CIBC research

8/7/2019 CIBC research

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GPS MONTHLY

CIBC World Markets Inc., P.O. Box 500, 161 Bay Street, Brookfield Place, Toronto Canada M5J 2S8 (416) 594-7000

See Legal Disclaimer section at the end of this report for important disclosures, including potential conflicts of interest.

GLOBAL POSITIONING STRATEGIES

Coping With Uncertainty

Economics (Buchanan): Risk aversion was on the rise due to higher oil prices, renewedeuro debt fears and emerging market policy restraint, even before the still not fullyclear effects of the earthquake in Japan. The markets reaction to events there reflects ageneral distaste for uncertainty. Solid domestic Q1 growth prospects support our viewthat the Bank of Canada will end its pause at the May meeting. Fragile recoveries anduncertainties will help keep major central banks elsewhere on hold (UK, US) or could

see a delay in announced tightening plans (ECB).

Foreign Exchange (Stretch): After a prolonged period of emergency monetary policyit seemed, at least ahead of the Japanese tragedy, that policymakers were gearing upfor normalization; FX dynamics being determined by monetary policy set against riskappetite. If we do not face the worst case scenario in Japan then the prospect of anending of QEII, heavily skewed market positioning versus the USD, a deceleration inglobal activity, led from Asia ex-Japan, points towards a broad based cyclical USD bouncein the upcoming quarter.

Government Finance (Lovely): Budget season is in full flight and theres plenty towatch out for. External risks have mounted, and we examine regional implications fromJapans disaster and high energy prices. In spite of global uncertainties, revised provinciagrowth forecasts show a further improvement vs. our earlier call, adding extra revenueto the fiscal plan and allowing some governments to more credibly trace a path backto balance.

Credit (Zapior): We assess the strength of the spread rally of the last 10 months inCanada and the US in an historical context, as well as within the framework of ou2011 spread forecast. Spreads are tracking the tight end of the range in the secondmost optimistic forecast scenario, while key spread drivers are more closely fitting themeet expectations scenario. Nevertheless, priced for perfection spreads should besustainable, even with economic headwinds, if the strong demand for credit product

continues.

Commodities (Spector): Most major crude gradesNorth American and otherwisehave rallied hard this year to date. The strength we have seen recently in Brent hasbeen broadly reflected across sweet grades globally. But US benchmark West TexasIntermediate has lagged other crudes, and we see this disconnect continuing at leastthrough the end of the year.

Peter BuchananEconomics

(416) [email protected]

Warren LovelyGovernment Finance


Katherine SpectorCommodities


Jeremy StretchForeign Exchange

+44 (0) [email protected]

Joanna Zapior, CFACorporate Credit416) 594-8498

[email protected]

Internet:http://research.cibcwm.com/economic_public/download/

gps_mar11.pdf

on Bloomberg:WGPS

March 17, 2011


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CIBC WORLD MARKETS INC. GPS Monthly- March 17, 201

2

Markets have regained a healthy respect for risk in recentweeks. Fears of a double-dip recession eased as 2010wore on, and there were hopes the momentum wouldcarry fully over into the new year. It didnt take longfor those high, and in some cases overdone, hopes tobegin to fade. As we went to press, markets were stilltrying to come to grips with the consequences of thehorrific tragedy in Japan. It will be some time before theinformation is available to make a complete and accurateassessment of the implications of events there, both for

Japan itself and other nations.

Even before disaster hit that country, there were signsthat investors were starting to revisit some of their moreoptimistic assumptions about just how well things wouldturn out on the economic front in 2011, in the face of anumber of developments. Surging gasoline prices raisequestions about whether US consumer spending cancontinue its healthier pace. With the focus on containingred ink, governments in the industrialized world arereaching for the spending ax. Moreover, monetary policy

in last years hot performersthe emerging marketsispoised to tighten further, hampering growth as inflationtops official targets.

ECONOMICSPETER BUCHANAN

No country is an islandleast of all Canada. The BanksMarch 1st statement emphasized geopolitical uncertaintieshinting at a broad risk category. That and still-containedinflation readings are a reason not to look for an Aprirate hike, although we still see the Bank pulling the ratetrigger at its May setting. While the ECB has struck ahawkish chord recently, central bankers in both the USand UK have also highlighted still fairly significant risks tothe recovery, reinforcing our view that it will be longer, ifanything, than the consensus now believes before policy

there edges back toward restraint.

Higher Oil Prices High on Global Worry List

Nosebleed oil prices are one reason why growth thisyear may not match the barnburner pace some werepredicting with arguably a touch too much confidenceearlier. Libya accounts for just 2% of global crude supplybut investors have been looking not just at events there,but the (arguably) still relatively small chance of contagionlaying low a top-tier OPEC producer like Saudi Arabia o

Iran.

Oil has risen dramatically before, only to crash back toearth, and there are still good reasons why history may

New Headwinds Give Central Banks Reason Not to Tighten Hastily

Table 1. Economic Update

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

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

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

All Items CPI Inflation (Y/Y) 2.3 2.4 2.5 2.1 1.9 1.7 2.0 1.8 2.2 2.1

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

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

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

Real GDP Growth (AR) 2.8 3.8 2.3 1.8 1.9 2.3 2.5 2.8 2.7 2.3

Real Final Sales (AR) 6.7 2.1 2.8 2.3 2.2 2.1 2.5 1.4 2.9 2.4

All Items CPI Inflation (Y/Y) 1.3 1.7 1.7 2.1 2.2 1.9 2.0 1.6 1.9 2.0

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

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


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repeat itself. Industrial-country inventories were adequatewhen the Middle Eastern political pot began bubbling.OPEC likes firm prices, not sky-high, recession-inducingones that crush oil demand, and the Saudis recent outputhike suggest the cartel has at least some spare capacity, incontrast to the situation when oil spiked three years ago.A $10-15 pullback in oil prices isnt implausable, given

this. But even if things dont play out quite that way, thehistorical evidence suggests that they would probablyhave to climb a fair bit higher to undermine the recoveryon their own.

Oil prices did surge ahead of five of the last six USrecessions. Most observers would argue, though, thatpricey oil was not the main reason growth floundered in anumber of these cases. The 2001 recession was arguablyfar more about the severe blow to investment spendingand consumer confidence from dot.com implosion, than$1.60/gal gasoline, and oils gyrations certainly didnt

blow up the US sub-prime mortgage market, later in thedecade.

The back-to-back recessions of the mid-1970s and early1980s were clearly much more an oil story. Both of thoseepisodes, however, involved a much harder blow to the

industrial economies, based on the increase in costs tooil consumers in those countries. Oil consumption costsrose by the equivalent of nearly 3% of GDP in the firstof these cases, and over 4% in the second (Chart 1)Given declining levels of oil intensity and other factors, oiprices would have to reach $160/bbl to match the first ofthose two knockout punches and nearly $200 to matchthe second. The Feds uber-hawkish stance, moreoverhelped accentuate the US economys troubles in the early1980s. Thats not to say that the impact of the recent

Table 2. Interest and Exchange Rate Forecast

Chart 1. Oil Supply Shocks

2011 2012

END OF PERIOD: 16-Mar Jun Sep Dec Mar Jun Sep Dec

CDA Overnight target rate 1.00 1.25 1.75 2.00 2.00 2.00 2.00 2.2598-Day Treasury Bills 0.94 1.20 1.65 1.90 1.85 1.85 1.85 1.90

2-Year Gov't Bond 1.58 2.25 2.35 2.50 2.40 2.75 2.85 3.00

10-Year Gov't Bond 3.14 3.65 3.55 3.50 3.60 3.85 3.95 4.00

30-Year Gov't Bond 3.69 3.90 3.90 3.85 4.00 4.10 4.25 4.25

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

91-Day Treasury Bills 0.09 0.15 0.15 0.15 0.15 0.15 0.15 0.20

2-Year Gov't Note 0.55 0.65 0.65 0.65 0.85 0.90 0.90 1.00

10-Year Gov't Note 3.20 3.55 3.45 3.30 3.50 3.80 3.85 3.95

30-Year Gov't Bond 4.37 4.60 4.55 4.40 4.65 4.75 4.80 4.80

Canada - US T-Bill Spread 0.85 1.05 1.50 1.75 1.70 1.70 1.70 1.70

Canada - US 10-Year Bond Spread -0.06 0.10 0.10 0.20 0.10 0.05 0.10 0.05

Canada Yield Curve (30-Year 2-Year) 2.11 1.65 1.55 1.35 1.60 1.35 1.40 1.25US Yield Curve (30-Year 2-Year) 3.81 3.95 3.90 3.75 3.80 3.85 3.90 3.80

EXCHA NGE RA TES CADUSD 1.01 0.96 0.99 1.01 1.01 1.02 1.02 1.03

USDCAD 0.99 1.04 1.01 0.99 0.99 0.98 0.98 0.97

USDJPY 80 84 87 89 88 90 92 94

EURUSD 1.39 1.29 1.31 1.32 1.33 1.35 1.34 1.32

GBPUSD 1.60 1.54 1.58 1.61 1.64 1.67 1.65 1.65

AUDUSD 0.99 0.94 0.95 0.96 0.97 0.98 0.99 0.97

USDCHF 0.92 0.97 0.97 1.00 1.01 1.01 1.03 1.06

USDBRL 1.67 1.70 1.66 1.63 1.62 1.62 1.61 1.62

USDMXN 12.04 11.75 11.85 12.00 12.00 12.00 11.85 11.50

0.0

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Iranian

Revolution

1973 OPEC

Embargo

Iraq's Kuwait

Invasion

Since Start

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Turmoil

Rise in OECD countries' oil costs, % of GDP


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price run-up has been inconsequential. In the US, the risein food and gasoline prices since the start of the year haseffectively offset most of the benefit to consumers fromthe recent tax stimulus (Chart 2).

Canada is divided between an oil consuming eastand producing west, and the provincial implicationsof oil prices have typically overshadowed the nationalmacroeconomic ones. All signs are that the relationshipbetween growth and oil prices is a non-linear onemeaning simply that some is good, a lot bad. The C$followed crude north in the 2008 spike only until priceshit $100/bbl. That would seem to suggest that for Canadathe negative effects of costlier oil, like weakness in trading

partners and auto sales, begin to increasingly outweighproducer rents once prices reach triple digits.

Chart 2. Oil and the US Consumer

We used a standard statistical modeling approach1 toget a better handle on the impact of oil price changeson the Canadian and US economies, and key variableslike the currency and rates. Our analysis suggests thatit takes about a year for the US economy to feel the fulpinch from an oil price shock (Chart 3). That suggestsone shouldnt take too much comfort from the recentresilience of energy-sensitive categories of demand likeauto sales.

Canada is one of the worlds top dozen net exportersof oil and oil products (Chart 4). As that might suggest,our analysis implies that in the near term higher crudeprices are a modest plus for the economy. A 25% rise

approximating the recent increase, ordinarily lifts real GDPgrowth by a couple of ticks in each of the two followingquarters. Beyond a couple of quarters, the negative effects(Chart 5), including the drag on key trading partners and

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Personal Disposable

Income, $Tn SAAR

*CIBC estimate

Chart 4. World's Largest Net Oil Exporters (2009)

Source: US DOE, CIBC calculations0 2 4 6 8

Canada

Mexico

Qatar

Kazakhstan

AlgeriaVenezuela

Kuwait

Norway

United Arab Emirates

Iran

Saudi Arabia

Russian Federation

MM Bbl/day

Chart 5. Impact of a 25% Oil Price Shock on CanadianReal GDPChart 3. Impact of a 25% Oil Price Shock on US Real GDP

Source: CIBC

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auto sales begin to outweigh the positive, hurting GDPgrowth. Beyond four to five quarters, the bad more thancancels the good, and the level of GDP is actually lowerthan it would otherwise have been. A further negative isthe increasing drag from induced C$ appreciation on thecountrys non-energy exports (Chart 6).

Spending Cuts Could Reverse Half of the Recent USTax Stimulus

Compounding the ill global growth consequences of

pricier oil is the drag from a couple of other sources. Oneis fiscal restraint, particularly in the US. Federal spendingcuts have clearly moved to the front of the policyburner. Although rising debt levels (Chart 7) will result indramatically higher interest payments over time, cuttingspending sharply while the economy is still recuperatingis not without risks. The blow from front-load spendingreduction is one reason we expected the US growthnumbers to sport a two- rather than three-handle movinginto 2011. Oil price hikes and government cutbacks havealso led us to pare a tick from our previous 2.8% forecastfor 2011 US GDP growth (Table 1). The headwinds from

fiscal restraint will intensify further in 2012 as measureslike the $120 billion social security tax cut expire. Federalcuts come, moreover, just as state governments are alsogoing on a fiscal diet.

Chart 6. Impact of a 25% Oil Price Shock on CADUSD (L),and on 10-Year GoC Yields (R)


A third cloud on the global growth horizon is the fact thatwhile inflation still looks fairly tame in most developedcountries, emerging markets are likely to have to tightenfurther to ensure long-term price stability. That will cooperformance in what, to this point, have been some ofthe worlds hottest performers. While those economiesare unlikely to sink into recession, growth simply wontsurprise to the upside the way it has in recent yearsChinas inflation rate remained stubbornly high at 4.9%in February. Monetary tightening and other restraintmeasures there will help to cool GDP growth to an 8.5%

pace this year, after last years over-10% advance.

After riding some strong tailwinds late last year, theglobal economy finds itself buffeted by new and, in somecases, completely unforeseen developments. While therisk of outright recession would still appear to be quitelow, those developments have led to a scaling back ofearlier optimism and an increase, for now at least, in riskaversion.

1 The approach is known formally as a vector autoregression, and involves

regressing each of a number of variables (Canadian and US real GDP growthCAD and 10-year government of Canada yields) on lagged values of each otherOur model is thus able to capture how a rise in oil prices impacts Canadian GDPdirectly and the induced effect from changes in the US economys performanceand the exchange and interest rates.

Chart 7. US Fiscal Outlook

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changes (% of GDP*)

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of Bush tax cuts beyond 2012, AMT indexation and

const. Medicare rates after 2011.

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basis-point deviation

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Source: CIBC

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FOREIGN EXCHANGEJEREMY STRETCH

Risk Dynamics and Policymakers

Having endured a prolonged period of emergencymonetary policy strategies it seemed, at least ahead ofthe tragic events in Japan, that policymakers and policydirection was increasingly being geared towards a degreeof normalization. It is likely therefore that FX dynamicsare set to be determined by a combination of changingmonetary policy influences and the pace of globalrecovery being set against market risk appetite; this asfactors such as the oil price have potentially significantimplications for the amount of USD to be re-cycled. The

benign by-product of a deceleration in global demand,led through current events, being a potential ease incommodity price inflation.

In terms of monetary policy direction, the next 2-3months looks set to be a pivotal period. Central bankersin general are increasingly aware of the need to begin(ECB) or in some cases extend the normalization process(BoC), this as emergency settings are increasingly seen tobe distorting behaviour. The by-product of such trends isthat one of the traditional dynamics of foreign exchange

performance, namely interest rate spreads, will seeincreased importance. While that is the case it could wellbe the ending of the one of the unconventional monetarypolicies, namely US QEII, which has a profound impact onFX markets.

The balance sheet of the US Federal Reserve hasballooned over the last five months as the second roundof quantitative easing has seen a plentiful supply of cheapUSD flood the market. Having seen the Feds balance sheetexpand to more than US$2.5 trn, up around US$280 bnsince the start of Q4, the end of QEII is in sight as the

US$600 bn target and June end date come into view.

But it seems likely that the front end of the US curve isset to remain locked for a considerable period, due to themarket not viewing significant risks of the Fed looking tohike until at least well into 2012. But a market looking toanticipate an end in the flood of cheap USD into the endof Q2 could trigger a reversal of broad USD negativity, thisas speculative positioning data into the start of March

reveals cumulative USD net short positions at record levelsand thus ripe for correction.

Continued positive but unspectacular US GDP growthallied to an end of cheap USD liquidity, no longer seeing

the USD perpetually used as a cheap funding currencypoints towards a trough in USD negativity. This shouldprove the case as structural risks in the eurozone remainprevalent into Q2, especially banking related pressuresBut with little prospect of the Fed looking to tightenpolicy until 2012 at the earliest, any USD reversal is likelyto be relatively short lived, not least when one considersthe longer term ramifications of US fiscal imbalances, thatbeing an issue which is likely to become more evident as2012 US Presidential race proceeds.

While the end of US QEII is a potential pivotal event in Q2

it perhaps may not be the only changing dynamic fromthe US side of the monetary equation. It seems there issome dissent within the Fed as regards the perpetuationof the extended period language in the Fed statementIt would seem that even though core inflation in the USremains well behaved and labour markets fragile thereference to keeping rates unchanged for an extendedperiod, i.e., the Fed keeping the front end lockedindefinitely, could be set for reassessment ahead of theculmination of QEII in June.

Chart 1. USD Cumulative Net Shorts at All-time Highs

Source: Bloomberg

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* USD Basket


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Would any removal of the phrase mean any imminentmove? The answer is no, but it may see the marketlooking to consider a pre-emptive bear flattening of theUS curve, in part as the markets attempt to front run

an end in the flow of cheap USD. Any rise in US shortend yields would be USD supportive, not least as broadstructural risks in Europe remain in terms of fundingpressures, economic weakness in the periphery, alongsidebanking sector liquidity issues this as markets speculateas to who is correct in terms of any euro bank capitalshortfalls, the ratings agencies or the central banks.

ECB Tunnel Vision

In Europe it seems that despite an increasingly two speed

economy the ECB is intent to repeat the monetary policymistake of 2008, hiking rates when economic conditionsare far from easy. It does seem that although the ECB hasyet to cure the regions banks from their lending addictionthey wish to signal an attempt towards normalizationeven if any move in April is more symbolic as opposed tothe start of a series of hikes. Moreover, should externalevents prove to get in the way of the ECB, notably interms of Portugal likely facing pressure for a bailout inupcoming weeks, dissension amongst euro politicians,despite the apparent agreement at the March 11 informalsummit, or in terms of the impending EU bank stress

tests, results of which are due in June, any EUR short terminterest rate support could prove temporary.

Although the agreement following the March 11 summitto enhance the funding ability of the EFSF to the full 440bn was encouraging, prompting ratings agency Fitch tostate the initiative materially enhances the crisis policyresponse, the process does nothing to alleviate the crisisprocess being utilised. The burden remains on individualstates to stem the fiscal crisis through prolonged

austerity measures, despite the risks to domestic growthor employment. The failure to agree to buy distressedbonds in the secondary market, taking the burden fromthe ECB, also remains a potential source of contentionWith Portugal set to be further pressured by tighteningmonetary policy the looming 4 bn bond redemption dueon April 15 remains a major hurdle.

In terms of the banks, the upcoming bank stress testsappear to be once again open to question as theeconomic criteria appear not as strong as those of lastyear, albeit the inclusion of an increase in short termfunding costs to replicate a funding crisis is welcomedBut with no reference to the amount of assets held onlenders books, allowing the exclusion of any write downson sizeable peripheral debt holdings, the credentials ofthe test remains questionable.

Banking sector pressures remain a key negative for the

eurozone with the ratings agencies and the authoritiesseemingly having very different assumptions of capitashortfalls. The Bank of Spain estimates that the savingsbanks have a potential liquidity shortfall of 15.15 bnthe rating agencies at least 50 bn, which on the basisof worst case scenarios could easily be double that. Whois right, the answer to that will go some way to undewriting EUR performance. With the authorities consistentlyhaving under estimated risks markets are likely to remainsomewhat circumspect in terms of official estimates.

Japanese Quake Concerns

While global policymakers have been increasingly lookingto normalize policy the horrific events in Japan have forsome proved to question the premise of the ability ofpolicymakers to normalise the global monetary stanceOf course in the short term the market has attempted todraw parallels with the Kobe earthquake. But in realitythe comparisons are not obviously compelling; the Koberegion accounted for around 12% of Japanese GDP, thecurrent crisis zone accounts for around a quarter of theGDP of Kobe. But of course the human tragedy is fa

worse. But it is the prospect of nuclear fallout, energyshortages and production shutdowns, impacting Japaneseexports, which potentially provide an aggressive economicdrag which could eventually prove more significant thanthe Y10 trn impact in 1995, equivalent to 2.5% of GDP.

In terms of the parallels with Kobe monetary policy isalready loose, in contrast with 1995. In terms of the JPYit could be argued there is little room for the currency toappreciate against the USD, as a further slide in USD JPY

Chart 2. US Twin Track Deficit

Source: Bloomberg, CIBC

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would further compromise Japanese exports; thus wecan expect the authorities to remain mindful of currencyperformance, with the threat of official action wherenecessary. But in REER terms the JPY is not as strong asUSD JPY would suggest, while Japanese corporates haveoutsourced a lot of productive capacity and exportedcurrency risks down the price chain, thus mitigating part

of the impact of the external value of the JPY.

Chart 3. USD JPY and Real Equilibrium Exchange Rates

Source: Reuters Datastream

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JAPANESE YEN REAL EFFECTIVE EXCHANGE RATE INDEX

JPY USD (RH Scale)

In terms of risk aversion trades the traditional beneficiariesremain the USD, CHF and JPY, although of course thescenario for the latter is confused by the aftermath of

the earthquake and subsequent economic disruption. Inthe short term we are likely to see JPY inflows, especiallyas domestic investors reverse carry trades, previouslybuying higher yielding currencies such as the AUD.Indeed it would suggest that uridashi demand is likely tobe compromised with a potential reversal of flows whichhas potentially negative implications for currencies suchas the Rand where there has been much issuance. Thuswe are likely to see short term JPY upside as positions aresquared, re-insurance flows arrive or are anticipated, whilethere could be some concerns over the unwinding ofJapanese holdings of US Treasuries to fund reconstruction,

a factor which could impact USD sentiment.

Over the medium to longer run the parlous state ofJapanese government finances is likely to prove a longerrun drag upon the JPY. With national debt at 225% ofGDP and with a fiscal deficit of near 8% the ability ofJapan to finance its debt mountain remains challenging.Until now Japan has financed its debt almost exclusivelythrough domestic debt purchases, approximately 90%of JGBs are held on shore, such demand allowing Japan

to run such deficits without facing ratings pressurescommensurate with nominal debt levels.

Should the current crisis and restructuring lead to areduction in domestic buying, likely bringing forwardan inflection point due to an aging population, this risksnegatively pressuring the credit rating over time, a point

highlighted by Moodys, risking long run JPY negativityMoreover, the more assets taken onto the BoJs balancesheet, the greater the risk that asset purchases aredeemed to be monetising debt. Thus it could be arguedthat current events while providing short term upside JPYimpetus increase long run depreciation pressures.

Chart 4.Japanese Debt Dynamics

Source: IMF, CIBC

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Over recent weeks it has been risk appetite or risk

aversion, driven by exogenous geopolitical and commodityshocks which have been key drivers of currencyperformance. Looking forward to Q2 it appeared likelythat monetary policy determination would prove to besignificant influence. But in addition to rising geo-politicarisks in MENA we have to add a natural and a potentiaman-made disaster to the list of risk criteria.

The perpetuation of such risks could prove to drivepolicy makers off course once more, which from a riskperspective would favour the USD and CHF, although thatdepends on the extent and duration of the negatives inJapan. But if we are not faced with a worst case scenarioin Japan then the prospect of an ending of QEII, heavilyskewed market positioning versus the USD, a decelerationin global activity, led from Asia ex-Japan (in the wake ofmonetary tightening policy), points towards a broad basedcyclical bounce in the USD in the upcoming quarter, notleast against those currencies impacted by growth andor commodity valuations. But any rebound has to be setagainst longer term structural fiscal negatives which areset to become increasingly problematic for the USD.


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GOVERNMENT FINANCEWARREN LOVELY

Budgeting in an Age of Uncertainty

Its show time. Weve already had a couple of earlymovers, but for Canadian governments, the 2011 budgetseason really gets rolling in the coming days and weeks.And once again, the most important policy documentof the year is being drafted at a time of extremeuncertainty.

The Worlds a Scary Place

For Canadian policy makers, the view outside provincial or

national borders is a little disheartening, with a numberof external risks yet to be defused.

As we went to press, the situation is Japan remained fluid,with ongoing uncertainty regarding efforts to stave offa nuclear catastrophe. While its still early to judge, theoverall impact on Canada looks to be limited. Japan mayrank as Canadas fourth largest export market, but is thetarget for little more than 2% of Canadian exports.

Provincial exposure to Japan nonetheless varies. Given

geographic proximity, Japan is British Columbias secondlargest export market, accounting for nearly 15% ofprovincial exports last year (Chart 1). While seeing agreater near-term hit to its trade, BC stands to benefitfrom Japanese rebuilding efforts, including added demandfor provincial lumber. Damage to Japans transportation

infrastructure could temporarily delay shipments ofCanadian wheat and other agricultural products, butunderlying demand for Canadian food products wontgo away.

Meanwhile, shutdowns in Japans auto industry wilreverberate in North America, disrupting global supplychains and temporarily crimping production at relatedplants in Ontario. A draw down of inventories and thesubstitution of non-Japanese models should limit the hit

to auto sales, however.

Notably, a shift away from nuclear power would translateinto demand for thermal coal and natural gas, resourcesCanada has in abundance. Indeed, an expected surge inJapan LNG imports could incent development of NorthAmerican shale gas deposits.

Of course, global concerns over nuclear safety wouldnegatively impact Saskatchewans uranium industrywhich is the worlds largest producer. Switzerland and

Germany have put the brakes on the nuclear industryand others could follow. For its part, Ontario has bankedon a growing fleet of nuclear reactors to meet its long-term energy needs. And while the government may stilpress ahead, recent developments signal greater publicopposition, with an added focus on safety translating intopotential delays and added costs.

As for the repatriation effect, Canada looks to be muchless impacted. Japanese investors hold $44 billion ofCanadian long-term debt, equivalent to 2.8% of GDPThats one-third the relative exposure in the US (Chart 2)

where Japan held $1.1 bn of long-term debt as of mid-2010. Nor was there a notable exodus of Japanese capitafrom Canadian markets in the wake of the 1995 Kobequake.

Oil Remains a Threat

Turmoil in the Middle East and North Africa may havebeen bumped from the front page by Japans disasterbut the situation in a number of countries remains

Chart 1. Provincial Trade Exposure to Japan Varies

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Cda BC Alta Sask Man Ont Qu NB NS PEI N&L

Exports Imports

Japan's Share of Cdn International Trade, % (2010)

coal, copper, lumber

agricultural products

vehicles / parts,

machinery & equip.


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unsettled. And while the Japan demand shock, andassociated risk-off trade, has seen crude give back some

ground, elevated energy prices remain a risk for the globaleconomy. As noted on pages 2-5, higher energy prices arenot the unambiguous plus for Canada that some mightthink, with the hit to US consumer purchasing power andlagged impact on the auto industry chief concerns.

But for a few Canadian provinces, higher energy pricesrepresent a positive terms-of-trade adjustment, creatingdisproportionate wealth and triggering superior rates ofreal economic growth. Consistent with their strong energytrade surpluses, growth in Alberta, Saskatchewan and

Newfoundland & Labrador will notably outstrip that inthe rest of the country this year and next (Charts 3 and 4).More investment dollars are flowing into these regionsand, as weve seen recently, underlying credit quality inthese provinces will continue to improve relative to mostothers.

There are other risks to be sure, including sovereign debtcrises and pronounced fiscal austerity across Europe, as

well as emerging market tightening to cool overheatedeconomies.

Provincial Growth Forecasts Boosted

In spite of external pressures, Canadas economy hasstrengthened of late. The economy regained importantmomentum in the latter stages of 2010, with thecountrys full-year growth rate topping 3%. A nice handoff and strong first half have seen us up our 2011 reaGDP forecast once more. At 2.8%, the national growth

pace is nearly a percentage point stronger than we onceforesaw back in the fall.

While acknowledging global economic risks, weve uppedour provincial forecasts to be consistent with the nationapace, with revised growth tallies presented in Table 1Canadas stronger economic backdrop is welcome newsfor Canadian finance ministers, with more GDP translatinginto extra revenue. Next weeks federal budget will showOttawas revenue on a stronger plane. And collectivelythe provinces could take in an extra $5 billion or morein 2011/12, compared to what was envisioned only a

few months ago. Dont expect extra federal or provinciarevenue to be fully applied against the fiscal bottomline.

External risks and some concerns on the domesticeconomyincluding record household debt burdenand currency-related pressuresargue for caution in2011 budgets. Building more of a cushion into growthforecasts and spending assumptions would eat up someof the extra revenue, but insulate against unwelcome

Chart 3. Provincial Trade in Oil

Chart 4. Oil Rich Provinces Take Lead Once More

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developments. British Columbia remains the gold standardfor fiscal prudence, and look for others to emulate (to adegree) its cautious stance.

While elections loom in many corners, governments needto remain focused on restraint. On its own, strongergrowth may not be sufficient to eliminate structuraldeficits, but extra revenue would imply less aggressivecutbacks to meet a given fiscal target. That could addimportant credibility to long-term fiscal plans and lessenanxiety around the ability of governments to dramaticallyslow spending in the face of health-related spending

pressures. After all, credit ratings and spreads hinge onthe credibility of fiscal projections.

There will be plenty to digest in the days and weeksahead, and a number of key elements to watch for in2011 budgets (Table 2). Risks are elevated and the politicalenvironment remains uncertain, with a high likelihood ofa near-term federal election and five provincial electionsscheduled for the fall. Still, 2011 should usher inimportant progress on Canadian fiscal healing, slowingthe growth in government debt and setting the stagefor an important step lower on net government funding

requirementssupportive for provincial spreads in todaysvolatile environment. Stay tuned for our complete post-budget recap.

Table 1. Revised Provincial Real GDP Forecasts

Y/Y % Chg 2010E 2011F 2012F Pre-Crisis1 Recession2 Recovery3

BC 3.5 2.9 3.1 3.5 -0.9 3.2

Alta 3.5 3.9 4.0 4.1 -2.3 3.8

Sask 2.4 4.3 3.8 2.9 -2.0 3.5

Man 2.7 2.9 2.9 2.5 0.0 2.8

Ont 2.9 2.7 2.6 2.2 -1.8 2.7Qu 2.9 2.4 2.5 1.9 -0.2 2.6

NB 2.4 2.0 2.3 2.1 -0.2 2.2

NS 2.3 1.8 2.2 1.1 -0.1 2.1

PEI 2.5 2.2 2.2 2.3 0.0 2.3

N&L 5.5 5.7 3.1 3.8 -5.3 4.8

Cda 3.1 2.8 2.8 2.6 -1.2 2.9

1. 'Pre-Crisis' refers to five-year average annual growth rate for 2003 to 2007

2. 'Recession' refers to two-year average annual growth rate for 2008 to 2009

3. 'Recovery' refers to three-year average annual growth rate for 2010 to 2012

CIBC Forecasts Reference Periods

Table 2. What to Watch For in 2011 Budgets

Economy

Outlook for real, nominal GDP and other key indicators

Where is economic growth coming from

How has economic outlook changed vs. prior forecast

Degree of prudence / buffer applied to consensus growth forecast

Allowance for higher interest rates and associated fiscal sensitivities

Key energy price assumptions and associated revenue sensitivities

Trajectory for the C$

Assumed strength of global economy and implied demand for key exports

Acknowledgement of risk factors

Budget Balance

Relative scale of budget balance (i.e., as % of GDP or revenue)

Change in balance vs. (a) original plan and (b) latest estimates (e.g., Mid-

Year Update)

Change to timeline for deficit elimination, if applicable

Transfers to and from stabil ization funds to address shortfalls

Details of Fiscal Plan

Own-source revenue growth vs. (a) trend and (b) nominal GDP projections

Reliance on volatile resource revenues

Changes in key tax rates or other revenue measures

Federal transfer share of total revenue

Expectation for federal transfers beyond 2013/14

How much extra revenue is consumed by incremental spendingHow does future pace of program spending compare to trend

Is government counting on unidentified or unrealized savings

How much of the budget is consumed by health care outlays

Size of forecast allowance / contingency reserve

Are other contingencies built into spending plan

Scope of new spending measures

Wage growth assumptions for future collective bargaining agreements

Reductions in publ ic sector headcount (i.e., l ayoffs, attrition)

Contribution from Crowns

Are asset sales planned

Changes to accounting methodology

Other special i tems

Debt/Borrowing

Relationship between budget balance and net change in debt

How is government debt defined

Trajectory for debt-to-ratio

Interest charges vs. revenue

Pension funded status

Drivers of net financing requirements (i.e., budget balance, capital outlays,

special pension payments, other entities, other adjustments)

Role of pre-funding in reducing underlying funding requirements

Refinancing requirements

Availabil ity of sinking funds

Size and orientation of borrowing program (i.e., domestic vs. international)

Reliance on short-term markets

Interest rate reset r isk

Foreign currency exposure


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CORPORATE CREDITJOANNA ZAPIOR

How Are We Tracking?

North American credit spreads have enjoyed a rally sinceJune of last year, albeit interrupted by a few bumpswhich were mostly driven by episodes of sovereignrisk. By and large, the rally has been justified by themodestly improving economic outlook, good corporatefudamentals, and strong demand for credit products.So what now? When we analyze the spread rally in thecontext of both historical performance and the spreadforecast that we had made for 2011 at the end of theprevious year, we conclude that current spreads may

have priced to perfection. This is fine if the recovery isnot interrupted and demand continues strong. However,when we consider, as our Economics Team does onpages 2-5, that headwinds have increased for the globaleconomy, pricing to perfection may come up for a test.

Without a Doubt, This Has Been a Rally

North American credit spreads, whether cash or CDS,whether investment grade or high yield, have enjoyed arally since June of last year (Chart 1). US high yield CDS

generated best spread performance with its spread 44%tighter since June. US investment grade spread is 37%tighter. Against this performance, Canadian cash bondspreads may at first blush appear to lag, having tightenedonly 22%.

Putting the Rally in Its Historical Context

From a historical perspective, current spread levels arenot the tightest ever (Chart 2). Nor would we expect

them to be. The tightest pre-crisis levels generally arenot considered attainable. It is, however, noteworthythat the bellweather investment grade US CDX indexas well as the Canadian investment grade spread, are

just about equal to their respective average spread fothe entire period since May 2006, when one excludesfrom calculations the deepest part of the financial crisis(September 2008 September 2009). The high yieldindex spread has cut through that average late last year.

Chart 1. Sustained Credit Rally

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Chart 2. Still a Big Gap to the Tightest-Ever Spreads

1 At the end of November 2010, we produced a US CDS spread forecast forthe following 250 trading days. We modeled the CDX index spread in relationto swap yields, equity index returns, and their volatilities, and included anadjustment for credit events. Our forecast was probabilistic we analyzedthe spreads and their drivers in five possible scenarios. Scenario parametersand our forecast results are detailed in a report published on December 8,2010 and available on the Macro Strategy website as Corporate Credit 2011Outlook.

Rally in the Context of Our Forecast: We Are TrackingOptimistic

To put things in the context of our 2011 forecast,CDS spreads so far has been tracking the second-most optimistic scenario, which we had dubbed beatexpectations1 (Chart 3). In fact, spreads have beeninitially hugging the lower (tighter) boundary of thespread range in that scenario, though they have backed

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What Does This Mean for Canadian Credit

Spreads?

A relatively weaker spread rally in Canada compared to theUS market suggests that the Canadian market has beenpricing in the recovery more conservatively, thus leavingitself less exposed to a potential correction. Rememberhowever, that the correlation between Canadian andUS credit spreads since mid-2006 has exceeded 90%(with Canadian cash spreads 93% correlated with USinvestment grade CDX spreads in that period, as wewrote in this report on November 10, 2010). Assumingthe two markets remain highly correlated, Canadianspreads would also likely see a correction if US creditspreads correct, even though the Canadian rally has notbeen as enthusiastic as that in the US credit markets.

Chart 3. How Are We Tracking?

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CDX Observed

CDX Model w ith event adjusted

CDX IG spread in bps

Actual CDX spread (light line) is show n as tracked b

our model spread (dark line). The red & green curve

delineate a 1 standard-deviation envelope for thexceed expectations scenario, & the blue line show

the median spread anticipated in that scenari

off the tights towards the median forecast spreadHowever, inputs into our spread model (namely ratesequities, and their volatilities) have been more mixed andgenerally gravitated towards the meet expectationsscenario. This suggests to us that spreads may bepriced to perfection, which would be justified only bycontinued upbeat economic news. If, as CIBCs Economics

Team argues, headwinds have increased for the globaeconomy, credit spreads might have reached their lowsfor this part of the cycle. However, if the currently strongdemand for credit product continues, it will be offsettingany spread widening pressures.

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COMMODITIESKATHERINE SPECTOR

Any casual observer of oil markets will have noticed thesharp divergence between US benchmark West TexasIntermediate and European benchmark Brent since thebeginning of the yearBrents premium to WTI hasrecently narrowed to around $11/bbl, but had traded aswide as $20 in February (Chart 1). Brent is not the outlierhere. In fact, WTI has lagged most other crude gradeswith the exception of equally PADD 2-handicappedWestern Canadian Blend.

Most major crude gradesNorth American andotherwisehave rallied hard this year to date. Thestrength we have seen recently in Brent has been broadlyreflected across sweet grades globally (Chart 2).

Comparing the term structures of WTI and Brent showsthe stark contrast between the two crudes (Chart 3). Inthe long-dated part of the curve, WTI currently tradesat a $4+ discount to Brent (historically, a $1.50-$2WTI premium was typical). At the front of the curve,the transatlantic spread is $11+ thanks to the deeper

contango in WTI and comparatively flat Brent structure.Strengthening global crude fundamentals, particularlysince the Libyan production outages, have now evenflattened the WTI curve significantly, but not as much asBrent.

NYMEX crack spreads give a similarly exaggerated view ofbroader refinery economics, compared to margins earnedby refiners running crudes that are not WTI-related. Casein point, since the beginning of the year, the spreadbetween NYMEX gasoline and WTI has increased nearly

$23 per barrel, whereas the NYMEX gasoline crack toBrent has increased by $10. The NYMEX heating oil crackto WTI is up over $26 but against Brent is just shy of $15(Chart 4-5).

West Texas Intermediate: Crudes Odd Man Out

Chart 1. M1 NYMEX WTI Minus Dated Brent

Chart 2. Price Change Since Jan. 1 (Price Level on Mar. 14

Chart 3. WTI & Brent Curves, Today and Month Ago

$(20)

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CIBC Commodities Strategy

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WTIs structural problems as a benchmark are notnews. The contracts landlocked physical delivery pointCushing, Oklahomameans that the crude tradeson a very regionally specific set of supply/demandfundamentals. Limited infrastructure to move crudebeyond Cushing, to the US Gulf refining centre, meansthat there are only so many moving parts in the WTIbalance.

Crude supply into Cushing (or PADD II more broadly) ison the rise, from both Canada and North Dakota. Lastyear saw a particularly sizable annual increase in thosevolumes. At the same time, operating refining capacityin the Midwest has been largely unchanged for the

past three years. Refiner demand for barrels into PADDII increases and decreases in response to planned andunplanned maintenance and refinery economics, but onaverage is not apt to increase in a significant way goingforward. Storage capacity at Cushing, on the other hand,has increased in response to widening WTI spreads. Some10 million bbl of capacity was added in 2009-10, andmore than that is expected online this year.

But at the end of the day, a structural shift in WTI spreadsis not likely to occur without additional infrastructureto move barrels beyond Cushing to the US Gulf. At the

moment, pipeline capacity additions are exacerbating theCushing problem; the second phase of TransCanadasKeystone projectthe Cushing extensionis bringingadditional barrels into Cushing from Steele City, Nebraska.What the market is waiting for is the third (XL) phaseof TransCanadas Keystone pipeline, which will not onlybring more barrels into the US from Canada, but will alsoextend down from Cushing to Texas. While Keystone XLmay not solve the midcontinent dynamic completely, itwill go some way in alleviating it.

As a trans-border pipeline, Keystone XL requires StateDepartment approval to proceed. The approval processhas taken longer than most had anticipated; the initiaEnvironmental Impact Statement for the project wasdeemed insufficient, and a second EIS has been submittedbut no decisions have been made. While TransCanadahad initially given optimistic guidance on the timeline fo

the project, the State Department has been quite cleathat, while a decision one way or another is expectedthis calendar year, a more precise schedule for approvacannot be assumed. As part of the Keystone XL projectthe Cushing-Texas leg of the project is subject to the StateDepartment approval even though that leg is not itselfinternational.

Our expectation is that Keystone XL will ultimately moveforward. Guidance from TransCanada confirms thatconstruction of the Cushing-Texas line could take aboutnine months. As such, it is hard to see this capacity onlinebefore the middle of 2012, and virtually impossible to seeit online this calendar year.

Recent market events have strengthened crude marketsglobally, even so far as to move the lagging WTI curveinto backwardation beyond this calendar year. Ifgeopolitics settle into a status quo, WTI spreads standto weaken significantlyparticularly in the Sep-Octperiod when planned PADD II refinery maintenancelooks heavy by historical standards (Chart 6). Grantedschedules are subject to revisionespecially if economics

at these refineries are still disproportionately favourablecome fallbut at the moment the data suggest heavyturnarounds. Short of severe, incremental supply-sidedisruptions, we still see it as unlikely that the Dec11contract expires higher than the Dec12 contract giventhe expected Keystone XL timeline.

Chart 4. NYMEX Heating Oil Crack (Left),Chart 5. NYMEX Gasoline Crack (Right)

Chart 6. CDU Planned Maintenance - Total PADD II

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