United States
Business Conditions -- Reinforcing the Growth Scare
Jun 09, 2006

Shital Patel (New York) and Richard Berner (New York)

Business conditions plummeted nearly 20 points in early June to 43%, according to the Morgan Stanley Business Conditions Index (MSBCI), our monthly canvass of industry analysts. June’s result represents the largest monthly drop in the four-year history of the survey, the first sub-50 reading since May 2005, and the lowest reading since April 2003. A sanguine interpretation of these oft-volatile results would note that the MSBCI is now catching up with other business gauges. But while the less-volatile three-month moving average declined three points to 55%, that’s the lowest reading since March. More ominously, the decline appears to confirm that that the long-awaited spring economic deceleration will be more intense than we expected only a month ago. The real question is whether the slowdown will be temporary or longer-lasting.

History, unfortunately, doesn’t provide much guidance on that score. The last time the MSBCI was below the key 50% reading was in April 2003, when the index hit 33%. At that time, the recovery was struggling, and consumers and companies were worried about the war in Iraq and other geopolitical tensions and the potential SARS epidemic. Three years later, uncertainties are different: Sustained high energy prices, high commodity quotes, rising inflation, and the implications for interest rates are the main concerns. This month nearly one-third of the analysts noted that high commodity prices, including energy, have hurt business.

In addition, we believe that the sharp correction in equity markets may account for some of this record decline by affecting analyst and business confidence. Each of the three previous large monthly drops in the MSBCI paralleled 5-7% slides in broad equity price indexes. And the volatility in our business survey makes it all too easy to read too much into even a record monthly decline.

Yet there’s scant hope for a rapid rebound in breadth, expectations, or dispersion gauges. The breadth of business conditions shifted towards weakness, while our expectations index also declined nearly 20 points to 53%. The dispersion of business conditions tilted towards weakness in early June as 30% of analysts noted that conditions deteriorated compared to 14% last month. The percentage noting improving conditions sank to 18% from 42% in June. Conditions in the manufacturing grouping, representing over one-third of the industries covered in the survey, plunged 31 points to 40%, while the services group fell 14 points to 46%. By sector, conditions deteriorated for the consumer discretionary, financials, and IT groupings and improved for consumer staples and materials. Conditions were mixed or unchanged for the energy, healthcare, industrials, and telecom services sectors.

But there are other signs that the June plunge won’t last long: The advance bookings index — the most forward-looking subindex — declined only six points to 69%, suggesting that business conditions may not be as weak as the headline figure suggests. Further, a full 38% of analysts noted that companies under their coverage plan to increase hiring over the next three months, up from 33% last month and the highest level since last November. Details follow.

Bookings: Missed the Downturn

Although the advance bookings index declined six points to 69% in early June, the level suggests that advance bookings continue to grow at a hearty pace. Advance bookings typically are forward-looking indicators, and they have done a relatively good job forecasting the direction of business conditions. We have been surprised that they remained so strong in recent months. The strength likely portends a less-intense-than-feared slowdown. Bookings actually rose in a few industries: the industrials, IT, and telecom services sectors.

Expectations: Still Improving…but Barely

Our new business conditions expectations index sank 18 points to 53% but remained above the 50% threshold, suggesting that analysts continue to believe that conditions will improve. Compared to last month, 38% of analysts expect business conditions to improve over the next six months, down from 58%. The percentage expecting deterioration increased to 33% from 16% last month. The consumer staples, energy, healthcare, industrials, and IT sectors expect conditions to improve, while the consumer discretionary, financials, and telecom services sector expect conditions to deteriorate.

Hiring Softer But Hiring Plans Strong in the Face of Weak Conditions

Not surprisingly, hiring over the previous three months dipped in early June. In line with May’s tepid payroll report, 35% of reporting analysts noted that companies under their coverage increased hiring, down from 42% last month. Hiring was strongest for the industrials, IT, healthcare, energy, and materials sectors.

Looking ahead, the percentage of groups planning to increase hiring over the next three months rose five points to 38%, the highest level since last November. Also, only 15% of analysts noted that companies plan to cut payrolls over the next three months, down from 21% last month. This is good news given May’s dismal labor report and supports our belief that there is still pent-up demand for hiring. The industrials, IT, materials, healthcare, and energy sectors plan to hire.

Capex Plans Cooling Slightly

Survey results suggest that the white-hot, first-quarter pace of capital expansion may be cooling slightly. 48% of respondents noted that companies under their coverage plan to increase capex over the next three months, down from 56% last month. Of these, a full 42% plan to increase spending by 6% or more, up from 29% last month. Every sector except healthcare had at least one group with plans to increase capex, but plans were most prevalent for telecom services, energy, industrials, IT, and materials. Semiconductor capital equipment, electronic manufacturing services (EMS), semiconductors, non-ferrous metals, and coal companies plan to increase capex by 10% or more.

Pricing Power Still Strong; Higher Costs Squeezing Margins

Although the pricing conditions index declined four points to 66% in early June, pricing power remained strong. The percentage of analysts noting that prices charged have increased compared to a year ago edged down three points to 53%, while the percentage noting that prices decreased climbed four points to 20%. The breadth of price increases improved as a full 43% of analysts noted that prices increased by 3% or more compared to a year ago, the highest percentage in the history of the question. Strong pricing power was prevalent for all groups except IT and telecom services.

The percentage of analysts noting that prices charged have outpaced unit costs over the last three months remained unchanged at 37%. Still, the percentage noting that material and/or labor costs have squeezed margins increased to 34% from 29% last month. Margins were squeezed mostly at the industrials, IT, and financial companies. Not surprisingly, margin expansion was prevalent for the energy and materials sectors. Compared to a year ago, half of the analysts noted that margins are higher, while 23% noted that margins are lower, down slightly from 26% last month.

Commodity and Energy Prices Taking Their Toll

30% of analysts this month noted that higher commodity and/or energy costs were either squeezing margins or top-line growth at companies under their coverage, which squares with the results from the question regarding margins. Still, 51% of analysts noted that increases in commodity and energy prices have not yet affected business, while 18% said that such increases have increased top-line growth or margins.

Financing: Not As Easy

The financial conditions index fell five points to 48% in early June, bolstering our claim that conditions have turned mildly restrictive (see "Have Financial Conditions Turned Restrictive?" Global Economic Forum, May 30, 2006). However, fully 80% of respondents noted that their companies’ ability to obtain credit was unchanged over the prior three months, while 13% noted that it was more difficult to obtain, up from 7% in May. Obtaining financing was more difficult at the large-cap banks, biotechnology, semiconductor capital equipment, semiconductor, and wireless services companies

Declining Dollar a Tailwind

Survey results suggest that the recent decline in the dollar has been more of a tailwind for revenues and earnings compared with last month. The dollar’s decline has increased top-line growth or margins for 31% of the industry groups, up from 21% last month. The dollar has helped the consumer staples, industrials, materials, and healthcare sectors. Nearly half (47%) of analysts noted that the dollar’s depreciation has not yet had an impact.

Analyst Commentary by S&P Major Sector

Consumer Discretionary: Business conditions deteriorated for the consumer discretionary group, and no groups had plans to increase hiring. The auto and auto related companies have plans to increase capex by a scant 0-3% over the next three months. Prices charged have increased compared to a year ago for most of the sector and have outpaced costs over the past three months. However, analysts expect conditions to continue to deteriorate somewhat over the next six months. The weakening consumer has hurt business for the restaurants, but business and group travel has been offsetting consumer weakness at the lodging companies. High commodity prices have been decreasing margins and top-line growth for most groups, although the decline in the dollar has helped increase top-line growth at the lodging companies.

Consumer Staples: Conditions were mostly unchanged for the consumer staples sector but improved somewhat for the food and drug retailers. No groups plan to increase hiring but the household and personal care and beverages manufacturers plan to increase capex by 0-3% over the next three months. Prices charged increased for most groups. High material costs have been squeezing margins for half the groups, although analysts expect the moderating commodity environment and traction of price increases to help margin growth in the future for the household and personal care companies. Business conditions are expected to improve somewhat for half the groups over the next six months, although conditions are expected to deteriorate somewhat for the food and drug retailers. The declining dollar is helping increase top-line growth for nearly all of the consumer staples groups.

Energy: Business conditions were unchanged from noticeably improved conditions in May. Companies plan to hire somewhat and increase capex over the next three months. Not surprisingly, margins are expanding for the energy companies, and analysts expect conditions to continue to improve over the next six months. However, some of the Canada-based companies have felt a negative effect from the US dollar’s decline.

Financials: Business conditions deteriorated somewhat on the margin for the financial sector, although conditions improved somewhat for the multifamily REITs and the financial guaranty companies. The mid-cap banks plan to increase hiring over the next three months, while multifamily REITs, non-life insurance and mid-cap banks plan to increase capex. Margins are flat to down for most groups over the last three months and most analysts expect business conditions to deteriorate somewhat over the next six months. The declining dollar hasn’t affected business for most groups but has increased top-line growth at the non-life insurers and large-cap banks.

Healthcare: Conditions were mixed for the healthcare sector; conditions improved somewhat for the managed care companies. Half the groups plan to increase hiring somewhat, although no groups plan to increase capital spending over the next three months. Prices charged have increased by 3% or more over the past year for most groups, and margins were higher over the last three months for half of the groups. Analysts expect business conditions to improve somewhat for most groups over the next six months. Christine Arnold, who covers the managed care companies, expects medical trends to decelerate and pricing to stabilize or rise. The declining dollar hasn’t affected most of the groups but has increased top-line growth at the biotechnology companies.

Industrials: Business conditions were unchanged for most groups in the industrials sector. Most groups plan on increasing both hiring and capex; the machinery and trucking companies plan to increase capex by 6-10% over the next three months. Prices charged increased for nearly all of the groups, although material and labor costs are squeezing margins for several groups. Business conditions are expected to improve somewhat for three of the groups and remain unchanged for three. Conditions are expected to deteriorate somewhat for the trucking companies. Higher commodity costs are decreasing margins for most groups including the trucking companies, which have typically been able to easily pass through fuel costs. The declining dollar has increased top-line growth at the business services, machinery, and commercial real estate services companies.

Information Technology: Business conditions were unchanged for most groups in the IT sector. Over half the groups plan to increase hiring and/or capex, and the semiconductor capital equipment, EMS, and semiconductor manufacturers plan to increase capex by 10% or more over the next three months. Prices charged continue to decline and margins were flat to down for the sector. Most analysts expect business conditions to improve somewhat over the next six months. High and rising commodity and energy costs have not affected business for the IT sector, but the declining dollar has decreased top-line growth for the communications equipment, specialized IT services, and enterprise hardware companies.

Materials: Business conditions deteriorated somewhat for the materials sector in early June, and bookings increased for the non-ferrous metals producers. Prices increased by 3% or more compared to a year ago for the sector, and prices charged have outpaced unit costs over the past three months. Analysts expect business conditions to remain unchanged for most groups in the materials sector over the next six months; conditions are expected to improve somewhat for the US coal companies. Dollar weakness is a positive for paper prices.

Telecommunications Services: Business conditions remained unchanged in early June. While the sector has no plans to increase payrolls, companies do plan on increasing capital spending. Prices continue to decline for the group, and labor costs are squeezing margins. Conditions are expected to remain unchanged for the sector, and the decline in the dollar has had no impact on business.

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Currencies
Long EUR/CAD as a Hedge Against Global Slowdown
Jun 09, 2006

Stephen Jen (London) and Charles St-Arnaud (London)

Entering a growth scare phase

The disappointing US May labor report, following Fed Chairman Bernanke’s warning, may mark a point of inflection (not necessarily a turning point) for the US economy. The question now is whether the US will decelerate towards trend, as Chairman Bernanke thinks is likely, or below trend. While our central case is the former, if US growth decelerates sharper than we expect, the global economic recovery will be undermined and commodity prices will be vulnerable to sharp corrections. In this risk scenario, we believe that short CAD against the EUR, the CHF and the USD (in descending order or preference) are sensible hedges.

We’re making a simple point

The CAD has been a non-energy commodity currency in recent decades. In recent years, however, it has become more of an energy currency. Further, the current spot rate of the CAD has exceeded that which can be explained by these already frothy commodity prices and other fundamentals. In other words, the CAD is over-valued even at the current elevated commodity prices. In a scenario where global growth falters, commodities will be vulnerable and an over-valued CAD looks particularly risky. As a hedge against global slowdown, we recommend short CAD against the EUR, the CHF and the USD, in order or preference.

The Fed and our view on the US economy

We assume that: (1) growth in the US will likely decelerate toward trend in the period ahead, as the soft landing in the housing market will be mostly, but not fully, offset by strength in investment in the non-housing sector; (2) Upside pressures on inflation will likely prove to be transitory; (3) While the Fed may or may not pause at its June 28/29 FOMC meeting, the FFR has not yet peaked; (4) Chairman Bernanke is not a dove: he is an inflation targeter at heart, with a ‘forecast-based’ policy framework; and (5) Uncertainty is perhaps permanently higher, and should thus be reflected in asset prices.

We have long dismissed talks of the Fed having lost credibility as an inflation fighter, and have argued that ‘inflationary pressures = USD strength, slow growth = USD weakness’. If inflationary pressures remain on the high side for a while longer, the USD will likely be supported, as either the Fed would keep tightening or would have a tightening bias. Ultimately, however, slower growth will likely propel a cyclical depreciation in the USD index.

B/U and B/D and the ‘dollar smile’

There are two aspects of the global growth discussion that perhaps deserve more attention. We intend to do more work on these issues we raise below, but here are two thoughts we have:

1. The correlation between US and the rest of the world’s (RoW) economic growth. We guess that, with the dominance of asset prices, the correlation between international growth may have risen in recent years, i.e., innovations in expectations of inflation and growth in the US should be quickly reflected in asset prices around the world, which, in turn, could drive the RoW’s economies. What this means is that cross-country differences in growth are rather constrained in size, and that we are likely to continue to see a US-led global business cycle.

Another reason that makes us suspect that global growth may be more synchronized than before is the role MNEs (multinational enterprises) play. Globalization has led to more enterprises operating production lines that cross national borders. In theory, this linkage through production should have led to a higher correlation between core and periphery countries. More outsourcing and more open trade should also enhance synchronization of global business cycles.

The bottom line here is that the US will likely continue to lead the global economy. The rest of the world can continue to recover only if the US does not slow significantly, in our view.

2. The relationship between US and global growth, on the one hand, and the dollar, on the other. We have long been of the view that the dollar is not a monotonic function of the US growth premium, but that it is a convex function. In a piece published on November 29, 2001, we introduced the ‘dollar smile’ concept. The basic idea is that the USD tends to perform well in ‘really good times’ when the US leads the world into a strong growth phase, as well as in ‘really bad times’ when the US leads the world into a recession. Greed and equity flows dominate the former (such as the IT bubble period of the late 1990s), while fear and bond flows dominate the latter (such as the violent risk reduction phase we just witnessed in recent weeks).

Our point is that, in the unlikely event that US growth actually decelerates below trend — not our central case but a scenario many investors have begun to contemplate, at the extreme end of the ‘fear mode’ — the USD could stage a surprise rally, particularly against the emerging market currencies and commodity currencies, such as the CAD.

We are most prejudiced against the CAD

First, the CAD is still over-valued. Since 2003, the CAD has appreciated by more than 30% against the USD, and has reached levels last seen in the late 1970s. Some investors/observers are suggesting that it will go to parity with the dollar based on various factors, including high commodity prices, strong domestic demand, and a currency that is considered capable of absorbing the unwinding of the ‘dollar bubble’. However, according to our calculations, even if we take into consideration the already-lofty commodity prices and the positive economic fundamentals of Canada, the CAD seems to be over-valued. Our calculations show that the median FV is in the low-1.20s. Parity would imply extreme mis-pricing.

Second, if one believes that the risk to commodity prices (both energy and non-energy) is biased to the downside, short CAD is a sensible trade. Decelerating global growth and falling energy prices would likely hit the CAD harder than other currencies.

Third, as the speculative CAD longs remain sizeable, the CAD is also exposed to further bouts of risk reduction.

Fourth, the yield differential between the US and Canada could start to put some pressure on CAD. The Bank of Canada stopped its tightening campaign while the Fed is still contemplating the possibility of increasing rates. This could increase the yield differential between the two countries, which is already 75bp.

Fifth, the productivity gap between the US and Canada is one reason why fair value models point to CAD being around 1.20. During the past 20-25 years, we saw a steady erosion of the relative productivity performance of Canada relative to the US. In order to sustain a lower USD/CAD, we will need a narrowing of the productivity gap between both countries, which is unlikely to happen soon.

Since the EUR and CHF are ‘low-beta’ currencies, in a global slowdown these currencies have a better chance of outperforming the dollar. This makes the EUR and CHF good currencies against which to short CAD, in our view.

Bottom line

We may have seen an inflection, rather than a turning, point on US growth. Depending on the extent of the deceleration in US growth, global growth will be affected. A gentle slowdown in the US that still permits the rest of the world to recover is perhaps the most USD-negative scenario, as a sharp collapse in US demand could trigger a safe haven run into USD assets. In a global slowdown scenario, we believe that the CAD will be vulnerable against EUR, CHF and USD.

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Currencies
World Interest Rates
Jun 09, 2006

Stephen Jen (London)

World interest rates as preferred measures of liquidity

In this note, I introduce measures of the global interest rates.  The turn in the global liquidity cycle is an important shock to financial asset prices.  I believe that interest rates, not money, are much more sensible measures of global liquidity. 

Interest rates, not money, are more relevant measures

In a previous note I published on March 16, 2006, Some Thoughts on the Global Liquidity Cycle, I challenged the popular view that central banks having ‘printed too much money’ was the root cause of bloated asset prices.  There are several points I made which I think are worth repeating.  I also add some other thoughts to this discussion. 

• Point 1.  The global liquidity cycle began to turn in mid-2004, not now.   As central banks eased their policy stance following the 2001 global recession, the opportunity cost of money was reduced to levels below the marginal productivity of capital, vaguely defined, in order to stimulate demand for capital goods.  What that policy also did was to encourage risk-taking in both the real economy and the financial markets.  In an environment of ‘Great Moderation’, the corresponding declining perceived volatility, and active forward guidance by the Fed, monetary easing has arguably had a greater impact on consumption than on investment (in contrast to what we learned in Econ 101, that the ‘IS’ curve is downward-sloping because investment is negatively related to interest rates, while consumption is a fixed function of disposable income.)   Since June 2004, the Fed has been tightening, and the global liquidity cycle turned then, not now. 

• Point 2.  Interest rates, not money, are the relevant measures of global liquidity.  The problem with the fixation on monetary tightening and the impact on asset prices now is, in my view, the erroneous focus on money (quantity of liabilities of the banking system) as the measure of global liquidity: I’ve seen charts on global base money, augmented by the Asian central banks’ reserves.  As I tried to argue in my note in March, monetary aggregates are highly problematic and overly simplistic ways of measuring global liquidity.  First, the US M1 Marshallian-k (the ratio of M1 to nominal GDP, or the reciprocal of money velocity) has been in a steady decline for the past decade.  Second, the US M3 Marshallian-k has been relatively flat since 2003.  These are two rather inconvenient facts for those who argue that ‘money’ is the right measure of liquidity.  Third, logically, it doesn’t make sense to look at money, because much of the investment positions the market warehouses are not at all related to bank credit, but non-bank activities.  A critical element in this argument is that investors’ perception of risk itself is an endogenous determinant of ‘global liquidity’.  Think of the concept of a ‘liquidity multiplier’: the market’s perception of risk and its risk-taking appetite are two key factors driving this multiplier, and are not necessarily factors under the control of the Fed or the BoJ.  Fourth, while there is some academic literature on the relationship between money and goods price inflation, which is still a subject of controversy in the academic world, I am not aware of solid theoretical or empirical work drawing a link between money and asset prices. 

• Point 3.  Asset prices will be affected by the tightening global liquidity cycle.  Notwithstanding the measurement problem mentioned above, rising interest rates (not falling money) in the world should ultimately have an impact on the mix of inflation and growth and corporate profits, and therefore asset prices.  The underlying mechanism is complex, but the ‘sign’ of the relationship between interest rates and asset prices should be negative as the global output gap closes.  If goods price inflation in the world continues to surprise on the upside, the reaction from the monetary authorities should be predictable and risky assets may remain under pressure.  For the Fed, whether they stop at around the neutral level or are forced to enter deeper into the restrictive zone makes a big difference for our call on the AXJ currencies. 

Introducing some measures of global liquidity

In this note, we introduce some simple measures of global liquidity: world interest rates.  The method is basic.  We calculated the GDP- (based on purchasing power parity) and equity market capitalization-weighted world interest rates, including only the interest rates in the US, Europe and Japan. 

• Global liquidity began to turn in mid-2004.  The global liquidity cycle peaked in late 2000, and bottomed by the end of 2001.  The tightening trend was led by the Fed, starting in mid-2004, and has continued until now.  We can debate whether global interest rates have been in the accommodative or neutral or tightening zone, but if the question is when the global liquidity cycle began to turn, my answer is mid-2004. 

• The level of the global short-term interest rates finally entered a ‘normal’ zone, from a historical perspective.    The global short-term interest rate is hovering at around 1.5% now, lower than the average of 2.0% for 1991-2000.  However, 1.5% is close to the level of the global short-term rates that prevailed during 1996-1999.  It is difficult to be specific on the ‘neutral’ rate of interest for any country; the concept of a neutral rate for the world is even more vague.  But it is possible that, after two years of tightening, at 1.5%, the G3 monetary authorities may have removed much of the accommodation.  With more tightening by the ECB and the BoJ, and marginally further tightening by the Fed, we could approach the historical average of 2.0%.  I will from now on assume that 2.0% of real short-term rates is the ‘neutral’ rate for the world. 

• The bond market conundrum is a major boost to the ‘global liquidity multiplier’.   In stark contrast to the global tightening cycles of 1994/95 and 1999/2000, long bonds failed to sell off this time around.  This is the familiar bond market conundrum, and I believe it is a major source of global liquidity in recent years as monetary tightening was rendered rather impotent for the economic activities that are sensitive to longer-term interest rates.  There are many possible explanations for the conundrum.  I will highlight two here.  The first is what I call excessive bearishness on the USD and the attempts by some western investors to break the ‘de facto dollar zone’.  The second explanation for the bond market conundrum I’d like to comment on is the persistent distrust of many investors of the new growth model for the global economy.  Numerous investors have long rejected the ‘asset-based’ growth model as artificial, ephemeral, and even immoral (from a Calvinist perspective). 

• Global equities seemed quite high.   I’m not an equity specialist, and will therefore refrain from making too many comments.  Equities in the US and Europe seem high.  Some of the sell-off in these markets, and in some risky assets such as LatAm and commodities, could be also a function of the lofty price levels we saw in April.  Re-pricing of risk, rather than restrained liquidity, would be an adequate explanation for the risk reduction, given the possibility that these assets were quite richly priced. 

• The risk of further risk reduction and the dollar.  If central banks are compelled to go further into the restrictive zone, because of upside surprises on inflation, the global liquidity cycle will continue to tighten.  Coupled with investors struggling to re-price risk, and the uncertainty over the disinflationary effects of globalization, further risk reduction triggered by a more hawkish Fed, ECB and BoJ could be positive for the dollar.  What we have witnessed this week, in my view, is more of a function of the massively large USD shorts in the market.  But if we see another round of risk reduction, the USD could be supported.  Most hedge funds are USD-based; all Asian and Middle Eastern investors are effectively USD-based; and the US real money accounts, which as I mentioned above, have significantly diversified into non-US markets in the past years, could also repatriate, just as Japanese investors periodically repatriate on spikes of risk aversion.  My call for USD/Asia will need to be suspended if this process of risk reduction continues. 

Bottom line

In this note, I introduce some measures of the world’s interest rates, which I believe are much more sensible indicators of global liquidity.

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Japan
Rate Hike Scenario Intact
Jun 09, 2006

Takehiro Sato (Tokyo)

Consensus starting to weaken

With the pullback in stock markets worldwide, the consensus expectation that the BoJ might end ZIRP at the July 13-14 meeting has started to weaken. However, we are sticking with our view that the BoJ’s hawkish stance will not be shaken by stock market corrections of this extent because the bank assumes that the weakness in stocks stems from the recent investment scandal in Japan and the Fed’s failure to communicate well with the market, and has nothing to do with economic fundamentals.

In light of this financial market instability, we think that rate hikes are likely to be once every six months at most, rather than once a quarter, as the market expects. We think that the BoJ’s policy rate will end up unexpectedly low, partly because of the fiscal policy schedule.

Reasons for an end to ZIRP in July

We doubt that stock market trends have much impact on when the BoJ ends ZIRP, for the following reasons:

1) Instincts of the central banker. Market trends are an important factor in monetary policymaking, but not the only one. Another one is whether medium/long-term price stability can be achieved. In this regard, BoJ officials believe that the output gap has narrowed considerably and the real policy rate (-0.5%, deflated by core CPI rate) is overly accommodative. They are concerned that, with the policy rate where it is now, inflation could exceed 2%, the upper end of the range of its "understanding of medium/long-term price stability by the policy board".

With some indications of a slowdown in the US economy, it may be odd to be concerned about Japan’s economy overheating, but we think that it is the instinct of central bankers and cannot be helped. The same can be said of the Fed governors. Since the US economy is seemingly slowing and appears to be heading for a soft landing, as the Fed expects, we think that it is odd for Fed officials to raise concerns about medium/long-term inflation. If the incoming data confirm economic trends consistent with the Fed’s base scenario, then both the Fed and the market are likely to regain confidence in the economic outlook.

2) No high Tankan hurdle blocking the end of ZIRP: The sell-off in stocks worldwide was spurred by Fed governors’ hawkish comments, which weakened expectations that the Fed will leave the policy rate unchanged at its June 28-29 meeting. However, we consider it unrealistic to expect stocks to continue to decline at their current pace until the next BoJ policy meeting in mid-July. Also, as previously noted, the BoJ secretariat assumes that the weakness in stocks has nothing to do with economic fundamentals.

An FOMC meeting and the release of the BoJ’s June Tankan survey, both key events, come up before then. The FOMC meeting is likely to mark the end of the bad news for the time being, regardless of whether the Fed decides to raise its target rate, and the Tankan could be important in terms of the market regaining its confidence if it shows a solid inclination among companies to invest in capital equipment and a further easing of deflationary pressures or an expansion in the inflationary gap.

It should be noted that the headline Tankan figure is not that important for policymaking. Since the upcoming Tankan covers late May to late June, a period that overlaps with the correction in stock markets worldwide, market trends may very well affect sentiment among large manufacturers. If the headline figure is roughly unchanged from the previous survey, then we do not see it decisively holding the BoJ back from ending ZIRP. Moreover, important items will be the production capacity DI, employment DI, and the revisions in the F2006 capex plans of large enterprises.

3) July would be an ideal time to maintain the interest rate gap. The market has already fully discounted the prospect of an end to ZIRP at the July meeting. Even with the current weakness in stocks, the ECB has raised its target rate by 25bp at its June 8 meeting and the Fed is likely to do likewise at its June 29 meeting. If so, the differential between their policy rates and the BoJ’s would stay basically the same and the July meeting would be an ideal time for the BoJ to raise rates.

Some believe that the Fed will raise rates at its June meeting to maintain its credibility in terms of fighting inflation. The notion that rate hikes bolster central banks’ credibility may be very antiquated, but we think that the BoJ would be left in an awkward position if it did not raise rates, given that it has embarked on a campaign towards rate hikes.

Pace of additional rate hikes likely to be modest

We think that a second rate hike will have much greater significance than the first, i.e., the end of ZIRP, because it should set the interval for hiking rates and the level at which the BoJ’s policy rate ultimately ends up at. We think that the second one will come six months later at the earliest, later than the market expects, mainly because of the likelihood that the Fed will wrap up its rate hike cycle by year-end; the prospects for discussions of a consumption tax increase to begin in earnest after a new administration takes over in September (and to heat up following the upper house elections in the summer of 2007); and the likelihood that prices will remain very stable thanks to a quiet productivity revolution. We accordingly expect the BoJ’s policy rate to end up at only 0.75% and the stock and bond markets to show a mini rally on an end to the negatives after the BoJ ends ZIRP at its July meeting, if expectations for a delay in the next rate hike circulate.

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Asia/Pacific
Rising Risk of 2007 Global Recession
Jun 09, 2006

Andy Xie (from Shanghai)

Summary and conclusions

The global liquidity bubble may be bursting. What is occurring now is not just another correction. I think that several hot markets could decline by 50-70% before global asset prices are normalized.

The Fed and other central banks are turning to inflation fighting. Several one-off disinflationary factors (e.g., emerging market crises, China’s SoE reform and Japan’s banking reform) in the past five years have allowed major central banks to maintain low interest rates despite strong growth. As these disinflationary factors vanish, the major central banks will have to decrease liquidity to stop inflation.

Part of the strong growth in the past three years was borrowed from the future, because liquidity was artificially high. As liquidity normalizes, I believe that a global recession in 2007 is a distinct possibility.

Some emerging economies with widening current account deficits have enjoyed the boom as the liquidity bubble has overlooked these deficits and exaggerated their growth prospects. Indeed, the asset bubbles make their fundamentals (e.g., currency strength and corporate earnings) appear stronger than would otherwise be the case.

As the liquidity bubble unwinds, their currencies should weaken and inflation should accelerate. Their central banks may have to tighten aggressively to avoid a crisis, which could push them into recession.

Most emerging economies have run current account surpluses in this cycle — but their assets are likely to be sold off along with the others. In my view, as their currencies should remain resilient, their central banks may not have to tighten much and their economies should perform well during the coming downturn.

The beginning of the end

If one can pinpoint a specific starting point for the current bear market, it may have been Ben Bernanke’s comment on June 5. When the Fed gets into inflation-fighting mode, liquidity tends to decline and a bear market is just a by-product. This is why I believe that the current sell-off is not a correction as in spring 2004 and spring and fall 2005. During the previous sell-offs, the Fed and other central banks were not worried about inflation.

Inflation has been a problem for the past six quarters. I believe that the major central banks have been in denial by citing low core inflation that was just catching up with headline CPI with a lag. Now, the central banks are worried about their inflation-fighting credibility and have abruptly changed their view.

The level of global free liquidity (short-term money growth rate minus nominal GDP growth rate) has increased by about 60% since 1996. Extraordinary shocks (e.g., emerging market crises, China’s SoE reform and Japan’s banking reform) have allowed the global financial system to store this much money without causing inflation. As the disinflationary factors vanish, the money is causing inflation.

Global liquidity has been sluggish but not declining in the past six quarters. As the main central banks get into inflation-fighting mode, the liquidity level may have to drop substantially. We do not know how much of the massive liquidity build-up since 1996 is sustainable, and the process of liquidity reduction is just beginning.

An emerging market crisis could mark the market bottom

The sell-off of the past four weeks has been mild. The MSCI emerging market index is down by about 20% from its peak on May 8, 2006, but is flat for the year. The index rose by 228% between March 12, 2003 to May 8, 2006. So far, the sell-off is mild relative to the boom.

Many argue that emerging markets are not expensive on price/earnings ratios, but this argument may be flawed. The commodity bubble has exaggerated the earnings of the commodity producers that dominate emerging markets. Also, the credit boom in the liquidity bubble has exaggerated the earnings of the banks, which dominate the emerging markets after commodity producers. Taking these two factors into account, emerging markets look quite expensive relative to developed markets and in absolute terms.

An emerging market crisis is likely to mark the end of the sell-off, in my view. Several emerging economies with widening current account deficits have been enjoying the boom as global financial markets overlook their deficits and feed them with cheap money. Inflation strengthens their currencies and decreases their interest rates. The resulting credit boom has exaggerated their economic growth rate, which temporarily validates foreign investors’ false expectations, in my view.

As the cheap liquidity comes to an end, these economies are likely to suffer weakening currencies and accelerating inflation. Their central banks may have to raise interest rates aggressively to maintain stability, which could push them into recession and result in a significant stock market sell-off. I see the potential for some erstwhile ‘hot’ markets to decline by 50-70%.

The risk of a global recession in 2007 is rising

The big question mark for the global economy is how much property prices have to decline. The most important effect of the global liquidity boom has been the rising property price/income ratio. If the ratio needs to return to the level of 1996, the global economy could suffer a major recession.

If we are generous and accept that half of the increase is a permanent re-rating of land prices relative to labor prices, the decline would still be enough to cause a sizable global recession. If the decline of property prices is gradual, as in Australia and the UK, the global economy could avoid an outright recession but experience prolonged sluggish growth.

However, the soft-landing of the property markets in Australia and the US was due to a strong global economy. It will be much harder for China and the UK to follow suit. They are the main sources of global growth. This is why I believe that the risk of a global recession in 2007 is rising.

It has been fashionable of late to separate inflation and growth in macro discussions. Many argue that growth is more important than inflation. This is wrong, in my view. The causality is the other way around. If inflation is low, liquidity can remain high, and financial speculation can manufacture growth.

Because financial speculation plays such an important role in generating growth, this cycle is all about inflation. In my view, when the main central banks start to worry about inflation, it’s game over.

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Taiwan
Looking for the Silver Lining
Jun 09, 2006

Denise Yam (Hong Kong)

Summary and conclusions

We spent two days in Taipei last week meeting with policymakers, clients and academics. The meetings confirm our concern over limited policy initiatives to boost weak domestic demand, leaving Taiwan dependent on exports for growth, and hence vulnerable to global cyclical fluctuations and external shocks. A breakthrough in cross-strait relations in the form of direct transport links and/or welcoming Chinese tourists and investors remains the most significant positive development that the Taiwan economy is longing for. We maintain our conservative stance on economic growth, interest rates as well as the exchange rate.

Steady GDP growth expected, but heavily dependent on exports…

Policymakers generally feel comfortable with the ongoing growth momentum, and see growth averaging just over 4% in 2006. Nevertheless, they concede that growth remains dependent on exports as domestic demand remains tepid, amid rising consumer credit NPLs, tightening consumer credit and sluggish local investment. When asked if they were concerned that Taiwan is excessively leveraged to the global economic cycle that may be in the process of slowing, officials seemed complacent. In fact, one official commented that this was not a near-term concern as global growth is not expected to slow until 2007.

Nevertheless, a researcher we met highlighted the chronic loss in terms of trade as a drag on Taiwan’s economy, in line with the call we have been reiterating over the past couple of years. He said that as Taiwan’s key export sectors meet with significant competition from lower-cost producers, the appropriate strategy is to move up the value chain in the export mix, but this process takes time. The deterioration in terms of trade could still persist for some time, in his view, undermining the contribution of exports to nominal income growth.

…amid limited impetus for domestic demand

During our trip, we were eager to seek the views of policymakers on Taiwan’s domestic demand, the cause of its weakness and the planned or recommended policy response. There was general agreement that overall economic development is being held back by the lack of direct and secure links with China and administrative inefficiencies amid frequent political events (elections and, worse still, scandals). Frustration with local economic prospects helps explain the significant capital outflows by local investors since 2H04. Meanwhile, increasing numbers of Taiwanese professionals and workers spend time working and consuming abroad. This leakage of capital, productivity and consumption is one of the structural drags on the economy.

In terms of policy responses to weak domestic demand, we did not hear of many significant initiatives during our meetings. Monetary tightening is unlikely to turn more aggressive, but there is no room for easing either. On the fiscal side, the ongoing fiscal deficit is limiting the government’s capacity to stimulate domestic spending. Big public investment projects such as highways and rail links are close to completion. The current tax reforms — tax hike proposals and the removal of tax incentives on investment — could be an additional negative on domestic demand. As a result, much hope is now placed on attracting foreign (especially Chinese) investment in Taiwan, through improvements in corporate governance and financial market efficiency.

Improvement in cross-strait relations is paramount

Cross-strait relations were the key topic of discussion in the majority of our meetings. Most policymakers highlighted the slow progress in cross-strait negotiations — due to the lack of consensus among the population and even within the ruling party — as a drag on economic development.

The Mainland Affairs Council kindly updated us on the status of ongoing negotiations with China in three main areas:

(1) Chinese tourists visiting Taiwan. Officials estimate that the annual benefit of Chinese tourism to Taiwan GDP will be about NT$20 billion, or 0.2% of GDP. The current obstacles are (a) China has not yet agreed to put Taiwan on the list of designated vacation spots, and (b) no direct transport links. Without resolving these issues, unilateral approval by the Taiwanese authorities may not have a significant impact on inbound visits.

(2) Taiwanese agricultural exports to the Mainland.

(3) Direct passenger and cargo chartered flights.

Nevertheless, it did not seem to us that there could be an imminent easing in restrictions on China-bound investments, which Taiwanese businessmen are most eager to see. Some worry about ‘hollowing out’, but others argue that ‘hollowing out’ is already close to completion. However, it is difficult to argue that the latest wave of offshore listings of subsidiaries of Taiwanese companies in response to restrictions on China-bound investment is not a hollowing out phenomenon. Our Taiwan equity strategist, Dickson Ho, has been stressing the negative impact of such offshore listings on the Taiwanese economy (see China Euphoria — Is It Sustainable? April 20, 2006).

We are hopeful that better cross-strait links will be a big boost to the Taiwan economy. Local capital outflows could slow or even reverse, justifying expectations for asset appreciation. Nevertheless, it remains to be seen when a breakthrough will come.

Property market — looking to foreign investment for support

Policymakers we met see the recent pick-up in Taiwan’s property market as healthy, and argue that assets are still reasonably priced. Residential property supply is not expected to be overwhelming, as a good portion of the projects are for ‘urban renewal’, i.e., old buildings will be torn down and replaced. Developments in new areas are expected to interest foreign investors upon improved prospects of direct transport links with the Mainland, according to one official. In particular, we noted that policymakers and academics were unanimously optimistic that property prices will see support upon the arrival of Chinese investors. This again highlights cross-strait links as a precondition for asset reflation.

Fiscal management — tax reform proposals may not be sufficient to balance budget

Although the fiscal deficit narrowed over the last two years on the back of robust economic growth, structural problems loom. Policymakers reiterated their target to lift tax revenues from 12.8% to 15% of GDP. Among the proposals to be further discussed or passed in this second year of tax reform are the energy consumption tax, the alternative minimum tax (AMT) and raising the value-added tax (VAT) rate from 5% currently. One official reminded us that the AMT, if passed, will likely only contribute NT$12.5 billion of revenues in the first year and increase gradually, so it is more of an initiative for equality than for tax collection. Meanwhile, it remains the government’s target to balance the budget in five years, and we have our reservations as to whether the current fiscal proposals are sufficient to reach this goal.

Monetary tightening to remain gradual

The gradual interest rate tightening conducted by the CBC is likely to continue. Officials expressed comfort with the current inflation levels. Headline inflation averaged 1.34% in Jan-Apr while core inflation averaged 0.59%, in line with targets of below 2% (headline) and 1% (core) respectively. The negative interest rate differential with the US$ has widened substantially, and was cited as one of the push factors of local investment capital. Although weak domestic demand makes it difficult to justify a more aggressive tightening path, the CBC reiterated its intention to neutralize monetary policy and bring real interest rates back to an appropriate level, although there was no consensus among the people we saw on where that level should be.

Capital account flows have bigger influence on the exchange rate than the current account

The officials attribute exchange rate movements more to capital account than current account flows. They specifically commented the tremendous amount of foreign capital ploughed into Taiwan equity markets over the last few years has been a driver of NT$ strength. Foreign ownership of Taiwanese stocks has risen to 32% currently from 7% in 2001. These foreign inflows seem to have more than offset the large outflows by domestic investors. Policymakers generally do not expect local investors’ capital to return from abroad, even upon further rises in NT$ interest rates, due to preferential tax treatment on earnings of overseas investments. We were a little surprised by the general complacency over persistent capital outflows by local investors, which officials justified with the observed ongoing foreign capital inflows and ample liquidity in the banking system. One possible explanation is a possible preference by policymakers to diffuse appreciation pressure on the currency.

CBC leaves NT$ to market forces

In line with the message that we have picked up from other Asian central banks, the CBC is not looking to intervene to control levels or the direction of the NT$. Companies engaged in export-import trade have been encouraged to hedge their exchange rate risks. One official told us that the CBC has explicitly warned that businesses should not expect the central bank to protect them against currency appreciation.

Policymakers we saw agreed that NT$ will see pressure to appreciate if the yen and renminbi head up further against the US$. They differ in opinion, nevertheless, on whether NT$ trajectory would be closer to the yen or the renminbi. They did highlight that the renminbi exchange rate is still tightly controlled, so the market-determined NT$ exchange rate may not show close correlation. Nevertheless, there was strong agreement among policymakers that China’s economy is the driver of growth as well as general currency sentiment in the region, including the yen. Nonetheless, policymakers also hold fast to the view that, over the long term, a country’s fundamentals should determine the direction of its currency.

Maintaining conservative outlook

All in all, our Taipei trip justifies our cautious outlook for Taiwan. Weak domestic demand, which is seeing little support or stimulus from government policies, leaves Taiwan dependent on exports for growth. Better cross-strait relations remain the magic pill for the Taiwan economy. We maintain our conservative forecast for real GDP growth this year at 3.6%.

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India
Global Pressure Prompts Tightening
Jun 09, 2006

Chetan Ahya (Mumbai) and Mihir Sheth (Mumbai)

RBI announces rate hike

The Reserve Bank of India (RBI) has announced a 25bp hike in both of the short-term policy rates — the reverse repo rate (the rate at which the RBI absorbs excess liquidity from the money market) to 5.75% and the repo rate (the rate at which the RBI supplies liquidity to the money market) to 6.75%. The rate hike was against market expectations. Unlike the quarterly monetary policy statement, the central bank has issued little explanation for today’s policy move. In its official press release, the bank indicated that the rate hike decision was based on a review of current macroeconomic and overall monetary conditions.

Global rate movement was the key driver

In our view, the RBI’s decision to raise rates between scheduled monetary policy reviews (with the next one due in the last week of July) was driven by changing global interest rate conditions, particularly in the US. Indeed, since January 2006, when the RBI last raised policy rates, the US Federal Reserve has resorted to three additional rate hikes and is likely to effect another rate hike in June. In the last monetary policy announcement in April 2006, the central bank had alluded to this when it mentioned that with increasing integration with the global economy, rising interest rates in major economies in response to uncertainties (including inflationary pressures) will have a bearing on monetary policy management in India.

Growth versus stability

We believe that the central bank was faced with two choices — 1) maintaining the growth momentum by keeping interest rates low; or 2) maintaining stability by falling in line with global interest rates and ensuring that it would not have resort to disruptive rate hikes in the future. With global interest rates continuing to harden since April, the RBI had little choice but to go ahead with the second option. We believe that in addition to global interest rate trends, the RBI’s worries on credit quality, asset prices and potential inflationary pressures will ensure that it continues to tighten:

Strain on credit quality: The RBI has been concerned about strong credit growth, particularly in select sectors, such as borrowing by individuals and real estate lending. It has initiated some quantitative measures to influence the quality of credit growth (including an increase in risk weights on commercial real estate, housing and consumer loans and an increase in provisioning required on standard assets in specific sectors).

Asset prices: Property prices have risen rapidly in most major cities over the past two years; indeed in some of the top tier cities, prices have gone up by 75-100% in this period. In the last monetary policy announcement, the RBI had indicated that the upturn in housing and real estate prices would pose a challenge to monetary authorities worldwide.

Potential inflationary pressures: While the headline inflation rate has remained largely below the central bank’s comfort zone of 5-5.5% over the past 16 months, the RBI has in previous monetary policy announcements highlighted that a full pass-through of high oil prices continues to remain a cause for concern.

Our soft landing scenario panning out

We believe that the measures taken by the central bank so far in terms of the rate hike and increase in risk weighting for bank lending to select sectors, and further likely increases in the rate before the year-end, will result in a significant credit growth slowdown, weighing on the overall growth trend. We expect bank credit growth to slow to 20% YoY by the fiscal year-end from the current 31% YoY and GDP growth to soft-land from 8.4% in F2006 to 6.8% in F2007.

Rate outlook and risks

Our US Economics team is forecasting that the Federal Reserve will continue to remain in tightening mode and will likely raise rates by 50bp by the end of the year. We believe that the RBI will keep pace with the Fed and raise the reverse repo rate by another 50bp to 6.25% by year-end.

The risk to our outlook is that the US Federal Reserve takes its policy rate to a much higher level than our current forecast of 5.5%. In such a scenario, the RBI will likely have to follow with larger rate hikes than our current expectations, increasing the risk of aggressive deceleration in the credit cycle.

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