United States
Changing the Fed Call
December 04, 2006

By Richard Berner and David Greenlaw | New York, New York

 We’re changing our Fed call: We no longer think that the Fed will tighten monetary policy next year.  The reasons: The risks that economic growth could stay weak for longer have increased, and consequently, the odds that inflation will rise further have declined.  Fed officials may start to see it the same way, although they have uniformly stated that the risks for inflation are still tilted higher.  Signs that slack in labor markets is appearing again might prompt policymakers to change their tightening bias to a neutral one at the December meeting. 

Incoming data depict a rapid deterioration in fourth-quarter economic growth, one that likely will extend into the first quarter.  We needed no convincing that the housing downturn still has a long way to go, and recent data reinforced that notion.  True, the intensity of the home sales decline has ebbed, but we’re not sure that demand bottomed in October.  But even if it has, we estimate that 1-family housing starts would have to contract by another 7-10% to reduce the current overhang of unsold homes in builder inventories.  And until that happens, buyers may wait for further concessions or amenities before stepping up. 

More important, a stunning array of weak results just in the past week undermined our view that supportive fundamentals would promote moderate gains in consumer spending and in business investment, and thus in production and perhaps even in hiring.  Tepid November car and truck sales and retailing results contradicted our expectation that accelerating real income would boost consumer outlays, and a downward revision to September’s data eroded the ramp for fourth-quarter gains.  And while we had discounted some of the astonishing boom in income since the beginning of the year, and still think that real income is highly supportive of spending, significant downward revisions to wage and salary income in the second quarter create uncertainty about future gains (see “Will the Real Consumer Income Please Stand Up?” Global Economic Forum, December 1, 2006).  In all, we now see consumer outlays advancing at the same 2.9% pace in the fourth quarter as in the summer — solid but not enough for stronger growth.

Both October data and revisions to September results for business investment also deflated our expectations that demand would improve.  We based those hopes on solid fundamentals: Orders for nondefense capital goods soared at a 16% annual rate over the summer, and rising operating rates, supportive financial conditions, and strong cash flow provided a solid backdrop.  In addition, falling vacancy rates and rising rents augured an extension of strong gains in nonresidential construction.  But a 5.1% October plunge in capital goods orders and consecutive declines in September and October commercial construction hammered our expectations for business investment in the fourth quarter.  Together with the housing downturn and the ongoing woes of Detroit’s automakers, this softness is trimming orders and production in manufacturing, as evidenced by the decline below 50% in the ISM manufacturing index. 

Four important implications flow from these weaker growth results: First, demand in a broad spectrum of industries seems likely to stay weaker for longer than expected, trimming fourth quarter growth to just 1.6%.  Second, the production adjustments needed to keep inventories lean probably will extend into the first quarter of 2007, eroding our expectations for an acceleration in that period and keeping growth below trend.  Third, with output decelerating, the risk that the pace of job growth will slow materially again is rising; the jump in jobless claims over the past two weeks may signal a faster pace of layoffs in construction and manufacturing. 

Finally, inflation fundamentals now seem less likely to push inflation materially higher.  Lingering price hikes will probably propel year-over-year inflation above current rates into early 2007.  But softer demand and eventual renewed declines in energy prices are likely to cap inflation expectations.  With output falling short of potential, slack in the economy will increase again after narrowing over the past four years.  Thus, a more extended period of subpar growth than we expected previously could bring inflation back down a bit ahead of schedule. 

Don’t get us wrong: We are marking ourselves to market, not throwing in the towel on the analytics of our previously above-consensus views on growth and inflation.  Indeed, we still believe strongly in two key themes.  First, in our opinion, this “growth recession” does not represent the beginning of a more ominous, cumulative downward spiral in the economy.  The odds of a recession are still below 30%, in our view, because financial conditions are supportive, the fundamentals supporting income are constructive, and strong global growth still seems likely to contribute to US net exports.  If it continues, the dollar’s recent slide likely will reinforce all three of those supports for growth.  Second, even persistently below-trend growth will not reduce inflation dramatically or quickly.  Inflation expectations are still elevated, slack in the economy probably will increase slowly, given the downshift in growth of potential output and the slow increases in capacity, and the dollar’s fall will reinforce the recent acceleration in import prices. 

As a result, while the odds of Fed ease this spring have increased, they are still well below 50%.  In our view, policymakers as a group believe that a long period of restraint and subpar growth is necessary to make sure that inflation really does come down.  But their views may be subtly shifting, along with incoming information.  Over the weekend Fed Vice-Chairman Don Kohn stated that inflation trends are shifting “from up to down,” and that “the trend seems to be shifting and our expectation is that it will shift towards a gradual decrease.  But the risks around that expectation are still tilted to the upside.”  In our view, a weak November employment report, with tepid job gains, an increase in the unemployment rate, and tame wage increases, might be the catalyst to translate that subtle shift into a neutral policy stance at the upcoming FOMC meeting. 

 

Against this backdrop, market participants already think there is a 70% chance that the Fed will ease monetary policy to rescue a floundering economy by April, and that 75 bp of ease is likely next year.  With that bias in the price, any sign of improvement in the economic outlook could quickly promote a backup in yields.  At this stage, however, it would take a convincing string of stronger economic data to persuade market participants that the economy’s deceleration was over. 

There are risks for us as seers in making this shift: “Whipsaw” — which occurs when the data flow turns back in one’s favor immediately after changing a long-held view — is the one every forecaster fears most, as the crosscurrents in the data could shift quickly towards improvement.  But the dynamics of the slowdown — involving further production adjustments and consequences for employment and capital spending — now seem likely to last longer, even when the housing and motor vehicle downturn stabilizes. 

For risky asset markets, meaning both equity and corporate debt, corporate earnings are now more tangibly at risk than before, because operating leverage will fade more quickly with a more prolonged period of sub-par growth.  No doubt, stronger growth abroad and a weaker dollar will be important offsets to weakness in the overall earnings picture.  But with a lot of good news in the price and volatility at rock-bottom levels, even benign overall economic outcomes may not assure parallel performance in risky assets.

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Global
ChinaGoes for Quality
December 04, 2006

By Stephen S. Roach | from Melbourne

The Chinese are getting serious in shifting the focus of their extraordinary economic development from quantity to quality.  This transition has been actively discussed in China for over three years, but in extensive meetings in Beijing last week, I sensed that the quality debate has finally come to a head.  This could have very important implications for China’s trade policies, commodity demand, environmental considerations, banking reform, and its capital allocation process.  It is a very big deal.

Western perceptions of the Chinese economy are formed largely on the basis of the quantity dimension of its remarkable transformation.  This is perfectly understandable, as the nation’s GDP per capita has more than quadrupled over the past 15 years -- taking China from the world’s 10th largest economy in 1991 to the fourth largest today.  With a population of 1.3 billion people, a 10% growth trajectory puts the scale effects of Chinese economic development in an entirely different league than the world has ever experienced.  Given the daunting transition from state to private ownership, China needed such hyper-growth to offset the massive job losses stemming from the reforms of its state-owned enterprises -- cumulative headcount reductions estimated at more than 60 million workers since 1997, alone.  The Chinese feel they had no choice other than to focus on the quantity of growth in the face of such extraordinary job loss.  The strategy was critical in order to maintain social stability -- by far, the single greatest risk to this first phase of China’s reform experience. 

But now the most disruptive phase of SOE reforms is in the past.  That eases China’s dependence on the quantity imperatives of economic growth and allows reformers the opportunity to focus on the long-neglected quality dimension of its transformation and development.  This shift in the character of economic growth couldn’t come at a better time.  The “negative externalities” of the quantity fixation are starting to loom increasingly formidable.  Long dominated by exceptionally rapid gains in export-led industrial activity, the Chinese growth model has been characterized by open-ended investment spending, undisciplined bank funding, environmental degradation, nearly insatiable demand for oil and other industrial materials, and mounting trade frictions.  With industrial output -- which makes up about 50% of Chinese GDP -- accelerating to a roughly 17% average annual growth rate over the past four years, those externalities have become increasingly serious.  By shifting its focus from quantity to quality, China is, in effect acknowledging an increasingly urgent need to address the negative repercussions of rapid growth head on.

 

Trade policy is the most immediate item on the quality agenda.  The first meeting of the newly established strategic economic dialog with the United States is now less than two weeks away -- set for December 14-15 in Beijing.  Led by US Treasury Secretary Hank Paulson, a high-level US delegation will not want to go away empted handed when it comes to coping with a large and ever-widening bilateral trade deficit with the China -- estimated at $202 billion in 2005 and at least $225 billion in 2006, and equal to fully 25% of America’s record multilateral trade deficit.  Paulson has already set the stage for a very important shift in the US-China bilateral trade discussions -- attempting to broaden out the debate from a single-minded fixation on the currency issue.  That’s not to say the US delegation won’t put pressure on China to accelerate the pace of renminbi revaluation, but it will also push for more Chinese progress on the equally important matters of financial sector reforms and protection of intellectual property rights (IPR).

What I found last week in Beijing is that the Chinese may well be willing to move more aggressively on the IPR issue than has been the case in the past.  There is a key reason for this shift: Inasmuch as China’s economic prowess has moved rapidly up the value chain in recent years -- from low-value-added items such as toys and textiles to increasingly high-value-added technology products -- there is a growing consensus forming within the Chinese leadership that IPR protection is now in its best interest, as well.  As one senior official put it best to me last week, “Since the China of tomorrow will be more about innovation and knowledge-based breakthroughs, we need to protect our own IPR.”  This speaks of a China that is now putting increasing value on the quality of its intellectual capital rather than on the quantity potential of its mass-production platform.  OECD data underscore how far China has come in investing in the basic research underpinnings of intellectual property: In 2006, it overtook Japan and stood second only to the United States in the global research and development spending sweepstakes.  Little wonder China now wants to protect its own proprietary knowledge base.

Interestingly enough, I saw a real-time example of what China can do on the IPR front when it puts its mind to the effort.  Like most airports these days, Beijing International Airport has become something of an indoor shopping mall.  Notwithstanding opportunities to make last-minute purchases of Chinese arts and crafts, the crowds were biggest at the Beijing 2008 kiosk, where travelers were fighting over newly minted souvenirs from the upcoming Olympics.  What I found most interesting in these products is that they are all “officially licensed” -- in many cases, complete with a numbered and laser-tagged authentication certificate designed to foil counterfeiting.  The Chinese have long complained how difficult it is to enforce IPR protection in a nation where factories and distribution facilities can spring up overnight.  Try finding official Beijing 2008 souvenirs in China’s fabled open-air markets that contain knock-offs of a wide range of Western products.  Let me assure you -- you can’t.  When the Chinese put themselves to the enforcement task, they can accomplish almost anything.  A recent anti-piracy effort -- the so-called “100-Day Campaign,” running from July 15 to October 25, 2006 -- is a high-profile example of China upping the ante in this area.  There is a great opportunity for a breakthrough on the all-important and long-contentious IPR issue at the upcoming US-China strategic economic dialog -- an outcome that could pull the rug out from under the increasingly vocal protectionists in the US Congress.

I also found a China more willing to focus on upgrading the quality of its manufacturing technology.  The degradation of the Chinese environment has now reached a serious threshold: Fully seven of the ten most polluted cities in the world are in China, according to World Bank statistics.  Moreover, China leads the world in water pollution by a wide margin -- emitting three times as many organic water pollutants as the number two polluter -- the United States, whose economy is five and a half times the size of China’s.  At the same time, Chinese production is woefully inefficient when it comes to reliance on energy and other raw materials.  For example, China currently requires about twice as much oil per unit of GDP as the rest of the world, according to the International Energy Association.  The recently enacted 11th Five-Year Plan has a stated target of reducing China’s oil per unit of GDP by 4% a year, or 20% over the 2006-10 period.  At the same time, the government wants to move away from a “commodity-heavy” growth model that gobbles up outsize portions of base metals and other raw materials.  Chinese leaders -- especially those at the National Development and Reform Commission who still guide the national planning process -- feel this can best be accomplished by shifting away from rapidly growing commodity-intensive fixed investment toward more of a “commodity-lite” growth model centered increasingly on private consumption.  Whether it’s curtailing pollution or cutting back a voracious appetite for energy and other industrial materials, I sensed a heightened awareness in official Beijing to tackle this important aspect of the quality problem head-on.

I noticed a similar approach toward the quality of Chinese bank lending.  Interestingly enough, there is a clear consensus amongst Chinese banking regulators as well as senior banking officials that another round of nonperforming loans is inevitable once the economy slows (see also Wendy Dobson and Anil Kashyap, “The Contradiction in China’s Gradualist Banking Reforms,” prepared for the Brookings Panel on Economic Activity, September 2006).  Both China’s regulators and bankers felt that the excesses of the current investment boom -- with fixed investment climbing toward the unheard of and worrisome 50% threshold -- have become a breeding ground for new NPLs.  China very much needs to increase the quality of its capital allocation process.  Reforms, according to the Chinese I met with last week, are the only means to accomplish this -- especially reforms that inject greater discipline into the investment and loan approval process.  The imposition of administrative edicts curtailing fixed investment in a number of overheated sectors is helpful in this regard, as is a new effort aimed at increasing the selectivity of foreign direct investment.  In both cases, however, the administrative policies are only band-aids until the establishment of a robust market-driven system of capital allocation.  Equally encouraging are recent public listings of the large Chinese banks, which should inject market-driven incentives into an increasingly commercialized bank lending business.  In the end, however, the centralization of a still highly fragmented Chinese banking system is essential in order to instill a rigorous, commercially-viable lending culture.  With a China slowdown likely to come sooner rather than later, I sensed a new urgency in Beijing in dealing with this critical aspect of the quality problem.

Finally, I picked up a subtle, but important, shift in China’s overall attitude toward reform.  Last spring, there were visible signs of a worrisome pushback against one key element of the reform process -- the opportunity for foreign multinational corporations to take strategic stakes in Chinese enterprises.  There was a gathering concern in some quarters that foreigners were buying precious State assets on the cheap -- especially as a surging Chinese stock market was quick to inflate the market value of foreign-acquired stakes.  According to insiders involved in China’s financial sector reforms, those fears have since subsided, as the pro-reform faction in the senior Chinese leadership appears to have recently won out in a struggle with Party conservatives.  A potentially worrisome dilution in the quality of reforms has been avoided as a result.

In the end, the quality of the growth experience is the ultimate arbiter of its sustainability.  China has elected to go for quantity since the onset of the current reforms back in 1978.  It has had remarkable success in staying the course.  But as China comes of age, it is only natural that such an approach change, with greater attention placed on the quality of the economic growth outcome.  There is, undoubtedly, an important tradeoff between these two dimensions of the growth experience.  A new emphasis on quality probably means that China will have to compromise on the quantity front.  The good news is that as a 10% growth machine -- and recently well in excess of that -- that’s a luxury China can well afford and seems willing to accept.  Contrary to widespread perceptions, China doesn’t need 10-11% economic growth to ensure social stability.  Its newly enacted Five-Year Plan, which is tilted toward meaningful improvement on the quality front, calls for “just” 7.5% average GDP growth through 2010. 

An external shock is the only real stumbling block I see in this potential realignment in the Chinese growth model.  A US-led shortfall of global growth or a politically-inspired outbreak of Washington-led protectionism are the biggest risks in that regard -- the former providing a temporary setback and the latter a more worrisome systemic risk (see my 1 December dispatch, “Unprepared in Beijing”).  But barring those possibilities, the China I saw last week seems more than willing to pay the price of slower growth and opt increasingly for quality over quantity.  That’s outstanding news for China and for the world as a whole.

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United States
Review and Preview
December 04, 2006

By Ted Wieseman and David Greenlaw | New York, New York

Treasury yields plunged to their lowest levels since January or February the past week, and the futures market moved to price in a high likelihood of a Fed rate cut by March at the latest after a run of gloomy data on the growth outlook easily trumped upside in inflation and a relatively hawkish speech by Fed Chairman Bernanke that was just about completely ignored. Although third quarter growth was revised up a bit more than expected from +1.6% to +2.2%, the fourth quarter now looks on track to be the weakest since 1Q03. We cut our 4Q GDP estimate to +1.6% from +2.8% after downside in capital goods shipments and non-residential construction suggested little growth in business investment, and a negative pattern of monthly revisions to 3Q consumer spending that provided a weaker starting point for 4Q together with worse-than-expected auto sales pointed to slower consumption growth.

Worries about the consumer were further raised by a big downward revision to 2Q income growth in the GDP data, while a sharp further rise in jobless claims — though likely at least partly a result of Thanksgiving seasonal adjustment problems — pointed to deterioration in the labor market. The icing on the cake for investors was a break in the ISM below 50, as there is a widespread belief among investors that an ISM below the 50-breakeven threshold all but guarantees an imminent Fed rate hike — never mind that Chairman Bernanke gave no indication that such a move is under consideration, and the Fed’s preferred measure of inflation posted a surprisingly high gain in October to remain well above the Fed’s “comfort zone”, a clear move towards which Fed officials have made clear is a requirement for any consideration of easier policy, barring a much more significant economic slowdown than currently appears likely.

On the week, benchmark Treasury yields plunged 9-20bp and the curve steepened sharply, with 2s-30s disinverting for the first time in a month, as the old 2-year yield plummeted 20bp to 4.53% and the long bond yield fell 9bp to 4.54%. The 3-year yield fell 19bp to 4.42%, the old 5-year 16bp to 4.39%, and the 10-year 12bp to 4.43%. The 2-year and 5-year auctions saw good demand from final investors, especially the former, and these bidders were well rewarded with strong post-auction gains. The new 2-year closed Friday at 4.52% after being auctioned Tuesday at 4.69%, while the new 5-year closed at 4.38% after being auctioned Wednesday at 4.51%. Amazingly, given a rally of this magnitude, TIPS actually outperformed significantly on the week, so all of the market gains were in real rates. The current 5-year TIPS yield plunged 27bp on the week to 2.14%, while the 10-year TIPS yield fell 17bp to 2.10%. A much more dovish Fed path was priced into futures market, with a high probability now seen of a rate cut by March and the expected 2008 trough of the anticipated rate cutting cycle moved down to 4.25% from 4.50%. The February fed funds contract gained 4.5bp on the week to 5.19%, putting the odds of a rate cut at the January 30-31 FOMC meeting at 25%, while the April contract surged 8.5bp to 5.075%, putting 70% odds on a cut by the March 20-21 meeting. Three rate cuts are fully expected next year, as the Dec 06 to Dec 07 eurodollar spread plummeted 21.75bp to a record low (by far) of -81.25bp, with the former contract gaining 2.25bp to 5.3425% and the latter surging 24bp to 4.53%. The low rate June 08 contract gained 23.5bp on the week 4.455%, moving the expected low point of the rate cutting cycle from 4.50% to 4.25%.

Even after a larger-than-expected upward adjustment to the third quarter, the second half growth outlook looked softer coming out of the past week, as we cut our fourth quarter forecast significantly. Real GDP growth in the third quarter was revised up to +2.2% from +1.6%. All of the net adjustment came in trade and inventories. A bigger-than-expected downward adjustment to import growth resulted in the contribution from net exports being upped to -0.2 percentage points from -0.5pp, while the inventory contribution was boosted to +0.2pp from -0.1pp. Final domestic demand growth was adjusted down marginally to +2.1%, with slightly lower consumption (+2.9%) and residential investment (-18.0%) offsetting slightly higher business investment (+10.0%) and government spending (+2.2%). Despite the better-than-expected Q3 growth outcome, the most notable aspect of the report was a downward revision to prior income growth, a worrying development for a consumer being hit by a significant deceleration in housing wealth gains. Incorporating the results of the second quarter Quarterly Census of Employment and Wages, the BEA cut wage and salary income in 2Q by US$100 billion, resulting in real disposable income growth being revised down to -1.5% from +1.7%. With this level shift carried forward into 3Q, year-on-year growth in nominal wages and salaries was revised down to +5.8% from +7.7% and in real terms to +2.9% from +4.7%. This points to less income support for consumers to offset a negative housing wealth effect — making continued solid job and income growth in the employment report even more important — as well as lower labor cost pressure than previously believed. We expect unit labor cost growth to be cut to +3.2% in 3Q from +5.3%.

At this point, we’re not overly concerned with the adjustments to income. There had previously been a widespread belief that the reported numbers were being somewhat distorted by a spike in one-off items in 1Q, when wage and salary income surged at an implausible seeming 13.3% annual rate, like stocks options and bonuses. So many analysts were already making some back-of-the-envelope adjustments to the income figures to try to strip this out. The adjustment to 2Q figures now probably makes this unnecessary, and we can probably rely on the reported numbers as showing a more reliable picture of the underlying trend (though keeping in mind that these figures have been very volatile recently and subject to large revisions each quarter that could well be repeated next time). And the underlying trend still looks quite positive and supportive of solid gains in consumer spending along with a rise in the personal savings rate. Real wage and salary income — the core driver of consumer spending, in our view — was up 4.3% year on year in October, aside from the unusual 1Q surge the best gain in six years. Going forward, we see tight labor markets continuing to support average wage gains a bit above +4%, which along with job and hours growth running over +2% should support aggregate nominal wage gains a bit above +6%.

While we expect to see some weather-related upside in energy prices (which appears to have already begun this week) in the near term, we believe that the peak in energy prices is past and that headline inflation will hold below +2% going forward. So we believe that real wage and salary income can continue to trend at about a +4.5% annual rate, enough to support a continuation of the recent +3% consumption trend as well as a rise in the savings rate as housing wealth effects fade. Certainly, however, these downward revisions to income place even more emphasis on continuing solid job and income growth in the employment report as a key to maintaining the economic expansion. For a full discussion, please see Dick Berner’s article, Will the Real Consumer Income Please Stand Up?

Even with the slightly larger-than-expected upward adjustment to 3Q growth, we now see the second half running weaker than we previously expected after cutting our 4Q estimate to +1.6% from +2.8%. The downward adjustment came from two sources — significantly weaker estimated investment spending after the soft durable goods and construction spending reports and less (though still reasonably solid) forecasted growth in consumption after a particularly unfavorable pattern of revisions to the monthly consumption numbers in 3Q and worse-than-expected November auto sales results.

On investment, durable goods orders plunged 8.3% in October, unwinding a similar-sized increase in the prior month. Much of the downside reflected a plunge in civilian aircraft after a spike in September. But underlying orders were significantly softer than expected, with the key core gauge — non-defense capital goods ex aircraft orders — falling 5.1%, driven by a plunge in high-tech orders (-10.2%) that swamped a solid rise in machinery (+1.4%). Shipments of non-defense capital goods ex aircraft fell 1.5% on top of a 1.6% drop in September, with the weakness concentrated in computers. These back-to-back declines in capital goods shipments provided a soft starting point for 4Q investment. We now estimate that the equipment and software component of investment will post only a 4% rise in 4Q. This was compounded by softness in business construction. Overall construction spending fell 1.0% in October on top of a downwardly revised 0.8% drop in September. Residential spending was down sharply in both months but, given the size of the drop in housing starts in October, actually wasn’t as bad as we feared. Instead, the surprise was concentrated in the private non-residential component, which fell 0.7% in October after a downwardly revised 0.6% decline in September. These drops marked a dramatic reversal after annualized growth of 26% over the prior six months and pointed to a drastic deceleration in recently booming structures investment in 4Q. We now look for the structures component of business investment to fall at a 2.5% annual rate in 4Q after gains averaging 14.5% over the prior four quarters. Combining the lower trajectories for equipment and software and structures, we currently see overall business investment on track for a gain of only 3% in 4Q, which would be the smallest rise in nearly three years.

Meanwhile, consumption growth now also appears likely to be less robust than we previously estimated. Although third quarter consumption was revised down only marginally to +2.9% from +3.1%, the distribution of this revision within the months of 3Q was about as negative for 4Q as could be, with real spending revised up in July, left unchanged in August, and revised down in September. So, even with an as expected and strong 0.4% gain in October real spending, the more negative ramp provided by the 3Q revisions led us to cut our 4Q consumption estimate to +3.1% from +3.5%. Weaker-than-expected motor vehicle sales results reported Friday — based on a nearly complete count, we estimate sales fell to a 15.9 million unit annual pace in November from 16.1 million in October and below Morgan Stanley’s forecast of 16.4 million — led us to cut this further to +2.9%.

Meanwhile, the manufacturing sector is struggling. The ISM composite diffusion index fell to 49.5 in November from 51.2 in October, the lowest and first sub-50 reading since April 2003. The orders (48.7 versus 52.1), production (48.5 versus 51.9) and employment (49.2 versus 50.8) gauges all showed decent declines to drop below the 50 breakeven. Eight of 12 industry groups reported growth in November, the same as in October.

Leading sectors this month included apparel, plastics, primary metals, computers and chemicals. Weakest sectors are not identified, but certainly we would expect industries impacted by housing or autos to be suffering. The prices paid index posted a surprising rise to 53.5 from 47.0. Most energy items were reported down in prices, but this was offset by upside in metals prices.

There seems to be a widespread view among investors that an ISM below 50 almost guarantees an imminent Fed rate cut, and this was certainly seen in the huge rallies in Treasuries and fed funds and eurodollar futures that followed the ISM release Friday. But it certainly does not seem to have made any such impression on Fed Chairman Bernanke at this point.

Market News International reported that it was told by ISM Chairman Norbert Ore that the ISM report was provided to the Fed Chairman Tuesday morning ahead of his relatively hawkish speech (actually drastically so compared to current market pricing). Bernanke suggested no meaningful change in the Fed’s long-held views on the economic outlook, including its continued worries about upside to inflation as the main risk to the outlook. On growth, he predicted another sub-par quarter in 4Q and then a return to trend in 2007 as the housing and auto recessions moderate — and he indicated that he saw the risks to that outlook as balanced, with the possibility of both weaker or stronger growth. On inflation, on the other hand, he only focused on upside risks. It certainly appeared from the speech that no substantive change to the FOMC’s statement after the upcoming December 12 FOMC meeting was then seen as likely and that a tightening bias would be retained. Certainly, the fact that inflation has remained so stubbornly high despite a now third quarter of sub-par growth must be perturbing the Fed and, barring a significant further deterioration in the growth outlook, would appear to rule out a near-term rate cut. Along with Bernanke’s speech, the market also ignored the surprisingly high 0.2% gain in the core PCE price index in October, which left the year/year rate stuck at +2.4%, just marginally below the +2.5% peak in August and well above the mid-point of the Fed’s 1% to 2% “comfort zone”. And these figures have actually surprisingly worsened during the ongoing soft patch. In the year through the end of 1Q, core PCE inflation was only up 2.0%, but in the seven months since the slow growth period began it has accelerated to a +2.4% annual rate, and in the three most recent months has picked up further to +2.7%.

Focus in the coming week will be squarely on Friday’s employment report.

In the run-up to Friday, there will only be a few other less important data releases and more supply news when the Treasury announces the 10-year reopening Thursday (we expect an unchanged US$8 billion size). We won’t be hearing much from the Fed as the traditional pre-FOMC meeting quiet period begins. Data releases due out include revised productivity and factory orders Tuesday, and employment Friday:

* The GDP data pointed to an upward revision to output in the third quarter, which implies a modest rise in productivity to +0.7% versus the flat outcome seen in the initial report. However, the big news in this report will likely be the sizeable downward adjustment to unit labor costs that was foreshadowed by the latest round of wage and salary revisions. We look for unit labor costs in 2Q to be revised all the way from +5.4% to -1.8%, with 3Q going from +3.8 to +2.4%. On a year-on-year basis, unit labor costs now appear to be up 3.2% through the third quarter — more than two full percentage points lower than the initial reading.

* We look for a sharp 5.1% decline in October factory orders tied to the previously reported plunge in the durables component, together with another anticipated decline in the non-durables category, reflecting lower energy prices. Inventories are expected to be up 0.5%, a bit below the trend seen in recent months.

* We forecast a 125,000 rise in November non-farm payrolls. Admittedly, the jobless claims data showed some deterioration in the second half of November. However, we believe that a couple of special factors should provide some upside support for job growth. First, it was unusually warm across the nation in the week prior to the November survey week and to a lesser extent in the survey week itself. Second, the Veterans Day holiday did not fall within the survey week. This typically happens only once every five to six years (and sometimes even less frequently depending on leap year patterns). There appears to have been some noticeable upside bias in the employment readings in past such instances. This calendar quirk also seems to impact the household survey. As a result, we expect the jobless rate to hold at the cycle low of 4.4% hit in October.

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Currencies
Is this a USD Story or a EUR Story?
December 04, 2006

By Stephen L. Jen | Milan



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India
2008: The Year of Payback
December 04, 2006

By Chetan Ahya and Mihir Sheth, CFA | Mumbai, Mumbai

Summary

India has witnessed one of its strongest growth cycles over the last three years.  However, we believe that a significant part of the acceleration in growth was borrowed from future growth.  As cyclical factors supporting growth reverse over the next two years, GDP growth is likely to decelerate.  After recording a growth of 8.5% in F2007 (fiscal year-ending March 2007), we expect India’s GDP growth to moderate to 7.3% in F2008 and 6.9% in F2009.  Our growth estimates are premised on the view that India is heading for a soft landing in its growth cycle, as the cost of capital is rising and macro stability parameters are at worrying levels, restricting policy-makers’ ability to allow the strong growth trend to continue.

Indiahas seen strongest growth cycle in recent history

India has achieved strong economic growth of 8.2% per annum over the past three years versus 6.2% per annum in the preceding ten years.  This compares with average economic growth of 10.3% per annum for China and 5.3% per annum for Emerging ASEAN countries in the past three years.  Although we believe that some acceleration is warranted due to structural factors, the greater part of growth has been a result of the sharp rise in capital flows in response to an increase in global risk appetite.  The global liquidity spillover into India has allowed the government to pursue relatively loose monetary and fiscal policies, which have supported the acceleration in cyclical growth.

Debt-funded domestic demand was key growth driver …

A large part of the acceleration in growth has been driven by domestic demand, which, in turn, has been supported by a sharp rise in bank credit, in our view.  Bank credit growth had accelerated to a new high of 33% as at end-June 2006, making the current credit cycle the longest in the past 35 years.  Indeed, during the quarter ended June 2006, the government also borrowed aggressively to fund acceleration in its expenditure growth.  The government is continuing to pursue the policy of ‘borrowing from the future’.  Apart from this aggressive leveraging trend supporting growth, the government had also protected domestic demand by choosing not to pass on the full cost of higher oil prices.

… but the credit cycle has reversed

We believe that the credit cycle has reversed due to the lagged effect of the steady rise in real rates over the past few months, increasing supply constraints in banks’ balance sheets (i.e., low deposit growth) and the Reserve Bank of India’s measures to control aggressive credit by increasing risk weights for banks lending to select sectors.  As regards government spending, the Finance Ministry has also clarified that the spike during the quarter ended June 2006 was due to the bunching up of expenditure, and it expects it to slow down.  We believe that the acceleration of growth during the quarters ended June and September 2006 is unsustainable.  Hence, even as the support from corporate capex remains positive, the weaker trends in the other three drivers, including external demand, government spending and household spending, should result in a slowdown in growth.

Pressure on macro stability indicators

Given that various macro stability indicators have already reached worrying levels, policy-makers’ ability to let the strong growth trend continue appears limited.  Headline wholesale price inflation (WPI) at 5.5% is threatening to cross the RBI’s tolerance range of 5-5.5%.  The banking sector’s balance sheet is already stretched, with the gap between credit (+28% YoY) and deposit (20.7%) growth continuing to remain high.  Excess liquidity without an adequate supply response in the form of absorption of investments has also resulted in higher asset prices.  Property prices have risen 100-300% in major cities in the past two years.  On the external front, the current account balance turned into a deficit of US$6.1 billion (3% of GDP) during the QE-June 2006, and recent monthly trade data indicate a further deterioration.

F2008 and F2009: Payback years

We believe that debt-funded consumption growth, which has been at the heart of the above-trend GDP growth over the past three years, will be hit by the rise in the cost of capital and the soft landing of the credit growth cycle.  We expect GDP growth to decelerate from an average of 8.1% over the three years ending F2007 to 7.3% in F2008.  We believe that the payback period for the high debt-funded growth that India had enjoyed is likely to continue through to F2009.  As a result, we expect overall growth to moderate to 6.9% in F2009.

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Euroland
Peeping Through 2007 Uncertainties Into 2008
December 04, 2006

By Eric Chaney and Elga Bartsch | London, London

 This coming Thursday, the ECB bank will raise the refi rate to 3.5%.  This will be a non-event, since officials have done their best to pre-announce the move, in order to stabilise money markets and defuse possible angry reactions from finance ministers.  Indeed, the main event will be the assessment by President Jean-Claude Trichet on the 2007 outlook.  ECB semantics specialists will count the occurrences of the word ‘vigilance’ coupled with ‘inflation’, but also of ‘uncertainty’.  They will watch for an allusion to ‘German VAT’.  Our best guess is that ‘vigilance’ will remain fashionable, associated with ‘inflation’ but not with ‘exchange rate’, that occurrences of ‘uncertainty’ will inflate and that ‘German VAT’ will be left to the Q&A session.  If we are right, money markets might conclude that, while further rate hikes next year are in the cards, an action as early as February is unlikely and that even a rate hike in March, which is part of our baseline scenario, cannot be taken for granted.

A long list of major uncertainties for next year

The fundamental reason for a more cautious monetary behaviour after this week’s move is the long list of uncertainties surrounding the near-term future.  On the external side: Recession or resilience in the US?  Downward spiral for the USD or stabilisation?  On the even more important domestic side:  Boom-bust effect of the VAT hike in Germany or smooth transition?  Creeping wage inflation or persistent moderation?  Softer growth in housing markets or hard landing?  Political stability or chaos?

Here is our call:

1. We assume a relatively soft landing in the US economy, i.e., GDP growth at 2.5-3.0%;

2. We believe that the USD will remain weak but won’t spiral down;

3. We think that domestic demand will slow sharply in the first quarter but that GDP growth will prove less volatile;

4. We see the end of wage deflation in Germany as good news but leading to benign wage inflation;

5. Moderation, not bust, in housing markets;

6. Last, we bet on political stability in Italy and only marginal changes in France, whatever is the result of the presidential election in May 2007.

Do not overlook upside risks either

While downside risks to our freshly revised call for GDP growth close to trend next year (1.9%, versus 2.0% for the 1999-2006 average) are significant, there are also upside risks.  So far this year, short-term economic indicators have consistently surprised on the upside, despite strong headwinds such as higher oil prices and rising interest rates.  On our estimates, these factors might cut GDP growth by as much as 0.7 percentage points in 2006, which stresses the robustness of the domestic economy.  We have revised upward our forecasts for both 2006 and 2007 because we have realised that the underlying trend growth of the economy was higher than we previously thought, perhaps because of a structural acceleration in productivity.  We might still be underestimating it.

Growth should re-accelerate in 2008

Projecting ourselves one year from now, we believe that GDP growth should re-accelerate in the euro area for several reasons.  First and foremost, the fiscal tightening embedded in the Italian and German 2007 budgets is front-loaded, as heralded by the VAT rate hike, effective in January.  Since we do not expect another round of fiscal diets in these countries at least, domestic demand should re-accelerate as consumers and companies feel the fiscal belts loosening.  In 2008, the reverse effect of the 2007 fiscal tightening should be positive for growth, as the German and Italian economies catch up with their longer-term trend.  Even assuming a fiscal diet in France in 2008 worth 1% of GDP (i.e., comparable in size to next year’s German plan), the net impact of fiscal policies should be positive.  Second, we expect the price of crude oil to decline further, from US$60/bl on average next year to US$50/bl in 2008, a 16% decline.  Last, we expect the impact of the current US slowdown on global trade to dissipate by then.  All in all, we see GDP growth accelerating from 1.9% in 2007 to 2.4% in 2008, that is, almost half a percentage point above trend.

Higher core inflation, lower headline

As unemployment, which is likely to stabilise at 7.6% next year, declines further in 2008, wage inflation should accelerate more than productivity and companies should benefit from stronger pricing power, in a context of sustained domestic demand, as we saw back in 1999.  As a result, core inflation should accelerate from 1.4% this year to 1.7% in 2008.  On the other hand, lower energy prices and the end of the VAT effect on German prices should help to bring headline inflation to 1.7% in 2008, from 2.0% next year.

The ECB is likely to turn slightly restrictive in 2008

From a monetary policy angle, 2008 will likely see a gradual closing of the output gap in the euro area and a moderation in consumer price inflation, mostly due to a base effect and lower energy prices.  Because of the risks of capacity pressures emerging, we expect the ECB to raise interest rate a further 25bp in early 2008, when the acceleration in growth is likely to peak.  As this would likely cause the monetary policy stance to become slightly restrictive, we see the ECB’s refi rate staying at 4.25% for the remainder of the year and expect GDP growth to return back to trend and inflation to ease gradually.  The slightly restrictive ECB policy stance combined with a cyclical deceleration will likely cause government bond yields to fall gradually over the course of 2008.  However, the 2008 bond market rally would start from a higher yield level of around 4.5%, we think.

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