Global
Debating Recession Risks
Sept 15, 2006

The Global Macro Team (New York, London, Tokyo, Sydney, and on the road)

Debate has long been a hallmark of Morgan Stanley’s research culture.  True to form, our macro team is embroiled in a vigorous exchange over the outlook for global financial markets.  Our credit strategists have been bearish on their asset class, but they argue about the timing and magnitude of the coming deterioration of credit quality and consequent widening of spreads.  Their discussion is merely a microcosm of our broader macro debate about the risks and ramifications of the emerging slowdown in global growth.  Thus, it’s hardly surprising that European credit strategist Neil McLeish’s bearish comments at our most recent Strategy Forum — the weekly Firmwide venue in which strategists prosecute these battles — triggered an avalanche of pushback from our ever-connected team around the globe.

The catalyst for the debate, of course, is the turn in the US housing market, which is already contracting sharply.  There is little doubt that the ripples from the plunge in housing activity will be drags on both the US and global economies, and a broad array of indicators suggests that US recession risks are rising.  But the argument over how much collateral damage will result and the nature of the offsets to US housing weakness is far from settled.  The key questions for investors are what portion of these threats to growth and financial stability is in the price of risky assets and whether we should buy or sell them. 

In order to shed light on as many aspects of the debate as possible, we want to share an edited version of this exchange with our readers. 

Neil McLeish: We’re moving to an outright bearish stance on European credit markets.  The market is fully priced for a Fed on hold but in my view is overlooking the downside risks to the economy.  The key question: What is the magnitude of any fundamental deterioration relative to today’s strong starting point both for corporate credit quality and market pricing.

The US recession risk model developed by Jonathan Wright at the Federal Reserve Board offers clues about future credit problems (see “The Yield Curve and Predicting Recessions,” FEDS Discussion paper 2006-7, March 2006).  This model was a good leading indicator for high-yield default rates over the last 20 years; now it is flagging a rising risk of a US recession over the next twelve months and therefore a rising speculative-grade default rate.  The magnitude of today’s rise in risk is closer to that seen in 1995 than to that in the credit crunches of 1991 or 2002.  But we do not believe that European high-yield credit spreads discount such a rise in defaults; hence our renewed caution on this market — and by extension, the risks to credit broadly.

Greg Peters: Neil, I want to stir the credit pot since I have a different point of view.  You may be right about European credit; it is more expensive than in the US, and managers have been more aggressively leveraging.  But we are much less negative than you are on the US, being slightly underweight credit and having barbelled our risk.  The problem for us is that corporate fundamentals in the States have been "stronger for longer," and thus hard to short.  In fact, I have been painfully wrong about balance-sheet releveraging.  I thought the private equity community would force Corporate America to embrace leverage, but in the universe of issuers we track that has not really happened. 

To be sure, companies are buying back a ton of stock and capex is up from the lows — but aggregate balance sheets remain pristine.  Corporate chieftains are gun shy and disciplined.  It’s not outlandish to think that, courtesy of the recent plunge in energy prices, companies may see margin expansion — yes, margin expansion.  Companies have pricing power and have passed along their energy-related costs.  I think top-line pricing is sticky, so any reduction in energy costs will go directly to the bottom line.  Either outcome is potentially supportive for credit. 

True, we must distinguish between corporate and consumer credit risks.  I think consumers are much more vulnerable than corporations, being income-short and overleveraged.  So we are very negative on consumer-related industries and prefer B2B credits.

My bottom line: Without signs of a clear deterioration in the fundamental landscape, it is hard to envision a meaningful spread-widening environment.  The wall of liquidity in US markets has also capped spreads.  As I see it, both will delay the coming credit downturn, and short sellers will continue to be frustrated.  And from an investor’s standpoint, timing is nearly everything. 

Stephen Roach: Greg, Neil's point was to hammer home the relationship between heightened US recession risk and rising credit default rates, and thus conclude that credit risks are not in the price.  You duck this issue entirely by saying, "without a clear deterioration in the fundamental landscape, it is hard to envision a meaningful spread widening."  The recession probability gauge that Neil presented challenges that assertion head on.  We can (and do) debate the validity or the accuracy of that gauge — but that is a different matter altogether.  Your point on investor appetite for these securities is obviously important for most spread markets — but it does not address the central issue that Neil was raising.

Neil McLeish: I’ll be the first to admit that (as Teun has pointed out convincingly and comprehensively) the recession risk indicator’s current probability of 45% or thereabouts has never resulted in an actual recession in the past (this required 70%-plus readings), although a 45% reading has certainly flagged several mid-cycle slowdowns. 

Ted Wieseman: Neil, it may be that the simple version of the Wright model gives you a 45% chance of recession.  But different models give different results: Estrella’s model (see Arturo Estrella and Mary R. Trubin, “The Yield Curve as a Leading Indicator: Some Practical Issues,” Federal Reserve Bank of New York, Current Issues in Economics and Finance, July/August 2006  Volume 12, Number 5) says it’s just over 30%.  That’s consistent with Stephen Jen’s re-estimation of the Wright model, which produced a 32% probability. 

McLeish: Yes, but as Steve notes, we are trying to assess what’s in the price of different asset classes and the probability distribution that each asset class assigns to a range of different future outcomes.  Credit markets don’t think there are only two states of the world — in this case, either recession or not.  There is a spectrum of outcomes.  My point is that European HY is pricing in a low probability of a meaningful mid-cycle slowdown in corporate earnings and related uptick in default rates over the next few quarters, and that such a slowdown is a higher probability today than it was 6 months ago.  From what I can tell, some other asset classes (European equities and US HY are the two I have discussed internally with the appropriate MS strategists) appear to be pricing a materially higher level of bad news than European HY.

Regarding US-European leverage comparisons, Greg's point is spot on.  The gap is much bigger on the HY side, where the European average leverage is 5.1x debt/EBITDA according to our numbers, whereas Brian Arsenault tells us that the US ratio is around 3.5x.  So the LBO craze has really had an impact here.  For investment grade, the gap is much smaller but Europe is marginally higher (Europe at 2x debt/EBITDA; US at around 1.8x per Greg’s recent report).

Peters: Let me return to Steve’s critique.  Recession risks may be rising, but I think they are still low.  Stephen Jen’s proprietary recession probability model puts the risk at 23%.  The index that Neil is using has to hit ~70%+ before it really matters.  I don't believe a US recession in 2007 is even close to the Firm's base case. 

I think you guys are ignoring what matters for credit — initial conditions.  Typically, rapid debt growth well in advance of a recession sets the table for defaults; when the recession hits, higher debt burdens crush cash flows and exacerbate the default experience.  However, today you see debt service coverage ratios at all-time highs, and companies are not aggressively expanding debt levels.  So I think it is difficult to envision fundamentals meaningfully deteriorating unless we see a real hard economic landing –— and even you don’t think that is in the cards any time soon.  Equally, can we have a hard landing if Corporate America isn’t fragile?  In this cycle, corporations have ample dry powder, and thus are much better prepared to withstand any potential consumer-related economic storm.  If I’m right, the default cycle could be less severe than past economic downturns.  For the record, I am no credit Pollyanna, but I'm just trying to provide a more micro observation that we recently gleaned from our data set. 

Eric Chaney: Let’s get back to the numbers for a minute.  If the probability indicator says 45%, it is 45%, not less, not more.  We should not then add another rule (recessions occur when the probability is above 70% for instance).  It is only because recessions are rare events that we try to extract more information from these indicators than they have in reality.  Maybe this is a behavioral issue, but it is plausible that markets consider that 0.45 is not different from zero and that 0.7 is not different from 1.  If true, this is more herd than rational behavior.

David Greenlaw: Hooray for Eric!  He and I will toss this one onto the scrap heap of overly simplistic approaches to business cycle analysis (where it can join the price of gold and the money supply).  Once upon a time, there may have been a fundamental model of the economy that was consistent with a significant role for the shape of the curve.  But does anyone really believe that is still the case?

Roach: But is that really the point?  This is not about arguing whether or not there is a "best mousetrap". It is about allowing your ever rosy minds to concede that recession risks are rising in another post-bubble shakeout -- with emphasis on the word risks.  In that climate, which is different from the scenario when recession risks were not rising, the market debate is very different.  It's really that simple.  The so-called model that has you guys so lathered up is nothing more than a stalking horse for the big — and I daresay perfectly legitimate — question.

Greenlaw: Recession risks will surely rise and fall (in the case of the US, they have been rising recently, but I strongly suspect they will soon begin to fall).  All I'm saying is that we should not rely on the yield curve model as the official arbiter of the mixed signals coming from different asset classes.  We can always tweak a model that has gone off track to make it look less bad (as Wright and other did by adding the funds rate to the yield curve equation).  But it also has to make some intuitive sense.  With all due respect, in my view, neither the old yield curve model nor Wright's revised version fit the bill if you believe (as I obviously do) that we are currently dealing with a “conundrum” in which the market is being driven by special factors rather than fundamental forces.  

Joachim Fels: I think it is premature to throw away the yield curve model for predicting recessions.  Let's face it: The track record of the curve in forecasting recessions about a year ahead is better than that of any economist or mechanical forecasting model I know.  The reason why the yield curve has helped predict recessions is that it is usually a good indicator for the stance of monetary policy.  An inverted yield curve has usually indicated a restrictive policy stance, and in most cases, recessions have been caused by excessive monetary tightening.  Of course, if long-term interest rates are pushed below short rates by other factors such as ALM flows or a compression of term premia, a recession model based on the shape of the curve will fail.  This has been the case for the UK, where the curve has been inverted for a while but the economy is doing fine. 

But in the US, the jury is still out.  I find it instructive to contrast the message from the inverted yield curve with the message from another (in my view better) indicator of the policy stance: the gap between the actual short rate and the natural, or neutral, rate.  On Manoj Pradhan's and my estimate, the Fed funds rate stands some 50-75 bp above the time-varying natural rate, indicating that monetary policy is restrictive, though less so than before most recessions except the one in 1970.  This roughly matches the message from the yield curve model:  A recession is not the likely outcome, but the risk of a recession (and I agree with Steve Roach that this is what really matters for markets) has clearly increased since the start of the year.  And if Dick and Dave are right that the Fed isn't done tightening yet, I would expect the recession risk to rise rather than fall in the next few months.

Elga Bartsch: My solution to the yield curve conundrum: We should estimate a probit model based on business-cycle indicators and then contrast its results to the verdict coming from other probit models based on financial variables, such as the yield curve.  This way we could back out the call for where these financial variables are headed, based on whether or not they under- or overprice the risk of a US recession, bearing in mind that other factors might be at work too.   However, no probit model offers a solid analytical framework in which to sort out the fundamental factors arguing in favor of or against a recession.  They just tell us in which direction the winds are blowing at the moment.

Teun Draaisma: There is a long history of market-based measures being better at forecasting economic turning points than any individual.  We can debate for a long time what is the right model, and I am sure we will.  I definitely trust those market-based models better than, say, any MS analyst survey.  They also have the additional benefit of being simple, and of triggering a great debate!

Eric is right, of course, that 45% risk of a recession is 45%.  But as a market strategist, we need to forecast markets, not economies, and the reality is that during mid-cycle slowdowns the recession risk increases and that markets get too cheap.  When risks are higher, rewards can be higher. 

Gerard Minack: Teun, I understand why you may want to tie your market call to a market-based indicator rather than an economist's forecasts.  But consider these comments:

First, aren't you implicitly assuming in your own bullish strategy call that the market-based recession indicator is incorrect and its next move will be lower? 

Second, isn't the real money to be made in forecasting those moves?  In other words, akin to Stephen Jen’s point, if the recession risk (captured by the model) rises, won't it be wrong to have been bullish equities now?  In short, to make money you still need to decide what’s in the price and forecast something.

Finally, when discussing the risks, isn't the correct way to look at the probit model one based on conditional probabilities?  That is, the point is not that there are no recessions when this model is at 45% and that they happen at 70%.  The question now should be: Given that we've got a 45% risk reading, what is the chance that we'll soon get a 70% reading?  I don't have the chart in front of me, but I suspect that on that conditional basis there's a 50% chance that you may have to write a sell equity note by year-end.

David Miles: I am very skeptical that we can learn much at all about the chances of recession from the shape of the yield curve today.  Those who try to do this are using the past correlations between the shape of the curve and what subsequently happened in the real economy.  But the correlations you get over the past several decades, between downward sloping curves and subsequent slowdowns, are really driven by the unpleasant episodes when inflation had risen a lot.  At those times central banks had to increase rates a great deal to slow the economy and this created sharply inverted yield curves at the shorter end. 

Today in most economies inflation — although it has ticked up a bit — is nowhere near the scary levels reached during those past episodes that created the correlation between inversions and subsequent recessions.  I also think that at a generally much lower level of inflation and of nominal interest rates, a much greater part of the shape of the curve is attributable to risk, or term, premia, and these have little to do with expectations of recessions.  I question the reliability of any quantitative statements on recession probabilities today based on what happened in the 1970s and early 1980s.

Roach: David, I agree with the inflation point, but the new world of quasi-price stability offers a new twist:  What if liquidity-driven asset bubbles and wealth extraction enabled by positively sloped curves drive the economy?  As the curve inverts, doesn't that then take away the "candy" that has supported bubble-dependent economies like the US?  We have a new transmission mechanism but similar outcomes.

Richard Berner: I strongly agree with David, given our work on term premiums.  As I see it, lower inflation and economic volatility that reduced term premiums have flattened yield curves on a secular basis, so the correlations from the past are less valid.  Given the distribution of outcomes around that new norm, we should expect more curve inversions with no necessary consequence for recession.  Investors have further squashed today’s über-low term premiums by selling volatility to enhance returns, creating a virtuous circle that prevents the curve from re-steepening — until they think volatility is too cheap and they want to buy it.  Ironically, for central banks, a decline in the term premium adds financial stimulus, requiring higher, not lower, short-term rates — just the reverse of the traditional interpretation of the yield curve.

Steve's point about asset bubbles is well taken, but I don’t think that the inversion of the curve necessarily takes away the “candy.”  If anything, the recent rally in stocks supports my view that low volatility which reduces long-term rates adds stimulus to both markets and the economy.  That's where we need valuation metrics to guide us.  But there's the rub: Stocks today may look cheap if you expect continued favorable outcomes but dear if a recession lies ahead. 

Takehiro Sato: I agree with David as well.  Let's think about Japan's case.  The JGB curve has been the steepest among the developed countries for a long time even when we were suffering a severe deflation, and still is, although there is a rising concern that the economy will go into a lull just like two years ago.  I know that Japan's case is peculiar, as monetary policy has been confronted with the zero-bound problem.  But I am not persuaded that a simple quantitative approach will yield robust conclusions, especially in Japan's case.

Stephen Jen: Recession probability calculations are very sensitive to which model you use.  A version of Wright's specification (yield spread + funds rate) that Luca Bindelli and I developed gives a 32% chance of recession in a year, but if we augment it with equity returns and credit risk premiums, the probability falls to 19%.  Adding building permits yields a one-year recession risk of 23%.  We like market-based indicators, but they are all pretty simplistic. 

More important, there is a circularity in interrogating the market's opinion of the economy, when it is our job to forecast growth and market prices — so we can forecast the market.  But that is no different from the Fed monitoring the 5Y-5Y break-even inflation.  One could argue that the Fed's job is to stabilize inflation, and therefore it has no business asking what the market is thinking about inflation.  However, having a recession predictor that gives us a number, however qualified, is helpful to get a sense of what is in the price. 

Moreover, Luca’s and my work underscores the disconnect between equity and bond markets.  This model tells us that the bond market alone sees a 43% chance of recession, but combined with the equity and credit markets, the odds fall roughly to 1 in 4.  At this point, the fate of the US economy is the single most important assumption we market strategists have to make.  We also need to know whether the markets are aligned with Dick’s and Dave’s view.  The exercise we did told me that the bond market is too bearish, while equities and credit may be a bit on the bullish side.  They net out to give us an aggregate probability that is sensible.  This is useful information to us.

Our bottom line: Watch multiple markets, not just bonds.  In our empirical work, we have included both the equity and the credit market as forward-looking indicators, precisely because we did not trust the bond market.  Thus, importantly, our measure is a composite measure of the three markets' collective opinion on the US economy.  If the resulting recession probability drifts from 23% to 50%, and we can see that it is due to all three markets saying the same thing, then we would indeed assume that the markets collectively think a recession is coming.  Whether the markets are right or wrong is still a judgment call. 

Berner: Stephen, your point about circularity is crucial in two respects.  First, it highlights the fact that any simple regression shows correlation but not necessarily causation.  All the explanatory variables in these recession indicator relationships are endogenous, so our estimates of the parameters may be biased.  Second, the relationship can show what's in the price — and that's very helpful for assessing whether or not to bet against markets.  But it may not be so helpful to inform our judgments about the fundamentals, if we judge, as Neil does, that the market has it wrong. 

Roach: The key question is the time series of these probability results — namely, have the risks gotten higher or lower recently.  Then we must earn our keep and attempt to predict the future moves in these probabilities in accordance with our own "models" of the future.  I stand by my view that the probability or risk of a recession is now rising and likely to rise further in the months ahead.  I rest my argument on two key developments — the post-bubble consolidation of an income-short American consumer and the coming slowdown of the Chinese producer.  The rest of the world will suffer as a result.

Gray Newman: The global business cycle has always carried important implications for emerging markets, because their economies are so geared to it.  But today, there is an important twist: Just as Greg thinks initial conditions matter for credit, initial conditions may determine how emerging markets would fare in the event of a US recession and a further decline in commodity prices.

There is little doubt that the surpluses we are seeing in the current accounts from Mexico and Brazil to Argentina and Chile owe much to the combination of high commodity prices and strong demand.  A global downturn would dent or in some cases eliminate those surpluses and lead to slower growth.  But that is hardly remarkable: I've never argued that emerging markets were immune from the global business cycle. Some such as Mexico have a more direct link with the US than do others.

What matters is how each economy has dealt with the abundance of recent years.  Some countries have taken advantage of the strong inflows to reduce or all but eliminate their external debt.  Brazil, which many thought was on the brink of default four years ago, this month has zero net external debt thanks to an aggressive campaign of debt buybacks and accumulation of international reserves.  A slowdown in global demand would likely crimp the growth dynamics in 2007, but the risk of the kind of financial meltdown that emerging markets are famous for is much less likely in Brazil. 

For every Brazil, however, there are other emerging markets, from Hungary to South Africa to Turkey, with significant financing needs from either large budget imbalances or hefty current account deficits.  A global recession for countries suffering from a growing financing need is a recipe for a much more severe contraction, and I'd be worried of the risk of debt accidents in those markets.

Serhan Cevik: Gray, I agree with your points.  I would add that the composition of an economic downturn matters to assess likely spillover effects on EM economies.  Take Israel: The US accounts for almost one-third of its exports, and therefore it may look vulnerable.  However, almost 80% of Israel's exports to the US are technology-intensive capital goods and services.  Whereas China is vulnerable to a slowdown in US consumer spending, Israel would be exposed to a capex downturn.  Second, we need to make a distinction between commodity exporters and importers.  I agree with you that Turkey’s financing needs leave it vulnerable.  But the silver lining in a sustained correction in commodity prices is that it would help Turkey’s current account.  As net imports of oil and oil derivatives increased to 7.8% of GDP this year, the country's external deficit widened to 6.5% of GDP, putting pressure on the lira as well as on inflation.

Important Disclosure Information at the end of this Forum

Currencies
Sovereign Wealth Funds and Official FX Reserves
Sept 15, 2006

Stephen Jen (London)

An under-appreciated class of funds

This note draws attention to the sovereign foreign currency funds that are not part of the official currency reserves.  These funds are large — totalling close to US$1.4 trillion — and will likely expand rapidly in the future.  In my opinion, they deserve as much attention from investors as the official reserves. 

Sovereign wealth funds

The world’s holding of gross official foreign currency reserves totalled US$4.9 trillion as of end-March 2006.  Asian countries account for US$2.52 trillion, while the monetary authorities of OPEC+3 (OPEC, Russia, Norway and Mexico) possess another US$579 billion.  How the monetary authorities of these Asian central banks and the oil exporters manage their reserves has attracted a great deal of investor attention since 2004.  In the past two years, I have also actively participated in the debate on diversification. 

However, there is a separate class of funds that have not received nearly as much attention as they should have, and discussions about them are often blurred with the discussions about the official currency reserve holdings.  Following Rozanov (Who Holds the Wealth of Nations? published in the Central Banking Journal, Volume XV Number 4, May 2005), I refer to these funds as ‘sovereign wealth funds’.  Many of these funds were originally established as oil price (or commodity price) stabilization funds to help block out disturbances from volatile oil prices on the budget, monetary policy and the economy.  However, with the sharp and, most likely, permanent rise in oil prices in recent years, these funds have evolved from ‘stabilization funds’ to ‘wealth accumulation’ or ‘wealth preservation’ funds. 

The aggregate size of the funds — at US$1.4 trillion — is quite large.  Oil-related funds account for US$845 billion, or 60% of the total.  The rest are either investment funds belonging to export-oriented Asian countries or non-oil commodity funds. 

I have these thoughts.

• Thought 1. High oil prices should keep these funds growing rapidly. OPEC nations are expected (according to the IMF’s World Economic Outlook) to run US$300 billion of C/A surplus this year and in 2007.  Much of these C/A surpluses will likely end up in these oil funds.  Annual growth of US$200-300 billion for these oil funds is not an unreasonable expectation.  The Norwegian Government Petroleum Fund, for example, rose from US$90 billion in 2002 to US$270 billion now.  Similarly, UAE is expected to run US$35-40 billion worth of C/A surpluses each year over the medium term if oil prices remain at around the current level.  At this pace, in theory, ADIA could gain an additional US$200 billion in assets in five years’ time. 

• Thought 2. Some of the new FX reserves could be ‘transformed’ into these sovereign wealth funds. Governor Zhou Xiaochuan of the PBoC commented earlier this week that China now has enough foreign currency reserves and that steps will be taken to contain the speed of their rise in the future.  Clearly, from a longer-term perspective, the best way to achieve this objective is to open up the capital account and encourage private overseas financial and foreign direct investments, in addition to enhancing consumption.  However, with prevalent expectation of CNY appreciation, capital outflows may not materialize even if the ‘floodgates’ are opened.  An alternative is something the PBoC has already done, when it transferred US$45 billion in 2003 to capitalize the two state banks, through the China Huejing Holding Company. 

This fund is somewhat similar in kind to Singapore’s Temasek.   At this point, we ‘guesstimate’ that there is close to US$100 billion in this fund, disbursed out of the official reserves to recapitalize the four state banks and to fund other financial operations. 

There are several other ways to keep the growth of China’s official reserves relatively low.  China could encourage the purchases of foreign energy interests (e.g., in Africa, Eastern Europe, or even the US).  It could spend money on infrastructure such as constructing the facilities for the Strategic Petroleum Reserve.  In theory, these activities could be carried out using the official reserves through the China Hueijing Holding Company, just as Singapore’s Temasek is used to acquire domestic and foreign assets.   

Further, Korea has created the KIC (Korea Investment Corporation) with seed money from the official reserves.  Singapore’s GIC already invests some of the MAS’ reserves.  China could, in theory, do the same through a ‘CIC’. 

• Thought 3. There should be greater risk-taking for sovereign wealth funds. I have talked about large reserve managers splitting up their reserves into a ‘liquidity tranche’ and an ‘investment tranche’, with the latter being exposed to more risk in exchange for higher expected returns. 

Already, some reserves are indeed being diversified across both currencies and assets.  The latest BIS quarterly report contains a chapter on the changing composition of official reserves.   It validates a view we have espoused for a long time that cross-asset diversification has been significant, possibly more so than cross-currency diversification.  The fact that the share of dollars in bank deposits, which account for about a third of all official reserve holdings, has declined sharply in the past four years, while the dollar share of total reserve holdings has not declined during this time, suggests that there were probably more dollar deposits deployed into riskier/higher expected return assets in dollars.  In other words, there could have been little currency diversification but a lot of asset diversification, in dollars.

Reserve managers, in theory, have the option of shifting the reserves in the ‘investment tranche’ into these sovereign wealth funds.  GIC and KIC are good examples: it may be more efficient for the ‘investment tranche’ to be managed by fund managers who specialize in higher-risk, higher expected return assets.  To satisfy the IMF’s definition of official reserves, investments have to be of a super low-risk type.  By shifting some foreign exchange holdings from reserves into these sovereign wealth funds, large Asian reserve holders could gain more flexibility with their portfolios.  With its official reserves approaching the US$1 trillion mark, China could, and maybe should, consider this set-up.

• Thought 4. Sovereign wealth funds are more difficult to track. Monitoring the currency and asset compositions of official reserves is difficult, but tracking the sovereign wealth funds would be nearly impossible, as these funds are blended with the massive pool of private capital.  This could be an advantage for the large reserve holders who don’t want their portfolio shifts to be tracked by the market. 

Bottom line

Investors should pay more attention to the sovereign wealth funds, not just because they are large (currently US$1.4 trillion) and growing fast, but also because they could capture the key changes in how the bloated Asian reserves and the oil funds are invested.  Asset and currency diversifications are likely to be more acute, as these sovereign wealth funds start to look more like private mutual funds and even hedge funds, and less like official reserves.  They will also be harder to track.  I believe that diverting some of the official reserves to sovereign wealth funds is a legitimate, and even likely, option for China. 

Important Disclosure Information at the end of this Forum

United Kingdom
Getting Closer to the 40% Debt Limit
Sept 15, 2006

David Miles (London) and Melanie Baker (London)

The upcoming reclassification of currently off-balance sheet government liabilities will bring us closer to the government’s 40% net debt limit.   Were debt to rise to the 40% limit in the next few years, that could lead to asset sales and a shift in the balance between public and private debt issuance.

Next week the Office for National Statistics is likely to re-classify some currently off-balance sheet government liabilities as being, effectively, government debt.   Bringing some part of the value of off-balance sheet items (Private Finance Initiative (PFI) deals) on balance sheet will raise the stock of net government debt.  The stock of net government debt currently stands at just under 37% of GDP.  Even in the absence of any re-classification, it is very likely that the net debt/GDP ratio will rise very close to the government’s 40% limit over the next few years.

Not seen as a major issue for investors.  Investors in gilts have — quite sensibly — not been overly excited by the prospect of the government coming near to breaching its 40% rule.  The political implications of getting very close to the 40% limit are, arguably, rather more significant than the economic and financial market implications.

But there are potential financial market implications that few have yet focused on.  Suppose we do get to the 40% level soon.  This would mean that, to avoid breaching the limit, net debt issuance would have to be no greater than 40% of the rise in GDP.  If trend GDP growth is about 2.5%, and inflation (measured by the GDP deflator) is at 2.0%, this puts a limit on net issuance of around 1.8% of GDP, which is about £21 billion at today’s prices.

Once at 40%, the implicit limits on borrowing would be hard to stick to.  Net annual issuance of around 1.8% of GDP may prove difficult to stick to, given the ongoing need to improve infrastructure in the UK; the potential for cost overruns in the preparation for the 2012 Olympics is another reason why holding public borrowing at significantly under 2% of GDP could be hard.  But there is another way through all this…

The government could sell off assets.  The public sector’s net worth — that is, the excess of the value of all public sector assets (tangible and financial) over its outstanding debt — is very substantial.  Today, public sector net worth stands at about 30% of GDP. Gross non-financial assets are some £800 billion.  There is scope for the government to sell off assets, allowing it an extended period to continue growing capital and current spending while keeping within the 40% net debt limit.

The scope for asset sales has been much enhanced in recent years by a combination of technological and financial market developments.  Technological advances mean that the scope for assets long held in the public sector to be run commercially is greater.  For example, it is now feasible to have road pricing which would allow parts of the road network to be run commercially without the need for toll booths that slow traffic flow.  The cash flows generated by road user charges are an asset well-suited to back securitisation issues.  Inflation swaps can allow issuers to turn standard bond issues into liabilities which are matched against revenues that are likely to move in line with inflation.

More private and less public issuance?  We might therefore expect the balance between public sector debt issuance and issues from the private sector to shift gradually over time.  Ten years from now, the balance between gilts and corporate debt within the balance sheets of pension funds and life insurance companies could look rather different from today.

Important Disclosure Information at the end of this Forum

Turkey
Productivity Cushion
Sept 15, 2006

Serhan Cevik (from Singapore)

The financial volatility shock will not lead to another boom-bust growth cycle, in our view. After enjoying 18 quarters of uninterrupted growth, Turkey is likely to remain as one of the fastest-growing (commodity-importing) countries in the world. According to the latest set of national accounts, real gross domestic product grew by 7.5% year on year in the second quarter — and 7.0% in the first half — of this year, on top of a cumulative increase of 33.5% in the previous four years. This is indeed the longest stretch of economic expansion in the country’s history, and confirms our view that the growth acceleration is a secular phenomenon. Although Turkey’s impressive performance certainly benefited from the abundance of global liquidity in the post-2001 period, prudent fiscal policies and far-reaching structural reforms have been the real driver of macroeconomic normalisation, in our view, resulting in productivity-led above-trend growth. This is why we believe that the recent financial volatility shock, albeit increasing uncertainty and lowering growth in certain segments of the private sector, is unlikely to lead, once again, to the infamous boom-bust business cycles.

A likely slowdown in domestic demand has more silver linings than adverse effects. Real private consumption increased by 10.1% year on year in the second quarter, up from 8.6% in the first three months of the year and following a 30.3% increase in the 2002-2005 period. As usual, spending on durable and semi-durable goods — posting a cumulative increase of 15.6% in the first half of this year after surging by 65.0% in the previous four years — was the overwhelming factor driving consumption expenditures. Likewise, private-sector gross fixed investment spending continue surging ahead with a 14.8% rise (and 21.5% in the first half of 2006), thanks to the corporate sector’s strong appetite for machinery and equipment purchases. Commercial building and plant construction also increased at an encouraging rate of 26.3% (and 25.2% in the first six months), signalling new capacity-building in the private sector. Of course, the volatility shock has brought a significant tightening in financial conditions, and will surely restrain domestic demand in the remainder of the year. Given the sensitivity of consumption (as well as investment) expenditures to changes in interest rates and credit availability, we have already observed a marked decline in certain categories of private consumption. For example, as the consumer confidence index dropped in the last couple of months with the turmoil in financial markets, domestic automotive sales declined by 41.9% year on year in July and 36.7% last month. However, we should not exaggerate short-term volatility and extrapolate these figures into the future. Our analysis of consumption dynamics points to a moderation, not a collapse, in consumer spending (see Secrets of Consumer Dynamics, September 4, 2006). And on the supply-side, the outlook is truly encouraging. Industrial production recorded a 9.5% year-on-year increase in July, thanks to very strong readings in investment- and export-oriented sectors. Indeed, while domestic demand moderates towards a healthier growth path, export growth has accelerated to an annualised growth pace of about 25% in recent months. This is why we decided, even against slowing domestic demand, to revise up our growth estimates from 5.6% to 6.0% in 2006 and from 5.8% to 6.2% next year.

Higher trend productivity growth supports output expansion and disinflation. Despite the prevailing scepticism, Turkey has enjoyed a sustained acceleration in the trend growth rate of productivity. For example, output per hour worked in the manufacturing sector increased by 38.5% on a cumulative basis in the post-crisis period (see The Power of Productivity, April 5, 2006). By any measure, this is a spectacular performance, but we appreciate the sources of productivity growth even more. Capital deepening has certainly played an important role, and should help to maintain higher productivity growth in the future. However, it is not just about the accumulation of physical capital, since there are indeed far more significant but underappreciated factors in play. The private sector, while increasing the capital ratio by investing in productivity-enhancing machinery and equipment, has also started employing workers with higher educational attainments. And coupled with improved labour quality, macroeconomic normalisation has acted like innovation, raising total factor productivity growth from 0.5% a year in the 1990s to about 5.0% in the past four years.

Economic growth is not an enemy of the disinflation programme. Not just in Turkey, but also around the world, it is always argued that an increase in economic growth would automatically lead to an increase in inflation, or a decline in the rate of growth would reduce inflation. In our opinion, this is simply nonsense. If potential output is growing rapidly, as it has been the case in the Turkish economy because of higher trend productivity growth, actual output can also continue growing at a rapid pace without intensifying inflation pressures. In other words, productivity improvements have already lowered the non-accelerating inflation rate of unemployment and raised the economy’s potential growth rate, which in turn result in strong disinflationary forces. This is why we believe that inflation will start moving towards the ‘price stability’ range next year and thereby allow the central bank to initiate a new monetary easing campaign.

Important Disclosure Information at the end of this Forum

Japan
2 1/2 Macro Worries of Domestic Investors
Sept 15, 2006

Robert Alan Feldman (Tokyo)

Intensive meetings with domestic investors over the last two weeks have identified 2 1/2 top macro themes. The first theme is the prospective Abe government:  What will it do? Will it last? The 1/2 theme is how foreign investors — who recently have accounted for more than 60% of customer account[1] trading in Japan — will react to an Abe government. The second theme is how a US slowdown will impact Japanese equities.

The Abe government

The likely policies under an Abe government have been well outlined. This is especially for the current stage of the political cycle, when Cabinet Secretary Shinzo Abe is still campaigning against two other candidates, Foreign Minister Taro Aso and Finance Minister Sadakazu Tanigaki. Abe has taken a high profile in the press in recent months, in particular with publication of a book outlining his views.[2] Moreover, the content of the Basic Policies on Fiscal and Structural Policy (the so-called ‘thick-boned’ report) for 2006 was published on July 7, including the results of the ‘joint spending and revenue reform’ initiative.

The surprise (to me) is how poorly investors have absorbed the plethora of information available, or considered its implications. For example, very few investors know about Abe’s dual approach to educational reform, emphasizing not only his desire for more civic education but also his emphasis on higher educational standards as a way to maintain Japan’s international competitiveness. Almost no one has considered which companies might participate in a drive to improve Japanese educational outcomes. For example, game developers stand to gain if Abe’s education policy mobilizes the considerable power of games to teach subjects in natural settings.

One can understand the skepticism of investors, however, about political promises. A key worry about the Abe government is whether it will have the same forcefulness as the Koizumi government. Already, there is much talk of pressure on Abe to allow increases in the public works budget for regional areas, as an election policy for the Upper House election next year. Abe has been explicitly negative about bowing to such pressure, but fears persist. The reason is simple:  Unlike Koizumi, Abe is not a maverick. Abe has yet to prove to the satisfaction of investors that he will say no to vested interests, instead of saying that he will say no.

Moreover, although articulate, Abe does not have PM Koizumi’s sound-bite style. The title of Abe’s new book, Utsukushii Kuni e (Toward a Beautiful Country) was not well received by some investors, because is was considered largely devoid of either vision or content. (Everyone wants a beautiful country. The question is what constitutes ‘beauty’, in this context.) Whoever reads the book will get a good sense of what Abe means by “beautiful country”, but it is hard to deny that the title is hazy. An unforgiving investor put it bluntly, “With a title like that, he must be trying to fool us.”

A corollary to the skepticism about Abe’s ability to implement is the ‘short Abe government’ scenario. A surprisingly large part of the domestic investment community considers this scenario likely to occur. According to this scenario, the Abe government will be short-lived, and fall after a poor showing in the Upper House election next year. There are two key ways that such a result might come about. One is a major failure in foreign policy, e.g., further deterioration of relations with China. The other is Abe bowing to domestic vested interests, such as regional public works demand. The gains from doing so would not help much in the regions, but would lose a lot in the cities.

An even more frightening scenario for investors is that a short Abe government leads to a lack of confidence that any strong government could emerge in the wake of such a defeat. The LDP would be torn by finger-pointing, with no clear leadership, while the opposition Democratic Party of Japan remains disunited over both foreign and domestic policy disputes. A return to the revolving door prime ministers of the 1990s[3] would clearly harm investor sentiment, because leadership from the prime minister is essential to keep productivity improvements and earnings-enhancing reforms on track.

Foreign investor perception of an Abe government

Foreign investors are even less well informed about Abe’s policies, for three reasons. First, the quantity and quality of information about Abe in the foreign press is quite limited, relative to the domestic press. Second, in order to make Japan stories digestible to foreign readers, editors often oversimplify and refer to stereotypes. Third, the amount of time that foreign investors have to devote to analysis of Japanese policy and politics is limited, compared to domestic investors. So there is less attention, less nuance and less focus. The upshot of these differences is that foreign investors will need more dramatic, more clear-cut messages from Abe on economic reform than domestic investors need.

There are two forms that such messages can take — personnel decisions and foreign visits. The key part of the personnel decisions will be to have cabinet members with backbone and brain trusts, i.e., those with the will to oppose unacceptable bureaucratic foot dragging and their own networks of expertise to oppose vested interests. Getting this message across will not be easy, but a large number of private sector Cabinet Ministers would be welcomed by investors — both foreign and domestic. (The model is that of PM Koizumi’s appointment of Heizo Takenaka as Economics Minister.)

In the end, I believe that both foreign and domestic investors need to see clarity of message, strong personnel choices, concrete policy agendas with legislative deadlines, and a focus on issues that will help Japan continue allocate resources efficiently.

The US growth debate

Japanese investors are well aware of the debate about growth in the US, but I detect a difference of temperature in the level of worry. Domestic investors in Japanese equities seem less worried about the US economy than foreign investors, particularly US investors in Japanese equities. There are several reasons for this difference.

First, as with information about Japan going to foreign investors, so the information about the US economy available to Japanese investors is necessarily less broad and deep than the information available to US investors in their home country. Japanese investors are thus less bombarded by the daily litany of bad news fed by the US press, especially about home prices. Second, foreign investors in Japan, particularly American ones, are likely to live in the parts of the US that have been hardest hit by the housing price declines. When one’s own house has lost value, it is easier to be pessimistic about the US as a whole. Finally, the sense of quagmire in Iraq is greater among US investors, and inevitably affects their view of the US economy.

Another problem is the US political outlook. Information from the US suggests that there is a growing possibility that the Congress could switch to a majority for the opposition Democratic Party. But Japanese investors seem somewhat slow in absorbing this information. My colleague Dave Greenlaw reminds me that there is no major economic legislation pending in the US anyway, and so the effects of Democrat recapture of the Congress may not be great. While the point is well taken, a loss of majority by the president’s party would lower the ability to respond to crisis, and could worsen gridlock on other matters.

So, if American investors in Japan are more pessimistic about the US than domestic investors in Japan, then American investors are more likely to switch into domestic demand stocks (e.g., banks, construction, machinery) than local investors — and earlier. Thus, negative news on the US economy could leave domestic investors playing catch-up on domestic stocks, as foreign investors fear weakness in export-oriented stocks.

Important Disclosure Information at the end of this Forum

Japan
Tankan Preview (Sept)
Sept 15, 2006

Takehiro Sato (Tokyo)

Keen interest in the September BoJ Tankan

The key to the September Tankan (to be released on October 2 at 08:50 JST) is whether sentiment at domestic corporations moves up or down in the wake of signs of deceleration in the US economy. The headline number (DI for large enterprises in manufacturing industries) in the previous Tankan proved firmer than the market had expected, at a time of sharp corrections in global asset markets. The deterioration in sentiment in materials-related industries was countered by improvement for processing and assembly industries, allowing the overall figure to pick up, albeit slightly. This time around, the commodities markets in general are correcting, spearheaded by oil, which should alleviate margin concerns for the materials industries. Conversely, the slowdown in the US economy is bad for sentiment in the processing and assembly industries. It is hard to generalize about how such changes in the external environment will affect the headline DI, but it seems prudent to assume that corporate sentiment will remain top-heavy; if sentiment does hang on despite the external environment, it would be something of a positive surprise. For these reasons, the Tankan again has more than usual importance. We marginally favor the latter (positive) scenario, incidentally.

The general trend in our industry has become that the BoJ Tankan forecast is announced soon after the Reuters Tankan, but this time there will be a gap of over two weeks between the two, as before. A lot of recent economic data has been diverging from forecasts, however, and international commodity prices have been correcting sharply, so corporate sentiment could change markedly in the coming two weeks while the BoJ is conducting its survey. So bear in mind that our forecasts are subject to revision in light of near-term market trends. Key indicators to be announced in the run-up to the Tankan announcement include the August Trade Balance (September 21), the July-September Business Outlook Survey (September 22) and the August Industrial Production figures (September 29).  

Forecasts for business conditions DIs

We foresee a current DI for business conditions at large manufacturing enterprises of +20, a 1ppt drop from the June survey. For large non-manufacturers we anticipate +20, similar to last time.

We expect manufacturers’ sentiment to remain steady in the face of rising uncertainty of the external environment, fueled by (1) companies’ increasing ability to manage profitably thanks to lower breakeven points, now that they have streamlined fixed costs and (2) a weaker yen in real effective terms. For non-manufacturers, too, we expect sentiment to be generally firm, reflecting improvement in corporate structures, even though the summer weather has scaled back demand in some areas.

As the business conditions DI moves up, there is a tendency for forward projections to turn weaker. However, in the Tankan for March and June, the outlook assessments came in higher than the current assessments for both manufacturing/non-manufacturing large enterprises. For the September Tankan, we expect the large enterprises/manufacturing outlook to be slightly higher as well, at +21.

The Reuters Tankan is a useful leading indicator for the BoJ Tankan, and our rough estimates of the BoJ Tankan forecasts on this basis suggest that manufacturing may dip 2ppt from the June survey. We look for a slightly higher reading for manufacturing in the BoJ Tankan than implied by the Reuters Tankan data, because having looked at the details of weak industrial production and machinery orders, we are not convinced that trends have changed.  Also, the Reuters Tankan tends to give overly bullish readings for the outlook DI, and we discount this when forecasting the levels of the BoJ Tankan.

Forecasts for management plans in F2006

(1) Sales and profit targets:  In the June Tankan, F2006 sales were projected up 2.2% YoY for large manufacturers in all industries, for growth of 0.8% in recurring profit. Actual recurring profits for listed enterprises in the April-June quarter were up around 15% YoY, in stark contrast to these more downbeat plans for full-year growth. However, we think that sales and profit forecasts in the September Tankan are unlikely to change much from the June Tankan figures, as most firms are unwilling to revise full-year outlooks far on the basis of 1Q results only. Major revisions for corporate earnings plans will probably be delayed till after 1H books have closed. Therefore, it would not be a negative surprise if profit plans in the September Tankan were largely unchanged from the June Tankan outlook.  Meanwhile, our top-down forecast suggests that large enterprises should expect about 13% YoY growth in F2006 recurring profit.

The gap between top-down and bottom-up forecasts owes something to data anomalies in the bottom-up forecasts of the companies. For example, firms have set conservative assumptions for crude oil price, forex rates, etc., which partly explains the tendency for their overall projections to stray from real earnings. The case of F2005 is still fresh in mind, when profit forecasts called for essentially flat YoY growth initially, but projected 10% growth at the interim, and eventually came in at close to 20% growth for the term. If the type of upward profit forecast revisions from F2005 resurfaces this term, our two-digit growth projection can still be reached.

(2) Capex plans: Revisions for capex plans for large companies in the BoJ Tankan have historically proven largest between the March and June surveys. We think this owes to few firms having set concrete plans by the March survey, but then a sudden burst of firms having both the previous year’s results and definitive plans for the current term set by the time the June survey rolls along. The revisions between the June and September Tankan are the smallest, for similar reasons: the survey is conducted before interim results are available, when firms are rarely in a position to revise their capex plans.

Based on this historical pattern of revisions, we expect capex plans for large companies in all industries to be up 11.8% YoY, with those in manufacturing industries growing at a double-digit clip for the second year running, at +16.6% YoY, but not much changed from projections in the June survey (revision rate: +0.2%). We expect steady upward revisions for large non-manufacturers, with capex at +9.1% YoY (revision rate: +0.2%), but again this represents only small revisions.

Recent machinery orders data for July showed the largest MoM drop since the statistics were first compiled, contrary to the firm capex projections above. But the details show that much of this is due to a backlash from growth in June, and to a decline in mobile phone orders that should not belong in capital goods anyway, so we do not think that this suggests changed trends.

Policy implications

At a time of unexpected weakness in manufacturing-related data such as industrial production, machinery orders, etc., the headline Tankan reading will be critical for measuring the pace of monetary tightening, in our view. A figure significantly below +20 could fatally undermine campaigning for an additional interest rate hike this year.

Important Disclosure Information at the end of this Forum

Disclosure Statement

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").

Global Research Conflict Management Policy

This research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosures

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.