Between the Lines
Jan 23, 2006
Stephen Roach (New York)
I can think of no better way to kick off the year than by indulging in the total immersion of MacroVision. This two-day event -- internal workshops on the first day followed by interactive sessions with clients on the second day -- is designed to challenge every strand of our macro DNA. It is, first and foremost, a time-out from the blur of market and business demands. It provides us with an extended period for real-time debate with our colleagues and clients from around the world. It is a deep drill into the big issues that we believe will shape the global economy and world financial markets in the year ahead.
Over the years -- 15 of them when the event was limited to our worldwide team of market strategists and economists, and now five years that included some of our smartest clients -- we have spent a lot of time refining the drill. The good news is the process works. MacroVision has had a great track record of success in coming up with many a big call. There was “global healing” in 1998-99 and the great “deflation scare” in 2003. Last year, the conclusions were especially prescient -- well-contained inflation, no bond bubble, and the outperformance of European equities. Alas, there were also some important misses in 2005 -- especially, the dollar and oil prices. But the overall score for the calls coming out of last year’s MacroVision was about as high as it gets. That gave the assembled crowd pause for thought in peering into 2006. It’s always tough for groupthink to put together two good years in a row.
I won’t bore you with the details, but we follow a carefully structured process in driving the debate toward actionable investment conclusions. Our internal deliberations start out with a broad list of discussion topics; this year’s agenda included the liquidity cycle, volatility, post-bubble adjustments, inflation targeting, the commodity super-cycle, and the global saving glut. We then spend a good deal of time narrowing and reshaping the results into three thematically-driven issues that we believe will be key in shaping the financial market debate in the year ahead. That sets the agenda for the client day, which this year focused on the following themes:
* Reforms, restructuring, and returns
* Consumer rebalancing
* Global capex boom?
We rely on a form of triangulation in order to boil down the results of MacroVision to their essence. Different groups debate each of the topics from very different perspectives -- first internally and then with clients. The magic of MacroVision occurs in what we call our synthesis sessions, where we bring the entire group together and compare and contrast the findings of the various workshops. This unmasks the tensions in our collective analytics -- the rough edges that often lead to the most powerful conclusions of the exercise. As a global macro junkie, the synthesis exercise has always appealed to me the most.
As I pondered my notes from this year’s MacroVision, I was particularly struck by the interplay between the consumer and the capex sessions. In general, the group was quite upbeat on the US and global consumption outlook. There was little sympathy for my long-standing complaint about the excesses of the asset-dependent American consumer. Few seemed concerned that an income-short consumption dynamic might falter as the housing bubble now started to deflate. Actually, few seem concerned about the US housing bubble, period. As one participant put it, “American consumers will continue to buy -- it’s our way of life.” As long as employment held up, went the argument, so would household spending. The group was nearly unanimous in believing that there was only modest downside to US consumption, at worst. Furthermore, they argued, any such slippage would likely be offset by improved consumption in Japan, Europe, and China. The global consumer was given a clean bill of health for 2006 by the MacroVision consensus. I was truly the skeptic -- on the outside, looking in.
The second thematic conclusion of MacroVision 2006 was equally compelling -- that any global capex recovery was likely to be limited. This was one of our most popular topics this year, and nearly all of our some 65 participants were at one of the two capex sessions. The group felt strongly that businesses in most major economies would remain reluctant to increase productive capacity -- with, of course, the important exception of China. Instead, incremental growth in capital spending was generally expected to be earmarked toward replacement outlays, especially for short-lived IT equipment. Two possible exceptions were noted -- infrastructure -- especially water, roads, and transportation -- and energy exploration and refining. Private equity participants reinforced this view; one noted. “Not one of our portfolio companies is thinking of adding significant capacity.”
Putting these two conclusions together -- solid consumption and modest gains in capital spending -- unmasks what I believe could well be one of the more important inconsistencies of this year’s MacroVision. I have always viewed capex as a “derived demand,” highly sensitive to business expectations of future demand growth. By contrast, I put far less emphasis on those models that treat capex as an autonomous demand -- driven more by business-sector-specific trends in cash flow and profitability. If I’m right -- and if the MacroVision consensus is correct on the consumption outlook -- then the derived-demand approach would argue for a far more vigorous capital spending outcome than the consensus is currently looking for.
A sharp pickup in business fixed investment could have very important implications for the global macro call. For starters, it would mean a much stronger outcome for world GDP growth than most are expecting, with the world economy drawing added support from the twin engines of both consumption and capex. Insofar as financial markets are concerned, an upside global growth surprise could be far more important than a sector-specific conclusion on consumption or capex. Such an outcome could well lead to a sharper cyclical rise in inflation than the consensus is looking for. And that, of course, could turn the financial market climate from benign to malign -- complete with a rout in the bond market, a deterioration in spread markets (credit and emerging-market debt), and more aggressive tightening by the world’s major central banks. As one MacroVision veteran put it, “This would be the ultimate pain trade.”
Such a scenario would also be strikingly reminiscent of the classic boom-bust cycles of yesteryear -- but with an important twist. Over the years, capital spending booms have typically signaled game over for most expansions. The cyclical rise in inflation and interest rates that such an outcome would elicit is invariably the coup de grâce. The trick comes in figuring out the leads and lags. If the investment cycle starts surging, the momentum of project completion is typically hard to arrest. That leads to the traditional end-of-cycle overhang on the supply side of the global macro equation. At the same time, there is good reason to worry about an increasingly fragile demand base. Not only would wealth-dependent US consumers be clobbered by a sharp rise in interest rates, but consumption growth elsewhere in the world may be much slower to move to the upside. All this hints at the possibility of a classic imbalance between global supply and demand. The twist comes on the price front. Even in the context of a possible cyclical pickup in inflation, the peak inflation rate in this cycle is likely to be quite low -- possibly no higher than 3% in the industrial world. As a consequence, in the bust that follows, the ensuing cyclical deceleration of inflation could well result in another deflation scare.
That possibility was not on the radar screen of this year’s MacroVision participants. As usual, we did a fair amount of polling of the group’s macro expectations over the next year. As can be seen in the accompanying table, the consensus was focused on another Goldilocks-like outcome for the real economy and financial markets -- limited interest rate risk, a modest rise in the stock market, a slight weakening of the dollar, and another year of outperformance by emerging market equities; among the developed-world equity markets, Japan was the favorite, followed by the US and Europe in that order. Like most of our macro polling these days, the group had a very autoregressive perception of the outlook -- extrapolating mainly on the basis of the latest trends. These are the polling results that always worry me the most -- momentum-driven scenarios that are not based on deep convictions. Should the story change for any reason, such a fickle consensus would undoubtedly head quickly for the exits -- a classic set-up for sharp and disruptive adjustments in financial markets.
MacroVision 2006 Polling Results
MS Macro Team
Fed funds rate
5.0% or higher
10-yr Treasury yield
10-yr German bund yield
Dollar-euro cross rate
1.25 to 1.30+
Yen-dollar cross rate
Oil price (WTI)
1300 to 1400+
China industrial output
13% or lower
13% or lower
US C/A deficit, % GDP
Best performing asset
The MacroVision consensus was quite accurate in calling financial markets in 2005. The crowd at this year’s gathering is positioned for an equally benign outlook for world financial markets in 2006. But the most intriguing conclusion was between the lines -- the implied risks of an upside surprise to global growth and a more cyclical outcome for the markets. My baseline call for global rebalancing has never felt lonelier. As we passed in the halls, many of the clients had a hard time making eye contact with me. Was it the height of complacency or well-founded optimism? We’re about to find out.
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Bullish on Capex
Jan 23, 2006
Richard Berner (New York)
Investors and CEOs alike are skeptical that a sturdy upswing in US capital spending is sustainable. At our MacroVision conference last week, for example, most investors conceded that continued growth in outlays to maintain and repair existing facilities was likely, but hardly any thought that companies would begin spending on expansion, and almost certainly not in the US. That seems inconsistent with their apparent optimism on global growth (see Steve Roach’s accompanying dispatch, “Between the Lines,” January 22, 2006).
As Steve notes, there is a strong tendency to extrapolate recent trends in our polling exercises, but there is also small wonder about this particular prognosis: The global investment revival in the current expansion has come up short in several respects, caution still seems to pervade the executive suite, and outsourcing remains a competitive issue. To be sure, US outlays for equipment and software rose by about 10% in 2005, and over the 11 quarters since capital spending bottomed, real equipment outlays rose by 30.9%. But that increase is only about 75% of the typical cyclical advance in past expansions. And US real outlays for business structures, after plunging by 26% in recession, have risen a scant 7% in the past three years.
My global colleagues are addressing the non-US capex conundrum elsewhere. For the US, however, I think a mix of four macro and micro factors will likely add up to hearty and sustained capital spending growth: Pent-up demand for capital goods remains strong; rising operating rates and the returns and pricing power that accompany them have reached the point where investing to add capacity makes sense; investors are starting to reward managers for growth as well as returns; and the surge in energy prices has made “old capital” obsolete and spurred the need for new, more energy-efficient equipment and facilities.
In my view, a reservoir of pent-up demand will continue to make the capital spending upswing sustainable. The logic: Aggressive actions by Corporate America to eliminate the post-bubble headwinds of overinvestment — not just in information technology (IT) but in basic industrial and transportation equipment as well — went too far, just as the excesses themselves went too far in the other direction. Pent-up demand then fueled the “maintenance and repair” capital-spending revival, first in IT, and increasingly in traditional industrial equipment. (It’s worth noting that bonus depreciation incentives pulled demand for longer-lived equipment ahead into 2004 at the expense of 2005, so growth in industrial equipment outlays fell last year to about 3-4% compared with 10.6% in 2004.) Moreover, as I see it, far from indicating that it will peter out, the disciplined approach to capital spending in this expansion means that it will last longer. It has restrained the growth of capacity below that of output, and capex is therefore not eroding margins or returns. As a result, both capacity and operating rates have a long way to go, and the expansion phase for capital spending is only just beginning.
Ideally, to measure pent-up demand for capital, we’d like to compare the stock of capital in relation to output, using capital/output ratios consistent with fundamentals. Lack of adequate macroeconomic data still precludes such calculations. But a look at capex-to-depreciation ratios, adjusted for inflation, hints at the dynamics of such analytics. When capex falls close to depreciation, the capital stock is barely growing, and the capital/output ratio is falling. Looking at such ratios for computers and software and for other equipment investment helped us identify what I’ve called Phase I (in IT) and II (in industrial equipment) of this ‘maintenance and repair’ spending revival. And while they’ve come well off their lows over the past three years, both are still below historical norms and thus signal that pent-up demand will last at least through 2006.
Rising operating rates are a second reason why capital spending likely will grow strongly in the coming year. Spending for expansion typically begins when operating rates start to rise above historical norms, and that time has now come. In industrial America, overall operating rates moved above their long-term average in December, and the 670 basis point increase from the trough four years ago is the second-biggest gain in the history of the data. The gains are more impressive outside technology and motor vehicles.
The reason for this dramatic rise, despite moderate gains in industrial output in this expansion, is capital exit and capital discipline. Companies hit by the combination of overinvestment and the 1997-98 crash in Asian currencies are shedding underperforming businesses and older, less productive capital via depreciation. Consequently, for example, manufacturing capacity outside IT and vehicles is 1.2% below its level in 2001. That discipline and the resulting better balance between supply and demand at both the industry and the micro level is a key reason why companies have been able to exploit the operating leverage in their businesses, boost returns back to record levels, and regain lost pricing power.
To be sure, capital discipline and the associated improvement in operating rates are far from ubiquitous. In IT, especially in semiconductors and communication equipment, a recent sharp pickup in capacity expansion has aborted a rise in operating rates; in the former, the growth rate in 2005 tripled to more than 38%. In motor vehicles, of course, rapid capacity growth reflects the more secular invasion by overseas nameplate manufacturers into the large and lucrative American marketplace. As a result, high returns and pricing power are absent in all of these industries. Moreover, of course, service-producing industries account for about two-thirds of US output, and some of these also suffer from excess capacity, although metrics for operating rates in services are hard to come by. But unpublished data on capital stocks and the improvement in pricing power in most of the 44 services industries for which there are producer price indexes suggest that here, too, corporate spending discipline has reduced or eliminated that excess and improved returns.
A third factor likely to boost capital spending growth is that the market is beginning to reward managers for growth as well as for hiking returns. Investors have until recently rewarded CEOs far more for boosting returns on invested capital than for growth, and rightly so: In the 1990s, overemphasizing growth eroded returns. That was then. Capital allocation is still critical, but investors are now demanding that companies, especially large and complex ones, divest and invest. As my colleague Henry McVey and the equity strategy team show, growth is trumping capital allocation in the marketplace. For example, the strategy team shows that the capex-sales ratio, which was a great barometer for identifying the future underperforming ‘capital pigs’ of the late 1990s, is now at the top of the list of factors that are working in the S&P 500 universe. Operating margins and dividend yields have sunk to the bottom of the list.
Not surprisingly, the market rewards factor is the one that resonates most with investors. With hurdle rates at 13.4% and the weighted-average cost of capital at most in the 7-8% range, it is dawning on investors that the companies they own can afford to be more balanced in their approach. Similarly, as Henry points out, the ROE spread over corporate debt is now at a 50-year high (see his “Phase II,” January 5, 2006). Indeed, activist shareholders, many of them financial sponsors, realize that companies are under levered and can boost returns not just by changing the capital structure, but also by using leverage to reposition businesses and finance new projects.
The final factor likely to nurture a strong capex expansion is the sharp rise in energy prices in relation to prices generally. That has made old, energy-inefficient capital, especially transportation equipment, obsolete, and has sharpened the incentives for companies to buy more new, fuel-efficient gear. Other, more prosaic examples abound: Those now-ubiquitous flat-panel computer screens have come down in price, take less space, use less power, and need less power to cool the rooms in which they are located than did their tubular predecessors. And solar energy panels aren’t just for homeowners; commercial use is soaring.
The recent history of so-so capital spending growth and perceived CEO caution are seen as obstacles to a healthy capital spending expansion. A typical comment from investors: “The expansion is four years old. If [the pickup in capex growth] was going to happen, it would have already.” But there are two additional hurdles. The first is outsourcing: Even if US operating rates are reviving, there is a presumption that capacity is more than ample globally, and it is cheaper to outsource facilities abroad. But it’s worth noting that the logistics of global supply chains argue for a portfolio of investment venues; unadorned cost considerations are not the sole criterion for deciding where to locate facilities. In addition, it’s worth remembering what Steve Roach calls the “global delta:” Slower growth in much bigger markets is still critical to corporate performance. Likewise, the fact that the flow of US foreign direct investment abroad (measured by the change in positions) amounts to only 14% of US capex is a crude but suggestive metric to set the scope of outsourcing in perspective.
The second hurdle: Uncertainty regarding domestic demand could restrain capex. After all, as Steve Roach correctly notes, expected business growth is a key ingredient in the willingness to invest. If “animal spirits” or actual demand growth were to falter more than temporarily, slower growth in investment would probably follow. On that score, the 6-point uptick in the Conference Board’s fourth-quarter CEO confidence index hints at stepped-up spending. And the strong level of survey-based capital spending plans — for example in the National Association for Business Economics’ latest industry survey — also signals healthy growth.
There can be no mistaking the risks to the capex expansion, some of which are derived from macro threats to overall growth. Curbs on supply that boost oil quotes could both slow growth and add to uncertainty (see my piece with Eric Chaney, “Oil Price — Tight Markets + Geopolitics = Upside Risks,” January 18, 2006). Rising interest rates could also slow growth. But solid fundamentals, rising CEO confidence, and market rewards are powerful capex tailwinds. And inward direct investment into the US is on the rise again, pointing to renewed interest by global companies in the US marketplace.
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Review and Preview
Jan 23, 2006
Ted Wieseman (New York) and David Greenlaw (New York)
Treasuries posted marginal front-end led losses over the past week as a solid run of economic data pointing to a robust industrial sector, an improving job market, and a mild pickup in underlying inflation along with hawkish Fed-speak (certainly, at least, relative to current market pricing, if much less so in an absolute sense compared to prior Fed rhetoric) were mostly offset by weakness in stocks and a surge in energy prices on geopolitical concerns. Contrary to the market pricing of a Fed that likely reaches a 4.75% funds target in March and then quickly turns around and begins cutting rates from mid year, the unanimous message from an active roster of Fed speakers the past week was that, while the FOMC may be approaching a pause in the rate hiking cycle, it would be a pause with a tightening bias, as upside risks to inflation, driven by rising resource utilization and the potential for further pass-through of higher energy prices to core inflation in an economy operating with little or no slack, were unanimously seen as the main risk to the outlook this year.
And the data released the past week provided some modest reasons for increased anxiety from the Fed on this score, with the industrial capacity utilization rate moving above its long-term average and core CPI continuing its recent mild acceleration. In addition to the CPI report, the most noteworthy releases the past week probably were those giving early indications for key early reports in January. With the early regional manufacturing surveys showing significant strength on an underlying basis and jobless claims during the survey week for the employment report bucking what had looked like a tough seasonal factor to plunge to a six-year low, early signs point to solid results from the upcoming employment and ISM reports.
Benchmark Treasury yields rose 1 to 3 bp the past week, continuing the very muted start to this year after similarly meager rallies posted over the prior two weeks. Indeed, so far in 2006, the 10-year yield has held in a narrow 4.29% to 4.46% range, as investors seem to be waiting for some direction on the economy and policy beyond the universally expected rate hike on January 31, with the February 15 monetary policy testimony by incoming Fed Chairman Bernanke being looked ahead to most keenly.
Opposing forces largely offset each other the past week to keep the market from doing much. On the one side, economic data were generally market negative, with at least mild sell-offs following releases of the Empire State, IP, CPI, jobless claims (which, surprisingly in this housing focused market, received much more attention than a simultaneously released sharp drop in housing starts), Philly Fed, and University of Michigan reports.
Fed-speak also was hawkish, at least relative to market pricing, even if it was perfectly consistent with previous policy statements and speeches. A busy calendar of Fed speakers, including regional Presidents Lacker, Fisher, Guynn, and Yellen and Governor Bies were uniform in expressing an upbeat outlook for the economy this year, while stressing inflation as the main risk to the FOMC’s central case of a benign outcome for the coming year. This was nothing new compared with the most recent FOMC statement or Fed speeches, which have made clear that, while the FOMC may be about to go on hold in its tightening campaign, the pause will be with a tightening bias and a vigilance against signs of accelerating inflation. Obviously, this is in sharp contrast to the market’s pricing of a switch to rate cuts after midyear. While the data and Fed speakers put some pressure on the Treasury market through the week, ultimately this was mostly offset by activity in other markets — with the S&P 500 falling 2% and February oil jumping 7% to over $68 a barrel on geopolitical concerns over Iran and Nigeria — and investors’ ingrained pessimism on the economic outlook.
This all netted out to only a marginal rise in yields on the week and a slight flattening of the curve, with 2’s-30’s down 3 bp and 2’s-10’s down 2 bp (to exactly zero), with the 2-year yield up 3 bp to 4.36%, the 10-year yield up 1 bp to 4.36%, and the long bond yield up half a bp to 4.53%. With the 3-year yield up 3 bp to 4.31% and the 5-year yield up 2 bp to 4.30%, the 2’s-5’s inversion hit a new cycle low, and this was associated with new extremes in the mid-2006 to mid-2007 eurodollar futures curve inversion. The data and Fed speakers led the market to price in a little more near-term tightening, with the April fed funds contract off half a bp to 4.645%, and the June 2006 eurodollar contract losing 1.5 bp to 4.795%. But, with the June 2007 contract rallying half a bp to 4.59%, the June 06 to June 07 spread flattened 2 bp to -20 bp (after hitting an all-time low of -21 bp midweek). The spread between the June 2006 contract (the highest yielding near-term) and September 2007 contract (the low rate) similarly flattened 2.5 bp on the week to -22.5 bp as the latter rallied 3.5 bp to 4.57%.
Economic data released the past week pointed to continued strength in the industrial sector, a mild pick-up in underlying inflation, continued cooling in housing market activity from extremely strong levels (with starts down 9% in December to 1.93 million, in line with other housing data showing moderation, but probably at least partly exaggerated by the unusually cold weather in December), and strength in the job market that seems to be translating into improved consumer attitudes. In the factory sector, industrial production rose 0.6% in December, boosted by a weather-related jump in utility output (+2.7%) and a further post-hurricanes recovery in mining (+2.5%), a category that is mostly oil and gas drilling. The key manufacturing gauge gained a less than expected 0.2%, but the softness was fully attributable to a surprising 2.8% drop in motor vehicles, as assemblies appear to have significantly undershot initial plans after a late month drop off. Ex autos, manufacturing production gained a solid 0.4%, led by upside in high tech, chemicals, and machinery. The overall capacity utilization rate rose four-tenths to 80.7%, while the manufacturing rate was steady at an upwardly revised 79.6%, both more than five-year highs, and both slightly above the averages recorded over the past thirty years of 80.6% and 79.4%, respectively, indicating the industrial sector is currently operating near full normal capacity. This, along with the recent drop in the unemployment rate to 4.9%, close to, if not beyond, where the general consensus would peg normal full employment, certainly supported the worry expressed in the most recent FOMC statement that “possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.”
And the CPI report for December did indeed continue to point to a mild acceleration in core inflation. The core CPI rose 0.2% for the third straight month, with the year/year rate ticking up to +2.2%. Beyond the tightening resource utilization in the economy and attendant increase in pricing power that argue for a more fundamentally based uptrend in inflation going forward, the unwinding of some apparent technical and sampling quirks over the past few months that had previously, in our view, artificially depressed core CPI seems likely to continue going forward.
First, CPI hotel rates rose 0.9% in December and are now up about 25% annualized over the past three months. The latest gains appear merely to reflect some catch-up after a run of strangely depressed readings around mid-year that were apparently distorted by a bad sample. Note, though, that even with the recent surge, CPI hotel rates are running only +3.5% year/year, while private industry surveys show rates up 7.5% and accelerating. We believe that the distortion in the hotel category is still shaving about 0.2 percentage points from annual core CPI inflation and expect this quirk to be unwound in the months ahead.
Second, the key owners equivalent rent category — which accounts for a significant 30% of the core CPI — came in a bit above trend in December at +0.3%. This modest elevation appeared to reflect the quirk that we have been highlighting for some time involving utility prices. In calculating OER, in cases in the rent sample where utilities are included in monthly rent checks they are backed out in order to derive a measure of “pure” rent that forms the basis of the OER measure. Utility prices fell 1.7% in December on the heels of some sharp increases in prior months. So, in this case, falling utility bills put some upward pressure on OER, and given the recent collapse in natural gas prices from the December peaks, this appears likely to continue going forward, further closing the gap between rent (+3.1% year/year) and owners’ equivalent rent (+2.5%). And, underlying rent itself appears poised for some acceleration. Apartment vacancy rates have been declining, and apartment REIT stocks have certainly pointed to improving business conditions, with Bloomberg’s apartment REIT index posting a total return of 30% over the past year.
We continue to look for the core CPI to drift up by a few tenths of a percentage point over the next year — from +2.2% to +2.6%. Further unwinding of technical quirks and sampling problems in OER and hotels could pretty much accomplish that alone — never mind the more fundamental case for a true underlying acceleration as continued above-trend growth strains resources in an economy that currently seems to be operating at basically full normal capacity.
Looking ahead to the next round of key data in the first week of February, reports released the past week pointed to solid results from the employment and ISM reports for January. Although the volatile headline sentiment measures in the Empire State and Philly Fed manufacturing surveys weakened in January, the, in our view, much more important underlying activity measures were robust. ISM-comparable weighted averages of the key activity gauges (orders, shipments, employment, deliveries, and inventories) rebased to a 50-breakeven level showed the Empire composite rising to 58.7 from 57.0, the highest reading since August, and the Philly rising to 56.3 from 53.0. Our preliminary forecast for the national ISM is a rise to 55.0 in January from 54.2 in December. Meanwhile, jobless claims plunged 36,000 in the week of January 14 — the reference week for the January employment report — 271,000, a six-year low, taking the 4-week average down to 299,000, the first sub-300 reading since October 2000. And continuing claims in the prior week fell 158,000 to 2.534 million, the low since the recession began in March 2001.
While there seems to have been some unusual seasonal volatility recently in these numbers that’s not unusual around this time of year (though it had appeared to us that the seasonal factor for initial claims this week actually should have biased the figure to the upside), in our view these results were clearly very encouraging. Our preliminary forecast for January payrolls is a rise of +250,000, with unusually warm weather during the survey period likely to provide a boost. And consumers certainly seem to have been cheered by the improving job market situation, along with the recent retracement in energy prices (though we believe the latter is clearly going to be moving in the wrong direction again given where wholesale prices are), as the University of Michigan’s consumer sentiment index for early January rose another 2 points, to the highest reading since July, bringing the cumulative surge off the post-Katrina trough to nearly 20 points.
There is a fairly busy calendar in the coming week of economic reports, though nothing that seems likely to do much to shake the market out of its recent narrow ranges. Supply will also continue to be a focus. In addition to the ongoing flood of corporate and asset backed supply, there should be another $30 billion in Treasury coupons in the coming week — $10 billion in 20-year TIPS Tuesday and an expected $20 billion in 2’s Wednesday — ahead of another estimated $49 billion in 3’s, 10’s, and 30’s at the quarterly refunding in a couple of weeks. Economic releases due out in the coming week include leading indicators Monday, existing home sales Wednesday, durable goods Thursday, and GDP and new home sales Friday:
* A sharp jump in consumer confidence together with positive contributions from the money supply, stock market, and unemployment claims should lead to a 0.2% gain in the index of leading economic indicators in December. If our estimate is close to the mark, the cumulative 3-month rise would be the highest in more than one and a half years.
* We forecast December existing home sales of 6.90 million units annualized. The recent pullback in the pending home sales index points to a further 1% dip in resales on the heels of a cumulative decline amounting to about 4.5% during the October/November interval. Still, the expected sales pace would be above the year ago level. Moreover, resales during all of 2005 increased about 5% versus a strong 2004.
* We look for a 0.2% rise in December durable goods orders. The volatile aircraft component was responsible for all of the sharp 4.4% gain in November durable goods orders. While one might normally expect to see some pullback on the heels of this type of performance, company data actually point to a further rise in aircraft bookings during December.
Otherwise, survey results point to a bit of moderation in the underlying pace of order activity. We look for only a slight rise in the key core category — non-defense capital goods excluding aircraft.
* We forecast Q4 GDP growth of 3.1%. A significant inventory rebuild, on the heels of outright drawdowns in both Q2 and Q3, should help support GDP growth in the fourth quarter. Meanwhile, the demand side of the economy suffered from the hurricane-related energy shock that hit at the end of Q3. Indeed, final demand is expected to be up only 0.3% with consumer spending posting just a fractional gain. However, given the pick-up in consumption over the course of the quarter, the ramp is very favorable heading into Q1. So, it would certainly be premature to count the consumer out on the basis of the Q4 results, in our view. On the price front, the overall chain weight index should be up 2.7% — close to the trend seen over the past year or so. Finally, the core PCE price index is expected to be +2.0%.
* We predict December new home sales of 1.25 million units annualized.
The monthly survey of homebuilders has shown a significant decline in sentiment over the course of the past few months. This points to some underlying deceleration in the pace of new home buying. However, the new home sales figures displayed some unusually large gyrations during October (+11.4%) and November (-11.3%) and we expect to see some flattening out in December.
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The Painful Retrenchment of Manufacturing
Jan 23, 2006
Vincenzo Guzzo (New York)
More disappointment. Earlier this week, National Statistics ISTAT released another disappointing industrial production report. Below expectations, industrial production stayed broadly stable in November (+0.1%M). The result was particularly worrying as it came after a cumulative 2.3% decline in the September/October period, putting an end to the favorable mini-cycle recorded over the summer months. The outcome was even weaker for the manufacturing sector (-0.1%M) as a large positive contribution to the monthly outcome stemmed from energy output (+2.4%M). Quarterly carry-over growth for manufacturing output in Q4 is now -1.8%Q, the sharpest deceleration since the 2001 recession. Even if the sector were to post a smart rebound in December, its contribution to overall economic activity during the last three months of the year would be heavily negative. These grim prospects introduce downside risks to our already cautious forecast of flat Q4 GDP growth. In other words, activity in Italy might have contracted again, the third time this would have happened over the past five quarters.
Two questions arise. First, how do these numbers reconcile with evidence of more upbeat sentiment among Italian manufacturing firms, as reported by several business surveys? Second, why is Italy performing so poorly, whereas the recovery in the rest of the continent — particularly in Germany — appears to have moved to a higher gear? Let us start tackling the first question. The overall business climate among manufacturers as gauged by the ISAE business survey averaged 90.3 in Q4, that is, 2.4 points or one third of a standard deviation higher than that observed over the previous months. While the indicator measuring the assessment of current output moved up by relatively less, it certainly did not anticipate such a large downward correction in production. Other surveys provide similar evidence, raising doubts about the alleged predictive power of these sentiment indicators.
Trying to reconcile hard with soft data: the role of revisions to past data. Some of the surveys often monitored by economists and financial market participants might be skewed towards the large-cap universe and thus benefit from the current prolonged upswing in the stock market. This is not applicable to the ISAE business survey, however, in that gathering information from a broad panel of over 4,000 firms operating in the manufacturing sector provides a comprehensive assessment of business conditions also among small and medium enterprises, not as exposed to the moods of financial markets. Three other possible explanations lie behind the apparent disconnect between soft data — firms’ assessment — and hard data — actual production. First, hard data tend to go through substantial revisions. Examples abound. Drawing from the most recent experience, in October ISTAT altered significantly the industrial production profile. Particularly large adjustments affected March and June data. As a result, the index was all of a sudden two full percentage points higher than previously estimated. Revisions could play a role again.
Industrial action might have played a role too. Second, four hours of general strike on November 25, as unions took to the street to protest against some of the measures contained in the 2006 budget, certainly weighed adversely on output. As usual, data on the strike differed substantially across sources and it was hard to assess the actual magnitude of the event. Yet, half a day of missed output out of the 21 working days in the calendar for November is probably a noticeable loss. One could easily argue that in a system that operates below full capacity as in Italy at present production could catch up over the following days. Nevertheless, even if we assumed that only 50% of the output of the day was lost, this would translate into a monthly drop in industrial production in excess of one percentage point relative to baseline. If this is true, then output will probably rise in December, although, as we said, even a significant rebound would leave industrial production on track for a sizeable quarterly contraction. Third, while business sentiment has indeed improved over the past few months, the assessment of current as measured by the survey in November was still slightly below the long-term average.
Behind the ‘decline’. Let us move to our second question. Why is Italy performing so poorly, whereas the recovery in the rest of the continent — particularly in Germany — appears to have moved to a higher gear? One point should be clear. Italy’s troubles are structural, not cyclical. In thirteen of the past fourteen years, Italy has underperformed the euro area, let alone the global economy. The country’s export performance, measured as the ratio between export volumes and export markets for goods and services, has declined by forty percentage points in ten years. Its manufacturing sector, which until 2001 had moved in synchronicity with its European peers, has since departed. In my view, five factors lie behind Italy’s structurally low growth: poor demographics, sizeable public debt services costs, unfavorable product specialization, continued loss of competitiveness and high services prices.
Natural selection process to continue. I think that the painful fall in manufacturing output volumes will continue in 2006. Italy is still highly specialized in traditional, low-growth, low-tech sectors such as leather, textiles, clothing, and ceramics. Not only has the economy concentrated with time a large share of its manufacturing output in these areas, but also the weight of these sectors has become comparatively bigger in the nineties. For a long time, the relatively cheap labor cost offered the country a competitive edge. Globalization has now meant the end of that growth model. While high value added players might be passing the test of international competition, the still large share of low value added ones that used to excel in the past is succumbing to international competition. This sort of Darwinian process of natural selection might still last for years.
The important role of politics. A shrinking manufacturing sector places an increasing burden on services and focuses more attention on the country’s high services prices, another often-cited malaise affecting the Italian economy. Businesses and professions sheltered from global competition keep enjoying fat margins at the expense of consumers and other sectors that have to confront that same competition. In a monetary union, where competitive devaluations are not on the menu any longer, the only way to regain competitiveness is through relative price adjustments. Germany has made progress through wage deflation. In Italy, where wage levels are comparatively low, competitive disinflation will more likely come from smaller increases in the prices of services. Politics might make this whole process less painful by restoring market forces in all those places where they would naturally belong.
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