with Chicago downgraded three notches by Moodys (to A3) one day before the Detroit bankruptcy announcement. But rating agencies hardly envision a wave of downgrades settling on the sector. Meanwhile, CDS spreads dont exactly betray particularly elevated or broad based anxiety in the US muni market. Canadas local government sector remains solidly investment grade. Of the fifty-odd entities rated by one of S&P, Moodys or DBRS, the vast majority are rated AA or higher (Chart 2). Notwithstanding some isolated actions, the average credit rating of Canadas large municipal issuers is actually stronger today than it was before the global financial crisis. Demographic Divergence and Other Dissimilarities A mass exodus from Detroit is commonly cited as a key catalyst for the citys financial disaster. Whereas Detroits population topped 1.8 million in 1950, today barely 700,000 call it home. Once Americas fifth largest urban centre, Detroit barely cracks the top 20 today. No major Canadian municipality has suffered the same sad demographic fate (Chart 3). Household formation, alongside a more resilient jobs market, a more closely regulated mortgage market and a strong banking sector spared Canada from a US-style
Chart 2

Detroit Credit Ratings Under Pressure for Years

AAA AA A BBB BB B CCC CC Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Detroit Average Credit Rating (S&P, Moody's)

Canadian Munis are Solidly Investment Grade

30 25 20 15 10 5 0 AAA AA+ AA AAA+ A A- BBB+BBB BBBDistribution of C anadian Municipal C redit Ratings

Source: Moody's, S&P, CIBC 

Source: Moody's, S&P, CIBC

CIBC World Markets Inc. Chart 3

Economic Insights - August 7, 2013

Population Growing in Nearly All Major Canadian Cities

Calgary (AB) Edmonton(AB) Oshaw a(ON) Barrie(ON) Toronto(ON) Kelow na(BC) Saskatoon(SK) Gatineau(QC) Abbotsford(BC) Kitchener(ON) Vancouv er(BC) Guelph(ON) Ottaw a(ON) Halifax (NS) Moncton(NB) Hamilton(ON) Sherbrooke(QC) London(ON) Regina(SK) Victoria(BC) Montral(QC) Winnipeg(MB) Brantford(ON) Peterborough(ON) Kingston(ON) Qubec(QC) St.John's(NL) Trois-Riv ires(QC) St.Cath.-Niagara(ON) Windsor(ON) Sudbury (ON) Saint John(NB)


Thunder Bay (ON) Saguenay (QC)

% Change, 2000-2012 0 10 20 30 40 50




Source: Statistics Canada, US Census Bureau, CIBC

housing contraction (Chart 4). This is an important consideration, given that property taxes generally account for 40% of municipal revenue. As our upcoming Metro Monitor report will detail, the vast majority of Canadian municipalities continue to possess healthy economic momentum. Nor do the large local economies north of the border suffer from the same degree of industry concentration as Detroit. Superior Fiscal Flexibility Granted, a shrinking population and stagnating/ unbalanced economy are hardly the sole precursors for municipal duress. A lack of fiscal flexibilityin particular, an inability to freely adjust revenue to better match expenseshas contributed to US municipal insolvencies in the past (for example, in Orange County, California).
Chart 4

Fiscal flexibility is less a worry in Canada. In truth, its often deemed a credit strength. Keyed by a legislative requirement to balance their operating budgets, and absent US-style revenue constraints, Canadas local government sector has a strong track record of matching revenue to spending (Chart 5). Its not always easy; to the extent tax measures are viewed as politically unpalatable, muted revenue growthan issue of latecan require painful spending restraint. Still, provincial governments hold municipalities to account, and wield the ultimate stick of provincial trusteeship in the extreme case that a municipal government fails to live within its means. In Ontario, for example, provincial advisors remain in close contact with municipal treasurers in order to monitor financial health. More than mere oversightand a legal inability to declare bankruptcyfinancial support from upper levels of government provides a further degree of comfort to municipal investors, with meaningful long-term capital funding frameworks and operational transfers today more predictable than in the 1990s. Pension liabilities also tip the scale in Canadas favour. Detroit carried a crushing pension burden into its Chapter 9 filing and look across the US state/local government sector and youll find plenty of other examples of staggering pension shortfalls. While there are challenges, Canadian municipalities arent plagued to the same degree by pension woes. In Ontario, for instance, municipal employee pensions are jointly managed by OMERS. In recent years, contribution rates have been increased and benefits reduced with a view to returning

CDN Housing Has Supported Property Tax Revenue

160 150 140 130 120 110 100 90 80 70 60 Resale Housing Price, Index: 2005=100



04 Canada



10 US


Source: Statistics Canada, NAR, CIBC

CIBC World Markets Inc. Chart 5

Economic Insights - August 7, 2013

CDN Munis Have Successfully Linked RevenueSpending

14 12 10 8 6 4 2 0 -2 -4 1982 1987 1992 Revenue 1997 2002 2007 2012 Spending Year-over-Year Growth, %

base. Public transit needs are particularly pressing in the largest urban centres. Its worth noting that a growth-driven increase in debt drove S&P to place the Region of Yorks AAA longterm rating on negative outlook. Still, the municipal sector hasnt exactly abandoned conservative financial management in response to capital spending pressures. Provincial governments set down requirements for longterm borrowing and, as in Ontario, can cap the share of revenue consumed by debt servicing costs. In general, a meaningful portion of capital spending continues to be funded via development charges and other internal sources, while sewer/water upgrades have generally been financed by ratepayers. Nor have Canadian municipalities resorted to raiding debt/pension reserve funds to meet financial pressuresan issue in some US jurisdictions. All this has left local government net debt at a scant 2% of GDP in Canadaa tiny fraction of that carried at either the federal or provincial levels of government (Chart 6). Across the border from Detroit, for example, Windsors tax-supported debt burden is actually falling. And for Canadian municipal bond investors, supply fundamentals look constructive, with year-to-date gross supply holding well shy of the level digested in recent years. Little wonder then that municipal credit spreads are trading near the tight end of the range observed since the recovery took hold (Chart 7). With populations growing, economies reasonably diversified, financial management practices sound and provincial oversight/support strong, investors in Canadas municipal government sector neednt fear a Detroit style crisis.
Chart 7

Source: Statistics Canada, CIBC

the plan to fully funded status over the coming 10 to 15 years. Granted, Canadian municipalities carry other postretirement liabilities (including accumulated sick leave), but as weve seen more recently, benefit reductions can succeed in reducing these liabilities over time. Capital Needs a Challenge If theres a worry for Canadian municipalities, its longterm infrastructure needs. Despite extraordinary fiscal stimulus in the wake of the global recession, Canadian cities still face meaningful capital spending pressures. In Eastern and Central Canada, these needs often relate to the replacement of aging infrastructure. In Western Canada, many cities are rushing to put in place the roads, sewers and other vital capital required to support a burgeoning population and rapidly growing industrial
Chart 6

Limited Debt at Local Government Level in Canada

40 35 30 25 20 15 10 5 0 2005 06 07 08 09 10 11 12 13 Local Govt Federal Govt Provincial Govt Net Debt-to-GDP, %

Recovery in Municipal Credit Spreads

AAA 10Y Muni Spread vs Ontario, bps 65





15 Jan-08






Source: Statistics Canada, CIBC

Source: CIBC

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Economic Insights - August 7, 2013

One, Two, Three, Four, Where Are 10-Years Headed For?

Avery Shenfeld and Emanuella Enenajor
Junes sudden bond market sell-off brought back memories of 1994 for those of us of a certain age. It seemed like virtually overnight, the spell that had been cast on the bond market, which had 10-year rates at 1.6% as recently as late April, was broken (Chart 1). The market has it right rates were too low to be sustained if an economic recovery truly takes hold in the US. But are we looking at 2%, 3%, 4% or higher, and by when? For that, its instructive to break down the factors that took us to such incredibly low yields, how those will erode over time, and what past sell-offs can tell us, or not tell us, about how this time might differ. Collectively, the evidence suggests 3% yields will be with us in the next six quarters or so, but that a four handle on 10-year rates in the US and Canada will be much further off. How We Got There QE or not QE, that is not the only question. Yields were falling long before quantitative easing, and long before the Great Recession. That trend decline since the early 1980s reflected fading memories of the 1970s inflation scare, a monetary policy commitment to price stability, and the resulting impacts on expectations for the mean and potential variance of long term inflation ahead. That showed up in the two components that collectively make up the 10-year bond yield: the expected future path of short term rates, and the term premium, defined as the additional yield investors demand over and above the
Chart 1

projected yield on rolling over short-term debt for the risk of locking in. Lower inflation implies that the central bank will generally have to be less aggressive in hiking short rates, given the trade-off that such hikes entail between giving up potential growth in the economy in exchange for a dampening of inflation. Moreover, since its the real rate of interest that matters, at lower expected inflation rates, the same degree of economic braking is achieved at a lower nominal rate. That factor was the key driver of the steady decline in interest rates seen in the past few decades (Chart 2). Low and stable inflation also begets less uncertainty about the potential range of inflation rates, thereby reducing the term premium. That was the other, albeit less important, driver of the decline in 10-year yields since 1 1981 . Real rates (measured against expected inflation) could be somewhat lower on 10-year debt because markets, looking at the track record of central banks in recent decades, no longer assigned much risk that inflation would end up well above the expected path. It was much the same story in Canada, with the term premium closely tracking that of the US (Chart 3) despite some differences in the path of central bank policy rates during this period. And then, of course, we did have QE, which in its recent round, as well as in the twist operation that preceded it, was directly aimed at reducing the term premium and flattening the yield curve. Estimates of its role vary and are necessarily imprecise, because we cant use a model
Chart 2

The Cat is Out of the Bag: Bond Yields Trend up

10-year interest 4%

Lower Short Rate Outlook Drives Drop in Yields

3% fcst C anada US



20 09

20 08

-2 01 0

20 12

20 13 Ju lN

M ar -

Ju l-

M ar -


Source: Bloomberg


-2 01 4

Source: Bauer and Diez de los Rios (2012), see endnote

CIBC World Markets Inc. Chart 3

Economic Insights - August 7, 2013

Term Premium Falling Over Time

4% 3% 2% 1% 0% -1% -2% Term Premia C da Term Premia US 10-year term premium

To Ben Bernankes surprise, merely mentioning tapering reduced bond market expectations for future supply on the market enough to shed nearly half the total benefits of QE (Chart 4). So while there is still some normalization risk, likely to be seen when the Fed really does begin to taper and then end QE, more of that sell-off is behind us than ahead of us. Where are We Headed Which brings us to the ultimate question: where are rates ultimately headed? History is actually not an easy guide, because the results have been so variable. But if, as seems logical, recent cycles will be more representative of this coming one than more distant cycles, there are reasons for investors to be bearish, but not hyper bearish, on US and Canadian 10-years. In the last cycle, during the period in which the US economy hit its non-inflationary potential, the real 10year rate averaged roughly 1.6% (Chart 5). If, as we expect, inflation drifts up to roughly 2% in 2014 and beyond, that would be the equivalent to the nominal 10year Treasury hitting 3.6% in five years or so, given how long it might take to close the currently yawning output gap. Score one point, then, in favour of a fairly gradualist trend climb in bond yields. Another angle is to look at the likely path for short rates, which as we noted, is the other ingredient along with the term premium that steers 10-year rates over time. Implied short rate expectations from OIS, Eurodollar and sovereign bond markets also lean towards gradualism, with Canadas short rates and those of the US not converging on 2% (a roughly zero real rate) until 2017 (Chart 6).
Chart 5














Source: Bauer and Diez de los Rios (2012), see endnote

to examine how QE has historically mattered, given that this is its first incidence. Instead, models have looked at equivalent changes in the stock of bonds outstanding, or at policy-change announcement day impacts on the curve. Collectively, the various rounds of bond buying are thought to have pushed 10-year yields lower by roughly 125 bps, carrying Canadian bonds and other substitutes along for the ride. Anatomy of the Sell-Off So whats changed? Mostly, the term premium, as markets brought forward estimates of when QE would be tapered and then eliminated. The Fed has gone to great lengths, eventually if not initially successful, to reiterate that its statements on QE tapering need not imply that the path for the fed funds rate had also become less dovish than earlier envisaged.
Chart 4

Whoops! Bernanke QE Chatter Reverses Years of Yield Repression

100 50 0 -50 -100 -150 QE: Impact on lowering Recent jump in 10-yr 10-yr yield term premium following "tapering" talk
basis points


US "Equilibrium" Rate Trends Lower

10-yr real rate associated with US economy reaching potential*

6% 4% 2% 0%




*avg interest rate in the 4-qtr period preceding a historical closing in the output gap

Source: US Federal Reserve, Bloomberg, CIBC

Source: CBO, BLS, Haver Analytics, CIBC

CIBC World Markets Inc.

Economic Insights - August 7, 2013 Chart 7

That makes sense on both sides of the border, for different reasons. In the US, the sheer scale of the output gap implies that the Fed should be in no hurry to aggressively pare back growth. In Canada, a record degree of leverage in the household sector means that any given bump in rates should entail a more meaningful drag on growth, due to the greater volume of debt being refinanced. As a result, the peak policy rate in the coming cycle could end up being well below the 4.5% level achieved in the prior expansion. Finally, in terms of where rates are headed through 2014, we have Bernankes threat that he would push back against an overly rapid run-up in yields that would threaten the recovery, including the pledge to reinstitute more QE to accomplish that. We have a clue to what sort of pace the Fed wouldnt see as excessive in a speech Ben himself delivered back in March, in which he presented, as reasonable, a path that would take 10-year rates to just over 3% by the end of next year (Chart 7). Thats roughly in line with our projection, which has the 10-year US rate just a shade under 3% at that time. How does the Canadian curve play out in that context? Two factors suggest that spreads will remain negative vs. Treasuries at the 10-year part of the curve, if only modestly so. First, given our faster forecast for US GDP next year, America will make greater progress against its output gap, helped by a more notable reduction in fiscal drag and its greater headroom for home building gains. That is consistent with a slower climb in short rates beyond 2015. Second, inflation expectations might be better grounded on this side of the border, as seems to be the case in breakeven rates implied by real return bonds (Chart 8).
Chart 6

Sharp Jump in Rates Not a Part of FOMC Game Plan

US 10Y Yield (%) 3.1 Forecasts From Bernanke's March 1st Speech 2.9 2.7 2.5 2.3 2.1 1.9 1.7 1.5 End2013F End2014F

Source: US Federal Reserve, Bloomberg, CIBC

The US might not see higher actual CPI rates in 2014 than in Canada. But the uncertainties created by the mountain of earlier QE buying could have some fearing less precision in containing inflation thereafter. Similarly, some will argue that Americas greater government debt burden provides a greater temptation to inflate it away. That too leans to a lower risk premium for inflation uncertainties at the 10-year horizon for Canadian bonds. Add it all up, and its still a bear market for bonds ahead. But the panic of 1994 looks unlikely to be repeated, or at least sustained, in the next two years.
Endnote Reference: (1) Bauer, G. and Diez de los Rios, A. (2012): An International Dynamic Term Structure Model with Economic Restrictions and Unspanned Risks, Bank of Canada Working Paper No. 2012-5. We thank the authors for providing us with their estimate of the term premium and expecations components of Canadian and US 10-year rates.

Chart 8

Markets See US Playing Catch Up on Policy Rate

5% 4% Market-Implied* Short Rate Path

Markets See Greater US Inflation Risk

3.0% Inflation expectations: long-term average


3% 2% 1% 0% 2013 2015 2017 2019

C anada


*US: Fed funds & eurodollar futures, Canada: OIS market, yield curve




Aug-10 Canada

Nov-11 US



Source: Bloomberg, CIBC

Source: Bloomberg, CIBC

CIBC World Markets Inc.

Economic Insights - August 7, 2013

Low Capital-Intensive Manufacturing in Canada Not Necessarily a Bad Thing

Benjamin Tal
The manufacturing sectors on both sides of the 49th parallel recovered nicely from the recession. But the improvement in the US is not only stronger, it is also much more capital-intensive. However, before you go long US manufacturing, consider the fact that capital intensity does not necessarily mean better profit or equity market valuation. In fact, the different nature of the Canadian recovery might give manufacturers here an edge as we enter the more mature stage of the recovery. US Manufacturing Recovery More Capital-Intensive The American manufacturing sector appears to be regaining momentum, after sputtering earlier this year. But looking beyond the recent bumps, from a cyclical perspective, relative to other sectors of the economy, the rebound in US manufacturing has been impressive. In Canada, while the recessionary pain was roughly in line with that experienced in the US, the recovery has been much less powerful (Chart 1). Since its cyclical trough, manufacturing activity has advanced by only 10% versus more than 18% south of the border. As a result, the current production level in Canada is still close to 8% below its pre-recession reading. There is little doubt that the ongoing shale gas revolution and the notable decline in natural gas prices did help
Chart 1 Chart 2

US manufacturing during the recovery. But it will be a mistake to read too much into the impact of the potential energy boom on US manufacturing. One would expect the most energy-intensive manufacturing industries, such as petroleum and coal, chemical, paper, printing and non-metallic minerals, to benefit most from recent developments in US energy. However, the opposite has been the case. Those energy-intensive industries actually lagged the sector as a whole (Chart 2), in part, reflecting the rapid improvement in energy efficiency in US manufacturing. If the manufacturing recovery in the US was not led by energy-intensive industries, it was certainly led by capitalintensive industries. Close to 75% of the improvement in manufacturing activity since its trough was in industries with above-median readings of capital intensity (measured as dollars of capital per worker) such as transport, computers & electronics, primary metals and machinery (Chart 3). The shift from labour-intensive to capitalintensive production is nothing new, but the trauma of the recession is working to accelerate this process. During the past five years, the ratio of production in high capitalintensive sectors to production in low capital-intensive sectors rose by more than 20%. Historically, it took eight years to achieve an equivalent rise in this ratio.

US Manufacturing Outperformed During the Recovery

Manufacturing Production

Low Energy Prices Were Not Behind the Improvement in US Manufacturing Activity

20% 15% 10% 5% 0% -5% -10%


Production 110 100 90 80 70 60 Index 2005Q4=100

15 10 5 0 -5 -10 -15 -20

y/y % change















Canada US

-15% -20% 08Q2-09Q2 09Q2-13Q1








All manufacturing

Energy intensive industries

Source: Census Bureau, Statistics Canada, CIBC

Source: Census Bureau, CIBC


CIBC World Markets Inc. Chart 3 Chart 5

Economic Insights - August 7, 2013

Capital-Intensive Industries Accounted For Most of the Improvement in US Manufacturing

Contribution to Production Growth Since the Beginning of Recovery (%) Transport Computers & Electronics Primary metals Machinery Others Fabricated metal prod. Misc manufacturing Plastics & rubber Wood Others 20.5 14.3 12.3 11.2 15.0 8.5 6.4 6.0 4.9 1.1 Average Capital Intensity
$'000 per worker

Relative to CDA, US Manufacturing Activity Has Been Much More Capital-Intensive in Recent Cycle
Ratio of Production Capital Intensive to Non-capital Intensive Industries Index 2007=100 US



130 125 120 115 110 105 100 95 90 85 80









Source: Census Bureau, CIBC

Source: Census Bureau, Industry Canada, CIBC

Naturally this led to a much more subdued improvement on the job front, with the ratio of manufacturing production to manufacturing employment currently at a record high and employment in the sector still almost 16% below its pre-recession level (Chart 4). In Canada the situation has been completely different. The more-muted manufacturing recovery was also less capital-intensive with the ratio of production in capitalintensive industries to non-capital-intensive industries actually falling during the past cycle (Chart 5). This trajectory is working to widen an already wide 40% gap between US and Canadian manufacturing capital intensityreflecting not only the natural composition of Canadas manufacturing base, but also the fact that in many cases high capital-intensive sectors in Canada are not as capital-intensive as their US counterparts1.
Chart 4

Is This a Good Thing or a Bad Thing? Intuitively, the capital-intensive nature of the US manufacturing recovery should be seen as good news. After all, it means a more productive economy with all the positive spin-offs associated with it. While that might be the case from a long-term perspective, what does it mean for the here and now? Yes, capital-intensive industries tend to pay more but they account for only one-third of employment (Chart 6), suggesting that higher pay does not fully compensate for the lack of job creation. What about profit? Here again, reality is different than perception. Despite the more capital-intensive manufacturing trajectory during the past cycle, the overall change in real operating profit in the US was not very different than seen in Canada. In fact, on average,
Chart 6

US Manufacturing Employment Still Miles From Pre-Recession Level

Production to Labour Ratio

Capital-Intensive Industries Pay Well, But Not Too Many Enjoy It

80,000 70,000 $

% Below Pre-Recession Level

US Data

120 115 110 105 100 95 90

Index 2006=100

0% -2%

Annual Mean wage

60,000 50,000 40,000 30,000 20,000 10,000 0 0 ($'000 per worker) 100 200 300

-4% -6% -8% -10% -12% -14% -16% -18%

06 07 08 09 10 11 12 13

Employment in capital intensive industries Others



C apital Intensity

Source: Census Bureau, BLS, Statistics Canada, CIBC


Source: Census Bureau, BLS, CIBC

CIBC World Markets Inc. Chart 7

Economic Insights - August 7, 2013

US Manufacturing Profit: Nothing to Write Home About

Real Operating Profit 100% 80% 60% 40% 20% 0% -20% -40% -60% 06 09 US Canada 12 y/y change

Chart 8

Capital Intensity Negatively Correlated with ROE

Capital Intensity vs. ROE By Sector (Canada) 30 25

Avg Y/Y Chg in Real Operating Profit Since Trough 21.0% 19.0%

14 12 10

Average ROE Since 1988 (Canada) %

ROE (%)

17.0% 15.0% 13.0% 11.0% 9.0% 7.0% 5.0% US C anada

20 15 10 5 0 0 ($'000 per worker) 200 400 600

8 6 4 2 0 Capital intensive sectors Non-capital intensive sectors

Capital Intensity

Source: Census Bureau, BEA, Statistics Canada, CIBC

Source: Census Bureau, Statistics Canada, CIBC

profit in Canada rose faster than in the US during the recovery (Chart 7). While that sounds surprising, the reality is that companies that depend largely on tangible assets for their competitive advantage are unlikely to earn superior returns on their investment on capital. That is largely because those assets can easily be replicated by competitorsa situation that often leads to excess capacity, price competition and erosion of returns on capital. In these businesses, growth requires another plant, a distribution centre, a retail outlet or capital to fund growing accounts receivable or inventory. Simply put, capital intensity is negatively correlated with profita fact that is clearly illustrated in Chart 8. Over the past twenty-five years, return on equity on capitalintensive sectors was half the return seen in non-capitalintensive sectors. The same goes for valuations, with numerous studies finding that, on a consistent basis, low capital-intensive firms yield better returns than high capital-intensive firms2. Advantage Canada The surge in capital-intensive manufacturing activity was financed largely by debt. Since 2010, borrowing by capital-intensive firms has risen twice as fast as that among non-capital-intensive companies (Chart 9), bringing their share in total manufacturing debt to more than 80%. With debt interest payments already on the rise, the US manufacturing sector is highly sensitive to any increase in interest rates. In contrast, the more labour-intensive

trajectory in the Canadian manufacturing sector suggests that Canadian manufacturers are not only more flexible in adjusting to changes in demand, but also, given a similar debt structure relative to their US counterparts, are notably less sensitive to the eventual increase in interest rates. In addition to some improvement in commodity prices, that might add another factor in support of our call that corporate profits in Canada will outperform that of the US in 2014.
Note: (1) The gap might be overstated due to different depreciation assumptions utilized in the US and Canada. (2) See, for example, Elmasr Hassan Capital Intensity and Stock Returns Journal of Investment Strategy Vol. 2 No. 1, or Raife Giovinazzo Asset-Intensity and Cross-Section of Stock Returns University of Chicago, 2008.

Chart 9

Borrowing by Capital Intensity in US Manufacturing

125 120 115 110 105 100 95 90 10 11 12 Capital intensive industries Non-capital intensive industries 13 Index 2010=100

Source: Census Bureau, CIBC

CIBC World Markets Inc.

Economic Insights - August 7, 2013

CANADA Real GDP Growth (AR) Real Final Domestic Demand (AR) All Items CPI Inflation (Y/Y) Core CPI Ex Indirect Taxes (Y/Y) Unemployment Rate (%) 13Q1A 2.5 0.6 0.9 1.3 7.1 13Q2F 1.6 1.4 0.8 1.2 7.1 13Q3F 1.8 1.3 1.3 1.5 7.1 13Q4F 2.2 1.6 1.9 1.7 7.1 14Q1F 2.4 1.7 1.7 1.5 7.0 14Q2F 2.5 1.5 2.0 1.6 6.8 2012A 2013F 1.7 2.3 1.5 1.7 7.3 1.7 1.4 1.2 1.4 7.1 2014F 2.3 1.6 2.1 1.7 6.8

U.S. Real GDP Growth (AR) Real Final Sales (AR) All Items CPI Inflation (Y/Y) Core CPI Inflation (Y/Y) Unemployment Rate (%)

13Q1A 13Q2A 1.1 0.2 1.7 1.9 7.7 1.7 1.3 1.4 1.7 7.6

13Q3F 2.0 2.5 1.8 1.8 7.4

13Q4F 3.1 2.9 2.0 1.8 7.2

14Q1F 3.8 3.8 2.1 1.8 7.0

14Q2F 3.8 3.8 2.2 1.9 6.8

2012A 2013F 2.8 2.6 2.1 2.1 8.1 1.5 1.6 1.7 1.8 7.5

2014F 3.3 3.3 2.3 2.0 6.7

After a surprisingly strong start to 2013, GDP growth likely decelerated to a 1.6% pace in Q2. That takes into account both Alberta flooding and the Quebec construction strike and is somewhat firmer than the Bank of Canadas ultra-cautious call. Although consumer spending acquired some speed, trade likely contributed little to growth in the quarter as a whole despite Junes solid numbers. Even with a second half lift from reconstruction, real GDP of only 1.7% this year should help to keep inflation under wraps, giving the Bank little reason to begin tightening before early 2015.

Revisions to US GDP data painted an even starker picture of sluggish growth toward the end of 2012 and at the start of this year. But strong June exports could see Q2 revised upward, and are another sign of life in the previously lackluster US manufacturing sector. Whether the Fed will taper as early as September remains a close call. However, given our modest 2% forecast for Q3 GDP, and subdued core inflation, we continue to lean towards a Q4 reduction in asset purchases. By that time growth should be starting to pick up more appreciably ahead of a strong 2014.

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