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UK
UK: Interest Rates Raised Again
May 11, 2007

By David Miles | London

The Monetary Policy Committee (MPC) at the Bank of England voted this week to raise the repo rate by 25bp to 5.50%.  In itself, this was not a surprise, though the brief statement accompanying the announcement is revealing. In it, the bank points to recent ‘firm’ output growth and limited spare capacity in the economy as factors behind the decision to raise rates again. 

The statement also highlighted rapid broad money and credit growth, stronger-than-anticipated business investment and producer prices.  But the statement also reiterates the view that inflation is likely to fall back to the target level of 2% in the fairly near term.

The bank statement made on May 10

In the United Kingdom, output growth has remained firm. Business investment has been stronger than expected and, although indicators of consumer spending have been volatile, the underlying picture is one of steady growth. Credit and broad money continue to grow rapidly. The pace of expansion of the international economy remains robust.

CPI inflation picked up to 3.1% in March. Lower gas and electricity prices and weaker import price inflation mean that CPI inflation is likely to fall back to around the 2% target in the course of this year. But the margin of spare capacity in firms appears limited and there are signs that businesses are more able to push through price increases. Relative to the 2% target, the risks to the outlook for inflation in the medium term consequently remain tilted to the upside.

Against that background, the Committee judged that a further increase in Bank Rate of 0.25 percentage points to 5.5% was necessary to meet the 2% target for CPI inflation in the medium term.

The May Quarterly Inflation Report and the MPC minutes (published on May 16 and 23, respectively) will give a better indication of how the balance of opinion on the MPC is evolving. It will be particularly interesting to see how the bank’s forecasts of the future path of inflation have changed since the February Report. The bank’s central forecast of inflation based on market expectations of where interest rates will go (which currently imply a further 25bp on rates by the autumn) will provide the basis for policy decisions over the coming months.

Our assessment is that the risks to inflation are more symmetric than recent inflation data, and the bank’s own statement this week, would suggest. We believe that the recent interest rate rises will force consumers to tighten their belts and consequently consumer spending and GDP growth will hit a prolonged soft patch from 2H07.

If the bank is right that inflation will move back down fairly quickly from its current level over the summer — and we expect that it is — it is plausible that the MPC will be considering reversing today’s interest rate hike in 4Q07. This is a view at odds with the prevailing market view that a further 25bp hike will come by the autumn.  It is based on our assessment that the cumulative impact of four rate rises since last August, in an environment of very low household saving and virtually stagnant levels of real disposable income, will be to slow the growth in consumer spending to a crawl over the rest of this year. If that happens, the Bank of England’s assessment of likely growth, and inflationary pressures, will probably be revised down.

The MPC’s own judgement is that consumer spending growth will probably remain pretty strong. If it turns out to be right, the chances of further rate rises will be high — indeed, should spending overall in the economy grow in line with the bank’s latest published central forecast, we imagine that rates would end the year higher. But we view the evidence as making a pretty sharp slowdown in household spending more likely.

First, household debt has never been as high, relative to incomes, as it is today. A very high proportion of the new debt taken out over the past two to three years has been at a fixed rate — with rates typically remaining unchanged for 2-3 years. So, over the course of the next year, a lot of recent borrowers will find themselves facing higher regular interest payments that will reflect the four rate rises seen since last August.

Second, the saving rate of households is exceptionally low. Indeed, if we strip out contributions made by companies into company pension schemes (which are counted as household saving), we find that the savings rate is close to zero.  Starting from that position, one would expect that the savings rate is more likely to stabilise or to rise rather than to fall further. If that happens, the growth in consumption will be no greater than the rise in real disposable incomes, and they are hardly rising at all.

Third, even before we have seen much of the impact of the four rate rises over the past nine months, personal insolvencies are on a dramatically rising trend. Banks and credit card companies have recently tightened their lending criteria and, in an environment where the consensus remains that rates will go higher, there is a good chance that the availability of credit will be tightened further. 

All in all, we see the current environment as one in which spending growth will slow significantly; if house prices start to fall — something for which there are no signs at the moment, but an event surely made more likely by every 25bp rise in interest rates — that will be a further drag on demand. The silver lining to this distinctly grey picture is that further rate rises would likely be judged unnecessary by the Bank of England.



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United States
Business Conditions: Hope Springs Eternal?
May 11, 2007

By Shital Patel and Richard Berner | New York, New York

The Morgan Stanley Business Conditions Index (MSBCI) edged up one point in early May to 46%, barely continuing its slow, steady improvement from the January low.  Perhaps more telling, the three-month moving average dipped one point to 44%.  However, our survey’s two key forward-looking indicators — the advance bookings index and the business conditions expectations index — showed stunning improvement from April.  Is recovery finally on the way?

Don’t expect anything more than a shallow recovery, although the worst of the US business slowdown appears to be over.  The capital spending outlook is still a wildcard, although durable goods orders surprised to the upside in March.  The spike in gasoline prices continues to weigh on the consumer as evidenced by April’s chain store results.  Conversely, however, while there are many risks to our economic outlook, we expect the booming global economy to contribute to US output, and expect real US growth to rebound to 2.5% in the second half of this year.

The tug of war between strong global and weak domestic fundamentals still nets to sluggish gains, echoed in the details of our survey.  Still, there are hopeful signs in domestic readings.  For example, past hiring and hiring plans both posted modest improvement in May, but both stand below their historical averages.  Capex plans were stronger than in April, with 54% of the groups planning to increase capex over the next three months, well above the historical average of 47%.  Pricing conditions improved in May to a 12-month high, although input costs have squeezed margins for more groups over the last three months.  Easier financial conditions could continue to be a tailwind: Our credit conditions index increased five points to 54% in May.  Sustainability is still an open question: While the forward-looking indicators are positive, the near-manic volatility of the advance bookings index and the short history of the business conditions expectations index lead us to downplay one month’s improvement. 

Indeed, the essentially flat MSBCI stands in sharp contrast with our forward-looking indicators.  The distribution of responses in May was nearly even, with 29% of the respondents noting improved conditions, 32% noting deterioration, and the remaining two fifths unchanged.  That does represent an advance over April, when only 18% of respondents noted improvement and 25% deterioration.  Yet only two groups — life insurance and chemicals — noticeably improved in May.  And reports of ‘somewhat improved’ were confined to financials, materials, energy and utilities.  Not surprisingly, groups with deteriorating conditions included consumer staples, industrials, healthcare, and consumer discretionary.

Other popular business indicators seem a bit more upbeat.  For example, the ISM manufacturing diffusion index surprised to the upside in April, jumping 3.8 points to 54.7, with sharp gains in the orders and production components.  Nearly 60% of the industries in our MSBCI are in services, so the manufacturing ISM might better correlate with our manufacturing sub-index.  Sure enough, the MSBCI manufacturing index has been above the 50% threshold since February of this year; it edged up one point to 53% in early May.  In contrast, weakness in services persisted in May.  The services sub-index has posted sub-50% readings since March, although it bounced four points to 45% this month.

What about those forward-looking components in our survey?  Our advance bookings index for the next 1-6 months surged 31 points to 68%, the highest level since June 2006.  Looking back, the advance bookings index has been a good predictor of moves in the MSBCI, so if this jump is any indication, business conditions should be following suit shortly.  Bookings increased for the industrials, IT, consumer discretionary, telecom services, and utilities sectors.  There is corroboration in other bookings gauges: In the April ISM report, the new orders index rose 6.9 points to 58.5, while March nondefense capital goods ex aircraft orders rebounded 4.7%. 

With advance bookings soaring, it is no wonder our business conditions expectations index jumped 11 points to 60% in early May, the highest level since May 2006.  A full 44% of analysts expect business conditions to improve over the next six months.  The groups expecting improved conditions include IT, energy, utilities, consumer staples, industrials, and materials.  Conditions for the consumer discretionary, financials, healthcare, and telecom services sectors are expected to deteriorate.

Analysts’ and managers’ optimistic expectations of business conditions over the next six months may also be due to the fireworks in Q1 earnings results.  Heading into the Q1 earnings season, analysts set a very low bar, slashing their estimates for S&P operating earnings in February to just 3.8% due to negative company guidance.  The macro context at the time was dismal: US growth was weaker-than-expected (we are now tracking Q1 GDP growth at a scant 0.9%), the subprime mortgage market was blowing up, there were concerns about contagion from the housing recession into the rest of the economy, and gasoline prices were back on the rise.  On the earnings front, however, the reality has proved far stronger than those low estimates suggested— earnings growth for the 84% of companies that have reported so far was 9.4%.  Including consensus estimates for those that have not yet reported, earnings growth still registers 8.0%.  And two-thirds of companies have beaten consensus expectations.  Moreover, companies are upping the ante: As of May 10, the ratio of positive to negative guidance for Q2 has increased from 0.39 in mid-April to 0.49, and managers remained positive about growth in the 2nd half of the year. 

Thanks to brighter prospects for the next six months, capex and hiring plans edged up in May.  54% of the groups plan to increase capex from current levels over the next three months, up from 50% last month and well above the historical average of 47%.  Only 2% of groups plan to decrease capex, down from 14%.  We continue to believe that fundamentals remain positive for a moderate recovery in capital spending. 

Payroll growth was weaker than expected in April, although much of the weakness appears to have been weather and calendar-related, so we are expecting some payback in May.  According to our survey, there are hopeful signs: 37% of the groups plan to increase hiring over the next three months, up from 32% in April; while 15% plan to cut payrolls, the same as last month.  Job and income growth are critical to our outlook so we will continue to monitor this indicator closely.

Since we are in the midst of earnings season, we repeated questions we asked analysts in February.  First, we asked whether there are upside or downside risks to their earnings estimates.  63% of analysts noted there are upside risks, up from 52% in February.  Specifically this month, there are upside risks to margins for 25% of the groups while there are downside risks to domestic growth for 25%.  13% of analysts believe that growth abroad might surprise to the upside.  We also asked whether the earnings quality of companies has changed over the past year.  Results were nearly identical to February:  32% reported that the earnings quality has worsened in the past year, while 22% said that the quality is better, and 46% of analysts reported that earnings quality is the same. 

Finally, we asked analysts, if companies exceeded their estimates to the upside, what was the primary cause.  For Q1, our strategy team has noted that revenue growth came in close to expectations while operating leverage helped margin growth surprise to the upside.  Contrary to these observations, a full 51% of analysts reported higher top-line growth as the primary cause of higher earnings, while 31% reported lower costs/expenses.  13% noted other causes including stock repurchases and capital management.

On the margin front, we asked analysts whether they believe margins will expand in 2007.  56% believe margins will expand, up from 42% in February, while 20% believe margins will shrink, down from 40% in February.  Sectors with the most upside to margins are energy, healthcare, industrials, and telecom services.  However, over the last three months, prices charged have risen faster than unit costs for 24% of the companies, down from 26% in April.  Material and/or labor costs outpaced prices charged for 47% of the companies, up from 36% last month. 

Prices charged may help pick up the slack in coming months.  Our pricing conditions index increased 11 points to 67%, the highest level since last May.  The percentage of groups that raised prices from a year ago stood at 56%, up from 41% last month, while the percentage decreasing prices decreased to 22% from 30%.  As in the past, prices charged increased for all groups except IT and telecom services..



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United States
USD: Gradually Rotate into Dollar Shorts Against EM
May 11, 2007

By Stephen Jen | London

Summary and conclusions

The G10 crosses have settled in a range.  I still see risks of further dollar depreciation, relative to the EUR, GBP and AUD, and believe a weakening US labor market should keep the dollar on its back foot for some time but suspect the bulk of dollar depreciation against the majors may be over.  I think investors should consider rotating into a short-dollar position against emerging market (EM) currencies. 

The main reasons behind my call change are (i) the US economy may have troughed and (ii) risk-taking appetite remains buoyant.  This should temper USD bearishness against the liquid G10 anti-dollars but, as the US begins recovery, should further enhance the attractiveness of selected EM assets and currencies. 

My call since February

In my recent note[1], I argued there would soon be confirmation of global economic decoupling, with a US soft-landing not undermining the growth acceleration in the rest of the world.  This growth divergence would fuel negative USD sentiment and likely push the dollar into a cyclically weak phase until the US economy business cycle established a clear bottom. 

Furthermore, I argued a healthy risk-taking appetite would permit dollar weakening, since it is usually a good safe haven currency.  Global de-coupling and healthy risk-taking should permit the dollar to weaken against some currencies.[2] 

Modifications to my call

Since February, the global environment has altered, justifying a modification to my currency call. 

First, the US business cycle may have established its trough in 1Q.  Data suggest capex has begun regaining strength, while consumption has held up.  Net exports are now meaningful to US growth.  Regarding headline GDP, one could argue the dollar may have seen its low against several liquid G10 ‘anti-dollars’. 

However, one should consider variables like US employment, the housing market and consumption, which may weaken.  GDP could drift toward the potential growth rate, as growth in labor productivity retraces from 1.4% toward what the Fed and we believe is the 2.5% trend.  Similarly, consumption could weaken as capex recovers.  These trends could be as important as headline GDP.  Therefore, the possible bottoming of US headline GDP doesn’t mean the dollar is safe yet.  I believe the bulk of cyclical dollar depreciation against these ‘core’ currencies may be over.  Any US upside surprises and downside surprises to its G10 counterparts could trigger a USD rally. 

Our forecasts for EUR/USD, from February, are downward, as we see a US economic recovery as more positive for the USD than the EUR:  1.35, 1.32 and 1.28 for end-2Q, 3Q and 4Q, respectively. 

Second, if the US economy is gaining traction or establishing a bottom, the world’s risky assets should extend their bullish trends.  Here, EM currencies should perform quite well against the dollar. 

I think investors should consider gradually rotating out of USD shorts against the ‘core’ G10 currencies and building USD shorts against the emerging market currencies. 

Four pillars supporting risky assets should remain

Four pillars supporting risky assets are: 

Pillar 1.  Ample global liquidity.  This ‘real’ liquidity arises from a mismatch between world savings and investment rates.  World capex has surprisingly been too low to absorb all available savings.  Annually, there are some US$800 billion worth of ‘excess savings’ from oil exporters and Asian exporters to chase after assets. 

Pillar 2.  There is a shortage of supply of financial assets.  Global sovereign bonds outstanding, except JGBs, have declined to 59% of GDP, while the pool of investible funds has surged.  Similarly, there is a shortage of real supplies of new equities and corporate bonds.  Buybacks have meant a dwindling amount of publicly traded equities, and solid corporate profits have obviated the need for corporations to issue debt. 

Pillar 3.  Global de-coupling and positive growth prospects.  Global de-coupling has effectively reduced overall financial risk, relative to a world powered by a single growth engine.  

Whether the US is in a refreshing mid-cycle slowdown, or cycle-terminating event is critical.  This question, I believe, is more complicated than deciding on the US housing market’s fate.  I see the global economy as healthy, with 2007 as the fifth consecutive year with global growth above 4.0%. 

The first phase of the globalization growth process entails a massive increase in world useable labor force and I believe we are at the tail-end.  The second phase should entail a sharp increase in capital expenditures, infrastructure and production capacity. 

The expansion of labor and of capital should enhance the global economy’s potential growth rate.  Risky assets, theoretically, should be in a secular bull market.  Apparent financial bubbles are actually  well supported by solid global economic fundamentals.  Inevitable ‘frictions’ from the globalization process will be just minor irritants. 

From this broader perspective, discussion on global de-coupling is unhelpful.  The cyclical risks to the global economy are inflation, and the likelihood of the global economy driving the US housing market rather than the other way around. 

Pillar 4.  Sovereign wealth funds (SWFs).  SWFs will be major medium-long term support for risky assets.[3]  Currently at around US$2.5 trillion, world SWFs will be gradually deployed to seek out riskier assets; a net negative shock to long bonds in most developed markets.  The net effect on risky assets will likely be positive. 

JPY to be dictated by the ‘portfolio effect’ in Japan

It may take longer for economic fundamentals to matter, as capital outflows from Japan may keep the JPY at roughly 120 ± 2.  Rates below would trigger more outflows, with those above making foreign assets too expensive for Japanese investors. 

Bottom line

The USD’s cyclical depreciating phase may be ending.  I see further USD weakening, but the risk-reward suggests caution on EUR/USD and GBP/USD longs.  If the US economy is gaining traction, risky assets should extend their solid performance.  USD shorts against selected EM currencies interest me more than USD shorts against core G10 currencies.



1Buy USD/JPY, EUR/JPY, EUR/USD and EUR/CHF – February 22, 2007

2Five days after releasing that note, the global financial markets went into a risk-reduction mode, undermining the trends (rising USD/JPY, rising EUR/USD, rising EUR/JPY and rising EUR/CHF) I had envisaged.  However, risk-taking recovered four times faster than the recovery we saw after a similar round of risk-reduction last May/June.  In retrospect, these current trends began in February, and were temporarily interrupted by the risk-reduction in February/March. 

3Please see my previous pieces on this topic: How Big Could Sovereign Wealth Funds Be by 2015? (May 3, 2007), Russia: The Newest Member of the SWF Club (April 26, 2007), Tracking the Tectonic Shift in Foreign Reserves & SWFs (March 15, 2007) and Sovereign Wealth Funds and the Official FX Reserves (September 14, 2006).



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Japan
Holes in the Consensus
May 11, 2007

By Takehiro Sato | Tokyo

Is NAIRU in the 3% range?

The consensus is that Japan’s NAIRU (Non-Accelerating Inflation Rate of Unemployment) is around the 3% range. Many think that prices, which have fallen back into negative territory, will start to pick up this summer thanks to the tight labor market.

We disagree, however. Given the persistence of prices, it is arguable whether NAIRU is actually in this 3% or so range in the first place. Also, rents, which account for the largest part of the CPI, are stable, despite the current rally in residential land prices. We think the relationship between rents and wages may be behind this. Moreover, wages lack upward momentum due to various structural factors, even though the labor market is tight. This makes a sharp upturn unlikely. Therefore, prices may not rise all that much even if the labor market tightens further. Below, we assess the current labor market using a UV curve, and we make a qualitative estimate of Japan’s NAIRU and its implications for prices based on a simplified Phillips curve.

Labor market mismatch due to demand shortfall

The job offers to applicants ratio (a measure of marginal labor market supply-demand conditions) is declining, but it was still above 1x as of March. This indicates that marginal labor supply-demand remains tight. On the other hand, the employees’ unemployment rate is 4.6% while the job vacancy rate is 3.5%, a gap of about 1 ppt, and this suggests there is still room for improvement in the labor market. In addition, the UV curve has been shifting up and to the right since the 1990s, suggesting that the equilibrium unemployment rate has risen (that is, that there has been a rise in the structural and frictional unemployment rates due to job mismatches). Regardless, there remains a demand shortfall of about 1%, based on labor market stock measures. This and the fact that the structural and frictional unemployment rates have risen during the economic expansion since 2003 provides a hint as to implications for consumer prices, in our view. Even if the employees’ unemployment rate falls by about 1 ppt (from 4% to 3%, say in terms of the total unemployment rate), eliminating the labor market mismatch, there is no way to know whether this will mean a rise in consumer prices.

Checking the relationship here between an employment mismatch caused by supply and demand and the core CPI inflation rate, we find the former leading the latter by roughly 10 months up until 2003. Starting 2004, however, their performance diverges, and it is currently difficult for us to predict future prices based solely on employment mismatches. This phenomenon is common to all industrialized countries as a flattening in the Phillips curve through globalization. In Japan’s case, however, the latest prices have re-entered negative territory, so it has manifested itself more vigorously. Structural factors appear to explain why the traditional relationship between the labor market and prices (wages) no longer holds: 1) the rising proportion of temporary and part-time workers, 2) rising retirement of senior workers (rising proportion of younger workers), 3) low mobility of the labor market in terms of shifting human capital, and 4) stepping up of wage restructuring pressures in the public and quasi-public sector. The last three factors are particularly likely to act to depress wages domestically over the next few years.

Can we divine future prices from past Phillips curves?

One reason to generally think that Japan’s NAIRU is around the 3% range is that the slope of a simplified Phillips curve that plots total unemployment rate and the core CPI inflation rate discontinuously steepens at around an unemployment rate of 3-4%. The relationship between the two over the past 30 years shows that the slope of the approximating curve rises to the left at a total unemployment rate of 3%. Looking at the same data starting in 1994, we see (1) the core CPI inflation rate, which dropped precipitously and became negative around a total employment rate of 3% between Jan-Mar 1994 and Apr-June 1995, (2) recovered to about +0.5% YoY through Oct-Dec 1997 around a total unemployment rate of 3.5%, and then (3) remained broadly negative YoY starting 1998 as total unemployment rate rose above 4%.

Tracing these trends backwards, in the process of the total unemployment rate dropping from 4% to around 3.5%, the core CPI inflation rate looks to take off into positive territory and regain a level around 1% in the process of declining to around 3%.

Regarding the high-ish rate of inflation in the early half of the 1990s, however, an essential factor seems to have been the endurance of a Bubble-era ripple effect from asset prices to general prices even after the Bubble collapse, in the form of price persistence. Similarly, the decline in prices through mid-1995 and recovery through 1997 could not have happened without the contraction in total demand caused by the human and natural disasters of Jan-Mar 1995 (the Great Hanshin Earthquake and the religious cult terror attacks in Tokyo), the rapid surge of the yen at the time and its subsequent correction, and the start of major fiscal packages. Because of the former (the persistence of prices), the idea that price reaction will be symmetrical with the past as the future total unemployment rate falls to 3% is particularly dubious. Given the remarkable productivity gains of the past decade because of the spread of IT and the advance of globalization, it would be natural to assume that the Phillips curve has shifted left since the 1990s. In this case, NAIRU could be lower than the 3% it is generally considered to be.

Rent, the largest structural item, remains a heavy weight

From a bottom-up viewpoint, a rise in rent, the largest single item in the CPI, should be the key to whether prices rise. Rent (including imputed rent) makes up about 20% of nationwide CPI, but even as land values are recently recovering, rent continues to move in negative YoY territory. This is also true for the Tokyo metropolitan area, where land values are clearly recovering.

The consensus is that rising land values stimulate rent increases, but is this true? In the opposite case, for example, it took about seven years after residential land prices peaked in 1991 for rent increases to stop in 1998. Even before the Bubble, residential land values and rents appear almost uncorrelated. Key, in our view, is the correlation between wages and rents. In fact, they are highly correlated and even statistically the two exhibit something other than a simple superficial correlation. If rents are linked not to land values but to wages, it is downward pressure on rents that is in fact increasing, since wages most recently are increasing their downward trend. Supply and demand in the rental market can also be expected to continue softening as the number of total households decreases and the elderly make use of their land assets. So, from the bottom-up viewpoint, we continue to see downward structural pressures on prices.

Macro policy and market implications

The above leads us, as frequently noted before, to project that core CPI rate could move in negative territory throughout 2007 both top-down and bottom-up despite a tight labor market. The BoJ is working feverishly to separate the latest negative price trends from policy trends, but it cannot avoid generating some effects on future policy formation. The derivative (OIS) market puts odds of an interest rate hike at the BoJ’s September Policy Board Meeting at about 80%, but we continue to see a possibility of a hike being pushed back until the start of 2008. Certainly, the persistence of negative price movements alone may not be a persuasive argument for the BoJ holding off on raising rates. However, we not only expect the negative movement to continue after mid-year, but we think it is also fully possible that if the economy slows a touch in the summer, interest rate hike expectations could cool and the BoJ’s forward-leaning stance could abate.

The asset class most likely to outperform under these macroeconomic circumstances (though we would hesitate to proclaim it) is JGBs. The end of deflation is already a tired story in the stock market, but it will be hard for the market to have much confidence in that until concrete proof is soundly present in the CPI, GDP deflator and unit labor costs. One reason why the Japanese market has lagged behind global equity markets is that macro and industrial policies such as the monetary tightening under the disinflationary environment, the government’s guidance toward banks to discourage financing to properties, and the tightening of consumers’ credit are generally intended to burst asset inflation, although policy makers are doing so quite independently. More fundamentally, there seems to be a problem in that corporations, which consistently lowered their leverage in deflationary times and should soon be increasing their leverage to raise ROE or even corporate value to fend off hostile takeovers, are being slow to move in that direction, against initial expectations. The negative stance by corporations is evidenced in the recent sluggish growth in bank lending. We can explain this in the hysteresis of asset price deflation still having its effect in corporate decision-making.

We expect prices to languish but we feel that CPI-linkers have already priced in further declines in prices through summer, and a small buying opportunity is nearing because of the resumption of the consumption tax debate. This is because deliberation of the consumption tax is bound to be a pressing policy topic after the July upper house election, regardless of whether the LDP retains power. Although it currently appears that the consumption tax debate is receding because of the rapid improvement in the primary balance due to strong tax takes, this is merely pre-election reticence. It is naïve to think that any single-year improvement in the primary balance can avoid a consumption tax increase, given the aging of society.



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Euroland
Euroland: In Tune for June
May 11, 2007

By Elga Bartsch | London

As expected, the ECB left interest rates unchanged at 3.75% after its out-of-town meeting in Dublin this past week. No prizes for guessing what’s going to happen next. In the subsequent press conference, ECB President Trichet clearly hinted at another refi rate hike in June, stating that “strong vigilance is of the essence” in order to fend off the upside risks to price stability. Looking beyond June, the ECB president was reluctant to commit to any particular course of action. Instead, Jean-Claude Trichet repeated that the ECB would do whatever was necessary to preserve both price stability and its own credibility. Note that it is the regular modus operandi for the ECB not to comment on the interest rate outlook or market expectations beyond the next move. In our view, it would be premature to conclude from this reluctance to give guidance for the second half of this year that the Council was split about the future course of action.

 

Naturally, the decision to tighten monetary policy will become more controversial as the tightening campaign progresses and gradually moves towards restrictive territory. We expect another rate hike in the second half of this year, bringing the refi rate to 4.25% by year-end. Currently, we would view the risks to this target to be tilting to the upside rather than the downside.  This is because — so far — there are no signs of a slowdown in the euro area economy. The latest batch of business surveys again surprised on the upside, and our GDP indicator hints at upside risks to our official GDP growth forecasts for the first half of this year (see Eric Chaney’s Ignoring the Euro — at Least for Now, April 27, 2007). If these upside risks were confirmed by official GDP data — first 1Q flash estimates are released this coming week — a full-year GDP forecast of 2.5% would probably look too low. In this case, both ourselves and the ECB staff might have to nudge our estimates higher.

Apart from pre-announcing a June rate hike, the ECB only made minor changes to its introductory statement. Instead of being described as robust, the economic expansion is now seen as “solid and broad-based” by the Council. As before, the risks to the favourable growth outlook are viewed to be balanced in the near term and perceived to lie on the downside in the long term. In our view, the risks to the near-term outlook are probably slightly tilted to the upside at the moment, given the buoyant mood in the corporate sector. Our proprietary metrics are indicating above-trend growth of around 0.75%Q (a decent 3% in annualised terms). As far as the inflation outlook over the medium term is concerned, the Council continues to see upside risks and cites the rise in the capacity utilisation rate as a “new and notable” factor. We would add that companies are starting to report rising bottlenecks in the quarterly manufacturing survey. So far, the bottlenecks primarily seem to stem from a shortage of material or equipment rather than from a shortage of workers. That said, the sharp fall in the unemployment rate and the strong rise in employment suggest that labour market conditions are gradually tightening.

 

Other inflation risks in the eye of the ECB Council include — as before — higher oil prices, indirect tax hikes and wage developments. Note that the implications of the introduction of ‘social VAT’ in France at that beginning of next year are not yet factored into the forecasts. Eric Chaney reckons that such an operation could add about one percentage point to the French CPI (see French Economics: Who Will Cure the Sick Man of Europe? April 30, 2007). This would probably translate into a rise of around two-tenths of a percentage point at the euro area level. This is not yet factored into our forecasts or the ECB staff projections. As ever, the ECB is concerned about the vigorous money and credit growth against a backdrop of already ample liquidity. But it stresses special factors such as the usually flat yield curve affecting money and credit growth. The ECB seems to take comfort from the slowdown in narrow M1 money supply growth and loans to the private sector and, if anything, seems to be downplaying the recent rise in M3 money supply growth. The focus on M1 money supply growth and on loan growth is interesting because these are the only monetary variables that we found to be significant for ECB interest rate decision when we estimated our ECB Refi-meter (see EuroTower Insights: When Will the ECB Stop? October 10, 2006). Despite all our efforts, we weren’t able to find any significance for headline M3 money supply growth, even if we used to the version that is adjusted for portfolio shifts.

Another 25bp rate hike at the June 6 meeting seems to be a done deal. The May press conference gave no indication of the ECB’s policy intentions for the remainder of this year. Hence, the language at the June press conference will be key in shaping market expectations for the remainder of this year. With growth showing few signs of slowing and with capacity constraints starting to tighten, it seems to us that the ECB’s work isn’t done yet. In terms of the timing of the next move after the June move, we believe that it will probably come in October, for two reasons. First, given that the ECB’s policy stance is gradually pushing towards the upper end of the neutral range, it might want to signal that it is getting closer to a pause in its tightening cycle by moving at a slower pace than the quarter-point-per-quarter tack that it adhered to in the first half of this year. Second, there is no press conference scheduled in August. This would mean that the final go-ahead signal for an imminent rate hike would need to come either in the August Monthly Bulletin or in a widely publicised speech by the ECB President (like in November 2005, when he announced the start of the tightening cycle at a high-profile banking conference). Alternatively, the ECB Council could decide to meet in person in August (like they did last summer).  We would thus not rule out a move in September.

 

If Council wanted to keep moving at a quarterly pace, it would certainly find a way to communicate its intentions at the appropriate moment. At the end of this month, our ECB Refi-meter model will provide an estimate for September. Assuming no major declines in any of the variables driving the estimate, such as business climate, inflation expectations, M1 money supply growth and loan growth, it will likely signal an elevated probability of a refi rate hike in September. If the ECB Council would indeed go out of its way to hike in September instead of October, the timing would likely trigger a debate about another potential rate hike in December. While we expect the ECB to take a break from tightening once a refi rate of 4.25% is reached, we view the risks to this forecast to be on the upside at present.



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Global
A Higher Risk Premium on Oil Prices
May 11, 2007

By Eric Chaney and Dick Berner | London, New York

We are again marking to market our baseline assumptions for crude oil prices.  Various supply-side events have pushed prices higher than we thought a month ago (see “Oil Price Spike: Sharp But Temporary,” March 30, 2007).  Some of those factors, such as risks to the stability of the Saudi regime, are likely to last, so we have slightly revised upward our end of 2008 price target, from $55/bbl (Brent) to $57.  Going forward, we are extending our baseline to 2009:  Assuming that the global economy should continue to grow at a robust pace, between 4% and 4.5%, with Asia as the main engine of growth, we think that oil and refined product prices should rise in real terms after having bottomed out in 2008.  We believe that in the long run, the real price of crude should rise faster than the real long-term rate of interest.

 

Supply risks have increased the risk premium

As for the crude market, several supply-side developments have raised the risk premium perceived by the markets:

•  Despite the threat of UN sanctions, Iran continues to increase its capacity to produce nuclear grade enriched uranium.  Markets may conclude that the probability of sanctions, including an embargo on Iranian exports of crude, is also increasing;

•  The presidential election in Nigeria has failed to stabilize the political situation in this key oil exporter.  The government seems to lack the will and the means to keep groups of ‘militants’ who ransom oil industries in check.  The fragility of the new government makes things even worse;

•  Terrorist threats have recently resurfaced in Saudi Arabia, evidenced by the recent foiling of a suspected plot to attack refineries and oil fields.  Although the reality of these threats is hard to assess, risk-averse markets have no other choice than to take them seriously, given that Saudi Arabia is not only the biggest oil exporter, but also the only one with significant spare capacity.

 

The weakness of the US dollar: an incentive to pump less?

In addition, the weakness of the US dollar is undermining OPEC producers’ purchasing power.  As in the past, we believe that swing producers such as Saudi Arabia will respond by maintaining a taut rein on production and ship more conservatively.  Also, the loss of market share and thus income resulting from a small cut in production is negligible for Saudi Arabia.  In a previous note, we used a very simple model of income maximization for Saudi Arabia to show that the higher the Kingdom’s market share, the lower its income elasticity (See “Big is beautiful” in “Price Decline Welcome, but Don’t Expect Much More”, Chaney & Berner, January 6, 2006). 

 

In the US, technical issues inflate product prices

As for product markets, several factors have pushed up gasoline prices relative to crude quotes (i.e., crack spreads have widened to $15–22/bbl).  Accidents at US refineries on the West Coast, in Louisiana, and Oklahoma have contributed.  According to Morgan Stanley analyst Doug Terreson, several of the refineries that were taken off-line recently, such as BP Whiting and Toledo, Exxon Beaumont, and Chevron and Conoco on the West Coast, are all very important plants, and some will remain off line for between 2 and 8 weeks.  That’s on top of normal spring maintenance. 

Strikes in Europe, such as those at Marseilles and Antwerp, have limited the ability of US distributors to import gasoline.  We also suspect that in the context of US refinery downtime, US importers may have to pay a premium on imports from European refineries because of the strength of the euro.  Looking ahead, refinery costs are rising, so global additions to capacity may be delayed and postponed.

Moreover, we can’t rule out further supply-induced energy price shocks.  The US hurricane season begins again in June, and weather experts expect an active one.  The Colorado State University Hurricane Forecast Center expects nine hurricanes, of which five may be intense Category 3–5 storms (see “Extended Range Forecast Of Atlantic Seasonal Hurricane Activity And U.S. Landfall Strike Probability For 2007,” April 3, 2007). 

Meanwhile, on the demand side, US drivers complain about $3 gasoline but are getting increasingly used to high prices.  Gasoline volumes slipped 1.3% in March, but real gasoline consumption is up 3.2% from a year ago. 

The RBOB (gasoline futures) market is severely backwardated, from $2.21/gallon today to $1.80 by December, and gasoline prices will likely come down later this year.  But the supply factors mentioned above have pushed the whole futures curve up, and the market is legitimately now discounting a somewhat higher path of gasoline prices through 2008 than a month ago. 

 

The long-term view: robust rise for the real price of crude

We have extended our baseline to the 2009 horizon.  Although global refinery capacity — including the capacity to crack heavy sour crude and to produce the middle distillates that the markets want — should increase significantly, we think that the fundamental driver of the price of oil will be the rate of reserves depletion outside of the Middle East.  According to our ‘modified Hotelling rule’, the real price of oil should rise faster than the discount rate of oil producers, which can be approximated by the long-term real rate of interest.  On a fourth quarter to fourth quarter basis for 2009, we have pencilled in a 9% increase in nominal terms, which means a 4% to 5% increase in real terms.  On average, the rise would be more moderate (2%), because of a low starting point.  Of course, uncertainties regarding demand, supply, and the risk premium are so high that our baseline is only trying to provide a reasonable assumption for this still important parameter for the global economy.  One thing is almost guaranteed: Oil quotes will continue to be volatile.

 

Our alternative scenarios

We have revisited our alternative scenarios:

(1) The hot case: A large-scale supply disruption, caused for instance by an embargo on Iranian oil, would send crude prices to $90 on average next year. If tensions escalated further, raising the risk of a military confrontation, prices could rise significantly higher.

(2) The cool case: So far, slower economic growth in the US has been fully compensated for by strong growth in Asia and Europe, i.e., the global cycle seems decoupled from the US one.  However, a more significant slowdown in the US, triggered for instance by a large rise in the personal savings rate, would probably affect Asian exporters.  If these countries do not stimulate enough their own domestic demand, maybe due to a lack of adequate economic policy instruments, then there would be no global decoupling.  Simultaneous downturns in the US and Asia would cut oil demand significantly and drive crude quotes toward US$ 40/bbl, temporarily.  The long-term equilibrium price of crude oil, which we see between $50 and $60 (for Brent), would not change.

(3) The super-cool case: A structural break in the global economy, caused by a sudden rise of protectionist barriers for instance, would cut the long-term equilibrium price of crude oil and other commodities, because the long-term GDP growth rate of the global economy would be weaker than in our fast-globalizing world.  As for crude oil, the low twenties could be revisited.



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Global
Past the Point of No Return
May 11, 2007

By Stephen S. Roach | New York

Even the old timers in the Congress had never seen anything like it.  On May 9, the US House of Representatives held what was billed as a tripartite hearing of three subcommittees on “Currency Manipulation and Its Effects on US Businesses and Workers.”  I was one of the “expert witnesses” at this hearing – invited to submit a written statement and then, along with the other six members of the witness panel, to present a five-minute oral summary in front of the assembled legislators (my written statement, “A Slippery Slope,” was published as a Morgan Stanley Special Economic Study on May 9).  The hearing concluded with an extensive question and answer session.  It was an experience I will never forget.  My worst fears were realized.  At the end of over three hours of grueling give and take, I left Capitol Hill more convinced than ever that the protectionist train has left the station.

I am not exactly a neophyte at this process.  Over the years, I have testified many times in front of Congress.  Most of my earlier appearances took place in cavernous hearing rooms, with few in attendance other than a scattering of Senators or Representatives, along with the ever-dutiful congressional stenographer.  There was even one instance several years ago when I actually testified to an empty room -- the congressmen left for a floor vote and the stenographer told me to just keep on talking.  That was not the case this time.  For this event, the hearing room was packed with spectators, media representatives from around the world, and members of Congress.  It was Washington theater in its highest form.

The attention was understandable.  I suspect this hearing could well mark a major turning point in America’s mounting resistance to trade liberalization and globalization.  For starters, congressional historians offered the opinion that three committees had never before come together in one hearing to focus on a single issue.  And yet in one room – the fabled hearing chamber of the all-important House Ways and Means Committee – members of three major committees having jurisdiction over matters of US international trade policy turned their attention to trade-related pressures bearing down on US middle-class workers and companies.  Present were House subcommittees from Ways and Means, Energy and Commerce, and Financial Services.  The very structure of this unique tripartite effort was carefully designed to send the strongest message possible.  The opening comments of Sander Levin (Democrat from Michigan), who chaired this session, underscored the determination of Congress to take its long-standing concerns over US trade policy to a different level.  In his words, “This is an exceptional issue and an exceptional problem that hasn’t been resolved.  We need to consider the next steps.  This is the real thing.”

In terms of the substance of the debate, three things surprised me about this hearing:  First, while the bulk of the discussion was about China, anti-Japan sentiment was formally brought into the picture for the first time.  The issue was the yen – characterized by the Congress as the world’s most undervalued major currency.  While the absence of explicit intervention by Japanese authorities over the past three years was duly noted, many representatives took the position that there has been unmistakable “implicit manipulation” of the yen.  Second, the case against China was framed mainly around the concept of the “illegal subsidy” – WTO-compliant jargon that frees up Congress to impose sweeping countervailing duties on Chinese exporters.  Taking a cue from Federal Reserve Chairman Ben Bernanke’s mid-December 2006 speech in China, Congress seems willing to support the Hunter-Ryan bill (H.R. 782), which argues that an undervalued RMB qualifies as a subsidy that is grounds for a WTO dispute (see Bernanke’s December 15, 2006 speech, “The Chinese Economy: Progress and Challenges”).  Third, the congressmen present at this hearing were highly critical of the US Treasury’s bi-annual foreign exchange review process and its failure to cite China for currency manipulation.  This puts the House on a similar track as the Senate – especially that espoused by the leadership of the Senate Finance Committee, whose Chairman (Max Baucus) and ranking minority member (Charles Grassley) endorsed a similar approach last year.  That is the first hint at a reconciliation strategy between the two chambers of Congress – particularly important if they are to go into a joint conference later this year after passage of their own trade bills.

Notwithstanding these new developments, the most important message is that Congress remains unwavering in its determined approach to move from rhetoric to action in 2007 on matters of trade policy.  Contrary to what most believe, this is not a case of anti-trade Democrats now taking over Congress.  I continue to stress that there is broad bipartisan support for anti-China “remedies.”  While the Democrats are now in charge of the Congress, on matters of trade policy they have been joined by many Republicans in their crusade.  There is no way, in my view, that new trade legislation will become law without the support of the GOP.  That’s especially the case in the event of a veto by President Bush, whereby the math of veto-proof support would require approval by nearly half the Republicans in the Senate and about 40% of those in the House.  The experts I’ve spoken with continue to assure me that such margins are well within the realm of possibility.

I didn’t go to this hearing with the naïve expectation that I would be able to change any minds.  And there was no surprise on that count.  There was little sympathy on the part of the Congress for linking trade deficits to domestic saving shortfalls.  To the contrary, there was a broad consensus that bilateral pieces of the massive multilateral US trade deficit are fair game – in essence, an opportunity to whittle away at the US external gap one country at a time.  The consensus of congressman at the hearing was that China was the problem – even though the non-Chinese piece of the overall US trade deficit slightly exceeded $600 billion in 2006, over two and a half times the size of the Chinese bilateral deficit with the US.  Many congressmen were especially upset with my characterization of “China bashing.”  One gentleman asked me to strike any such references from my testimony, claiming that, “We’re not China bashers.  We are just trying to seek the truth.”  At the same time, literally no once responded to the concerns I voiced over the unintended consequences of protectionism – namely that China bashing could backfire in the US, the rest of Asia, and the broader global economy.  The bottom line here is very clear: The US Congress just doesn’t do macro.

There’s always a chance that I’m over-reacting to an escalation of Congress’s rhetorical assaults on China – that this will just be another year of bluster.  Anything is possible when it comes to Washington.  But I have spent more time on Capitol Hill in the past three months than at any point since I left the Fed in 1979.  Since mid-February, I have testified three times on US-China trade frictions, and in each of these instances, I have seen steady progression toward a protectionist endgame.  On the basis of everything I have heard over the past several months, I remain more convinced than ever that Congress has finally thrown down the gauntlet.  The May 9 tripartite hearing hammered that point home with disturbing clarity.  As Barney Frank, Chairman of the House Financial Services Committee, said, “This problem is not going away.  We are going to have to act.”  If Congress changes its mind and backs away, it fears it will lose all credibility on this key issue with American workers.  With respect to China, I am afraid that means the US Congress has now gone past the point of no return.



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