Global Resilience
Oct 09, 2006
Stephen Roach (New York)
Convictions are deep that a $46-trillion world economy has acquired a new Teflon-like resilience. On the surface, recent events appear to bear that out: Despite unprecedented outbreaks of terrorism, mounting geopolitical instability, soaring oil prices, and the bursting of a major equity bubble, the global economy has hardly skipped a beat. In fact, by the IMF’s metrics, world GDP growth appears to have surged at a 4.9% average annual rate over the 2003-06 period -- the strongest four-year global growth spurt since the early 1970s. And most forecasters, including those at the IMF, are banking on a similar outcome for 2007. Is this resilience a new organic feature of an increasingly globalized world, or has it come at a much greater cost than widely appreciated?
I am firmly in the latter camp -- that the world may have paid a very steep price for its newfound resilience. That price, in my opinion, is very much associated with the second-order effects of excess liquidity -- namely, a profusion of asset bubbles, record disparities between current account deficits and surpluses, and a mounting protectionist backlash. In a myopic rush to celebrate the immediate dividends of faster economic growth, the costs of what it has taken to achieve that outcome have all but been ignored. As long as global growth remains strong and the liquidity cycle remains accommodative, I suspect those costs will continue to be finessed. But when the tide goes out and the global growth engine slows for any one of a number of reasons, an increasingly integrated global economy and its tightly interdependent financial markets could well have to come to grips with these costs head on. That remains the biggest potential pitfall of 2007, in my view. The excesses of the global liquidity cycle explain much of the new cushioning role world financial markets have played in warding off major shocks during the past several years. While we see visible manifestations of excess liquidity everywhere -- asset bubbles, historically low spreads on risky assets, and unusually low volatility in major equity and bond markets -- we are lacking in good metrics to measure it. For a forecaster, that makes it tough to render a judgment as to when -- and under what conditions -- the liquidity cycle goes from being a tailwind to a headwind insofar as its impacts on world financial markets and the global economy are concerned. The explosive growth of non-traditional sources of liquidity -- especially derivatives -- seriously complicates the measurement problem. BIS data put the notional value of global over-the-counter derivatives markets at US$285 trillion in December 2005 -- up more than 40% from volumes just two years earlier and more than six times the nominal level of world GDP. The notion of being awash in liquidity takes on a very different meaning in this context. Derivatives, or not, I have a very simple view of what drives the global liquidity cycle -- central banks. That’s not because of their control over the commercial banking system. Indeed, because of the rapid growth of cash capital markets and derivatives, the banking sector has lost market share steadily in the intermediation of total credit. According to IMF statistics, the combined capitalization of global equity markets plus the outstanding value of debt securities totaled US$96 trillion in 2005 -- fully 73% larger than the assets of the world’s commercial banks. With loan-to-asset ratios typically in the 60% range, that would put cash positions in global equities and bonds at nearly three times the volume of worldwide bank lending. Despite the banking sector’s relatively declining slice of total credit intermediation, I still believe that central banks are key in anchoring the markets through their impacts on inflation and inflationary expectations. Their creation of high-powered money -- and the price they set for overnight funding -- remain the defining characteristics of the global liquidity spigot. My favorite gauge of the quantity dimension of liquidity is the so-called “Marshallian K” -- the difference between growth in the money supply and nominal GDP. In essence, this measures the surplus of money that is not absorbed by the real economy. Joachim Fels has constructed such a measure for the “G-5-plus” group of industrial countries -- the US, Japan, the 12-country euro area, Canada, and the UK. This measure is based on “narrow money” (i.e., M-1) -- the monetary aggregate that still has the tightest linkage to central bank policy adjustments. The trend in this version of the global Marshallian K is now ticking below the “zero threshold” for the first time since 2000 -- consistent with earlier turns in the liquidity cycle that have been associated either with recessions (1991 and 2000-01) or abrupt adjustments in financial markets (1994). Stephen Li Jen has made an analogous estimate of the price dimension of the global liquidity cycle -- calculating a weighted average of real, or inflation-adjusted, overnight policy rates for the G-10 economies. His latest estimate places the real G-10 policy rate at 2.8% -- well above the 1% reading of mid-2004 but still short of the longer-term average of 3.2% realized over the 1991 to 2000 period. Significantly, the change in real policy rates is every bit as great as that which occurred in the mid-1990s and in 2000 but the current level of the inflation-adjusted cost of overnight money remains far below past peak rates in the 4-5% zone. Combining these estimates of both the quantity and price dimensions, there can be little doubt that the global liquidity cycle has turned; however, it is equally apparent that the über-accommodation of 2001-03 has not been followed by a major tightening. Instead, with inflation remaining generally well-behaved, central banks have been more comfortable with steering the liquidity cycle back toward the so-called neutrality zone -- embracing the concept of policy normalization that fits the Goldilocks-type script of the fabled soft landing. This underscores perhaps the trickiest aspect of the liquidity call -- the stock versus the flow. The move from excess monetary accommodation to policy neutrality certainly constricts the flow of global liquidity. But given the extremes of monetary ease that were adopted in the post-bubble deflationary scare of 2001-03, the subsequent reductions in the flow of global liquidity have yet to bring the stock down into a more restrictive position. Shifts in the price dimension of the liquidity cycle described above render a similar verdict -- overnight money is more costly than it used to be but hardly onerous in the absolute sense. In my opinion, given the excesses of liquidity that built up in the first three years of the present decade -- both in terms of quantity and price -- the cycle has not turned enough to alter the financial market landscape. This is quite consistent with the broad consensus of investors who I speak with around of the world -- most of whom remain awestruck over the ample liquidity still available to support a broad array of financial assets. In other words, the flow may now be a negative but the stock is still a huge positive. If that continues to be the case, then many of the seemingly anomalous results currently evident in financial markets are likely to persist. By this, I mean a persistence of unusually low spreads in risky assets -- such as emerging market debt and high-yield corporate securities. I am also referring to rock-bottom levels of volatility in major equity and bond markets. The asset-liability mismatch only compounds this phenomenon, as a still ample stock of liquidity continues to be drawn into higher-return risky assets. The high priests of each of these risky asset classes all have very persuasive arguments as to why the fundamentals have changed -- in effect, why the current assessment of risk is far more benign than in the past. Call me a cynic, but I don’t buy the theory of “riskless coincidence” -- that the fundamental underpinnings have simultaneously improved for all risky assets at precisely the same point in time. If there’s ever been a visible manifestation of the excesses of the stock of global liquidity -- despite an adverse shift in the flow -- this is it. Like it or not, the excesses of global liquidity have created a profusion of “this time it’s different” stories. I might be persuaded that one or two of them are intriguing -- it’s the profusion that kills me. The same, of course, is true about the bubbles in the bigger asset classes -- first equities and now property. As those assets went to excess, we heard similar stories about new and powerful fundamentals -- dotcom-enabled productivity transformations in the case of equities and demographically-driven demand for shelter in the case of residential property. Each of these stories is, of course, based on a plausible kernel of truth. The problem is that the arguments eventually were taken to excess by the same liquidity-driven amplification mechanisms that Robert Shiller stresses have been a hallmark of financial bubbles of the past. As was the case with post-equity-bubble adjustments, as the US property bubble now bursts, those same amplification mechanisms are likely to be reversed -- with potentially important implications for asset-dependent American consumers, a US-centric global economy, and world financial markets. The greatest risk, in my view, is that we have focused too much on the visible manifestation of excess liquidity and not enough on the second-order effects. Here, I am referring to the American consumer’s shift from income- to asset-based saving -- and the resulting depletion of national saving that has given rise to massive US current account and trade deficits. In a climate of persistently subpar job growth and near stagnation in real wages, these external imbalances have also sparked worrisome political tensions -- namely, a Washington-led outbreak of China bashing. The excesses of the global liquidity cycle are not just about surging demand for financial assets and/or the risks of inflation. They lie at the heart of a much broader set of tensions that are bearing down on the world economy. The good news is that the stewards of globalization --namely the IMF and G-7 finance ministers -- are now mindful of these risks. The bad news is that they don’t have any power over the monetary and fiscal authorities who can actually make things happen. All this underscores the perils of an exquisite moral hazard dilemma. Central banks have created a monster -- not just liquidity-driven excesses in financial markets but also major cross-border imbalances in the global economy and mounting political tensions associated with those imbalances. Nor do I believe that the instability of this disequilibrium can be resolved through a mere normalization of monetary policies. Ultimately, a more meaningful shift to policy restraint will probably be required. At the same time, by waiting this long to face up to the excesses of the global liquidity cycle, the systemic risks embedded in world financial markets and the global economy have only gotten worse. A monetary tightening that goes too far risks a collapse in this proverbial house of cards. Yes, the world economy has been very resilient over the past five years -- but at a real cost. Increasingly, the celebrants of global resilience are dancing on the head of a pin.
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Is the Slowdown Ending?
Oct 09, 2006
Richard Berner (New York) and David Greenlaw (New York)
| 2005E | 2006E | 2007E | Real GDP | 3.2% | 3.4% | 3.0% | Inflation (CPI) | 3.4 | 3.4 | 1.9 | Unit Labor Costs | 2.0 | 4.8 | 3.5 | After-Tax “Economic” Profits | 5.5 | 18.9 | 2.2 | After-Tax “Book” Profits | 32.6 | 16.7 | 1.5 |
Source: Morgan Stanley Research E = Morgan Stanley Research Estimates True, our spring and summer growth estimates are now pegged at rates averaging about half a point lower than we thought just a month ago, pulling down our forecast annual average for 2006 by 0.1%. Looking ahead, however, we’re betting that growth in the next couple of quarters will rebound slightly above trend, and in the first quarter of 2007 to 3.4%, or 0.6% more than we thought last month. While we no longer think the Fed will raise rates again this year, we believe that the combination of lingering upside risks to inflation and this growth dynamic means that there is a good chance that the Fed will tighten once more early in 2007. At a time when the growth debate centers on whether a soft or hard landing is more likely, our prognosis takes a different tack: We now estimate that growth over the three quarters ended in spring 2007 will average 3.1%, or about ¾ percentage point above the standard forecast. As a result, our forecasts of real growth in 2006 and 2007 are each about a quarter point higher than the consensus on a Q4/Q4 basis. Contrary to the standard view, we think the bulk of the slowdown is over, despite the obvious downside risks to overall growth from a steep housing recession. Among the reasons for this out-of-consensus call: The plunge in energy quotes is adding to consumer discretionary spending power. Easier financial conditions are increasing financial wealth and enabling consumers to refinance debt on attractive terms. Recent data give us even more confidence that the economy’s job and income generating capacity has improved, and still-healthy overseas demand seems likely to lift US exports. To be sure, spring and summer growth was weaker than we thought last month. Official estimates lowered second quarter growth by 0.3 percentage point to a 2.6% annual rate, and we’ve pushed down our estimate of growth in the quarter just ended to 2.5% from 3.1% last month. The main culprits for the downward revisions in those two quarters were a more prolonged depressing impact of the previous rise in energy quotes on consumer spending and temporary weakness in net exports. We’ll concede that there is still some downside risk to our estimate of third-quarter output growth as manufacturers cut production and thus inventories in response to the earlier softness and to Detroit’s overhang of SUVs on dealer lots. Most challenging, there’s no end in sight to the housing recession, posing lingering downside risks to near-term growth. But our prognosis for single-family housing demand and activity is in or close to the lowest decile of Blue Chip economic forecasts, and we believe that the projected decline in starts is aggressive enough to eliminate the inventory of unsold new homes by late in 2007. We expect new 1-family home sales to bottom roughly 10% below July sales levels (August’s pace of 1.05 million was probably an aberration). Construction must fall faster than sales in order to reduce inventories to normal levels, so we expect starts to tumble by another 7% by December — a drop that will trim about a percentage point from GDP growth in the second half of 2006 — and a further 0.5% over the course of 2007. And we believe that we’ve allowed for job and income losses and declines in housing-related consumer spending in calibrating our outlook. In addition, the outcome of the housing-wealth consumer spending debate is still critical to the outlook. In that regard, we continue to think that the deceleration in home prices will be far less severe than feared (see “Bust, not Rust?” Global Economic Forum, September 29, 2006). And we believe that the link between housing wealth and spending is only one-fifth or even one-tenth that envisioned by the pessimists (see “The Great Housing Debate,” Global Economic Forum, September 18, 2006). In contrast with conventional views, however, we think that the list of positives for growth is beginning to grow stronger. First, we expect that a powerful surge in discretionary income will lift spending, courtesy in part of the recent plunge in energy quotes that is adding to consumer discretionary spending power. Pump prices don’t yet completely reflect the 75-cent/gallon slide in wholesale gasoline quotes, but with WTI quotes hovering at $60/bbl and crack spreads narrowing dramatically, there is room for further declines to about $2.25/gal. The gasoline price drop alone would give consumers up to $100 billion in discretionary wherewithal, compared with the August peak. And the slippage in natural gas and heating oil quotes could knock $20-30 billion from winter heating bills, even if winter weather returns to normal following last year’s unseasonably warm winter. Equally, recent data give us even more confidence that the economy’s job and income generating capacity has improved. Job gains were tepid in September — payrolls rose by just 51,000 — but faulty seasonal adjustment issues may have artificially depressed government and private education payrolls. In addition, the August job tally was revised up by 66,000, bringing the average monthly job gain in the summer quarter to 121,000. That’s far from strong but enough to produce moderate gains in wage and salary income. Moreover, statisticians project that they will revise March 2006 payrolls higher by a whopping 810,000, or 68,000 per month, in the year ended in that month. Some of those monthly revisions may be extrapolated forward in the six months since March. That the population- and payroll-concept-adjusted version of the household employment count has advanced by a monthly average 261,000 in the past six months, compared with just 118,000 monthly for payrolls, offers some support for that notion. While any upward revisions to job growth won’t by themselves affect official income estimates (statisticians update income estimates with a quarterly tally of wages that is close to the benchmark population count), faster-than-expected past payroll gains hint that any pickup in economic growth will concurrently boost jobs and thus pay. Third, easier financial conditions are increasing financial wealth and enabling consumers to refinance debt on attractive terms. Since July, broad indexes of stock prices have risen by 6% or more. Over the same period, the 60 basis-point slide in bond yields, especially because it has been associated with a drop in term premiums, has also added to financial stimulus (see “Conundrum Redux?” Global Economic Forum September 25, 2006). Benchmark swap and credit spreads tightened roughly 10 bp over the same period. And there is no sign that lenders are tightening credit availability. Finally, still-healthy overseas demand seems likely to lift US exports. Solid gains in surveyed export orders and in capital goods bookings hint at improving demand both overseas and at home. With growth likely to move back over trend in the next two quarters, inflation risks still linger. Measured by the personal consumption price index (PCEPI), core inflation has risen to 2.5% on a year-over-year basis. In our view, while monthly price increases may be slower, inflation has yet to peak, much less recede. Inflation expectations remain elevated, although the latest University of Michigan canvass indicates that 5-10 year expectations declined in September to 3% from 3.2% last month. While industrial operating rates stalled in August, the unemployment rate fell back to cycle lows in September. With slack in the economy minimal and unit costs accelerating, we believe that inflation risks are still tilted higher. Measured by the CPI, core inflation is likely to peak at 3.1% early in 2007, while core PCEPI inflation may peak at about 2.7%. Despite a very recent backup in yields, the inverted yield curve and the 51 bp spread between December 2006 and December 2007 eurodollar rates suggests that market participants still strongly believe that the Fed will ease significantly over the next twelve months. We will concede that the Fed is likely to stay on hold for the balance of 2006 —that’s a change from our call a month ago. In contrast with market pricing, however, given lingering inflation risks and a strengthening economy, we think there is a better-than-even chance that Fed officials may raise rates early next year. Together with a renewed increase in term premiums, that sea change in perceptions should push yields back over 5%. Against that backdrop, we agree with our colleague and equity strategist Henry McVey that equities still look more attractive than bonds. Risks, of course, still abound. A cold winter could push energy prices up sharply, robbing consumers of needed discretionary income. The backup in yields could tip a tender housing market into a steeper decline with collateral damage to related economic activity. Investors should not ignore upside risks, however; a strong global growth dynamic could push growth higher, rewarding cyclical industries.
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Review and Preview
Oct 09, 2006
Ted Wieseman (New York) and David Greenlaw (New York)
Treasuries posted a decent bear steepening sell-off the past week, after an initial surge through the first part of the week was sharply reversed Thursday and Friday, with a particularly large sell-off following the employment report. Although the 51,000 gain in non-farm payrolls was significantly lower than expected and other details of the report were mixed — upward revision to August jobs, drop in the unemployment rate on a strong gain in household employment, and new year/year high in average hourly earning, but weakness in hours worked and a sluggish sequential gain in earnings — what particularly captured market attention was the preliminary estimate of the benchmark revision, which pointed to a huge upward adjustment to payroll growth in the year through March. Investors certainly seemed to be extrapolating this miss forward and assuming that recent sluggish payroll growth might not really be nearly as soft as currently being reported. Other incoming data were mixed but on balance positive. Upside in construction spending and inventories and capital good shipments in the factory orders report led us to increase our 3Q GDP estimate to +2.5% from +2.2%. Strength in auto and chain store sales pointed to a robust underlying retail sales report for September, supporting our estimate that a 3.5% jump in consumer spending in 3Q will be the prime driver of overall GDP growth and providing a robust starting point for 4Q spending. On the negative side, in addition to the soft September payroll gain, both the ISM surveys were disappointing on a headline basis, though more robust in their underlying details. On the week, benchmark yields rose 5-7bp and the curve steepened slightly. While these were obviously hardly devastating losses, given the market’s massive positive run recently they still represented the market’s worst week in three months. And it was certainly a volatile week, with the 2-year yield trading through an 18bp range and the 10-year 15bp. On the week, the 2-year yield rose 5bp to 4.74%, the 3-year and 5-year and 10-year 6bp each to 4.67%, 4.64% and 4.70%, respectively, and the 30-year yield 7bp to 4.84%. After some absolutely wild swings over the course of the week, futures markets eventually ended up pricing in a significantly less dovish near- and medium-term Fed path on the week. At Wednesday’s peaks, the market was pricing in a good chance of a rate cute by January, a full 50bp of cuts over the first half of next year, and a reduction in the funds target to 4.50%, or possibly lower, by late 2007/early 2008. By Friday’s close, after futures prices were crushed in the aftermath of the employment numbers that apparently convinced investors that labor market conditions were not weak enough to prompt early Fed cuts, odds of rate cut by early next year were sharply scaled back, only about 25bp of cuts were seen in the first half of next year, and the expected trough fed funds target was moved up to near 4.75%. On the week, the January fed funds contract lost 1bp to 5.235%, mostly pricing out any risk of a December rate cut, and the February contract lost 3bp to 5.205%, reducing the odds of a January move to less than 20%. The Dec 06 to Dec 07 eurodollar spread steepened 3.5bp to -51 (after having plunged to an all-time low of -67bp Wednesday), with the former off 2.5bp to 5.36% and the latter losing 6bp to 4.85%. The Dec 06 to June 07 spread, which moved to -44bp Wednesday, wound up Friday at -30.5bp, up 1bp on the week. The low rate Mar 08 contract rallied all the way to 4.64% Wednesday before ending the week at 4.835%, a loss of 7bp on the week. The September employment report was mixed. Non-farm payrolls rose a meager 51,000, though this was partly offset by a significant upward revision to August (+188,000 versus +128,000). In September, downside was concentrated in manufacturing, retail, temp workers and government and private education, the latter probably reflecting some seasonal adjustment issues with the start of the new school year. Other details were mixed. A strong gain in the household employment measure resulted in a decline in the unemployment rate to 4.6% from 4.7%. Average hourly earnings rose a modest 0.2%, but the year/year rate rose to a cycle high +4.0%. The average workweek was steady at 33.8 hours, resulting in a 0.1% decline in aggregate hours worked. While these September results appeared on balance to be market-supportive, investors were severely spooked by the BLS’ initial estimate of the likely benchmark revision to payrolls to be formally released in February. BLS projected a whopping 810,000 upward adjustment to the level of March 2006 employment, which would be the largest revision in over a decade and a massive divergence from the very small revisions that had previously been seen since the implementation of the birth/death adjustment a number of years ago. The latest benchmark adjustment implies that payroll growth in the 12 months ended March 2006 was actually +237,000 per month instead of the currently published figure of +169,000. While not technically appropriate, it tends to be assumed that the revision can be extrapolated forward to the most recent months at least to some extent. In view of the disconnect between the household and payroll surveys and the recent revisions to compensation growth, we had anticipated at least a modest upward revision to payrolls. However, the actual adjustment went well beyond our expectation. It’s worth noting that the population and payroll concept-adjusted version of the household employment count has continued to run significantly ahead of the establishment count, with the former up 1.6% year/year in September and the latter 1.3%. In the past six months, as payroll employment growth has slowed to +118,000 a month, the adjusted household measure has been much stronger at +261,000. So, the market’s apparent extrapolation forward of the March benchmark adjustment certainly does appear to have some basis, given that the prior household/establishment survey disconnect did correctly predict (in direction if certainly not in magnitude) this March 2006 revision. Key early indicators for September consumer spending released the past week pointed to a robust month for consumer spending, at least in real terms, as a likely price-related plunge in gas station sales should weigh significantly on nominal results. Motor vehicle sales rose to a 16.6 million unit annual rate in September from 16.0 million in August, returning to the year-to-date average from the lowest sales pace of the year. Meanwhile, very strong results from department and clothing stores paced overall chain store sales to solid improvement, pointing to good gains in key discretionary spending categories of retail sales. While reported results for September will likely be significantly weighted down by a sharp pullback in gas station sales, real consumer spending in September looks to have advanced at its strongest pace in over a year, pointing to both a solid gain in 3Q consumption and a sharply positive ramp for further upside heading into 4Q. Clearly, the recent collapse in gasoline prices has likely played a key role in the recent improvement in consumption. In addition to the consumer spending results, incoming data the past week directly bearing on third quarter growth, construction spending and factory orders, led us to up our 3Q GDP estimate to +2.5% from +2.2%. So, having steadily marked our 3Q estimate down from +3.1% in early September to a low of +2.0% a week ago, recent incoming data have turned around and surprised a bit on the upside. Construction spending posted a surprising 0.3% gain in August, though there were slight net downward revisions to July (-1.0%) and June (0.0%). In August, a fifth straight sharp decline in residential spending (-1.5%) in line with weak housing starts was offset by the sharpest gain in private non-residential spending (+3.4%) in nearly a year and a rebound in government spending (+1.1%) after a decline in July. The upside in non-residential spending was broadly based and led by commercial real estate, offices, factories and hospitals. The divergent residential and non-residential results continued to point to significant weakness in residential investment being partly offset by robust business investment in structures. Meanwhile, in the factory orders report, non-defense capital goods ex aircraft shipments in August were revised up to +0.7% from +0.3%, pointing to stronger 3Q capital spending. Overall factory inventories in August rose 0.4% as expected, but July was revised up to +0.8% from +0.6%, pointing to smaller inventory drag in 3Q. The September ISM surveys were weaker than expected on a headline basis, but less so in their underlying details. The headline manufacturing ISM composite diffusion index fell to 52.9 in September from 54.5 in August. Underlying details were more positive. 12 of 18 industry groups reported growth, up from nine in August. The key orders index (54.2) held unchanged and the production gauge dipped only slightly (56.1 versus 56.6). Instead, the drop in the overall index was led by the inventories measure (46.4 versus 50.2), which knocked about a half point off the overall index, and the employment gauge (49.4 versus 54.0), which does not have a good near-term correlation with factory job growth in the employment report. The prices paid index fell to 61.0 from 73.0, a 14-month low, with price declines seen for oil, gasoline, natural gas, aluminum and lumber. Meanwhile, the headline non-manufacturing ISM business activity index fell to 52.9 in September from 57.0 in August. Note that unlike the manufacturing version, the non-manufacturing headline is not a weighted average but a separate question considered by the ISM to be most analogous to the production gauge in the manufacturing survey. Other activity measures were stronger than the headline, particularly a big gain in the orders index (57.2 versus 52.1) to a four-month high. The prices paid index fell to 56.7 from 72.4. A number of energy products and lumber were reported down in price, but a variety of items, led by a number of metals, were still reported higher in price. By sector, 10 of e18 industries reported growth in September, compared with 11 in August. While we think that the housing market recession has significantly further to run (and Chairman Bernanke’s estimate that residential investment will subtract 1 percentage point from second half GDP growth was right in line with our forecast), some data released the past week, coming on top of the better-than-expected new and existing home sales reports for August, suggested that the recent plunge in rates may be providing some at least temporary support. The National Association of Realtors’ pending home sales index, a gauge of home sales working their way towards closing when they are counted as existing home sales, rebounded 4.3% in August. And the Mortgage Bankers’ Association’s weekly mortgage applications survey reported a significant rise in applications for mortgage for new home purchases in the latest week. This survey is volatile on a week-to-week basis, but averaging the weekly results across the month showed a 3% gain in September from the more than three-year low hit in August. Homeowners with adjustable rate mortgages also seem to be wisely taking advantage of the plunge in rates to refinance into fixed rates, as the mortgage applications index for refis has surged 24% in the past four weeks to the highest level in a year. The upcoming holiday shortened week only has a few key data releases, highlighted by retail sales Friday, along with Fed news and supply. The minutes from the September FOMC meeting will be released Wednesday and the Beige Book prepared for the upcoming FOMC on Thursday. There will also be a few Fed speakers, with remarks on Wednesday by Richmond Fed President Lacker, who dissented in favor of hiking rates at each of the last two FOMC meetings, likely to receive the most attention. On the supply calendar, the Treasury will announce a reopening of the 10-year TIPS Tuesday for auction on Thursday. We look for an US$8 billion size. Key data releases due out include the trade balance Thursday and retail sales and the University of Michigan consumer confidence report Friday: * We expect the trade gap to narrow US$1.5 billion in August to US$66.5 billion, with exports up 1.5% and imports 0.2%. On the export side, industry data point to a decent increase in aircraft, while other capital goods seem poised for a solid rebound after the sharp decline last month that contrasted with good growth in factory shipments. Imports should be restrained by the initial impact of falling oil and gasoline prices (which should be much larger next month) and flat volumes for petroleum products, which hit a record high in July. Port data have also been pointing to some moderation in growth in Asian imports. * We forecast a 0.4% rise in overall retail sales and a flat reading ex autos. A solid rise in motor vehicle sales and relatively upbeat chain store results point to a modest rise in overall retail activity after factoring in the price-related plunge in sales of gasoline. Indeed, excluding auto dealers and gas stations, sales are expected to be up 0.6%, which would represent the best gain since May. Company reports suggest that unusually cool temperatures across much of the nation gave sales at apparel outlets a considerable boost. This factor should also be evident in the general merchandise category, which is expected to show its sharpest gain since January. Meanwhile, the cooling of housing markets should continue to lead to some softness in the furniture store component. Still, we see real consumption spending running at a +3.5% pace in 3Q, with the recent swing in energy prices largely responsible for an expected pick-up to +4.0% in 4Q.
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Learning from the A380 Debacle
Oct 09, 2006
Eric Chaney (London)
Airbus’ success over Boeing over the last ten years and the beautiful maiden flight of the A380 last year were legitimate subjects of pride for many Europeans, who continue to think that the future of Europe is in innovation and technology, rather than in leisure parks. Let’s face it: the fairy tale has turned into a nightmare that even the fiercest eurosceptics wouldn’t have imagined possible. Shares of parent company EADS are plummeting, while a hastily reshuffled management has announced further delays in deliveries, cut earnings forecasts until 2010, questioned the launch of the A350, and admitted that the company is facing a challenging short and medium-term financial outlook. To add insult to injury, officials in France, Germany and Spain are already voicing concerns about the unavoidably painful restructuring plan the new management tries to set up. So far it has a name, Power8, it has goals, such as increasing productivity by 20%, but not much substance. The giant is wounded but nurses and doctors are pointing fingers and fighting each other. That is very sad indeed. It might even have serious macro consequences in the long term: aerospace is a textbook example of an industry which has positive effects on total factor productivity because of its high innovation rate. However, if policy makers face the facts and think in cold economic terms instead of prestige or power, the shock could prove positive for the future. In short, the lesson they should draw from the A380 debacle is: hands off, please. A Listian case, in 1970 Back to 1970, when France’s Aerospatiale and Deutsche Airbus, a grouping of leading German aircraft manufacturing firms, joined forces under the auspices of their respective governments, Boeing from the US was enjoying a quasi-monopoly on the civil aircraft industry, judging by volumes. Entering successfully on the global aircraft market had proved practically impossible: the entry ticket was just too big. This was a clear case of market failure leading to inefficient allocation of resources and excessive prices for customers, i.e., airline companies and, in the end, for consumers. For once, a governmental intervention was justified. One could argue that building a European aircraft industry able to compete with the world leader was a ‘Listian’ case, in the name of the German economist Friedrich List. Following the steps of the first US Treasury secretary Alexander Hamilton, List opposed Adam Smith’s laissez-faire theory of trade and argued that building a national economy required a certain degree of protection in some circumstances, such as the ‘infant industry’ case. As often, Britain chose to wait and see but, in 1979, British Aerospace joined, on the heels of Spain’s CASA. When, in 2001, Airbus became a single fully integrated company co-owned by the European Aeronautic Defence and Space Company (EADS) and BAE Systems, Airbus seemed on its way to become a normal and highly successful company, offering a belated tribute to List. Sick of political interference However, below the surface and hidden behind the very real successes of Airbus, which will again deliver more aircrafts than its rival Boeing this year, the reality of the business was deteriorating, as the A380 debacle has now proven. On top of engineering issues, EADS and Airbus have in my view suffered from the extraordinarily complicated structure of management designed to keep the balance of power between German, French and Spanish interests. It won’t be the first time that a large manufacturing company goes through a serious crisis, as it happened to Boeing a few years ago. And Airbus, which is the most successful manufacturer of single aisle aircrafts, is far from being defeated. The A380 project, although delayed, is a very long-term bet, spanning over several decades, not several years, and, in the end, might decide the future of the company. My colleague Scott Babka recently invited two highly respected experts, Pr. Philip Lawrence and Mr. Richard Aboulafia, to articulate their diverging views on the success or failure of the new jumbo jet, in a fascinating debate (The A380 Debate, September 5, 2006). Having no expertise at all on the issue, I can only say that, even if Pr. Lawrence, who believes that the project will be successful, is right, the company will need in-depth restructuring, wide scale cost cutting, rationalisation of production lines and, maybe, to make new strategic choices. These are the medicines that any company in crisis would have to take in order to survive and thrive, later on. But in order to deliver, management will need shareholders behaving like shareholders, not stakeholders. In plain English, if governments continue to interfere with management regarding key positions and factories, the very future of the company could be jeopardised. If there might have been a Listian case 36 years ago, it is certainly no longer the case today. At stake: innovation and productivity I believe that more than the particular case of Airbus is at stake. According to Eurostat, the aerospace industry generated €29 billion of value added, that is, 0.6% of total value added in the non-financial business sector of the EU in 2002. This looks small and even smaller in terms of employment: 363,900 employees, or 0.3% of the workforce. However, these numbers underestimate the importance of the sector, which is highly research-intensive. For instance, in France, 28% of the value added generated by this industry was devoted to research budgets, versus only 7% for the manufacturing sector in general, according to the same Eurostat source. In Germany and the UK, although smaller, the data show the same qualitative research intensity. Not only are aerospace industries big research spenders, but the dynamics are impressive: between 1996 and 2002, patent applications in the field of ‘aircraft, aviation, cosmonautics’ grew by 117%, more than twice the speed recorded by the manufacturing sector in general (46%). This is why the future of this particular industry matters from a macro perspective: innovation, research and patents all contribute to enhance total factor productivity, the only way to generate wealth for already mature economies. Hostage of French elections? The short-term outlook appears bleak. Because the French state and the Lagardere group hold together 30% of the company, it won’t be easy to take drastic decisions before the French presidential elections. I hope my pessimism will prove wrong. Maybe French politicians will remember that a Frenchman, Mr. Carlos Ghosn, did a lot to save an ailing Japanese car manufacturer. Shareholders and the government let him be free to do what he thought had to be done. Shouldn’t politicians conclude that the quality, not the nationality, of the CEO is what matters?
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A Myopic Budget That Does the Job (Probably)
Oct 09, 2006
Vladimir Pillonca (London)
The 2007 Budget will allocate a significant €34.3 billion of resources across the economy, but the focus has shifted from resolving structural issues to finding revenue-increasing measures. Somewhat bigger… but actually pretty similar. The overall fiscal package has been upgraded to €33.4 billion from the €30.0 billion previously announced. This package is split into two components: 1) €18.6 billion of economic growth-enhancing measures; and 2) € 14.8 billion (1% of GDP) of net fiscal tightening. What matters the most for the path of the economy — the net fiscal tightening — is broadly unchanged. Mission possible — but not easy. We think that reaching the 3.0% budget deficit limit next year is plausible, and while the margins are fairly tight, the government forecast is for an ambitious 2.8%. The latest setback has been the upward revision of the government’s expected budget deficit to 4.8% for 2006 from around 4.1% in 2005. This was due to the €13.4 billion ruling on VAT deductibility on corporate car fleets by the European Court of Justice. But stripping out this one-off, the budget deficit would have been a better-than-expected 3.6% in 2006, according to the government. We think it might have been even lower, given strong economic growth and buoyant tax receipts so far this year (In the first half of 2006, the budget deficit has declined to an encouraging 2.9% of GDP, though quarterly data are somewhat volatile). The VAT ruling will, however, have a lasting impact on the overall level of government debt. The government predicts that the debt-to-GDP ratio will ease from 107.6% in 2006 to 106.9% in 2007 (excluding the VAT ruling, it would have stood at 106.8% in 2006 and fallen to 106.1% in 2007). We think this leans on the optimistic side, but it is not implausible. Despite its flaws and short-termism, this budget still amounts to a step forward. Italy’s public finances look set to benefit, at least in the near term. What’s missing is a long-term solution to issues such as pensions and healthcare spending. We don’t think a recession will follow. Despite large fiscal retrenchment, our central expectation remains for GDP growth to slow from 1.6%YoY this year to 0.9%YoY in 2007, which we judge only slightly below trend growth. Risk may lie on the downside of our central forecast, but a decline in the savings ratio should enable consumption to hold up relatively well in 2007, while the changes to income tax should support lower-income consumers at the slight expense of higher-income earners. Mixed news for bonds…reasonably good for equities. A possible sovereign credit downgrade cannot be entirely dismissed later this year, given the high reliance on non-permanent revenue-increasing measures at the expense of more structural areas, such as pensions. However, the state of Italy’s public finances looks set to benefit appreciably, especially in the near term. This should lower bond issuance and benefit fiscal credibility. Cutting payroll taxes is good news for corporate profitability, though the size of this measure has been downsized somewhat. Two birds with one stone: Corporate profitability and inflation. Reducing the payroll tax wedge (the difference between the employee’s take-home pay and the employment costs faced by the employer) is a sound initiative, costing about €6.0 billion. This wedge will be cut by five percentage points and will be split 60% to firms and 40% to workers. While workers will receive their reduction at the start of 2007, employers will receive their share in two installments (January/February and July/August). This measure will be only applied to permanent jobs, and excludes sectors such as insurance, banking and utilities. (This set-up entails a fixed deduction for the employer on the first €5,000 of the annual employees’ earnings as well as other tax deductions — notably IRAP — and is intended to benefit proportionately more lower-earning jobs.) Reducing firms’ wage costs should underpin profit margins as economic growth slows next year. Ultimately, lower wage costs should help to moderate inflation slightly. Cuts are hard, tax revenues are easier … In July, the government cited four critical areas on which to act to permanently cut expenditures: 1) pensions 2) healthcare 3) public employment and 4) local public administrations. Acting on these areas is crucial to raise the primary surplus, which has been declining for eight years. Raising the primary surplus is critical to reduce the high level of debt, estimated at almost 108% of Italy’s GDP in 2006. A lasting solution of Italy’s public debt sustainability needs to address the expenditure side of the equation. … so it’ll be taxes then. According to government’s description, the total fiscal package will be financed by €13.0 billion of increased revenues and €20.4 billion of expenditure cuts, but our impression is that the bulk of the financing comes from a boost on the revenue side of the equation. Tax evasion — a national sport that needs tackling. Quantifying tax evasion is difficult, but working out how much extra tax revenues it will generate is harder still. The budget estimates that it will yield approximately €8.0 billion in 2007. Tackling tax evasion is highly desirable, and extending the tax base should make it easier for the government to lower taxes in the future. However, we see downside risks to the government’s revenue-raising objectives on this front, especially in the near term. Pensions: Not this time round — TFR does the trick, controversially. Curbing pension expenditures has been avoided to shun a confrontation with trade unions. Instead, a more creative solution has been chosen. The government will transfer half of the employees’ severance pay contributions (those which employees do not allocate to pension funds) from the employers’ dedicated reserves (‘TFR’) to the INPS, a government-owned social security body. This transfer is expected to generate about €5.0 billion in 2007 government revenues, according to government estimates. But this money is not a permanent transfer — it is simply a loan and, therefore, a future government liability. It isn’t a long-term financing solution. Bad for pension funds? This transfer mechanism might induce the government not to encourage employees to put their contributions into pension funds (‘moral hazard’) — further complicating Italy’s longer-term pension sustainability issues. But the legality of this transfer is subject to debate, and this procedure could potentially be overturned by the European Court of Justice. Conclusions. While we think that the 3.0% budget deficit ceiling is reachable next year, this budget has compromised on structural issues, and the hard work of reforming pensions has been delayed yet again. This myopic approach suggests that Italy’s longer-term fiscal sustainability remains a topic of debate, as will the possibility of a sovereign credit downgrade. Households’ higher take-home pay should help to ensure that consumption holds up despite the higher overall fiscal pressure, and we don’t expect a recession to occur next year. Despite its flaws and short-termism, this budget still amounts to a step forward, in our view. Italy’s public finances look set to benefit, at least in the near term.
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Doubts Fade, Hopes Grow
Oct 09, 2006
Robert Alan Feldman (Tokyo)
What a difference a month makes. At the Morgan Stanley Japan Equity conference in New York on September 20-21, the sentiment was bad. Japan was underperforming. The macro indicators were troubling. The new government was not in place. Many investors wondered out loud whether staying invested in Japan was a good idea. Now, in early October, the world seems to have changed. Many of the reasons for pessimism just three weeks ago are gone (or at least discounted), and good news has become the order of the day. Doubts fade As I wrote last week, “If investors are thinking ‘cycle’ while the economy is doing “wiggle,” then the most likely result is confusion and skepticism.” This problem — dissonance between the model used by investors and the true model of the economy — may still exist. However, the quarterly BoJ Tankan report on the economy was a positive wiggle — as was industrial production for August announced prior to the Tankan. Moreover, investor visits to the BoJ have recently shown a change of tune. Even the hawks at the BoJ are cooing like doves, in light of the very subdued consumer price data in the wake of adjustments to the consumption basket. So, doubts about the macroeconomic indicators have faded. Doubts about policy direction have also faded. Our conference occurred before Mr. Abe became prime minister, before he chose his Cabinet, and before he chose his Council on Economic and Fiscal Policy (CEFP). Now, he is prime minister, and has appointed a strong Cabinet and an extremely strong CEFP. As investors learn more about the many new faces in the government, they become more impressed. For example, both academics on the new CEFP have Ph.D.s from US universities, and both have been active, forceful proponents of deregulation. Moreover, the appointment of special councillors to the PM on important policy issues (e.g., education) suggests an even more muscular concentration of policy initiative in the PM’s office. Yet another clarification concerns Japan’s policy versus Asia. Just a few weeks ago, there were widespread fears that Japan-China relations might worsen further. Now, however, an early summit between Chinese leaders and PM Abe has been arranged. It seems very unlikely that either side would have agreed to a summit unless an agreement to improve relations had already been reached. Moreover, the need for cooperation between the two countries has been made even clearer by the announcement from North Korea that it intends to test a nuclear weapon. Both China and Japan are strongly opposed to such a test. The common interest of the two countries in a nuclear-free Korean peninsula overwhelms any differences they may have on other issues. Moreover, worries about the global economy have faded too, especially with the drop of oil prices below US$60/bbl. Of course, concerns about the US housing market persist, but even these have eased in light of lower gasoline prices. Hopes grow So far, so good, but the jobs of corporations and of the new government are far from done. As my colleague Takehiro Sato points out, the results in the BoJ Tankan suggest that companies remain very conservative in their earnings forecasts. Their conservatism is understandable. After all, managements that undershoot profit guidance are punished in the stock market more than those who overshoot. So the natural tendency in earnings guidance is to low-ball. Whether companies really need to learn to be more balanced in earnings guidance will become apparent over the next few weeks as half-year results begin to emerge. In our view, there remains significant upside in the equity market from potential earnings upgrades. PM Abe has a lot of work ahead too. His trips to Korea and China are crucial in reassuring investors that the focus will be on the future. In the domestic policy realm, he now must spur his Cabinet ministers and special councillors to create agenda in the key policy areas, such as medical reform, pension reform, education reform, deregulation, innovation, labor market flexibility, land reform, tax reform and a host of other issues. The key sign will be the creation of task forces among ministries and the Cabinet, with significant participation by the private sector. At this point, investors are giving the business sector and the government the benefit of the doubt. Now all we need is execution. In my view, this execution will occur, for the simple reason that the incentives faced by corporations and politicians impel action. Those who fail to deliver will be marked down by investors and/or voters. Knowing this, the corporations and politicians should deliver, if only to save themselves.
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