Global Fallout from America's Post-Bubble Shakeout
Aug 28, 2006
Stephen Roach (New York)
It’s hard to imagine that a US-centric global economy wouldn’t be at risk in the aftermath of a bursting of the US housing bubble. Lacking in internal support from private consumption, the non-US world remains heavily reliant on selling exports to wealth-dependent American consumers. As the United States now comes to grips with the aftershocks of another post-bubble shakeout, so, too, must the rest of the world.
There’s no consumer in the world like the American consumer. In 2005, US personal consumption expenditures totaled $8.7 trillion. At market exchange rates, that was about 20% higher than consumption in Europe, a little more than three times that in Japan, nine times that in China, and fully 17 times consumption levels in India. The comparisons are equally striking when private consumption is expressed as home-currency shares of each economy’s respective GDP -- 70% for the US in 2005, 54% in Europe, 57% in Japan, 38% in China, and 64% in India. Putting it another way, one measure of America’s “excess consumption” -- defined in this case as the difference between growth in consumer outlays and disposable personal income -- was about $210 billion in 2005, or almost half of total consumption in India.
In the first installment of this essay, I concluded that over-extended US consumers would be quite exposed to the correction in the US residential property market that now seems to be unfolding (see my 25 August dispatch, “Another Post-Bubble Shakeout”). Downside adjustments to US consumption stem from three macro forces -- a negative wealth effect traceable to a flattening out of home prices, multiplier effects attributable to the employment cutbacks in construction activity, and possible increases in income-based saving to compensate for the loss of asset-based saving. During the ascendancy of the Asset Economy over the past 10 years, average growth in real consumption (3.7%) exceeded that of real disposable personal income (3.2%) by 0.5 percentage point per year. In light of the post-housing bubble headwinds noted above, I could easily see a reversal in this relationship, with consumption growth falling short of real income growth over a protracted period of time. Moreover, to the extent that the direct and indirect effects of weaker construction activity depress baseline income generation, the consumption outcome could be under even greater pressure. All in all, I wouldn’t be surprised if real consumption growth in the US averages 2.0% to 2.5% over the next couple of years -- about 1.5 percentage points slower than the vigorous asset-dependent growth trend of the past decade.
Should it occur, such a 40% haircut to the US consumption growth rate would have important consequences for the remainder of a US-centric global economy. In large part, that’s because the non-US portion of the world is very much lacking in domestic consumption support of its own and, as a result, remains heavily dependent on exports, much of them to the US. For example, over the 2003-05 time period, real growth in private consumption expenditures averaged just 1.2% in the Euro area, Japan, and in Asia’s newly industrialized economies (i.e., Korea, Taiwan, Hong Kong, and Singapore). By contrast, export volume growth averaged 7.1% in the same three regions over the past three years -- fully six times the pace of consumption growth. Meanwhile, in the US, there was much closer alignment between export and consumption growth over this same period -- 5.7% average growth in exports versus 3.5% growth in consumption. This underscores a sharp dichotomy in the balance between external and internal demand in the developed economies: For the non-US portion of the advanced world, the spread of export over consumption growth over the 2003-05 interval was nearly six percentage points -- almost triple the 2.2 percentage point spread in the US. Consequently, with the world’s dominant consumer likely to retrench in the aftermath of a bursting of its housing bubble, the rest of the world can hardly be expected to sidestep this blow.
Vulnerability is not only a problem for the consumption-short economies of the developed world but is also a big risk in the export-led developing world. That’s especially the case in China. Exports now account for more than 35% of Chinese GDP and the largest portion goes to the US -- close to 40% when transnational shipments from Greater China (Taiwan and Hong Kong) are included. The rest of Asia is in a similar position. According to Andy Xie, about 10% of the total GDP for Asia ex Japan is earmarked toward shipments to the US (see Andy’s 22 August 2006 dispatch, “Asia: The Decoupling Myth”). If anything, that estimate probably understates the Asian dependence on end-market demand from the US. China’s ever-expanding Asian supply chain means that component producers such as Korea, Taiwan, and even Japan are vulnerable to a consolidation of US consumption. The same, of course, can also be said for non-Asian external sourcing of Chinese materials requirements -- a pipeline that now stretches into South America (i.e., Brazil), Australia, Canada, and, more recently, Africa. In short, if the American consumer sneezes, economies in both the developed and the developing world could easily catch a cold.
A bursting of the US housing bubble could give rise to alternative rebalancing scenarios in world financial markets. If the US consumer retrenches gradually, the ensuing rebalancing would most likely have benign implications for asset prices -- that is, foreign investors will probably not lose confidence in dollar-denominated securities. However, in the event of a sharp and abrupt pullback of the post-housing bubble American consumer, a more disruptive strain of global rebalancing could be unleashed -- as foreign investors draw into question both the return and the relative interest rate advantages of investing in US assets. In that latter case, both the dollar and longer-term US real interest rates could come under serious pressure.
It is important to stress that the sharp consumer retrenchment scenario does not require a precipitous decline in US housing prices. As noted above, my baseline guesstimate translates a flattening out of housing values and a concomitant cyclical decline in residential construction activity into a 1.5 percentage point slowdown in trend consumption growth. The saving response of saving-short US households undoubtedly is pivotal to any pullback. A modest increase in the preference for saving shouldn’t do serious damage. However, a sharp increase in the personal saving rate implies a more severe consolidation in consumer demand -- an outcome that could very much unsettle foreign investor appetite for dollars. The degree of global imbalance -- a record gap between surpluses and deficits that could well exceed 6% of world GDP in 2006 -- is hardly comforting when contemplating the downside to financial markets under more severe consumer-adjustment scenarios.
All this sounds terribly bearish for the global economy and world financial markets. Yet that need not be the case. I continue to bank on the more benign rebalancing option -- drawing comfort from a newfound commitment by the stewards of globalization (i.e., the IMF, G-7 finance ministers, and major central banks) to tackle the weighty problems of global imbalances (see my 1 May dispatch, “World on the Mend”). Significantly, this commitment doesn’t guarantee immunity to the global growth dynamic in the aftermath of a bursting of the US housing bubble. In fact, as the excesses of the wealth creation cycle come to an end, I continue to believe that weaker US and global growth remains a distinct possibility. But with the global authorities now determined to deal with imbalances on more of a multilateral basis, there is good reason to hope that a crisis-prone strain of global rebalancing can be avoided. For a US and world economy that is about to experience another post-bubble shakeout, that could well be an important silver lining to otherwise dark clouds.
Important Disclosure Information at the end of this Forum
The Message from Jackson Hole
Aug 28, 2006
Richard Berner (New York)
The Grand Tetons’ majestic beauty once again seemed to overwhelm concerns about monetary policy or the state of the global economy at the Kansas City Federal Reserve’s annual Monetary Policy Symposium this weekend in Jackson Hole, Wyoming. This venue unfailingly provides a relaxed backdrop in which to debate and reflect on sweeping issues with the best of the best. This year’s conference represented a transition in leadership, as central bankers from around the world gathered to inaugurate Ben Bernanke’s tenure as Fed Chairman.
But it also appeared to usher in a new set of economic paradigms, as the forum’s billing — “The New Economic Geography: Effects and Implications for Monetary Policy” — made clear. The agenda: What are the benefits and costs of globalization and how will the tensions arising from the unequal way they are shared be vented? Would the likely path of adjustment for reducing global imbalances be malign or benign for the economy and financial markets? What are the evolving effects of globalization on inflation and economic activity and its implications for monetary policy?
The first two issues occupied the bulk of the formal agenda, and some presenters challenged accepted wisdom. As Chairman Bernanke noted, the questions are old but the new scale, pace, and breadth of today’s globalization may have changed the answers. Indeed, some presentations argued that the new geography helped wage earners in rich countries in surprising ways. Others challenged thinking about the current account adjustment process: The sheer size of the imbalances pre-occupied those who emphasized the dark side, while tentative evidence that developing countries benefit by lending to rich ones and the greatly enhanced capital-market flexibility led others to expect a more benign outcome.
By comparison, most participants seemed to regard the impact of globalization on inflation as settled. That globalization has permanently suppressed inflation is the new orthodoxy. In contrast, the consensus viewed deficit arithmetic as too daunting and exports too small to think that global growth could provide support for US economic activity. Consequently, the issue for most was whether the coming popping of the US housing bubble threatened a US recession.
I’m suspicious of this consensus about inflation and growth, and believe that the answers to these questions are far from settled. Indeed, the ambiguity over these issues simply brought home the uncertainties surrounding the current policy debate: There is little doubt that the inflation process has changed, but the paradigm that I emphasize assigns roles to monetary policy and domestic as well as global forces in determining inflation. I still see upside risks to US — and for that matter, global — inflation. Likewise, for the first time in two decades, I think there’s a good chance that hearty overseas growth will significantly offset housing-market weakness and contribute to US economic activity and the process of current-account adjustment. These are more than just quibbles or subtle differences in emphasis; the outcome will substantially affect investment conclusions.
There’s no mistaking the global, secular decline in inflation; nor can anyone dismiss the notion that globalization has played an important role in containing it. Increased competition from the integration of low-wage economies like China into the global economy has been a positive supply shock that has limited pricing power in the West. Thus, it is important to assess overseas economic conditions, including economic slack, in making a call on US inflation. But the new convention goes further, arguing that globalization has permanently altered the inflation process by flattening the “Phillips curve,” or the relationship between inflation and slack in the economy. For any given unemployment rate, according to this new paradigm, low prices and wages abroad will suppress the bargaining power of US and other industrial-economy companies and workers.
However, I’m skeptical that globalization is the dominant factor that kept inflation and wage gains low in the past; the legacy of disinflationary monetary policies, deregulation, and cyclical forces likely were more important. On the surface, moreover, the globalization story seems inconsistent with the record profit margins at US companies; if global competition had reduced pricing power forcefully, it probably would have pressured margins. As I see it, the rapid growth in employer-paid healthcare insurance premiums and increased pension contributions have played at least an equally important role in reducing take-home pay over much of this expansion (see “Globalization and Inflation,” Global Economic Forum, June 19, 2006). And I agree with those at Jackson Hole who argued that by excluding soaring energy quotes — ironically the product of globalization — a focus on “core” inflation risks missing the influence of such price hikes on inflation expectations, wage setting, or the cost structure in industrialized economies.
Most important, I think that cyclical forces both at home and abroad are now contributing to gradually rising inflation. In that context, policymakers assessing economic slack globally should not lose sight of the role of domestic slack. If anything, recent developments hint that US potential growth and thus prospective economic slack may be lower than previously thought (see “Is Potential Growth Downshifting?” Global Economic Forum, August 25, 2006).
As noted, there was scant support at Jackson Hole for the notion that overseas growth could support US economic activity. It’s not hard to see why: It hasn’t happened for twenty years, as the US has been the main engine of global growth in good times and the provider of a safety net for the global economy in times of stress, as in the Asian financial crisis. Export volumes must grow twice as fast as imports to promote even a moderate contribution to US growth. Ironically, too, despite their acceptance of globalization, some still view exports as an appendage to the huge US economy. For them, the key issue was whether a coming housing collapse threatened a US recession.
In contrast, I think that for the first time in two decades healthy growth abroad will matter for the US outlook. First, the improvement in global growth is broadly based, lately has been driven less by exports and more by domestic demand, and seems sustainable. Second, US-based companies are increasing market share abroad, so faster growth in overseas demand will disproportionately boost US exports. And I expect import volumes to grow more slowly, reflecting slower US domestic demand growth, the substitution of US production for imports in some industries, and reduced oil import volumes (see “Betting on Global Growth,” Global Economic Forum, August 14, 2006).
The ever-changeable weather in the Tetons is often the proverbial pathetic fallacy, a metaphor for the conference: Last year’s weather was nothing short of spectacular, with the temperature ideal and hardly a cloud marring the intensely blue sky by day or the starry firmament at night. Likewise, although highly mindful of challenges and changes in the economic climate, the participants’ outlook was relatively sunny.
That was then. This year’s weather was often unsettled and uncertain. Cold, gloomy and sometimes rainy conditions obscured the mountains’ splendor, followed quickly by periods of warmth, sun and bright fluffy clouds, only to revert back to chill. Likewise, the participants’ outlook seemed to vacillate between hopes for a continued benign economic climate and fears of an imminent popping of the putative housing bubble. Discussions over meals, in the halls, and on the mountains centered on the potential threat to housing wealth, construction employment, and consumer psychology of even moderate price declines. For their part, Fed officials gave little hint of what their next move would be; if anything, their nods or headshakes at analytical conclusions or assertions about the outlook underscored the prevailing uncertainty. Approaching the issue from a risk-management perspective, however, there seemed to be broad agreement that the Fed could wait at least a short while to assess further incoming information.
The outcome of these debates will substantially affect financial markets. As I see it, there is an emerging dichotomy in financial-market pricing: Risky asset markets discount hopes for better inflation news and a benign economic outcome, while fixed-income investors seem more focused on the downside economic risks and their implications for monetary policy. But neither seems to put stock in the combination of upside risks to inflation and growth.
I have long thought that supply-induced energy price shocks remain the biggest single threat to global economic activity. Last year, as officials returned from Jackson Hole, they monitored the imminent threat to lives, energy supplies, and property in the Gulf Coast from the approach of Hurricane Katrina and her then-unknown siblings. So far this year, the tsunami of geopolitical tensions has acted as a different sort of supply shock in energy markets — one less abrupt but perhaps more persistent. Yet as policymakers left Jackson Hole behind, the approach of tropical storm Ernesto, which may become the year’s first hurricane, is a reminder that threats to energy prices persist.
Most analysts and policymakers are focusing on storm clouds in US housing markets. I’ll be the first to admit that there are downside risks to housing activity, although our housing outlook is in the lower quintile of Blue Chip survey respondents for both this year and next. And the combination of sinking housing markets, higher energy prices, and higher interest rates certainly represents a bigger threat to growth than the sum of its parts. But I don’t think that the housing wealth-consumer spending linkage is as tight as the pessimists believe. Coupled with hearty overseas growth, the recent moderation in energy quotes and interest rates may substantially offset the housing hurricane (wholesale gasoline prices have plunged by 45 cents since early August, and 10-year real Treasury yields have declined by 35 basis points since their late-June peaks). And that may challenge the emerging orthodoxy concerning the direction of risks to the US and global economic outlook.
Important Disclosure Information
at the end of this Forum
Review and Preview
Aug 28, 2006
Ted Wieseman/David Greenlaw (New York)
Treasuries posted small long-end led gains over the past very quiet week, building on the sharp gains of the prior week to send yields to further new multi-month lows and leave 2’s-10’s near its biggest inversion since March. With very little on the economic calendar, the market was choppy every day but only within very narrow ranges. But even with minimal net market movement on a day-by-day basis, until a slight reversal Friday after Chairman Bernanke said nothing market-moving to open the Jackson Hole conference, belying some market jitters that he might make some hawkish remarks on the policy outlook, the curve ground steadily flatter every day. Early month-end related buying, or in anticipation of such, appeared to be a significant contributor to this trend, as the Treasury index duration extension this month is unusually large, the biggest in several years. A small number of economic releases had little impact. Indeed, the market actually sold off a bit after weak existing and new home sales reports, as apparently investors have become so negative on the housing market that results have to be really terrible to much impress them at this point. On the other side, in an increasingly common dichotomy in the incoming data, these soft housing reports contrasted with more signs of strength in the factory sector, with a very solid durable goods report underneath a soft headline reading that pointed to stronger capital spending and bigger inventory accumulation in both Q2 and Q3, leading us to up our expectation for the Q2 GDP revision a tenth to +3.0% (from the +2.5% advance estimate) and boost our Q3 forecast two tenths to +3.5%.
After this very quiet past week, the economic calendar is extremely busy in the coming week, with main focus on Friday’s employment report, the core inflation numbers in Thursday’s personal income report, and the FOMC minutes Tuesday amid a flood of other notable releases before Friday’s early close ahead of the Labor Day holiday.
For the week, benchmark Treasury yields fell by 0.5 to 4 bp and the curve flattened, with 2’s-10’s and 2’s-30’s each down 4 bp on a half bp dip in the 2-year yield to 4.86% and 4 bp declines in the 10-year and long bond yields to 4.79% and 4.93%. The 3-year yield fell 2 bp to 4.79% and the 5-year 3 bp to 4.75%. Near-term Fed tightening expectations in the futures market were scaled back a bit further, while the amount of easing priced in for next year was ultimately unchanged after initially peaking at a new high Tuesday. The November fed funds contract gained 1.5 bp to 5.31% and the peak rate January contract rose 2.5 bp to 5.315%, so the market is down to seeing only about a 25% chance of any further rate hikes this cycle. Clearly Chicago Fed President Moskow’s warning that additional rate hikes are a distinct possibility did not resonate with investors, who for some reason were significantly encouraged by Fed Chairman Bernanke’s not talking about monetary policy in a speech on Friday, as most of the week’s move in fed funds futures took place after the Chairman’s remarks on “Global Economic Integration: What’s New and What’s Not?” Meanwhile, the amount of easing priced in for next year was flat, though from the lower assumed starting point for the peak funds rate. The Dec 06 to Dec 07 eurodollar spread, after moving to a series of record lows that peaked at Tuesday’s -46.5 bp close, reversed course the rest of the week to end flat at -43.5 bp, with the Dec 06 contract rallying 3 bp to 5.41% and the Dec 07 contract gaining 3 bp to 4.975%, moving close to fully pricing in a 4.75% funds target by the end of next year. Benchmark TIPS breakeven spreads declined for a second week, with the 5-year breakeven down 5 bp to 2.49% and the 10-year 3 bp to 2.55%, both at the low end of the range seen since early April. With the 5-year move again outpacing the 10-year, however, the Fed’s preferred market-based measure of inflation expectations, the 5-year/5-year forward breakeven inflation rate continued to hold right near a relatively elevated 2.6%.
The only key data releases the past week were home sales and durable goods, and in keeping with the consistent recent trend, the housing market numbers were weak and the factory sector numbers were strong.
Existing home sales fell 4.1% in July to 6.33 million units annualized, the low since early 2004. Sales of single-family homes (-5.0% to 5.51 million) more than accounted for the decline as condo sales (+2.8% to
818,000) rebounded slightly after big prior declines. This left both components down 13% from their June 2005 peaks. The inventory of unsold homes continued surging, rising 40% year/year to another record high.
With sales also down significantly, the months’ supply of unsold homes jumped to 7.3 to 6.8, with single-family supply up to 7.2 months from 6.7, the high since 1993, and condo supply rising to 8.2 months from 7.8, a record in the limited eight-year history of these data. Prices showed further indications of a sharp deceleration, with the median sales price up only 0.9% year/year. We’ll get a truer reading of house price trends on September 5, when OFHEO will release its Q2 figures, and while they have problems with mix shifts distorting the underlying picture, directionally at least, the median existing home sales figures are suggesting a sharp deceleration from the +12.5% year/year gain the OFHEO house price index posted in Q1. Meanwhile, new home sales fell 4.3% in July to 1.072 million units annualized, the lowest reading since February and second lowest in the past three years, and there were downward revisions to April to June sales totaling 86,000 units, or 2.5%. Inventories of unsold new homes also continued to surge, rising 1.1% in July for a 22% year/year gain. The months’ supply rose to 6.5 in July from 6.2 in June, the high since November 1995. This is above the long-term average of 5.4 months seen the past 20 years, though clearly not as bad as the comparable existing home sales figures.
Durable goods orders fell 2.4% in July, partly reversing a 3.5% surge in June. The downside was accounted for by drops in two volatile categories, motor vehicles (-7.0%) and defense capital goods (-15.1%), the latter partly reversing a large spike last month. Underlying orders were much stronger, with the key core gauge – nondefense capital goods ex aircraft – up 1.5% on top of an upwardly revised June gain (+1.4% v.
+0.4%) and a significant rise in May (+1.3%). Upside in July was led by machinery and computers. Nondefense capital goods ex aircraft shipments gained 1.3% in July on top of an upwardly revised June gain (+0.1% v. -0.5%), while inventories surged 1.0% in July also on top of an upwardly revised June (+0.8% v. +0.7%), pointing to stronger growth in Q2 and Q3.
As a result, we boosted our expectation for the revision to Q2 GDP growth to +3.0% from +2.9%, up from the advance estimate of +2.5%, and we now see Q3 growth tracking at +3.5%, up from our prior +3.3% estimate.
Looking at Q3, the very strong July retail sales report points to robust consumption in Q3 (we currently estimate +4%), which should contribute the bulk of the upside, +2.8 percentage points we estimate, to overall GDP growth. Investment looks set for a solid gain that we estimate will add another three-quarters of a point, and the recently very volatile government category, as the federal component has swung wildly back and forth the past few quarters, looks set for a rebound after the Q2 drop that should add another half point or so. Upside in these final domestic demand categories should offset a likely very large decline in residential investment that we expect to subtract a full percentage point from growth. Finally, we expect inventories to subtract marginally, and we are building in a further narrowing in the real trade gap over the course of the quarter that we expect to add about a half point. We will have a much clearer view of the net exports picture, the most significant wildcard in our +3.5% Q3 GDP forecast, after the release of the July trade report on September 12.
After the very slow past week, the economic calendar in the coming week is extremely busy, with focus on a number of key releases Friday (which will have an early close ahead of the Labor Day Weekend), particularly the employment and ISM reports. There will also be significant supply, with a $22 billion 2-year auction Tuesday and $14 billion 5-year auction Wednesday. With this supply combined with the 3-year, 10-year, and 30-year reopening at the mid-month refunding, the Treasury index duration extension is unusually large this month, biggest in several years, so the potential impact of month-end adjustments will likely remain a market focus through Thursday. In Fed news, there will be little in the way of speakers, but the release of the minutes from the August 8 FOMC meeting on Tuesday will be a significant market focus, with the main question being just how close the decision to pause was and whether dissenting Richmond Fed President Lacker was an outlier or representative of a larger hawkish group within the Fed uncomfortable with the pause. Key economic data releases due out include Conference Board consumer confidence Tuesday, revised GDP Wednesday, personal income and factory orders Thursday, and employment, ISM, construction spending, motor vehicle sales, and University of Michigan consumer sentiment Friday:
* We expect the Conference Board’s consumer confidence index for August to fall 3.5 points to 103.0. Sentiment appears to have deteriorated during the first half of August as the national average price for regular grade gasoline broke through $3 a gallon. In fact, the bulk of the responses to the Conference Board tally were probably completed around the time that prices at the pump peaked. So we look for a pullback in the Conference Board gauge.
* We look for Q2 GDP growth to be revised up to +3.0% from +2.5%, mostly as a result of adjustments to construction and inventories.
* We forecast a 0.6% gain in July personal income and 0.9% surge in spending. Even though the labor market report has shown a slackening in payroll growth of late, another uptick in average hourly earnings points to a solid gain in income during July. Meanwhile, a sharp jump in motor vehicle sales, along with a weather-related advance in service outlays, should lead to the sharpest jump in spending since January. Finally, the core PCE price index is expected to be up only 0.1%, with the yr/yr rate holding at +2.4%. The apparel category is likely to match the sharp drop seen in the CPI, and this item has an even larger weight in the PCE index than in the CPI.
* The 2.4% drop in the durables component, in which sizable drops in the volatile defense and motor vehicles categories offset underlying strength, should be partly offset by a decent advance in nondurable goods orders, leaving overall factory orders down 0.8% in July. The inventory/sales ratio is likely to rise two tenths to 1.18, a bit above the record low of 1.15 hit in May.
* We look for a 140,000 gain in August nonfarm payrolls. In the face of continued low readings for initial unemployment claims and ongoing gains in withheld tax receipts at the federal level we remain somewhat suspicious of the moderation in the payroll employment figures over the course of the past four months. Moreover, even though the more volatile household survey showed signs of a possible correction in July, the underlying trend remains impressive. And, from a fundamental perspective, the apparent moderation in productivity growth to a pace more in line with the sustainable trend seems unlikely to be associated with a marked deterioration in labor demand. Still, we are unwilling to go against the grain too much this month given the steady string of disappointing payroll readings of late – especially since the deceleration in job growth appeared to coincide with the latest climb in energy quotes, and prices at the gas pump were near a peak around the time of the August survey period. So we look for only a very slight improvement in payroll gains relative to the 112,000 per month average seen since April. Some of the upside is likely to be evident in the manufacturing and retail trade sectors. Finally, the unemployment rate is expected to retrace a portion of the jump seen in July, while average hourly earnings should moderate a bit following the outsized gains registered of late.
* Based on positive overall results in ISM-comparable versions of the early regional manufacturing surveys – strong Philly Fed and Empire State surveys, but a pullback in the Richmond Fed – we look for the national ISM to hold unchanged at 54.7 in August after the solid gain posted last month to a relatively strong level, with modest upside in the orders and employment indices expected to be offset by dips in other components. The prices paid index is likely to moderate to a four-month low, but remain at a lofty level.
* We forecast a 0.1% dip in July construction spending. The housing starts results point to a further drop in the residential category.
However, this should once again be largely offset by solid gains in the nonresidential and public categories.
* Preliminary industry reports point to only a modest pullback in August motor vehicle sales to a 16.6 million unit annual rate on the heels of the solid 17.1 million unit selling rate posted in July. While some incentives remain in place, unsold inventory stood at a 55 days supply at the end of July – about normal for this time of year. So there is little motivation for automakers to step up the aggressiveness of incentive offerings.
Important Disclosure Information
at the end of this Forum
Productivity Is Accelerating
Aug 28, 2006
Eric Chaney (London)
One thing has escaped from analysts’ attention about euro area GDP data so far this year: Labour productivity, the holy grail of economic welfare and stock market performance, has significantly accelerated. The reason for this oversight is, unfortunately, the poor performance of the European statistical system: very few countries dispose of timely and reliable data on productivity per worker, not even mentioning productivity per hour. Do not incriminate Eurostat for this pathetic situation: the small EU Directorate cannot invent data that do not even exist at the national level in several large European economies. However, it is not because productivity is poorly measured that it should be overlooked. On our tentative measure, productivity per worker in the business sector, which grew on average by 0.7% on average from 1999 to 2005 on OECD estimates, picked up to 2.0% (annualised rate) in the first half of this year, with a peak at 2.4% in the second period. More importantly, productivity per hour accelerated from 1.3% on average in the first six years of EMU to 2.4% in the last six months. There is certainly a cyclical, thus temporary, dimension in the resurgence of European productivity. However, I am firmly convinced that cyclical developments do not explain everything. A combination of accelerating corporate restructuring due to globalisation and consistent investment in information technology by European companies is the other and more fundamental reason explaining the acceleration of productivity. This should have important consequences for investors.
Guessing the reality of productivity growth
In order to gauge productivity trends, we start from the OECD series on productivity per worker in the business sector for the euro area. Since several labour market reforms, such as the 35-hour working week in France or the regularisation of illegal immigrants in Spain and Italy have seriously distorted the data, some corrections must be made, as explained in an earlier note (“Productivity Revival”, Eric Chaney and Anna Grimaldi, August 18, 2004). In addition, the secular trend of part time employment is reducing the aggregate number of worked hours per worker, even if in Germany, Belgium, the Netherlands and, to some extent, France, the number of hours worked by full time employees is probably on the rise, as ‘Siemens type’ agreements with unions (working longer hours without full compensation) progressively spread over the continent. There is also a cyclical dimension in part time jobs. These positions are more flexible than full time ones: in bad times, companies first layoff temporary workers, then workers on short term contracts, then re-negotiate part time agreements. In better times, things go exactly the other way around. Consequently, the share of part time workers is probably increasing faster than trend at the present time. In our estimates, we have opted for a relatively conservative assumption: while aggregate worked hours declined by 0.8% p.a. on average from 1999 to 2004, we have assumed that the rate of decline has diminished since then, to only -0.3% this year. Because of the cyclical behaviour of part time jobs, I would suspect that the decline might be in fact larger. Adding up all these various corrections and discounting a slowdown in top line growth in the third and fourth quarters of this year, we are left with a 2.1% growth rate for hourly productivity in the business sector, to be compared with 2.2% in the 2000 boom year, when GDP growth reached 4.0% in the euro area. A similar performance for productivity, with much slower growth (2.3% on our probably conservative estimate), is a clear sign in my view that the improvement is not only cyclical.
Investors had noticed
Interestingly, while European productivity seems on the mend, US productivity is giving signs of deceleration (See “Is Potential Growth Downshifting?”, Richard Berner, August 25, 2006). From an equity standpoint, this should play in favor of European stocks, on a relative basis, since productivity acceleration typically implies a rise in the profit share (as illustrated by the stunning rise of the profit share in Germany over the last three years) in a first stage, and the opposite in case of deceleration. As a matter of fact, investors had taken good note of this change in relative trends: from January 2003 (2003 was the turning point for productivity per worker in the euro area) to date, euro area stock prices as measured by the broad €-Stoxx index have outperformed US stocks (as measured by the S&P 500 index) by 42%, when measured in the same currency. If, as I believe, we are only at the beginning of a structural productivity revival in Europe, long term investors should not consider that this trade is already out of fashion.
Important Disclosure Information
at the end of this Forum
Aug 28, 2006
Oliver Weeks (London)
While current inflation levels remain remarkably low in Poland we continue to see signs of gradually building price pressure. With no sign of fiscal tightening and strong domestic demand, Poland seems likely to weather any slowdown in Euroland demand better than its neighbours. The combination of supply side shocks and rising wage pressure suggests the MPC may currently be too relaxed. Unusually, risks to the National Bank’s inflation projections seem on the upside to us. We still see a good chance of the rate hike cycle beginning this year.
Supply side shocks can start to boost CPI. Of the upside risks to the Bank’s projections, food prices (27.2% of the local CPI basket) remain the most immediate in our view. The combination of early season flooding, unusual heat and late rain has clearly damaged crops throughout the EU. The European Commission’s latest forecasts put cereals yields in the EU 25 down 2.7% on 2005 (but still 6.8% up on 2003). Locally the picture appears worse. The Hungarian Agriculture Ministry puts Hungary’s grain crop down 12%, while the Czech Agrarian bureau forecasts a 15% fall. The Polish Agriculture Ministry puts the harvest down 20% - possibly an exaggeration - while the EC puts barley yields down 10%, wheat down 13% and potatoes down 5%. The impact on prices will be softened by still high grain stocks, particularly in Hungary, after two years of strong harvests. However, feed wheat export prices from Ukraine are already 24% above 2005 levels. Polish wholesale prices for maize and rye were up 17%Y and 25%Y in July. Prices for meat continue to fall but are likely to follow grain with a lag. Vegetable prices, uncushioned by stocks and generally well below EU levels, may show more rapid rises. Any reopening of the Russian market would add to the pressure. So far food price growth has remained well below that elsewhere in the region, only nudging up to 0.2%Y in July, helping to push the HICP (food weight 19.9%) well above local CPI. Elsewhere on the supply side the Bank assumes that downward pressure from globalization can continue. Clothes prices were down 7.0%Y in July, taking 0.4pp off headline inflation, but it may be optimistic to assume such falls can be sustained given price rises in China. With energy and raw materials also taking industrial PPI to an 18 month high of 3.5%Y in July, we expect December CPI to reach 2.0%Y, well above the Finance Ministry’s most recent 1.5% forecast.
MPC in no hurry to hike yet. The position of the Monetary Policy Council so far seems to remain relaxed. The dovish Stanislaw Nieckarz has continued to argue that rates can fall further or at least stay on hold through 2008. Even the most hawkish member, Dariusz Filar, has argued the MPC can wait at least ‘four to five months, before hiking. The Council is likely to have in mind the experience of 2004 when it hiked rates - with hindsight erroneously - in response to a temporary food price shock that was not sustained and not reflected in core CPI movements. Continuing uncertainty over the replacement for Governor Balcerowicz may also discourage overt hawkishness. This time however we think the case for reacting may be stronger. In particular we think net core inflation, closely watched by some of the Council, is likely to accelerate further.
Demand pressure also rising. There are increasing signs that supply side pressure could be passed on to consumers. While the recovery in investment has been slightly disappointing, household consumption has begun to strengthen significantly, contributing 3.4 percentage points of the 5.2%Y real GDP growth in Q1, more even than in the 2004 pre-accession boom. Real retail sales growth has strengthened further to 11.3% over the following four months, boosted by the delayed benefit indexation in March and a still accelerating housing market. While Polish workers have helped keep UK wage costs down, there are also signs that the exodus may finally be contributing to labour bottlenecks at home - a factor not fully accounted for in the Bank’s model. The quarterly NBP survey indicates 57% of construction company managers reporting labour shortages. Total vacancies reported by GUS were up 36%Y in Q2. Recorded unemployment has fallen 4 percentage points in the last two years. Real wage growth in the corporate sector in July was 4.5% while employment was up 3.3%Y. While in the export-dominated industrial sector this has been more than absorbed by productivity growth, in the economy as a whole unit labour costs are now rising, up 2.9%Y in Q1. Meanwhile farmers’ income is increasingly being boosted by EU transfers. In the public sector health workers will receive a 30% pay rise beginning in October, while a draft act envisages accelerated wage rises in the army, both measures already raising wage expectations elsewhere.
Risk of fiscal loosening remains. Budget execution remains strong so far (if hardly anti-cyclical), a result of strong revenue growth and fairly disciplined expenditure control. The likely return of Zyta Gilowska to the Finance Ministry may further raise market confidence in fiscal management. Nevertheless risks remain on the side of loosening in our view as negotiations on the 2007 budget law intensify. In the short term costs related to co-funding of delayed EU projects are likely to rise. In the longer term the official commitment to a PLN 30 billion central budget anchor may still leave room for looser policy at the wider general government level, as Agriculture Minister Lepper has noticed. The ESA general government measure is clearly not a priority for the government given its lack of interest in Euro entry. PiS’s main concern seems to be taking over full control of local governments, the civil service, security services and vetting institutions, which may yet require fiscal concessions to Samoobrona and LPR. Already the initial 2007 budget outlines appear to require difficult cutbacks. While GDP and inflation forecasts (4.6% and 1.9%) appear conservative, planned nominal tax revenue growth at 11.9% looks high. On the spending side the need to compensate for the planned cut in social security contributions, rising EU and defence-related spending, plus draft spending bills on social transfers, drought aid, mortgage subsidies, and support for the coal sector, will further test the government’s commitment. Meanwhile on the funding side privatisation revenue looks likely to remain negligible and the planned introduction of a withholding tax on UK based bond investors may cost more than it raises.
Zloty strength is a risk but should not stop rate hikes. The most realistic risk of downside inflation surprises remains that of zloty appreciation in our view. Gas distributor PGNiG recently cuts it request for an October gas price hike after recent PLN strength against the USD. The NBP forecast assumes unspecified depreciation on a trade weighted basis, but the balance of payments position remains strong. Portfolio holdings have already adjusted down significantly while official transfers from the EU and workers remittances will continue to accelerate. Given the weakness of wage growth until this year the currency remains very competitive on a labour cost adjusted basis. Nevertheless a resumption of the sharp 2004-5 appreciation trend that has contributed to current inflation levels looks unlikely to us. With Euroland likely to slow and Polish domestic demand likely to remain relatively strong next year, the current account deficit seems likely to widen. The Polish interest rate differential is less compelling both for foreign investors and for locals considering whether to borrow in FX. Indeed the recent surge in foreign currency borrowing seems likely to slow as Regulation S restrictions on FX lending begin to bite. If some Council members are counting on the zloty to counterweight inflationary pressures as much as in the recent past, they may be too relaxed. Certainly Mr Nieckarz’s suggestion that inflation could be allowed to reach the upper end of the 1.5-3.5% target band before the Bank needs to react is slightly alarming. Nevertheless, we expect majority votes for a first rate hike of 25 bp in November and three 25 bp hikes in the first half of 2007 as a new governor asserts credibility.
Important Disclosure Information
at the end of this Forum
The Incredible Shekel
Aug 28, 2006
Serhan Cevik (from Athens)
Israel’s economy and financial markets have shown a remarkable resistance. Who would have expected the shekel becoming stronger in the face of a global financial earthquake and serious military shocks at home? Just incredible, but not really surprising in our view. We have long argued that prudent fiscal management and structural reforms in the last couple of years have strengthened the Israeli economy and made its financial markets more resilient against shocks. As a result, despite the narrowest interest rate differential vis-à-vis the developed world, the shekel has kept appreciating, especially against the dollar, and curtailed inflation pressures in the domestic economy. But is this Goldilocks performance sustainable going forward? We believe so, and here is why. Although simultaneous military campaigns have introduced downside risks to the growth outlook and strained public finances, we expect these shocks to be temporary and the economy to recover to its robust growth trend later this year. Among all the factors contributing to our benign assessment, the shekel’s fundamental valuation holds the key to macroeconomic performance in the near future.
The shekel is still undervalued by about 30% against the currency basket. Our exchange-rate valuation models suggest that the shekel is undervalued by 12.5% against the dollar, even more so (about 30%) against the currency basket. This is not a surprising finding, since Israel has experienced a period of deflation, a post-recession acceleration in productivity growth, and a significant relative correction in the fiscal stance. Of course, we do not expect the shekel to appreciate all the way to its fair value any time soon, because of residents’ portfolio diversification into foreign assets, the global monetary tightening cycle, and higher risk premium associated with geopolitical uncertainties. Nevertheless, external accounts — showing a current account surplus of 3.5% of GDP and the continuing inflow of foreign direct investments — and productivity improvements — making Israel even more competitive in international markets — support a more favourable valuation for the shekel.
Fiscal discipline is the best way to minimise the fallout from military shocks. Israel has a long and unsuccessful history of experimenting with Keynesian policies whenever a shock depresses domestic demand. As the performance in the past three years has clearly shown, the best way to minimise the fallout from the hostilities in Lebanon and the Palestinian territories is maintaining fiscal discipline and letting the private sector take the lead in the output recovery process. In our view, the current administration, albeit having a tendency to increase “social” spending, is likely to keep the overall fiscal framework intact and the budget deficit below 2% of GDP this year. However, although the debt-to-GDP ratio declined from over 100% in 2003 to 89% in the first half of 2006, it is still too high and puts pressure on the business sector. This is why Israel, experiencing a slowdown in the third quarter, needs uninterrupted fiscal prudence more than ever. Following an annualised growth rate of 5.9% in the first half of 2006, the drop in consumer and business spending will no doubt lower real GDP growth in the near future. But we believe this is going to be temporary and expect a rebound in the fourth quarter, keeping the annual growth rate at around 4.8% this year.
Monetary tightening is almost over, but there are still risks, in our view. Even though inflation is now back within the central bank’s target range of 1-3%, there are still underlying inflationary pressures in the economy that cannot be easily dismissed by the shekel’s strength. The rate of business-sector GDP growth, even after the expected deceleration in the third quarter, is likely to remain robust enough to narrow the output gap going forward. Furthermore, our US economics team thinks that the pause is not necessarily the end of monetary tightening and therefore expects the Federal Reserve to raise the policy rate to 5.5% at some point in the remainder of this year. Therefore, the Bank of Israel, albeit certainly coming to the end of its monetary normalisation campaign, may still need to tighten the policy stance in the last months of the year. That would not, however, threaten but support our call on the shekel and a flatter yield curve.
Important Disclosure Information
at the end of this Forum
No Pain, No Gain
Aug 28, 2006
Serhan Cevik (London)
The Turkish economy is now creating better jobs, but just not enough to absorb the flood of workers. No one said that correcting decades of distortions and mismanagement would be easy and painless, but Turkey achieved macroeconomic stabilisation at a reasonable price. While output growth reached an annualised rate of 7.4% in the post-crisis period, employment growth lagged far behind and failed to lower the unemployment rate to the pre-crisis level. Even though it will likely take years, if not a decade, to see the unemployment rate below the 6% mark, the latest figures nevertheless show an encouraging dynamism in the labour market. The unemployment rate declined from 9.2% in 2005 to 8.8% in the second quarter of this year, as the number of employed increased by 139,000 over the course of the last 12 months. According to our computations, seasonally adjusted figures also confirm the downward trend in unemployment, declining from 10.1% of the civilian workforce last year to 9.7% in 2Q06. Furthermore, the composition of employment is getting much better, with the share of agricultural employment coming down from 34.9% in 2002 to 28.4% this year. However, we think it is still too early to start celebrating, because the most important reason for the drop in unemployment is the dropouts from the labour force.
The adjustment phase is certainly painful, but should keep bringing dynamism to the economy. Structural changes are always difficult, and the Turkish case is no exception. The growing awareness in the corporate sector to increase productivity in today’s operating environment shaped by declining inflation and increasing competitive pressures has slowed the pace of employment growth. Even so, especially considering institutional obstacles, the economy has already started enjoying the benefits of rationalisation in factor allocations. For example, while employment in the agriculture sector declined by 778,000, or 11% year on year, in the last 12 months, non-farm employment increased by 917,000, or 6% year on year, and lowered the non-farm unemployment rate from 12.5% in 2005 to 11.5% this year. As a result, the agriculture sector now accounts for 28.4% of total employment, leading to a marked decline in unpaid (family) employment, from 20.9% in 2002 to 15.6% this year, and to an increase in farm productivity for the first time in ages. All these changes in the composition of employment and production (which, by the way, have taken place in all accession countries) are very important for Turkey’s economic prospects going forward, but still not enough to raise the employment rate and accelerate income convergence towards the European average in the near future.
Employment and labour-force participation rates remain disappointingly low. Although the unemployment rate usually grabs the attention, a proper analysis of the labour market requires further digging of the data. And the picture we get is not nice at all, to say the least. First, the employment rate stood at 44.3% of the working-age population in the second quarter of this year, down from 44.8% in 2005 and 48.5% in 2000 before the crisis. Second, the labour force participation rate — the percentage of population either working or seeking work — kept declining from 51.7% in 2000 to 49.3% in 2005 and then to 48.6% this year. In other words, despite all the encouraging developments, the state and structure of the Turkish economy is not robust and flexible enough to create as many jobs as necessary for the country’s growing population. Consequently, many become discouraged and withdraw from the workforce, resulting in an odd, technical drop in the unemployment rate. Indeed, if we include these ‘discouraged’ workers, the jobless rate would be 15.3%, not the 8.8% suggested by the official headline figure.
Improving the investment climate is the key to job growth, lower inflation and even political stability. What happens in the labour market is absolutely crucial to inflation dynamics and monetary policy. This is one of the reasons why we have been calling for the end of the monetary tightening campaign (see Marx’s Ghost, July 17, 2006). But socio-economic conditions also influence political cycles and will become even more important as the election season comes closer. Interestingly, these seemingly conflicting objectives — achieving price stability and winning an election — have a common solution. That is, removing structural and institutional obstacles to investment would complement the central bank’s efforts to bring inflation down and at the same time is the best way to increase the economy’s labour absorption capacity and thereby score high with the voters next year. A World Bank study, for example, suggests that bringing Turkey’s business environment to the OECD average would lower the unemployment rate by 4 percentage points. It is no doubt a tall order, but moving beyond normalisation requires a new vision and willingness to break taboos. Globalisation is already forcing all countries to develop more flexible labour markets and adopt more prudent fiscal policies. Unfortunately, Turkey still scores badly on both fronts, with a national minimum wage scheme and rigid regulations that have become political tools, and the highest tax wedge on employment among OECD countries, which encourages firms to substitute capital for labour.
Important Disclosure Information
at the end of this Forum
Rate Left Unchanged for Third Consecutive Time
Aug 28, 2006
Deyi Tan (Singapore)
At its recent meeting, the Central Bank of Malaysia (BNM) kept the overnight policy rate unchanged at 3.50% for the third consecutive time. This is in line with our and market expectations. The decision to put rates on hold is consistent with the message the Central Bank has been conveying so far. BNM has been saying that it would tighten only if inflation is deemed to be due to demand-side pressures, secondary round effects or wage-price spiral. Although July inflation accelerated to 4.1%YoY from 3.9%YoY in June, it was not due to any of those three reasons but due to food prices, which accounted fully for the 0.2ppt pickup. On a side note, July data again showed that the impact from the electricity tariff hike since June is minute. By our estimate, the electricity tariff hike would add only 0.1ppt to headline.
Central Bank believes that inflation has peaked and that inflation and growth will moderate in 2H06. However, it remains vigilant on oil price concerns and the pass-through effect from producers to consumers. Nonetheless, if growth and inflation turn out the way the Central Bank expects, the benchmark rate will likely remain at 3.5% for the rest of the year.
Looking forward, the expected inflation trajectory of the Central Bank is consistent with our view. Given that retail fuel prices in Malaysia are fixed and that the government has made a political promise to keep fuel prices unchanged for the rest of the year, the impact from higher oil prices will be secondary, but that has been benign so far. Hence, we believe it is more likely that base effects would cause inflation to decelerate. Our simple calculations show that the July inflation re-acceleration is likely to be one-off, and we look for inflation to come down to mid 3’s levels by year-end.
Important Disclosure Information
at the end of this Forum
The information and opinions in this report were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley & Co. International Limited and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Dean Witter Asia Limited and/or Morgan Stanley Dean Witter Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley & Co. International Limited, Taipei Branch and/or Morgan Stanley & Co International Limited, Seoul Branch, and/or Morgan Stanley Dean Witter Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or JM Morgan Stanley Securities Private Limited and their affiliates (collectively, "Morgan Stanley").
Conflict Management Policy
This research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.
This report does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, reports prepared by Morgan Stanley research personnel are based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a company. Facts and views in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: This publication is distributed by Morgan Stanley & Co. International Limited, Taipei Branch; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Dean Witter Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
This publication is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated and Morgan Stanley DW Inc., which accept responsibility for its contents. Morgan Stanley & Co. International Limited, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International Limited representative about the investments concerned. In Australia, this report, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act.
Trademarks and service marks herein are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. This report or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities is available on request.