United States
Does Volatility in Housing Data Mark a Turning Point?
March 23, 2007

By Richard Bener | New York

Housing data have turned extremely volatile in the past few months, with monthly changes in both sales and starts swinging far more sharply than the norm.  For example, housing starts rebounded by 9% in February following a 14.3% January plunge.  And absolute monthly changes (that is, without regard to sign) in single-family starts and home sales have averaged over 9% since October, or about two-thirds higher than the norm of the past four decades.  The relative instability in these data obscures both the level and underlying trend, making judgments about direction problematic.  Could it also signal a turning point in housing activity, or does it merely represent noise in the data and crosscurrents in an ongoing downturn?

I raise the question because high-frequency economic statistics sometimes become more volatile at economic turning points, and such volatility thus may be an indication that a turning point is at hand.  For example, the average absolute monthly change in durable goods orders is 35% higher in recessions than in expansions, and some other indicators show a similar pattern.  But I don’t think that housing activity is yet at a turning point.  As I see it, the volatility in housing starts and sales partly reflects the influence of abnormal swings in the weather.  It may also indicate that the intensity of the housing downturn is ebbing as builders realign production with demand.  But fundamentals — including the mismatch between supply and demand and even modest incipient curbs on demand from tighter lending standards — suggest that the housing recession is far from over.

That’s why I think February’s sharp rebound in housing starts is more noise than signal.  Abnormally warm and benign weather in November and December skewed housing data higher, prompting many, including the Fed, to talk about tentative signs of stability in housing.  A return to seasonable winter weather or even storms and brutal cold in some regions unmasked the ongoing decline in housing demand that has taken new home sales down by 31.5% from their peak in July 2005, and sales of existing homes down by 10.4%. Weather dislocations probably distorted readings on housing starts lower in January and in some parts of the country in February.  For example, Northeastern 1-family starts bounced 16% in January, only to tumble by 26% in February as winter really kicked in.  Conversely, February’s 37.4% leap in Western one-family starts followed a weather-induced 28.6% January plunge.  A clean read on housing activity thus may not be available until spring. 

Apart from the weather distortions, it’s difficult to assess whether February’s starts data in isolation are good or bad news for housing.  That’s because builders erect roughly 30% of starts for custom-built homes on an owner’s lot; and of the remaining 70%, some houses are presold, and some are built “on spec” — without a confirmed buyer.  A pickup in starts that represented custom-built or presold homes would be good news, indicating that demand was improving.  Conversely, a pickup in “spec” housing would simply add to the inventory of unsold new homes already on the market, lengthening the housing downturn and pressuring home prices lower.

It’s certainly possible that both new and existing home sales could decline by another 5-10%, given the fundamentals underpinning demand.  That’s true even though indicators of housing affordability and housing traffic have rebounded, mortgage applications have stabilized, and the subprime meltdown will not likely prove anywhere near as dire for housing as many reports seem to suggest.  Moreover, starts have even further to go: Assuming new one-family home sales decline by about 10% from January’s levels and then begin a slow recovery, I calculate that single-family housing starts may have to decline as much as 22% from February’s levels to eliminate the overhang of unsold new homes in inventory relative to the future lower level of demand. 

Market participants decided a long time ago that a shaky housing market was the economy’s Achilles’ heel, that it would trump lingering inflation concerns, and that the Fed would ease monetary policy to head off an economic downturn.  I think that a shaky housing market may continue to fuel fears of a broader economic downturn until one of three things occurs: 1) The spring selling season demonstrates that housing is stabilizing; 2) Rebounds in capex and consumer outlays are strong enough to promote confidence in the two-tier economy; or 3) Energy prices reverse course, adding to discretionary spending power.  None is likely in the immediate future. 

Now that the Fed has effectively shifted to a neutral policy stance, however, market participants will be especially sensitive to any signs that could tip the Fed towards an early easing.  For example, tighter lending standards in the wake of the subprime meltdown will crimp mortgage lending activity and housing somewhat.  Weak housing data likely would continue to fuel additional hopes for Fed ease, an eventual recovery, and a steeper yield curve. 

Uncertainty about the outlook has increased, and uncertainty is the enemy of growth, so some hesitation is possible.  And higher energy quotes could sap consumer wherewithal.  But sentiment on growth, apparently including at the Fed, has turned sufficiently negative so that positive growth surprises would be more important for markets than economic weakness.  And in the context of a neutral Fed stance, such surprises together with any upside on inflation readings would promote an especially strong reaction..

 

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Currencies
Another Bout of Generalized Dollar Weakness in 2Q
March 23, 2007

By Stephen Jen | London

Summary and conclusions

We believe that (i) as the US drifts deeper into the temporary soft patch and the RoW de-couples from the US, and (ii) risk-taking gradually recovers, the dollar will likely remain on its back foot — this is the ‘Dollar Smile’ idea.  In our view, the dollar is vulnerable to broad-based but modest weakening against most currencies in 2Q, except against the JPY and the CHF.  

Specifically, we attach a one-third probability that EUR/USD will set an all-time high (i.e., trading to the high 1.30s) in 2Q if sentiment regarding the two economies continues to diverge.  (This is the first time ever that I have considered these figures for EUR/USD.)   Cable, AUD and NZD should strengthen on the back of more upside surprises on inflation in these Anglo-Saxon countries, powered by die-hard housing markets.  However, the JPY should weaken, or at least significantly under-perform other non-dollar currencies in 2Q, due to continued capital outflows and rebuilding of JPY shorts outside Japan.  A JPY rally story is only likely later this year, in my opinion. 

In addition to our view that the US will remain in a soft patch but the RoW will continue to de-couple from the US, the assumption we make on risk-taking is also important.  Our central case assumptions are firstly that general risk appetite will continue to recover gradually — mainly because of the very positive global economic fundamentals and the still ample global liquidity and, secondly, that the struggles in the US credit markets will not spread to infect the entire world.  More rigorous risk-rebuilding could translate into greater downward pressures on the USD in 2Q.  On the other hand, if we are wrong in our assumption that investor risk-aversion will intensify sharply, then the dollar will struggle to sell off and will not rally too much. 

Having said this, we believe that the dollar will eventually reassert itself in 2H, which is when the Fed and we expect the US economy to recover.  Our basic themes over the next two years remain unchanged, that both EUR/USD and USD/JPY should gradually drift lower by end-2008.  But right now, the near-term risks are increasingly skewed in precisely the opposite direction.   

Against our previous forecasts of 1.28 and 1.24 for EUR/USD for end-June and end-year, we now expect EUR/USD to trade to 1.35 and 1.28 at these two dates.  For 2008, we maintain our medium-term view that EUR/USD should continue to drift lower.  For USD/JPY, compared to the previous forecasts of 117 and 112 for end-June and end-year, we now expect to see 120 and 114.  We see USD/JPY at 108 by end-2008. 

Changing forecast environment 

I think it is important to highlight that the way we think about our currency forecasts has changed in recent months.  During 2001-2006, the 12-18-month forecasts were key in anchoring the main themes that would drive the exchange rates in the short run.  Further, most of the themes were centered on the dollar.  Our belief was that if we got the dollar call right, we would get much of the exchange rates right, and short-term wiggles in exchange rates would be overwhelmed by the structural trends.  In retrospect, that was indeed the correct strategy. 

However, the global environment has changed.  By the middle of 2006, the G7 dollar index had reverted to the center of its structural fair value, according to our FV framework.  It has stayed fairly valued since then.   Further, investors were no longer fixated on the US C/A sustainability question, as they became more mindful of alternative explanations for global imbalances.  This meant that the structural dollar story no longer dominated currency trading, and idiosyncratic and country-specific factors mattered more.  This is also why, for the first time in six years, we have in our forecasts the dollar outperforming some currencies and underperforming others.  Cyclical factors and investor sentiment matter more now; short-term innovations in macro data now have a much bigger influence on longer-term forecasts, rather than the other way around, primarily because of our proximity to possible turning points in the business cycles of the global economy and individual economies. 

This is why we find ourselves making revisions to our 12-month forecasts more frequently than we used to.  The latest round of risk-reduction, changing investor sentiment, Euroland’s resilience and the rest of the world’s cyclical performance are all arguably bigger sources of uncertainty for currencies now than previously, at least relative to the structural factors dictating the trend in the dollar. 

Two key themes in the new forecasts

Here are the key thoughts behind our forecast changes.

  • Theme 1.  The US will stay in the trough of the ‘Dollar Smile’ for much of 1H.  After a head-fake with a preliminary estimate of 4Q GDP growth of 3.5%, it is now clear that the US economy is well into its soft patch.  Headline GDP growth figures in the US were 2.6%, 2.0% and 2.2% respectively in the final three quarters of 2006, and growth is on track to expand by only 1.9% in 1Q this year.  What is remarkable is the weakness in capex in recent months — something that many, including ourselves, had counted on as a ‘cylinder’ in the engine of growth for the US.  Adding to this relatively weak trajectory is the possible elevation in the cost of credit in the US, as credit standards are raised by lenders and investors turning more cautious with their deployment of risk capital.  While I personally don’t subscribe to the view that this process will eventually bring down the ‘house of cards’ in the US, I do think that the sheer size of the credit market and ‘what we know we don’t know’ about this market will likely keep the level of angst among investors high regarding the US. 

Even if the Fed had not altered its bias because of the stagflationary bent in recent data, the dollar would not necessarily have been that supported, in my opinion.  As the impact of the meltdown of the US sub-prime mortgage market propagates through the system, the net impact on the US economy will be negative, although the severity of this negative shock is debatable. 

Although the US will likely remain in a benign and necessary soft patch in 1H, the RoW should be able to de-couple from the US.  I confess that I have struggled to find analytical proof of my claim, that the RoW will be much more resilient to a US soft landing than in the past.  However, the US has been growing at sub-potential pace for four consecutive quarters, and yet the RoW continues to gain strength.  I see this as a proof of my inkling.  The burden of proof, in my opinion, rests on those who argue that the RoW will eventually crumble, with a lag from the US business cycle. 

Crowded EUR/USD long positions may restrain EUR/USD somewhat, but we believe that the risk to EUR/USD is still biased to the upside in 2Q.  Growth in Euroland remains resilient, and the latest German retail data suggest that VAT has had a minimal contractionary impact on Germany.  We are thus raising our end-June EUR/USD target to 1.35, and attach a one-third probability to EUR/USD setting a new all-time high some time in 2Q.  Similarly, cable should surge higher, if we are right in our view on the dollar’s vulnerability in 2Q. 

• Theme 2.  Risk-rebuilding, rather than risk-retrenchment.  I believe that risk-taking has already begun to recover, and this trend is genuine and stable.  Some commentators may have been too bearish and risk-averse, and the risk is for risky assets to continue to rally as investors’ risk-taking is rebuilt.  As I argued in my recent pieces,  I believe that the global economic fundamentals are not just good, they have continued to improve as the world has become much more balanced geographically and sectorally; in theory, this should reduce risk and enhance risk-taking.  At the same time, I believe in the real sources (low global investment rate) of liquidity.  It is highly uncertain whether the meltdown in the US sub-prime market will really lead to a meaningful reduction in ‘endogenous money’ in the world, thereby curtailing risk-taking.  Oil exporters and Asia will still generate US$800 billion of current account surplus every year, in my view.  This liquidity matters. 

Professional investors had, until last night, been overly cautious, in my opinion.  In the question of the week we ran last Thursday in the FX Pulse on risk-rebuilding, only 11% of the respondents thought that risk-taking would recover. 

To me, risk-rebuilding implies that investors will deploy more capital to expressing their bearish USD view, against not just the majors but also the emerging market currencies. 

Bottom line

We believe that the dollar will be vulnerable in 2Q against most currencies, except against the JPY.  (i) The US being deep in its soft patch and the RoW being able to de-couple from the US and (ii) a gradual recovery in risk-taking appetite should lead to a weaker dollar in 2Q.  When the US economy reasserts itself in 2H, so will the dollar.

 

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Currencies
Proposing an ‘Asset Shortage Hypothesis’
March 23, 2007

By Stephen Jen | London

Summary and conclusions

The world is suffering from a shortage of financial assets.  We believe that this is one of the key factors behind the elevated financial asset prices.  In this note, we take a first look at this hypothesis of ours.   We find that the world’s supply of sovereign bonds and equities has indeed been low.  Adding this hypothesis to the ‘excess savings’ argument provides possible justification for elevated asset prices. 

Our idea      

The motivation behind the formulation of our hypothesis was our colleague Gray Newman’s observation a year ago that the supply of Brazil’s sovereign bonds was dwindling, reflecting the positive fiscal performance of Brazil in recent years.   Gray argued that this was a main reason behind the narrowing in the interest rate spread between Brazil and the US.  We found this observation intriguing and speculated on whether this ‘problem’ might be much more broad-based. 

With the exception of 2001, the global economy has been in a strong phase for the past one-and-a-half decades.  For the developed financial markets, 2000 was the last ‘blemish’, and for emerging markets, the last ‘blemish’ occurred in 1997/98 (the Asian Currency Crisis and the Russia default).  The combination of solid real economic fundamentals and extraordinarily buoyant asset prices has puzzled investors and commentators.  Some have taken a positive view, which we also support (e.g., excess savings, financial globalization and the ‘Great Moderation’), while others have taken a dim perspective (e.g., the Fed as ‘irresponsible serial bubble-blowers’, central banks’ inflation target being too narrow and Asia’s mercantilist currency policies distorting the global liquidity conditions). 

For years we have consistently been in the former camp, embracing and generating ideas and frameworks that support the ‘New Paradigm’ and focusing on important structural changes that the global economy has experienced in the past years.  In this piece, we propose a further ‘benign’ justification for the bloated asset prices in the world.  Here are our thoughts:

1.         Robust global growth has substantially improved fiscal positions worldwide.  Fiscal positions are sensitive to trend economic growth.  Since 1996, global growth has averaged 4.1%.  Compounded over 12 years, this translates into a 60% expansion in real global GDP in this cycle.  For comparison, the average global growth rate over the two decades ending in 1995 was only 3.0%.  Economic prosperity, all else equal, should be positive for fiscal positions, particularly if the acceleration in growth comes as a ‘surprise’.  New debt issuance should decline and the stock of debt outstanding should stabilize if not decline.  

2.         ‘Great Moderation’ has also obviated the need for governments to resort to aggressive pump-priming.  Not only has the average growth rate been higher in the past decade than in the previous decades, but the variability in growth has also declined — this is the ‘Great Moderation’ notion.  With lower variability in growth, there has also been less of a need to resort to fiscal ‘pump-priming’ to jump-start aggregate demand.  With the exception of Japan, few countries in the world have had to do this in the recent past.  Even in the case of Japan, the government fiscal deficit peaked at 8.3% of GDP in 1999 and stayed above 8.0% until 2002, and has been declining ever since (it should drift under 5% this year).  Like point 1 above, in theory, this general trend should also help restrain the need for large issuance of sovereign debt. 

3.         Possible reasons for low equity issuance.  There are several reasons to suspect that, in recent years, companies may not have been enthusiastic issuers of new shares in the market.  First, until recently, valuation has been considered too low.  In fact, this has been one of the key reasons why companies have been buying back their shares, and why private equity has been so active recently.  This low perceived equity valuation may in turn have been due to the tardiness in the recovery in investor confidence since the tech meltdown in 2000: even though equity indices have staged a most impressive rally since then, investors have been more cautious than bullish on equities throughout this rally.  Second, the abundant supply of global liquidity and the positive corporate profit positions may have obviated the need for companies to issue new shares for financing.  In any case, there are reasons to justify the ‘de-equitization’ process we have observed anecdotally. 

The ‘global excess savings’ or ‘inadequate real investment’ thesis would then be accentuated, if it is combined with this notion that the world’s supply of financial assets has also been restrained.  Too much demand and not enough supply of financial assets can only mean one thing. 

A first look for some evidence supporting our idea

We looked for some validation for this thesis that the world’s supply of financial assets may not have kept pace with the global economy or the global financial markets.  

The world’s total outstanding sovereign debt, as a percentage of GDP, has stagnated at around 70-75% of GDP since 1997.  Further, if Japan is removed from the data, global sovereign debt outstanding has actually declined sharply in the past decade, falling by around 6% of GDP during this time.  If we consider that the financial markets have grown disproportionately with respect to nominal GDP, we can conclude that ‘there is not enough sovereign debt’ in the world to satisfy demand.  The extraordinarily low global yields are thus due to not only excess demand for sovereign bonds (the ‘excess savings’ argument) but also inadequate supply of sovereign bonds (our argument).  The two notions are, of course, not mutually exclusive. 

Let’s now look at what has happened to the supply of equities in the world. Since 1996, the nominal value of the net equity issuance in the world has risen by 52%, about the same as the increase in the real GDP of these economies, but less than the rise in the nominal GDP (94% over the 11-year period).  Deflated by the world’s M1, the real value of the net new equity issuance declined by 34% in the past 11 years. 

Implications and thoughts

There are several key implications from this ‘Asset Shortage’ hypothesis.  (1) Asset supply and demand may justify sustained misalignments in asset valuation relative to the economic fundamentals.  One of the factors driving the bond market conundrum could be just as important for equities as well.  (2) The right policy response, in our view, is not to hike interest rates to burst the bubble, but rather to help manage such massive systemic risk.  (3) Evolving demographics may have powerful effects on this structural imbalance between supply and demand.  ‘Aging’ may push up excess savings in the world, but when a population is aged, the supply of sovereign debt could escalate.  (4) Geographic differences in asset supply could also be very important.  With the US as the largest supplier of sovereign and risky assets, it should not be a surprise that much of the world’s excess savings are still channeled there. 

Bottom line

We propose an ‘Asset Shortage’ hypothesis, suggesting that the world is suffering from a shortage of financial assets.  The world’s supplies of sovereign bonds and net equity issuance have indeed been very low in recent years.  This may help explain the elevated global financial prices. 

 

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CHF
Low Expectations
March 23, 2007

By Luca Bindelli | London

Summary

We think there is room for further CHF weakness in the coming months. We make the following points:

1.         The recent inflation developments will create more problems than previously anticipated for the SNB to justify and communicate further normalization.

2.         We still think the actual resilience and strength in the Swiss economy will likely require higher rates, but in the long term. For now, the speed of the CHF depreciation will not give ammunition to the SNB for further hikes.

3.         The ECB is more hawkish than expected, raising strong doubts on any eventual narrowing in the interest rate differentials. In addition, risk taking should resume, thereby creating additional hurdles for the CHF to strengthen.

4.         USD/CHF may hold in a range for a while, but will likely increase in 2H.

The SNB will find it difficult to motivate further hikes

Last week, the SNB raised its main rate by 25bp. This was largely expected. However, Swiss inflation has been surprisingly low since the beginning of the year. The recent energy price drop, but also the lack of pass-through from the exchange rate, have affected overall CPI inflation more than previously anticipated. The last two inflation prints have indeed been well below the June and September 2006 SNB forecasts. According to the SNB’s own inflation forecast, the March projected inflation path is now ‘S-shaped’. After correcting for the short-term ultra-low inflation projection, inflation should accelerate temporarily toward the end of this year. The SNB believes that this acceleration should be the result of the recent CHF weakness. However, this effect will not be long-lasting as the inflation projection starts to flatten out as soon as early 2008. This is mainly due to the impact of previous tightening.  If we assume that inflation continues to grow at the 2009 trend, the 2% target would be reached by late 2010.

By several metrics, be it the long-term average of the interest rates or the ‘rule of thumb’ normal interest rate (potential growth rate plus inflation rate target), Swiss monetary policy is still accommodative.  However, the problem is more to justify further rate hikes within the SNB’s inflation-targeting framework. While, we acknowledge that the SNB will likely raise rates in June by 25bp, it will do so more to ‘buy insurance’ against any upward surprise. Afterwards, the SNB will likely stop there for a while, especially as the June inflation forecasts should show a further disinflationary impact from previous tightening. To us, the market is too richly priced for the September and December meetings.

The CHF depreciation is not rapid enough to cause concerns

The Swiss economy is strong and may even grow stronger in the long term as the labor supply shock (full liberalization for EU nationals) is set to increase the potential Swiss growth.  However, because of the current gradual slowdown, inflation pressures stemming from economic capacity are bound to remain limited. Later on, when the labor market’s structural shift fully impacts the growth pace of the Swiss economy, inflationary pressure should indeed rebuild, thereby requiring higher interest rates. However, this is more an end 2007-2008 story, we think.

But could the CHF weakness create sufficient risks in the short term to trigger a reaction from the SNB? Looking at the past episodes, we think this is unlikely to happen in the current environment. The last episode of tightening due to CHF weakness goes back to February 2000. Back then, the trade-weighted (TW) CHF depreciated sharply (and increasingly so). It decreased at a pace higher than 5% (YoY) by the end of 1999. Exports increased, and so did imported inflation (above 5%), which in turn helped inflationary pressures to build up. Accordingly, the SNB had significantly revised upward its inflation forecast with respect to its end-1999 forecast, predicting a breach of the 2% target by mid-2001. The SNB response was quick and sizable. In the most recent episode, and while exports have been growing steadily, CPI inflation barely moved. Also, the depreciation in the TW CHF is much smaller in terms of pace (though more persistent) and did not feed through to imported inflation. Another important difference lies in the Swiss labor market. Back in 2000, unemployment decreased very rapidly (from 2.4% to 1.6 % between 4Q99 and 4Q00) and wages increased steadily. In the most recent episode, we saw a smaller decrease in unemployment (3.7% in 4Q05 and 3.1% in 4Q06), mainly due to a greater liberalization of the Swiss labour market. This has helped keep wage inflation relatively subdued. With the economy expected to hover around its potential level, and with inflation expected to remain well controlled, we do not see an imminent rationale for further firming of policy.

ECB’s rhetoric to weigh on the CHF

The interest rate differential with the Euro Zone is likely to remain stable, at best, in the near future. However, with the recent hawkish rhetoric from ECB policymakers, chances are leaning toward a widening of the interest rate differential. As confirmed by the recent German growth forecast revisions, the euro area economy is proving very strong, and the ECB is likely to take further action. If we add to that a decline in risk aversion (and EUR/CHF volatility), it is difficult to imagine how the CHF would reassert itself in the near term.

The CHF could still offer a hedge against US growth uncertainty

When US growth slows, countries with low interest rates tend to see their currency appreciate, on average, as highlighted in a recent American Economic Review paper (H. Lustig & A. Verdelhan, March 2007, The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk).  Thus, US investors could hedge the increased risk of a US slowdown by buying CHF.  In the coming months, the CHF could still prove resilient against the USD, despite the interest rate differential. As the dust settles on US growth concerns, and because it would no longer provide such a hedge, the CHF could struggle again.  However, this should not apply to other CHF crosses, as we believe signs are increasingly pointing toward a decoupling of the world from the US economy.

 

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Canada
Politics in Focus
March 23, 2007

By Charles St-Arnaud | London

With Canadian economic growth and inflation both running in line with expectations, political events are taking center stage. This week and next are filled with events that are likely to attract investors’ attention: i) the release of the federal government budget on last Monday and the subsequent vote in Parliament; ii) the continued probability of a  federal election this spring; and iii) elections in the province of Québec next Monday. The removal of some of the political risks and the continued solid fiscal situation should provide further support for the Canadian dollar going forward.

2007 Federal Budget

On Monday, March 19, FM Flaherty presented the 2007 Budget. The Budget did not contain any surprises, as a lot of the measures announced were already hinted at previously. Here are the main points that may affect financial markets:

1. Fiscal balance remains. FY2006-07 will mark the tenth consecutive budgetary surplus for Canada, with a massive surplus of C$9 billion and, according to the Budget, years 11 and 12 are on their way. As a result, federal debt as a percentage of GDP should fall below 30% in FY2008-09. Canada now has the strongest fiscal position of all the G7 countries and is among the best in the OECD.

2. Increased provincial transfers. In the latest Budget, FM Flaherty announced a major overhaul of the equalization program and increased funding for post-secondary education, infrastructure initiatives, reduction of greenhouse gas emissions (EcoTrust), day care and market labor training. The total transfer to provinces is about C$10 billion over the next three years, of which 40% will go to Québec. This could be seen as a helping hand from the Conservatives to both the Liberals and the ADQ (two parties that support federalism) for provincial elections in Québec.

3. Tax cuts. The Budget also includes some measures to relieve some of the fiscal burden on individuals and corporations. For individuals, a new child tax credit for families is the major relief. On the corporate side, a special 50% depreciation allowance to manufacturers for equipment purchase before 2009 has been put in place to boost investment in the sector.

4. Debt consolidation. The Budget announced that, starting in 2008, the borrowing requirement for certain federal agencies will be consolidated into the Government of Canada requirements. The impact for the markets will be an increase in Government of Canada debt issuance of about C$10 billion in FY2007-08.

5. Economic impact. The total economic stimulus coming from new spending announced in the Budget will amount to C$7.4 billion (roughly 0.5% of GDP) in the coming year. This new fiscal stimulus to the economy will provide further support to domestic demand and reduce the probability of the Bank of Canada reducing interest rates in the near term, in our view.

Overall, the announced budget was clearly aimed at pleasing the opposition parties and getting their support when the Budget will be voted in the House. The Bloc Québecois has already said that it will back the current Budget, as for the first time the federal government has acknowledged the ‘fiscal imbalance’ situation and decided to act on it. This will assure the survival of the current minority government.

The budget was also clearly pre-electoral, with the increases in spending and transfers to provinces. The Conservatives desperately need more support from the centrists and in Québec if they want to form a majority government at the next elections.

Odds of a federal election

The budget was one of the first opportunities the opposition had to defeat PM Harper’s government and call elections. However, it seems that the Budget will be passed. As previously said, the Bloc Québecois announced that it will back it, given the large transfers attributed to Québec, as the federal government recognizes the existence of the ‘fiscal imbalance’ and has decided to implement measures to fix it.

The Conservatives will be facing another confidence vote over the next few weeks. The Clean Air Act, a bill on measures to reduce greenhouse effect gases, is likely to be defeated if presented in the current form. All three opposition parties (Bloc Québecois, Liberals and New Democratic Party) have said that they would vote against the bill if the government does not incorporate the will to respect the Kyoto objectives.

Elections in Québec

Monday, March 26 will be elections in the French-speaking province of Québec. As has been the case since the first election of the Parti Québecois in 1976, investors are always a bit nervous and worried by the prospect of the election of the pro-independence party. The latest polls show that the main three parties are neck and neck in the race, with roughly 30% of the vote each. The political system in Québec and what history tells us are likely to mean a reelection of the Liberals. However, given the very tight race, a minority government is likely. This could cause some instability in the short term. However, given the experience in Ottawa, it could also prove to be not so bad after all. The big wildcard at the moment is the performance the ADQ. So far, the ADQ never gained more than five seats (of the 125 at the Assemblé Nationale) and 20% of the popular vote. Some political commentators have started to speculate that the ADQ could become the official opposition, while the PQ would be third.

 

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Japan
Japan: Labor’s Low, Stable Share of Income: So What?
March 23, 2007

By Takehiro Sato | Tokyo

Wage increases becoming apparent at the margins

The spring wage negotiations are wrapping up. Following renewed questions during this year’s round about allocations to labor, some changes have already started to become apparent. Labor has sought to share in the benefits of the economic recovery through an increase in labor’s share of income, and some large companies have changed their stance on holding down personnel costs and made some efforts to increase starting and base salaries. Actually, hardly a day passes now without news of wage increases.

We think companies’ gradual move away from a stance of holding down personnel costs, thanks to the economic recovery, and the increases in some base salaries, and not just the offering of overtime pay and the linking of bonuses to earnings, are welcome changes. In going overboard in trying to hold down personnel costs, companies risk not only diminishing incentives and thus the quality of labor efforts, but also introducing various distortions into the economy, such as widening differentials stemming from growth in non-conventional employment. Companies’ stance of holding down personnel costs is rooted in the factor price equalization theorem, i.e., the tendency for wages worldwide to converge, on the notion of the same wage for the same work. As such, it would not make sense for only Japanese companies, especially in industries that deal with tradable goods, to raise nominal wages much more than competitors in other countries. Under current conditions, wage increases that are out of line with productivity growth could threaten not only companies’ earnings bases but also their underlying business bases.

Also labor’s share of income typically rises during economic downturns because of downward rigidity in wages. The rise is a result rather than a cause of economic downturns. But in any case, wage increases that ignore productivity are not likely to lead to favorable outcomes in the longer term because they could weaken business investment through a decline in capital’s share of income.

Trends in labor’s share of income in G3 countries

We believe that a review of some facts is in order before criticizing labor’s low share of income. First, Japan’s is not particularly low relative to other G3 countries’: 51.7% (nominal employee income divided by nominal GDP; four-quarter moving average) as of October-December, higher than Germany’s 49.6% but lower than the US’s 56.5%. The low ratio does not mean that spending is very weak in Germany. On the contrary, spending has actually held up surprisingly well following the January VAT hike. It thus becomes apparent that there are problems with directly linking the level of labor’s share of income with economic performance.

Second, for better global comparisons, we look at changes since 2000, a period characterized by wage cuts. Labor’s share of income declined more sharply in Japan than in the US, but it started to bottom in 2004 and has recently turned up some. For all the talk about wage inflation risk in the US, labor’s share of income has been fairly stable since 2006. In Germany, where wages had been structurally high, labor’s share of income has declined more sharply than in Japan and shows no signs of bottoming yet. Much the same doubts arise here, however. We intuitively think it is a bit of a stretch to directly link the trend in labor’s share of income with spending trends in the US, where the ratio has been the most stable; in Japan, where the ratio has turned moderately upward; and in Germany, where it is still declining. Spending in Japan is lagging by that much.

No direct connection between labor’s share of income and economic performance

Based on the simple observations above, we would say that an increase in labor’s share of income does not necessarily lead to an improvement in spending or economic performance. Relative to wage increases, the ratio has been more stable in the US than in Japan, which we think suggests that increases in the ratio through wage increases are insufficient and need to be complemented by some other factor for spending to be stimulated in Japan.

At the risk of falling into the circular logic trap, we think that another factor may be growth in nominal GDP, the denominator of labor’s share of income. In other words, spending growth depends on a sustained rise in nominal wages (nominal employee income) and corresponding nominal GDP growth. Nominal growth is generally weak in Japan, perhaps about to top the 1% threshold finally, and weaker than in the US, where it is above 6%, and in Germany, where it is above 3%.

We nevertheless see no need to be entirely pessimistic. Nominal growth looks likely to top real growth in F3/08, 2.7% versus 2.4%, for the first time in 13 years. Moreover, nominal growth could be stronger mainly because of how strong consumer spending may turn out for January-March, and may even reach 3% due to a favorable base effect. Real and nominal growth could reverse through a rebound in the domestic demand deflator and a normalization of the growth in the import deflator.

We should note here that the deflator is a proxy for prices and also for incomes. An improvement in the deflator is an improvement in nominal income per unit output, and if labor’s share of income is stable, nominal employee income should rise by the increase in nominal income times a set ratio (labor’s share of income), and nominal spending should increase in proportion with nominal income, assuming a constant savings rate. In other words, spending rises in proportion with nominal growth, assuming that labor’s share of income stays constant. The drivers of economic growth, according to economic textbooks, are increases in total factor productivity together with the amounts of labor and capital inputs. At a more intuitive level, we think the driving forces are incentives to maintain and improve living standards and appropriate inflation expectations. These two are absent among Japanese consumers today, however, resulting in a vicious cycle of weak spending.

Social security reforms could bolster spending

Not all hope is lost, however. People instinctively want to maintain and improve their living standards, and inflation expectations naturally rise as an economy gradually pulls out of deflation. In fact, the official land prices survey, which was just published on March 22, offered a fresh surprise in sharper-than-expected price growth in the central Tokyo metropolitan area. We think an important factor in terms of the former is the outlook for the social security system. Policies that bolster confidence in the system would lead to an improvement in spending, in our view. If the government commits to using increases in tax revenue from a consumption tax hike to finance social security and the system gains credibility, then we do not think that a consumption tax hike will necessarily hurt spending. 

 

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