Euroland
More ECB Tightening to Come
December 08, 2006

By Elga Bartsch | London

The unanimous decision by the ECB Governing Council to raise the refinancing rate by 25bp to 3.5% this week was widely expected. The subsequent press conference proved to be more controversial, as it gave somewhat conflicting signals. Thereby, ECB President Trichet created room for flexible monetary policy manoeuvres by the ECB next year. But, on balance, the tone of the press conference was more hawkish than many in financial markets had expected. Our read of the press conference is that the ECB is still determined to hike interest rates further in 2007, despite the recent rise in the EUR and an expected moderation in growth. Even after this week’s rate hike, the ECB still regards its policy as accommodative. The ECB staff projects HICP inflation hovering around 2% over the next 24 months, based on market expectations for another refi rate hike next year. The risks to these staff projections are seen as being to the upside by the Council. Hence, the Council will monitor these risks “very closely” going forward and will act in “a firm and timely manner” to ensure that these inflation risks do not materialise. On the whole, the press conference has not induced us to alter our call for further ECB tightening in 2007.

In the ‘traffic-light system’ of signalling the timing of the next move, which the ECB has religiously stuck to throughout this tightening campaign, the phrase “monitoring risks very closely” suggests that another rate hike could come as soon as February. But messages regarding the timing of the next move at the press conference were somewhat conflicting. While the introductory statement deliberately used a phrase that the ECB knew the markets would interpret as hinting towards another hike in February, ECB President Trichet seemed to rule out a move at the February meeting at one stage during the Q&A session. In addition to the usual mantra that the ECB does not pre-commit to a certain course of action in advance and can act at any time if needed, he insisted that interpreting the statement as signaling a move in February was “not the correct one”. His intervention confirmed our view that the next interest rate hike should only come in March, when new staff projections will be available, when a first assessment of the impact of the German VAT hike will be possible and when the ECB will have a better idea of how soft the soft patch in the US economy is going to be and what repercussions it would have on currency markets. Later, however, the ECB President seemed to backtrack from ruling out a move in February by saying that he “will say nothing on February, absolutely nothing”. So, we will probably have to look to future public interventions by ECB Council members to clear up the confusion.

Nonetheless, it seems to us that the ECB is surprisingly close to another interest rate hike — certainly closer than the market has been expecting. The inflation risks that the ECB will likely monitor closely in the coming months include a stronger-than-expected pass-through from past oil price increases, further increases in indirect taxes and administrative prices, wage developments and continued rapid money and credit growth in the face of already ample liquidity. Compared to these upside risks to price stability, the downside risks to the growth outlook are a secondary concern, according to the ECB President. These downside risks stemming from a potential renewed rise in crude oil prices, protectionism and “disorderly development owing to global imbalances” (the ECB’s elegant description of a USD crash) only matter to the extent that they affect the inflation outlook, the ECB President elaborated.

Another ECB rate hike, which would lift the refi rate to 3.75%, would probably bring the policy rate to the neutral level in the view of the ECB. We gather this from the fact that the phrase “further withdraw of monetary accommodation will be needed” was missing in the statement. In our view, the absence of the phrase does not mean that the ECB is unlikely to hike further. Rather, it means that the next move will not imply a withdrawal of monetary accommodation. The “need to act in a firm and timely manner”, highlighted by the ECB, shows that it is willing to go further if needed. We are currently forecasting a total of 50bp of ECB rate hikes in 2007. Our forecast is above current market expectations and above what the ECB assumes in its staff projections. But market expectations of, at most, one more interest rate hike in 2007 might prove to be too low. But a second rate hike in 2007 is not a done deal yet either.

Important Disclosure Information at the end of this Forum

United States
False Dawn for Housing Demand?
December 08, 2006

By Richard Berner | New York

At first blush, housing demand looks like it’s bottoming or even recovering: New and existing home sales have leveled off at more realistic three- or four-year lows.  An index of housing affordability rose by 7.5% in the past three months, after tumbling by about 27% in the prior three years.  A homebuilders’ canvass suggests that prospective homebuyers are kicking the tires in greater numbers.  A gauge of consumers’ opinions on homebuying conditions in the University of Michigan’s sentiment surveys jumped by 14.5% in the past three months.  And mortgage applications to purchase a house jumped 11.3% in the past eight weeks.  Moreover, job and income growth improved through October. 

However, these hopeful signs may be a false dawn for housing demand.  The reasons: Buyers can afford to wait.  With affordability still well below the mean of the past 20 years, and following a 14-year boom, pent-up demand is scarce.  Homeowners who want to trade up or move won’t buy new homes until they have assurance that they can close the sale of their current residence.  For the immediate future, moreover, expectations that builders will cut prices on existing inventory give buyers an incentive to wait, and those beliefs won’t likely fade until a better balance between supply and demand emerges next year. 

The good news: The tentative signs of improvement noted above do imply that the intensity of the sales decline is probably lessening significantly, and the process of adjustment on the supply side necessary to eliminate the overhang is well under way.  But buyers may not step up until affordability improves further.  And builders will have to cut construction significantly further to reduce inventories of unsold homes.

Despite the improvement in some metrics, anecdotal evidence of — and even folklore suggesting — a potentially apocalyptic outcome abounds.  For example, courtesy of cancellations reportedly running at 35-40% by desperate buyers who are forfeiting deposits, some observers think that the decline in housing demand has been far greater than official statistics portray.  Thus, they reason, the likely magnitude of the needed decline in housing activity and cuts in price to move merchandise will wreak havoc with the economy.  I disagree.  Concerns that cancellations imply dramatic distortions in the housing statistics are overblown, and it’s worth explaining why. 

Our guesstimates do suggest that the decline in sales of new, 1-family homes has probably been sharper than recorded in the official data.  That’s because the Census Bureau derives new home sales from a sample of the number of deposits taken and/or sales agreements signed, and the sales thus recorded are gross, not adjusted for subsequent cancellations.  We can make a rough estimate of cancellation rates using builder data from our housing team.  The team stresses that builders report cancellation rates in relation to orders, and orders are not the same as sales; they are non-binding agreements requiring a refundable deposit to hold a specific lot/unit and lock in a base home price.  Indeed, in normal times, we estimate from historical experience that order cancellation rates are roughly 20-25%, so such rates haven’t rocketed from zero or low levels (except for one high-end builder).  While there are no data for sales cancellation rates, they are probably lower.  Thus, both the level and the change in order cancellation rates likely overstate the impact on recorded sales.

In the 2005 boom, order cancellation rates dipped to about 18%, compared with today’s 32.5% (both based on a weighted average of seven major builders that account for nearly one-third of new single-family homes sold in the third quarter of 2006).  Assuming that order cancellation rates increased by twice as much as those on forfeited sales contracts results in an increase in the cancellation rate for sales of about 6 percentage points over the past year.  Netting the change in forfeitures thus estimated from the official data for new, 1-family home sales yields a sales decline of about 28% in the third quarter of 2006 compared with a year ago, rather than the 22.5% in official data (of course, that may overstate the weakness in demand if our assumptions are off).

The bad news is thus that demand has been somewhat weaker than recorded in official data, and that the inventory situation (in terms of months’ supply) may thus be worse than the 7 months in official data.  Concern over inventories is valid, but looking at such adjusted months’ supply data may not be grounds for such worries.  The reason: Just as adjusting for cancellations boosts months’ supply when sales are falling, such adjustments will reduce months’ supply as demand stabilizes.  Cancellation rates will probably tumble as that occurs, reversing the plunge in “adjusted” home sales more quickly than the official data would show, and thus reducing months’ supply more rapidly than official data. 

It’s also worth noting that the inventory data themselves to some extent overstate the overhang of unsold new homes.  That’s because roughly 20% of the so-called inventories are vacant lots on which houses have not been started, and at least in the aggregate, these are the easiest on which to cut or defer construction.  So the months’ supply of completed houses or those under construction relative to sales appropriately adjusted for cancellations may amount to less than the 7 months portrayed in the official statistics.

Uncertainty over both the housing outlook and the potential for collateral damage from the housing recession on the rest of the economy may plague investors for at least several months, if not longer.  However, markets work off changes in direction, as the recent rally in homebuilders’ shares indicates, so the first real signs of a turn in housing could have important market implications.

Risks surrounding the housing outlook seem evenly balanced.  The housing recession isn’t over; the case for a prolonged, if less intense decline seems solid based on our metrics of demand and supply.  But those measures are uncertain at best, and there are also some risks that housing could turn around somewhat faster than we think.  For markets, there’s no doubt that such a turn would be the bigger surprise.

Important Disclosure Information at the end of this Forum

UK
Fiscal Policy: Not Much of a Change
December 08, 2006

By Melanie Baker and David Miles | London, London

In his Pre-Budget speech, the Chancellor, rather unsurprisingly, sounded confident of meeting the Treasury’s fiscal rules and economic forecasts for this year.  However, there were no major new tax or spending announcements in the Pre-Budget Report.  All in all, the new forecasts could be described as showing a slight deterioration in the fiscal position compared with the forecasts at the time of the Budget in March.  However, the revisions made to borrowing and debt forecasts were small.

Economic forecasts more optimistic than our own. The Treasury has revised its GDP growth assumptions used in the fiscal projections.  On average, over the profile, these forecasts are stronger, although 2007/8 and 2008/9 are revised down a quarter of a percentage point.  However, the Treasury’s forecast for 2.75% GDP growth in 2007/8 still looks optimistic to us; our central forecast is that GDP growth slows next year.  Despite, on average, higher GDP growth over the forecast horizon and a higher money GDP profile compared with its previous forecasts, the Treasury forecasts for overall public sector net borrowing and for net debt (including as a percentage of GDP) worsen.

Upward revision to potential growth.  The main reason for the upward revisions to GDP growth in the later years of the Treasury’s projections is a 0.25 percentage point upward revision to the Treasury’s assumption on potential growth.  At 2.75, this is now significantly higher than our own assumption of 2.5%.  While 2.5% is the new ‘cautious’ assumption used in the actual fiscal projections, it is our central assumption.  The Treasury has revised up its estimate of trend growth largely on a revised assumption for working age population growth.  This revised assumption is largely the result of upward revisions to assumed inward migration.  The Treasury appears to be assuming that inward migration continues at a high level.  However, it is not clear to what extent this assumption has also been built into the Treasury’s projections for, for example, health and education spending.  Such sustained inward migration suggests that estimates of future spending may need to rise further.

Borrowing forecasts revised up slightly

Overall changes to the current budget and public sector net borrowing (PSNB) numbers are relatively small, with the latter revised higher by £1-2 billion each year. For this fiscal year (i.e., to end-March 2007), gross gilt issuance will total £62.5 billion, compared with the £63 billion planned at the time of the Spring Budget.

•           Forecasts for current spending are a little higher than in the Spring Budget (as are forecasts for receipts), where higher inflation in 2006 appears largely to blame for the increases in forecast spending.  Receipts are higher, helped somewhat by the higher forecasts for money GDP (which helps offset the impact of forecast lower receipts from North Sea taxes), but also by about £2 billion more in revenue per year from various taxes including the announced rise in air passenger duty. 

•           Importance of asset sales. Assumed asset sales are now somewhat smaller in the Treasury’s numbers at £5.6 billion this year and next, compared with £6.6 billion on the previous forecasts.

•           Dangers for the fiscal rules.  In terms of the fiscal rules, the Treasury (rather unsurprisingly) expects them to be met. 

•           The sustainable investment rule. The Treasury’s projections for net debt as a percentage of GDP remain below the 40% limit.  We continue to think that risks to the Treasury’s projections are largely on the upside: There is a possibility that the ONS might further reclassify some currently ‘off balance sheet’ government liabilities as government debt, and the government is committed to meeting any overruns related to the 2012 Olympics. 

•           The golden rule. The ‘golden rule’ is that, over the cycle, the current budget shows a surplus as a percentage of GDP on average.  For the balance on the current budget, the Treasury now forecasts an additional year of deficit in 2007-8 (-£1 billion compared with a £1 billion surplus previously) and lower surpluses in the following years, compared with its previous forecasts.  The Treasury announced that it still expected to meet the ‘golden rule’ over the cycle (which is now forecast to end in early 2007 compared with 2008/9 previously).  Using that assumption, we also see the Treasury meeting the golden rule this cycle, although by a slim margin.  However, we are less optimistic that the public finances are on track to meet the golden rule over the next cycle.

Treasury cautious on longevity bonds

Among the related material published with the Pre-Budget, the Treasury has considered the issuance of longevity bonds, but announced “no current plans” to do so:  “Although an argument could be made for governments issuing longevity bonds, the decision to do so would imply an outright transfer of additional longevity risk onto the government’s balance sheet, which would raise policy issues that extend beyond a strict interpretation of debt management policy.”  Given how much longevity risk the government already has, we regard this as an unsurprising and rather sensible judgement to make at this stage.

Important Disclosure Information at the end of this Forum

Japan
Low on Drama, High in Content, - Economic Policy in Abe’s First 60 Days
December 08, 2006

By Robert Alan Feldman | Tokyo

Introduction

It is crucial for investors to pay attention to the debates at the Council on Economic and Fiscal Policy (CEFP), the highest economic policy board in the nation. The results from the six meetings under PM Abe so far are encouraging. PM Abe has tilted strongly toward the private sector members of the CEFP. He has also set deadlines, and set homework for his ministers.

The road tax showdown

As in the Koizumi days, there is a clear fissure on the committee. The private sector members push for radical policies, and the ministers are reluctant to alter the status quo. At the end of each topic, the PM gives his opinion.

A clear example came last week, when the discussion of budget policy included a section on the earmarking of road-related taxes for road building. Under current law, tax receipts from certain auto-related sources, particularly the gasoline tax, are earmarked for road building and may not be used for other purposes. However, PM Koizumi made it a point to include an end to this earmarking as an element in the mid-year policy outlook this year. The question is whether PM Abe will stick to the same line.

At the end of the CEFP debate on the matter, the clincher came from PM Abe, who said, “As the nation ages, we need to consider how best to use scarce resources and to allocate burdens. That the special road taxes are not a sacred cow has been a matter of agreement since the Koizumi days. Of course, we will build needed roads, but it is necessary to change the process of automatically allocating road-related taxes to road building.” PM Abe’s statement shows to me that he will not allow the old guard to come back.

How to use the tax windfall

Another issue is use of the windfall rise of tax revenue. The recent strength of the economy and return to tax-paying status for many firms has brought about JPY3 trillion more revenue this year than the Ministry of Finance expected. There have been calls from parts of the LDP to use most of this money for election-oriented spending.

However, at the CEFP, PM Abe said, “I must make it clear that my Cabinet will not change course on the matter of eliminating wasteful spending. I will not flinch. We will implement the five principles outlined by the private sector members of our committee.” Principle #2 is: “Use natural tax revenue increases for reducing the burden on future generations, and not for spending increases.” Thus, the tax windfall will be used for deficit reduction, as the five principles say.

Procedure matters a lot!

Less transparent to investors are matters of procedure and personnel. However, these matters are crucial in evaluation of both progress and prospects. In both areas, PM Abe has made important progress.

In the area of tax policy procedure, PM Abe made one striking change:  He transferred the government tax commission from control by the Ministry of Finance to direct control by the Cabinet Office. Under the old system, there were three key bodies in the debate with three wholly different objectives. The LDP Tax Committee viewed the tax system as a political tool. The Government Tax Commission viewed the tax system as a revenue too. And the CEFP viewed the tax system as an economic revival tool. The three bodies had great difficulty coordinating, in light of their different goals and reporting lines. Under the new system, which PM Abe created with the stroke of a pen, the Government Tax Commission was shifted to the Cabinet Office. Moreover, since the CEFP is also part of the Cabinet, the two committees now have identical incentives. In addition, since the LDP tax committee also reports ultimately to the PM, in his role as party president of the LDP, coordination among all three committees will be easier.

Constructive competition:  CEFP versus bureaucrats

PM Abe has also created policy competition. An example is labor market reform. The private sector members of the CEFP proposed a special expert committee on labor market reform, to report directly to the CEFP itself. At the CEFP, the Minister of Welfare pointed out that his ministry already had a Labor Policy Commission with oversight of such matters. He thought that his commission should endorse any conclusions of an expert committee. PM Abe supported the new expert committee, and asked that it give a “spirited” report. This is a clear swipe at the ministry, and indicates that the bureaucrats are no longer in charge of labor policy.

Flowers that bloom in the spring

Where is all this going? There is, in my view, a grand design. PM Abe has given clear reform signals in a number of areas. The reports by the task forces on various issues will be ready by the spring. As these groups deliberate, a parallel process on each issue will occur within the LDP. There will be a three-way debate between the task forces under the CEFP, the LDP and the bureaucracy. As new proposals emerge, PM Abe will make decisions. The decision he made on the budget — i.e., to use the tax windfall for deficit reduction, not spending — prefigures the decisions he is likely to make on other issues.

Behind the scenes lurks a key political element, the July 2007 Upper House election. None of the policies PM Abe envisions for Japan can be implemented without a strong showing in the election. The negative public reaction to readmission of postal reform rebels to the LDP — even under very harsh conditions for readmission — shows the need for the PM to show clear progress on the reform agenda. Hence, in my view, he has a strong political incentive to side with the CEFP against anti-reform elements in the LDP and in the bureaucracy.

Market implications

There is a tendency among investors, particularly domestic investors, to pooh-pooh policy debates as irrelevant to asset prices. Nothing could be further from the truth, in my view. The stability of JGB yields depends crucially on progress in fiscal reform. Moreover, the huge increase in Japanese corporate profits today stems directly from the policy decisions made over the last decade. Looking forward, the potential for further profit improvements depends crucially on reforms taken today.

My view is that investors would be wise to keep a close eye on policy discussions. Important sources of future profit growth lie therein.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.