Business Conditions
Limp Start to a Second-Half Revival
Jul 14, 2006

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

Business conditions in July bounced back from June’s surprising 20-point decline, according to the Morgan Stanley Business Conditions Index (MSBCI), jumping six points to 49%.  However, the sub-50 reading implies that business conditions aren’t yet improving and marks a limp start to what we believe will be a second-half revival.  The less-volatile three-month moving average declined four points to 51%, the lowest reading since June 2005.  Moreover, while still strongly in positive territory, the advance bookings index also fell nine points to 60%, the lowest reading since February.  Our new expectations index was stable at 53%.  Despite these generally weak results, we’re not retreating from our view that the economy will improve in the second half of the year.  The risks from higher energy quotes notwithstanding, the analytics in our view are compelling.

Survey results also suggest that pricing power could be peaking, although we believe that inflation risks still tilt higher.  July’s pricing conditions index declined one point to 65%, the lowest level since August 2005 and down from the peak of 76% in October 2005.  Some of that decline may reflect the spring downdraft in non-energy commodity prices which has since partly reversed.  On a slightly more ominous note, our thesis that margins are flattening may now be underway: Material and/or labor costs have outpaced prices charged over the past three months for 36% of the groups, up from 29% last month.  That’s far from margin compression but likely marks the start of a convergence between earnings and sales growth.

The July results also challenge our view that continued demand for capital goods and sturdy income gains will promote upside growth surprises in the second half of 2006.  This month’s canvass suggests that companies may be reining in their capital spending plans.  Only 37% of groups plan to increase capital spending over the next three months, down from 48% last month; this is the lowest level since November 2004.  Also, only 28% of groups plan to increase hiring, down notably from 38% last month and the lowest reading since January.  But results do support the idea that hearty overseas growth will help US top- and bottom-line results: 28% of analysts noted that results from overseas operations have held up better than domestic earnings while 28% said they have held up the same; only 9% said that overseas results were worse.  30% of companies covered in this survey have no overseas operations.

The MSBCI continues to anticipate changes in other business surveys.  In June, the 31-point decline in the MSBCI manufacturing grouping predicted the dip in the ISM manufacturing PMI.  In early-July the manufacturing sub-index bounced 16 points to 56%.  The services grouping also predicted a decline in the non-manufacturing PMI in early June; the July decline of three points to 43% suggests little if any improvement.  Since the services group represents 65% of our sample, the headline MSBCI remained below the 50% threshold. 

The good news for July is that the breadth of business conditions improved somewhat: 20% of analysts noted that conditions improved compared to 18% last month.  The percentage noting deteriorating conditions fell to 24% from 30% in June.  By sector, conditions continued to deteriorate for the consumer discretionary, financials, and IT groupings, and improved for consumer staples, healthcare, industrials, and materials companies.  Conditions were unchanged for the energy and telecom services sectors. 

Expectations: Unchanged

The business conditions expectations index remained unchanged at 53% this month.  Compared to last month, 37% of analysts expect business conditions to improve over the next six months, down a tick from 38% last month.  The percentage expecting deterioration decreased to 30% from 33% last month.  The consumer staples, energy, healthcare, and IT sectors expect conditions to improve, while the consumer discretionary, financials, industrials, and telecom services sector expect conditions to deteriorate.

We also asked analysts whether they are more likely to raise or lower second half 2006 earnings estimates for companies under their coverage.  They are still bullish: 31% of analysts said that they were more likely to raise estimates somewhat while 4% said they would raise estimates significantly.  24% of analysts said they would lower estimates.  Analysts covering healthcare, industrials, and financials sectors were most likely to revise estimates higher. 

Pricing Power Peaking? Higher Costs Squeezing Margins

As noted above, the pricing conditions index declined one point to 65% in early July, falling a cumulative 11 points from the peak in October 2005.  The percentage of analysts noting that prices charged have increased compared to a year ago edged down one points to 52%, while the percentage noting that prices decreased went up two points to 22%.  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 declined to 20% from 37% last month.  The percentage noting that material and/or labor costs have squeezed margins increased to 36% from 29% last month.  Margins were squeezed mostly at the consumer staples, IT, and financial companies.  Margin expansion was prevalent for the consumer discretionary, healthcare, and materials sectors.  Compared to a year ago, 48% of the analysts noted that margins are higher, while 33% noted that margins are lower, up from 23% last month.  However, for some industries such as household and personal care, prior price increases will lead to increased margins as non-energy commodity prices retreat.

Bookings: Boom Over?

The advance bookings index declined nine points to 60% in early July, six points below the long-run average, suggesting a consolidation in ordering.  But the bulk of the July strength in bookings was in the industrials sector, suggesting that the weakness in capital spending plans may be short-lived.  Other groups which noted higher bookings were oil services, mortgage finance, communications equipment, non-ferrous metals and mining, and wireless services.  Publishers, specialized IT services, software, and, not surprisingly, homebuilders had lower bookings.

Capex Plans: Just a Pause?

In early July, only 37% of analysts noted that companies under their coverage plan to increase capex over the next three months, down from 48% last month.  Of these, 41% plan to increase spending by 6% or more.  This calls into question our belief that double-digit gains in capital spending will contribute to above-consensus second-half growth.  Nonetheless, we believe that rising operating rates, still healthy pent-up demand for capital goods resulting from corporate capital discipline, rising labor costs that may trigger additional capital-labor substitution, and persistently high energy quotes that create incentives to invest in energy efficient equipment will help sustain demand for capital goods.  Oil services and non-ferrous metals and mining companies plan to increase capex by 10% or more.

Hiring Plans Also Weaker

Not surprisingly given disappointing employment reports, hiring over the previous three months dipped in early July.  One third of reporting analysts noted that companies under their coverage increased hiring, down from 35% last month.  Looking ahead, the percentage of groups planning to increase hiring over the next three months plunged ten points to 28%, the lowest level since January.  However, only 11% of analysts noted that companies plan to cut payrolls over the next three months, down from 15% last month and 21% in May.  The industrials, IT, materials, and energy sectors plan to hire.

Financing: Turning Restrictive

The financial conditions index fell another five points to 43% in early July, reinforcing our claim that conditions have turned mildly restrictive.  This is the lowest level since October 2002.  However, fully 83% of respondents noted that their companies’ ability to obtain credit was unchanged over the prior three months, while 15% noted that it was more difficult to obtain, up from 13% in June.  Obtaining financing was more difficult at the large cap banks and custody banks, biotechnology, machinery/multi-industry, electrical equipment, semiconductors, aluminum, and wireless services companies.

Currency Moves and Earnings

This month we also asked analysts whether currency moves will be a headwind or tailwind for earnings in the second half of 2006.  The tails have it: 27% of analysts noted that currency moves will be a tailwind while 20% said they will be a headwind.  Several groups in the consumer staples sector, as well as the non-life insurers, biotechnology, business services, machinery/multi-industry, software, systems and PC hardware, and paper and forest products groups, would benefit from currency moves.  Conversely, earnings would be depressed at the life insurance, REITs, pharmaceutical, electrical equipment, commercial real estate services, information processing, aluminium, and wireless services companies.

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Currencies
Sterling Now Number Three on the Popularity List
Jul 14, 2006

Stephen Jen (London)

The GBP is good, even though it is over-valued

In this note, I reiterate my view that special factors will likely keep EUR/GBP relatively stable, and support cable at levels above its fair value of around 1.63.  Specifically, I maintain my modestly negative outlook for the GBP, but expect any decline in cable towards its fair value to be gradual.  EUR/GBP should not break out of its familiar range. 

In a previous note, we presented our view that the GBP should be treated as a derivative of the EUR.  In this note, we highlight one of the important factors we mentioned: the popularity of the GBP as a reserve currency.  In IMF data on the currency composition of foreign reserves, the GBP has surpassed the JPY as the number three reserve currency (behind the USD and the EUR).  It is likely that the GBP’s popularity among foreign reserve managers will increase further, in my view.  For the foreseeable future, the GBP will be able to keep up with the EUR, even though the GBP does not have quite the same liquidity premium of EUR. 

The consensus view has been negative on the GBP

For several years now, the consensus view on the GBP has been persistently negative, against both the EUR and the USD.  While the EUR is generally seen as a good alternative reserve currency to the USD, because of its liquidity premium, the GBP is not really considered to be in the same league as the EUR as an international currency.  Second, the resemblance between the structure of the UK’s economy and that of the US (e.g., a buoyant but soft-landing housing market, a low household savings rate, twin deficits, etc.) makes investors uneasy about owning the GBP, both against the USD at these levels and especially against the EUR.  Third, the interest rate cycles between the UK and Euroland have been out of synch and, going forward, will most likely not be supportive of the GBP.  Fourth, in terms of valuation, cable remains overvalued, by around 13%.  Even though the EUR is almost as overvalued as the GBP, for some reason, investors tend to be more cognizant of how pricey the UK is, and less critical of European prices. 

This consensus view has not been correct

While all the above-mentioned reasons are logical and compelling, short cable and long EUR/GBP have not been particularly profitable trades in recent years.  As we pointed out in our earlier note, the variability in EUR/GBP has been extraordinarily low since mid-2003.  During this time, EUR/GBP has hovered within a narrow band of 0.66 to 0.71.  Measured volatility has collapsed since July 2003, ironically not long after the UK Treasury released its verdict on the ‘Five Tests’ declaring that the UK would not join the EMU just yet. 

I have the following points:

1. EUR/GBP has remained very stable, despite the large changes in the cash yield differentials.  First, there does not seem to be a strong relationship between the cash yield differential and the GBP/EUR rate since late 2002.  The cash yield premium of the UK rose from 75bp in November 2002 to 275bp by August 2004.  The spread is 175bp now, and could, if consensus forecasts are correct, fall further to 100bp by year-end.   Nevertheless, EUR/GBP barely moved during this period.  Second, there seems to be a vaguely negative relationship between the two schedules.  Specifically, during 1999-2000, the EUR weakened against the GBP 18 months or so before the Euroland cash rate rose against the UK cash rate; and in 2002-2003, the EUR strengthened against the GBP, a little before Euroland interest rates fell meaningfully below the UK interest rate.  In short, the orthodox view that EUR/GBP should track the relative business cycles of Euroland and the UK is categorically refuted by the experiences of the past seven years.  I don’t see why EUR/GBP should suddenly start tracking cash yield differentials, as many analysts and investors believe will happen. 

2. Despite the ‘Five Tests’, investors may already be treating the UK as a member of the EMU.  Since mid-2003, the EUR has been the ‘centre of gravity’ for the GBP, rather than the USD, as the volatility of cable rose when that of EUR/GBP declined.  The UK is already a well-integrated member of the EU, and is looking increasingly inseparable from Euroland, even though the UK is not a member of the EMU.  Due to the UK’s perceived greater transparency and the liberal nature of its financial, corporate and labor structure, UK companies may have been seen by foreign investors as a springboard to access the European market.  In short, the structural convergence of the UK and the EU may have significantly muted the volatility in EUR/GBP:  this cross will still move, but may only do so within a narrow range. 

3. Asian central banks may see the GBP as a high yield proxy for the EUR.  In our January 26 note, we also argued that “many Asian central banks see the UK as a good (i.e., higher-yielding) proxy for the EUR…The latest BIS reports on the turnover of the currency markets and the currency composition of official reserves showed that the GBP has significantly gained ‘market share’, both in terms of central banks’ holdings of GBP assets and the GBP’s share in the currency markets.  In a way, the GBP is increasingly seen as a variant of the EUR.  Capital repelled from the US and Euroland has gone to GBP”. 

The GBP is an increasingly popular reserve currency

The IMF recently released its quarterly data on the currency composition of foreign reserves.  This COFER database is the most comprehensive data on this subject available anywhere.  Remarkably, the share of the global official reserves held in the GBP has recently surpassed that in the JPY.  The GBP is now the number three reserve currency in the world.  The GBP has been particularly popular among emerging market central banks.  For the world, the share of the official reserves in GBP rose from 3.6% a year ago to 4.0% at end-1Q06, compared to a decline for JPY from 3.9% to 3.4% during the same period.  This trend is even starker for the developing countries.  Since end-2004, for these countries, the EUR share has risen by 0.2%, but the GBP share has increased more than twice as much — by 0.5%.  The JPY share, on the other hand, has declined by 0.8%, about the sum of the increase in the EUR and the GBP shares.  The USD share has actually risen by 0.2% during this period.  In a way, what we have witnessed is diversification from the JPY, rather than the USD, into the GBP and the EUR. 

I have the following thoughts:

• The BoE has a lot of credibility.  In addition to the above-mentioned fact that the GBP may be seen as a high yield proxy for the EUR and the UK’s integration with the EU, the BoE has a fantastic track record on inflation control.  This has accentuated the role of London as the leading financial center in the world, surpassing New York.  The deep, liquid and transparent financial markets in the UK have enhanced the GBP’s status as a legitimate and viable reserve currency and as a store of value.

• The UK’s underlying debt market is very liquid.  When foreign central banks hold a reserve currency, they usually hold sovereign debt as the underlying asset, and do not park their money on cash deposits.  Therefore, liquid and well-developed financial markets are essential.  The US Treasury market is ‘monolithic’, while the European sovereign debt markets are more fragmented.  Not only is the US Treasury market multiple times larger than the total size of the major markets in Euroland, but the fact that the European markets are not homogeneous also hurts the EUR’s liquidity, from a reserve manager’s perspective.  The UK’s debt market, in comparison, is nearly as liquid as the large European markets.  This liquidity argument puts the USD way ahead of the EUR, and narrows the gap between the EUR and the GBP as reserve currencies. 

• Why the JPY is not going to be a popular reserve currency.  To understand fully why some currencies are more popular as international currencies, we need to ask why the JPY is not a popular international currency.  First, the JGB market, although deep, is low-yielding, and almost guarantees future capital losses.  As Japan recovers, and as its demographic trend deteriorates further, JGBs could become even less popular as a reserve currency.  The unattractiveness of the JGB market is yet another in the list of reasons why the JPY is not a key international currency, despite the large size of Japan’s economy.  For example, Japan’s financial markets and policy making are simply not as transparent as in the US or the UK.  There could also be historical reasons why many Asian central banks do not wish to hold the JPY in their reserves.  Having said the above, I stress that our bullish-JPY outlook is predicated on the likely direction of private flows.

EUR/GBP to remain in a range

I remain unimpressed by the EUR, and believe that EUR/USD will end the year at a lower level than the current spot (our forecast is 1.24 for end-2006 and 1.20 for end-2007).  I have a similarly negative bias on cable, but this is likely to be a gentle grind lower, as valuation (negative for GBP) is partially offset by diversification flows (positive for GBP). 

Bottom line

Even though the GBP is too expensive against the USD, I believe that one should not be too bearish on cable.  The GBP is likely to continue to track the EUR.  Relative economic fundamentals or yield differentials have not had any impact on EUR/GBP.  Our hunch that the popularity of the GBP as a reserve currency is growing has been validated by the latest IMF data, which show that the GBP has now surpassed the JPY as the third most popular reserve currency in the world.

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France
Next on the Fiscal Ultra Diet List?
Jul 14, 2006

Eric Chaney (from Paris)

Germany will implement the largest tax increases of the history of the Federal Republic next year, according to my colleague Elga Bartsch, who estimates that the implied net fiscal tightening will take 1% of GDP.  Don’t be mistaken, this has already been approved by the Cabinet and will most probably pass the Houses’ hurdles.  Germany has decided to clean up its public balance sheet, and will do it.

Italy should undertake the largest spending cuts of the history of the Repubblica, amounting to 3% of GDP, if the multi-year financial plan of the government is taken at face value.  My colleague Vladimir Pillonca considers that, on a net basis, the implied fiscal tightening should amount to 2% of GDP in 2007, enough to pull back the economy into recession, after a nice recovery this year.  Will Professor Prodi and Padoa Schioppa really do that? We’ll know better when the 2007 budget is unveiled, in September.

Yet, the big picture is clear: as we wrote last week (Euroland: Tightening the Fiscal Belt, Eric Chaney, Elga Bartsch and Vladimir Pillonca, July 7, 2006), the EMU fiscal pendulum is moving toward restrictive policies, because two of the three largest economies have bitten the bullet and signed in for ultra-severe diets, although of very different kinds.

Sweet diet for France in 2007

By contrast, French ‘rigueur’ tastes like a sweetie.  Finance Minister Thierry Breton, who has just sent the feared ‘spending ceiling letters’ to his cabinet’s colleagues, is personally committed to fiscal stabilisation, as shown by his promotion of Michel Pebereau’s report on French public finances, a report he had himself sponsored.  However, the official spending target for next year’s state budget (24.7% of GDP on a National Accounts basis) is to keep spending growing less than prices, but nevertheless growing.  The largest expenditure item, civil servant wages, will not be significantly dented, as the number of civil servants should be cut by 15,000, a droplet in the vast pool of French civil servants, employees of public services or workers on government-sponsored programmes, who altogether totalled 6.8 millions at the end of 2005.  Should we expect more progress from the second budget, i.e., social protection (24.7% of GDP)?  In my view, we should expect even less.  The main field where restructuring and rationalisation could significantly cut spending (and thus alleviate payroll taxes and boost jobs) is the healthcare system.  However, after the reform implemented last year, which, while modest, managed to rein in so far unbridled medical spending, there is practically no chance that the current cabinet could take the risk to confront doctors or hospital workers.  Although the details of both budgets are still unknown and could bring some surprises, I believe that fiscal policy will be at best neutral next year, if not slightly expansionary, at least until the presidential and general elections.  Since GDP growth is likely to slow next year, as German and Italian domestic demand weakens and interest rates start to bite the housing sector, we expect the general government deficit to rise to 3.1% of GDP after 3.0% this year.  However, depending on the result of the elections, things might change significantly afterwards.

Budgetary policies: not yet debated ahead of elections

At this stage, neither the right nor the left wing parties have chosen their heroes, although Mrs. Segolène Royal and Mr. Nicolas Sarkozy are clearly front-running in their respective camps.  It is thus difficult to figure out what kind of fiscal policy could result from a victory of either side.  The socialist party has agreed on a leftist platform, promising higher taxes for high income earners and companies, and huge increases in welfare spending, as if France were a lagging country in this regard.  Taken at face value, this platform seems to imply a resolutely expansionary fiscal policy, and only very rosy GDP growth assumptions allow the Socialist Party to say that it would be consistent with EMU rules.  However, things might turn differently once a real candidate is chosen.  She or he could feel free to amend the platform, depending on her or his strategy.  On the right-wing side, Mr. Sarkozy’s UMP platform is more focused on structural reforms, such as the labour market, than on budgetary policy.  Although some factions within UMP are addicted to big government practices, this is probably not a majority, and I guess that the electoral base of the right would not be shocked by a debt stabilisation programme. 

A fiscal ultra diet in 2008…or 2009?

Whoever wins the presidential election, the reality check will come soon: gone are the days when the government could take temporary liberties with economic fundamentals by devaluing the French franc or looting savers’ pockets through well-designed tax incentives for life insurance contracts, for instance.  In addition, the French public is sensitive to the vertiginous rise of the public debt, as abstract as this concept might be.  In my view, France will have to opt for tough fiscal measures in order to bring the national debt back under control on a sustainable basis soon after the election.  25 years ago, Italy, Belgium, the Netherlands and Ireland were the serial fiscal sinners of Europe — always promising to curb their debt, never delivering.  Since then, Ireland, the Netherlands and, more recently, Belgium have joined the virtuous camp while France and Germany have started to catch up with Italy.  France cannot afford to be left alone on a risky fiscal path:  anticipating higher taxes, taxpayers would increase their saving effort, triggering a vicious circle of weak domestic demand and rising public deficits.  In my view, the fiscal diet will come either in the 2008 budget or, if the winner of the presidential contest has made unrealistic promises, in the 2009 one.

The later the fiscal diet is decided, the stricter it will be, in my view.  In the meantime, French politicians should pay attention to economic news from Germany and Italy, since these countries have chosen opposite fiscal stabilisation strategies.  Given the high level of public spending in France (53.8% of GDP in 2005), the Italian strategy is in my view the best one for France.  However, unless some dramatic changes take place in the mindset of a big government addicted French public, higher taxes are likely to be part of the diet, I am afraid.

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United Kingdom
Consumer Worries
Jul 14, 2006

Melanie Baker (London) and David Miles (London)

We continue to worry about the outlook for consumer spending.  Although our central case is a (sub-par) recovery in spending growth, we still see the potential for even weaker consumer spending as one of the main risks to our central GDP outlook.  Debt levels and debt service costs, likely slower growth in discretionary income than last year and downside risks to the housing market are among the main sources of downside risk to our central forecast for growth in consumer spending of just under 2% in 2006 and 2007.  Many UK households need to remain rather prudent in managing their finances and spending; levels of ‘visible’ savings (excluding corporate pension contributions) are probably still below a comfortable level for many households.

Mortgage rates have begun to rise in the UK and even a small rise in interest rates creates difficulties for many households.  Mortgage possession actions entered (not all of which will result in actual repossessions) have picked up significantly — although at 33,442 in 1Q06 they remain some way below the peak during the severe housing market downturn of the early 1990s (in 3Q91 there were 51,037 possession orders).  But individual insolvencies have also risen sharply over the past year or so. Household debt service as a proportion of disposable income (in aggregate) is at levels last seen in 1992, when the economy was in recession and when base rates were significantly higher than they are today.  All this has happened when base rates set by the Bank of England are at a relatively low level and have not been changed in almost a year. However, quoted (fixed) mortgage rates have already started to rise and quoted credit card lending rates have risen some 65bp since January 2005.  Against this backdrop, data this week showed that the unemployment rate has also risen to a six-year high.  Although rising unemployment continues to be accompanied by significant employment growth, a further slowdown in employment growth would increase our (already significant) worries regarding the consumer spending outlook.

Bank of England simulations, described in its recent Financial Stability Report, show that even a sharp fall in growth and in the level of house prices has a limited impact on the capital of the banking sector.  So threats to the solvency of UK institutions that have lent on mortgages and granted unsecured debt to households are fairly remote.  Even a 25% fall in house prices and a 1.5% fall in GDP is estimated to reduce the capital of the UK banking sector by only about 15%.  A major factor behind the relatively muted response to falls in house prices and slower growth is that the doubling of house prices in the UK since 2000 means that the great majority of those with secured debt have a large amount of excess collateral — nearly all of which is owner-occupier housing equity.  But the knock-on impact on aggregate spending — as opposed to bank capital — of households adjusting to debt problems by scaling back spending is likely to be significant.

‘Visible’ household savings probably still need to rise.   It might appear from recent savings data that, in aggregate, the household sector is adjusting to the rise in debt and in debt servicing costs. The household savings rate rose sharply in the UK in 4Q05 and 1Q06 (to an only one-percentage-point-below-average 6.0%).  At first glance, this suggests that households may already have taken steps to save more.  However, much of this increase in savings appears to have been the result of increased pension contributions by companies into their employee pension schemes.  Increases in ‘household available resources’ in the national accounts from ‘changes in net equity of households in pension funds’ (largely the balance of contributions less payments to/from pension schemes) was £3 billion over the past two quarters.  Without this inflow (largely attributable to extra contributions by employers rather than employees) into household resources, the household savings rate would have fallen in both quarters.  However, it is not clear that rising savings from this source would be particularly visible to households.  Even if they are visible, they remain a source of highly illiquid wealth and not a source of assets to help smooth consumption.  Households probably still need to raise their ‘visible’ savings rate to a more comfortable level.

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Asia/Pacific
The Global Macro Transition
Jul 14, 2006

Andy Xie (Hong Kong)

Global macro is in transition: The global economy is in transition from low inflation to moderate inflation.  Deflation shocks (e.g., emerging market crises, China’s SoE reform and Japan’s banking reform), and not just globalization and technology, have kept inflation unusually low for the past decade.  As deflation shocks end, the equilibrium inflation rate is significantly higher.

Liquidity reduction may be necessary during the transition: Central banks have been able to increase money supply without worrying about inflation due to the deflation shocks.  The level of money supply is high by historical standards, and is inflationary without deflation shocks.  As inflation picks up, central banks are forced to withdraw liquidity to prevent inflation from overshooting.

Bear market is likely to last through liquidity reduction: Global asset prices relative to labor income are high by historical standards, reflecting abundant liquidity.  As inflation forces central banks to withdraw liquidity, asset prices need to adjust to liquidity reduction.  All assets are likely to depreciate during liquidity reduction.

Inflation data will consolidate investor opinions: The range of investor opinions has widened substantially, reflecting a market in transition.  Inflation data are likely to pick up around the world, which would cause investors to price in higher interest rates for longer.

Summary and conclusions

Investor opinions have been diverging in the past two months.  The majority have turned cautious.  While expecting a period of high volatility, most do not expect a bear market, thinking: (1) that the Fed would not raise interest rates high enough to cause a recession, even if inflation were a problem; and (2) that the Chinese government would not tighten enough to slow the economy significantly due to employment concerns.

Central banks, including the Fed, view inflation as a bigger problem than recession, I believe.  As the inflation problem becomes more apparent, central banks like the Fed will stop flip-flopping and express their determination to deal with inflation, regardless of the short-term economic impact.

I also believe that China’s central government is determined to bring the economy under control as: (1) wasteful investments have become apparent, which threatens the banking system; and (2) property speculation threatens social stability.  As administrative measures have failed to control the economy, China is likely to shift to monetary policy as the main policy tool for tightening.

Inflation fighting by central banks is likely to cause liquidity reduction in the next 12 months.  Deflation shocks since 1997 have allowed central banks to create a massive liquidity boom.  A reversal under inflationary pressure would be severe too.  A bear market for all assets may have begun already and could linger for 12-24 months.

Diverging investor opinions

In talking to investors over the past two weeks, I have noticed widening investor opinions on the market outlook.  Caution has taken over most long-only investors.  However, I did not sense unusually high cash levels among them either.  They are fully invested bears, in my view.  They think that the market may test the June low again in the coming months.  The contradiction between outlook and cash level is probably due to the fear of big market bounces that may make monthly performance look terrible.

The hedge fund community is still cautiously bullish.  In contrast, they were very bullish before for as long as I can recall.  The bearish sentiment appears to rise with the funds under management.  Macro funds are the most cautious.  Some macro funds are already expecting a 1998-style emerging market meltdown.

Apart from macro hedge funds, the overwhelming consensus is still that the market is experiencing a correction, not a bear market.  The argument is: (1) that the Fed would not cause a recession even if inflation rises significantly; and (2) that China would back down from tightening the moment that the economy shows signs of weakness due to employment consideration.

Misunderstanding central banks…

Investors may be underestimating the importance that major central banks attach to inflation.  As the global economy has been fighting deflation over the past ten years, investors may be extrapolating the central bank attitude from the wrong standpoint.  Central banks put price stability above growth, because an economy can get out of recession quickly but not inflation.

The fundamental call on inflation is that the current money stock in the global economy is too high for price stability.  Its inflationary effect was held back by deflation shocks.  As deflation shocks end, the money stock has to decline to hold back inflation.

Globalization has turned a big chunk of inflation in each economy global.  For example, during the Asian Financial Crisis, inflation in the US came down sharply despite the strength of the US economy.  The same remains true as the inflation trend reverses.

Financial globalization also forces central banks to synchronize their tightening.  When one central bank tightens, it strengthens its currency, which lifts inflation in other economies and puts pressure on other central banks to tighten.

One important element in global inflation is the rise of Asian export prices.  These were on the decline for ten years, and were a significant force in keeping global inflation down.  Whether the current reversal is due to rising prices of raw materials or rising wages is not that important.  What is important is that it is rising.  Its reversal exemplifies what is happening to global inflation.

High oil prices are another source.  Commodity speculation was the last bubble manifestation of the ten-year liquidity boom.  After several years of high oil prices, oil exporters are flush with cash and not eager to sell anymore.  Thus, oil prices may remain high despite sluggish demand.

The bottom line on inflation is that it can come from any direction.  Financial globalization means that money supply could cause inflation through any bottleneck in the world.  Unsustainably high money stock is the ultimate culprit.

… and misunderstanding China

Another popular consensus view is that China’s tightening is not for real and, if it were, the Chinese government would back down at the first sign of economic weakness for employment consideration.  The main justification for this view is from what happened in 2004: when the spring tightening caused economic weakness in the summer, the government backed off in the autumn.

First, the purpose of tightening is to limit and decrease inefficient investments that would cause another wave of bad debts.  A high GDP growth rate does not necessarily require tightening.  The problem stems from the fact that growth comes from a disproportionate increase of inefficient investment.  Such growth can only last as long as liquidity is plentiful and interest rates are low.  Today’s growth could be tomorrow’s bad debts.  The primary purpose of tightening is to prevent bad debts.

Second, shifting to consumption-led from investment-led growth could create more jobs.  In addition to cyclical tightening, China is undertaking structural reforms to shift demand from investment to consumption.  They include reforming healthcare, education and pensions.  Consumption is likely more labor-intensive than fixed investment.  Macro tightening does not necessarily mean that employment would deteriorate.

Lastly, 2006 is not 2004.  In 2004, tightening was justified on preventing wasteful investment.  Now, overcapacity, white elephant projects and rampant land speculation are visible everywhere, not just in theory.  If the government does not deal with the excesses, bad debts could become too big for the government to deal with.

Most investors want evidence, not just rhetoric from the government, to believe that tightening is real.  In 2004, declining steel prices were the leading indicator for demand.  Steel prices are on the decline again.  However, investors do not believe that it is a good leading indicator now.  Loan growth is another leading indicator.  It has not slowed yet.

As investors have such a high level of skepticism, the market will recognize that China is serious about tightening when coincidence indicators turn down.  Energy consumption is probably the best coincidence indicator.   Monthly electricity consumption could be the best guideline.

Bear market, not a correction

Global liquidity reduction should cause a bear market.  The bear market may have already begun.  Considering how long and intense the liquidity boom has been so far, the liquidity reduction could be severe. 

During the liquidity boom of the past ten years, virtually all asset classes have appreciated much faster than labor income.  Bonds took off first, property second, emerging market stocks third, and commodities last.  The sequence on the way down could be the same.

Bonds are the first asset class to depreciate and could bottom first also.  G-7 bond yields have risen by over 100bp from the lows two years ago.  As the market continues to be surprised by rising inflation, the bear market for G-7 bonds is not yet over.  Bond yields could rise by another 100bp in the next twelve months, I believe.

Property is the second asset class to peak.  The depreciation has been gradual so far.  The potential for faster correction exists (see Global Property Cycle Turns Down, June 28, 2006).  As the property market is much slower than the financial market, it is likely to be the last asset class to bottom.

The global equity market peaked in early May.  After an initial sharp correction, it is now bouncing around in a range.  Earnings downgrades are likely to drive the next leg.  The liquidity boom has exaggerated corporate earnings, mainly through property appreciation to boost consumption power.  As the property cycle turns down, consumption may grow at a slower rate than income, causing the share of earnings in GDP to decline.

Commodities are likely to bottom after equities.  The proliferation of commodity funds and the dominance of first-time investors could make the money in this sector sticky.  In particular, rising inflation has become another selling point for commodities.

The sequence of asset price depreciation is quite critical to monetary policy.  If commodity prices were the first to adjust, there would be less inflationary pressure and central banks would have time to tighten, i.e., declining commodity prices could underwrite a global soft landing.  As commodity prices refuse to go down, inflation accelerates more and central banks have to raise rates more, making a hard landing more likely.

Bottom line

The liquidity boom of the past decade is winding down due to inflation.  The transition to normal liquidity requires liquidity reduction, which causes a bear market.

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Japan
Navigating with Opaque Charts (Part II)
Jul 14, 2006

Takehiro Sato (Tokyo)

In today’s BoJ policy board meeting, the unsecured O/N call rate target was raised to 0.25% in a unanimous vote as expected, while the ODR (the Lombard rate) was raised to 0.40%, instead of 0.5%, an unexpectedly smaller margin. The vote for the ODR hike was split at 6-3. The unlimited rollover for Lombard lending was maintained, and the Rimban value and frequency was maintained as well, which were not surprises.

Regarding the statement, it seemed a bit more hawkish than expected in the following points. (1) The current assessment was changed from a “recovery” to an “expansion”. (2) There was no reference to downside risks in the economy and prices. Also, there are slight differences between the English and Japanese text, and our impression is that the English text looks a bit dovish.

Meanwhile, regarding the adjustment of the policy interest rate, the BoJ added a prerequisite, saying that “the Bank will adjust the level of the policy interest rate gradually in light of developments in economic activity and prices if they follow the projection presented in the Outlook Report”. The implication of a prerequisite is likely to have an unexpectedly significant impact, in our view. The key points are as follows:

1. The ODR (the Lombard Rate): The ODR was raised to 0.4%, instead of 0.5%, which implies that the BoJ was partly defeated in its battle with the MoF. Our impression is not very positive here, as it does not seem to signal an end to bad news for market participants. If the ODR rate is maintained towards the next policy rate hike for the unsecured call rate, to 0.50%, there will be a sizable rise in demand for the Lombard lending facility, which is likely to continue squeezing the market function. Indeed, the BoJ’s decision in a sense turns a blind eye.

2. The statement: Our general impression is a bit hawkish. The key points are as follows:

a) The current assessment to the economy has changed from a “recovery” to an “expansion”. The current assessment was “recovery” up to the June Monthly Report, while it was raised to “expansion” this time, which suggests a shift of the basic assessment towards the current output gap. Indeed, the BoJ assumes that it has turned positive, in line with the Cabinet Office’s assessment.

b) No reference to downside risk in the economy and prices. Specifically, although the BoJ had previously indicated downside risks such as the slowdown in the US economy and the IT inventory adjustment in the April Outlook Report, it unexpectedly did not refer to such risks in this statement.

c) As for references to the future monetary policy path, there are some slight differences in the English and the Japanese text, with the English text appearing a bit more dovish. For example, the English text states that “an accommodative monetary environment ensuing from very low interest rates will probably be maintained for some time”. In this, the phrase of “for some time” conveys a somewhat longer-term impression than the Japanese text. (However, this is basically identical to the April Outlook Report.)

d) As for the level of the policy interest rate, the BoJ added a prerequisite, saying that “the Bank will adjust the level of the policy interest rate gradually in light of developments in economic activity and prices if they follow the projection presented in the Outlook Report”.  If our prices outlook is correct, this sentence should have an unexpectedly significant impact.

With regard to the future monetary policy, we look for the next rate hike in January 2007. A moderate pace of rate hikes is likely to continue despite concerns for a global slowdown, as we assume that the path of basic economic fundamentals is still on the upside.

In this case, the catalyst for the next rate hike will be the December instead of the October Tankan. This is because upward revisions to business plans such as sales/profit and capex are expected in the December rather than October Tankan, following F1H06 results.  

Also, the reflation-oriented macro policy framework is expected to be enhanced under the new (possibly Abe) Cabinet, in line with the Takenaka and Nakagawa economic policy philosophy, which is why we look for the interval for rate hikes cautiously at around six months.

The reset and reshuffle of CPI statistics on August 25 is likely to be another factor to make the rate hike process fairly slower than the market expectation, as the margin of the core CPI inflation rate is likely to be squeezed by this and the declining base effect of oil and energy prices. This point is important in terms of the above-mentioned prerequisite in the statement.

On the other hand, there is a tail wind for the BoJ such as the yen rate and fiscal policy.

Regarding the yen rate, it is at a historically weak level on a real effective basis. Therefore, even if the US-Japan policy interest rate gap narrows ahead, the BoJ is likely to have plenty of latitude against the currency fluctuation, and the BoJ is likely to have a freer hand.

Regarding the fiscal policy, the recent sharp rebound in tax revenue has made the timing of the consumption tax rate hike somewhat later and the margin of rate hike smaller than originally assumed. So, if the fully fledged fiscal tightening does not start until F2009, the BoJ is likely to have a sizable moratorium of nearly three years. In this sense, we may have to assume that the final destination of Japan’s policy interest rate may be higher than our original assumption of 0.50-0.75%.

With regard to the market outlook, rate hikes should be neutral for the stock market, as we look for higher investment returns due to better economic performances while the policy interest rate is rising. Thus, our view remains of a return reversal towards 1,700 for TOPIX from upward profit forecast revisions towards the interim term end.

As for the bond market, it is likely to remain comparatively solid due to an absence of concerns for major near-term rate hikes. Going forward, even if speculation rises over additional rate hikes, we think that the 2%+ level is likely to pose tough resistance for the longer end of the curve (10 years). From a fundamental standpoint, expectations for a stable inflation rate thanks to globalization of the labor market are likely to support bond markets globally.

Meanwhile, as for the dollar/yen rate, we think that it is quite solid due to the wider US-Japan interest rate gap, which will be maintained throughout the year based on our house view for US interest rates, and any possible dip of the dollar/yen rate is likely to be just temporary due to a wider negative carry. 

[Reference: Press Release]

Change in the Guideline for Money Market Operations

1. At the Monetary Policy Meeting held today, the Bank of Japan decided, by a unanimous vote, to change the guideline for money market operations for the intermeeting period, effective immediately from the announcement of the decision.

The Bank of Japan will encourage the uncollateralized overnight call rate to remain at around 0.25 percent.

2. With respect to the complementary lending facility, the Bank decided, by a 6-3 majority vote, to change the basic loan rate applicable under the facility to 0.4 percent, effective immediately from the announcement of the decision, and maintain the temporary waiver of add-on rates for frequent users of the facility. With respect to the outright purchases of long-term interest-bearing Japanese government bonds, purchases will continue at the current amounts and frequency for some time, with due regard for future conditions of the balance sheet of the Bank.

3. Japan's economy continues to expand moderately, with domestic and external demand and also the corporate and household sectors well in balance. The economy is likely to expand for a sustained period. Developments are broadly in line with the projection in the Outlook for Economic Activity and Prices (hereafter the Outlook Report) released on April 28, 2006. The year-on-year rate of change in consumer prices is projected to continue to follow a positive trend.

4. The Bank has maintained zero interest rates for an extended period, and the stimulus from monetary policy has been gradually amplified against the backdrop of steady improvements in economic activity and prices. In this environment, maintaining the previous level of the policy interest rate may result in large swings in economic activity and prices in the future. Taking account of the current assessment of economic activity and prices from the two perspectives outlined in the New Framework for the Conduct of Monetary Policy (March 2006), the Bank judged it appropriate to adjust the level of the policy interest rate at this juncture so that a desirable course of economic activity and prices was to be maintained. Today’s policy decision will contribute to ensuring price stability and achieving sustainable growth in the medium to long term.

5. On the future path of monetary policy, the Bank will conduct monetary policy by carefully assessing economic activity and prices. The Bank will adjust the level of the policy interest rate gradually in the light of developments in economic activity and prices if they follow the projection presented in the Outlook Report. In this process, an accommodative monetary environment ensuing from very low interest rates will probably be maintained for some time.

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