United States
Has Inflation Peaked?
November 20, 2006

By Richard Berner | New York

By several metrics, the Fed’s game plan to promote a gradual decline in inflation seems to be working.  Inflation itself has plunged, thanks to the sharp drop in energy prices, to just 1.3% in the year ended in October.  And measured by the “core” CPI (excluding food and energy), it has cooled in the past four months to a 2.4% annual rate based on annualized 4-month changes, and has slipped even on a year-over-year basis to 2.7%.  Moreover, some inflation fundamentals are working in the right direction.  For example, inflation expectations have stabilized, growth has slowed below trend, and operating rates have slipped.  Has inflation peaked and will it head steadily lower?

As I see it, the case for lower inflation — over time — is solid, and we still think that inflation will peak over the next several months.  But the judgment that the peak has already passed is likely premature for three reasons.  First, inflation expectations are still slightly elevated despite the slide in energy quotes over the past three months.  Second, while growth has slipped below trend, measures of slack in both product and labor markets continue to suggest that companies have pricing power and that costs are likely to rise.  And we continue to expect a pickup in growth, which would refresh pricing power and push costs higher.  Finally, and perhaps most controversially, the global dimension matters: Global growth relative to capacity is still strong, boosting US import prices despite relative stability in the dollar.  As a result, I believe that the current inflation lull won’t last and that inflation risks are still tilted higher. 

To be sure, some of the news on inflation fundamentals has lately moved in the right direction.  Fueled partly by tumbling energy prices, longer-term inflation expectations have stabilized.  For example, 5-10 year inflation expectations measured by the University of Michigan’s consumer survey fell to 3% in early November from 3.2% in August, and distant forward inflation compensation in the TIPs market has declined to 254 bp, or 12 bp below the August peak.  No doubt, the slide in energy prices also helped slightly lower core consumer inflation. 

In addition, “pipeline” pricing indicators have moved lower.  Courtesy of the housing recession and of sharp declines in energy and feedstock quotes, the intermediate goods “core” producer price index has decelerated on a six-month change basis from 8.1% in June to a 5.6% annual rate in October.  Pricing for lumber and other construction materials, industrial chemicals, fertilizer and the like has cooled considerably.  Likewise, the ISM manufacturing price diffusion index plunged to 47% in October, and in non-manufacturing the index fell to a three-year low of 51.7%.  Small-business pricing indicators have also declined, with just 16% of firms in the National Federation of Independent Business October canvass reporting that they raised prices — nearly a two-year low.  And import prices for non-automotive consumer goods declined earlier this year, and some of those declines may now be showing up in consumer inflation with a 4-6 month lag.

Finally, growth has slowed below trend, eventually allowing some slack to open up in product markets and limiting firms’ pricing power.  Over the past three quarters, the pace of overall GDP has run about a half a point under our estimate of its 3% potential rate of growth.  And industrial operating rates have slipped about 0.7 percentage point from their highs, as capacity growth has outstripped the advance in production over the past six months.  Both the housing recession and sharp cutbacks in motor vehicle production have contributed, with operating rates in wood products, nonmetallic minerals, and motor vehicles and parts each down about 1000 basis points from their peaks in late 2005.  Just as so-called “speed effects” raised pricing power when operating rates were rising, the decline in operating rates reverses some of those effects.

Nonetheless, I think that inflation risks are far from one-sided.  Indeed it’s impressive that inflation expectations are still slightly elevated despite the plunge in energy quotes and the corresponding reduction in headline inflation to just 1.3% in October; just three months earlier, gasoline prices were still climbing and overall inflation was running 300 bp higher.  In my view, the term structure of TIPS spreads should not be comforting to the Fed or market participants, with 10-year breakeven inflation down 40 bp from the August peak, compared with 12 bp for 5-year, 5-year forwards. 

In addition, while slack has lately increased in product markets, it is still limited.  In my view, the economy’s potential growth rate has downshifted to about 3% from 3½% over the past few years (see “Is Potential Growth Downshifting? Global Economic Forum, August 25, 2006).  And that implies that the recent period of slow growth is just beginning to offset the above-trend pace of the past few years.  Indeed, even with the recent retreat in operating rates, they are still well above historical norms.  That still suggests that companies have pricing power and in many cases can pass costs through to higher prices. 

In contrast, in labor markets, slack has lately dwindled.  Job opening rates are back to six-year highs, and the jobless rate at 4.4% stands at a five-year low.  Surveys suggest that companies large and small are hiking or planning to hike pay.  Moreover, while employment is a lagging indicator, productivity has slowed to 1.3% in the third quarter as job growth caught up with the economy.  If anything, productivity dipped below its 2½% trend more than a year ago as the prospective upward revisions to hours worked hint that nonfarm business productivity rose by just 2.1% in the year ended in the first quarter — 60 bp lower than depicted by official data.  The combination is promoting an acceleration in unit labor costs to roughly a 3-4% rate.  Some of that acceleration will squeeze profit margins, but some may show up in higher prices.

Finally, in my view, globalization is not always and everywhere disinflationary (see “Globalization and Inflation,” Global Economic Forum, June 19, 2006).  In fact, it appears to me that global growth is outstripping the increase in global capacity, raising inflation risks outside our borders.  That may account for the recent boost to US non-fuel import prices despite relative stability in the dollar.  More recently, consumer import prices have re-accelerated to 1%, hinting that today’s rising import prices could show up in core inflation in 3-4 months.  In addition, the bounce in energy prices that we expect in the winter months may again lift prices in some “core” components (see “Oil Update: Short-Term Rebound Ahead,” Global Economic Forum, November 17, 2006).

Markets are pricing about a one-in-three chance that the Fed will begin to ease in a few months — a realistic notion if inflation continues to ebb and growth continues to fall below trend.  That’s one possible scenario; incoming data suggest that the housing recession is far from over, and cutbacks in motor vehicle output will depress growth in the current quarter.  So consumer and business capital spending, government outlays, and net exports must all improve to promote the moderate pickup we expect in Q4.  Even if growth is a bit more subdued than we think, however, the Fed legitimately will have a high threshold for easing.  After all, this is just the slowdown they wanted to promote a gradual decline in inflation, and it would take a couple more benign inflation reports for the FOMC to drop its tightening bias. 

But two other scenarios are also possible.  In one, inflation risks remain elevated and growth gradually picks back up; in that case, the Fed will likely stay on hold for a considerable period.  But if, as we suspect, those inflation risks again translate into somewhat higher inflation and growth improves, there is still a legitimate case for the Fed to take out more inflation insurance. 

Among these three scenarios, at current market pricing, the risks don’t favor bond investors.  The Fed and we see the risks still tilted to higher rather than lower inflation and expect that growth will improve from the recent below-trend pace.  Correspondingly, for markets that are priced for inflation to fall, the risks that yields rise back towards 5% are higher than for their falling below 4½%.

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Global
Oil Update: Short-Term Rebound Ahead
November 20, 2006

By Richard Berner | New York

While refined product and crude prices have drifted significantly below our last oil price outlook, we aren’t inclined to change our longer-term forecast path of prices much.  Two months ago, we expected that crude quotes would average US$69.6/bbl in the fourth quarter (see “Oil Update: Easing Has Started, But Mind Short-Term Risks”, Global Economic Forum, September 7, 2006).  Halfway through the quarter, however, Brent crude has averaged US$58.  Ironically, it turns out that we were too bullish on prices then because the same factors that we thought were at the root of the post-August-peak price drop continued to work over the past few weeks.  Among them: Slower growth in demand and, more importantly, an easing of the supply restraints that lifted prices through the summer.  Warm weather accentuated the price declines.

Looking ahead, two time horizons are relevant: In the short run, we believe that prices will rise from current levels.  However, the winter peak in prices is likely to be lower than we had anticipated in our September baseline, following some easing of product supply conditions.  Thus, we continue to think that oil prices will ebb in the medium term, and we stick to our long-held targets: around US$55/bl for Brent/WTI at the end of 2007 and US$50 at the end of 2008.

Go long — for now

Conditions are ripe for a near-term rally: First, global demand remains strong.  In particular, US diesel and jet fuel demand is skyrocketing: According to energy consultant Bjorn Dingsor, US jet fuel demand in the past four weeks is up 18% from the same period in 2005.  Refined product markets are still relatively tight, and OPEC has announced a production cut of 1.2 mb/d.  Moreover, product inventories are still declining sharply and crude stocks will fall now that the peak in US Midwest (PADD2) refineries maintenance has passed.  Unseasonably warm weather in much of North America has depressed oil and natural gas prices, masking those supply and demand factors.  Merely returning to more normal temperatures would lift prices somewhat higher in our view (see Shital Patel’s note, “Winter Weather: Cause for Concern?” Global Economic Forum, October 27, 2006).  The strengthening of the seasonal contango in oil and gas markets reflects the expectation that the winter heating and holiday travel seasons are on the way. 

But watch El Niño

Economic growth isn’t the only factor driving short-term fluctuations in energy demand.  US oil demand is likely to rise in 2007 (the US EIA forecasts a 1.5% increase following no growth in 2006) because the winter of 2006-07 is unlikely to be as warm as that of 2005-06 — the warmest winter on record.  Indeed, US government meteorologists this week predicted that in December, January and February, although heating-degree days will fall 2% short of the 30-year average for that period, they likely will average about 9% more than in last year’s extraordinarily warm winter.  On the other hand, a strengthening El Niño event in the equatorial Pacific makes extreme cold days, especially in the Northeast, less likely, according to NOAA’s Climate Prediction Center.  It expects warmer-than-average temperatures across the country’s northern tier, where heating needs typically are the greatest — the Pacific Northwest, the northern and central plains, the Midwest, the Northeast and northern mid-Atlantic, as well as most of Alaska during December 2006 through February 2007.

Price signals work: demand

Back to the longer-term picture, it’s important to note that crude oil demand has been weak this year, despite record global GDP growth (5.0% on IMF estimates).  According to estimates freshly revised by the International Energy Agency (see the IEA’s October Oil Market Report), OECD demand for crude oil is likely to decrease by 0.2% this year.  Yet, GDP growth in the industrial world has accelerated from 2.5% in 2005 to probably 3.0% this year, on estimates from our global economics team.  This dichotomy is particularly striking in the residuals of our oil demand dynamic equation, which relates crude demand to global GDP growth: If past relationships were still holding, then demand should have increased by 2.2 mb/d, whereas the IEA now anticipates a 0.9 mb/d increase only.  In our view, the weakness in oil demand at least partly reflects energy conservation, as developed economies react to the 190% rise of the real price of oil over the past six years, compared with the 1986-1999 average: Substitution among sources of energy and conservation are rational economic reactions to higher relative prices.  Those reactions have taken time to develop, and won’t reverse quickly, so that even with prices falling somewhat, we expect energy use/GDP to decline throughout our forecast horizon.

Price signals work: supply

Price signals are also working on the supply side of the equation to ease tight markets.  The main bottleneck in refined product markets has been in the production of the middle distillates that the global economy wants the most: diesel and jet fuel, which are closely associated with the boom in global trade that is resulting from globalization.  The middle-distillate yield of the global refinery complex has sharply increased over the last few months, decisively contributing to ease tensions in both refined and crude markets.  This is in our view another example of the power of price signals: because refinery margins were particularly high for middle distillates, refiners have invested in order to produce more of these products with existing refineries.

Will OPEC really cut?

So far, the 1.2 mb/d cut announced by OPEC remains to be implemented.  In the real world, Iran has increased production and only Saudi Arabia, the Emirates and Kuwait have cut production, although modestly.  In theory, Saudi Arabia should be more prone to cut production in order to stabilize prices when its market share is high (see Price Decline Welcome, but Don’t Expect Much More, January 6, 2005), because its income elasticity diminishes as its market share increases.  However, revenue maximization is not the only parameter that enters into the Kingdom’s equation; strategic considerations also matter.  For Saudi to cut production aggressively while Iran does not makes a valuable gift to a strategic adversary.  Consequently, while we acknowledge that the cartel collectively has the means to limit the downside in prices, we also think that the loose cohesion in OPEC limits this power.

Cheaper oil should favor a soft landing

On balance, and despite upside risks in the short term, we now see the price of crude oil decreasing by 7% next year and another 16% in 2008 as a result of symmetrical moves of the demand and supply curves.  With global GDP growth running significantly above trend for the fourth year in a row — global GDP growth should average 4.75% over 2003-2006, practically one point above current estimates of trend growth for the global economy — this is quite welcome.  First, cheaper oil prices should help consumers in importing countries to regain some pricing power.  This is particularly important for the US and Europe, where tighter monetary and/or fiscal policies have or will soon dampen domestic demand growth.  Second, lower headline inflation should contribute to stabilize inflation expectations and thus help central banks to keep inflationary pressures at bay.  In more concrete words, cheaper oil should limit the risk of excessive tightening by the Fed and the ECB and thus help promote a soft landing of the global economy.

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United States
Review and Preview
November 20, 2006

By Ted Wieseman | New York

Treasuries posted modest front-end led losses the past week after some big back-and-forth and at times puzzling swings ― a heavy calendar of just about across-the-board market-friendly data was shrugged off ― didn’t net out to much. Most notable among the week’s strange gyrations was the huge intraday sell-off Thursday on massive volume in the futures market that dramatically reversed big initial gains that followed a benign CPI report as longs were apparently liquidated en masse. Almost as odd was a surge higher Friday that kicked in after no initial reaction to a weak housing starts report and instead appeared in large part to reflect flight to quality and resulting short covering on rumors about potential hedge fund blow-ups (as reported by news sources, including Reuters and Dow Jones).

That all the week’s volatility and swings back and forth ultimately netted to not much movement, either in Treasuries or in Fed pricing in the futures markets, was surprising given that the economic data were clearly market-friendly both on growth and inflation. Incorporating the results of the retail sales, CPI, business inventories and housing starts reports, we now look for third quarter growth to be revised up to +2.0% from +1.6%, down from our forecast of +2.3% coming into the week, and we trimmed our 4Q forecast marginally to +2.9% from +3.0%.

Meanwhile, the surprisingly low +0.1% rise in core CPI that dropped the year/year rate two-tenths from its prior decade high to +2.7% and should translate into a further slight moderation in core PCE inflation to +2.3% put the idea on the table that the Fed could soon drop its tightening bias. While we think it is too early to see any reasonable likelihood of such a change as early as the December meeting, another couple of good core inflation results heading into the January meeting could certainly call for such an adjustment then. In our view, however, with growth accelerating and cost pressures rising, it is too soon to call the all-clear on inflation risks, and we do not expect the upcoming data to support such a move.

The yield curve saw a moderate flattening move over the past week after a late week pullback from the extremes hit Wednesday when 2s-10s hit a cycle low, with 2s-10s moving 2bp lower and 2s-30s 4bp lower on a 4bp rise in the 2-year yield to 4.77%, a 2bp increase in the 10-year yield to 4.60%, and an unchanged 4.69% long bond yield. The 3-year yield rose 4bp to 4.66% and the 5-year 3bp to 4.60%. There was a lot of volatility but ultimately very little net change in Fed pricing in the futures markets. The February and April fed funds contracts each gained a half bp on the week to 5.24% and 5.175%, respectively, pricing a marginal risk of a rate cut at the January 30-31 FOMC meeting and a 30% chance of a cut by the March 20-21 meeting. On the other hand, a slightly less dovish path was priced in on a longer-term view. The Dec 06 to Dec 07 eurodollar spread steepened 3.5bp to -57bp, with the former gaining 1bp to 5.37% and the latter dipping 2.5bp to 4.80%. The formerly low-rate Mar 08 contract sold off 2bp on the week to 4.75%, while the new low-rate June 08 contract lost 1bp to 4.745%.

Retail sales dipped 0.2% in October as a 0.6% rise in auto dealer receipts that sharply contrasted with a pullback in unit sales partly offset a 0.4% drop ex autos. The ex autos weakness was concentrated in another sharp price-related plunge at gas stations (-6.0%). Excluding autos and gas, sales ticked up 0.3%. In line with the chain store sales reports, results from most key discretionary categories were sluggish, including general merchandise (-0.3%), clothing (+0.1%), and electronics and appliances (0.0%), but significant gains at food (+1.0%) and drug (+1.3%) stores provided a lift. With the about as expected October results, the most notable part of the report was a sharp downward revision to ex auto sales over September (-1.2% versus -0.5%) and August (0.0% versus +0.2%). These downward revisions suggest that 3Q consumption growth will be revised down to +2.8% from +3.1%. The negative ramp heading into 4Q provided by the downward revisions to September and August initially led us to reduce our 4Q forecast to +3.2% from +3.7%, but we adjusted down our price assumptions after the bigger-than-expected drop in headline CPI, and now project a 3.5% rise in 4Q consumption.

Housing starts plunged 14.6% in October to 1.486 million units annualized, a more than six-year low. The key single-family component fell 15.9% to 1.177 million units, a low since July 2000 and down 35% from the peak hit in January. Multi-family starts were down 9.1% to 309,000, toward the lower end of the relatively steady range seen over the past decade or so. Single-family starts have now probably fallen sufficiently that significant progress should start to be made in working down bloated inventories of unsold new homes, while multi-family starts should be a relative pocket of strength going forward, given the much stronger fundamental backdrop in the apartment market. That this plunge starts in October may help to correct the imbalances in the housing market received some support from the National Association of Homebuilders’ survey. The NAHB’s composite housing market index posted a second straight increase in November, rising two points to 33 after having hit a nearly 16-year low of 30 in September. This index is on the same 50-breakeven scale as the ISM, so a 33 reading is still terrible in absolute terms, but the modest improvement off the lows at least provides some indication that the intensity of the housing downturn may be moderating. The text of the report was upbeat — “More and more builders are seeing light at the end of the tunnel. Our members are telling us that the market is steadying after a significant downward correction. On the demand side, we look for sales to stabilize and gradually move up in the coming months.”

Nevertheless, the much bigger-than-expected drop in housing starts in October (though at least a partial rebound seems likely in November, if for no other reason than the unusually warm weather) pointed to weaker residential investment in 4Q than we previously projected. We now expect a drop in 4Q close to the 17.4% plunge recorded in 3Q, with the predominant new home building component (the rest of residential investment is made up almost entirely of broker commissions and home improvements) down 24%, also in line with 3Q.

The final data release the past week bearing on our GDP projections was the business inventories report. Retail ex auto inventories, the key new piece of information in this release, rose 0.1% in September, less than BEA assumed in preparing the advance estimate of 3Q growth, partly offsetting the upside surprise in wholesale inventories reported previously. All other things being equal, this should be made up for with a slightly smaller inventory drag in 4Q, however. Netting the results of the retail sales, housing starts and inventories reports, we cut our expectation of the 3Q GDP revision to +2.0% from +2.3% (compared with the advance estimate of +1.6%), and we trimmed our estimate of 4Q growth to +2.9% from +3.0%.

Meanwhile, the inflation news released the past week was benign and appeared to at least slightly open the door to the Fed’s dropping its tightening bias in the months ahead. The consumer price index plunged 0.5% in October for a second straight month, dropping the annual rate to a four-year low of +1.3%, as energy prices plunged 7.0%, with gasoline (-11%) and utilities (-2.5%) both down sharply. Meanwhile, the core gauge ticked up only 0.1%, a low (to two decimal places) since June 2005, leading to a moderation in the year-on-year rate from the prior decade high of +2.9% to +2.7%. Though the key owners’ equivalent rent category accelerated slightly to +0.4%, this was more than offset by downside in a variety of other items, including hotels (-0.5%), apparel (-0.7%), new cars (-0.1%), used cars (-1.2%) and airfares (-1.4%). It would appear that the mid-year growth slowdown and resulting easing of demand pressures on resource utilization produced some underlying moderation in prior inflation pressures. But with growth accelerating in 4Q ― a pick-up we expect will extend into 1Q07 as the worst of the housing and auto recessions pass ― the economy still operating with little if any slack, inflation expectations remaining modestly elevated, and labor cost pressures accelerating, we think it is too soon to sound the all-clear on inflation risks.

With the Fed’s predominant focus on upside risks to inflation within the context of its benign baseline case ― a bias clearly set forth in the minutes from the October FOMC meeting and unanimously reiterated in recent Fed speeches and comments ― one good inflation report is unlikely to significantly alter its thinking at the upcoming December FOMC meeting. But there are two more CPI reports before the January FOMC meeting, and if the results, contrary to our expectations, were to come in as benign as the October results, it would certainly provide a sound basis for the Fed’s dropping its tightening bias at that meeting.

The PPI report was also relatively benign, though not nearly as much as it appeared at first sight, as another wild swing in PPI motor vehicle prices ― the worst yet in years of unreliable numbers ― sharply depressed the results. Excluding the peculiar auto price numbers, the core PPI rose 0.1%, in line with the recent trend, which has shown some moderation relative to the +0.2% average seen last year. Car and truck prices in the PPI have been so bad for so long that the real core PPI at this point excludes food, energy and autos. Pipeline inflation pressures also eased a bit in the month, with core intermediate (0.0%) and core crude (-1.3%) prices slowing on some softness in chemicals, building materials and scrap metal.

The recession in the auto sector significantly pressured manufacturing activity in October and, based on the key early regional surveys, sluggishness may have extended into November. Industrial production rose 0.2% in October, as a sharp rebound in utility output (+4.1%) that reversed a plunge last month offset a pullback in manufacturing output (-0.2%), which was weighed down by a big decline in motor vehicle production (-3.9%). Motor vehicle assemblies fell to their lowest level since the 1998 GM strike in October, but current assembly plans point to decent sequential improvement in November and December. Excluding motor vehicles, manufacturing output ticked up 0.1%, a smaller gain than expected, based on hours data from the employment report. All of the gain was in high-tech products (+2.3%); ex autos and tech, factory output dipped 0.1% on top of a 0.3% decline in September, with narrowly mixed results from the largest components. Looking to November, results from the Empire State and Philly Fed manufacturing surveys on an underlying basis diverged as sharply as they ever have. An ISM-comparable weighted average of the key activity measures rebased to a 50-breakeven scale showed the Empire State rising to 59.7 from 56.3, the highest reading since March and second highest since 2004. Meanwhile, on this basis the Philly Fed fell to 50.9 from 53.6, just above the more than three-year low hit in September. This was by far the widest gap between the two surveys since the Empire State began in 2001. Given that the Philly results were more in line with the softening seen in our Morgan Stanley Business Conditions Index survey of our equity analysts, which fell five points in November to 40, we are lending more credence to its results.

Our preliminary ISM forecast is for a marginal decline to 51.0 in November from 51.2 in October, but we will be watching upcoming results from the other regional reports from the Richmond, Kansas City and Dallas Feds for more clarity.

The upcoming week promises to be extremely quiet. There will be early market closes on both Wednesday and Friday surrounding the Thursday Thanksgiving holiday, almost no economic data, and not much in the way of Fed news, with only one notable speech, by hawkish dissenting Richmond Fed President Lacker on Tuesday. The Treasury will announce 2-year and 5-year issues Wednesday for auction the following Tuesday and Wednesday. We expect unchanged US$20 billion and US$14 billion sizes, respectively. As for data, the only notable releases are leading indicators Monday and the University of Michigan consumer confidence report Wednesday. We expect the index of leading economic indicators to rise 0.4% in October, its sharpest gain since March, with a very large positive contribution from the real money supply and significant adds from consumer confidence and stock prices offsetting negative contributions from supplier deliveries and building permits. In light of the 4-point pop in the ABC News/Washington Post consumer comfort index in the latest week to a more than four-year high, the Michigan index for all of November is likely to be revised up from the early month reading.

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Currencies
G10: Reserve Diversification Dictated by Market Caps
November 20, 2006

By Stephen Jen | London

Summary and conclusions

We have long argued that the Asian central banks’ official currency reserves are excessively large, compared with what these economies require for liquidity purposes.  We have also suggested that these ‘excessive reserves’ will likely gradually be invested in assets with higher expected returns and higher risk.   This entails ‘two-dimensional’ diversification, as official reserves are diverted away from sovereign bonds in the major economies, towards equities and emerging markets. 

In this note, we propose that, as Asian central banks start to invest the ‘investment tranche’ of their official reserves in a way similar to ‘sovereign wealth funds’, their strategy is likely to be a function of the market size and liquidity of the targeted markets.  Our best guess is that, in the first years, central banks will predominately (though not exclusively) diversify across assets within the large markets.  In subsequent years, they will diversify into the non-major economies, when liquidity in the non-major markets improves.  This order is critical, as it suggests that it will at first be a ‘sovereign bonds versus corporate bonds and equities’ story.  Only later will central bank diversification turn into a ‘major currencies versus minor currencies’ story. 

According to our calculations, cross-asset diversification is not dollar-negative.  In fact, the current currency composition of reserves is broadly consistent with the market caps of the major economies in risky assets.  The exception here is that when central banks start to invest in equities, the JPY will be a major beneficiary.  However, when central banks start to diversify across currencies, the currencies of BRIC (Brazil, Russia, India and China), the CAD, AUD, NZD and KRW should do particularly well, at the expense of USD, EUR and GBP.

Two-dimensional diversification

Some investors may still think that by ‘diversification’, Asian central banks have in mind selling dollars and buying euros.  In contrast, we believe that it is critical to consider whether Asian central banks may intend to adopt ‘two-dimensional’ reserve diversification, whereby central banks move away from US Treasuries across both asset classes and currencies. 

Exhibit 1 shows that, along the horizontal axis, central banks’ reserves are currently very concentrated in USD, EUR and GBP assets.  Data from the IMF show that about 90% of the world’s reserves are in USD and EUR assets, and 98.5% of official reserves in the world are invested in the USD, EUR, GBP, JPY and CHF.  Along the vertical axis, we list the main categories of investible assets, in order of increasing risk: from sovereign bonds, agencies, corporate bonds, equities and eventually to private equities and real estate.

Over an extended period of time, around the next five years or so, what will the portfolios of the Asian central banks look like?  We believe it will eventually cover the big box in Exhibit 1, with assets spanning the whole spectrum indicated on the vertical axis, and central banks holding a wide range of currencies.  In other words, reserve assets will continue to move up and to the right in the chart.  Asian central banks will reduce the proportion of sovereign bonds in their total holdings, and increase their holdings of agency bonds and corporate bonds.  The big step, however, will be for central banks to start holding equities.  After that, private equities and real estate could also be held in a similar ‘investment tranche’ of the central banks’ reserves.  Already, other sovereign wealth funds such as GIC and ADIA have very broad portfolios exposed to a wide range of assets.  Norway’s Government Pension Fund is also a benchmark for the Asian central banks.  Similarly, central banks will be quite keen to invest in emerging market currencies.  

While central banks are likely to try to diversify across both assets and currencies, we believe, at first, it is more likely that they will diversify more across asset classes than across currencies.  In other words, we suspect that Path A in Exhibit 1 is more likely than Path C. 

We use market caps as our guidelines

We believe that the size of the targeted markets is possibly the dominant determinant of whether Asian central banks would be interested in investing in them

We make the following observations. 

• Observation 1.  The US risky asset markets are huge.  Including Agencies, and excluding the non-traded securities, the US sovereign debt market is about US$8.7 trillion, substantially larger than the markets in Euroland, Japan and the UK.  If we further exclude the JGB market, which few foreigners own, the US accounts for about 60% of the ‘G3’ sovereign markets (US + Euroland + UK).  Looking at corporate debt and equity markets and adding back Japan, the US accounts for 56% of the G4 corporate bond markets, according to market cap, and 50% of the G4 equity markets.  At the same time, the EUR accounts for 35% of the sovereign markets in the ‘G3’, 22% of the G4 corporate debt market by market cap and 23% of the G4 equity markets by market cap. 

In short, if we assume that the Asian central banks stay with the G4 but diversify into riskier assets (move upward in Exhibit 1), the US markets and the dollar would absolutely dominate, in not just sovereign debt, but also risky assets such as corporate bonds and equities.  In fact, the current currency composition of the world’s reserves of 66% in USD and 25% in EUR don’t look too out of line, particularly when we consider any special (e.g., geopolitical) reasons for central banks to hold dollars.  Thus, cross-asset diversification does not imply a weaker dollar; this is something we have argued for a long time. 

• Observation 2.  China, Canada, Brazil, India, Russia and Korea have big sovereign debt markets.  What if central banks aggressively diversified across currencies?  If, contrary to our belief, central banks aggressively invest in sovereign bonds in a wider range of countries (i.e., they diversify across currencies, but stay within the sovereign space), the CNY, CAD, BRL, INR, RUB and KRW should, in theory, ‘benefit first’, due to their relatively larger market cap in sovereign bonds.  If we add these five markets to the sovereign markets of the US, Euroland and the UK, the latter three would account for around 85% of this new global sovereign bond portfolio for official reserves, while the former five would account for 15%.  Whether the USD or the EUR would be sold disproportionately is difficult to say. 
• Observation 3.  Japan has a very large equity market.   Since the world’s equity markets are roughly 43% larger (in terms of market cap) than the world’s sovereign bond markets, central banks’ moving into equities would have a very meaningful effect on currencies, not to mention the bond-equity relative performance.  Like the US and Euroland, Japan has a very large equity market, as do the UK, Canada and Switzerland.  If central banks were to decide to invest in equities, the JPY would most likely be the single-biggest beneficiary, as the JPY is currently under-represented in the world’s reserve holdings (accounting for only 3.3% of the total reserves) as few countries want to hold JGBs.  But if central banks start to invest in equities, there will be a significant increase in demand for JPY assets. 
• Observation 4.  Korea, Australia, Canada and NZ have large corporate debt markets.  If, further, we assume that central banks migrate into the corporate bond markets in a wide range of countries, the KRW, AUD, CAD and NZD should, in theory, benefit.  Assuming that central banks first enter the corporate bond markets of the G4, before spreading out to the non-G4 corporate bond markets, then, on the margin, the KRW and three commodity currencies benefit. 

However, we should note that, since the world’s sovereign bond market is some 4.5 times the size of the world’s corporate bond market, spreading out into the corporate bond markets in a wider range of countries is not likely to have as big an effect as other forms of diversification. 

Chinacould breach the US$2 trillion mark by 2010

Our timeframe for this transition from proper reserves to ‘sovereign wealth funds’ is five years, primarily because we believe that there will be an immense amount of new reserves accumulated by China.  With the trade surplus now accounting for more than 70% of the incremental increase in China’s reserves, compared with 30% prior to 2005, China’s reserve growth is likely to accelerate further.  It is entirely feasible for China to go on accumulating reserves at the pace of US$250 billion a year.  This would mean that China’s level of reserves could reach the US$2 trillion mark by 2010. 

Of course, this back-of-the-envelope calculation is not that realistic, because of the uncertainties regarding the import trajectory and capital outflows.  Nevertheless, the point here is that, at the current trend, assuming no major changes, China could have US$2 trillion in reserves within five years.  We believe it is highly likely that China will diversify its reserves in both dimensions. 

Be mindful of the distinction between the ‘tranches’

We have discussed the ‘liquidity’ and the ‘investment’ tranches of Asian central banks’ reserves.  Our belief is that most Asian central banks have reached saturation levels for liquidity purposes.  China may have passed that point at the beginning of the year, when its reserves were less than US$850 billion.  The discussion above applies to ‘excess reserves’, i.e., the reserves that are in excess of the ‘liquidity tranche’.  In other words, two-dimensional diversification only applies to these excess reserves (or the ‘investment tranche’), not the entire pool of reserves.  What this also means is that virtually all the incremental reserve increases are likely to be aggressively diversified ─ probably China’s strategy this year to date. 

Bottom line

Two-dimensional diversification of reserves is virtually a certainty in the coming years, in our view.  Whether central banks first diversify across assets or across currencies makes a big difference.  We suspect that they will diversify across assets first, simply because of the availability of liquidity in the major markets, though it is clear that central banks will start buying some amounts of non-G3 assets.  Cross-asset diversification is not USD-negative.  Investment in equities would be significantly positive for the JPY.  Diversification into non-G3 sovereign bonds would benefit the BRIC currencies and the CAD.  Diversification into corporate bonds would benefit the KRW, CAD, AUD and NZD.

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Global
Technical Deflation
November 20, 2006

By Serhan Cevik | from Dubai

The decline in oil prices and the shekel’s strength moved Israel into the deflationary territory. The consumer price index declined by 0.7% in October, following a 0.9% drop in the previous month. The outcome, coming much lower than our and consensus estimates, was the lowest reading since 1948 and moved the annual rate of change in the CPI into the deflationary territory. With a mere 0.1% cumulative increase in the first ten months of the year, the year-on-year inflation rate declined from the recent peak of 3.8% in April to 1.3% in September and -0.2% last month. This is a curious development, given the fact that the economy is nowhere near recession and indeed growing at a robust, above-trend pace for the third consecutive year. To be honest, the sudden drop in inflation has had nothing to do with real factors in the domestic economy, but basically a result of a sharp fall in energy quotes and dollar-linked housing prices. While the correction in commodity prices is a global phenomenon, the latter is a reflection of the shekel’s fundamental revaluation and likely to keep putting downward pressure on the headline inflation figure in the coming months as well (see Ruled by the Shekel, November 8, 2006).

The exchange rate pass-through effect on domestic prices is the source of inflation volatility. Just like other energy-importing countries, Israel suffered from the rise in global oil prices in the first eight months of the year, which made a significant inflationary contribution. However, the recent fall in oil prices in international markets has led to an 8% drop in domestic fuel prices in Israel, lowering, for example, the transportation category of the CPI by 1.9% and accounting for approximately 0.4 percentage points of the 0.7% drop in the overall index last month. But the correction in energy prices is just part of the bigger story. In our view, the immediate and overwhelming pass-through from exchange rate fluctuations to consumer prices is the key factor driving inflation dynamics. The shekel’s sustained depreciation pushed inflation to 3.8% earlier this year, but now its appreciation towards the strongest level in five years has become a channel for deflationary pressures in the economy. Working through dollar-denominated and indexed prices, the shekel’s strength lowered, for example, housing prices by 1.8% in October and 5% on a cumulative basis in the first ten months. Even if we exclude the effect on imported goods and services, the housing component (which constitutes more than 20% of the CPI) is enough to make an almost instantaneous deflationary contribution.

The shekel should remain strong and even gain further ground next year. For a long time, we have kept arguing that the shekel is fundamentally undervalued against the dollar as well as on a trade-weighted basis. The recent appreciation is encouraging, but there is more to come, in our view. First, the economy has already recovered to its strong growth trend from the military shock. According to our projections, real GDP growth will be around 4.8% this year, just a touch lower than 5.2% in 2005, and no less than 4% next year. Second, the current account surplus increased from 0.7% of GDP in 2003 to 1.9% last year and is now running at about 4.5% of GDP — a significant achievement against the oil shock. Third, with improving economic prospects, foreign (direct and portfolio) investment increased from US$3.2 billion in 2002 to US$9.5 billion last year and US$17.1 billion in the first ten months of this year. Last but not least, foreign investors still own just about 2% of Israel’s tradable domestic bonds, which should increase as long as there is no ‘exogenous’ shock.

Cutting interest rates may not necessarily curb the appreciation of the shekel. After the recent sharp drop, inflation is likely to remain below the lower bound of the central bank’s target range of 1-3%, in the deflationary territory for a while. However, such a deviation is not an indication of inappropriate monetary policy, in our opinion, but simply reflects the excessive sensitivity of price indices to currency movements. Therefore, as the effects of the correction in energy prices and the shekel’s valuation become less pronounced, inflation should move within the target range next year. With ‘core’ inflation running at about 2%, we see no reason for an aggressive shift in monetary policy.

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Singapore
3Q GDP Less than Expected
November 20, 2006

By Deyi Tan | Singapore

3Q economy rose 7.2% YoY. 3Q GDP rose 7.2% YoY (versus +8.2% YoY in 2Q06).  This is higher than the 7.1% advance estimate put forth by the government in October but less than the 7.4% predicted by ourselves and the market.  Nonetheless, GDP growth year-to-date stands at 8.6% YoY, leaving upside risks to our 7.5% YoY full-year forecast.  The government has revised upwards its 2006 full-year forecast from 6.5-7.5% to 7.5%-8.0%.

3Q headline domestic demand-driven; however, strength there was dichotomous. The economy was driven by domestic demand (+8.0% YoY versus +4.9% YoY in 2Q06).  Domestic demand contributed 5.4%-pt to headline (versus +3.6%-pt in 2Q6).  However, domestic demand momentum was dichotomous.  Public consumption expanded strongly at 23.4% YoY (versus +10.3% in 2Q06) as the government increased operating expenditure on security and external relations (+41.1% YoY versus +12.5% in 2Q06) in preparation for the IMF/World Bank annual meeting.  Gross fixed investment also rose 10.3% YoY (versus +11.5% in 2Q06) on the back of stronger construction and works (+5.9% YoY versus +5.4% YoY in 2Q06).  Machinery and equipment capex, riding on still-respectable export growth, rose 18.0% YoY (versus +16.4% in 2Q06).  On the inventory front, there was less destocking compared with the same period a year ago (+0.2%-pt versus -1.2%-pt in 2Q06). 

Private consumption remained subdued in 3Q06. On the other hand, private consumption (+2.2% YoY versus +3.2% in 2Q06) did not improve despite an expected boost from tourism dollars from the IMF/World annual meeting.  This is in line with 2.3% YoY growth in 3Q06 retail sales.  The sustained improvement in the labour market has not translated into greater consumer spending power.

External demand moderation consistent with global soft-landing scenario. Having peaked in 1Q06 at 16.1% YoY, exports of goods and services moderated to 10.3% YoY (versus +13.3% in 2Q06).  Domestic demand kept import growth at a relatively higher 10.9% YoY (versus +12.8% in 2Q06), leading to a smaller net external demand growth contribution at +2.2%-pt (versus +4.9%-pt in 2Q06).

On the supply side … Manufacturing rose 10.6% YoY (+12.7% in 2Q06), in line with what was observed in the industrial production numbers.  On the other hand, services rose 6.5% YoY (versus +7.0% in 2Q06).  The deceleration was broad-based among sectors such as financial services (+8.4% YoY versus +9.4% YoY in 2Q06), businesses (+5.1% YoY versus +6.2% YoY) and transport (+3.4% YoY versus +3.6%).  However, wholesale and retail trade accelerated (+10.6% YoY versus +10.1% YoY).

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