Hungary
Near-term Bump(s) in the Road
February 13, 2007

By Pasquale Diana | London

The debate over the path of Hungarian policy rates has intensified markedly over the recent period, also fuelled by central bank commentary. A near-term inflation spike due to hikes in regulated prices will likely take CPI inflation above 9%. While this is temporary, there are risks of higher headline inflation becoming entrenched into expectations, which justifies higher interest rates. At the same time, activity data have begun to soften significantly, due to the implementation of the government’s fiscal package. This will translate into a growth slowdown and an improvement in both fiscal and external balances, which should reduce Hungary’s risk premium and, together with lower inflation in the latter part of 2007, provide room for rate cuts. Our view is that the NBH will remain under pressure in the near term, as reflected by the high probability of tightening priced into the curve. However, a resilient HUF, weakening activity data and changes in the composition of the board will likely stop the NBH from tightening beyond the current level of 8%, though we acknowledge near-term risks to our view. In the second half of the year, we see rate cuts taking the base rate to 7% by year-end.

It’s all about second-round effects

Recent commentary by NBH policymakers (mostly hawks) has shown heightened concerns on inflation, prompting renewed speculation about a near-term rate hike. To be sure, the recent news on regulated price hikes has prompted an upgrade to our CPI forecast as well. Even so, we believe that inflation is set to peak at around 9.5%Y in March, and will neither reach double-digits nor peak in 2Q rather than 1Q. We acknowledge, however, that risks of second-round effects exist and will need careful monitoring. In particular, our sense is that two variables deserve careful monitoring in the coming months: wages and market services inflation.

With regard to wages, the latest data make it difficult to distinguish trend from noise. Headline wage growth accelerated markedly in August, to over 10%Y, driven by a large rise in private sector compensation. In the last release (November 2006), wage growth eased back to 6.6%Y. Note however, that the profile of year-on-year wage growth over the second half of 2006 was affected by the timing of bonus payments. In August, companies likely brought forward annual bonus payments ahead of the September hike in wage-related taxes; this was followed by a drop in the year-over-year rate in November, as these bonuses used to be paid towards year-end in previous years. For a clearer picture, we need to look at the headline ‘core’ wage growth number (ex-bonuses), and the trend seems to be upwards.

In terms of market services inflation, the NBH is likely to look at this as a measure of whether higher regulated prices are translating into higher inflation expectations and faster price pressures in core, demand-sensitive components. Looking at data up to December, market services inflation has remained well behaved thus far, ending the year at 7.2%Y, on a modest uptrend.

We think there are good reasons to expect the 1Q inflation spike to be contained and to not translate into higher inflation expectations. First, historical precedent: in 2004, administered prices rose sharply in the early part of the year and the NBH took no action, on the (correct) assumption that this would prove to be a one-off. Second, and more importantly, domestic demand has already weakened substantially in late 2006 and will continue to weaken going into 2007, due to the fiscal tightening. The latest retail sales data (November), which show the weakest growth in retail spending since 2001, set the consumer up for a very weak end to 2006. And this year, we expect wage growth to average roughly 6.4% for the economy as a whole. With headline inflation averaging 7.5%, overall employment growth likely to turn negative and a higher average tax wedge than in 2006 (due to higher PIT and social security contributions), real disposable income growth will contract by around 4.5% y/y in 2007, bearing down on final demand. With such pronounced weakness on the demand side, it is less likely that retailers will feel inclined to pass on higher costs onto consumers, but will rather take a hit on margins.

Politics about to heat up?

Thus far, we have focused on a near-term inflation spike as a potential bump in the road. Political tension could prove to be a second bump, potentially causing the markets to reassess the country’s risk outlook. The ruling Socialist Party has lost some ground in the opinion polls, and now trails the right-wing opposition Fidesz party by up to 20 percentage points in the opinion polls. While the Socialist leadership is likely prepared for such a drop, it is less clear that the rank and file of the party are willing to tolerate this slide for much longer, and might press the PM to withdraw from some of the more unpopular measures (such as the healthcare or pension reforms). In addition, public sector union action (announced for end-February) might lead the government to renege on its plan to freeze public sector wages (see above), and opposition demonstrations (likely in mid-March) will likely put the government under renewed pressures, much as they did last September.

Our central view is that PM Gyurcsany will survive through this tense period, partly because there is nobody within the Socialist party that looks willing to assume the leadership at this stage. We also note that the reported opinion polls numbers showing the gap between Fidesz and the Socialists having widened include only those voters that have made up their minds. We note that 40-50% of the electorate remains undecided and that the gap between the two main parties is much smaller (around 10%) when one looks at the whole electorate, and does not display a clear widening trend. PM Gyurcsany appears aware of the importance of sticking to his promises. After all, a return to fiscal profligacy during the year would most likely result in credit actions by the rating agencies, a sharp HUF sell-off, higher borrowing rates and higher mortgage payments for Hungarians who have borrowed in FX, all of which could hurt support for the PM even more. That said, increased political noise is likely to create market jitters in the near term.

NBH: watch the February Inflation report; composition matters

Our central scenario is that the NBH remains on hold throughout the inflation spike. This view will be tested already at the February meeting, the last one that the hawkish Governor Jarai will chair. The test will be especially severe if traditional doves such as Peter Bihari (but possibly also Csaki, Oblath or Nemenyi) decide to temporarily join the hawkish camp (Jarai, Auth, Adamecz, maybe Kadar or Kopits) due to concerns on near-term price stability. The February inflation report will provide an important input for the next rate decision. While higher regulated price hikes are likely to translate into a near-term upgrade to the CPI forecast, we note that the NBH now faces a more benign set of external assumptions. Despite the recent uptick, oil prices are still around 10% lower than assumed in November, and the currency is 5% stronger against the euro. Lower energy prices and a stronger EUR/HUF assumption will likely translate into a downward revision to the medium-term (2008) forecast, as also anticipated by NBH Chief Economist Hamecz.

Also note that from the March meeting onward, Jarai will be replaced by another governor, who is almost guaranteed to be more dovish. And in July, two more hawks (Auth and Adamecz) will leave the Council.  These changes are likely to result in a board even more dominated by doves. Assuming that the fiscal numbers show the expected improvement and that the 1Q inflation spike is reabsorbed quickly, we see aggressive rate cuts in the second half of the year, taking the base rate to 7% by end-2007.

 

Important Disclosure Information at the end of this Forum

Israel
Tech Nation
February 13, 2007

By Serhan Cevik | from New York

Israelbenefits from a strategic position in the global technology market. Jaffa oranges are still delicious, but no longer relevant to Israel’s economic performance. The structure of the economy has changed completely over the course of the past two decades. With macroeconomic stabilization and a wave of immigration bringing in an amazing stock of human capital, Israel has moved away from labour-intensive, low valued-added sectors to technology-intensive manufacturing industries and services (see Technology — Deus Ex Machina, February 12, 2001). As the share of agriculture declined to a mere 2% of GDP, high-technology goods and services have developed even beyond wildest projections and now account for about one-third of GDP and 75% of industrial exports. Furthermore, unlike the Asian IT story, Israel’s technological capabilities are not just limited to electronics but range from communication equipment and software development to advanced chemicals and biotechnology. Indeed, with R&D investment reaching 5% of GDP, Israel has acquired a strategic position in the global technology market and become one of the most competitive economies in the world.

Technology-intensive exports are the leading engine of economic growth in Israel. Israel’s technology-intensive growth model is a great achievement and will keep improving its economic prospects, but it is nevertheless not impervious to business cycles, in our view. For example, the collapse of the global IT bubble in 2001 (along with domestic security concerns at the time) lowered Israel’s high-tech exports by 21.4% and consequently total exports excluding diamonds by 12.8% in the 2001-02 period. Since then, however, technology-intensive sectors that contributed more than one-third to output contraction a few years ago have once again taken the lead in pushing the rate of economic growth beyond ‘traditional’ limits. As a result of the strengthening global investment cycle, Israel’s exports grew by 60% on a cumulative basis in the past four years, even exceeding the peak reached in the heyday of the IT boom. Although exports of high-tech goods and services are no doubt very important for growth dynamics, traditional sectors of the economy have also performed quite well in recent years, especially compared to the pre-2000 period. These medium-low and low-tech groups recorded a cumulative export increase of 52% since 2002, thanks mainly to a 23.5% drop in the real effective exchange rate. And looking forward, the latest figures suggest strong performance, albeit with risks arising from business cycles in the US and China.

A sharp slowdown in export growth is unlikely, but remains a risk for the economy. While becoming more balanced, the levers of growth remain dependent on exports with a skewed geographical distribution. The US is Israel’s largest export market, absorbing 40% of its exports. This is why the 15% drop in America’s IT spending after the burst of the bubble lowered imports from Israel by 5.5% in 2001, and then the 21.5% recovery in technology expenditures in the last four years boosted imports from Israel by 50% or US$6.8 billion. In addition to the link with the US business cycle, Israel has benefited from China’s powerful investment growth, which increased trade between the two countries by 30% to US$3.8 billion last year. All these features obviously make Israel’s technology-intensive economy vulnerable to a sharp slowdown in exports, but we do not expect a deep correction in the global investment cycle and international trade flows. The world economy has so far proven to be resilient, and Morgan Stanley’s projections point to a mild mid-cycle consolidation of growth this year. Moreover, our US economics team predicts the growth rate of real business spending on equipment to slow from 6.7% last year to 4.1% in 2007 but then speed up to 4.9% next year. Such a growth profile would imply a slowdown in Israel’s output growth from 5% in 2006 to 4.5% this year — in line with our own estimates. However, lower interest rates and the shekel’s strength have already given a boost to domestic demand. As a result, we now see real GDP growth at around 5% this year and accelerating a bit further in 2008, thanks to the necessity of technology investment in today’s global economy.

Important Disclosure Information at the end of this Forum

Japan
G7 Seems Content to Rubberstamp a Weak Yen, but…
February 13, 2007

By Takehiro Sato | Tokyo

Risks are asymmetrical: Japan’s GDP and the BoJ’s MPM

The G7 statement from last weekend’s governors and finance ministers meeting in Essen as expected made no direct reference to the yen rate, and the tone of the communiqué regarding the foreign exchange markets also repeated that of views to date. In response, the yen hit a new low against the euro in overseas market trading on February 12. Turning to the outlook, potential catalysts for a reversal of yen depreciation, as our currency strategy team is saying, are the release of Japan’s October-December GDP data on February 15 and the BoJ’s monetary policy meeting on February 20-21. Personally, however, I am sceptical as to whether the outcome of these events could kill off the carry trade

Although we are forecasting healthy 0.9% QoQ growth and annualized growth of 3.8% for October-December GDP, much of this is in reaction to the negative growth in consumption in July-September, and this degree of rebound has already been discounted by the market. Consumption in the current January-March quarter is still not as solid as we’d like, with the mild winter hitting sales of seasonal merchandise. In these circumstances, an impressive GDP figure could simply exacerbate concerns about the sustainability of future growth. Yet if the growth rate disappoints, the markets are likely to switch their focus back to the weakness of Japan’s economy. In this sense, the near-term risks from the upcoming GDP data are asymmetrical.

There is a good deal of uncertainty about the BoJ’s next monetary policy meeting (MPM), given the lack of visibility on the circumstances that led to deferral of a rate hike in January, and the markets are struggling to weigh up the risks and pick a side, but we view the possibility of a February hike as marginally greater than 50%. However, even if the BoJ does bump up rates by another quarter point and prices subsequently drop back below year-earlier levels, the outlook for monetary policy becomes opaque again. The risk is that if the price outlook is going to be the basis for the decision, the window for a rate hike may only stay open in February and March, and then close for the rest of year. So if the opportunity is by-passed in February, we would expect the policy rate to stay at 0.25% until the end of the year, and to rise no higher than 0.50% even if there is an increase. Under these conditions, any rate hike that did come could be widely seen as the last on the horizon, and any spike in the yen would also likely prove temporary. Since the carry trade essentially targets forex translation profits rather than exploitation of the gap in interest rates, it is a stretch to believe that a mere 0.25% narrowing of the spread between US and Japanese rates would arrest the yen depreciation mentality.

Reassessment of the potential strength of Japan’s economy is the catalyst for a yen turnaround

This line of reasoning implies no let-up in the yen’s depreciation. Some of our colleagues are actually hearing calls in the market for the yen to sink to ¥125 or ¥130 against the US dollar.

I personally take the contrarian position, however. It is a rule of the market that just when everyone is convinced that the yen will weaken and has buried doubts, the turning point will come. For example, when market participants have maximized their short positions in the yen and have no scope to move further, a seemingly minor item of news can spark yen repurchasing. The market will turn when confidence in yen depreciation is at its peak. This happens frequently in equity as well as forex markets.

My view is that the prospect of upside risk for Japan’s economy is more likely to be a catalyst for yen reversal than the type of events outlined above.

For example, even if the BoJ shows no signs of lifting its policy rate within this year, any sign that the growth potential of the economy is outpacing the downbeat consensus view from the start of the year could make the market nervous about yen selling. We in the Japan economics team, while acknowledging that consumption is still flabby and that beating deflation is taking time, do sense upside risk for Japanese exports in light of the pick-up in overseas economies since the end of last year. Our forecast for Japan’s real-term export growth in calendar 2007 is at half of the 2006 level, calling for deceleration from 10% to 5%, but the US economy recovered to a cruising speed of 3.5% annualized growth in the October-December quarter of 2006, and our US economics team has raised its forecast for 2007 growth from 2.4% as of end-December to 2.8%. This incorporates growth of 3.2% in US consumption, but the strong growth in recent employment and income data suggest to me that further consumption upside would not be a surprise. When the US is prospering, Asia feels the benefits, which augurs well for Japan’s exports to China. This situation makes our forecast for real Japanese export growth to be half of the 2006 level vulnerable to criticism as overly conservative.

At this point, the consensus view of Japan’s consumption is guarded, and no one is talking about upside risk. But the encouraging recent path of the global economy makes it hard to imagine that Japan would be the only area to miss out. It may not take long for the perception of upside for Japan’s exports to strengthen, and this is where I see the risk.

Based on the above, I believe that the emergence of upside risk for Japan’s economy could pave the way for a natural reversal of yen depreciation. Our currency strategy team appears to share this basic view. However, it is likely to take a while for this optimistic view to germinate, and the scale of carry trade speculation may become larger in the intervening weeks or months.

Where the risks lie

Views on the Japanese economy could become more bearish, bucking the above scenario. For example, there is the risk — as we have highlighted previously — that the prospect of a drop back into negative growth for the core CPI could reignite deflationary concerns and make overseas investors leery of Japan’s economy. That said, the case that such a drop in consumer prices would be the result simply of lower oil price, and not necessarily bad news for Japan’s economy because it would fuel improvement in the terms of trade, should also gain some acceptance. The BoJ governor has already begun to pre-empt price decline risks with this counterargument. We see the market implications of a negative turn for prices as mixed, and believe that the market’s reaction would not be uniformly negative.

However, the US Treasury Secretary remarked before the G7 meeting that yen trading is dictated by a competitive market and tacitly suggested that the current level can be deemed tolerable. This means that yen weakness may be consistent with fundamentals, but signifies that the US authorities are conscious of fragility in Japan’s economy. Lingering doubts about the economy’s health would imply no need to move rate hikes forward, and such comments are probably not what the BoJ wants to hear.

 

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.