Razor-Edge for Risk-Assets
Apr 11, 2006
Joachim Fels (London)
Conundrum solved
With global bond markets in bearish mood and 10-year benchmark yields approaching the 5%, 4%, and 2% thresholds in the United States, the euro area and Japan, respectively, Alan Greenspan’s interest rate conundrum is in the process of being solved. Central bankers, analysts and journalists almost fell over each other trying to explain the supposed conundrum last year — why had US long-term bond yields remained so low or even fallen further after the Fed started its successive interest rate normalisation campaign in mid-2004? Some claimed it was due to strong demand for long-term bonds from Asian central banks, pension funds and life-insurers. Others thought it reflected the death of macro-economic volatility and surprises due to much more credible and skilful central bank policies. And others yet, including Alan Greenspan’s successor Ben Bernanke, attributed the conundrum to a global savings glut, especially in Asia and the Middle East, which supposedly depressed real interest rates. Back then, I was sceptical of these explanations, as they didn’t really fit the stylized facts, and the recent significant rise in bond yields makes these explanations look even less convincing now, in my view. If excess savings or central bank credibility were the reason for low bond yields, have they evaporated all of a sudden? If Asian central banks and pension funds had such a strong appetite for long-term bonds, why did yields rise in the first place? And where are these buyers now? Global excess liquidity was the answer I remain convinced that the main explanation for the conundrum was global excess liquidity, which was pushed into the financial markets by the G-3 central banks. True, the Fed had started to normalise interest rates. But throughout last year, the Fed funds rate still remained below neutral and, more importantly, the ECB and the Bank of Japan where at the pump, keeping short rates extremely low. As I argued in a piece published before Alan Greenspan coined the ‘conundrum’ phrase, even if the Fed kept tightening, the ECB and other central banks would take over as providers of excess liquidity (Liquidity Springs Eternal, 17 January 2005). As I see it, global excess liquidity was the only explanation that was consistent with the synchronised global rally in virtually all asset classes, not only bonds. And the fact that bonds are now selling off as the Fed has moved beyond neutral since the start of the year, the ECB has started to normalise rates, and the Bank of Japan is preparing its exit from ZIRP, lends further credibility to the excess liquidity explanation for what happened last year. Liquidity is now becoming less plentiful as global short term interest are rising and hence bonds are selling off. A new puzzle: risky asset are still flying high However, just as the conundrum dissipates, a new puzzle has emerged. Despite the rise in short-term interest rates and the sell-off in global bond markets, risky assets are still shining. Equities have rallied further, the yields of low-rated corporate bonds (formerly known as ‘junk’ or ‘high yield’) have fallen further with their spread to safer paper shrinking closer towards historical lows, emerging market debt and equity markets are doing well generally despite some jitters here and there, and commodities — especially metals — are rallying, too. Normally, higher interest rates should make it more difficult for risky assets to rally as the discount factor for expected dividends is rising and as higher long-term bond yields and money market interest rates make investments in these safer assets more attractive. But the opposite appears to be happening right now, with investors eager to take on more risk in a rising interest rate environment. A new puzzle? It must be growth: goldilocks is back This puzzle is easier to solve than the conundrum: the only logical explanation for the apparent dichotomy between bearish bond markets and bullish markets for risk-assets is that investors are making a big bet on the continuation of strong global economic growth. Incoming economic data from many countries suggest that the global economy had an excellent start into 2006, following a slightly disappointing last quarter of 2005. With many institutions revising up their growth estimates for the global economy recently, more and more investors are becoming convinced that growth is here to stay. Central bankers appear to be in the same camp: both the Fed and the ECB are on record with fairly upbeat assessments of the growth outlook. Against this backdrop, the rally in risk assets and the simultaneous global rise in real bond yields are not that puzzling at all — they fit the growth explanation. Note that while real bond yields have risen, inflation expectations in the bonds market have remained broadly unchanged. Hence, investors are betting not only on strong growth but also on a continuation of the low inflation environment. It’s goldilocks all over again! The razor’s edge for risky assets In my view, risk-assets will have a tough time rallying much further this year. I hasten to emphasize that the reason for my bearishness is not the supposed end of the so-called yen carry trade, which has been much-discussed in recent weeks, for two reasons. First, the empirical evidence for a sizeable yen carry-trade is extremely thin. Cross border bank lending statistics published by the Bank of International Settlements (BIS) do not support the notion that there has been much cross-border borrowing going on in yen in recent years. The share of cross-border bank lending denominated in yen has fallen steadily from about 12% of total cross-border lending to only just above 4% recently. Second, with expected double-digit returns in emerging markets and equities, it is simply not very convincing to claim that a rise in Japanese short-term interest rates from 0% to, say, 0.5% should make the carry-trade much less attractive. My worry is thus not the end of the carry trade, but it is growth. More precisely, growth would have to follow a razor’s-edge like path -- neither too hot nor too cold -- in order for risk-assets to continue to do well. If growth were to accelerate from its current strong path, central banks would worry more about rising resource utilisation and inflationary pressures and would push short rate significantly higher. This would eventually undo the rally in risky assets because global liquidity conditions would move from less abundant to tight. Conversely, if growth slows significantly in the course of this year, risk-assets would sell off, too, as the buoyant growth expectations embedded in current prices would be disappointed. To sustain the current ‘nirvana’, growth would have to slow at best slightly and chuck along at around its trend path, inflation would have to remain low, and the Fed would have to stop tightening before long. This scenario cannot be excluded, but I find it too good to be true. My most likely scenario: growth falters, bonds rally, risk-assets sell off My own scenario for global asset markets this year remains unchanged from my 2006 outlook piece last December (see The Passing of the Batons, 8 December 2005). Following a climb higher in global bond yields and a good period for risky assets in the first half of the year, I see global growth slowing, led by a US slowdown, and the Fed ending its tightening campaign and switching towards an easing bias. This would spark a rally in bonds and mark the end of the outperformance for risky assets. The US yield curve would steepen in a bullish move, and US bonds would outperform European and Japanese bonds. The main risk to this view is that global growth remains strong, which would lead to a further tightening by central banks and a continued sell-off in bonds. But even in this scenario, risk-assets should suffer as liquidity would successively be drained and money market funds and bonds would become more attractive as interest rates rise. Thus, unless they are confident that the global economy can continues to move along the razor’s edge of neither too hot nor too cold growth and low inflation, investors should be cautious on risk-assets and stay closer to shore.
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Adjustment Pain
Apr 11, 2006
Serhan Cevik (from Tunis)
Structural changes and institutional bottlenecks limit the pace of employment growth. Political consolidation and macroeconomic normalisation have helped to make Turkey one of the fastest growing countries in the world. As real gross domestic product surged by 33.5%, on a cumulative basis, in the past four years, per capita income increased from $2,146 in 2001 to $5,008 last year. Even slow-moving socio-economic variables, like poverty rates and income distribution, have shown gradual, but sustained improvements (see Less Misérables, March 8, 2006). Nevertheless, traditional, labour-intensive sectors struggle against increasing competitive pressures in today’s low-inflation environment and contribute to the discouraging state of the country’s labour market. The unemployment rate, for example, after improving, on a seasonally adjusted basis, to 9.9% at the end of 2004, increased to 10.6% last year. In our view, the prolonged phase of ‘jobless growth’ is a result of global labour arbitrage — yes, it affects even developing countries — and, more importantly, structural adjustments and institutional bottlenecks in the Turkish economy. The economy is struggling to create enough jobs for Turkey’s growing workforce. The latest figures give mixed messages on the state of the labour market. The number of employed, following a 5.1% rise in 2004, increased by just 0.3% to 21.9 million last year, while the 1.0% growth in the workforce caused an increase in the number of unemployed from 2.4 million to 2.6 million. Even so, a drop in the labour-force participation rate — the percentage of population either working or seeking work — was still enough to ‘improve’ the average unemployment rate by 10 basis points to 10.2% last year. The participation rate, on a downward trend since the 1950s, has indeed become the crucial factor in analysing labour-market developments. As the pace of job growth slowed last year, we witnessed a substantial increase in the number of ‘discouraged’ workers to an all-time high of 2.0 million. Therefore, a broader definition of the jobless rate, including withdrawals from the labour force, worsened from 13.8% in 2004 to 17.4% at the end of 2005. But why is Turkey, while experiencing the longest stretch of economic expansion, struggling to create jobs? Like many other issues in economics, there is no single-variable explanation. First, structural changes, which are in fact encouraging for the longer run, slow the pace of employment growth in the short run. Second, there is a widening mismatch between the average educational attainments and the needs of Turkey’s developing industrial complex. And third, institutional bottlenecks keep the economy’s labour absorption capacity at a mere 15% of the increase in working-age population. Capital-intensive production models partly reflect the changes in relative factor prices. With technological advancements and an expanding network of global manufacturing bases, more and more Turkish companies have adopted capital-intensive production models over the course of the last four decades. Furthermore, Turkey’s improving economic prospects in the post-crisis era and favourable global conditions have led to a dramatic decline in the cost of capital. In turn, responding, in a rational manner, to the changes in relative factor prices, the corporate sector has accelerated the pace of capital deepening, raising machinery and equipment purchases by a staggering 196.8% in real terms. Although this limits the demand for labour input, at least in the short run, it is still not enough to explain the rise in capital/labour ratios beyond what the state of the labour market suggests. In our view, arbitrary ‘adjustments’ in the minimum wage, reaching over 53% in real terms in the last four years, resulted in a distortionary increase in the marginal cost of labour relative to the cost of capital and thereby encouraged firms to substitute capital for labour as well as to globalise their supply chains. The factor substitution process is, of course, far more powerful in labour-intensive sectors and, as a result, limits employment growth, particularly, among low-skilled workers (see Capital-Labour Substitution and Jobless Growth, April 23, 2004). The shift from labour-intensive industries to capital-intensive sectors is a drag on job creation. Productivity growth, initially coming on the back of cyclical factors, is now a structural phenomenon, in our view. Greater openness and macroeconomic stabilisation intensify competitive pressures and force businesses to become more efficient in order to keep production costs low. As a result, labour productivity, measured by output per hour worked, has increased by 38.5%, on a cumulative basis, in the post-crisis period. However, there are significant industry- and firm-level divergences in productivity growth stemming from managerial shortcomings and technological backwardness. Especially, traditional, labour-intensive sectors of the economy struggle with lower productivity and higher unit labour costs. For example, the average return on equity in the clothing industry declined from 12.0% in 2002 to 5.9% in 2003 and 1.6% in 2004 (see Of Lemons and Dinosaurs, March 1, 2006). And as one would expect, declining profitability in labour-intensive industries is now promoting a shift towards capital-intensive manufacturing sectors and services and consequently changing the composition of employment. Agriculture and manufacturing sectors are no longer a silo of low-paying jobs. Along with structural adjustments in manufacturing sectors, employment in the agriculture sector declined by 15.9% in the past four years. As a result, the sector now accounts for 27.0% of total employment, down from 35.2% just a couple of years ago. The adjustment phase may be painful for certain segments of the society, but given Turkey’s extremely low farm productivity, these changes, if proved sustainable, will no doubt bring a new dynamism to the economy. Indeed, we are already seeing early signs of factor reallocation. Non-farm employment, for example, increased by 17.1% and led to a marked drop in the non-farm unemployment rate from 15.1% to 13.7% last year. In other words, the economy is creating jobs, but the composition is changing in line with the changes in Turkey’s economic structure away from low-skilled, low-paying jobs. This is why, in order to raise the demand for labour, the authorities need to introduce reforms that would reduce the productivity-adjusted cost of labour relative to the cost of capital in Turkey and to the cost of labour in other countries. A modern, post-agrarian economy needs higher educational attainments. Macroeconomic stability is the foundation for sustainable growth, but not enough to accelerate the pace of employment growth. Despite all the improvements, Turkey still has a rigid labour market and a distortionary tax regime. For example, the national minimum wage scheme, coupled with employment taxes that are the highest among OECD countries, creates chronic unemployment among low-skilled workers, especially when the economy is experiencing structural changes. Indeed, according to the World Bank, if Turkey adopted the average business environment of the top performing quartile of OECD countries, the unemployment rate would drop by 4 percentage points, from around 10% to about 6% today. Having said that, we also realise that Turkey’s labour-market problems are not just about laws and regulations. Since only 20% of the workforce has high-school education, Turkey needs a comprehensive education reform as well in order to make educational attainments compatible with the needs of a modern, post-agrarian economy.
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Japan
Apr 11, 2006
Takehiro Sato (Tokyo)
Detail Jan-Mar GDP could be disappointing Jan-Mar GDP (to come out on 19 May) looks likely to be weaker than we expected. We had a sense of such a disappointment coming, in light of the lackluster Household Survey in January-February, but the likelihood rose somewhat with the Cabinet Office’s February composite index (released on 7 April), which covers personal consumption, investment and external demand, based on the GDP estimation method. Our estimate of real GDP growth in January-February, based on a basic extrapolation of GDP demand components using the January-February average growth in the composite index relative to October-December and our estimates of government spending and inventories, which are not part of the composite index, is only 0.1% relative to October-December. This figure would bring F2005 real growth to 3.2%, in line with our 3%+ call; however nominal growth to 1.9%, slightly short of our original expectation of 2%. With January-March growth likely to have been effectively 0%, the base effect for F2006 drops to 0.9ppt in real terms (0.2ppt in nominal terms) vs our current forecast of +1.3ppt, in which case our bullish F2006 forecast would meet with some difficulties. GDP weakness a surprise for government, BOJ A weak Jan-Mar GDP report would likely affect the government’s and BoJ's policy schedule. We had expected the government to confirm, with the January-March GDP report, nominal growth of 2% in F2005 and then declare that deflation has ended in its June monthly economic report. However, if the Q1 GDP report turns out to be unexpectedly weak, the government would unlikely be able to ignore it. In recent reports, amid an absence of a narrowing of the GDP deflator, the government has mentioned a narrowing of the negative output gap (or a swing to positive territory) as an important criterion for declaring an end to deflation. However, with potential growth in the 1-2% range, real growth of around 0% would mean a temporary widening of the output gap. PM Koizumi and those around him, though, seem more focused on making such a declaration by the time a new LDP president is elected in September than on recent economic data. In sum, we think a more likely catalyst for the government will be the Apr-Jun GDP report on August 11 and that the declaration will be made in the August or September governments’ monthly economic report, just before PM Koizumi steps down. We believe the timing would be good for the PM, being an elegant way to mark an end to his tenure. Meanwhile, weak GDP growth would make things a bit difficult for the BOJ in terms of ending its ZIRP (zero interest-rate policy). The April 9 Nihon Keizai Shimbun reports an upward revision of the BoJ's official view on Japan’s potential output growth rate from 1% to the latter half of 1% in the Outlook for Economic Activity and Prices to be released on April 28. Such an upward revision, however, would result in a temporary further widening rather than improvement of the output gap in January-March relative to that at the time of a 1% potential growth rate. Also, if the government pushes back an announcement of an end to deflation to August-September, the BOJ would not have a completely free policy hand until later. However, we doubt the BOJ has any intention of linking its policy to a government declaration of an end to deflation. The last thing BOJ officials would want, in our view, is to end up with less of a freer hand if the bank poorly links its policy with such a declaration, which has elements of a political sideshow. We accordingly do not sense any need at this time to change our expectation of a BOJ end to ZIRP in July-September (specifically July 14) on account of weak Jan-Mar GDP. Similarly, a slowdown in real GDP growth in Oct-Dec 2005 did not lead to a change in the Fed’s basic policy stance because the slowdown was attributed to special factors. Economy fundamentally strong, however We have some doubts, however, that the economy slowed in January-March to the extent suggested by the Cabinet Office’s composite index. The biggest factor behind the GDP slowdown was private consumption, which shrank 0.4% QoQ in January-February. We again point out, however, that the sample bias in the underlying data, the Household Survey, probably has worsened since January. The 44 big-ticket spending items in the larger-sample Survey of Household Economy, used for the supplementary estimation of consumer spending on a GDP basis, have been consistently higher than in the Household Survey since May 2005. Also, METI’s Current Survey of Commerce and other supply-side data indicate consumer spending remains strong and all components of the current and future conditions DIs in the March Economy Watchers Survey show grassroots sentiment is improving on a nationwide basis. Hence, even if the GDP data show a substantial slowdown, we do not think the government or the BOJ will make much of an issue of it because of statistical problems relating to the Household Survey, and we would maintain our basic assessment of the economy. If anything, the insufficiency of Japan’s GDP data in reflecting economic realities would become apparent. Risks Despite hot market sentiment, the recent economic data have been slack, including the Household Survey numbers, February industrial production (down 1.7% MoM), and the March Tankan (large manufacturing enterprises’ business conditions DI at 20, down from 21). We would not take these results at face value because of the special factors that had an impact. For instance, the monthly industrial production data are probably not appropriately adjusted for the impact of the Asian lunar new year. The headline Tankan results were weaker than expected, but the supply-demand, employment, and production capacity DIs indicate a solid improvement in business sentiment, and planned capex was solid as of March. The market has also been ignoring the weak headlines. If we were to point out any risk factor, it would be unexpectedly weak GDP data, which could lead overseas investors to regard Japanese stocks as even more overvalued. The lag between the end of the quarter and the release of GDP numbers in Japan is a relatively long one and a half months. Such news is likely to be discounted until late April, when a number of March economic data come out. Risk factors for the above scenario include indications in the March data of solid consumer spending and other economic fundamentals, which would obviate the need for much of a downward revision of Jan-Mar GDP figures. We are more than minimally optimistic, given the very strong grassroots sentiment in the March Economy Watchers Survey. We think March spending data will have to be very strong to compensate for the weak January-February figures, however.
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Brazil
Apr 11, 2006
Heloisa Marone and Gray Newman
At first glance, it would appear that Brazil is set up for the perfect storm. Even as emerging markets around the globe have been struggling to handicap the next moves of the Federal Reserve, Brazil’s finance minister was forced to step down in late March and political tensions have flared ahead of Brazil’s presidential election. Indeed, the Brazilian real sold off from 2.10 in early March to a low near 2.25 late in the month, while equity and debt markets tumbled as well. But just as quickly as the sell-off had begun, the markets began to recover again. Some argue the rapid bounce back is proof of nothing more than near-sighted complacency by investors hungry for returns without regard to risk. Without denying that there is a healthy degree of complacency engendered by the abundance of global liquidity, behind all of the talk of a perfect storm in Brazil there has been a development worth examining: an economy that is showing signs of acceleration. Whether you look at the latest data on industrial output or a host of other series from electricity to the use of credit cards and checks, Brazil’s real economy appears to be gaining ground in 2006. Industrial production rose by 5.4% in February, above expectations and was the strongest year-over-year result since June 2005. Meanwhile, electricity demand in March 2006 was up over 2% against the average of the three months ending in February. The most recent data suggest that trend electricity growth is running near 19% on an annualized basis during the first three months of the year, an uptick from what we saw last year. Investment quickens pace The best news from February’s industrial output release was not that headline growth was above consensus, but that capital goods grew almost twice as fast. The capital good production series has its fair share of volatility, but is showing annualized trend growth near 20% through February. Capital good production was up 10.6% on a year-over-year basis in February. We watch capital goods production carefully because it provides us with an important proxy for investment spending. The central bank has repeatedly made clear that its ability to continue easing interest rates would depend in large part on sufficient growth in investment spending to ensure that an uptick in demand is met with sufficient growth in supply conditions to limit inflationary pressures. The strong performance of capital goods production is also mirrored in our other measures of investment spending. In recent months, seasonally adjusted investment spending has been growing on average more than 1.5% per month (after seasonal adjustment): that represents annualized growth above 20% and is more than two times the pace seen last year. Producer optimism Producer confidence is also gaining ground. While the business confidence index for current conditions remained growing at a similar pace in the first quarter of 2006 as it did in the last quarter of 2005, the growth pace for the expected business conditions index went up sharply from around 3% to over 9.5%. Moreover, the improvement in confidence does not appear to be restricted to large firms where exporters tend to be more concentrated. In fact, the growth in the business confidence index for small and medium firms has accelerated since early this year, from around 3.4% in the last quarter of 2005 to around 8.9% in the first quarter of 2006, one and a half times the growth pace of larger firms. The increase in the optimism of producers, especially for small and medium-scale producers that most probably direct their production to the domestic market, is likely to mark the end of the inventories rundown process that had begun in the second half of 2005. We expect to see an acceleration of the output growth rate in coming months. Hours worked on the rise Indeed, the most recent survey of manufacturers by the national industrial chamber (CNI) corroborates our thesis that the inventories rundown process is close to an end and that we should start to see clear signs of rebound in the economic activity. The CNI survey found that the number of hours worked in production increased by just under 2.1% in February (after seasonal adjustment), interrupting the declining trend of the previous three months and bringing the number of hours worked in production back to October’s level. In response to increasingly stronger signs that domestic demand is recovering, we should see longer hours worked translated into an expansion in the number of jobs. The recovery in domestic demand is particularly important because of our concern that export-led growth is likely to be less powerful in 2006 given the strong Brazilian real. With the export sector likely to show some softening, we have watched the first months of 2006 carefully to determine whether the domestic demand is increasing at a strong enough pace to sustain the output growth rate as export demand begins to wane. The first signs from 2006 suggest that domestic demand continues to gain ground. While we expect to see a marginal deceleration in growth in March, leading indicators like electricity usage, consumer sentiment and credit inquiries are all painting a picture of an economy that remains strong. Vehicle sales, particularly of domestic vehicles, are the only indicator showing some weaker results, which we attribute partly to the exchange rate. We are also continuing to see an improvement in consumer confidence, that along with strong consumer credit growth, low inflation, and good employment prospects should boost consumption. Despite a slowdown in February, the number of credit inquiries for the use of personal checks gained ground again in March and went up by almost 9% year-over-year. After over 10 months of flat results, credit inquiries for credit card sales (SCPC) are also showing a significant improvement, rising in March by almost 6% year-over-year. Bottom line While some of the conditions for a perfect storm remain on the external horizon, we would argue that the improvement in domestic demand and consumer pocketbooks reduces the risk of a negative political surprise in 2006. And although we doubt that the transition from external demand to domestic demand is likely to be without some bumps, we are already seeing enough of an upturn in domestic demand to believe that 2006 should be a year of good growth in Brazil. Perhaps most importantly, investment spending appears to be gaining ground, which should provide the central bank with room to continue easing rates without worrying that it will miss its 4.5% inflation target for the year. Brazil faces a number of challenges on the fiscal front which we hope to see addressed in 2007 after the elections. But those expecting poor growth in 2006 are likely to be disappointed. Abundance seems likely in 2006: the real challenge is whether it provides the manoeuvring room to push through additional reforms or leads to complacency. On that front, we think we will have to wait until after the elections to learn the outcome.
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