The Fallacy of Global Decoupling
Oct 30, 2006

Stephen S. Roach (New York)

Surely, there must be more to a $46 trillion global economy than the American consumer and the Chinese producer.  Not only is that the current verdict of financial markets, but it is consistent with the sentiment I have been picking up from a broad cross-section of our clients -- business executives, investors, and senior government officials -- as I travel the world this fall.  While they concede the possibility that these two engines of global growth may, indeed, slow in 2007, there is a general belief that other economies are now perfectly capable of filling the void.  Hope springs eternal that such a global decoupling would allow an increasingly vibrant global economy to keep growing while barely skipping a beat.  My advice: Don’t count on it.

Given the dominant role that the US consumer has played in driving the demand side of the world economy and the equally important role played by the Chinese producer in shaping the supply side, decoupling won’t be easy.  By our calculations, China and the US collectively have accounted for an average of 43% of PPP-based global GDP growth over the 2001-06 period -- well in excess of their combined 35% share of world output.  Globalization makes decoupling from such a concentrated growth dynamic especially difficult, as ever-powerful cross-border linkages have become increasingly important in tethering the rest of the world to these dominant engines of growth.  Decoupling requires economies to cut the cord and develop new sources of growth.  In my view, for an economy to be classified as a “decoupler” it must satisfy three conditions: First, it must have self-sustaining domestic demand -- especially private consumption.  Second, it needs to have a diversified export mix -- both in terms of products and destinations.  And third, it must have policy autonomy -- the ability to establish independent settings for monetary, fiscal, and even currency policies.

The global decoupling thesis can be drawn into serious question on all three counts.  That’s especially the case with respect to the lack of support from domestic demand outside the US.  It is important to make the distinction between the two major components of private domestic demand -- consumption and fixed investment.  What concerns me the most in this regard is underlying weakness in private consumption outside the US.  Investment strength isn’t likely to provide an enduring offset.  Inasmuch as business capital spending is basically a “derived demand” -- largely dependent on expectations of the capacity requirements of future growth in consumer-driven end-market demand -- consumption support is absolutely critical for an economy to prosper on its own. 

Therein lies the problem: Real consumption growth in the world’s second and third largest economies -- Japan and Germany -- remains stuck in a sluggish 1.5% zone.  Nor has the rest of Europe fared any better, with overall Euro-zone consumption on an anemic 1.3% growth trajectory over the past five years.  Moreover, contrary to popular perception that heralds the birth of the young and vibrant Asian consumer (see the cover story in the 21 October issue of The Economist, “America Drops, Asia Shops”), private consumption has actually been a drag on economic activity in this key region of the world.  That shows up most clearly in declining consumption shares of Asian GDP -- the best way to measure the growth impetus of any sector.  By IMF estimates, consumption shares in all of emerging Asia fell from around 70% of GDP in 1970 to less than 50% in 2005.  In particular, China’s private consumption share fell to a record low of 38% of GDP in 2005 and most likely has fallen further in 2006.  Nor is Japan an exception to Asia’s anti-consumer mindset; the consumption share of Japanese GDP fell from 58% in early 2002 to 56% in mid-2006.  The message here is inescapable: Euphoria over the emergence of the Asian consumer is premature, at best; this region’s growth story is still very much dominated by surging exports and fixed investment. 

Not only do Teflon-like US consumers reign supreme in terms of relative growth performance, but they also have the scale that the rest of the world is lacking.  In 2005, US consumption totaled about $9 trillion -- 20% larger than consumer spending in Europe, 3 1/2 times that of Japan, nine times the size of China’s consumer, and fully 17 times the scale of Indian consumption.  While I am actually quite bullish on Indian consumption, it is far too small to offset consumption weakness in the larger economies.  Chinese consumption is also puny by comparison, and the case for a consumption-led rebalancing of China’s investment- and export-led growth dynamic is still at least 3-5 years in the future.  Europe and Japan have the only consumers with a mathematical possibility of filling the void left by a shortfall of US consumption.  Yet, with the global labor arbitrage putting unrelenting pressure on real wages and labor income in these high-wage economies, they are the least likely to pull it off.

Nor does the second factor -- export-diversification -- provide much support for global decoupling.  As America’s record $800 billion trade deficit suggests, exporters around the world are still heavily dependent on the US as the main engine of global demand growth.  That’s especially the case for America’s NAFTA partners: Canada, the 8th largest economy in the world (at market exchange rates), sends 84% of its exports to the US -- enough to account for fully 27% of its GDP.  Mexico, the second largest economy in Latin America and the 13th largest in the world, ships 86% of its exports to the US -- enough to account for 24% of its GDP.  But the impacts of US-centric trade flows are also evident elsewhere.  In China, the fourth largest economy in the world, shipments to the US account for about 40% of total exports (allowing for re-exports through Hong Kong) -- enough to amount to nearly 15% of its GDP.  And, by inference, Asia’s increasingly China-centric supply chain is heavily dependent on China’s major export market -- the US.  That means a US slowdown would not only send China-led reverberations to Japan, Taiwan, and Korea but it would also have ripple effects throughout the global commodity-producing complex that has become so dependent on China in recent years -- namely, Australia, New Zealand, Canada, Brazil, parts of Africa, and, of course, Russia. 

Elsewhere in the world, it’s a mixed bag in terms of US-centric export concentration.  In Japan, where the five-year export growth trend (+5.2%) has been more than three times the pace of private consumption growth (1.6%), fully 24% of its total exports currently go directly to the US.  Moreover, it also turns out that another 14% of Japanese exports go to China -- now its second largest export market -- which, as noted above, is itself highly levered to end-market demand in the US.  Consequently, it’s hard to envision Japan escaping the consequences of a US slowdown.  Europe, where only about 8% of total exports go to America, is probably best situated to withstand a shortfall of US demand, but increasingly tight trade linkages to Asia also leave European exports indirectly exposed to the US.  In short, there can be no mistaking the world’s US-centric pattern of export growth -- a characteristic that leaves a consumption-short global economy highly vulnerable to any protracted pullback by the American consumer. 

Policy autonomy is the final piece of the global decoupling puzzle, and I‘m afraid there is not much ground for optimism on that score either.  Insofar as fiscal policy is concerned, budget deficits are already excessive in most parts of the world -- suggesting little further latitude for stimulus.  The policy mantra in G-3 central banking circles is “normalization” -- aimed at bringing an end to an era of excess monetary accommodation.  The recent cyclical deterioration in inflation underscores the imperatives of such a policy campaign.  While it may make sense for America’s Federal Reserve to ease monetary policy in 2007 if the US economy starts to fade, such actions would not be appropriate either for the European Central Bank or the Bank of Japan.  That’s because the Fed has completed the normalization process, whereas the ECB and the BOJ have only just begun -- leaving them with considerably less leeway to provide the countercyclical easing that a successful global decoupling would require.  Interestingly enough, monetary authorities in the developing world may be able to lean the other way -- largely because quasi-pegged currency regimes still tie their monetary policy stance to that of America’s Fed, which could move into an easing mode on 2007.  That’s especially the case for China.  But given the fragmentation of the Chinese banking system, along with the government’s increasingly determined cooling-off campaign, I think it is unlikely that China can succeed in using discretionary stabilization policy to de-link its economy from the US.

All in all, the case for global decoupling is a weak one.  The non-US world continues to be heavily dependent on exports as a major source of growth -- with the bulk of that dynamic overly reliant on end-market demand in the US.  If, as I suspect, the US consumer now enters a sustained slowdown in a post-housing bubble climate, there will be unmistakable reverberations on US-centric export flows in many major regions of the world.  Lacking in internal demand to fill the void left by a US-led shortfall in external demand, and with only limited policy options available to counteract such a development, America’s slowdown could quickly become a global slowdown.  Meanwhile, Beijing’s increasingly determined efforts to cool off a runaway Chinese investment boom could transmit an equally powerful downshift through its pan-Asian supply chain and the world’s commodity complex. 

Contrary to widespread belief, a US- and China-centric global economy hasn’t changed its stripes overnight.  A failure to rebalance has left an unbalanced world highly vulnerable to a slowdown made in both America and China.  To me, that means the risks to global growth remain skewed to the downside of consensus expectations, which are currently centered on the IMF’s latest forecast of 4.9% world GDP growth in 2007.  Global decoupling could certainly prove me wrong, but I think such a possibility is wishful thinking.

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United States
All About Income
Oct 30, 2006

Richard Berner (New York)

The economy has decelerated more sharply than we expected, with third-quarter growth a tepid 1.6%, so it’s important to diagnose the miss and assess what it means for the outlook.  The sharp decline in housing activity was not the reason; we’ve been pessimistic on housing activity and think a prolonged housing recession still lies ahead (see “Is the Housing Recession Over?” Global Economic Forum, October 20, 2006).  Instead, the offsetting support we expected from global growth, capital spending, and government outlays has fallen short.  Real final sales apart from housing activity had risen at a 2.8% annual rate in the second quarter, and we had expected a third-quarter acceleration that did not materialize.  Nonetheless, we still think a pickup in growth is likely. 

The key reasons for our unflagging optimism: The income fundamentals supporting domestic demand and the global growth backdrop remain solid, setting the stage for a significant snapback in US growth.  Just as the production rebound in the first few years of this expansion outpaced income and jobs, sturdy income gains are now outpacing output.  And growth abroad is outpacing ours.  The immediate risk is that vehicle production cuts in Detroit will take some steam out of fourth-quarter growth, at least partly unwinding the 0.7 percentage point contribution to summer growth from vehicle output. 

As I see it, domestic income fundamentals are most important.  The sharp deceleration in annualized hours worked over the three months ended in September to -0.4% of course threatens labor income, but we believe that a pickup is coming soon.  Offsetting the recent deceleration in hours, real wages are finally starting to grow, courtesy of firmer labor markets, a deceleration in benefit costs, and a break in energy quotes.  The tightening in labor markets began to promote a significant acceleration in nominal wages as long as two years ago, at least as measured by average hourly earnings.  And with the deceleration in benefits, employers have been willing to allow more compensation gains to filter into take-home pay (see “Politics and Wages,” Global Economic Forum, October 27, 2006).  Until recently, soaring energy quotes kept real wages subdued, but the recent plunge in gasoline prices changed the picture, lifting real gains in average hourly earnings by 2.1% in the year ended in September, and by more in October.  Depending on winter weather, we think there is a bit more to come in the form of lower home heating bills (see “Winter Weather: Cause for Concern?” Global Economic Forum, October 27, 2006).

The existence of several different wage metrics complicates analysis; some, like the wage component of the Employment Cost Index, show that real wages rose only by an estimated 1.3% in the year ended in September.  On the other hand, just-released data from the comprehensive ES-202 Quarterly Census of Employment and Wages suggests that real wages per worker were rising by nearly 3% in the year ended in the first quarter.  As I see it, each wage measure has its own unique problems, and I guesstimate that real wages are rising by roughly 2%. (see “Will the Real Wage Measure Please Stand Up?” Global Economic Forum, January 6, 2006).  Even a modest pickup in hours will thus refuel labor income.

That refueling may already be underway.  According to the University of Michigan canvass, the index of consumer confidence jumped 8 points in October, building on August gains spurred by falling  gasoline prices.  “The expectation of an improved pace of economic growth, larger wage gains, and a low unemployment rate during the year ahead” all fueled the October surge.  Respondents reported that their real income expectations were more favorable in early October than at any time since the January 2004 survey.

More broadly, domestic income has been growing faster than GDP over the past year; gross domestic income rose by an estimated 7.2% compared with 5.8% for nominal GDP.  Some of that may be statistical.  But beyond wage gains, that gap reflects two other improving sources of income that will support spending: Corporate profits and state and local government budgets.  After-tax economic profits rose by an estimated 14.3% in the third quarter compared with a year ago, when adjusted for the hit to earnings from Hurricanes Katrina and Rita last year.  In our view, higher operating rates, favorable financial conditions, and strong corporate cash flow will all support faster growth in business investment.  While real US equipment and software spending slowed to just a 2.5% annual rate in the past two quarters, that deceleration seems to reflect one-time adjustments in fleet purchases of vehicles and in outlays for communications and photocopy equipment.  Indeed, the 13.8% real increase in imported capital goods deliveries over the past two quarters speaks to vigorous demand. 

For their part, state and local governments have also participated in this income bonanza, with receipts soaring at an estimated 7.3% rate over the past year.  That falls short of the torrid pace of taxes flowing into Uncle Sam’s coffers.  But it has outstripped the growth of non-Federal purchases of goods and services by 230 basis points and contributed to rising surpluses that officials likely will spend on a host of unmet needs in coming months.  And it’s hard to imagine that real Federal purchases of goods and services will continue to contract, as they have in the past two quarters.  Call me cynical, but it is an election year. 

In our view, global growth is also likely to be a source of support or at least a neutral factor for the US economy in coming quarters.  That’s a controversial call, and we’re well aware of the hurdles: US real exports must growth twice as fast as import volumes to narrow the trade gap in real terms, the US propensity to import is high, and truly autonomous domestic demand isn’t booming in many of our major trading partners. 

Don’t confuse this with a call for ‘global decoupling;’ that’s a separate issue.  I agree with my colleague Steve Roach that if US domestic demand decelerates significantly further, the rest of the world will feel it (see Steve’s dispatch “The Fallacy of Global Decoupling”).  But that does not mean that strength abroad won’t help US exports.  After all, capital goods constitute 40% of US exports, and capital spending is booming in many parts of the world.  Even in the Eurozone, real business investment rose by 4.8% over the past year, and Eurozone imports rose by more than 8%.  And my colleague Eric Chaney sees Eurozone economic activity accelerating in the fourth quarter.  I see no reason why real US capital goods exports can’t rise at the same 14.4% pace over the next year that they rose over the year ended in the third quarter.

Market sentiment has been almost euphoric about the benefits for risky assets of the softest of landings, fueled partly by tumbling energy quotes that would mitigate the housing-led downshift in growth.  Given our relatively bullish growth call, we had expected both the recent backup in real, long-term yields and the improvement in risky asset prices.  Now, the prospect of more subdued growth and its implications for earnings have rekindled fears of a harder landing.  As we see it, however, renewed hopes for Fed ease are likely to be frustrated so long as the economy grows at a moderate (translation: somewhat below-trend) pace.  With the Fed firmly on hold, markets will continue to be hostage to the rhythm of corporate news and economic data.

As noted earlier, one near-term risk is that measured output could again fall short of expectations in the fourth quarter as Detroit’s production cuts trim more from GDP than expected.  Another is that the combination of still-tight energy markets and a bitter cold snap would push energy prices sharply higher, perhaps rekindling fears of stagflation.  But investors should also consider upside risks: The ebullience in consumer sentiment might turn out to be sustainable, validating equity-market hopes for sturdy growth.

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United States
Winter Weather
Oct 30, 2006

Shital Patel (New York)

Winter weather gyrations often play havoc with the economy and at least can distort the normal rhythm associated with the changing of the seasons.  Two competing weather forecasts make the current climatic outlook a wildcard for the economy and financial markets.  The National Oceanic and Atmospheric Administration (NOAA) on October 19 reiterated its view that a warmer-than-normal winter was coming (  If it occurs, such a balmy backdrop would be a boon to consumers and could mitigate the housing recession.  However, the venerable Farmers’ Almanac on August 26 predicted “widespread cold from coast to coast” with lots of snow.  A bitterly cold winter would push up heating demands and energy quotes, and hobble construction activity.  Which of these prognoses is correct and should investors find legitimate grounds for concern?

As I see it, there’s an asymmetry to these outcomes: A deep freeze would have somewhat bigger adverse consequences for markets and the economy than the largely fleeting beneficial effects of a warmer-than expected season.  That’s because the combination of still-tight energy markets and cold weather could significantly drive up energy quotes and heating bills.  A freeze would also depress already-sinking housing activity and other construction.  In contrast, a gentle winter might offer a temporary lift to consumer budgets and some outdoor activities. 

To assess the impact, let’s first handicap the professional meteorologists vs. folklore.  The pros at NOAA construct their seasonal outlooks using several forecast tools ranging from simple statistical techniques to complex models.  They also cross-check their outlook with scientists from other NOAA offices, universities, and the International Research Institute for Climate Prediction.  They place a lot of emphasis on these predictions because they believe weather- and climate-sensitive industries account for roughly 25% of US GDP.  On the other hand, the Farmer’s Almanac bases its forecasts on sunspots, moon phases, and other solar patterns and atmospheric trends.  They claim to have 80-85% accuracy.

If you don’t like these methods, there are several other techniques to predict the weather.  Prognosticators at the Woolly Worm Festival in Banner Elk, NC turn to the woolly bear caterpillar for their winter forecasts.  Their caterpillars are divided into 13 bands — one segment per week of winter — and the darker and larger the segment, the more severe the weather.  For the 2006/07 winter season, the woolly worm is predicting cold and snowy weather for the first four weeks, seasonably cool but no snow for weeks 5-11, and cold and light snow for the final two weeks.  Festival organizers claim 57% accuracy.  Others have looked at pigs’ spleens and tree bark to predict the weather.

Method aside, the outcome of the weather this winter could have an important impact on economic activity.  NOAA forecasters expected a warmer than normal winter for 2005/06 and their forecasts were quite accurate.  Last January was the warmest January since 1970 while February was only slightly warmer than normal and December was slightly colder.  And record temperatures in January no doubt had an impact on retail sales, which registered a 2.7% gain excluding motor vehicles.  There were also sharp gains in housing starts.

While this winter is predicted to be 6% colder than last winter according to the NOAA, the forecast is still for slightly-warmer-than-normal temperatures, which would help trim heating bills.  Using the NOAA’s seasonal outlook, the Energy Information Administration (EIA) predicts that households that heat their homes using natural gas (58% of households) will spend roughly $119 less this winter on fuel compared to last winter.  According to the EIA, natural gas in storage is at record levels.  The front month contract for natural gas closed yesterday at $8 while the February contract is at $8.50.  Our energy team believes that if we have a warm January, natural gas prices could face a prolonged period of weakness (sub $7/mmcf) in near-term prices until the inventory is worked off.  So even though temperatures may be colder this winter compared to 2005/06, lower prices should provide some relief to the consumer.

Households that use electricity to heat their homes (30% of households) will most likely pay $58 more this winter season, according to EIA estimates, while heating oil users (7% of households) will spend $91 more.  The 5% of households which use propane to heat their homes will spend $15 less this winter compared to last year.  Thanks to lower fuel prices, overall average winter fuel expenditures will be an estimated 4.8% lower this year compared to last winter.

We have long thought that lower energy prices along with accelerating wage and salary growth would provide relief to the consumer, more than offsetting the effects on spending of a housing-wealth slowdown.  The $0.83 plunge in retail gasoline prices has already given consumers more than $90 billion (annualized) in relief.  A mild winter could provide $11 billion of additional spending power.  Additionally, warmer weather may draw consumers out of their homes, where they would be more prone to spend money at the malls and dining out.  Milder winter temperatures could also help moderate the housing downturn by facilitating construction, capping headline inflation and thus interest rates, and making it easier to shop for houses.  In contrast, a deep freeze could promote a renewed surge in energy prices, damping both consumer outlays and housing activity.

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Ending 2006 on a Strong Note
Oct 30, 2006

Eric Chaney (London)

Not yet the peak?

October manufacturing surveys from the main countries of the euro area are raising an intriguing question.  We had already assumed that the peak of this leg of the cycle was behind us with, for once, cyclical indicators and GDP data converging to locate it in the second quarter of this year.  Two indicators from October surveys are suggesting another possibility.  First, the demand indicator rose to its highest level since August 2000.  Second, companies have raised production plans for the next two-to-three months, after having been excessively cautious until August.  This raises the possibility that the peak in production growth, as measured by the current production index, could be reached in November or December.  Beyond the pure cyclical dimension of the peak issue — although having a fair idea of where the European business stands is not irrelevant for investors and policy makers — there is a more important question: what is behind the surprising performance of the euro area so far this year?  Business surveys do not give direct clues to answer this question, but there are some serious suspects, such as a protracted monetary stimulus, a significant spending gap in the private sector, and enhanced productivity.

A temporary pause in production

There was actually a significant correction in the current production indicator, which fell from 1.4 standard deviations above the long-term average to 0.9.  Most of the payback generated from Germany, not a surprise after the spectacular jump posted last month in the same country.  Belgium and the Netherlands also reported some deceleration while Italy accelerated.  But even though current production in the whole euro area slowed, the move was just in line with earlier producers’ expectations, which brought back the Surprise Gap into perfectly neutral territory.  As our statistical work shows (see A Compass for the Cycle, Eric Chaney, July 27, 2005), the Surprise Gap is a reliable indicator of acceleration or deceleration only when it departs significantly from the zero line.  Hence, the drop of the Surprise Gap should not be interpreted as a bad omen.  In reality, because expectations formulated in August were particularly downbeat, I suspect that the Surprise Gap will rebound sharply next month, pointing to a possible re-acceleration.

A broader-based recovery

The biggest surprise came from production plans, significantly revised upward in France (where manufacturers now seem to be catching up with their neighbours), Belgium and the Netherlands and stable at relatively high levels in Germany and Italy.  More friendly oil markets and a slightly weaker currency may have helped, but the fundamental reason for this upgrade is stronger order books, in my view.  With demand growing significantly above trend, by more than one standard deviation since April, and giving no signs of cooling, producers have no choice left but to accelerate production.  With capacity utilisation rates rising fast, companies also have a strong incentive to increase their stock of productive capital by spending more, which typically generates the virtuous circle of the accelerating phase of the business cycle where we currently stand.  Our most recent Analyst Survey introduced an important qualification: large companies, at least large market caps, when in possession of large cash positions, have a preference for share buybacks or acquisitions, compared to spending on capital goods or R&D (see A Second Warning from Corporate Europe, Eric Chaney, October 10, 2006).  However, the bigger picture remains that strong profits, low real interest rates and strong demand are all converging to foster the recovery of corporate investment in Europe.  With a broad-based recovery in terms of sectors and, as October surveys indicate, in terms of regions as well, the euro area economy looks better prepared to weather the negative internal and external shocks that may happen in 2007.

Above-trend GDP growth in 3Q and 4Q

We are using for the first time a new GDP indicator, which aims at being more coherent than our previous tool, now that new data from the services sector are available.  In short, we have added to our list of explanatory variables an indicator of business confidence in private services in order to extract the relevant information from producers in this sector, as we already do with manufacturing and construction.  In order to catch the value-added generated by the financial sector, we use the yield curve (i.e., the spread between short and long-term interest rates) as a profitability proxy, for lack of surveys over a long enough period of time.  On the other hand, we have removed variables that were not consistent with our ‘producers-know-better’ philosophy, such as the US ISM or short term interest rates.  More details are provided in a technical annex to the Business Cycle Watch.  The new GDP indicator is a bit less upbeat for the third quarter than its antecedent — 0.6% (quarterly rate) instead of 0.7%, but significantly more for 4Q — between 0.6% and 0.7%, thanks to the upgrade of production plans, but also to a significant improvement in services.  The important point here is that the unavoidable deceleration that should follow the very strong reading in 2Q seems nevertheless to leave GDP growth above trend.

The uncertainties over 2007 have not disappeared

Looking forward, it is still too early to figure out how companies will react to the VAT rate hike in Germany and, more generally, to the German-Italian fiscal tightening next year.  However, one thing appears clearly in my view: the euro area economy will enter 2007 at a faster speed than we thought, thanks to the strength of domestic demand.  It would be exaggerating to attribute this surprise only to advanced purchases by German consumers ahead of the VAT rate hike.  After all, the German consumer, although on the mend, is still the weak link of domestic demand in Europe.  A combination of cyclical (monetary policy stimulus and pending demand) and structural factors (productivity and lower structural unemployment) is in my view at the root of the revival of growth in Europe.  Next year’s headwinds will test this idea.

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South Africa
To Breach or Not to Breach? That Is the Question
Oct 30, 2006

Michael Kafe, CFA (Johannesburg)

At 5.1% y/y, the September CPIX reading that was released on Wednesday came in marginally above consensus expectations of 5% y/y, but higher than our own forecast of 4.9%y/y. The upside surprises came from food, domestic worker and other household operation costs.

Food prices have peaked

With regard to food prices, we mentioned earlier in the week that our model suggested that food prices would rise by 0.8% m/m, based largely on an increase in the implied dollar cost of diesel and a jump in the 6m wheat futures price index in February this year. However, we pencilled in a 0.6% increase because we felt that the predicted increase was completely out of synch with the average 0.4% m/m increase that we have seen in the past six months. Unfortunately, it turns out that it did not pay to tweak the model. Food prices jumped a whopping 1.2% m/m in September, thanks largely to a 2.3% increase in meat prices, a 3.2% increase in fats and oils and a 1.3% increase in coffee, tea and cocoa prices.

But more importantly, we also mentioned that we would look for a deceleration in food inflation after this particular reading, as we expect the onset of harvests during the October-December harvesting season to take some pressure off food prices, although high demand during the festive season could well place a floor under meat, fish and grain product prices. The direction of $ZAR will also be important.

Catch-up in domestic worker costs

It also turns out that our aggressive forecast of a 4% jump in domestic worker costs still fell short of the 6% increase that was reported for September. Clearly Statistics South Africa is playing serious catch-up here. As we explained in our note earlier this week, we have been rather sceptical about the cumulative 2.6% decline in domestic worker costs that was reported for the six months ending February 2006. Clearly, there must have been some measurement problems there. Anyway, the important thing is that the numbers now appear more realistic.

In addition to the higher-than-expected jump in domestic worker costs, Statistics South Africa also reported a 1.5% m/m increase in household consumables (washing soap, cleaning materials, disinfectants, etc).  This is the highest increase since April 2002. We were expecting a 0.3% print here.

Decline in petrol prices supportive

Finally, oil prices also had a role to play. The 3.3% fall in the ‘running cost’ component of the transport sub-index was pretty much in line with our forecast of -3.1%. Further declines in the regulated price of petrol in October and November will likely take CPIX below 5% in October/November. Interestingly though, there was only a 0.1% increase in public and hired transport costs, despite the huge increases of up to 20% that were implemented this July. At some point, Statistics South Africa should pick this up...perhaps in the December survey.

To breach or not to breach?

Looking forward, the upside surprise in this month’s reading takes our peak in CPIX up from 5.9% to 6.1% by March next year. However, it is important to note that this call is still based on our official oil price forecast of US$69.6/bl by December and US$70.3 by the end of March 2007. Also, we have US$ZAR at 7.50 at year-end and 7.60 at the end of March 2007 before depreciating to 8.10 by December 2007.  Thus, a move in US$ZAR back to the 7.80-8.00 region could hurt. But perhaps more importantly, if oil prices do not spike in the coming winter season, the inflation out-turn should be more benign. In fact, for every passing day that the rand stays around current levels and oil prices remain below US$60/bl, South Africa’s inflation trajectory should only get better!

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