Commodity Correction and the Lira
Sept 21, 2006
Serhan Cevik (London)
The sharp fall in commodity prices may be a harbinger of a trend shift. After surging from US$10 a barrel in 1998 to US$78 this summer, the price of crude oil has recently fallen more than 20% from its peak to the lowest level since March. The downturn is not just limited to energy prices, as almost every commodity market is experiencing a similar retreat. But is this the beginning of a structural shift, or just a short-term correction? The extent of the commodity bubble may have shocked all of us, but the underlying features are no mystery. In the case of energy-related commodities, an unprecedented increase in global demand outpaced capacity expansion and consequently resulted in an explosive price increase. Unfortunately, political tensions and other supply constraints have intensified this shock originating from an extremely tight supply/demand balance and also set the stage for speculative behaviour. Indeed, we cannot assess the state of commodity markets independently from the global liquidity cycle fuelling speculative frenzies across all ‘asset’ classes in the post-2001 period. The sudden influx of financial investors into commodity markets has introduced excessive risk premiums and driven prices higher than justified by fundamental factors. According to the International Energy Agency, hedge fund holdings in energy markets, for example, increased from US$3 billion in 2000 to about US$100 billion last year, inflating one of the biggest speculative bubbles in recent history. However, the tide may already be receding, as fundamentals and geopolitical considerations point to lower commodity prices.
Fundamental reasons make us more optimistic on commodity-importing economies. Speculative investments that flooded commodity markets in recent years could be easily liquated, especially when market participants start getting news about funds losing billions of dollars because of leveraged bets on higher energy prices. Even beyond such considerations, there are good fundamental reasons to become more optimistic on commodity-importing economies. With a more favourable supply/demand balance, inventories of crude oil and refined products have risen to recent peaks. Furthermore, the expected slowdown in the global economy should lead to a sustained drop in commodity prices. This is why Morgan Stanley’s global economics team revised down oil projections from an average of US$73 a barrel to US$68.3 in 2006 and from US$68.5 to US$65.6 next year. With risks tilting toward the downside, we expect the price of oil to ease even further, to an average of US$52 in 2008. However, given the degree of high uncertainty, our scenario analysis also includes ‘cool’ and ‘super-cool’ scenarios projecting oil prices coming down to US$46 and US$43, respectively, next year and to US$42 and US$22 in 2008 (see Eric Chaney and Richard Berner, Easing Has Started, but Mind the Short-Term Risks, September 7, 2006). Although capacity constraints should keep the oil market vulnerable to geopolitical and climatic supply disruptions, we believe that a sustained downward shift in prices would have significant positive effects on the Turkish economy.
If the decline in commodity prices is a trend shift, Turkey stands to benefit a lot. The shock of soaring commodity prices has been a major contributor to Turkey’s inflation and current account troubles (see Commodity Bubble and the Lira, June 7, 2006). This is of course not surprising, given its growing dependence on imported sources of energy. Turkey’s total energy imports — composed of oil, oil products, natural gas, liquefied petroleum gas and coal — increased from US$11.6 billion in 2003 to US$21.2 billion last year and, on our estimates, to US$28.3 billion this year. In other words, net energy imports surged from 4.4% of GDP in 2003 to 5.2% in 2005 and 6.5% this year, accounting for more than 70% of the worsening in the current account deficit from 4.4% of GDP in 2003 to 7.4% this year. But we need to be careful about the volume and price effects that may distort the picture. Indeed, if we take out the price effect, net energy imports would have been 3.1% of GDP (or US$7.3 billion lower) in 2005 and 2.9% of GDP (or US$13.6 billion lower) this year. In other words, Turkey’s current account deficit would have narrowed from 5.8% of GDP in 2004 to 4.4% last year and 3.7% this year. This is why we have always been careful about passing judgment on external imbalances of the Turkish economy. If the correction in commodity markets turns into a sustained phenomenon, every US$10 drop in oil prices would trim Turkey’s energy imports by US$4.2 billion and its current account deficit by US$3.5 billion on an annualised basis. Even considering the effect of petrodollar liquidity and correlation trades, such a correction would support the lira as well as the disinflation process.
Important Disclosure Information at the end of this Forum
Downgrading GDP on Intensifying Uncertainty
Sept 21, 2006
Andy Xie (Hong Kong)
We are cutting our Thai GDP growth forecasts to 2.4% from 3.5% for 2H06 and to 4% from 4.5% for 2007, on intensifying uncertainty as a result of last night’s military coup. We see the political situation remaining unsettled for at least another year.
The Thai economy has already lost momentum due to high oil prices and rising interest rates. The case for a recovery was based on a revival of investment, which appears unrealistic now. We expect government investment to remain stalled and private investment to weaken further on worsening sentiment.
Fresh round of political uncertainty
Higher oil prices and interest rates have already hurt private consumption in Thailand. Private consumption growth slowed to 3.9% in 1H06 from 4.3% in 2H05 and 4.6% in 1H05. Sustained political uncertainty has led to weaker growth in both government expenditure and private investment. Overall domestic demand (ex-inventories) slowed to 4% in 1H06 from 7% in 2005. Export growth has also weakened.
Last night’s military coup has brought a fresh round of uncertainty to the political environment in Thailand. Although the leader of the coup, General Sonthi Boonyaratglin, has announced his intention to implement a quick transition to an interim government, we believe that the final outcome is far from clear. How long will it take to move towards a democratically elected government? Will there be an effective split or a complete splintering of TRT (Thai Rak Thai)? Moreover, the opposition party is not fully positioned to a form a full majority government on its own, considering its relatively poor reach in the rural parts of the country. How long will the constitutional amendment take? Who will assume interim leadership?
Slowdown likely to be prolonged
The military coup was not expected by the market at all. It appears that the market has systematically underestimated political risk in Thailand. We believe that the uncertainty could last through to 2007, severely affecting the macro outlook.
We see three potential scenarios for political developments going forward:
1. Stagflation (USD/THB at 40): The military puts together a series of ineffective and semi-legitimate governments as in the past. These governments are cobbled together with some known faces, but are not organized effectively to move the economy forward. Each government lasts a short period of time without effective governance. Business confidence continues to sink slowly. The economy goes into stagflation. Capital flight weighs on the baht, resulting in inflationary pressure and restraining the central bank from cutting interest rates. The economy is stuck with stagflation through to 2007. USD/THB is likely to trade at around 40 by end-2007.
2. Snap-back (USD/THB at 35): The military quickly organizes an election with the participation of all parties. A legitimate government is formed in early 2007. The TRT or another form of it is most likely the winner. Government-led investment gets back on track. The economy snaps back and, after pausing in 2H06, delivers 8% growth in 2007 on reviving capex. The central bank raises interest rates again. USD/THB falls to 35. Inflation falls to below 3%.
3. Chaos (USD/THB at 45): Mr. Thaksin’s supporters fight back. The provinces descend into chaos. Business confidence collapses and capex vanishes. Inflation spikes up to 10%. However, fearing for the economy, the central bank doesn’t raise interest rates. The Thai economy sinks into a vicious spiral of baht depreciation and rising inflation. Towards the end of 2007, the Bangkok middle classes stage a revolution to bring back democracy. USD/THB rises to 45.
We believe that the first scenario — i.e., stagflation — is the most likely outcome. The snap-back scenario would involve the TRT in one form or another. This would probably have happened without the coup. The staging of a coup suggests that the existing course of political development was unacceptable to the military. We think the ‘chaos’ scenario is unlikely for now as the Bangkok middle classes will most probably accept the situation for the time being, while the rural population has historically played little part in changing national politics.
Cutting our growth estimates for 2H06 and 2007
We were already building in a sharp deceleration in 2H06 GDP growth, to 3.5% from 5.5% in 1H06. We now lower our 2H06 growth estimate further, to 2.4%, as the fresh round of uncertainty looks set to further dampen consumer and business sentiment. We now expect private consumption growth to decelerate to 2.5% in 2H06, versus our previous estimate of 3.3%. We see households slowing down purchases of discretionary items (e.g., automobiles, restaurant services and other personal services) while still maintaining some growth in purchases of non-discretionary items (e.g., food and beverages). Similarly, we are cutting our private investment growth forecast to -0.4% from 3%.
Fixed investment growth experienced a sharp slowdown from double-digit levels in 1H05 to 5.2% in 1H06. The case for recovery was based on the removal of political uncertainty and commencement of a government-led investment push. However, considering the unsettled political situation, we think that government investment is unlikely to pick up any time soon. In addition, the increasing uncertainty is likely to discourage private investment. We do not anticipate investment growth in Thailand in 2H06.
Net exports recovered in 3Q06 and have been range-bound. Export growth is likely to weaken on a high base, but sluggish domestic demand and slower import growth should help maintain poor but positive growth in external demand.
We believe that the wild card for the 2H06 growth outlook is inventory. There was substantial de-stocking in 1H06, and some rebound is possible in 2H06. However, considering the level of political uncertainty, businesses are unlikely to stock up significantly in anticipation of better sales ahead.
We are also cutting our 2007 GDP growth estimate to 4%, versus 4.5% previously, based on our expectation of slower consumption and investment growth.
Long-term growth outlook worsens
We believe that the Thai economy has structural barriers to high growth, principally over-dependence on oil, poor infrastructure and lack of quality education for the poor. The country requires a powerful and effective government to drive investment and de-bottleneck the economy.
The military coup is not just a cyclical event — it signals weak governments ahead, in our view. Hence, the structural barriers to high growth are unlikely to be removed. As a result, we see a risk that the valuation of Thai assets may be lowered fundamentally.
Important Disclosure Information
at the end of this Forum
Questions the Diet Will Ask Mr. Abe
Sept 21, 2006
Robert Alan Feldman (Tokyo)
Now that Shinzo Abe has been officially elected as the new LDP Party President, and with the clarification of the Diet schedule, investor attention will likely return to the substance of policy. Mr. Abe won a solid victory in the LDP presidential election on September 20, taking 66% of the votes. The schedule is now clear. He becomes prime minister on September 26, announces his Cabinet that day, presents his basic policy speech on September 29 and tests his debate prowess in Diet questioning on October 2-3.
The days surrounding these events are likely to be crucial for perceptions of Mr. Abe and for how markets react to him. Inside Japan, there is much speculation that Abe may return to factional politics and old-style support for regional economies. Outside Japan, there is a near certainty that he will do so. I believe that these judgments are not correct. I attribute them to the cynicism of political pundits. In addition, the degree of penetration of information about Abe outside Japan is very low. (The same is true in surprisingly large parts of the financial community inside Japan too.)
The key uncertainties in economic policy
The main economic question Mr. Abe must clarify is how he will achieve the 3% growth rate that he mentioned as a possibility for the country, especially with signs of slowing both at home and abroad.
There are certain answers that he is NOT likely to give, in my view. First, he is not likely to propose any major public works program. He has already opposed such projects openly in public, and could not justify such a strategy after endorsing the large spending cuts proposed over the summer by his right-hand man for economics, LDP Policy Affairs head Hidenao Nakagawa. Second, his government is not likely to bash the Bank of Japan (BoJ). Governments usually lose public fights with the central bank, and the potential gain from the BoJ returning to the zero interest rate policy is very small. Third, he is not likely to blame foreign countries. To bash others for not growing faster enough in order to pull Japan along would place Japan as the world’s economic caboose.
What he IS likely to say will focus on canonical elements of growth theory, in my view. That is, the government’s role is to enhance the supply of labor, capital and other factors of production, provide a legal framework for their use, remove barriers to optimal utilization, raise the level of technology, encourage flexibility regarding labor and capital movements, and destroy vested interests. Once these things are achieved, then markets should work and maximum growth should be achieved.
Not everyone will be convinced by the logic. There are considerable parts of the country who do not believe that markets ever work. However, given the way that Abe talks about ‘Japanese values’, he is likely to couch the argument for a growth strategy, small government and a market economy in such terms as ‘a society that rewards effort’, ‘equal pay for equal work’, ‘no democracy without capitalism’, etc. If Abe starts from these values, it will be hard for him to lose the debate, in my view.
The policies that stem from this approach to the economy are not only a continuation but also an expansion of the Koizumi policies. Indeed, in Abe’s recent book, he discusses destruction of vested interests as a key to achieving an equal society. He then launches into a critique of the public sector, with its overstaffing and low productivity. I believe that investors who think that an Abe administration will be a throwback to old LDP politics are likely to be surprised — positively.
The second part of the economic debate should concern income differentials. Mr. Ozawa, the newly re-elected leader of the opposition Democratic Party of Japan (DPJ), will almost surely attack Abe as the heir of the policies that the DPJ claims are turning Japan into a country of haves and have-nots. A key requirement for winning the Upper House election next year is for Mr. Abe to refute this allegation.
The response is likely to have several components, both in evidence and in logic. The evidence shows that the Gini coefficient has worsened over the last decade. However, there are several rejoinders. First, data show that the largest part of the widening has come from mere aging of the population, not something that occurred as a result of economic reforms. Second, the deterioration of income equality started well before the Koizumi reforms. If anything, the reform process, by raising growth, has prevented income differentials from widening further than they would have under the old policies. Third, the policies of the DPJ’s precursor — the Socialist Party — were very much a part of the source of stagnation borne of the old economy.
In addition to refuting the left’s contention that income differentials are due to reform, Abe is also likely to present a wholly separate case, i.e., that income differentials are justified if they reflect effort. Once again, Abe is likely to change the argument about what constitutes fair distribution of income from a Marxist view of the left (‘From each according to his abilities, to each according to his needs’) to a capitalist one (reward for effort). In addition, on grounds of social cohesion, Abe is likely to define national social minimums. These levels will be low, but adequate, and will not be incentives to work, in my view.
If Mr. Abe indeed follows my expectations in appointing his Cabinet, giving his policy address, and debating with Mr. Ozawa, investors are likely to feel much more comfortable. While earnings, not politics, are the key driver of stock prices, the new Abe polices should at least solidify the foundation for future earnings growth, in my view. In these uncertain times, a firmer foundation could be an important support for both equity and bond markets.
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.