Europe and Macro Risks
January 25, 2007
By Eric Chaney | London
Three main themes emerged from Morgan Stanley’s annual Macrovision seminar, held in New York on January 19: liquidity, commodities and protectionism. In short, liquidity should remain abundant; commodity prices should stabilise but investors in commodity-related assets should be rewarded in the long term; and protectionism and unfriendly business policies, although likely, should not derail the globalisation mega-trend. You may call these conclusions complacent, or realistic, as you like. But I think it is worth thinking about from the opposite angle: What would happen if the Macrovision consensus was wrong, i.e., if liquidity dried up, or commodity prices tumbled, or protectionism suddenly rose? In this article, I will focus on Europe.
In short, my conclusions are: 1. A liquidity crisis could seriously hit markets where the presumption of a housing price bubble is the strongest, and would also be a serious issue for the global financial platform that London has become; 2. A drop in commodity prices would benefit European economies in general, but probably less than the US, because Europe is the main beneficiary of the recycling of petro-dollars; 3. A rising tide of protectionism would have the most serious consequences for the EU, which is both the largest exporter in the world and the least protected. What if a financial accident happened in Europe? Although most investors and market participants would concede that the world economy is awash with liquidity, it is harder to get a consensus view about what this exactly means. As Stephen Roach concluded, “macro conclusions on liquidity are likely to be more subjective than objective” (Foolproof, January 22, 2007). However, we know what a liquidity crisis is: a period during which some economic agents which, in normal times, have access to capital markets, either directly (companies, sovereign states) or indirectly (by the intermediation of banks) see this access more or less restricted. I see two very different types of circumstances that could initiate a liquidity squeeze. First, central banks could tighten monetary policy excessively, either because inflation gets out of control, or as a result of an overly optimistic judgment on the health of the real economy. Although policy mistakes should never be excluded, my subjective view is that, as far as the ECB and other European central banks are concerned, this risk is extremely low. The other case is a financial accident, itself the result of excessive investment in risky assets, because of abnormally compressed risk premia. Although the probability of such financial accident is arguably low, it is certainly more likely than a central bank ‘overkilling’. For markets as well as for policy makers, the real surprise would be a large-scale financial accident originating in Europe, not in the US, where we are now used to the collapse of large and high-profile hedge funds. Apparently, risks are concentrated in the financing of bubbling housing markets, private equity operations such as LBOs and the vertiginous rise of credit default swaps (CDS) and collateralised debt obligations (CDOs), of which a large part is traded over the counter and thus hard to locate or quantify. Rising interest rates and, in parallel, rising risks of default by private borrowers could spark a chain reaction of financial collapses. The swiftness and boldness of the policy response by monetary authorities would be the most critical parameter, were such an accident to occur. The weakness of the EU financial system is its fragmentation and, to some extent, lack of depth and transparency. Since this system has never been tested since the monetary union took place, in 1999, it might have hidden default lines. On the other hand, the very close relationship between central banks, not only within the euro area, but also with non-EMU members such as the UK or Sweden, whose central banks belong to the European System of Central banks, is a trump card. I guess that the quality of cooperation and exchange of information between the Bank of England and the ECB, given the utmost importance of London capital markets, would be critical and I would trust Messrs Trichet and King in this regard. But even if the policy response is appropriate, there might be serious casualties. London as a global financial centre where most European hedge funds and private equity firms are concentrated would be at the top of my list, followed by the markets where housing prices look the most overstretched (London being one of these markets). According to a recent OECD study, the most exposed markets in Europe are, by decreasing order of risk: Denmark, France, Sweden, Ireland, Norway and Spain (OECD Economic Outlook, December 2006). If commodity prices fell, not everybody would smile Being the second-largest net importer of commodities in the world, the EU would benefit from a large drop in commodity prices, without any doubt. Companies’ profits and consumers’ purchasing power would rise and this would result into stronger consumer spending and corporate investment. There are nevertheless some caveats. First, both nominal and real long-term interest rates would probably rise. A mix of stronger demand growth and lower inflation would probably slow the monetary normalisation process the ECB is embarking upon, but it would not reverse it, because of the still low level of real rates. Also, capital inflows from oil and other commodity exporters (Russia) would dry up, leading to a rise in real long-term interest rates. Last, lower inflation would increase real rates all along the yield curve. A second negative macro consequence would be that demand for infrastructure and capital goods, but also luxury goods, from commodity exporters such as the Middle East would tumble. Since Europe is the main provider of such goods to commodity rich countries, some sectors in European exports, particularly capital goods producers, could be hit. Protectionism: A serious risk for Europe Protectionism is a multiple-headed monster. Beyond well-documented traditional trade protectionism, such as tariffs and duties, it may take other forms, such as government-sponsored exchange rate policies, non-tariff barriers and ‘capital protectionism’ (i.e., restrictions on foreign ownership of local companies). Among all these risks, the former look the less likely while the latter is gaining popularity across the globe, including within Europe (see Not 1914, but Maybe 1930, Eric Chaney and Vincenzo Guzzo, March 3, 2006). The paradox for Europe is that it is the region that has the highest stake in keeping global trade and global capital flows as free as possible and, at the same time, is the least well equipped to respond to possible protectionist measures taken by other regions. First, the EU is by far the largest overseas exporter in the world, with a market share of 16% in 2004, versus 10% for the US and less than 7% for Japan and China. China may overtake Europe in the next five years, but we are not yet there. Second, the EU is among the least protectionist economic areas, especially vis-à-vis developing countries: a WTO study showed that, in 2002, 97% of EU imports of non-oil, non-arms goods from less-developed countries (LDCs) were duty-free, while this proportion was only 14% for the US and 63% for Japan. Last, because trade policy is a federal issue in the EU, handled by the Commission and not by national governments, the need to form a consensus makes the EU slow to take initiatives, and also slow to react to others countries’ initiatives. Practically, the EU could be the main victim of a trade war flaring up between the US and China — a concern expressed by Macrovision participants. This point, unfortunately, is largely misunderstood by many EU politicians and public opinions, in my view. In conclusion, although sharing the Macrovision consensus view, I believe that there is some complacency in the assessment of macro risks in Europe, in financial markets as well as in policy circles. It is probably time to think about buying some insurance, especially if insurance instruments, such as volatility futures, are cheap.
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Inflation and Monetary Policy in the UK
January 25, 2007
By David Miles | London
The Monetary Policy Committee (MPC) at the Bank of England was split 5-4 on the vote over a rate rise at its January meeting. Inflation had clearly been somewhat higher than the committee had expected, but with no clear signs of wage pressures having picked up it was not obvious that its previous central forecast that consumer price (CPI) inflation would move back to target later in the year should be significantly altered. This was why the decision on the rate rise was such a close one. Our central forecast is that at unchanged rates annual CPI inflation will hover fractionally above 3% for the next couple of months but drop back quite rapidly towards the 2% target by mid-summer. Retail price inflation (RPI) may rise a little further to around 4.6% in the very near term. But as energy and fuel price rises — stemming from significant oil and gas price increases in the first part of 2006 — fall out of the year-on-year comparisons, inflation on all measures is likely to fall back sharply by autumn. The drop in the annual rate of inflation is likely to be more rapid for CPI inflation than for headline RPI inflation since the RPI includes the impact of the rate rises that will have increased mortgage payments for many home owners. With a central forecast for annual CPI inflation in January at marginally above 3.0%, it becomes a knife-edge issue as to whether the figure would be rounded to 3.1% or down to 3%. Our assessment is that it is close to a 50/50 chance that the 3% limit is breached and a letter written by the Governor to the Chancellor explaining why inflation had moved more than 1% from the 2% target level. But with inflation on our central forecast likely to then drop back to target — which we suspect is also the MPC’s view — our assessment of the single most likely outcome on monetary policy is that no more rate rises will be warranted. The key risk — well flagged in the MPC minutes — is that wage settlements pick up and inflation becomes more entrenched than our central forecast. In that case, a period of rates moving above 5.25% (which we judge to be close to a neutral level) would be expected. But there are also risks that growth turns out rather significantly below trend and that inflation pressures subside even more sharply than our central forecast. So, the risks either side of our central forecast for rates now looks more symmetric than before the January rate rise. We have updated our assessment of the probability distribution of rates for June of this year in the light of the January rate rise and how that decision was reached. Our assessments of the single most likely outcome (the mode), the probability-weighted outcome (the mean) and the outcome with an equal chance that the rate is above or below it (the median) are all now close to the current rate of 5.25%. This is a reflection of a high degree of symmetry of risks around our central forecast of where rates might go over the next six months.
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Barrel by Barrel
January 25, 2007
By Serhan Cevik | London
The fall in oil prices is good news for Turkey’s import-dependent economy. After surging from US$10 a barrel in 1998 to US$78 last summer, the price of crude oil has fallen more than 30% to its lowest level in two years. The correction is a result of a confluence of factors — including warm weather in the northern hemisphere, a moderate improvement in supply conditions and a reduction in the scale of speculative investment flows. Although geopolitical tensions and other supply constraints may still threaten the delicate balance in the commodity markets, the decline in energy and other commodity prices will bring significant benefits to Turkey’s import-dependent economy, in our view. After all, the global commodity bubble is behind the terms-of-trade shock that has worsened the country’s current account deficit and inflation dynamics in the past couple of years. Therefore, a sustained downdraft in international commodity prices should ease pressures on the economy and help to reaccelerate the disinflation process in the coming months. Soaring commodity prices are the most important reason for the widening current account deficit. The average price Turkey paid for imported crude oil surged from US$16.5 a barrel in the 1990s to US$26.9 in 2003 and then to a peak of US$64 last year. As a result, energy imports — crude oil, oil products, natural gas, liquefied petroleum gas and coal — increased from US$11.6 billion in 2003 to US$21.2 billion in 2005 and US$28.2 billion last year. Put differently, the country’s energy imports snowballed from 4.8% of GDP in 2003 to 5.9% in 2005 and 7.3% last year, accounting for 60% of the deterioration in the current account deficit from 4.4% of GDP in 2003 to 8.5% in 2006. This is why we have always called for caution in analyzing nominal figures and removing distortions created by surging commodity prices. For example, had the price of oil remained at its 2003 level, Turkey’s net energy imports would have been US$7.3 billion (or 2.1% of GDP) lower in 2005 and US$13.1 billion (or 3.4% of GDP) lower in 2006. Accordingly, the current account deficit would have narrowed from 5.8% of GDP in 2004 to 5.1% last year (or 4.8% if we also take into account the rise in gold prices), instead of widening to 8.5% of GDP. The fall in oil prices should lower the current account deficit and accelerate disinflation. According to our calculations, a US$10 drop in the price of crude oil lowers Turkey’s energy imports by US$4.2 billion and the current account deficit by about US$3.6 billion on an annualized basis. In other words, if oil prices remain at an average of US$54 this year, Turkey’s current account balance would improve by around 1% of GDP. This is not a small effect, and should improve the competitiveness of Turkish firms and domestic demand growth. Furthermore, coupled with the strengthening of the lira, lower energy quotes would reaccelerate the pace of disinflation. Indeed, after increasing by 76.5% between the end of 2003 and last July, domestic fuel prices have already come down by 18.5% in the last six months. Therefore, if the correction in oil and refined product prices becomes a sustainable phenomenon, we are likely to see faster disinflation this year. In our opinion, this would allow the Central Bank of Turkey to start cutting short-term interest rates as soon as disinflation becomes visibly clear and well-entrenched. Turkeystill needs to improve energy efficiency and reduce oil dependence. Since Turkey imports more than 70% of its energy demand, it is not surprising to see net energy imports accounting for 75% of the current account deficit. Although the recent correction in the commodity markets is certainly good news, let us not ignore market volatility and forget the fact that the scarcity of fossil fuels and political fragilities in oil-producing regions will keep oil-importing countries vulnerable to price shocks and supply disruptions. This is why we have long argued that Turkey needs to reduce its excessive import dependency in energy generation and improve efficiency in distribution and consumption. Without alternative energy technologies, the country’s existing energy infrastructure would eventually fail to meet the rising energy demand and become a bottleneck for economic development. Reducing oil dependency is of course a big challenge, but it could also present new opportunities, especially in terms of (foreign) investment growth, in our view.
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Growth Still Fast but Should Not Trigger More Tightening
January 25, 2007
By Denise Yam | Hong Kong
Economy expands 10.7% YoY in 2006: GDP growth beat expectations in 2006, partly attributable to the upward revisions to figures in the first three quarters (1Q from 10.3% to 10.4%, 2Q from 11.3% to 11.5%, 3Q from 10.4% to 10.6%). Growth actually decelerated for the second straight quarter in 4Q06 to 10.4% (+10.6% in 3Q), led by a slowdown in fixed asset investment that more than offset continued strength in exports and domestic consumption. Nominal GDP reached Rmb20.94 trillion for the year, up 13.9% YoY. We estimate that China’s GDP per capita reached Rmb15,935 or US$1,998 in 2006. Fixed investment slowed: The slowdown in (urban) fixed asset investment growth to 18.6% in 4Q from 24.2% YoY in 3Q was the main driver behind the growth deceleration. Including capex in rural areas, total fixed investment in the economy also cooled, up 24% for the year, down from 27.3% in 1-3Q, and totaling Rmb11 trillion. Urban FAI in December alone rose just 13.8% YoY, far below expectations, and the slowest ever recorded since the introduction of the new dataset in 2004. This probably helped explain the softer growth in industrial production in December (+14.7%) and 4Q (+14.8%), although for the full year, industrial output growth picked up to 16.6%, from 16.4% in 2005. Consumer demand robust and resilient: Macro tightening over the past few years and the resulting gradual slowdown has not affected consumption, as policymakers have intended. Support given to the household sector, such as raising minimum wages in cities and subsidies and support to rural households, has given a boost to consumer demand. Retail sales growth accelerated to 14.6% YoY in December, and averaged 13.7% for the year, picking up from 12.9% in 2005. Although we remain wary that China’s ‘retail sales’ data incorporate part of the fixed investment story, such as the sales of construction and renovation materials and furniture, consumers are indeed spending more. There has been some genuine pick-up in the sales of non-investment-related consumer goods, such as cosmetics, jewellery and autos. CPI inflation higher than expected, but caused mainly by food: The sharp pick-up in CPI inflation to 2.8% YoY in December triggered concerns of more monetary tightening through interest rate hikes. However, we deduce from the full-year statistics that food inflation, especially in grains, picked up significantly in December. The 2006 average of 2.3% implied that food prices jumped at least 5% YoY in December, compared with 3.7% in November and 2% in the first 11 months of last year. This alone would have accounted for most of the uptick in inflation in the month. Overall consumer inflation averaged 1.5% in 2006, easing from 1.8% in 2005. Producer (+3.1% in December versus +2.8% in November) and raw materials (+5.0% versus +4.8%) prices showed stable gains. We do not think that the latest price indices data should trigger a rate hike in the immediate term. Reiterating concerns: While describing 2006 economic performance as satisfactory, with “faster growth, higher efficiency and lower inflation”, the National Bureau of Statistics reiterated concerns about the outstanding problems in the economy, which include: (1) a weak agricultural sector, (2) the imbalance between investment and consumption, (3) the external imbalance, (4) excess liquidity in the banking system, and (5) energy consumption and pollution. Liquidity management still dominates policy stance in short term: We agree that macro controls need to be maintained to prevent overheating again. With sustained availability of low-cost capital from the balance of payments surplus, China remains vulnerable to a revival in speculative and unproductive fixed investment. We estimate that the balance of payments surplus totaled around US$250 billion in 2006 (9.5% of GDP), up from US$207 billion in 2005 and US$206 billion in 2004. As investment in China is driven by liquidity rather than returns, monetary policies are more effective when they address the QUANTITY rather than the PRICE of available capital. The People’s Bank of China has indeed focused on liquidity management in the last few months, by lifting reserve requirements and issuing bonds to soak up liquidity in the interbank market. Interbank rates appear to be reacting to the latest hike in the reserve requirement and increased bond issues, with 7-day Shanghai interbank offered rate (SHIBOR) climbing above 2% since January 24, a level last seen in late December. We believe that it is vital to follow the trends in the interbank market, following the formal introduction of the SHIBOR and a more market-driven reference curve for the onshore market. In our view, the PBoC is paying increasing attention to enhancing money market mechanisms so as to effectively gauge the demand and supply of funds. We continue to expect that, in the immediate term, liquidity management through reserve requirements and bond issues should dominate the policy space. Movements in interbank rates have probably become more relevant as an indicator of policy stance than the traditional deposit/lending rates. Nevertheless, higher deposit and lending interest rates remain an ingredient of our medium-term outlook for China. We believe that rates will need to head higher towards a more neutral level consistent with the pace of economic growth, which will enhance the efficiency in capital and resource allocation over the medium term. We continue to look for hikes of an average of 54bp per year in deposit and lending rates in the next two years. We forecast 9.3% real GDP growth in 2007: We expect China’s export growth to slow in 2007, in line with softer global demand. Domestic fixed investment is also forecast to moderate further. We therefore project 9.3% real GDP growth in 2007, down from 10.7% in 2006. Consumption growth is expected to remain robust amid supportive government policies. The trade surplus, nevertheless, will likely continue to expand as Chinese producers, saddled with ample capacity, push output onto the international market. Our forecasts incorporate further expansion in the trade surplus to US$218 billion this year, from US$178 billion in 2006. The current account surplus is expected to reach 8% of GDP this year. The continued shift in China’s policy focus from growth to rebalancing, restructuring and redistribution underlies our medium-term view on the economy. Investment opportunities will likely come through sustained gains in domestic consumption in the years ahead, as opposed to exports and investment over the past few cycles.
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Further Slowdown Ahead
January 25, 2007
By Sharon Lam | Hong Kong
Today’s GDP data confirm that the Korean economy slowed, but not by as much as the headline number would suggest. Headline real GDP growth eased to the lowest level since 2Q05 at +4% YoY in 4Q06, from +4.8% in 3Q06. This also fell short of market expectations, which centered on 4.2%. However, taking into account the -0.2% margin for statistical discrepancy, the headline number was pretty much in line with expectations. Almost all categories registered slower growth, most visibly capex. Construction spending was the only element that continued to reaccelerate. Nevertheless, a slowdown trend cannot be denied as sequential growth contracted to +0.8% QoQ (seasonally adjusted) in 4Q from +1.1% in 3Q, which ticked up from +0.8% in 2Q. This dashed the hopes of investors who were starting to believe that the Korean economy might be recovering after the 3Q rebound. As we predicted, the 3Q rebound has proven to be only temporary. Full year 2006 GDP growth concluded at 5%, slightly shy of our forecast of 5.1%. We keep our 2007 forecast unchanged at 4.3%. A brief glance at the growth breakdown: Private consumption (in line): Consumption slowed along with overall growth as expected, but its contribution to GDP growth remained steady at around 40% — the same as in previous quarters since consumption began to recover after the credit card bubble. On a YoY basis, private consumption growth eased to +3.6% in 4Q from +4% in 3Q. We believe that government action will be required to revive consumption; otherwise, we should expect more deceleration in the coming months, though we continue to stress that this downturn will be mild, given the absence of over-consumption. Government consumption (in line): Government spending picked up further in 4Q, growing at its strongest level since 2002 at +6.5% YoY, compared with +5.8% in 3Q. This increase had been expected as more budget spending was pushed into 2H06 to help a slowing economy. Nevertheless, the significance of government spending is still too small to make a difference to the economy — the government continues to stick to fiscal discipline in order to maintain a strong sovereign rating. We do not expect any considerable increase in government spending even during this election year, but we believe that the government could use administrative policy to help the economy. Facility investment (disappointment): We had predicted capex growth to cool amid expectations of weakening exports and corporate profitability due to excessive currency appreciation. Meanwhile, we also thought that the capex recovery cycle, which started in late 2005, should end after one year since Korea’s capex growth is now more due to replacement than physical expansion. The slowdown in 4Q capex came in worse than expected, with growth easing to +5.8% YoY, compared with +9.9% in 3Q. As we expect to see a more noticeable weakening in exports in 1H07, we believe that capex growth will contract further in the coming months, which will eventually drive down loan demand. Construction investment (upside surprise): The construction sector has continued to bottom out since 2Q06 and the jump in 4Q was stronger than expected, climbing +2.9% YoY versus around -0.6% in 3Q and -3.9% in 2Q. The replacement of infrastructure destroyed by serious flooding during the summer may partly explain the increase in construction spending. We expect construction activities will keep improving this year as the government has pledged to increase home supply. Meanwhile, output from real estate-related activities also jumped to +4.9% YoY in 4Q, the strongest growth since 2002, but one may argue that this could be a result of the rush to make transactions before the government’s housing tax measures come into effect in 2007. Inventory decline (more than expected): The decline in inventory took away 0.9% of GDP growth in 4Q, as the clearing of backlogged orders resulting from the labor strikes in 3Q dipped into inventory. If new production was used instead of inventory, then 4Q’s GDP growth could have actually been higher. Nonetheless, we also interpret the use of inventory as an indication that manufacturers are anticipating lower demand ahead, and are thus reluctant to increase production, preferring to tap into inventory. Exports (in line): Export of goods in volume terms was weaker in 4Q, slowing to +11% from +13.4% in 3Q. If not for the delayed shipments that pushed into 4Q after the labor strikes in 3Q, export growth could have been weaker in the last quarter. We expect to see greater loss in export momentum in 1H07 as demand from both the US and China cool, while Korea’s export competitiveness suffers from the export price in US$ terms, which is needed to help offset the sharp currency appreciation. Bottom line We view these data as confirmation that the economy’s 3Q rebound has not continued as some had hoped, but rather it has slowed on weaker exports and capex. We expect more export-led deceleration in 1H07, with a bottom likely in 2Q07. On the other hand, we believe that construction activities will keep picking up moderately, which could help consumption via the creation of jobs. Steady housing prices are also essential to help revive consumer sentiment in 2007, in our view. We believe that house prices are unlikely to crash in 2007 as housing supply should jump more significantly starting in 2008. Meanwhile, we believe that the central bank will keep the interest rate untouched in 1H07 in order to create a balance between a slowing economy and rising property prices. We still see chances of more rate hikes should the economy start to recover in 2H07 as we predict, because the current interest rate, which is barely at a neutral level, is still too low to combat any property market bubble. While we do not see any significant risk to the economy (no noticeable asset bubble, no credit bubble and no consumption bubble), we also think that the Korean economy is lacking growth catalysts due to structural challenges. As a result, although we believe that momentum will pick up in 2H07, we do not expect to see any sharp rebound. However, upside risks still exist if the government relaxes housing policy or encourages more consumption.
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