First Japan, Now Germany
Oct 02, 2006
Stephen Roach (New York)
At the end of the 1980s, the apparent ascendancy of the Japanese and German economies was one of the more astonishing developments of the modern era. The defeated powers of World War II had literally risen from the ashes, while the victor — the United States — was widely believed to be sinking into a permanent state of decline. Yet nothing could have been further from the truth. Japan’s bubble economy burst, and the combination of German reunification and European integration ushered in a long period of structural malaise in Germany. Meanwhile, America did what it does best — reinvent itself on the back of an extraordinary renaissance of productivity-led restructuring. I suspect that this debate is about to come full circle: First Japan and now Germany — the world’s second and third largest economies — are on the mend. Meanwhile, a saving-short, asset-dependent US economy may struggle to stay the course.
In the rush to embrace the new powers of globalization — especially China and India — we risk losing sight of the old stand-bys. The United States, Japan, and Germany still collectively account for 43% of world GDP as measured in dollar-based market exchange rates. In purchasing power parity terms — an IMF-based metric that attempts to adjust for disparities in foreign exchange rates — the combined weighting of the three economies is 30%. Either way, there can be no mistaking the dominant role the powerhouses of the industrial world still play in driving the global economy and world financial markets. Nor do I buy the view that we should forget about Germany and bury it in some amorphous pan-European aggregate. Notwithstanding the advent of the euro, the ECB, and meaningful progress on the road to pan-regional economic integration, individual European countries still have very distinct economic identities. A high-productivity-growth German economy is a case in point — as is the Italian economy with its steadily declining productivity trend. The just-released Global Competitiveness survey of the World Economic Forum underscores a similar conclusion: German business competitiveness is ranked second only to the United States and well above that of the UK (#8) and Japan (#9) — to say nothing of France (#16), Spain (#30), and Italy (#38). And, of course, Germany still accounts for the dominant share of European GDP — 28% of the 12-country Euro area as measured on a PPP basis. It may not be fashionable in Europhile circles, but I have no problem still looking at Germany as one of the top three powers in the global economy. Yet in recent years, I am just as guilty as anyone — if not more so — in turning my attention as a global economist to China and India. Both of these nations are in the midst of stunning transitions that could well remake the global economic order over the course of this century. And China and India are already having major impacts on the mix of world trade, as well as the global pricing of labor and commodities. But they remain far from the pinnacle of prosperity enjoyed in the rich countries of the industrial world: Per capita GDP in China is still only about 5% of the combined average in the US, Japan, and Germany, and India’s standard of living is less than half that of China’s. Compared to the tortoises of the developed world, the developing world’s hares seem to be running at lightening speed. But as Aesop reminds us, slow-moving leaders with a massive head start should never be taken for granted. The leaders aren’t exactly standing still either. As I travel the world, I sense something big is brewing in the mix of industrial world economic activity. Four years ago, there were whispers of revival in Japan. They came mainly from the business sector, where a massive restructuring was gathering momentum. Anecdotal at first, these reports turned out to be an accurate portent of a stunning turnaround to come in the Japanese economy. Today, there are similar whispers in Germany. I have been to Germany twice in the past three weeks, and in meetings with a wide range of German business managers, the verdict was nearly unanimous — a powerful restructuring is now bearing fruit. Like the case in Japan a few years earlier, this could well be the start of a reawakening in the world’s third-largest economy. The official data flow has yet to capture the full extent of these turnaround stories. Japanese GDP growth has accelerated to a 2.6% average annual rate in the past three years — double the anemic post-bubble trend evident since the early 1990s. But the economy still remains far too close to a deflationary quagmire. The German economy is turning in a very good year in 2006 — a 2.1% increase in real GDP, or nearly double the 1.25% average gains of 2004-05; however, with a large VAT tax hike looming, there is understandable concern of a sharp payback in 2007. Our forecast of 0.7% German GDP growth for next year reflects just such a possibility. Trends in GDP growth don’t tell the full story. Beneath the surface, something important is stirring on the productivity front in both economies — for my money, the ultimate arbiter of an economic turnaround in any nation. Japanese productivity growth averaged 2.1% over the 2003-05 period — nearly double the 1.2% trend over the 1995 to 2002 interval. There has also been a pickup — albeit more recent — in German productivity; output per worker has expanded at a 1.7% average annual pace in the five quarters ending mid-2006 -- more than double the anemic 0.7% trend from 1998 to 2004. The improvements in Japanese and German productivity mirror a comparable trend that has been evident in the US for a much longer period of time — a 2.8% average annual increase over the 1996 to 2005 period, or a doubling of the anemic 1.4% trend recorded over the 22-year 1974 to 1995 interval. Undoubtedly, a portion of the recent improved productivity growth in both Japan and Germany is traceable to a cyclical, or transitory, acceleration in economic activity. Some of that cyclical impetus will be unwound if, in fact, aggregate economic growth slows in both economies in 2007, as we are currently forecasting. Yet history suggests that an adverse shift in the cyclical climate could well turn into an opportunity. In studying corporate restructuring for now close to 20 years, my experience tells me that once the business sector gets religion in facing up to competitive challenges, cyclical pressures in operating conditions invariably lead to an intensification of cost cutting and other forms of restructuring. The US is a case in point: Corporate restructuring began in earnest in the first half of the 1980s, but it wasn’t until the mild recession of the early 1990s that those efforts intensified and finally bore fruit in the form of a powerful and sustained productivity revival beginning in the mid-1990s. Elga Bartsch has come to the same conclusion regarding prospects for German restructuring in 2007 in the face of her forecast downshift in German GDP growth next year (see her 21 July 2004 report, “German Restructuring in a G3 Perspective”). She believes Corporate Germany will rise to the occasion and intensify its cost-cutting efforts in such a climate. Having spoken with a broad cross-section of focused and very determined German business managers over the past few weeks, I am very sympathetic to this view. I also believe that the improved flexibility of German labor markets, together with a long-overdue increase in the IT content of Corporate Germany’s capital stock, will provide important tailwinds to German productivity in a tougher cyclical climate (see my 22 September dispatch, “The New Wirtschaftswunder?”). Robert Feldman has made a similar point with respect to Japan (see his 9 June 2006 research note, “Equities, ULC, and the BOJ”). Meanwhile, there’s new twist to America’s miracle: Even productivity bulls like Dick Berner are starting to wonder whether the US can stay the course of its decade-long productivity bonanza (see his 25 August 2006 dispatch, “Is Potential Growth Downshifting?”). And so the story comes full circle. Both Japan and Germany currently seem to be where the United States was in the early 1990s — upping the ante on corporate restructuring, thereby sowing the seeds of an early-stage productivity revival. At the same time, the US may well have “maxed out” on its restructuring and productivity story; the “capital deepening” associated with the transformation to an IT-enabled production platform is well advanced and the heavy lifting on corporate cost-cutting may be more in the past than in the future. And, yes, the US, with its massive current account deficit, faces its own set of tough cyclical challenges — especially as saving-short consumers now come to grips with the bursting of America’s “last asset bubble.” There is a certain sense of déjà vu in all of this — but this time with a very different twist: America is widely thought to be at the top of its game as the global economic hegemon, while Japan and Germany have long been written off as has-beens. Just as the tables were turned a mere 15 years ago, a similar about-face could well in the offing. A repositioning of the Big Three economies has potentially important implications for global rebalancing. A post-bubble retrenchment of the American consumer should undoubtedly provide cyclical relief to the US current account deficit (see my 29 September dispatch, “Cyclical Rebalancing”). But the sustainability of any such improvement depends on whether the rest of the world — in this case, Japan and Germany — can convert productivity gains into consumer-led growth dynamics. The jury remains out on that count. Without progress on labor market reforms and retirement security, households in Japan and Germany may remain predisposed toward saving. But if those problems can successfully be tackled and consumption support starts to kick in, the outcome could be a huge plus for global rebalancing.
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Which Matters More
Oct 02, 2006
Richard Berner (New York)
Both bond and equity markets have rallied significantly during the past month over the prospects for lower inflation, and legitimately so. Courtesy of the recent plunge in energy quotes — which likely took the energy subindex in the CPI down in September by nearly 5% from the year-ago, hurricane-elevated levels in September 2005 — headline inflation probably dipped to a 32-month low of 2.2%. In contrast, CPI core inflation probably rose to a 2.9% rate, the highest in more than ten years. Headline inflation in September thus likely dropped below the “core” measure for the first time in four years. This inflation dichotomy raises an important question: Which should matter more for central banks and financial market participants, headline or “core” inflation? My answer, unfortunately, isn’t simple: Both matter. While the headline measure clearly has the potential to mislead, thanks to volatile short-term energy and food price swings, longer-term increases in those important components can influence inflation expectations. Moreover, as slack in the economy has dwindled, energy-using companies have greater scope to pass through energy price increases to their customers. Equally, however, core inflation measures can misrepresent the trend. Short-term distortions in components like owners’ equivalent rent may understate or overstate reality, or may represent changes in relative prices rather than in the underlying trend. Thus, neither policymakers nor investors should discard the information in one metric or the other. Core inflation measures famously had their origins in the oil and food price shocks of the 1970s, when the rise in those volatile components pushed overall inflation from 3% in 1972 to 12% two years later. As a junior economist then at the Fed, I agreed with my bosses and colleagues that analysis of the sources of inflation was essential, because the severe recession following those supply shocks would reverse part of the rise in inflation. But the joke among many Fed staffers and others in the politically-charged atmosphere in Washington was that core inflation measures were a way of removing the influence of prices that rose a lot. And we soon realized that it was monetary policy itself that fostered higher inflation. As staffers, Steve Roach and I watched with alarm as monetary policy contributed to an era of ‘stagflation’— high and rising inflation, low productivity gains, and low earnings growth (see “The Curse of Arthur Burns,” Global Economic Forum, October 22, 2004). That was then. Three decades of disinflationary monetary policy have since brought inflation and inflation expectations down, and monetary policy has enormous credibility both home and abroad. While the outcome is still uncertain, the Fed under new Chairman Bernanke has earned credibility by steering a course for policy aimed at realizing the Fed’s medium-term goals of price stability and maximum sustainable growth. But US policymakers continue to focus more on core inflation measures than on the headline metrics, while those abroad are more inclined to use the latter as policy guides. Arguments on both sides of the issue and on both sides of the pond have their merits. As Charles Bean, Chief Economist at the Bank of England, put it a month ago at Jackson Hole in discussing the disinflationary dividends from globalization, “…that the rise in oil prices is the flip side of the globalization shock to me renders highly suspect the practice of focusing on measures of core inflation that strip out energy prices while retaining the falling goods prices.” As the Fed has been discussing a so-called ‘numerical objective’ for price stability, this debate assumes even greater importance. Indeed, one aspect of the discussion centers on how we measure inflation expectations. Central banks and market participants appropriately look to inflation expectations both as forward-looking guides to inflation’s direction and indicators of policy credibility. Rising inflation expectations hint that an increase in inflation could be self-sustaining, while low and ‘well-anchored’ inflation expectations are the hallmark of successful monetary policy. The Fed has trained market participants to think of inflation expectations as an important guide to policy, and their importance has apparently increased under Fed Chairman Bernanke. But surveys and market-based measures of inflation expectations focus either implicitly or explicitly on headline rather than on core inflation measures. For example, while the University of Michigan doesn’t ask respondents which measure to use for its consumer canvass, energy prices clearly have a strong influence on the one-year median measure. And breakeven inflation or inflation compensation in the TIPS market is defined in terms of the headline CPI for urban consumers. The plunge in energy prices thus has provided markets and policymakers additional comfort through the recent decline in surveyed measures of inflation expectations and from current and distant-forward (5-year, 5-year) breakevens. Although those measures of inflation expectations don’t move in lockstep with energy quotes, I think that some of that comfort may be overdone. After all, inflation itself is the benchmark for economic and policy performance, and while both policymakers and markets must look ahead, they cannot ignore the past. The rise in core inflation over the past two years in my view is partly the product of a monetary policy that in 2003 prevented inflation from falling too low. Now policy is aiming at reversing that increase in inflation. Obviously, exactly what level of inflation the central bank aims at matters a lot for investors. And whether or not officials formally use core inflation as a guide, they must filter movements in energy quotes to get at the underlying inflation trend. I think this metrics debate means the Fed is unlikely to adopt a numerical objective for price stability soon. Officials no doubt will want to vet the measurement and other issues thoroughly before codifying any number as a target or any inflation range as a guide to monitoring progress to get there (see “A Higher Inflation Objective? Global Economic Forum, August 11, 2006). The logic for the rally in bonds is very different from the rationale behind the advance in equities, and for once I think the equity markets have it right: Bond markets seem to focus more on the benefits for headline inflation of the energy price decline, while apparently ignoring the economic stimulus that might come from it. In contrast, as US equity strategist Henry McVey correctly notes, equities seem to have rallied on both factors: Lower inflation keeps rates down and the Fed in check, while lower gasoline prices keep the consumer afloat. Nonetheless, it’s time to invest carefully. My colleague Eric Chaney and I think that energy prices have peaked after a five-year advance. But we also think that the recent plunge in energy quotes may temporarily reverse with the onset of the winter heating season and stepped-up demands for energy (see “Oil Update: Easing Has Started But Mind Short-Term Risks,” Global Economic Forum, September 7, 2006). Thus, it would be unwise for now to count on a continued downdraft in energy quotes that would provide more fuel for both bond and equity markets. The likelihood of a rebound in energy quotes could stall the rally in both.
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Review and Preview
Oct 02, 2006
Ted Wieseman and David Greenlaw (New York)
Treasury yields ended the past week modestly higher, with the curve a bit flatter. In addition, the dovish Fed path priced into futures markets was scaled back a little, giving back a small part of the huge rallies of the prior week, as housing market reports were not as disastrous as investors have come to expect, consumer sentiment measures showed significant improvement in line with plunging gasoline prices, and other regional manufacturing surveys suggested that the very weak Philly Fed survey that prompted such a huge rally the prior week was probably somewhat of a downside outlier. These data trumped figures that pointed to a sharper slowdown over the 2Q/3Q period. Second quarter GDP was revised down a bit more than expected to +2.6% from +2.9%, and based on smaller-than-expected gains in inventories and capital goods shipments in the durables report, we trimmed our 3Q estimate to +2.2% from +2.5%. We continue to look for a significant reacceleration in 4Q to near +3 1/2%, with significant support coming from the recent plunge in energy prices. The key early round of September data to be released in the coming week — employment, ISM and motor vehicle and chain store sales results — will be important in judging the degree to which the mid-year slowdown may be coming to an end and how positively we are ramping into 4Q. Benchmark Treasury yields rose 2-5bp over the past week and the curve flattened slightly (at least on a like-for-like basis, as the roll into the new 2-year reset the benchmark curve several bp steeper). The curve bear steepened through Thursday, but decent month-end buying gave the longer end a good relative lift Friday. A 5bp rise in the old 5-year yield to 4.60% led the way down. The old 2-year and the 3-year yields were up 4bp each to 4.72% and 4.62%, the 10-year yield rose 3bp to 4.63%, and the long bond yield ticked up 2bp to 4.76%. The 2-year and 5-year auctions met with strong demand from final investors, particularly the latter, which saw near-record indirect bidder participation, but the auction results provided no support to the market. Both issues ended the week in the red, with the new 2-year yield closing Friday at 4.69% after being auctioned Wednesday at 4.660% and the new 5-year closing at 4.585% after being issued Thursday at 4.569%. After moving to new extremes Monday, the dovishness of Fed policy priced into futures market was scaled back over the rest of the week, ending up modestly less dovish for the week as a whole. The front few fed funds futures contracts were all unchanged, but odds of a rate cut in December or January were scaled back as the January contract lost 1bp to 5.225% and the February contract sold off 2.5bp to 5.175%. In the eurodollar futures markets, the maximum one-year inverted Dec 06 to Dec 07 spread steepened 2bp to -54.5bp, with the former off 2bp to 5.335% and the latter losing 4bp to 4.79%. The low rate Mar 08 contract lost 4.5bp to 4.765%. Growth over the second and third quarters looks to have been a bit more sluggish coming out of the past week than we had estimated coming into it. We had previously expected 2Q growth to be revised down to +2.8% and saw 3Q tracking at +2.5% for a 2.7% annualized rise over the two quarters. Instead, 2Q was revised to +2.6%, and we trimmed our estimate of 3Q to +2.2%, for a 2.4% annualized gain. We continue to look for a significant pick-up in 4Q to near +3.5%, with the recent plunge in energy prices expected to play a key role in the upside. We initially trimmed our 3Q forecast to +2.0% from +2.5% in response to the durable goods report. Durable goods orders fell 0.5% in August, as a sharp correction in high-tech products after two very strong months and pullbacks in machinery, primary metals, electrical equipment and appliances and non-defense aircraft were largely offset by gains in motor vehicles, fabricated metals and defense. The key core gauge, non-defense capital goods ex aircraft, dipped 0.3% after three strong prior gains. Non-defense capital goods ex aircraft shipments, a key gauge of capital spending, ticked up 0.3% after a 1.6% rise in July. This was less than we were assuming in our GDP forecasts and led us to trim our estimate of 3Q business investment to +9% from +12%. Durable goods inventories also rose a significantly less than expected 0.2%, pointing to a larger inventory drag in 3Q than we had previously expected. On the positive side, capital goods backlogs continued to surge, suggesting significant upside to capital goods shipments and thus investment going forward, with unfilled orders for non-defense capital goods ex aircraft jumping another 1.1% in August for a 15% annualized year-to-date gain. Subsequently, 2Q GDP growth was revised down a bit more than expected to +2.6% from +2.9%. Underlying details were a bit stronger than we estimated, though — final domestic demand growth (+1.6% versus +1.7%) was revised down less than we anticipated, and the miss on overall GDP instead came from a surprising downward revision to inventories. This implied a smaller inventory drag in 3Q, so we raised our post-durables GDP forecast a couple of tenths to +2.2%. In addition to the expected 9% rise in business investment, consumption should be the key driver of 3Q GDP. Based on the results of the August personal income and spending report, we bumped up our estimate of 3Q consumption to +3.6% from +3.5%. An estimated 3.6% gain in government spending should also make a significant positive contribution to growth in 3Q, with the recently oddly highly volatile federal government component expected to rebound after falling 4.5% in 2Q. On the negative side, residential investment appears on track for about an 18% decline, which would knock a full percentage point off growth, and we estimate modest negative contributions from both inventories (-0.3pp) and net exports (-0.4pp). These latter two represent the greatest source of uncertainty at this point, and our estimates could change considerably as new data come in, with the next key release on this front being the August trade report on October 12. Despite these incoming data that pointed to slower actual growth over the 2Q/3Q timeframe than previously expected, this housing-fixated market was much more interested in home sales reports that were far from good in any absolute sense but were not the disasters the market has come to expect from the housing market data. Indeed, current market pricing, both the level of rates and the dovish Fed path in the futures markets, seems to be highly dependent on the idea that a collapsing housing market is going to bring the whole economy down with it, so apparently anything but awful incoming news on housing is bond market negative at this point. New home sales rebounded 4.1% in August to 1.05 million units, but only because of sharp downward revisions to prior months, with July lowered to 1.009 million from 1.072, a three-year low. The recent sharp decline in housing starts seems to be starting to get the inventory situation under control. Homes available for sale dipped 0.4% in August, the third decline in the past four months. Inventories were still up 19% year on year, but this was down from a peak of +27% in April. Meanwhile, existing home sales dipped a less-than-expected 0.5% in August to 6.30 million units, a low since January 2004. Inventories of existing homes remained significantly more problematic, rising 38% year on year to a record high, contributing to the first year on year decline in the median sales price since 1995. Despite these indications of stabilization in sales in August, we certainly do not believe that housing market activity is at a bottom yet and see significant further downside in sales and starts going forward. Some higher-frequency and more timely data, however, have exhibited mixed signals on whether the housing recession is seeing at least a temporary pause in reaction to plunging interest rates. The Mortgage Bankers’ Association’s weekly survey of mortgage applications has recently shown some pick-up in applications for new purchases, with the September average of the weekly levels so far showing a modest rebound from the several year low hit in August. On the other hand, in the University of Michigan survey, the index measuring consumers’ attitudes towards whether it is a good time to buy a home, dipped another point in September to the lowest level since 1990, with 41% of respondents saying now is a bad time to buy, also the worst showing since 1990. On the positive side, among the 57% who still think it’s a good time to buy a house, there has been a huge recent increase in the share of respondents citing low prices/good deals as a reason why they feel this way. So apparently the decline in median sales prices and anecdotal reports of greatly increased incentives being offered by builders has not gone unnoticed by prospective buyers. Our expectation that the 2Q/3Q lull in economic activity will end with a decent acceleration in 4Q depends importantly on a positive impact on consumers from the recent collapse in energy prices. Consumer sentiment measures released the past week were encouraging on this score. The Conference Board’s index of consumer confidence rose 4.3 points in September to 104.5, rebounding from the lowest reading of the year in August as gasoline prices plunged. The current conditions (127.7 versus 123.9) and expectations (89.0 versus 84.4) gauges showed about equal-sized gains. The closely watched question on views of the current job market saw decent improvement, with the percentage of respondents describing jobs as “plentiful” rising 1.4 pp to 25.9% and the percentage saying jobs are “hard to get” up 0.2 pp to 21.3%. The University of Michigan’s confidence index was revised up to 85.4 for all of September, a five-month high, from the early month reading of 84.4 and 82.0 in August. Upside was led by a 10-point surge in the expectations index to an eight-month high. Note that the consumer expectations index in the Michigan survey is a component of the index of leading economic indicators. Meanwhile, the weekly chain store sales reports so far in September have been running a good bit above plan and early anecdotal reports point to a decent rebound in auto sales as well. So, at this point, it looks like September consumer spending was probably pretty strong (at least in real terms — the collapse in gasoline prices will weigh on nominal numbers somewhat). We will have a much clearer picture of September retail sales after the upcoming week’s auto and chain store reports. The weak Philly Fed survey that had such a huge positive impact on the Treasury market the prior week was looking to be a bit of a downside outlier after results from several other regions released the past week suggested some deceleration in factory sector activity in September, but not nearly as sharp as implied by the Philly results alone. On an ISM-comparable weighted average basis, the Philly Fed fell sharply to 50.2 in September. Deceleration on balance among the other four District Banks that release manufacturing surveys — New York, Richmond, Dallas and Kansas City, the latter three released the past week — was much more modest, with ISM-weighted composite indices from these regions averaging 54.0. We continue to look for a relatively modest deceleration in the national ISM in September and expect that the recent drop in energy prices will prompt some renewed upside in the months ahead. A number of key economic data releases are due out in the week ahead, with focus on the employment report. Significant attention will also be paid to the ISM report and the early indicators of consumer spending from the motor vehicle and chain store sales results. There will be a number of Fed appearances, with particular focus on speeches Wednesday by Fed Chairman Bernanke and Vice Chairman Kohn, the former speaking on “Savings” and the latter on the “Economic Outlook.” Note that there will be an early close on Friday ahead of the Columbus Day holiday weekend. Data releases due out include ISM and construction spending Monday, motor vehicle sales Tuesday, factory orders and non-manufacturing ISM Wednesday, chain store sales Thursday, and employment Friday: * We forecast a 1.5-point decline in the September ISM to 53.0. The regional manufacturing surveys were mixed, with significant weakness in the Philly Fed but much more moderate softening seen on balance in the others. We expect to see some modest slippage in the headline ISM tied to a softening in order volume and production. Meanwhile, the pullback in the price index should certainly continue. Looking ahead, we continue to anticipate a rebound in factory sentiment over the months ahead as the impact of lower fuel prices feeds through the economy. * We look for a 0.5% decline in August construction spending. A sharp drop in the residential category — as implied by the housing starts figures — should be partially offset by a solid gain in private non-residential activity as well as a bounceback in the government component. * Preliminary industry reports point to a modest rebound in September motor vehicle sales to 16.5 million units annualized, near the year-to-date average after the ten-month low sales pace of 16.0 million units posted in August. With the production cuts planned for 4Q expected to get inventories under control, automakers have not been as aggressive with incentives as we head towards the model year-end as in recent prior years, and the consumer response to current incentives has been muted. * We forecast a 0.2% dip in August factory orders. The modest decline in the durables component along with an expected small increase in non-durables, with some initial impact of the recent plunge in petroleum product prices before a likely much bigger impact next month, point to a slight dip in overall factory orders. * We look for a 140,000 gain in September non-farm payrolls, a modest uptick in the pace of job growth relative to recent months. Indeed, unemployment claims data — both initial and continuing — have been reasonably favorable of late. And weather conditions around the survey period were generally favorable across much of the nation. Obviously, this is in sharp contrast to last year when Hurricane Katrina triggered massive destruction and significant dislocations. We also expect the favorable weather conditions to help lead to a rebound in the workweek. And we look for a trend-like advance in average hourly earnings, which should push the year on year growth rate to +4.0% for the first time since mid-2001. Finally, the unemployment rate is expected to hold steady this month.
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Budget
Oct 02, 2006
Eric Chaney (London)
The 2007 budget should be a decently good vintage for the French economy, given the extraordinary electoral circumstances that will prevail in 2007: a presidential election in May, followed by general elections in June. Against this backdrop, one would have expected the incumbent government to flatter the electorate by trying to boost growth by means of budgetary stimulus, leaving to its successor the task to clean up the fiscal mess. My reading of the draft budget as it is now in the hands of the National Assembly is that it is a fair compromise between electoral contingencies and the imperious necessity to rationalise public spending, streamline the tax system, and cut the ever-growing public debt. Actually, the public debt should decline already this year, for the first time since 2001. In my view, the next government will have to go deeper in reducing still-bloated headcounts in the civil service and reforming social security funds (healthcare and pension mainly). However, as far as direct taxation policy is concerned, both for individuals and companies, it is fair to say that this government has done a good job. Tough on public spending Overall central government spending, including interest on the debt and civil servant pensions, should decline by 1% in volume terms; that is, it should not increase by more than 1.8%, the normative inflation rate the government has in its macro projections. Although less impressive than the €15 billion cuts announced by the Italian government, this is nevertheless relatively tough by French standards. In particular, the number of civil servants should decline by roughly 15,000, i.e., half of the number of those due to retire. Plotted against the total headcount of the civil service (around 2.3 million), this is still quite small, but it is nevertheless twice as high as last year and the largest headcount count recorded in the last 15 years. One would only wish that spending by local governments, which increased by more than 3% this year, would be as muted as central government spending. Tax cuts: no surprises As already programmed by previous bills passed by the Assembly, the top marginal income tax rate will be cut from 50% to 40% and the capital gains tax for companies will be almost fully scrapped next year. Almost indeed: in order to find some extra resources, the budget is re-integrating capital gains into the income tax base for cessions above €22.8 million but less than 5% of the capital of the target company. This should not change the big picture: corporate capital gain taxes (for shares held for more than two years) will disappear from the French tax landscape. Elsewhere, the cap to local taxes of no more than 3.5% of value added was already known, but might be important in some regions, given the highly uneven distribution of local tax rates. Too optimistic on growth? Overall, the Treasury expects the general government deficit to decline to 2.5% of GDP next year, from an estimated 2.7% this year. The budget is based on a 2.25% GDP growth assumption (between 2.0% and 2.5%), just one-tenth above trend growth, and similar to the assumption made for 2006. With hindsight, last year’s growth hypothesis looks pretty accurate — our current estimate is 2.3% for 2006 GDP growth — although at that time, it had been criticised for being too optimistic, including by yours truly. However, I continue to think that next year is not going to be as good as the government is expecting, because of the fiscal tightening implemented in Germany and Italy, and also the rise in short-term interest rates. Our own forecast, 1.9% GDP growth in 2007, would be consistent with a slightly higher deficit, at 2.7% of GDP. Maastrichtcompliant, for deficit and debt Even so, France would comply with EU budget rules for the third year in a row and, this time, without one-off factors. More importantly, the debt/GDP ratio would continue to decline, to 64.9% of GDP on our estimates (63.6% on the government projections). Since the decline this year was largely the result of changes in the management of the very short-term debt, rather than due to structural changes, a further decline was not warranted. This is thus good news for French sovereign bonds, in a context of intensifying competition between sovereign issuers in the euro area.
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September Tankan Review
Oct 02, 2006
Takehiro Sato (Japan)
What’s new: The September Tankan was mostly in line with our upbeat scenario, aside from the stronger-than-expected headline. Large manufacturing sentiment was unexpectedly solid for the current assessment, and was cautious for the future assessment. The headline was roughly flat after smoothing. Sales/profit and capex plans for large corporations were virtually unchanged, again as expected. In all, the Tankan should be a tailwind for the BoJ’s soft-landing scenario for the economy. Conclusions:Corporate earnings plans remain cautious. We think overall targets diverge from reality, despite upbeat Apr-Jun results, due to conservative assumptions. Companies will need to raise outlooks after continued healthy numbers in Jul-Sep. We anticipate firm economic momentum driven by capital investment, given favorable profit trends. Policy implications: We do not see decisive support for an additional policy rate hike from this Tankan survey, and with a solid headline and managements sticking with its plans based on a cautious outlook, we expect a delay until Jan-Mar 2007 after the December Tankan survey. We reiterate our view that the pace of additional rate hikes after ZIRP reversal should be very slow. Risks: The main risks are loss of a volume effect from a slowdown in overseas economies and weaker corporate earnings from a rebound in commodity markets that have eased somewhat. Yet these two risks should not occur at the same time. Furthermore, overseas economics are currently firm, and softer energy and primary product prices are contributing to reacceleration of the global economy. Economy on pace for the BoJ’s soft-landing scenario The September Tankan was mostly in line with our upbeat scenario, aside from the stronger-than-expected headline. Large manufacturing sentiment was unexpectedly solid for the current assessment, and was cautious for the future assessment. The headline was roughly flat after smoothing. Sales/profit and capex plans for large corporations were virtually unchanged, again as expected. In all, the Tankan should be a tailwind for the BoJ’s soft-landing scenario for the economy. However, we do not think this Tankan will be a direct catalyst for an additional rate hike within the year, as (1) despite the strong headline, the future assessment grew more apprehensive versus the previous two surveys, and (2) management plans for F2006 are largely unchanged. We reiterate our scenario, with the next rate hike likely in the January-March quarter on the heels of the December Tankan. Results for major DI values The headline DI for large manufacturing (+24) improved by 3ppt, and the large non-manufacturing DI (+20) was basically unchanged. The former showed stronger-than-expected improvement, perhaps the result of a stronger US equity market, lower long-term interest rates and softer commodities prices during the survey period. Meanwhile, for outlook DIs, large manufacturing dipped 3ppt (+21), while large non-manufacturing climbed 1ppt (+21), and they now stand at the same level. For large manufacturing enterprises’ current conditions, the materials industry DI improved to +21 (+3ppt), as did the processing/assembly industry DI, to +25 (+2ppt). However, the outlook DIs for large manufacturing enterprises fell 3ppt to +21. Reviewing the breakdown for the outlook DIs, improvement continues for materials industries (+1ppt), but the processing industry was down a comparatively sharp 5ppt, which shows that companies in the main processing/assembly industries, such as electrical machinery, general machinery, autos, and precision instruments, are growing increasingly wary on the outlook. Although the business conditions DIs show improvement in current levels, while at the same time increasing caution in the outlook DIs, we think the combination of worsening sentiment on the outlook for processing/assembly now contrasts well with the solid outlook for materials industries. Regarding the prices DI, the output price DI for large manufacturers (+2) improved by 5ppt, and rose to positive territory for the first time since March 1991. The input prices DI also improved, by 4ppt to +45, thanks to higher energy/materials prices. As a result, the corporate margin DI (defined as output price DI minus input price DI) for large manufacturers improved by 1ppt over the last Tankan to -43, aided by improvement in the output price DI. We think this limited improvement in the margin DI, in concert with volume effects from higher demand as well as restructuring efforts (as rising capacity utilization lowers the break-even point and enables fixed costs to be lowered) will likely help drive upward revisions to bottom-up corporate earnings forecasts. Increasingly tight labor conditions are evident in the employment DI for large enterprises. The employment DI dropped by 1ppt to -8, while the outlook DI fell by 3ppt to -11 (tighter labor conditions spell a lower DI). The sense of labor shortages that began in SMEs now seems to be spreading in earnest to large enterprises. Meanwhile, the manufacturing production capacity DI signalled a decline in capacity shortages at large enterprises, with the DI here improving by 1ppt to -1 (looser supply/demand means higher DI). The production capacity DI has remained unchanged as a whole at 0. Still, the outlook DI for production capacity mirrors the employment outlook DI, also pointing to increasingly tight conditions overall. F2006 management plan revisions (1) Sales and recurring profit plans:Large manufacturers look for sales of +3.1% and recurring profit of +1.7%, as firms have left these plans virtually unaltered. Such developments are basically as we had expected. Corporate forecasts on a consolidated basis include earnings from overseas production/sales subsidiaries, while the Tankan figures are based only on domestic businesses, which we think is having an impact. For example, parent results are weak in the automotive industry due to sluggish domestic automobile sales in contrast to relatively upbeat consolidated numbers. Bottom-up sales plans also do not sufficiently discount for potential upside from the end of deflation. We anticipate a new pattern of sales gains that adds a price effect (margin improvement from raising product and service prices) to existing volume growth within the context of nominal growth in the 2% range. Conservative assumptions for crude oil prices and forex rates (¥111.64/$) are responsible for the divergence of bottom-up profit outlooks from reality. Initial profit targets were flat (YoY) in F2005, but increased to +10% at interim results and wound up near +20% at the final stage. We think companies are exercising greater caution in their profit outlooks as the shift to quarterly results announcements puts more attention on performance in each quarter. The corporate allocation rate has steadily risen over the past two years versus the flat labor allocation rate. This means that corporate income growth is outpacing employee income growth, with companies receiving larger benefits from economic expansion. While our top-down forecast for F2006 recurring profit (+13% YoY) is still much higher than the bottom-up view, it is not out of reach, in our view, given the aforementioned latent opportunities for upward revision. (2) Capex plans: Capex plans for large manufacturers (+16.9%), non-manufacturers (+8.5%) and overall (+11.5%) were revised down slightly. However, the results were not surprising in that the September Tankan does not typically see firms revise plans much. The biggest revision for capital investment plans (Tankan level) typically comes from the March to June reports, and the June-September change is limited since companies still revise full-year earnings targets and capital investment plans after reviewing interim results even with the transition to quarterly results announcements. We expect large companies to modestly raise capex plans in the December Tankan survey and then reduce values based on actual results (outlooks and confirmed) in the March and June reports for the following year. While automotive momentum is a weak spot for manufacturing this year, electronic components, electric machinery and other IT-related sectors are outpacing plans. The defining characteristic of Japan’s recent economic expansion is extension of the overall capital investment cycle from new sectors picking up the slack as momentum weakens in other areas. There is also evidence of a similar pattern among non-manufacturers. The main sources of non-manufacturing capital investment are sustained replacement demand from the electric power industry and the recent arrival of upgrade timing for rolling stock in the railway industry. Communications and financial services should also contribute. We hence expect replacement demand to continue supporting the capital investment cycle. Note that when including software but excluding land (to give a closer image to nominal GDP), figures for small- and medium-sized enterprises were raised significantly, leading to an upgrade of 1% to +8.7% for enterprises in all industries. This is consistent with our economic outlook on real investments in F2006 (+10% YoY). Policy implications Although the headline figures were stronger than market expectations, the September Tankan results cannot be the conclusive factor for the BoJ to raise the policy rate by the year-end. We stick to our basic view that the pace for additional rate hikes is likely to be slower than expected by the market. The results suggest further improvement of the output gap based on Tankan DIs, a key indicator for the BoJ, and we maintain our general outlook for normalization of monetary policy. BoJ officials are very well aware of the potential for a sharp erosion of confidence in monetary policy if the economic reverted to deflation and recession, particularly with recent weak personal consumption. We also expect the BoJ to carefully avoid agitating the government and ruling parties from adopting too much of a hawkish tilt at this point. While some observers anticipate a backlash against the BoJ under the new cabinet’s growth-oriented policies, we question this view and point to steady policy normalization implemented in March and July despite reflation policies being promoted by ruling party officials. In fact, rate hikes benefit everyone (government, ruling parties and the BoJ) if the economic is healthy. Economic conditions will dictate the direction of monetary policy in this respect, in our view. We think that the BoJ will proceed with rate hikes at a measured pace if the economic outlook holds up. Intervals between rate hikes might be longer when the outlook is uncertain. On top of that, authorities should stick to a rate-hike path even if the core inflation rate remains near 0% due to lower oil prices, in our view. The impact of core inflation on monetary policy can easily be misinterpreted since we have become familiar with the backward-looking policy framework from the quantitative easing period. A key point is the BoJ’s shift to a forward-looking policy approach based on two pillars when it ended quantitative easing. The recent inflation rate hence no longer has a decisive impact. Investors should be monitoring BoJ views on the inflation rate outlook and asset price trends. The BoJ retains a free-hand in policy decisions even if lower oil prices restrict overall prices. Risks In contrast to the previous Tankan in July, the Tankan this time showed strong sentiment in materials industries, but a cautious outlook in processing/assembly industries. As such, the main risks are that renewed increases in commodities prices could stall margin improvement faster than companies currently expect, or that the volume effect that is offsetting a negative price effect currently will subside due to a slowdown in overseas demand. We doubt that these risks would come to fruition in tandem, however. While the US economy is exhibiting signs of a slowdown, the resilience of Latin American economies to US rate hikes has improved with upbeat domestic demand and a sharp reduction of net external debt in Brazil and Mexico thanks to recent resource price gains. European consumption is firm, and Chinese and other Asian economies are healthy. The overseas economy is doing well without excessive reliance on US momentum. Additionally, softer energy and primary product prices after the unwinding of speculative positions are contributing to reacceleration of the global economy.
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GDP Growth Stays Strong
Oct 02, 2006
Chetan Ahya and Mihir Sheth (Mumbai)
GDP growth was 8.9% in F1Q07 The Central Statistical Organization (CSO) announced that GDP growth in the quarter ended June 2006 (QE Jun-2006) was 8.9% YoY compared with the 9.3% registered in QE Mar-2006. This was ahead of our and consensus expectations of 8.5% and 8.4%, respectively, largely on account of stronger-than-expected manufacturing growth. The industrial segment accelerated to 10.2% in QE Jun-06 from 9.5% in the previous quarter. The services segment growth stayed strong at 10.6% in QE Jun-06 as compared with 10.9% in the previous quarter. However, the agriculture segment growth decelerated to 3.4% in QE Jun-06 from 5.4% registered in QE Mar-06. Manufacturing segment growth accelerated to a new high The manufacturing segment growth accelerated to a new high (since quarterly data has been made available) of 11.3% in QE Jun-06. This compares with the 8.9% recorded in the previous quarter. This was also reflected in the aggregate BSE 200 corporate sales growth (excluding energy companies), which accelerated sharply to a new high of 28% YoY during the quarter ended June 2006 from 18% during the quarter ended March 2006. What drove the strong growth? External demand had been weak, with goods trade data as well as the port traffic trend decelerating in the period. Hence, most of the acceleration in growth appears to be driven by domestic demand, which in turn has been supported by a sharp rise in bank credit, in our view. Bank credit growth had accelerated to a new high of 33% as at end-June 2006, making the current credit cycle the longest in the past 35 years. Indeed, during the quarter ended June 2006, the government also borrowed aggressively to fund acceleration in its expenditure growth. The government is continuing to pursue the policy of “borrowing from future”. Apart from this aggressive leveraging trend supporting growth, the government is also protecting domestic demand by choosing to not pass on the full cost of higher oil prices. Revising our full-year GDP growth estimate for F2007 to 7.8% from 7.6% Reflecting the stronger-than-expected manufacturing segment growth, we are upgrading our GDP growth forecast for F2007 to 7.8% from 7.6%. We now expect the industry and services segments to register growth of 9.2% and 9.4% in F2007 as compared to our earlier estimates of 8.7% and 9.2%, respectively. We still look for a slowdown in growth in the second half of F2007. Even as we expect the support from corporate capex to remain positive, the weaker trend in the other three drivers, including external demand, government spending and household spending, should result in a slowdown in growth from the quarter ended September 2006.
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Current Account Surplus Widens
Oct 02, 2006
Deyi Tan
August’s current account balance (CA) surplus widened to a US$813 million surplus, the highest level since October 2005 and third successive surplus in the row. The CA surplus widened on the back of sustained momentum in exports (+17.0% YoY versus +17.7% YoY in July) and as imports weakened to 11.2% YoY (versus +16.3% YoY in July). Net services and transfers balance stayed at a similar level to July (US$541 million versus US$531 million in July). Weak domestic demand is the factor behind the widening current account surplus: On the import front, momentum weakened across the board. Consumer (+6.8% YoY versus +15.6% in July) and raw materials & intermediates imports (+2.9% versus +4.8%) decelerated. The adverse impact of continued political uncertainty is reflected in the domestic business confidence and capital imports, which contracted 10% YoY (versus +7.1%). Machinery and manufactured exports still healthy: On the export front, segments such as machinery and manufactured goods, the larger contributors to export growth (+3.0%-pt & +2.2%-pt, respectively) expanded at a commendable pace (+6.7% YoY & 14.4% YoY) despite the base effect. However, food and mineral fuel exports contracted 0.9% YoY and 23.4% YoY from double-digit expansion in July, subtracting 0.1%-pt and 1.7%-pt from headline respectively. In terms of export destinations, demand from the top two export destinations (Japan and US) was relatively tepid (+3.8% YoY and +5.6% YoY, respectively). In comparison, export momentum to the EU15 and Australia was healthy at 12.3% YoY and 38.5% YoY, respectively. 2006 Current Account Forecast: Our 2006 current account forecast stands at US$4.0bn (2.0% of GDP).
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September Inflation Decelerates to 2.7%
Oct 02, 2006
Deyi Tan
September inflation dropped to a 17-month low at 2.7% YoY from 3.8% in August. On a sequential basis, prices declined 0.3% MoM, after rising 0.1% in August. While the headline number decelerated, core inflation maintained the 1.9% YoY pace seen in August. Fuel prices accounted for bulk of deceleration: Food price inflation was steady at 2.8% YoY (versus +3.0% YoY in August), with the %-pt contribution standing at 0.7 (versus 0.7 in August). However, non-food inflation fell to 2.6% YoY (versus +4.2% YoY in August). In particular, prices in the transport and communication segment rose a milder 3.1% YoY (versus +7.3% YoY in August), accounting for 0.6%-pt of the headline deceleration. This is a combination of both high base effects and downwards adjustment in retail fuel prices in September compared to August. In that regard, motor fuel prices rose a lesser 9.5% YoY (versus +10.3% YoY in August). Prices for tobacco and alcohol also rose a slower 8.5% YoY (versus +9.8% YoY in August). However apart from this, inflation in the rest of the segments was range-bound, with housing and furnishings prices rising 2.3% YoY (versus +2.2% YoY). Monetary policy implications: The latest inflation numbers show moderating price pressures. Our base case is still for the central bank to keep rates unchanged until year-end. However, we believe that the odds of a rate cut before the year-end are rising. Firstly, we believe that there is a risk that domestic demand could weaken more than expected due to the inability of the interim government to provide confidence for private investment and consumption to pick up. Secondly, we believe that if crude oil prices decline to US$50 or lower, inflation could decelerate sharply and the balance of payments condition would also improve significantly, providing an opportunity for the central bank to cut the policy rate at the December meeting.
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