A Real View of the Global Economy

The euro zone double dip recession, a softer Chinese showing, and sub-par numbers in North America weighed on overall growth prospects.

Improved performances across most emerging economies should lead to a better showing: 3.1% in 2013 and 3.7% in 2014. The latter pace reflects a more balanced global recovery with greater contribution from advanced economies.

EMERGING MARKETS

The Chinese economy will grow 7.9% in 2013, supported by a modest acceleration in real estate and infrastructure investment. Growth could surprise on the upside if the U.S. economy improves beyond our current forecast. Chinese monetary policy will likely shift to a neutral stance in the second half of this year, as inflation accelerates.

In Brazil, economic activity is stabilizing at low levels. Fourth-quarter real GDP growth was weaker than expected, creating a poor hand-off for 2013. Rising inflation will take some steam out of household consumption and likely force the central bank to tighten before the end of this year.

Other emerging economies will see a modest acceleration with respect to 2012, as resilient domestic demand offsets external weaknesses.

DEVELOPED ECONOMIES

In Japan, real GDP declined for a third consecutive quarter during the last three months of 2012. Recently announced fiscal stimulus measures and a looser monetary stance should boost economic activity in the coming quarters. Annual real GDP growth will be around 1.0% this year, as the Japanese economy rebounds from its 2012 recession.

In the euro zone, economic activity will stabilize at depressed levels in the first half of 2013, and a languid recovery is set for the second half. Rising unemployment and private sector de-leveraging will continue to hinder credit demand, offsetting the accommodative monetary stance of the European Central Bank. Real euro zone GDP will contract around 0.4% in 2013.

Indecisive Italian elections and the Cypriot bailout bring the euro zone debt crisis back into the forefront. Across the euro zone, weak economic conditions will conspire against fiscal adjustment plans hindering consolidation efforts.

UNITED STATES

The U.S. economy is set to grow by 1.9% in 2013, slightly below the average pace since the recovery began in 2009. Growth should accelerate through the year, with 2014 chalking up a sturdier 2.8%.

In the absence of any further measures from Congress, deficit reduction will subtract 1.3 percentage points from real GDP growth in 2013, split roughly down the middle between tax hikes and spending cuts.

Automatic spending cuts should shave 0.6 percentage points from economic growth in 2013, while the expiry of the payroll tax holiday and higher tax rates on high-income earners will reduce real GDP growth by a further 0.7 percentage points. For 2014, the fiscal drag is estimated at roughly 1 percentage point, largely on the back of spending cuts. However, this estimate does not include new measures that may come out of the budget process.

Supported by stimulative monetary policy, the housing market will continue to strengthen over the next several years. Residential construction investment is likely to add 0.4 percentage points to economic growth this year and contribute around 400k jobs to U.S. payrolls (roughly 20% of the total net job gains). Rising household wealth from higher home prices should add an additional 0.2 percentage points to annual economic growth over the next two years.

While home prices and construction activity rebounded in 2012, there remains scope for further improvement. At their current level, housing starts are still 40% below their demographically-supported trend of 1.5 million. Starts should rise to slightly over 1 million by the end of 2013 and further to 1.3 million by the end of 2014.

CANADA

Canada's economic growth slowed to a crawl in the second half of 2012, setting 2013 up for a sub-par annual average 1.6% pace. While 2013 got off to a weak start, GDP growth should clock in at 2.1% on a Q4/Q4 basis.

As the fiscal drag in the U.S. abates, a stronger U.S. economy should help boost Canada's export sector and business investment, underpinning a healthier 2.6% growth rate in 2014.

The national jobless rate is likely to hold above 7% in 2013, before heading modestly lower in 2014.

A cooling resale housing market should curb the pace of household debt growth per year, helping to stabilize the debt-to-income ratio, but constraining consumer spending growth over the medium term.

Amid rising inventories of newly completed homes, residential construction is expected to be a soft spot.

Mortgage rule changes often prove to be temporary; after falling sharply in 2012, home sales are likely to stabilize in mid-2013, as low interest rates support demand. Most of the unwinding of a likely moderate over-valuation should occur in 2014-15, as interest rates start to grind higher.

Core inflation is not expected to return to the Bank of Canada's 2.0% target until the end of 2014.

FINANCIAL MARKETS

The decline in global economic tail risks has led to a dramatic improvement in investor confidence.

Risk spreads have compressed as investors have moved into riskier assets in their search for yield and financial market volatility has reached a 5-year low. Corporate profits will advance, but at a single digit pace, creating more upside for equities over the medium term.

Financial stimulus and a persistently low interest rate climate will continue to be defining characteristics of 2013.

The U.S. Federal Reserve is engaged in a third round of quantitative easing, purchasing US$85 billion per month in Treasuries and mortgage backed securities. We expect these purchases to continue until 2013Q4.

The U.S. central bank will be accommodative well after their asset purchase program ends. The Federal Funds rate is expected to remain at current levels until the second half of 2015.

Signs of increased slack in Canada's economy and the recent moderation in household debt growth suggest that the Bank of Canada is likely to remain on hold through the remainder of 2013. At the end of next year, we see scope for a modest 50 basis points in hikes to the Overnight Rate target as economic conditions strengthen.

The price of WTI crude oil is likely to average in the US$90-95 range in 2013. However, oil producers in western Canada will be challenged by a large price discount caused by an inventory supply glut in the U.S. Mid-West.

10-year government bond yields in Canada and the U.S. will likely end 2014 at 2.70% and 3.00%, respectively.