Will the Inventory Cycle Prolong Sluggish Growth?
January 05, 2007
By Richard Berner | New York
Manufacturing and housing have always called the tune for the business cycle, and pessimists worry that the current downturns in each will continue to be a one-two punch for the economy, threatening recession. The weakness in manufacturing stems from three sources: sharp cutbacks in motor vehicle output to align supply with demand; the spillover from the housing recession to construction materials, furniture, appliances, and construction machinery; and the deceleration in capital spending that first appeared in the spring.
But another classic, cyclical development adds a layer of downside risk: At first blush, it appears that an inventory pileup resulting from the unexpected slowing in demand and the lagged response of output could prolong the manufacturing recession and increase the risk of an overall economic downturn. Inventory cycles have always played a key role in triggering recessions, even in the brave new era of “just-in-time” (JIT) inventory management. After all, when tech companies lost track of inventories in the slowdown of 2000, tech and telecom companies slashed output, helping to precipitate the downturn. In fact, reductions in nonfarm inventories cut 1.1 percentage points from GDP over the four quarters of 2001. That was then. In the year ended in October 2006, nominal business inventories rose by a stunning 7.3% — more than twice as fast as manufacturing and trade sales (including both wholesale and retail trade) — hinting at further significant production cutbacks to bring them down. How big are the risks? In my view, further production cuts in some industries are likely, but fears of a broad-based inventory overhang are overblown for four reasons. First, it’s misleading to look at nominal inventories and sales, because prices of stocks — especially of energy goods and materials and supplies — have risen significantly faster than those of finished goods over the past four years. Indeed, over that span, the chain price index for goods output rose at a 0.2% average annual rate, while that for nonfarm inventories rose at a whopping average 4% annual clip. In my judgment, with a few exceptions (notably motor vehicles, lumber and wood products), real inventory-sales ratios adjusted for inflation were lean at the start of the slowdown, and have risen only moderately over the past year. Indeed, so persistent is the growth of JIT technology in retailing that I-S ratios in most retail segments continue to fall even as sales slow. A second reason to discount the inventory bogeyman is that manufacturing companies — especially in housing- and automotive-related businesses — have already cut production aggressively. How should we judge “aggressive” in the brave new world of JIT supply-chain management? JIT means more frequent ordering in smaller lots courtesy of IT-enabled supply-chain and logistics management, which translates into a much faster response from one end of the chain to the other. JIT thus will mute the amplitude of inventory cycles compared with those in the past, so comparisons with the downturns of the 1960s, 1970s and 1980s may be invalid. Through that lens, production cuts for the year ended in November in appliances, furniture and carpeting (-5%), construction materials (-2%), and motor vehicles (-15% through October) look aggressive; they are only somewhat smaller than production cuts in those industries in the 1990-91 and 2001 recessions. Indeed, cuts were especially aggressive in the quarter just past: We estimate that the slower pace of nonfarm inventory accumulation cut more than a percentage point from fourth-quarter GDP growth. It’s worth noting in passing that the magnitude of that adjustment and the one we assume in the next couple of quarters may overstate the weakness in production and GDP. That’s because statisticians at the Bureau of Economic Analysis (BEA) estimated that GDP-based output of new motor vehicles soared at a 27.4% annual rate in the summer quarter, while analysts at the Fed estimate that motor vehicle output measured by industrial production plunged by 17.5% in that same period. I agree with Fed staff that measurement issues associated with BEA’s estimate probably overstated both GDP and motor vehicle inventory change in the third quarter, and that, as noted in the minutes of the December 12 FOMC meeting, “the gradual unwinding of those effects would probably lead to an understatement of real GDP growth over the next several quarters.” In the real world, therefore, the automotive-related inventory adjustment is probably over. A third reason not to hyperventilate about inventories is that imports may shoulder a significant portion of the adjustment. Indeed, the offshoring of production has a silver lining: It shifts the inventory cycle to overseas locations and reduces the cyclicality of US output. A symptom of those developments is the high and, in some industries, rising correlation between swings in imports and those in inventories. The bad news in that regard is that the current automotive downturn partly represents an energy-price induced secular shift away from the large SUV and truck market segment, which Detroit still dominates, so the brunt of the adjustment in this case has fallen on US output. The good news is that domestic auto output peaked three years ago, so that the latest purge may realign output in that segment with demand. The final, and most important, reason to expect a more muted inventory cycle henceforth is that demand weakness in some cases may be ending or at least is becoming less intense. We’re suspicious that the recent stability in home sales may not last, and we believe that unseasonably warm weather may artificially — and temporarily — inflate housing and construction activity at least through January. Payback will come when the weather turns colder, as it surely will even if global warming has altered the climate. Moreover, housing starts must fall significantly further to trim inventories of unsold new homes. But even allowing for further declines in housing activity, I think that the intensity of the downturn and thus the spillovers into manufacturing should wane by midyear. The automotive downturn, in contrast, may not quickly morph into recovery, but barring further significant weakness in demand, it seems to have ended in October. As evidence, December’s manufacturing report from the Institute of Supply Management (ISM) hints that the intensity of the factory downturn may be ebbing. The “customer inventory” index (which assesses the perceived inventory situation at purchasing managers’ customers) is higher than a year ago but stabilized at about 50%. Elevated stockpiles are evident in a few sectors such as electrical equipment, furniture, and paper. Most important, the upturn in production and domestic orders and growth in export bookings all suggest stabilization as the housing and automotive headwinds fade. For some financial markets, the threat of prolonged inventory adjustments is manifest in the price. Fixed-income markets discount a period of sluggish growth and eventual Fed ease. Commodity markets are now joining in, discounting weaker global growth. Neither is priced for a relatively quick turn in the growth recession, and therein would clearly be the surprise. That’s not to say there are no downside risks — far from it. Further demand weakness is certainly possible, especially if the production cuts begin to spill over into job cuts. Capital goods demand is another potential weak spot, as recent bookings declines attest. But an end to the inventory cycle could come sooner than many expect, and with it, somewhat firmer economic activity.
Important Disclosure Information at the end of this Forum
Cyclical Dollar Correction in 1H; Story May Change in 2H
January 05, 2007
By Stephen Jen | London
Summary and conclusions In my view, the cyclical dollar correction that we witnessed in 2006 will likely be extended into 1H07, when the US economy is expected to show further ‘moderate’ growth. Many of the same thoughts I had in 2006 will carry over to 1H07. By 2H, however, market sentiment toward the dollar could improve significantly as the US economy reverts toward potential growth. One key theme, in my view, is my belief that the global economy is experiencing a mid-cycle slowdown. To me, for 2007, the dollar’s movements will be propelled more by the desire to buy the higher-beta currencies out of ‘greed’ rather than to sell the dollar out of ‘fear’. In order of what I believe will be the best to the worst-performing currencies in the first half of this year, I list the following categories: (1) AXJ currencies; (2) JPY, SEK and NOK; (3) EUR, GBP and AUD; (4) USD; and (5) CAD and MXN. By 2H, I expect the ranking of currencies to shift to: (1) AXJ currencies; (2) JPY; (3) CAD and MXN; (4) USD; and (5) EUR, GBP and AUD. This will be a mix of cyclical and structural stories The fact that I see the USD underperforming some currencies while outperforming others suggests that 2007 will no longer show a clean dollar move, in contrast to the previous five years. Since the USD will remain vulnerable as long we linger around the trough of my ‘Dollar Smile’, for the year as a whole, I don’t think that 2007 will be described as a generalized dollar move. Not only will the US business cycle likely turn this year, which should alter the sentiment on the dollar, important structural factors will also continue to buffet EUR/JPY, for example. One factor many USD bears are still fixated on will, in my view, not be a detractor to the dollar: the US C/A deficit. The US C/A deficit (as a percentage of GDP) is likely to have reached an important inflection point in 2006. In fact, our US economists expect the US C/A deficit to decline from 6.7% in 2006 to 4.7% by 2008 — consistent with my view that what we are witnessing is a ‘20%-balancing-down-80%-balancing-up’ scenario that is benign in nature and necessary to re-establish a more sustainable path for the external imbalances in the world. A very benign global economic backdrop Importantly, I continue to make the assumption that the prospective slowdown in the US and the global economy is a mid-cycle event, and not at all what some pessimists have in mind. My thesis, which I have proposed in the past, is that the world is far from having reaped all the benefits from globalization. The problem I have with the pessimists is that they may be focusing too much on the aggregate demand (AD) side of the equation and not enough on global aggregate supply (AS). To me, global AS will continue to grow at a rapid pace so as to keep the world in a ‘Goldilocks-like’ state for several more years. There could be differences in the growth trajectories of various countries, but the overall outlook for the global economy is very positive: the world will continue to be propelled more by AS than AD, in my view. The single-biggest positive economic shock that the global economy has experienced in the past decade is the effective doubling of the global labor force. It has taken investors, commentators and policy makers several years to fully understand the implications of such a positive supply shock. However, I believe we are only half-way through the story. The effective doubling of the global labor force has significantly depressed the global capital-to-labor (K/L) ratio, i.e., there are not enough ‘widgets’ for the size of the labor pool in the world. To re-establish global equilibrium of the K/L ratio, in the coming years, the world will need to embark on large capex spending. Most (not all) of the new capex should, theoretically, take place where the new labor is located, but in practice there are infrastructural and implementational constraints on large-scale capex in these countries There is no economic theory that argues that the marriage of K and L needs to take place locally. Goods globalization is about accentuating the comparative advantages of countries. But to the extent that economic activities in the developed world (e.g., services) are increasingly less capital-intensive, the global economy could experience a period of low capex, high return on capital and low interest rates — exactly the curious combination we have witnessed in recent years. Until the world raises its capex, I believe that global interest rates will remain low and the convergence between equities and bonds will likely take place through an increase in the P/E ratio (an expansion in the multiples) rather than from a sharp sell-off in bonds. The global economy has already registered five consecutive years of growth above 4.0%, making this the longest string of growth on record, despite continuous skepticism from many circles on the sustainability of the global/US economy. Based on the K/L framework, I believe that we will see several more years of strong global growth with low inflation. Cyclical considerations for the dollar As the US shows signs of weakness in H1, the USD could remain on the soft side against the EUR, but should weaken meaningfully against the AXJ currencies. This outlook is consistent with my ‘Dollar Smile’ framework. In a way, what the world gives up in terms of headline growth it will gain back through ‘better quality’ and more balanced growth — both geographically and sectorally. By 2H, when the US economy is expected to regain composure, EUR/USD should sell off, while USD/AXJ could fall further, as risk capital accelerates toward Asia. The ‘de facto dollar zone’ is essentially a higher-beta alliance than the EU and the rest of the world, in my opinion. Structural considerations for the dollar There are four key structural considerations that I believe will distort the cyclical story for the dollar, and make it less ‘clean’ of a ‘dollar story’ for the currency markets. I list them in alphabetical order. • Structural consideration 1. Carry trades. Cash yield differentials will likely remain important, though not dominant. As I acknowledged in my year-end piece, in retrospect, I did not respect the power of ‘carry trades’ (short JPY, short CHF) as much as I should have. Nominal cash yield differentials will likely remain an important factor for exchange rates through currency hedging and as a result of enhanced central bank transparency. Low volatility will accentuate the effects of nominal cash yield differentials. I stress that this is not the dominant factor, but an important factor to consider. • Structural consideration 2. Diversification. Despite comments from some central banks, there is still no sign of wholesale diversification by central banks, based on the IMF’s COFER. Having said this, I make the following points. First, while, according to the COFER data, neither the developing nor developed countries, as groups, have diversified, due to the fact that developing countries have, in the aggregate, a lower USD exposure than developed countries, and that the reserve holdings of the former have grown much faster than that of the latter, the world’s dollar exposure has declined steadily. In other words, even with no diversifying (reducing their USD holdings) by any country, the world’s dollar exposure could still continue to drift lower. The pace of the decline in the world’s reserve holdings in dollars in the last two years has been around 1% a year, with about two-thirds benefiting the EUR. Second, investors need to broaden their frame of mind in thinking about currency diversification: this is no longer a dollar-versus-euros proposition. From a longer-term perspective, diversification will be two-dimensional (across currencies and across assets) and will involve substitution between the G3 currencies (USD, EUR and GBP) and the non-G3 currencies. Not only have the ‘sovereign wealth funds’ already gone that way, increasingly, the ‘excess’ official reserves will also be managed in the same way, in my view. In 2007, we are likely to see the beginning of this process. • Structural consideration 3. ‘Global Funneling’. The rally in EUR/JPY has become one of the most powerful and out-of-consensus trends of the last two years. I proposed the ‘Global Funnelling’ idea to explain this trend, whereby financial globalization has tilted capital flows in favor of countries that offer developed financial markets. The fall in oil prices earlier this year lowered the C/A surpluses of the oil-exporting countries but boosted those of the Asian countries, leading to a muted net impact on total excess savings from these countries. ‘Global Funnelling’ will likely continue to exert an upward push on EUR/JPY and prevent it from collapsing. • Structural consideration 4. Protectionism. As the US slows, with a Democratic Congress, I fear that the risk of protectionism has risen significantly. I believe there is a high probability that the 110th Congress will resort to protectionist measures against both China and Japan in 2007. This is one of the biggest risks to the dollar, in my view. To pre-empt this process, I suspect that Beijing will continue to guide USD/CNY lower, which in turn should drag all of USD/AXJ lower. How these structural factors may matter for currencies First, as I mentioned above, these structural factors will distort the cyclical story for the dollar. Second, unless protectionism becomes an acute issue, JPY could stay on the weak side, particularly against EUR and GBP. In fact, JPY is most sensitive to the interplay between these four structural factors, and therefore could be particularly volatile this year. Bottom line Against a benign global economic backdrop, the dollar is likely to continue to be primarily driven by cyclical factors this year. The USD should be most vulnerable in 1H, but should reassert itself in 2H, at least against the EUR. The key structural considerations are not valuation or the US C/A deficit, but (i) carry trades, (ii) diversification, (iii) Global Funneling and (iv) protectionism.
Important Disclosure Information at the end of this Forum
Winter Wonderland
January 05, 2007
By Elga Bartsch | London
We believe that the performance of the labour market will be key in gauging the sustainability of the cyclical recovery in Germany, Europe’s largest economy, in the face of a number of negative factors weighing on GDP growth this year (see Putting the Recovery to the Test, December 15, 2006). We do not doubt the sustainability of the recovery over the medium term and forecast GDP growth to re-accelerate over the course of this year. But we believe that a considerable tightening of fiscal policy equivalent to 0.75% of GDP (most notably a three percentage point VAT hike that became effective on January 1) will create a sizeable speed-bump on the road to recovery. As a result, the next few months are likely to show a short-lived soft patch in German GDP growth, we think. But in order for the soft patch to remain short-lived, consumers and, even more so, companies will need to look through the dip and remain in reasonably good spirits. Only if we were to see companies noticeably scaling back their investment plans or their hiring intentions in response to that soft patch would we become concerned about the sustainability of the recovery into 2008. Currently, we are forecasting GDP growth to pick up to 2.4% in 2008, making our GDP growth estimate of 1.5% for this year a classic mid-cycle dip. In recent months, the labour market data reported by the Federal Labour Agency have clearly been considerably stronger than expected, showing a sharp plunge in December unemployment and a robust rise in November employment. Yet, we need to bear in mind that the unemployment data are biased to the downside due to a number of special factors. These factors include unusually warm winter weather, an earlier cut-off date for the sample and the introduction of a new scheme to prevent seasonal lay-offs in the construction industry, which allows idle construction workers to collect short-shift subsidies instead of registering for unemployment benefits. Some of these factors could be reversed as early as January, so watch that barometer! Others will likely prove more lasting. While the unemployment numbers are likely to be biased downwards substantially, the employment ones aren’t. And recent employment trends have been very robust indeed. Total payrolls expanded by a decent 45K on the month in November, which translates to an annualised rate of expansion of 1.4%. Payrolls now stand 1.1% above the level recorded a year ago. In addition, well-paid jobs subject to social security contributions rose 1.5% compared to last year during October, the latest available data point. We take the fact that growth in this kind of job is now outpacing total payrolls, which had been bloated in the past few years by mini-jobs and government-sponsored one-euro jobs, as very good news. This view is further underpinned by our employment indicator, which aggregates hiring intentions across the main sectors of the German economy and which has climbed to a new historical high since the start of the series in June 1997. This upbeat assessment of the labour market outlook is shared by German consumers, who have become considerably less concerned about a potential rise in unemployment. The fly in the ointment though is that a large number of these new well-paid jobs created thus far are temporary jobs. The rise in employment at temp agencies is typically a good leading indicator for the labour market. The same can be said to some extent for private sector vacancies, public hiring announcements, job openings posted to web-based recruitment platforms and, possibly, even the weight of the jobs sections of major newspapers. By and large, all of these have been encouraging. In addition, the operational environment for temp agencies in Germany has been liberalised in recent years. While their share in overall employment, at less than 2%, is still relatively small, it has started to grind higher as result of the strong employment growth of around 7% recorded in the sector. Even though reliable statistics on temp agency employment are only available up to the end of 2005, some rough and ready calculations suggest that up to 80% of the jobs created last year are temporary in nature. It should become clear in the coming months, as German companies navigate the soft patch in the current upswing and as they enter another round of wage negotiations with the trade unions, whether or not they will become more inclined to make hires on a permanent basis too. If they are, German labour market performance will likely remain robust in 2007 and unemployment will likely fall further. But if overly generous pay rises were agreed upon in some of the key sectors this spring, this could very quickly put a lid on companies’ intentions to invest and to hire in Germany. Barring such a mishap the German unemployment rate, which is falling below the euro area average as we write, could eventually break below its previous cyclical trough. Such a crossover would be a testament to the gradual liberalisation of the labour market and the relentless corporate restructuring over the last decade.
Important Disclosure Information at the end of this Forum
Risks to Inflation Are Key for the 2007 UK Economic Outlook
January 05, 2007
By David Miles | London
Risks to inflation are key for the overall UK economic outlook in 2007. With a central profile of around-trend GDP growth and inflation remaining above target, but gradually declining over 2007, our central (single most likely) scenario is that interest rates remain on hold throughout 2007. However, with inflation risks on the upside of our forecasts and, in our view, the Bank of England’s central projection, we think that the risks to this profile for interest rates are skewed more in the direction of further rate rises rather than further cuts. This is particularly the case in the first half of 2007, when inflationary risks related to wage growth will likely be at their highest. Central inflation projection: 2007 and 2008 On our central forecast, we see year-on-year inflation rising in early 2007 before gradually declining back towards 2.0% (the Bank of England’s target). We believe it is likely that GDP growth runs slightly below potential in 2007 and that current upward pressure on inflation from factors such as electricity and gas bills fall out of the year-on-year comparison (For a more detailed discussion of our inflation outlook, see Inflation Outlook: Upside Risks to Forecasts, M Baker & V Pillonca, December 14, 2006.) At the beginning of 2007, it looks likely that year-on-year CPI inflation will be very close to 3.0% and RPI inflation a bit above 4%, partly as year-on-year petrol price comparisons become positive (to some extent reflecting the rise in fuel duty) and with RPI additionally boosted by the direct effect of the Bank of England rate rise on the mortgage interest payment component of RPI inflation. However, over 2007 and into 2008, we expect a decline in both RPI and CPI inflation, with the latter very close to the Bank of England’s 2.0% target in 2008. This is the result of several specific components whose contribution to year-on-year inflation should become less positive (or more negative) for overall inflation. These components include utility bills, apparel and food (the latter two partly as retailers respond to a consumer which struggles to pick up much pace in 2007). In addition, recent data show that year-on-year consumer goods import price inflation (ex-cars) became negative in October 2006 (after a recent peak of 3.1% in April 2006), possibly reflecting the steady rise in trade-weighted sterling over the past year. Unless we see a sharp unwind in this sterling move in 2007 (which while not our best guess, is plausible, in our view), it seems likely that this lower import inflation will feed through into lower CPI inflation. Upside risks to the central inflation projection On balance, we see the risks to our central inflation projection as skewed to the upside: Spare capacity small. We think there is little to no spare capacity in the UK economy. Current estimates of spare capacity are subject to greater-than-usual uncertainty because of the uncertain size of migration and uncertainty over the responsiveness of migration to hiring pressures, as has been emphasized by the Bank of England. Nonetheless, our models indicate that there is slack amounting to less than a quarter of a percent of potential GDP. Such a small level of slack may leave UK inflation vulnerable to demand shocks. Wage increases may become more inflationary. So far, wage growth has been very benign, but a number of factors are coinciding at an important time for wage negotiations (the turn of the year). These give us some cause for believing that wage growth risks are on the upside across a range of sectors and jobs. First, RPI inflation (more important in wage negotiations than CPI) is likely to rise above 4.0% year on year by the beginning of 2007; second, the minimum wage rose 5.9% in October 2006; third, discretionary income (the amount of money households have left after paying taxes and energy bills and after debt repayments) has been squeezed, which may persuade some to push hard for higher wages; fourth, profit growth has been relatively strong in the UK this year. Interest rates: on hold with upside risks Our central (single most likely) scenario is that interest rates remain on hold throughout 2007. With inflation risks still on the upside, we think that the risks to this profile for rates are skewed more in the direction of further rate rises rather than further cuts. Bond yields, however, end the year at levels that seem to imply little chance of interest rate increases of all but the most minor and temporary sort. Given that situation, we believe that gilts will move lower (yields move higher) over the course of 2007 — a process that started at the end of last year but which we think has some way still to go this year. Equity prices seem to reflect risks more fairly and stock market valuations seem more robust to the impact of a pick-up in inflation and interest rates.
Important Disclosure Information at the end of this Forum
Taking Our Hat off to the MoF
January 05, 2007
By Takehiro Sato | Tokyo
JGB issuance is slashed in the budget proposal for F3/08 The government’s draft budget for F3/08 has taken shape. There were some concerns that in the latest round of drafting the Abe administration would be unable to withstand pressure from conservatives to spend ahead of the Upper House elections, and that the era of pork-barrel budgets might return. In fact, the broad framework had already been decided in June’s so-called ‘large-boned’ policy outline for the next five years with a view to creating a primary balance surplus, and the stance of fiscal discipline has not been relaxed under the new government. The final stages of budget negotiations were uneventful. The eye-catcher in this budget is that with the prospect of a large increase in tax revenues, JGB issuance is being cut back almost commensurately to ¥25 trillion, underlining the policy of putting Japan on a sounder fiscal footing. The JGB plan features an increase in issuance of 30-year and inflation-linked bonds and a sharp reduction in 15-year and short-term issues, and balances the MoF’s need to lengthen the duration of its issuance with the needs of investors. According to the MoF, the average time to maturity of its market issuance will be 7.0 years, two months longer than in F3/07. The blueprint for JGB issuance plans suggests that the value of issuance in the market will continue to fall sharply in the three years from F3/08 through F3/2010, as a result of declines in issuance values for new financing bonds as well as refinancing bonds, and raises the possibility that the financial authorities will formulate issuance plans with a fair degree of latitude. We expect long-term interest rates to remain stable and low due to tight supply/demand, although monetary policy is gradually tightened. Path to reducing government debt exposure This is not to say that we are unreservedly optimistic about the future, however. According to the MoF, the value of refinancing bond issuance (¥99.8 trillion on F3/08 budget draft base) is likely to start rising again from F3/2011 and should reach the ¥110 trillion level in 2015. This means that, before then, the administration will face the tasks of not only securing a stable surplus in the primary balance by reining in expenditure and increasing tax revenue, but also as a medium-term requirement extending beyond that point, ensuring that the surplus in the primary balance is large enough to reduce the weighting of government debt. While assessments of how large a surplus in the primary balance will be needed to stem the high levels of government debt exposure depend on assumptions for long-term interest rates and nominal GDP growth, our calculation based on how the economy has been managed in the past five years suggests that the requisite percentage of nominal GDP is about 2% – in other words, a primary balance surplus of ¥10 trillion or thereabouts. Given the greying of society, we think that it would be hard to raise such a sum from spending cuts alone, and that we may need to accept that the consumption tax rate could rise into double-digits in the long run. Meanwhile, we forecast that the ruling parties will have a tough time in next summer’s Upper House elections and that the next general election is likely to be delayed until the last opportunity in summer 2009. Under that scenario, the feared rise in consumption tax could be pushed back to F3/2011-12. The possibility of such a tax hike has not receded, however. The MoF’s policy of fiscal restraint can be seen as having been reinforced by the recent resignation of the head of the government’s Tax Commission. Be prepared for further flattening Fretting over the future of Japan’s finances can go on forever, but even with the worst levels of government debt exposure among developed nations, we expect the issuing climate to remain favorable thanks to the MoF’s very careful and precise application of debt management policy, and hence we think we can all but rule out a classic debt crisis involving damage to the government’s ability to raise funds and soaring long-term interest rates. Lending support to this scenario from the macro angle is the ongoing rise in the current account surplus (with growth in the savings surplus) backed by a notable increase in the income balance surplus. Sluggish corporate demand for funds supports this from a flow of funds perspective. Although bank lending has been trending up in YoY terms, its momentum has been dipping since the summer. When lending is steadily expanding, long-term interest rates are no longer capped by loan rates, but when lending growth is stagnant, this arbitrage is likely to kick back in. In fact, as the profit plans of banks begin to be thrown into disarray by lending shifts, a quiet return to bond investment is seemingly underway in places. Even if we see a slight rise in short-term interest rates as monetary policy normalizes, we think that tightness in bond market supply/demand should prevent long-term rates sliding fully in response to monetary tightening. While there is some risk that expectations for monetary tightening may recede if the core inflation rate reverts to a negative reading in the immediate future, leading to steepening of the yield curve in the short- and medium-term zone, in general bond investors should be prepared for flattening of the curve in the longer run. For equity investors, rates that are stable and low should be viewed not as loss of opportunity gains, but as a chance to take advantage of a rising floor for asset markets in an accommodative monetary environment.
Important Disclosure Information at the end of this Forum
PBoC Claims Control with Reserve Requirement Hike
January 05, 2007
By Denise Yam | Hong Kong
PBoC raises reserve requirement (RR) by 50bp again to 9.5%, effective January 15. As with the previous hikes, each 50bp locks up Rmb160 billion in banking system liquidity. The latest hike could be triggered by the sharp drop in interbank rates in the last couple of weeks. The 7-day interbank repo rate dipped below 1.5% today, down from 2% last week. RR not yet a binding constraint. Financial institutions’ deposits with the PBoC were Rmb3.8 trillion (Oct-06, latest data available for the central bank’s balance sheet), equivalent to 11.5% of total deposits, well above the required 9.5%. As the RR has not been a binding constraint on liquidity, the reserve/total deposit ratio has actually been drifting downwards since 2005, consistent with the reheating in loan growth. However, it seems that the PBoC is progressively raising the RR towards a binding level. Balancing of two liquidity management tools. The PBoC currently employs two main tools in managing liquidity: (1) adjusting the reserve requirement ratio, and (2) varying the size of open market operations (regular bond issues). The effective impact of the latest RR hike on liquidity depends on what the PBoC then decides to do with its bond issues. Indeed, following the last RR hike in November 2006, the overshooting of interbank rates led the PBoC to soften on bond issues, muting the impact of the liquidity tightening. (For our detailed analysis on China’s liquidity management and sterilization of balance of payments inflows, please refer to Soft Patch in 4Q but Friendly Liquidity Cushions Landing, November 17, 2006.) What to expect next week: (1) Although system-wide reserve deposits exceed the requirement, underfunded banks will need to borrow to meet the new requirement. We expect interbank interest rates to shoot up, possibly triggering a correction in the stock market. (2) However, should interest rates overshoot, the PBoC will likely ease on bond issues next week, and continue to use quantity auctions to guide interest rates back to the targeted level. For reference, the 7-day interbank repurchase rate shot up to 3.7% following the November 15 RR hike, and the PBoC downsized bond issues and switched to quantity auctions in place of pricing auctions to guide interest rates back down. Bottom line The PBoC claims control, but will unlikely be too harsh. It appears that the central bank was alarmed by the sharp decline in interbank rates of late, which again raised concerns over excess liquidity and euphoric stock market performance. Loan creation in 2006 was estimated to have exceeded Rmb3 trillion, more than 20% above the original target. The latest RR hike sends a message that macro controls are to be maintained to prevent reheating in the economy. However, learning from how the PBoC has been managing liquidity over the past few months, we believe that the surge in interbank rates will be limited by adjustments in the size and mode of PBoC bond issues.
Important Disclosure Information at the end of this Forum
November Export Growth Rebounds
January 05, 2007
By Chetan Ahya | Mumbai
November exports and imports growth at its highest in two years. Exports growth accelerated to 17.5% YoY in November, after recording a decline of 3.4% in October. Imports also rebounded to 21.4% YoY in November (versus -1.5% in October). Even on a sequential basis, both exports and imports rebounded (up 6.2% MoM and 9.4% MoM in November) after contracting 9.5% MoM and 9.9% MoM, respectively, in October. Consequently, the trade balance stood at RM8.8 billion in November (versus RM9.4 billion in October). Export momentum remained broad-based. A pick-up in export growth was observed across all major segments except crude petroleum, which continued to exhibit negative growth at -24.3% YoY in November (versus -3.2% YoY in October). Particularly exports of electrical and electronic products rebounded to 9.3% YoY, adding 4.3%-pt to the headline number (versus -5.9% YoY and -2.9%-pt in October). Exports of chemical and chemical products, palm oil and wood products also picked up sharply to 49.2%, 42.4% and 42.5% YoY in November (versus -8.2%, 21.0% and 3.2% YoY in October), respectively. In terms of market destinations, exports to all the major destinations showed robust pick-ups in November compared to the previous month. Exports to the US, EU and Japan accelerated to 14.3%, 33.4% and 18.5% YoY in November (versus -6.6%, 11.7% and -2.9% YoY in October), respectively. Imports growth recovered in November. By end-use classification, imports of capital and intermediate goods jumped to 27.1% YoY and 19.9% YoY in November following a decline of 3.8% YoY and 0.8% YoY in October. Consumer goods imports also accelerated to 42.2% YoY (versus 3.8% YoY in October).
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in this report were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley & Co. International Limited and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Dean Witter Asia Limited and/or Morgan Stanley Dean Witter Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley & Co. International Limited, Taipei Branch and/or Morgan Stanley & Co International Limited, Seoul Branch, and/or Morgan Stanley Dean Witter 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 JM Morgan Stanley Securities Private Limited and their affiliates (collectively, "Morgan Stanley").
Global Research
Conflict Management Policy
This research observes our conflict management policy, available at www.morganstanley.com/institutional/research/management_policies.html
Important Disclosures
This report 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. This report 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, reports prepared by Morgan Stanley research personnel are 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 this report change apart from when we intend to discontinue research coverage of a company. Facts and views in this report 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: This publication is distributed by Morgan Stanley & Co. International Limited, Taipei Branch; 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 Dean Witter Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
This publication is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication 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, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated and Morgan Stanley DW Inc., which accept responsibility for its contents. Morgan Stanley & Co. International Limited, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International Limited representative about the investments concerned. In Australia, this report, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act.
Trademarks and service marks herein 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. This report 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 is available on request.
|
