What happened to the global recovery? — Sherry Cooper

The European crisis continues to rile markets as the situation in Spain worsens. Bond yields have surged in Spain and Italy as money leaves Europe for, among other places, the U.S. and Canada. Ten-year yields in both countries have touched record lows and the Canadian dollar, along with the U.S. dollar, is reflecting its safe-haven status. Stock markets are jittery, especially in Europe, and oil prices have resumed their decline.

U.S. corporate earnings for the second quarter to date have generally been good. However, concern is mounting regarding revenue misses, especially in the industrial sector, reflecting the sour global outlook and stronger U.S dollar. European sales are falling sharply and sales to the rest of the world have slowed. Earnings growth is coming largely from cost cutting rather than from revenue gains, which has its limits. The eurozone debt crisis has a direct impact on business confidence that cannot be avoided, even on this side of the Atlantic.

The U.S. economy likely slowed in the second quarter following tepid 1.9% first quarter growth. Fiscal drag was a contributor to the slowdown as was a contraction in consumer durable spending. Business investment continued to grow at a mid-single-digit pace, especially in commercial construction, and residential construction remained a strong gainer, albeit from an exceptionally weak level. 

The pace of new-home construction rose to its highest level in four years in June. In addition, the Midwest drought is driving corn and wheat prices higher and agriculture production down. Owing to better weather, Canadian corn and wheat farmers may well receive a windfall, although livestock producers everywhere will pay higher prices for feedstock.

Job growth in the U.S. is positive, but disappointing as the unemployment rate remains hinged above 8%. This fact is constantly bombarding the public as the election campaign heats up. Personal disposable income growth has been tepid and labour negotiations are once again on the front page. Labour bargaining power has been relatively weak in North America. 

From the Post Office to Caterpillar to state governments, employers are seeking steep concessions from their workers as they attempt to preserve their bottom lines. Despite record earnings, Caterpillar (the company that shut down its London, Ontario plant when unions would not agree to a 50% pay cut) is insisting on a six-year wage freeze and a pension freeze for many of its production workers in its Joliet, Illinois plant. 

This is an important test case that other businesses are watching closely. Caterpillar has been a leader in tough labour negotiations, finding new ways to cut labour costs, such as two-tier wage scales and higher worker contributions for health insurance. Caterpillar is confronting the International Association of Machinists—a hard-lined union that has had successful strikes at Boeing and Lockheed Martin. The strike has been going on for 12 weeks and the results will be a bellwether for other negotiations.

In addition, the year-end tax increases and spending cuts of the U.S. fiscal cliff have increased uncertainty and contributed to the malaise.

Canada has been sideswiped by the global weakening and Euro Area crisis, as oil prices have fallen significantly while the Canadian dollar remains relatively strong. The oil patch has been hard hit by the price declines, the persistently wide differential between Canadian and U.S. crude prices, and reduced exports to the U.S. 

Pipeline capacity problems continue and shale oil production in the U.S. is growing rapidly. With the States becoming more fossil fuel independent, it behoves Canada to get to work on an east-west pipeline such as the Northern Gateway pipeline, which the Premier of B.C. now seemingly opposes, or some other method to enable oil exports to China. The Chinese are anxious to do oil business with Canada—either in Canada or from Canada. The recently announced purchase of Nexen by CNOOC—China’s largest offshore oil producer—is a prime example.

The Canadian stock market has underperformed markedly this year and has been mired roughly 3% below end-2011 levels since May of this year. With the exception of the European peripheral markets, which have been slammed with double-digit losses, Brazil’s market has been the only one to underperform Canada this year. Earnings expectations have fallen. 

Not only has the oil sector been hit, but Canadian financial services earnings momentum will continue to fade, reflecting slower lending growth, tighter interest margins and continued weak capital markets activity. The new issue business, for example, is quite weak and repeated ‘risk-off’ days have suppressed trading volumes.

Canadian households are burdened by record debt levels relative to income; and, while far better off than their American neighbours, consumer confidence isn’t great and the housing sector is finally slowing. Growth in the second quarter was probably below 2% and is likely to stay at that tepid pace for the rest of this year. 

Exports have been hard hit by the global slowdown, falling commodity prices and strong Canadian dollar. While commercial construction is strong, residential construction growth is likely to slow (although you would never know that in Toronto), and government spending is declining.

Bottom Line: Overall, tepid growth and heightened risk accompanied by fiscal tightening will remain, despite record-low North American interest rates. In this environment, the Federal Reserve can do little to boost activity and the Bank of Canada has no stomach for it. We are far removed from the early days of this upturn when job creation was improving, profits were surging and expectations for both earnings and revenues were handily exceeded quarter after quarter. With the eurozone crisis worsening and with no solution in sight, sentiment and activity will continue to disappoint.