Power Shift
January 08, 2007
By Stephen S. Roach | New York
Do not underestimate the significance of the political shift that has just taken place in the US Congress. Not only have the Democrats taken back control of both houses of the US legislature for the first time since 1993, but this is also the first instance in over half a century when they have recaptured both the Senate and the House of Representatives simultaneously. The potential impacts on the economy and financial markets should not be minimized.
This shift in political power is occurring at a unique juncture in the US economic cycle. The profits share of national income currently stands at a 50-year high of 12.4% (see accompanying figure). At the same time, the portion going to labor compensation is just 56.3% -- the lowest a newly elected Congress has faced since 1965. In other words, the Democrats are assuming power at a point in time when the returns to capital are at historical highs and the rewards to labor are at more than 40-year lows. This underscores the most profound economic implication of all: Just as the pendulum of political power has swung to the left in the United States, I think there is a very good chance that the pendulum of economic power could swing from capital back to labor in the years ahead. Don’t look to the modern history of the American political cycle in attempting to discern the outcome. The shift in congressional control that has just occurred -- with the Democrats retaking the leadership of both houses of Congress simultaneously -- last occurred back in 1955. In the 25 years that followed, the Democrats maintained control of both the House and the Senate. It wasn’t until the election of 1980 -- Ronald Reagan’s first term -- when the Senate went Republican for the first time since 1953. And it wasn’t until the election of 1994 -- a stunning mid-term defeat for Bill Clinton -- when the House of Representatives went Republican for the first time since 1953. Long the resident party in power insofar as Congressional control was concerned, it has been fully 54 years since the Democrats did what they did last November. By simultaneously seizing control of both houses of the US legislature -- albeit with the narrowest of possible margins in the Senate -- modern-day Democrats find themselves essentially in uncharted waters. That’s not to say politics haven’t mattered in shaping recent economic cycles in the US. In looking at the past 40 years, the tug-of-war between capital and labor does appear to have been influenced by the party affiliation of the President. Three of the most recent upsurges in the labor share of US national income occurred in Democratic Administrations: LBJ’s Great Society Program was key in pushing up the labor share in the late 1960s and early 1970s. Similarly, there was a significant increase in the compensation share of national income in the final years of the Carter Administration in the late 1970s. And the last time there was a meaningful gain in the labor share was in the late 1990s during the second Clinton term -- albeit in that case, the increase stopped well short of that which occurred in the Johnson and Carter Administrations. In this context, a White House that remains in Republican control appears to argue against a shift from capital to labor. But it should be pointed out that in none of those earlier instances of Democratic leadership was the ascendancy of labor instantaneous -- typically there were lags of around 2-3 years. Moreover, at no point in those earlier political cycles had the pendulum swung as far in a pro-capital direction as is the case at present. In the end, it may well be that a weakened Bush presidency is in no position to stand in the way of forceful pro-labor initiatives from the new Democratically-controlled Congress. We’ll know soon enough. Confirmation of a pro-labor shift should be evident in the early months of 2007. Look for the new Congress to push ahead on several fronts: The first hike in the minimum wage in 10 years is a “done deal” -- a two-year 40% increase from the current $5.15 per hour to $7.25. Imminent tax hikes on the oil industry are also on the radar screen, as is focus on the excesses of executive compensation. Moreover, an intensification of protectionist pressures is a distinct possibility, as the newly elected Congress views America’s gaping trade deficit as a threat to the job and income security of middle-class workers. Despite Republican control of the White House, most of these initiatives could well be veto-proof in the current political climate. And, most likely, they are just a down-payment on what is likely to be a multi-year pro-labor agenda of newly empowered Democrats. Of all these possible developments, the one that worries me the most is the mounting risks of protectionism -- especially the scapegoating of China. Over the past couple of years, the so-called Schumer-Graham approach -- a proposed 27.5% tariff on all Chinese goods sold in the US -- has been the lightning rod in US-Sino trade tensions. At the request of newly-appointed US Treasury Secretary Hank Paulson, the two senators withdrew their bill last fall; they were mindful that the draconian tariff proposal could not only deal a lethal blow to global trade but that it was probably not even WTO compliant. Yet far from having given up, both Schumer and Graham appear more determined than ever to craft a different measure -- this time, joining forces with Senators Baucus and Grassley, the two leading members of the Senate Finance Committee. Look for a new and important bipartisan proposal on trade coming jointly from these four senators in the first half of 2007. The intensification of anti-China sentiment in the Congress was fueled by three major developments in the aftermath of last November’s election -- a disappointing outcome of the mid-December US-Sino strategic dialogue in Beijing, inflammatory and mis-directed statements by Fed Chairman Ben Bernanke (see my 18 December dispatch, “Who’s Subsidizing Whom?”), and the latest foreign exchange report of the US Treasury, which disappointed congressional hard-liners by once again failing to charge China with currency manipulation. Collectively, these developments seem to have instilled a newly-elected Congress with an even greater sense of determination to get tough on China. An equally significant development on the protectionist front is that political leadership in the anti-China campaign could swing from the Senate to the House. In fact, it is hard to identify a free-trade advocate in the House who is in a position to derail this increasingly fast-moving train. I have personally presented the counter case to the China blaming to so many politicians, I have lost count. As a saving-short nation, America is biased toward chronically large deficits -- I remain convinced that our large bilateral imbalance with China is an outgrowth of a serious and worrisome saving deficiency. A Congress that closes down trade with China -- or materially alters the terms on which this cross-border commerce is occurring -- runs the real risk of simply transferring the China piece of a gaping multilateral US trade deficit to another trading partner, imposing the functional equivalent of a tax hike on American consumers. This is a lose-lose response to Congress’s growing frustrations with the win-win rubric of the globalization debate. Logical or not, the point is that no one in the US Congress is listening to the other side of the debate. That could well put Washington in the increasingly dangerous position of veering ever closer to the slippery slope of protectionism. A move by China -- especially on the all-important intellectual property rights issue -- could go a long a way in defusing this tension. But my latest discussions in Beijing do little to encourage me that anything is in the offing on this side of the debate either. Courtesy of this sea change in the US political landscape, important changes are likely in the US economy and financial markets. The stock market could be adversely affected by the negative earnings implications of a shift from a pro-capital to a pro-labor political climate. The bond market could be hurt by perceived risks to inflation brought about by new pressures on labor costs in conjunction with the potential inflationary fall-out of mounting protectionist risks. The US dollar could be hit by China’s diminished appetite for dollar-denominated assets -- a painfully logical response to Congressional intensification of China blaming. Nothing is forever. The political and economic climate has been amazingly hospitable for financial markets for a long time. But with this climate have come tensions and consequences that have sparked a powerful response from America’s body politic. Therein lies the change agent: As is always the case when the pendulum of political power swings too far to one end of the spectrum, it is now starting to swing back the other way. That puts the US Congress on a very different path than has been the case in a long time. And it also suggests that the pendulum of economic power could well be starting to swing from capital back to labor. Courtesy of this power shift, it’s as if the movie of the past six years is about to run in reverse.
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Is the ‘Growth Recession’ Ending?
January 08, 2007
By Richard Berner | New York
| 2006E | 2007E | 2008E | Real GDP | 3.3% | 2.6% | 3.0% | Inflation (CPI) | 3.2 | 1.4 | 1.9 | Unit Labor Costs | 3.3 | 3.2 | 2.7 | After-Tax “Economic” Profits | 21.7 | 3.4 | 7.1 | After-Tax “Book” Profits | 18.9 | 1.7 | 4.4 |
Source: Morgan Stanley Research E = Morgan Stanley Research Estimates Incoming data suggest a stronger pace of economic activity than we thought likely a month ago, prompting us to raise somewhat our sights on near-term growth after cutting estimates sharply last month. In December, we expected real growth in the last quarter of 2006 and the current one to run at annual rates of just 1.6% and 2.3%. We now estimate a somewhat-stronger 2.5% rate for both periods. To set it in perspective, that is still a much weaker pace than we had thought likely back in November, but the tone of the data flow seems significantly to reduce the sense of vulnerability to shocks prevalent at the beginning of December. The key questions now: Does this improvement signal the end of the ‘growth recession’ that seemed so deeply entrenched a month ago? And what are the implications for financial markets? While the data are stronger, we think their details reinforce key themes in our outlook for a ‘two-tier’ economy. And we believe that they still net to a period of below-trend growth — the definition of a growth recession — lasting until midyear. On the weaker side of the ledger, the housing recession isn’t over, and home prices are decelerating; capital spending remains a question mark; and profit margins seem finally to be flattening. Conversely, strong income and job growth still seem likely to support at least a moderate pace of consumer outlays; we also expect that hearty overseas growth — even if it is slowing — will buoy net exports. And recent aggressive cuts in production to trim inventories in housing-related and automotive-related areas of manufacturing probably mean that the downside risks from these headwinds are fading (see “Will the Inventory Cycle Prolong Sluggish Growth?” Global Economic Forum, January 5, 2006). Sorting through these crosscurrents is even more complicated now because just as the weakness of the October/November data may have understated the economy’s strength, the unseasonably warm weather in several parts of the country in December and January may now overstate it. But if the downside risks to growth abate, the focus for the Fed and financial markets may return to inflation. And in our judgment, cyclical inflation risks linger despite the recent cooling in inflation and declines in energy prices. That means the Fed will stay on hold for an extended period, and longer-term yields may grind higher for now. Growth recessions sometimes have a nasty way of turning into the real thing, as real or financial shocks hit a vulnerable economy, and pessimists have emphasized that today’s risks in that regard mainly arise from the ongoing housing downturn. Further weakness in housing demand and activity, the spillover effects on employment, manufacturing, and on housing-related spending from these declines, and the contraction in household wealth from declining home prices and its potential to trigger consumer retrenchment represent a triple threat to the broader economy. Judging by the recent spate of housing data, however, it appears that the housing recession might be nearing a bottom. Home sales have stabilized, inventories of unsold homes are declining, employment in construction and related industries hasn’t collapsed, consumer spending continues to grow, and nationwide home prices appropriately measured haven’t declined. In our view, however, the housing recession isn’t over, for three reasons. First, despite the recent stability in demand, further declines in home sales may occur. There’s scant pent-up demand for housing, and buyers can afford to wait for sellers and builders to offer concessions on unsold inventory. 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. Cancellations mean that official sales data overstate demand, although concerns about cancellations and unsold inventory are overblown (see “False Dawn for Housing Demand?” Global Economic Forum, December 8, 2006). Second, even when demand really stabilizes, single-family housing activity must decline further to realign supply and demand, and that process will take more time. And third, unseasonably warm weather may be distorting recent readings on both housing demand and activity. Nonetheless, 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. Weakness in capital spending also seems likely to extend the period of subpar growth into the first half of 2007. While we believe that Corporate America’s capital spending discipline following the excesses of the bubble years has been a key reason for the subdued pace of business investment over this recovery and expansion, there’s no mistaking the distinct, cyclical downshift in capex growth — especially in equipment and software — over the past three quarters. We estimate that such spending rose at just a 2.6% annual pace over the last nine months of 2006, compared with a 9.5% annual rate over the previous two years. Ironically, perhaps, most of the slowing has occurred in low-tech equipment, especially in transportation equipment. To be sure, some of the deceleration may represent a “payback” for the boost to spending from the “bonus depreciation” feature of the tax law that only expired for vehicles and other long-lived assets in January 2006, so the pace over last year was artificially depressed. But some also likely reflects uncertainty about the outlook, as uncertainty is often the enemy of growth. Near-term prospects aren’t buoyant, given the fact that core capital goods orders have declined at an 8.6% annual rate over the past three months. But because we think that capex discipline has created pent-up demand for capital goods, we think the pace will quicken in 2007. Two other supports for growth seem more certain. First, strong real income and job growth still seem likely to support at least a moderate pace of consumer spending. Most encouraging for income, despite the evident slowing in the pace of economic activity, employment gains are holding up and firm labor markets seem to be boosting pay gains. Certainly, job growth by past standards is anything but spectacular, averaging just 136,000 (a 1.2% annual rate) over the past three months. But considering the two-tiered economy — the drag from housing and manufacturing recessions together cost 43,000 jobs in each of those months — employment gains have so far outpaced expectations. What’s more, slight increases in the workweek have boosted private labor inputs (hours worked) at a much faster 2.7% annual rate over the past three months. Together with firming pay gains — average hourly earnings jumped at a 4.6% annual rate in the past three months and 4.2% from a year ago — and lower energy costs, those increases have boosted real wage and salary gains sustainably above 4%. It’s worth noting that the household canvass of employment gains, while less reliable than the broader payroll survey, continues to signal significantly faster monthly job growth — by an average 128,000 over the past three months and 82,000 over the past year after adjusting for conceptual differences between the two surveys. Upward revisions to the payroll data, to be released next month, may narrow the gap. Such brisk job growth has failed to lower the unemployment rate below 4.5% because labor force participation — long stagnant in this expansion — has risen steadily over the past two years to a 3½ year high in December. It likely took tighter labor markets and faster wage growth to induce people to return to the job market. Corroboration of labor-market tightness, moreover, isn’t hard to find: In October, the private job openings rate reached a 5-year high, and the median duration of unemployment plunged in December to a 5-year low. We also expect that hearty overseas growth — even if it is slowing — will buoy net exports. Growth in domestic demand abroad is still stronger than in the United States. Results from our major trading partners hint that domestic demand abroad has eclipsed the US pace for the first time since the 2001 recession. For example, in Canada and Mexico, real final domestic demand rose by 4.2% and 6.1%, respectively, over the past year, the former nearly twice the US pace. Such a growth gap is essential, given that real US exports must grow twice as fast as imports meaningfully to improve net exports. If concerns about growth abate, what about inflation? We still believe that inflation will move lower in 2007. A steady and slightly restrictive monetary policy and a year of subpar growth should bring core inflation measured by the Fed’s preferred gauge — the personal consumption price index (PCEPI) — down towards 2% over 2007. But the path to a sustained decline in inflation may be bumpy, because some of the same cyclical forces that raised inflation in 2006 are still in play and likely will lift core inflation over the next few months back to a 2½% rate in terms of the core PCEPI. First, inflation expectations linger at somewhat elevated levels. Longer-term inflation expectations calculated by the University of Michigan’s consumer canvass have declined from their summer peaks but remained at 3% in late December. True, distant-forward (5-year, 5-year) inflation compensation has moved down by 25 basis points from summer levels, but it has stopped declining. Second, operating rates seem likely to rebound as the automotive- and construction-induced manufacturing recession winds down and as stronger growth in exports and capital spending help lift economic activity. Factory operating rates have dipped by about ¾ percentage point over the past three months as production contracted. Despite the dip, manufacturing capacity utilization is still about ¾ point above its long-term average, and non-manufacturing purchasing managers reported in December that operating rates have stabilized after declining over the past year. In addition, non-automotive consumer import prices have reaccelerated to a 1.1% rate in December; typically, such increases are partly “passed through” to domestic prices with a six-month lag. The acceleration in unit labor costs is also a minor negative. We estimate that the combination of strong pay gains and anemic productivity lifted such unit costs to a 3½% rate over the past year, and a further acceleration seems likely through midyear. Finally, quirks in seasonal adjustment may have exaggerated the recent improvement in core inflation, and some of those likely will reverse in coming months (see “Inflation Uncertainty,” and “CPI: A Shocking Development,” Global Economic Forum, December 15, 2006 and December 18, 2006, respectively). Lingering inflation risks and renewed economic resilience likely will keep the Federal Reserve on hold for most of 2007. In contrast, market participants still hope for an easier monetary policy sooner, although recently stronger data have dashed hopes for easing in the next few months. For now, we think 10-year yields will edge towards the upper end of a 4½-5% range and the yield curve will re-steepen before receding with inflation late in 2007. Supporting that move, we think that liquidity will dwindle, and term premiums and volatility will rise slightly in coming months (see “Critical Macro Investment Themes for 2007,” Global Economic Forum, January 3, 2007). The downside risks to US economic activity involving housing, a fading consumer, and capital spending haven’t been completely neutralized by the recent run of stronger data. Indeed, unseasonably warm weather in much of the United States recently may be adding a gloss to economic indicators and masking a weaker economic reality. However, that reality is mixed: Warm weather may have boosted construction activity and employment in December, and is currently depressing energy prices to the benefit of consumers. But it likely also depressed energy consumption; the number of heating degree days in December fell 14% below the average of the past decade. Moreover, there are new threats to growth. Mortgage credit quality, at least among sub-prime lenders, is deteriorating. While that’s hardly a surprise, a consequent tightening of lending standards could reduce the ample credit availability that has helped support housing. And an incipient flattening of profit margins means that corporate cash flow is poised to decelerate. At the same time, upside risks should not be overlooked: As the housing and automotive recessions wind down, ‘two-tier’ may morph into trend growth or more. For markets that have thrived on low volatility, these crosscurrents may begin to reverse that trend.
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Review and Preview
January 08, 2007
By Ted Wieseman | New York
For a fourth straight month, the Treasury market was clobbered by a stronger-than-expected employment report, turning what had been a very strong start to the new year into more moderate net gains for the week as a whole even after the market managed a significant recovery off the initial post-employment report plunge through the day Friday as dip buyers stepped in. Prior to the employment report, key economic data had been a bit mixed but mostly good, with solid results from the two ISM surveys and upside in auto and chain store sales results that pointed to another strong retail sales report in December, but some softness in the details of the factory orders report that led us initially to trim our 4Q GDP forecast to +2.4% from +2.7%. But pessimism about the employment report appeared to dominate market focus and build through the week, with significant support from a very weak ADP employment survey (whose credibility with investors has likely been dashed for the foreseeable future), leaving benchmark yields 12-15bp lower on the week just ahead of Friday’s employment report release. However, yet again, the employment report came in much better than expected, with strength in payrolls earnings, and the unemployment rate, along with some strength in government jobs that led us to boost our 4Q GDP estimate back up a tenth to +2.5%. Any lingering hopes for a near-term rate cut by the Fed — which had been raised a bit in the pre-employment report rally — were just about completely abandoned after the employment numbers, but a somewhat more dovish medium-term Fed view into 2008 survived Friday’s correction. The main focus in the coming week will be on the December retail sales report, which appears likely to build on the upside seen in November and leave 4Q real consumption on track for a strong gain near +4%. On the week, benchmark yields declined 5-7bp, and the curve was little changed, as the 3-year, tracking a relatively strong showing by the red eurodollars, and the long bond outperformed. The 2-year yield fell 6bp to 4.75%, the 3-year 7bp to 4.67%, the 5-year 5bp to 4.64%, the 10-year 6bp to 4.65%, and the 30-year 7bp to 4.74%. A less dovish near-term, but more dovish medium-term Fed path was priced into futures markets. The April fed funds contract lost 1bp to 5.23%, the high rate since October, and all but ruled out the possibility of a rate cut by the March FOMC meeting. The May contract lost 0.5bp to 5.19%, cutting the odds of a rate cut by the May FOMC meeting to about 30%. Beyond that meeting, however, a more dovish path remained even after a partial correction Friday. The red 2008 eurodollar contracts led the upside in that market, rising 8.5-9.5bp. The Mar 07 to Mar 08 spread flattened 9bp to -52bp, with the former losing 0.5bp to 5.325% and the latter gaining 8.5bp to 4.805%, while the low rate Sep 08 contract gained 9.5bp to 4.755%. Given the plunge in energy prices — with the February crude oil and gasoline contracts both down 8% on the week — TIPS held in surprisingly well, with the benchmark 5-year and 10-year inflation breakevens only falling 2 and 3bp, respectively, to 2.21% and 2.27%. This resulted in the 5-year/5-year forward breakeven that the Fed tracks declining 4bp to 2.33%, a low since October 2005. Coming after the recent weakening trend in jobless claims and the soft results from the ADP survey, the December employment report came in much better than expected. Recalling the significant improvement in the Conference Board consumer confidence report’s assessment of current labor market conditions, consumers certainly had the right call on this one. Non-farm payrolls rose a larger-than-expected 167,000 in December and November (+154,000) and October (+86,000) were revised higher by a total of 29,000. December upside was led by widespread gains across service sectors, notably business services (+50,000), health (+38,000), restaurants (+23,000) and information (+12,000), the last of which had its best month since the dot-com bubble burst. Construction (-3,000) was down again but much less than in the prior couple of months, probably as a result of the unusually warm weather, while manufacturing (-12,000) posted a sixth straight drop, with autos again a significant contributor. Other details of the report were strong. The unemployment rate held steady at a near-cycle low 4.5%, with household survey employment surging another 303,000. Average hourly earnings jumped 0.5% for a cycle high 4.2% year-on-year gain. With aggregate hours worked up 0.2%, aggregate weekly payrolls, a proxy for wage and salary income, jumped 0.6%, pointing to another robust gain in personal income in December. This was the final employment report the Fed will see before the January 30-31 FOMC meeting. The stronger tone of the recent incoming data, which has represented a notable shift from that seen heading into the December meeting that led some FOMC members to express “a little” extra worry about downside risks, in our view reinforces the likelihood that the FOMC will retain its tightening bias at the upcoming meeting. That being said, in our view, the Fed is solidly on hold at this point, and the tightening bias is probably much more reflective of an effort to publicly reinforce the Fed’s inflation-fighting resolve and rein in still somewhat elevated inflation expectations than a true policy leaning. The two ISM surveys also provided upbeat news on December growth. The manufacturing ISM composite diffusion index rebounded to 51.4 in December from 49.5 in November, returning to growth after one month of declining activity. Solid gains in the key orders (52.1 versus 48.7) and production (51.8 versus 48.5) measures led the gain. Comments from survey respondents suggested that housing continued to be a significant drag for impacted sectors, but the recent pick-up in motor vehicle assemblies from the October trough has provided a boost to associated industries. The prices paid index fell to 47.5 from 53.5, with lower prices for copper, steel, rubber and petroleum products cited. Meanwhile, the headline business activity index in the non-manufacturing ISM survey dipped to a still elevated 57.1 in December from 58.9 in November. Other key activity measures were mixed — the orders index fell 2.7 points to a four-month low of 54.4, but the employment index gained 1.7 points to a three-month high of 53.3. The prices paid index rose to 59.1 from 55.6, sharply diverging from the manufacturing survey’s result. Various energy products and skilled labor were among the commodities reported up in price. Early signs on December consumer spending ahead of Friday’s retail sales report were encouraging. Motor vehicle sales jumped to a 16.7 million unit rate in December from 16.0 million in November, while chain store sales results were better than expected overall, as improved results at discounters and clubs offset some weather-related softness at clothing and, to a lesser extent, department stores. Combined with likely price-related upside at gas stations, we forecast a 0.8% gain in overall retail sales in December and a 0.5% rise ex-autos, which would continue to leave 4Q as a whole on track for a robust 4% rise in consumption. Several reports bearing on 4Q GDP released over the past week led us to trim our forecast slightly. First, construction spending dipped a worse-than-expected 0.2% in November, but this was offset by an upward revision to October (-0.3% versus -1.0%). In November, significant gains in private non-residential (+1.4%) and government (+1.0%) spending were offset by another big drop in residential activity (-1.6%). The October upward revision was also led by significant upward adjustments to private non-residential (+0.5% versus -0.7%) and government spending (+1.9% versus +0.8%). The net of this was no impact on our GDP estimates but swings among the components, as we marked down our residential investment forecast but marked up our estimates for business investment in structures and government spending. Second, the underlying details of the November factory orders report were weaker than expected. Non-defense capital goods ex aircraft shipments were revised down slightly in November (+2.0% versus +2.1%) and October (-1.5% versus -1.4%). The computers subcomponent of this grouping surged 52.1%, a bigger gain than we had assumed. Since computer investment in GDP is mostly based on industrial production data instead of shipments, this larger-than-expected upside in computers had a small additional negative impact on our estimate of overall investment on top of the marginal downward adjustments to overall capital goods shipments. In addition, manufacturing inventories rose a less-than-expected 0.2% in November and October was revised down a tenth to +0.3%, pointing to an even bigger inventory drag in 4Q than we previously expected. Finally, state and local government employment was stronger than we expected in December, which had a positive impact on our assessment of 4Q government spending. Taking these together, we trimmed our 4Q GDP estimate to +2.5% from +2.7%. We expect strong positive contributions from consumption (+4%), net exports (+1.0 percentage point), and government (+5%). But in keeping with the ‘two-tier’ nature of the current economy, these should be partly offset by large drags from residential investment (-21%) and inventories (-1.1 percentage points), with more than half the drag from the latter expected to be from the auto sector. Business investment (+2%) looks to have posted its smallest gain in about three years. Although the last of these is somewhat worrisome, if the economy does manage to post 2.5% growth in a quarter in which housing and autos together appear on track to subtract about a point-and-a-half, it would certainly suggest to us significant underlying resilience that we expect increasingly to show through over the course of the year as the housing and auto recessions moderate. The upcoming week has a fairly light data calendar, with main focus on Friday’s employment report. There are only a few Fed appearances, the most closely watched of which will be a speech on Monday by Vice Chairman Kohn on “The Economic Outlook”. There will be a bit of Treasury supply in the form of a new 10-year TIPS to be announced Monday and auctioned Thursday. We look for an unchanged US$9 billion size. Data releases due out include the trade balance Wednesday, Treasury budget Thursday, and retail sales Friday (which will have an early close ahead of the Martin Luther King, Jr. holiday weekend): * We look for the trade gap to widen US$2.5 billion in November to US$61.4 billion, with exports up 0.3% and imports gaining 1.6%. On the export side, we expect a modest rise in capital goods as a decent gain in high-tech products is partly offset by a dip in aircraft shipments, an uptick in autos in line with the upturn in assemblies after the October trough, but some softness in industrial materials based on the non-durable shipments results. On the import side, petroleum products should be little changed after the sharp fall last month, as both prices and volumes appear to have flattened out after plunging in October. But higher natural gas prices should lead to slight upside in overall energy imports, while a pick-up in inbound shipments through the major West Coast ports points to a decent gain in non-energy goods imports. * We estimate that the federal government ran a budget surplus of US$40 billion in December, up sharply from US$11 billion the prior year. A number of factors appear to have been responsible for the big swing. First, the government is expected to record US$13 billion of proceeds from the latest round of spectrum auctions. Second, corporate tax payments continue to surge — up an estimated US$12 billion (or +16.5%) versus last December. Third, a calendar quirk will shift some Medicare payments into January. Finally, federal government spending was temporarily elevated at this time a year ago due to the effects of the Hurricane Katrina disaster. * We forecast a 0.8% rise in overall December retail sales and 0.5% ex-autos. A gain in motor vehicle sales, along with another price-related upswing in purchases of gasoline, should lead to a solid rise in headline retail sales. However, excluding the auto dealer and gas station categories, sales are expected to be up only a 0.1%. Still, on the heels of the outsized advance seen in November, this is somewhat better than we had been building in. This reflects the better-than-expected December chain store results. Indeed, while apparel outlets appear to have experienced another weather-related sales decline, the general merchandise category appears headed for a decent December gain. And although the home electronics category is due for a payback following the near-record sales spike seen in November, the performance over the two-month interval should reflect solid underlying sales momentum. Finally, we continue to see real consumer spending running at +4.0% in 4Q — a performance that has been exceeded on only a handful of occasions over the course of the current economic expansion.
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Kicking-Off 2007 with an Inflation Dip?
January 08, 2007
By Thomas Gade
Euro-area HICP inflation could be in for an unexpected, temporary dip during the first month of 2007. Two factors are responsible for this development. First, the impact of the German VAT hike, which became effective on January 1, may be more drawn out than previously expected. Second, the sharp pullback in the volatile energy prices provides preliminary evidence of an at least temporary dip in inflation. We do not expect this to prevent the ECB from hiking rates by another 25bp during 1Q. Focusing on the short term, there are a number of immediate financial implications. First, European inflation markets may be priced for too much inflation during the first months of 2007. Second, the short end of the curve may initially rally on the dip in inflation. Third, to a lesser extent, yield spreads between the euro area and the UK and the US may temporarily widen. Euroland HICP inflation was in line with market expectations at 1.9%Y in December, according to the preliminary release from Eurostat. The preliminary estimate may still be revised in the final release, which has happened 15 times during the last two years, according to Eurostat. However, with the attention of markets now settling on the January inflation number, there might be more interesting times ahead for investors focused on inflation trends. We think that inflation may unexpectedly dip to 1.8%Y and possibly lower in January due to a combination of a delayed impact of the German VAT hike and lower oil prices. However, it is still early January and there are risks involved with this call. The jury is still out with respect to the German VAT hike, and energy prices are volatile and could rebound in the short term. The first driver, the three-point German VAT hike, became effective on January 1. Anecdotal evidence suggests that the impact of the VAT hike, i.e., the pass-through to consumers, may be more drawn out as many retailers have not raised prices yet. Even before the VAT hike, a number of large retailers have promised clients not to raise prices. This picture now seems to be confirmed by a number of German press reports. However, as profitability among German retailers tends to be low, according to the German Retailers’ Association, it seems unlikely that retailers can absorb the full VAT hike in their profits and that approximately one-third would likely be passed on to consumers. The remaining share would then be shared between retailers and suppliers. Over all consumer goods affected by the VAT increase, we still expect companies to pass on two-thirds of the VAT hike to consumers, but should the anecdotal evidence hold and the predictions of the German Retailers’ Association be echoed in other consumer goods categories, the pass-through may not only be delayed until after the January sales, but also could be less than expected overall. Penciling in this change in expectations would mean that the VAT hike would likely add one-tenth to Euroland inflation in January and two-tenths in February, possibly spilling into March. This one-tenth shift between January and February is contrary to previous expectations. The second driver, wholesale oil and gasoline prices, has pulled back sharply during the first week of January, adding to a potential dip in pump prices. During the first week of January, oil prices have dropped 13.5% from the average oil price in December and are currently trading below US$55/bbl, while wholesale gasoline prices have pulled back slightly less. Already this is gradually feeding through to pump prices in Germany. Should the current level of oil and gasoline prices prevail during January, this alone will likely shave off one-tenth of Euroland inflation. However, oil prices and energy prices in general are very volatile, and we would not rule out a rebound in oil prices during either this or the coming months. The inflation developments are not likely to prevent the ECB from hiking the refi rate by another 25bp by March, we think. However, from a macro point of view, a downward inflation surprise would still offer a number of financial market opportunities. European inflation markets may be priced for too much inflation during the first months of 2007. Further, the short end of the curve may initially rally on the dip in inflation. Finally, yield spreads between the euro area and the UK may widen should inflation surprise on the downside in the euro area and rise in the UK during the first months of 2007, as our UK colleagues expect (see UK Economics: Growth Outlook: Benign Central Case Belies Risks, January 5, 2007). As inflation in most economic regions will be affected by lower oil prices, the change in expectations on the impact of the German VAT hike should be the main driver of this movement.
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2007 Will be Another Tough Year
January 08, 2007
By Chetan Ahya | Mumbai
Summary Although headline GDP growth in Thailand remained respectable at 4.7% during the quarter ended September 2006, we believe that the underlying growth trend continues to weaken. Indeed, GDP growth before adjustment of inventories slowed to 3.2% YoY for the quarter ended September 2006. In our view, growth conditions are unlikely to improve significantly in 2007. In fact, the lagged impact of the sharp appreciation in the exchange rate over the last 12 months increases the downside risk to Thailand’s 2007 GDP growth outlook. We believe that, in 2007, Thailand will likely record the lowest growth in the SE Asian region, at 4.5%, with potential downside risk. No sign of domestic demand recovery yet Government spending is still restrained, and there is little sign of a recovery in private consumption or investment. Consumption and investment indicators, such as automobile sales, retail sales, consumer goods imports, consumption credit and capital goods imports, continue to show weakness. While the positive impact of the recent decline in oil prices has yet to be reflected in the growth numbers, we do not expect this to provide a major source of support to private consumption. Fiscal policy likely to lack vigor While the interim government has announced that it will try to revive public spending, we think that fiscal policy support will remain moderate. We expect growth in the central government’s nominal expenditure to decelerate to 10.9% YoY in 2007 from the rate of 11.6% YoY observed in 2006. Although the government might be successful in pushing consumption spending higher, public capex growth is likely to be muted in 2007. Any meaningful rise in spending on large new projects is unlikely to start before the last quarter of 2007, even if the government starts work on this area immediately. For instance, the cabinet recently approved the construction of five electric train (mass rapid transit) routes costing US$4.5 billion, but we believe that actual construction will probably begin only in early 2008, even for the first route. The government is likely to announce the terms of reference and bidding package for the first part (Bang Sue-Taling Chan) of the first route (Red Line) by March 2007. This is expected to cost about US$0.3 billion out of a total of US$1.4 billion for the Red Line, and is likely to be completed over a period of three years. The process of preparation by bidders and review of bids by the government could take several further months before the winner of project is announced. The final signing of the contract for the project is therefore likely to take place by the year-end, in our view. We believe that the actual spending is likely to start in the first quarter of 2008, with full implementation of the project commencing only in the latter part of 2008. For the other parts of the Red Line, Purple Line and Blue Line, the tendering processes will likely start only in the second half of 2007. External demand unlikely to be supportive either With the continued weak trend in domestic demand, over the last 12 months the overall GDP growth trend has been supported by relatively healthy growth in exports. However, in a scenario where global growth and trade could moderate over the next 12 months, the growth environment could become even more challenging. Moreover, we believe that export growth will also be affected on account of the sharp appreciation in the Thai baht over the last 12 months. The real effective exchange rate for the Thai baht moved close to a seven-year high in October 2006. Swift monetary policy response needed Weakening domestic demand is also corroborated by the monetary indicators. Credit growth has decelerated to more than a two-year low, at just 4.0% as of October 2006, from 9.1% recorded at the start of 2006. The G-Sec yield curve has flattened, with the spread between 10-year bond and 91-day bill yields compressing to just 14bp as of November 2006, the lowest in eight years. Weak domestic demand has helped slow core inflation (excluding energy and food) to 1.5% in December 2006 from 2.5% as of January 2006. We expect domestic demand to recover modestly with the support of slightly higher government consumption spending and lower oil prices in 2007. However, we believe that there is a need for a significant cut in policy rates in order to revive domestic demand in a meaningful manner. The recent move by the Bank of Thailand (BoT) to impose controls on capital inflows to prevent appreciation in the baht confirms its hesitation to cut interest rates aggressively. We maintain our view that rate cuts will be likely slower and smaller than are warranted by domestic demand conditions. Political uncertainty weighing on monetary policy decisions Continued political uncertainty is making it difficult for the BoT to act in a swift manner. In our view, the BoT is likely to maintain its policy rate higher than that warranted by domestic demand conditions. We believe that the BoT is maintaining a conservative stance, with its monetary policy biased in favor of macro stability. However, this stance has an attached cost in the form of lower growth. The recent bombings in Bangkok and the ongoing problems in Southern Thailand only add to concerns over political stability. Moreover, we believe that the BoT is unlikely to initiate aggressive rate cuts ahead of the first US Fed rate cut. We expect the BoT to cut its policy rate by only about 50bp by the end of 2007. This is unlikely to spark a meaningful recovery in domestic demand. Bottom line: No meaningful recovery in 2007 Until a new democratically elected, stable government is in place, we expect the government’s policy-making process to be less than optimal, resulting in GDP growth undershooting its potential. It seems unlikely to us that elections will be held before the first quarter of 2008. While the first rate cut, which we expect in 1Q07, may drive some positive sentiment, it is unlikely to provide more than short-term respite, in our view.
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