Denial on Protectionism
May 14, 2007
By Stephen S. Roach | New York
Rarely have I seen such a disconnect. The US Congress is moving full steam ahead on anti-China protectionism, and no one seems to care – especially investors in ever-frothy financial markets. “In the end, America always does the right thing” is the common refrain when this matter is discussed in business circles, amongst government officials and policymakers, and even in academic forums. Taking their cue from such a blasé assessment of protectionist risks, liquidity-fueled investors – from China’s A-shares to America’s Dow – see little to worry about on the trade front.
Our global team of market strategists at Morgan Stanley is in broad agreement that protectionist risks are not being discounted in the markets they follow. That conviction runs deep throughout our coverage of all major asset classes – equities, bonds, credit, and currencies. US equities are leading the pack in the denial game. As David McNellis and Henry McVey noted recently, the US market’s recent outperformance has been concentrated in the mega-cap S&P 100, companies which generate 34% of their revenue outside the United States. Teun Draaisma underscores a similar trend in European cyclicals, like capital goods producers, which are trading at a P/E premium of some 25% higher than the rest of the market. Naoki Kamiyama concurs with respect to Japan, noting the resilience of technology and auto equities – as well as the conviction that Japan is not the target of Washington’s China bashers. Our emerging market equity strategists stress similar conclusions, although Jonathan Garner notes the developing world may have more potent defenses to ward off an external shock – namely, outsize foreign exchange reserves and reduced reliance on external portfolio funding of their balance of payments. Our Asian team is particularly struck by the denial of protectionist risks; our regional strategist, Malcolm Wood, ascribes this to a “boy-cries-wolf-syndrome,” whereas China strategist Jerry Lou marvels at the excessive levitation of the domestic A-shares as Washington moves closer and closer to imposing sanctions on Chinese imports. The fixed income view is virtually identical insofar as an assessment of US-led protectionist risks are concerned – they are simply not in the price. The absence of any deterioration in the inflationary premium – a classic repercussion of trade frictions – is viewed as prima-facie evidence in support of this conclusion. Yet, as both Jim Caron and Dick Berner note, the recent tightening of TIPS spreads and the concomitant flattening of the US yield curve hardly discount any inflationary pressures that might arise from protectionism. Greg Peters bemoans that no one seems to care about this in the US credit space. This is consistent with a similar verdict rendered by his European counterpart Neil McLeish, who argues that tight credit spreads are an outgrowth of expectations of continually low default rates that do not allow for any possibility of a narrowing between the return and cost of capital for low-quality borrowers. Yet that’s precisely the outcome that would undoubtedly occur in a protectionist scenario. Stephen Li Jen rounds out the picture, noting that an outbreak of serious China bashing would be a uniformly negative event for the dollar, with most of the action concentrated on the Asian axis of foreign exchange markets. The dollar’s recent weakness, in his view, is simply a continuation of a five-year gradual decline – a far cry from a much sharper adjustment that might occur if a capital-deficit nation like the US lashes out against one of its major foreign lenders. So, whatever the asset class, wherever the region, the verdict is pretty much the same – financial markets are currently ascribing almost no chance to a protectionist surprise. As I speak with a broad global cross section of investors and business executives, I get a similar impression. The electronic polling we conduct at major investor conferences around the world reveals the same sense of disbelief in a protectionist endgame. Two reasons are usually cited in support of this conclusion: First, there is a strong belief that the US will eventually come to its senses and do the right thing by living up to its role as the architect and leader of the pro-trade, post-World War II global economic order. Globalization is viewed as America’s invention, whereas protectionism is seen as the antithesis of Washington’s global vision. Second, the “boy-cries-wolf” critique that Malcolm Wood notes above is very much alive and well in financial markets today. The protectionist rumblings of the last couple of years have been just that – more bluster than action. Investors stress that every time they have tried to play this risk as an actionable outcome, they have lost money. The appetite to chase another protectionist scare is heavily influenced by such misadventures in the markets. So what makes me so smart? Or perhaps, to put it more delicately, do I really have a better read than the markets on what the US Congress is up to? My answer is that it is not an either/or proposition. This is not a case of the binary outcome – globalization or protectionism. Instead, it is much more about probabilistic risk assessments of a wide range of possible outcomes. With the help of our team of market strategists, the way I read the broad consensus of investor sentiment right now is that virtually no risk is being assigned to a protectionist endgame. My experience in Washington over the past three months – three separate appearances in front of the Congress and considerable consultation with congressional and Administration senior staffers – leads me to conclude that this risk assessment is far too sanguine. I continue to think that there is a 60% chance that a WTO-compliant bill aimed at curbing the trade deficit with China will be passed by a veto-proof majority in both houses of Congress by the end of this year. Even if I am wrong by a factor of two, for my money, the markets are still far too relaxed on this key issue. I certainly don’t profess to be a political vote counter, either. We have a team in Washington that is far more adept at that than I am, and we also rely on the insights of several consultants. Their conclusions are also much more cautious on the protectionist risk scenarios than those currently being discounted in financial markets. Of course, there’s never a sure thing when it comes to assessing Washington risk on any issue. The smokescreen of mixed signals is endemic to the place. The recent compromise between the Bush Administration and congressional Democrats on labor standards and trade agreements is classic in that regard. Some view this as a sign that the Democrats are retreating to the high ground of the protectionist debate. Others claim this represents a White House capitulation that is aimed at tempering more extreme actions by the Congress. I am more sympathetic to the latter interpretation but concede that anything is possible in the classic grey area of Washington ambiguity. In the end, I stand by my view that Congress is merely picking its spots. It does not want to be labeled as one-sided in the trade debate. Compromise on the labor standards issue underscores that point. At the same time, I see no let-up in efforts to single out China. The latest such initiative in this regard is the Hunter-Ryan bill currently under consideration in the House (H.R. 782), which treats currency manipulation as a subsidy that can be remedied by broad-based, WTO-compliant countervailing duties. On a different track, Congress is also moving forward on the Davis-English Bill (H.R. 1229), which would nullify the special dispensation from trade rules currently given to non-market economies like China. Both of these bipartisan initiatives have broad support in the House. And our sources suggest that there is plenty more in the congressional hopper – in the Senate as well as in the House – insofar as anti-China legislation is concerned. Ultimately, if the protectionist-risk scenario becomes a legitimate threat, Congress will have to pick the horse it wants to ride and solidify support around one approach. I suspect that this narrowing process is now under way and is likely to reach a conclusion by the end of this summer. So what’s an investor to make of all this? I would stress three key conclusions: One, an outbreak of protectionism is not in the price of world financial markets in any way whatsoever; if the odds start to shift, most major asset classes – equities, bonds, credit, and currencies – would be highly vulnerable. Two, these risks are being dismissed not just because they have been a bad bet in the past several years but also because of the deeply held perception that the United States ultimately always does the “right” thing. Three, the odds of anti-China trade legislation being enacted by the US Congress are high and rising, in my view; this could well become more apparent after the second installment of the Strategic Economic Dialog between the US and China, slated for May 22-24 in Washington DC. Should those high-level talks produce another set of non-results – very much the risk – I suspect Congress will most assuredly up the ante. For financial markets steeped in denial, that could be a most bitter pill to swallow.
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How Much Inflation Is in the Price?
May 14, 2007
By Richard Berner | New York
Neither Treasury Inflation-Protected Securities (TIPS) markets nor the nominal US Treasury yield curve is pricing in much upside inflation risk. Small wonder: Recent good inflation news and the Fed’s anti-inflation resolve have given market participants appropriate comfort. US core inflation measured by the Fed’s preferred gauge — the personal consumption price index (PCEPI) — dipped to a 2-year low of 2.1% in March. And the FOMC said following its meeting last week that “the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected,” indicating a continued determination to make good on its anti-inflation promises. But in my view, some factors still skew inflation risks higher, and thus TIPS and plays on a steeper yield curve thus may provide good inflation insurance. Here’s why. Both TIPS spreads and distant forward inflation compensation have declined to low levels and the yield curve has flattened recently, reflecting a benign inflation outlook. In the past month, ten-year TIPS spreads have tightened by 10 basis points (bp) to 241 bp and distant-forward (5year, 5 year) breakeven inflation (BEI) has dipped by about 5 bp to 237 bp. Neither is far from its average of the past four years. In the same period, the yield curve from 2-year to 10-year yields has flattened by about 3 basis points (bp) to be essentially flat, while 10-year yields have dipped by nearly 10 bp. However, simply reading TIPS spreads, distant forwards or the yield curve isn’t sufficient to tell us about inflation expectations. That’s because both breakevens and forward BEIs consist of two elements. The first is expected CPI inflation over the relevant time period (for example, in the case of the 5y5y BEI, the five-year horizon covered by the five-year forward rate). The second element is the risk or term premium that compensates investors for the inflation risk component of holding a nominal longer-term security (or forward rate). As long as that risk premium is positive, the inflation expectations embodied in today’s breakeven level of 240 bp are actually lower than that level. Of course, the inflation component of the term premium is devilishly tricky to measure, so it is hard to know how significant an element it might be in the BEI calculus. Brian Sack has recently tried to provide some bounds on the premium by looking at smoothed forward rates for one-year BEI at all time horizons over the next ten years. He notes that such forward BEI rates rise steadily from about three years out to ten years. Based on the idea that investors know that the Fed would not tolerate such an inflation path and could prevent it from occurring in that period, the observed rise in forwards is more likely to be associated with a positive inflation risk premium than with rising inflation expectations. Using a variety of assumptions, he goes on to estimate that the ten-year inflation risk premium lies between 15 and 40 bp. Consequently, adjusted for such risks, markets are discounting CPI inflation of about 1.8% to 2.2% over the next ten years (see Brian Sack, “How Low Is the Inflation Risk Premium?” Inflation Linked Analytics, Macroeconomic Advisers, May 9, 2007). As a ten-year average, I think that such an expectation is reasonable. But what’s priced into markets for ten-year securities — which will affect the calculation of distant forwards— may be affected by near-term events. And what’s in the price for both inflation expectations and the risks around them may be too low, given near-term fundamentals and the threat of protectionism. That’s not to say that it is much too low. We do think that core inflation has peaked, and March’s good inflation news on the core PCEPI reinforces that belief. Declines in the core CPI and chained core CPI suggest a similar move. Inflation expectations are still low. The housing recession should help by reducing the increases in rents and owners’ equivalent rents; although both are running over 4%, recent data suggest a sharp deceleration. Increased economic slack will also help. We estimate that GDP growth will average just 2.2% over the six quarters ended in the third quarter of 2007, below anyone’s estimate of potential growth. However, we also think that the dispersion of inflation risks has risen and declines will come slowly. Labor markets are only beginning to evince growing slack. A looser and less-certain relationship between slack and inflation than in the past implies that inflation will slowly decline. Moreover, higher energy, food, and import prices, a potential surge in protectionism, and slowing productivity growth each pose upside risks to that baseline inflation view. There’s no mistaking the impact of higher energy quotes on headline inflation; indeed, following a 0.6% rise in March, we expect that the CPI rose by 0.5% in April and may rise by another 0.6% in May. Some of the energy price hikes may also boost core inflation. And they have already pushed up inflation expectations; measured by the University of Michigan’s canvass, 5-10 year inflation expectations rose to 3.1% in April. Likewise, the jump in animal feed quotes is hiking beef and poultry prices following flat to declining prices last year, and the effects on citrus quotes of this winter’s California freeze linger. The acceleration in non-auto consumer import prices to a 1.9% rate in April has just started to show up in consumer inflation gauges, and more is coming, especially if the dollar weakens further (see “Inflation: The Latest US Import?” Global Economic Forum, April 20, 2007). And I agree with Steve Roach that an outbreak of protectionism would pose further upside inflation risks (see his dispatch today, “Denial on Protectionism,” and “Protectionism and Inflation,” Global Economic Forum, May 7, 2007). The slowing in productivity growth, to 2.1% over 2005 and 1.6% over 2006, raises questions of whether trend productivity and thus potential output are lower than previously thought, implying a more inflation-prone economy. Indeed, some still fear a return to stagflation. We don’t. We still think that trend productivity growth is roughly 2½%, which is good news for long-run inflation prospects. In the past two years, we think that a below-trend, cyclical productivity undershoot has been underway as job growth was catching up with the economy. But we expect productivity growth to stabilize this year at 1.6%, and we forecast a return to 2½% productivity growth in 2008 (see “Risks to the Outlook,” Global Economic Forum, May 7, 2007). TIPS markets often price in a spring increase in headline inflation, reflecting the usual spring run-up in gasoline prices. That seasonal carry built in a rise in TIPS spreads of about 12 basis points about three weeks ago and should have helped lift TIPS spreads. Tighter TIPS spreads and the prospect of rising headline inflation in the next few months make TIPS attractive today. To be sure, Jim Caron and George Goncalves point out that the nominal yield curve typically flattens between mid-May and mid-June, so a window may open in the next few weeks in which to scale in to this trade (see “US Cross Rates Strategy: Unfolding in Stages,” May 11, 2007). Risks to the inflation outlook abound, in my view warranting a somewhat higher inflation risk premium than appears to be priced in to markets. To be sure, more profound economic weakness could smother inflation expectations and inflation, as could a stronger dollar, a cooling of protectionist risks, or a drop in energy quotes. None seems likely soon, however; if anything, the economy may be improving somewhat, the dollar is in a range, and both protectionism and energy quotes are heating up. The threat of protectionism could add an unexpected layer of risk to the inflation outlook, because it would block competition in US markets from cheaper overseas goods and services. Escalating protectionism, moreover, might extend and/or intensify the dollar’s recent decline. Neither seems to be in the price.
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Review and Preview
May 14, 2007
By Ted Wieseman
Treasuries posted moderate losses across the curve over the past week after the Fed made almost no changes in its policy statement, disappointing some investors who had hoped for a more dovish tone after recent softness in growth and core inflation, and incoming growth data — after a lot of back and forth volatility — ultimately pointed to a more severe slowdown in Q1 but a sharper recovery moving into Q2, further dimming hopes for near-term rate cuts. For the first half as a whole, we came out of the week expecting about the same growth as we did coming in — +1.8% v. +1.9% — but after some significant surprises and sizable revisions the pattern now looks quite different. We cut our estimate of the Q1 GDP revision to +0.9% from +1.4% (versus the +1.3% advance estimate), but boosted our Q2 forecast to +2.7% from +2.4%. Two aspects of this revision were of particular note. First, the inventory correction in Q1 now looks to have been much bigger than initially estimated. Indeed, real inventories now appear likely to have posted an outright decline in Q1, leaving economy-wide inventory/sales ratios lean and setting the stage for a production snapback in Q2. Second, though the monthly chain store results looked disastrous in April, the official government data painted a much less negative picture, so the slowdown in Q2 consumption, while still significant, looks likely to be significantly less severe than we had feared after those chain store results. With growth potentially on the mend to some extent in the current quarter and cost pressures still rising — as seen the past week in import prices and early stage PPI readings, with expected follow-through in the coming week in a pick up in core CPI inflation in April — there seems little prospect of any near-term shift in the firmly on hold policy stance the FOMC laid out in its official policy statement after the Wednesday’s FOMC meeting. On the week, benchmark Treasury yields rose 3 to 5 bp, with the 3-year the worst performer, as investors appear to have already moved to abandon this sector after the last new 3-year auction at the past week’s refunding saw very low participation by final investors and dealers were quick to dump out of unwanted positions they were stuck with as a result at the auction. The 2-year yield rose 4 bp to 4.71%, the old 3-year 5 bp to 4.65%, the 5-year 3 bp to 4.58%, and the old 10-year and 30-year 4 bp each to 4.68% and 4.85%. The 10-year leg of the refunding went quite well, but the 3-year and 30-year reopening definitely did not. All three issues ended the week in the red, with the new and final 3-year closing at 4.616% after being auctioned Monday at 4.574%, the 10-year ending at 4.670% after being auctioned Tuesday at 4.612%, and the bond reopening losing 1 bp relative to Thursday’s 4.838% award. The intermediate part of the TIPS curve underperformed a bit, with the 5-year TIPS yield up 4 bp to 2.18% and the 10-year 5 bp to 2.29% The Fed’s nearly word-for-word repeat of the March policy statement after Wednesday’s FOMC meeting was in line with our expectations, but proved disappointing to at least some investors hoping for a more dovish spin after the sluggish Q1 GDP outcome and benign March inflation report. Initially this led to a significant near- and medium-term repricing of the Fed in the futures markets, with the timing of the first expected rate cut shifted out to December from October and the trough of the expected rate cutting cycle moved up more clearly towards 4.75% from a closer call between 4.50% and 4.75%. Subsequently, the near-term repricing was taken back and the first expected rate cut (barely) shifted back to October, but the less dovish medium-term view was sustained. On the week, the August fed funds contract lost a half bp to 5.22%, while the October and November contracts were unchanged at 5.165% and 5.115%. Eurodollar futures losses were led by a 7 bp drop in the June 08 contract to 4.845% and a 6.5 bp decline in the Sep 08 contract to 4.78%. The low rate contract was again shifted out by another quarter — the formerly low rate Dec 08 contract lost 5 bp to 4.75%, while the new rate Mar 09 contract fell 4 bp to 4.745%. A lot of the missing data BEA had to make assumptions for in preparing the advance Q1 GDP estimate was filled in over the past week, and we also received some key April data in the retail sales report. Significant surprises and revisions in the March and initial April data (to which early estimates of Q2 growth are very sensitive) had our first half growth estimates swinging around significantly through the week. Ultimately we ended up with only a marginally slower estimate for the first half as a whole — +1.8% v. +1.9% coming into the week — but with a significantly more pronounced Q1 slowdown, driven by downside surprises in inventories and trade, followed by a bigger Q2 rebound on a combination of a smaller slowdown in consumption and a larger snapback in inventories partly offset by a much less positive view on net exports. We now look for Q1 GDP to be revised down to +0.9% from the advance estimate of +1.3% and the +1.4% we expected coming into the week, but we see Q2 on track for a rise of +2.7%, up from our prior +2.4% estimate. These overall revisions also contained even bigger adjustments to our estimates of the mix between final sales and inventories in the two quarters. Four key releases over the past week drove this rethinking of the likely pattern of first half growth — retail sales, trade, and wholesale and retail inventories. Retail sales fell 0.2% in April, as auto dealers’ receipts dropped 1.0%. Ex auto sales were flat. The April weakness, however, was offset by upward revisions to March, with ex auto sales adjusted up to +1.1% from +0.8%, leading to a two-month average far stronger than implied by weak chain store results. In April, significant weakness was seen in clothing (-2.0%), general merchandise (-1.2%), and sports/books/music (-0.8%), though much less so than implied by terrible chain store sales reports. These declines were offset by unusual upside in furniture (+1.2%) and electronics/appliances (+0.7%) that sharply contrasted with weak housing activity and company level reports. Gas stations (+1.7%), food stores (+0.5%), and drug stores (+0.9%) also saw good gains. The key retail control component rose 0.2% in April, better than the 0.1% drop we expected after the miserable chain store results, and March was revised up sharply to +1.2% from +0.7%. Frankly, we’re a bit suspicious of the supposed strength in this underlying retail spending gauge given the poor chain store reports. Combined results over the March/April period for clothing and general merchandise certainly look way too strong compared to company level reports, so we are wary of potential downward revisions or a delayed negative catch up in May. Still, for now obviously we take the hard data as they are, and the results point to significantly stronger consumer spending growth over the Q1/Q2 period than we previously expected. It now looks like consumption in Q1 will be revised up to +4.2% from +3.8%, matching the Q4 surge. And we now see Q2 on track for a 2.0% rise, a significantly less severe slowdown than our +1.2% forecast before the retail sales report. On the negative side, the trade deficit widened far more than expected. The trade gap jumped to $63.9 billion in March from $59.7B in February, with exports rising a solid 1.8% but imports surging 4.5%. The import upside was broadly based, but about half the gain reflected a reversal of the bizarre plunge in petroleum products in February. The rebound was largely price related but was also supported by a jump in real petroleum imports (+11%). Services, food, non-petroleum industrial materials, autos, and consumer goods also posted good gains. Capital goods were the only notable soft spot. The upside in exports was led by industrial materials, mostly from a spike in gold. Autos, consumer goods, and services also posted good gains, while capital goods declined slightly on a correction in aircraft after record recent results. The March trade deficit was significantly wider than BEA assumed in preparing the advance estimate of Q1 GDP. Even making some generous assumptions on their price/volume estimates, we now estimate that the net exports contribution to Q1 growth will be cut to -0.7 percentage points from -0.5pp. Moreover, the March results provided a much worse starting point for Q2 than we previously assumed. The real goods trade deficit (-$60.7B v. -$57.7B) didn't widen nearly as much as the overall trade gap, but was still much bigger than we had assumed. Even building in some narrowing in the real trade deficit in the next few months, we now see net exports being neutral for Q2 growth versus our prior assumption of a half point add. We still see the diverging domestic demand growth trends between the US and our major trading partners as likely to lead to net exports being a significant support for growth on a medium-term basis, but this trend seems to have stalled temporarily in the first half of this year. BEA’s assumptions for March wholesale and retail inventories also proved way too optimistic (BEA’s assumptions for missing data in advance of GDP reports are usually pretty close to the mark, but this has been an unusual quarter in which they were mostly off significantly). While this points to a much larger inventory drag in Q1 than previously estimated, it also sets the stage for a stronger production snapback in Q2. Wholesale inventories rose a much less than expected 0.3% in March and February (+0.4% v. +0.5%) was revised lower. BEA assumed a 0.7% rise in March. Retail ex auto inventories were even more dramatically off the mark in March, falling 0.5% after a slightly downwardly revised February (+0.7% v. +0.8%). BEA assumed a 0.3% rise in March. Building in the downside surprises in wholesale and retail inventories on top of the previously reported downside surprise in manufacturing inventories, it now looks like there was an outright decline in real inventories in Q1, with the inventory contribution falling to a substantial -0.8 percentage points from the advance estimate of -0.3pp. This much sharper inventory correction in Q1 would be good news for Q2 production, and we now look for a swing to relatively modest inventory rebuilding after the expected outright liquidation to add 0.8pp to Q2 growth, up from our prior +0.3pp estimate, reversing the additional expected subtraction in Q1. Within our overall GDP forecast revisions for Q1 (+0.9% v. +1.4%) and Q2 (+2.7% v. +2.4%) are important shifts in the expected mix of final demand versus inventories. While we expect overall GDP to be revised down 0.4pp in Q1, we expect final sales (GDP excluding inventories) to be revised up 0.1pp to +1.7%, and we expect final domestic demand (GDP excluding inventory and trade) to be revised up 0.4pp to +2.4% (reflecting about equally the stronger path we now see for consumption and the previously reported upside surprise in March construction spending). As for Q2, the upside in consumption relative to our previous estimates raised our final domestic demand forecast to +1.8% from +1.5%, but the cut in our estimated trade contribution to zero from +0.5pp lowered our final sales forecast to +1.9% from +2.1%. The half point stronger positive we see from inventories, however, offset this and ultimately added up to overall GDP tracking 0.3pp stronger. While we wait for the key CPI report in the coming week — where we expect some of the apparent seasonal quirks that suppressed the core in March to be reversed and lead to an above-trend April outcome — inflation data released the past week continued to point to rising cost pressures from import and raw materials prices. Overall import prices posted a sharp gain in April line with the upswing in oil prices (since reversed), and while the core “ex fuels” gauge was more contained, the trend in key underlying details remained worrisome. In particular, we focus on consumer goods import prices as a leading indicator for core CPI goods prices, and this component continued to accelerate, rising to +1.9% year/year, high since 1995 and up sharply from -0.3% a year ago. Meanwhile, early stage readings in the PPI report reflected the ongoing surge in raw materials costs. After surging a near record 7.7% in March, the core crude index rose another 0.4% in April on a spike in copper scrap prices. The core intermediate gauge jumped 0.8%, biggest rise in nearly a year, on upside in fertilizers, plastics, and metal goods. Main focus in the upcoming week will be on the CPI report on Tuesday, where we look for a reversal of the downside surprise in March. The Empire State survey Tuesday and Philly Fed Thursday will help set early expectations for the May ISM, with the obvious question being whether the surprising jump in April was a fluke or a real indication of improving factory sector activity. This week’s initial jobless claims figures will cover the survey week for the May employment report and help set early expectations. While we think the big drop in initial claims the past week largely reflected odd seasonal factors compared to prior years with the same calendar and look for a snapback to 315,000 this week, such an outcome, along with the favorable weather, would suggest an improvement in job growth in May after the weak April results. Other data releases due out include housing starts and industrial production Wednesday, leading indicators Thursday, and Michigan consumer confidence Friday: * We forecast a 0.5% rise in the overall CPI in April and a 0.3% gain in the core. A further climb in gasoline prices and another jump in quotes for food should help push up the headline CPI this month. Meanwhile, the hotel category, which appeared to be artificially depressed in March, is expected to register a partial bounce back in April — with more upside likely to follow in May. The key medical care component is also likely to move higher this month, while apparel should flatten out following some recent volatility. We see the core CPI at +0.26% before rounding in April, with the yr/yr rate ticking down to +2.4% (v. +2.5% in March). Finally, the TIPS index is expected to post a sharp jump — to 206.8 (vs 205.35 in March). * We look for April housing starts to fall to a 1.42 million unit annual rate. Employment in the residential construction sector held up surprisingly well in April. However, on the basis of the recent homebuilder survey results and the elevated inventory of new homes available for sale, we expect a sharp 6.5% decline in April starts. Looking ahead, we continue to expect starts to bottom at about a 1.20 million unit annualized pace during the third quarter. * We forecast a 0.5% gain in April industrial production. Although the April labor market report showed a decline in hours worked within the manufacturing sector, we look for a jump in auto assemblies, a trend-like gain in productivity growth, and a partial rebound in utility output to provide significant support. In fact, the motor vehicle category is expected to jump nearly 3%, with manufacturing excluding motor vehicles ticking up 0.1%. And we see a 2.2% rise in the utility category following on the heels of a weather-related 7% plunge in March. * The index of leading economic indicators is expected to post a 0.2% decline in April following the small uptick seen in March. Negative contributions from unemployment claims, vendor deliveries, and consumer confidence should more than offset the upside coming from the stock market and money supply components.
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Business Conditions: Hope Springs Eternal?
May 14, 2007
By Shital Patel
KEY POINTS * What’s new The MSBCI edged up one point in early May to 46%, barely indicating improvement from the January low. 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 on the way? * Conclusions Don’t expect anything more than a shallow recovery, although the worst of the business slowdown appears to be over. The tug of war between strong global and weak domestic fundamentals still nets to sluggish gains, echoed in the details of our survey. And the near-manic volatility in our forward-looking gauges leads us to downplay one month’s improvement. * Market implications Our results are consistent with market expectations of sluggish but positive growth. If the spike in the forward-looking indicators proves an accurate portent, however, the actual results may take investors who are betting on no improvement in business conditions by surprise. * Risks Slower growth abroad could depress US business conditions and earnings, while a prolonged spike in gasoline prices or a deeper housing recession could force consumers to retreat. DETAILS 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. Shital Patel & Richard Berner (New York) Slower growth abroad could depress US business conditions and earnings, while a prolonged spike in gasoline prices or a deeper housing recession could force consumers to retreat. 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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Inflation Will Remain at Bay, for Now
May 14, 2007
By Luca Bindelli
Summary We have not changed our short-term view: CHF weakness is here to stay. We still believe that inflation risks remain a long-term issue. We make the following points: 1. Last month’s inflation print should be taken with a grain of salt. Once we strip the clothing component out of CPI, the monthly reading fades to 0.4% on the month, which is unlikely to cause concern at the SNB. More interesting will be housing price developments. 2. Imported inflation will not be a problem as long as downward price pressures from globalization outweigh CHF depreciation. We have developed a model to quantify these effects on inflation. 3. The underlying structural changes have somewhat increased the uncertainty surrounding monetary policy-making. But it would be very surprising if the SNB reacted to the CHF, as this could trigger additional volatility in the currency markets. House Rental Prices Deserve a Close Watch The April inflation print should not be a source of concern, as it was mainly due to end-of-the-period sales in clothing. Once we strip this component out, monthly CPI inflation falls from 1.1% to 0.4%. House rental prices will be more relevant, we think. In terms of budget, this component corresponds to roughly 20% of the overall Swiss CPI. Any significant move in this component should have non-negligible impact on the CPI. Most of the recent inflationary pressure stemmed from house rental prices alone. In the last three months, house rental inflation was 2.3%Y. Still, we see the risk of rental prices driving overall inflation outside the comfort zone as limited at this stage. The construction sector has managed to keep up well with demand and therefore helped withhold price pressures. Asking prices for owner occupied apartments and houses have been increasing lately. But this, too, is far from a concern. Besides, only roughly 30% of the population owns their living place in Switzerland. This would hinder any inflationary pressure arising from a wealth effect through higher consumption. Globalization Impact on Prices Is Key Whether inflation is going to trigger further policy normalization is the key question for the CHF. Several commentators believe that CHF weakness will translate into higher inflation and force the SNB to raise rates. However, we demonstrate that the Trade Weighted Exchange Rate Index (TWI) changes have no significant impact on inflation and that several other key factors should help keep inflation low instead. Apart from monetary policy, the recent labor market reforms and economic restructuring, as well as globalization have likely significantly affected the Swiss price dynamics. In this note, we quantify the impact of imported inflation and exchange rates on overall inflation. We also address how openness has affected Swiss inflation, and ask whether downward inflation pressure will remain. In summary, our questions, (and answers) are the following: (i) Has the responsiveness of prices to domestic output fluctuations changed through time? Is it lower now due to increased openness? Yes to both. (ii) Does imported inflation impact domestic inflation significantly? Yes, but only modestly so. (iii) Does the exchange rate have a significant impact on overall inflation? No. To answer these questions, we augmented the traditional Phillips curve with a few relevant variables. First, we allowed for the output gap to enter in the Phillips curve conditional on the level of openness in the Swiss economy. Second, we allow for imported inflation, oil inflation, house rental inflation and the TWI to enter the equation. Finally, the SNB introduced in early 2000 its new inflation-based policy framework. In order to account for this change in monetary policy, we use a dummy variable. We make the following points: As expected, the output gap plays a key role in affecting inflation. More interesting though is that the output gap, once conditioned on the degree of openness, is also significant. Its negative sign means that openness lowers the sensitivity of inflation to the output gap. In other words, we have an econometric confirmation of a flattening of the Phillips curve due to openness (e.g. globalization). The role of domestic capacity in affecting Swiss inflation has therefore diminished through time, as openness has increased. As trade barriers are set to decrease further, we should expect Swiss inflation sensitivity to domestic capacity to further decrease. Oil price changes do play a role, although the impact has been very small throughout the period considered. Not surprisingly, the impact of house rental inflation in driving overall inflation is much more important. Almost a third of its change is reflected in overall inflation changes. Most interesting, and surprising, is the insignificant role played by the changes in the TWI. This reflects the poor pass through from exchange rates to import prices and ultimately to overall inflation. The imported inflation is positively linked to overall inflation, but its impact is small. One could think of the increased foreign and domestic competition as reducing the pricing power of firms, limiting their ability to raise prices during favorable economic conditions. In turn, these might be offset by “downward” rigidity during downswings. An explanation as to why imported price matters while exchange rates do not is because of the foreign prices component. This means that when facing changing foreign prices (food, intermediate inputs mainly), importers are more likely to pass these changes to their customers (as they may be more easily justifiable). But on the other end, we may think that contracts are set with reference to a fixed exchange rate level and that most firms can hedge their currency risk at a low cost. In turn, when exchange rates move, these might not be fully passed on to consumers. This could explain why the TWI does not impact overall inflation significantly. Interestingly, this is compatible with the SNB study mentioned earlier where a much larger proportion of firms were reactive to changes in intermediate product prices (76% of the respondents) than to exchange rate changes (46%) in setting their prices. Still, the imported inflation impact on overall inflation remains small and suggests that the recent CHF depreciation has been offset by downward price pressure due to higher foreign competition. Changes in openness also have an impact on overall inflation to a limited extent. Finally, the impact of the change in the monetary policy framework in 2000, as reflected by our dummy variable, has been substantial. In fact, we estimate that the adoption of inflation targeting shaved off a half percentage point from the Swiss inflation rate after 2000 (on average). This is likely linked to the increased transparency and credibility attached to the new policy framework In sum, the new policy framework, the higher degree of domestic and foreign competition, and the related degree of openness were, and still are, key factors behind the lowering of inflationary pressures in Switzerland. In the longer term, however, the effects stemming from globalization are likely to vanish progressively and price pressures may well start to build up. The Probability of the SNB Intervening Is Still Small As background, we should keep in mind that the economy is doing well, but that it is undergoing structural changes that somewhat diminish visibility. On the other hand, as we argued, inflation is well in control and the risks to inflation are tilted to the downside in the short term. Should the SNB raise rates in response to the exchange rate weakening? As we hinted earlier, the answer is likely no, especially if one thinks that such action would trigger more volatility in the currency markets without significantly altering the inflation path. The SNB has the time to raise rates further down the road, as structural changes impact the economy. A “wait and see” mode would enable the SNB more visibility, hence less risk in steering the economy. In a flexible currency regime, a reaction to the CHF only makes sense if it is expected to threaten the SNB mandate, as the SNB itself has repeatedly argued. While an intervention outside an official meeting date is a possibility, we do not think it likely to happen in the near term. To Sum Up We think that inflation will remain low in the coming months but that higher inflation is a distinct possibility in the longer term. To us, the SNB is unlikely to hasten its normalization pace. We expect that the CHF will still struggle in the coming months, as the market expects excessive tightening after June.
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Slight Upward Revision to Oil and CPIX Forecasts
May 14, 2007
By Michael Kafe | Johannesburg
Key Points: What's New: Last week, our European colleagues revised their oil price forecasts upwards, thanks to a perceived re-evaluation of the risk premium associated with potential supply disruptions. Incorporating these upward revisions into our CPIX model, our CPIX peak remains unchanged at about 6%Y in April/May, falls to 5.5%Y by the end of the year (5.3%Y before), dips down to about 5%Y in 2Q08 before rising to close 2008 at about 5.4%Y (5.2%Y previously). Implications: This new trajectory still comes in below the Reserve Bank's estimates for the next 12 months but rises marginally above its end-2008 estimate of 5%Y. However, with inflation remaining within the target band, we still do not see the need for further tightening. Details: Despite improving fundamentals (i.e., slower demand and abundant supply), the crude futures curve remains in contango. Our European colleagues believe that this could be a result of market participants having re-evaluated the risk premium associated with potential supply disruptions. Also, they believe that Middle East producers may be willing to offset the impact of a weaker dollar on their terms of trade by pushing prices higher, at a time when the US retail market continues to be hobbled by refinery and transportation constraints (see A Higher Risk Premium on Oil Prices, Eric Chaney and Richard Berner, May 9, 2007). As a result, they have bumped up their baseline forecast of crude prices for the remainder of 2007 by just over 2%. For 2008, the forecast is some 4% higher on average. Incorporating these new numbers into our CPIX model and making adjustments for the recent movements in domestic oil prices, we have a CPIX peak of about 6% in April/May. The slight drop from our most recent estimate of 6.1%Y (see South Africa: More Thoughts on The MPC’s Intriguing Inflation Trajectory, April 16, 2007) is mainly because of the downside surprise in the March reading, which came in at 5.5%Y versus our forecast of 5.7%Y — thanks to a lower-than-expected out-turn in domestic food prices. Our end-2007 forecast now comes in at 5.5%Y versus our initial estimate of 5.3%Y. Importantly, although this number now comes in higher, it is still below the SARB's estimate of 5.9%Y for the year-end. For 2008, we initially had a dip below 5%Y in 2Q, thanks largely to positive base effects from the expected high readings in 2Q07. With the 2Q07 reading now having been revised marginally lower, in addition to a higher oil price forecast for 2Q08, we now have the dip in 2Q coming in at about 5%Y. Needless to say, the higher oil price forecast for the remainder of 2008 takes our end-2008 reading to 5.4%Y from 5.2% previously. Once again, this number is higher than the SARB's estimate of 5%Y for 4Q08. However, one must bear in mind that the SARB has such a low reading for 4Q08 presumably because of the rather high base it has in 4Q07. Were that base to come in lower, its end-2008 reading could come in marginally higher than 5% — still not a level that would call for a further tightening in the monetary policy stance. As things stand now, the nominal effective exchange rate of the rand has appreciated by more than 2% since the April MPC meeting, dated Brent prices are down 3.7%, front-dated white maize futures prices are down 6.5%, yellow maize futures prices are down 3.3% and wheat futures prices are up 0.4%. This would suggest that, were the SARB to mark its forecast to market today, its CPIX trajectory could actually come in lower than what was published in April.
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The Rise of the Middle Class
May 14, 2007
By Serhan Cevik | London
Macroeconomic normalization has helped improving socioeconomic conditions. The global economy has enjoyed a remarkable period of strong growth in recent years, raising hundreds of millions of people out of absolute poverty, especially in developing countries. Nevertheless, income distribution has so far shown no material improvement, with the world’s richest 1% owning 40% of all income and wealth. There is of course an intense debate on reasons behind the unequal distribution of income within and between countries. In our view, the globalization of financial systems and structural changes — ranging from technological advancements to urbanization — are the key determinants of the shares of labor and capital and therefore income distribution. Turkey, too, has faced similar challenges and more. However, the efforts to normalize macroeconomic conditions and to address structural weaknesses have helped, eliminating economic distortions and moderating the volatility of income growth in Turkey. As a result, the economy has experienced the longest stretch of uninterrupted growth and a marked disinflation towards the single digit territory. In turn, with a more egalitarian distribution of income, Turkey’s per capita income more than doubled from $2,091 in 2001 to $5,477 last year. Though market participants tend to focus on political developments these days, we should not overlook socioeconomic trends that are crucial for voting behavior. The scale and intensity of poverty have become far less distressing in recent years. The number of people living below the absolute poverty line (based on minimum food consumption) already declined from 929,000 (or 1.4% of the population) in 2002 to 623,000 (0.9%) in 2005. Moreover, with 2.5 million new jobs in non-farm sectors of the economy, the number of people living below the general poverty line (which includes both food and non-food expenditures) declined from 18.4 million in 2002 (and the post crisis peak of 19.5 million in 2003) to 14.7 million in 2005. In other words, the poverty rate in Turkey improved significantly from 27% in 2002 (and 28.1% in 2003) to 20.5% in 2005. Even though structural constraints still result in asymmetrical trends, there is an unambiguous improvement across the socioeconomic landscape, in our opinion. Take, for example, the distribution of income. The Gini coefficient, a widely used gauge of income concentration, fell by 13.6%, from 0.44 in 2002 to 0.38 in 2005. After years of deterioration, Turkey’s middle class is once again becoming a powerhouse. Thanks to a 40% real income growth between 2002 and 2005, the share of national income going to the poorest quintile of society increased from 5.3% to 6.1%, while the share going to the richest quintile fell from 50.1% to 44.4% of all income over the same period. However, the most significant improvement is taking place at the ‘centre’ of the income spectrum, in our view. The combined share of middle-income households — the second, third and fourth quintiles — increased from 44.6% of all income in 2002 to the peak of 49.5% in 2005. We believe that all these developments reflect the strength of income generation as well as the normalization of public finances that used to transfer wealth to the country’s super-rich households. If this trend remains intact, the rise of the middle class will become a secular force for financial deepening and economic growth in the years ahead. Having said that, we also realize structural constraints and entrenched inequalities that result in wide and persistent income differentials across regions and social groups in Turkey. No wonder, if we analyze income distribution according to 5% segments instead of quintiles, social disparities become far more apparent, with the poorest 5% of the population getting 0.8% of all income versus 18.4% received by the richest 5% of households. Socioeconomic improvements are encouraging, but the expectation gap is also important. There are so many complex factors contributing to social disparities — ranging from the link between earnings and educational attainments and the concentration of financial wealth to gender inequalities and the size of households. For example, while labor earnings are the most important source of income for the majority of the population, the richest quintile receives more than 70% of all financial and real estate earnings, compared to the lowest quintile getting a mere 1% of non-labor income. This is partly a result of Turkey’s archaic tax system that created a haven for evading or avoiding income and capital gain taxes (see Of Taxes and Fat Cats, December 14, 2004). Likewise, children of poor and less educated families generally experience a slower progress in skill development and consequently face a restricted opportunity landscape as adult workers. Once again, this is a result of the inequality trap stemming from the fact that the lowest quintile of households accounts for a mere 1.2% of total spending on education versus 70% by the richest 20% of the population. Therefore, although socioeconomic improvements are encouraging, social frustration and the expectation gap, especially in rural areas, still present a challenge to political stability. Of course, beyond short-term implications in the coming elections, Turkey needs to maintain macroeconomic normalization and improve the investment climate in order to accelerate employment and income growth and thereby reduce poverty and income inequality.
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