Normalization: Act II
June 11, 2007
By Stephen S. Roach | New York
There is an important context to the recent violent correction in sovereign bond markets. It is the defining feature of the second act of the great normalization saga. In the aftermath the deflation scare of 2002-03, policy settings and markets were subjected to very unusual conditions. The restoration to normalcy has been a long and arduous process. Central banks led the first phase and are now being followed by a normalization of bond and stock markets. A third act is likely – one dominated by spread markets, such as corporate credit and emerging-market securities. Financial markets are more carefully scripted than you might think.
It has now been four years since the worst of the deflation scare. But the repercussions of this potentially devastating risk scenario are still very much in evidence today. Heeding the painful lessons of Japan, America’s central bank threw caution to the wind when a post-equity bubble shakeout pushed core inflation through the 1% threshold in early 2003. It was quick to take its policy rate down to the rarefied 1% zone and, in inflation-adjusted terms, held the real federal funds rate in negative territory for three years, from 2002 to 2004. While the Fed led the charge in this battle against deflation, similar efforts were undertaken by other major central banks during this period. The Bank of Japan augmented its zero interest policy with an extraordinary “quantitative easing.” And the European Central Bank took its policy rate down to “zero” in real terms and tolerated excess growth in Euroland M-3 for over three and a half years. The medicine worked – or at least so it seemed on one level. Taking comfort that deflation risks were receding, beginning in June 2004, the Federal Reserve embarked on a 17-step policy normalization campaign – in effect, weaning the US economy from the anti-deflationary treatment of über monetary accommodation. And then at 5.25% on the nominal federal funds rate in mid-2006, the Fed stopped – sending the markets a signal that something close to a 2.75% real policy rate was sufficient to cope with inflation risks. At that point, US monetary policy was judged to be “neutral” – having neither a restrictive nor expansive impact on the Fed’s dual mandate of price stability and sustainable economic growth. From this perspective, the normalization of US monetary policy was largely complete. Similar efforts are now under way at the European Central Bank, and at 4% on the nominal refi rate, our Euro team believes comparable normalization objectives will be achieved with another 50 basis points of monetary tightening by year-end 2007. The Bank of Japan, of course, remains the exception. But with deflation risks a lingering concern, a full move to normalization would be premature. Excluding the BOJ, Act I of the post-deflation normalization campaign is now largely over. Act II features the financial markets – in particular, the long end of the yield curve that has been pinned down by the so-called bond market conundrum. A number of explanations have been offered for the persistence of unusually low real long-term interest rates in the past several years – ranging from the excesses of the liquidity cycle and the so-called global saving glut to policy-related dollar buying of Asian central banks and the persistent disinflationary headwinds of globalization. Whatever the reason(s), the slope of the yield curve – which had either been negative or flat for nearly two years – was certainly far from normal. That now appears to be changing. The 50 basis point back-up in 10-year US Treasury yields over the past month is a major step on the road to bond-market normalization. From a relative valuation perspective, this also has important implications for equity markets. Last week, when the bond market sliced through the 5% yield threshold like a hot knife cutting butter, the equity market was forced to respond to the bond market’s normalization campaign – in effect, re-syncing valuations with the emergence of a more traditional yield curve configuration. There could well be more to come in this act of the play. A third act is likely in the great normalization saga – this one starring the spread markets. So far, credit spreads remain abnormally tight, as do those on emerging markets debt instruments. There is no inherent reason why these assets deserve special exemption from a financial market normalization scenario. As investors take their cue from the long end of government bond markets and begin to seek compensation for more of a two-way bet on the inflation trend, the risk on spread products should increase commensurately. The resulting increase in the funding costs of levered carry trades should also have an impact on spread-product normalization. Moreover, to the extent higher levels of both short- and long-term real rates begin to take a toll on expectations of real economic activity, expected default rates on domestic credits should rise. An analogous set of downside risks to export-dependent developing economies should also increase. In my opinion, the confluence of these developments should be more than sufficient to take a meaningful toll on heretofore high-flying spread markets. Risk assets need to be priced for risk. That realization could well be the principal feature of Act III in the high theater of financial market normalization. Inflation and inflationary expectations play the decisive role in driving the transition between these three acts. This is hardly a shocker. After all, it was the absence of inflation – and the risks of a potential deflation – that sparked the unusual policy moves and market responses of the past five years. If inflation comes back with a vengeance, then the neutral settings of policy normalization are, of course, entirely inappropriate. If, on the other hand, inflation stays within the tolerance band of price-targeting central banks, then there’s not much drama to the script laid out above. Moreover, given the ample liquidity that would probably still exist in such a “perfect scenario,” the curtain could go down early and there might not even be a third act involving the riskiest part of the return spectrum. The trick, of course, comes in that grey area when inflation flirts with the upper bound of central bank tolerance zones. That’s precisely the case today, with fractional upside breakouts in the US (+ 2.3% y-o-y on the core CPI and slightly lower than that for implicit consumption deflators) and with Euro-zone inflation of 1.9%. However, since the inflation genie is far from out of the bottle in either economies, on a worst-case basis, it is hard to conceive that either the Fed or the ECB will have to take their policy rates much beyond those implied by the neutral settings of the normalization campaign described above. That’s pretty much the scenario markets are now currently pricing in. It was also the scenario endorsed by the consensus of clients at our just-concluded annual European investment seminar in Cap d’Antibes; while the pack saw inflation as the biggest macro risk over the next year, fully two-thirds of the conference participants expected the magnitude of any upside breakout in European inflation to be confined to the 2.5-4.0% zone. This is in broad alignment with market views in the US. Unlike the weak-economy, Fed-easing mindset that dominated market expectations in early 2007, futures markets are no longer discounting any Fed rate cuts through early 2008. Further out, medium-term expectations are centered on a snugging of no greater than 25 bps through mid-2008. With the ECB slightly behind the Fed insofar as policy neutrality is concerned, markets are pricing in a couple of more policy tightenings by Trichet & Co. by early 2008. In both cases, market expectations are in broad alignment with the calls of our own teams of Fed and ECB watchers. For what it’s worth, I’m still a broken-record advocate of the growth-relapse scenario – especially for the US, where I continue to look for a post-housing bubble retrenchment of the American consumer. Should those fears start to creep back into the markets, a bond-bullish rethinking of normalization risks cannot be ruled out. Obviously, in the face of a strong rebound in 2Q07 GDP, trend-following markets believe the US slowdown has run its course. By contrast, as was the case in the aftermath of the bursting of the equity bubble seven years ago, I wouldn’t be surprised if another growth scare was in the offing before the current post-bubble shakeout runs its course. Nor do I buy the inflation-fear scenario that gets bandied around the markets these days. To me, the globalization-induced headwinds to inflation remain mighty stiff – even in the face of Chinese and Indian wage inflation. With these pay rates still only about 5% of manufacturing wages in the West, the global labor arbitrage remains very much intact – as does its ability to continue to push world prices lower. At the same time, I worry increasingly about the protectionist wildcard – in particular, an anti-China policy blunder by the US Congress that could stoke inflationary expectations and leave the hopes and dreams of bond market normalization in tatters. I also continue to fear that central banks are far too smug about the effectiveness of their inflation-targeting tactics – especially in an era when the combination of low inflation and low interest rates is biased toward a steady string of asset bubbles. Normalization with respect to the narrow CPI target hardly guarantees a normalization of broader macro risks that might stem from boom-bust outcomes in major asset markets. The three-act normalization play presupposes an inherently stable macro climate that has changed very little in recent years. Such complacency could be the biggest risk of all.
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Repricing the Outlook
June 11, 2007
By Richard Berner & David Greenlaw | New York
Forecast at a Glance | 2006E | 2007E | 2008E | Real GDP | 3.3% | 2.3% | 3.0% | Inflation (CPI) | 3.2 | 2.7 | 2.2 | Unit Labor Costs | 3.1 | 2.9 | 2.6 | After-Tax “Economic” Profits | 22.5 | 6.6 | 7.3 | After-Tax “Book” Profits | 19.4 | 5.5 | 4.9 |
Source: Morgan Stanley Research E = Morgan Stanley Research Estimates Financial markets have suddenly repriced to reflect our baseline economic and monetary policy outlook, one that includes improving growth, lingering inflation risks, and thus the Fed on hold for all of 2007. The most striking evidence of that repricing is the jump last week in 10-year US Treasury yields above 5% and the complete disinversion of the Treasury yield curve from bills to bonds for the first time since late 2005. According to Morgan Stanley technical analyst Drew Baptiste, the move in the 10-year yield above 5.01% broke a 20-year bull downtrend, and a chorus of investors are now discussing how high rates can go rather than how much they will decline. Both say something about what is now in the price. Of course, it is critical to assess why rates have backed up, both to analyze what the market is discounting and further to appraise the outlook. In our view, the bond-market selloff primarily reflects the market’s re-rating of global and US growth and policy prospects. As evidence, the jump in yields since early May has been global and has occurred primarily in real Treasury yields rather than inflation compensation (see “The Conundrum Unwinds,” Global Economic Forum, May 21, 2007). For example, 10-year Bund yields rose by 48 basis points (bp) over that period, or by about the same amount as 10-year Treasury yields. Likewise, five-year and 10-year TIPS (real) yields rose by 59 and 47 bp, to 2.73% and 2.70%, which represent three- and five-year highs, respectively. In contrast, 10-year breakeven inflation was essentially unchanged over that period. That investors have virtually abandoned hopes for Fed ease is evident in Fed funds contracts through January, at 5.23% indicating two bp of ease. Looking ahead, it’s equally important to assess how recent developments might change the baseline view. In our case, we see two offsetting factors that are shifting the risks to our baseline: First, incoming data suggest economic resilience both at home and abroad and signal upside risks to growth and to inflation. Conversely, interest rates have backed up more quickly than we expected last month, threatening tighter financial conditions and more subdued growth and inflation. These crosscurrents likely will yield slightly stronger growth and slightly higher yields than we expected a month ago, although qualitatively our outlook isn’t much changed. Here’s why. To review the effects of incoming data, look back just a month ago at second-quarter US growth prospects. On May 7, we thought growth would pick up from 1.3% in the first quarter to 2.4% annualized in the second period. Improvement in capital spending and net exports would more than offset the ongoing drag from the housing recession and the new restraint from higher energy quotes on discretionary spending power and thus consumer spending. The end of low inventory accumulation would trigger a production snapback. Since then, statisticians cut their estimate of first-quarter growth in half to 0.6%, and we now track second-quarter growth at 4.1%. Incoming data for consumer and business capital spending, construction activity, and net exports all point to improved near-term growth in final demand. In all, we now see real final sales running at a 3.2% annual rate in the second quarter, up from an estimate of 2.1% just a month ago. Moreover, industrial surveys from purchasing managers turned higher, hinting that gains in output likely will outstrip demand growth, just as reduced inventory accumulation lowered the growth of output below the pace of demand in Q1. And solid May gains in payrolls, hours, and average hourly earnings suggest that April’s weather-depressed employment results may have been temporary, and that income support for consumer spending remains intact. While spring economic growth thus may hit 4% annualized, that rate isn’t indicative of its sustainable trend. Rather, it mainly represents a snapback from the depressed first-quarter rate, which in part was held back by the supply shock of US oil refinery downtime and surging imports to make up the shortfall. Averaging growth in the two periods together (with a slight upward revision to Q1) offers a much better sense of the recent pace. The average reveals that first half growth is running at about a 2½% annual rate, or fractionally better than last year’s second half, when an intense housing downturn and Detroit’s significant inventory reductions sapped growth. Looking ahead, renewed intensity in the housing downturn and the lingering effects of higher gasoline quotes on consumer spending likely will cap growth below 3% in the second half of 2007, essentially in line with our outlook of a month ago. Two housing headwinds still loom: First, mortgage lenders continue to tighten lending standards, and the impact of that restraint on demand has in our view only begun to appear. In addition, builders have yet to correct fully the mismatch between housing demand and supply. With unsold new homes representing at least 6.5 months’ and more likely 7.2 months’ supply, we think builders must cut one-family housing starts by 20% (not annualized) from April’s level to restore balance. The upshot: The housing recession is far from over (see “The Housing Mismatch,” Global Economic Forum, May 25, 2007). Moreover, the jump in gasoline prices further menaces consumer discretionary spending power. In early May, we thought regular unleaded gasoline would peak at about $3/gallon, but prices have climbed by another 25 cents. Apart from normal seasonal factors, each penny/gallon costs consumers about $1.3 billion in extra outlays. The good news: Wholesale gasoline quotes have slipped by about 20 cents from their peak about a month ago, hinting that the impact on supply of refinery shutdowns may be abating. Even if prices have peaked and decline slightly in June, however, the hike in prices over the December-June period will have cost consumers about $80 billion at an annual rate. The more sedate rise in food quotes has also hurt (recalling that food accounts for nearly 14% of consumer budgets, compared with just 3.3% for gasoline); we estimate the drain on consumer budgets from these two factors will have totaled $116 billion or 1.2% of disposable income. But the recent resilience of incoming data together with the analytics of our view imply that the odds of growth slipping below 2% again have receded dramatically; indeed, there are some upside risks to growth. Four key themes underpin those analytics. First, we think gains in jobs and income will be strong enough to support both moderate gains in consumer spending and a rise in thrift. Second, we believe that booming growth abroad will promote a sustained improvement in net exports and thus output and jobs for the first time in two decades. US net exports haven’t improved yet this year following their contribution of half a point to US growth n 2006, but we think that they will; recent trade data and upward revisions to past data are promising in that regard. Courtesy of hearty global growth and a weaker dollar, we now see corporate earnings running at a 6-8% rate both this year and next (see “Corporate Profits, the Dollar and Global Growth,” Global Economic Forum, June 1, 2007). In addition, we believe that corporate capital spending discipline in recent years implies that “pent-up” demand will support business investment outlays. Finally, as detailed below, we think financial conditions are on balance still supportive of growth (see “How Sustainable is the Rebound?” Global Economic Forum, May 29, 2007). Against that backdrop, we are still wary of upside risks to inflation. We do think that core inflation measured by the personal consumption price index (PCEPI) peaked at about 2.5% in 2006, and the April downshift in core inflation to 2% reinforces that belief. Moreover, inflation expectations are still low. The housing recession should help by triggering a supply-induced moderation in rents and owners’ equivalent rents. These items collectively account for nearly 40% of the core CPI, implying that any slippage from their recent growth rate of about 4% will make it very difficult for core inflation to sustain a move higher. Moreover, increased economic slack should help to cap inflation. We estimate that GDP growth will average just 2% over the six quarters ended in the third quarter of 2007, below anyone’s estimate of potential growth. But we also think core inflation will move up slightly over the next few months, and that the dispersion of inflation risks has risen. 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. Rising energy and food quotes 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 and May. 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 “How Much Inflation is in the Price?” Global Economic Forum, May 14, 2007). The recent backup in yields by itself adds financial restraint to the outlook, especially because we think that a more uncertain outlook has lifted term premiums and will slightly restrain growth and help cap inflation. But because we believe the rate rise is largely the product of stronger global growth, the resulting financial restraint is limited. Moreover, to assess its impact on US growth, it is important to set this change in financial conditions in perspective. Four factors are critical in that regard. First, the restraint is modest, at least so far. For example, equity prices even following the selloff are still up 5-8% this year and 18-20% over the past twelve months. And real rates are still below historical norms. Second, a weaker dollar, tight credit spreads, and still-ample credit availability leave overall financial conditions favorable. For example, while mortgage-lending standards have tightened significantly, lenders have loosened standards on commercial loans to large firms and to credit-card borrowers over the last three months. Third, as we see it, the economy is less sensitive to changes in interest rates than in the past. Finally, any change in financial conditions works with a lag. Thus, the easier financial conditions prevailing in the past are still helping growth (see “Are Financial Conditions Turning Restrictive?” Global Economic Forum, June 8, 2007). Although some upside risks to rates along the maturity spectrum remain, and yields could temporarily overshoot, we do not view the recent upshift in yields as the start of a bear market in bonds. But the recent resteepening of the yield curve may have further to run. While markets may continue to shift from pricing the chance of Fed ease to Fed tightening, high hurdles to tightening likely will keep the Fed on hold at least through the balance of the year, and now more likely through early 2008. That will anchor short-term rates, as the long end of the yield curve discounts new, more uncertain scenarios. Thus, 10-year Treasury yields will probably trade in a 5-5¼% range for now and the yield curve over time will continue to steepen. Our interest rate strategy team headed by Jim Caron thinks that the curve from 2s to 10s will steepen by 75 bp; qualitatively, we agree (see “Bear Steepening, It's Different this Time,” June 8, 2007). By mid-2008, declining core inflation will likely allow the Fed to lower the funds rate by 25 bp to 5%, reflecting our confidence in sustainable growth and risks to inflation. That’s three months later than we assumed last month. In that context, 2-year notes may dip to 4.6-4.7% and 10-year notes may trade near 5¼% early in 2008. Uncertainty in the economic and monetary policy outlook will be a key factor in the bond-market prognosis. Uncertainty influences the shape of the yield curve through changes in the “term premium” — the compensation investors demand for moving out the risk-free yield curve. Term premiums seem to have risen by 10-15 bp recently, partly as higher rates have reduced mortgage prepayments, increased the duration of mortgages and servicing rights, and thus promoted selling of Treasuries to hedge and shorten portfolio duration. Rising term premiums add slightly to financial restraint because they raise the level of interest rates with no change in market participants’ mean views of the fundamentals. Rather, they increase as uncertainty around those means has escalated. A secular decline in term premiums that began in 1990 has steadily flattened the equilibrium shape of the risk-free yield curve, as Fed credibility about capping inflation rose and the uncertainty (and volatility) about future inflation declined. But the curve has been unusually flat to inverted since late 2005. We would argue that the unusual behavior actually began in mid 2004, and some can be traced to the Fed’s change in behavior. Specifically, the Fed emphasized at the start of its campaign to renormalize interest rates that “With underlying inflation still expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.” We think that statement was appropriately aimed at avoiding a damaging replay of the bond-market bloodbath of 1994, in which investors eventually priced in far more Fed tightening than was likely and which slowed economic growth in early 2005 by more than the Fed intended. The change in communications succeeded in altering both expectations of future tightening and the term premium. As evidence, the relationship between the slope of the yield curve and the real Federal funds rate shifted down by nearly 100 bp in mid 2004 and has largely remained there until recently. In our view, the relationship has begun to move back toward the one prevailing before 2004, but it probably won’t revert entirely because the secular decline in term premiums is still intact. It is obviously difficult to disentangle how much of the recent repricing of the long end reflects the change in expectations of the global growth and policy outlook and how much reflects an increase in the term premium. That’s because the term premium isn’t observed: Models are needed to calculate it. In addition, the market’s fundamental expectations overlap with the term premium, because the former reflect the repricing of the market's mean expectations, while the change in the term premium reflects in part the increase in uncertainty around that mean. Nonetheless, the analysis is critical for monetary policy. If a rising term premium — rather than the weighted sum of expected future changes in short-term interest rates — has recently contributed both to higher long-term yields and to a steeper yield curve, both imply slower, not faster, future growth, exactly the opposite of the traditional interpretation of the yield curve. And if the term premium has rebounded for whatever reason, making the current structure of interest rates less stimulative than otherwise, then the level of short-term rates the Fed needs to achieve its goals will be lower than otherwise (see “The Term-Premium Case for Higher Yields,” Global Economic Forum, January 20, 2006). Familiar downside risks to growth linger. In the near term, they center on consumer outlays, and through 2007 they are primarily in housing activity. This spring’s developments in energy markets underscore the lingering threat from supply-induced energy price shocks. Global factors and incipient protectionism add to upside inflation risks. Worries of rising global inflation and the catch-up response by central banks could be a trigger for yields to overshoot — and that may be the biggest near-term hurdle for risky asset markets.
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Review and Preview
June 11, 2007
By Ted Wieseman & David Greenlaw | New York
Big long-end-led losses over the past week extended the Treasury market sell-off to five weeks, with the bulk of the damage coming in an utter rout on Thursday that was driven in large part by collateral damage from severe losses in the mortgage market, with additional pressure from a technical breakdown in Treasuries and at times seemingly disorderly capitulation of long positions. Along with the collapse in Treasuries, major losses in fed funds and eurodollar futures prices left the market priced for essentially no Fed easing at all on any time horizon. The economic calendar the past week was relatively light and had little direct impact on what was clearly a primarily technical and flow-driven move. But the fundamental underpinning of this ongoing reversal in the market and accompanying abandoning of Fed rate-cutting hopes — recognition that the sluggish first quarter very likely marked the trough of this mid-cycle slowdown and that growth is on track for a significant pick-up in 2Q — continued to receive significant further support in the latest week. Incorporating the results of the foreign trade, factory orders, wholesale trade and chain store reports, we boosted our 2Q GDP forecast to +4.1% from +3.4%, with the much better-than-expected foreign trade results that pointed to a significant positive contribution to second quarter growth from net exports the key driver. Upward revisions to March inventory and 1Q foreign trade data also pointed to a slight upward revision to 1Q growth to +0.8% from +0.6%. A surge in the May non-manufacturing ISM to its best level in a year coming after last week’s robust employment and manufacturing ISM reports for May provided further confirmation of the second quarter pick-up on top of these more direct GDP inputs from April. Benchmark Treasury yields rose 4-16bp over the past week and the curve steepened significantly. Indeed, for the first time since late 2005 the entire benchmark yield curve, from the 4-week bill through the 30-year bond, is now upward sloping. The most recent week’s sell-off brought the cumulative losses over the past five weeks to 34bp (for the 2-year) to 51bp (for the 5-year). In the latest week, the 2-year yield rose 4bp to 5.01%, the 3-year 9bp to 5.02%, the 5-year 14bp to 5.055%, and the 10-year and 30-year 16bp each to 5.12% and 5.22%. According to Morgan Stanley technical analyst Drew Baptiste, the move in the 10-year yield above 5.01% broke a 20-year downtrend. Whatever small lingering hopes investors had for Fed rate cuts coming into the week were just about fully abandoned. In the near term, essentially zero chance is now seen of a rate cut by year-end, with the November fed funds contract off 0.5bp to 5.235%, the December contract 1bp to 5.225%, and the January contract 2bp to 5.23%. On a medium-term basis, losses among the red eurodollar contracts ranged from 5.5bp to 5.30% for the June 08 contract to 14bp to 5.365% for the Mar 09 contract. This steepening in the reds left the former as the new low-rate eurodollar contract, a measly 6bp lower than the 5.36% rate on the front-month June 06 contract. As they have been throughout this sell-off, the Treasury market losses in the latest week were real rate-driven, with intermediate TIPS only managing marginal outperformance on the week. The 5-year TIPS yield rose 14bp on the week to 2.73%, a new high since the issue was revived in 2004, and the 10-year TIPS yield also rose 14bp to 2.70%, a five-year high. Over the course of this five-week sell-off, the 5-year TIPS yield has risen 59bp, causing the benchmark 5-year inflation breakeven to decline 8bp to 2.32%, while the 10-year TIPS yield has backed up 47bp, resulting in the benchmark 10-year inflation breakeven rising 1bp to 2.41%. This combination has lifted forward breakevens, however. Based on the benchmark issues, the 5-year/5-year forward inflation breakeven that the Fed has indicated it tracks as an important market-based gauge of inflation expectations rose 6bp in the latest week to 2.51%, the high since November. The past week had a light data calendar, but the almost unbroken month-long run of increases to the outlook for second quarter growth nevertheless continued, as we boosted our 2Q GDP forecast to +4.1% from +3.4% on better-than-expected results from the April factory orders and, especially, trade reports. This represents a nearly 2 full percentage point upward adjustment in just a month — after the much worse-than-expected March trade report was released on May 10 we cut our 2Q forecast to +2.2% and it’s been almost nothing but upward revisions ever since. In addition to the hard GDP input data for April, survey and other key indicators for May continued to provide further confirmation of this sharp pick-up, with a surge in the non-manufacturing ISM survey for May to its best level in a year adding to the prior week’s strong manufacturing ISM and employment reports. In addition, based on wholesale and international trade revisions, we see 1Q GDP being revised up slightly to +0.8% from +0.6%. It is certainly becoming increasingly clear that the still quite sluggish first quarter will have very likely marked the trough of the mid-cycle slowdown. There were four data releases over the past week directly impacting the GDP outlook and all were positive — factory orders, wholesale trade, chain store sales and foreign trade. The factory orders report provided more confirmation that business investment is getting back on track in 2Q after the recent soft patch. Overall factory orders were on the soft side at +0.3% in April after an upwardly revised 4.1% surge in March, as a result of supply disruptions in gasoline refining that held down the non-durables component. But the key core gauge of capital goods demand, non-defense capital goods ex aircraft orders, was revised up significantly, with April boosted to +2.1% from +1.2% and March to +4.6% from +4.4%. This was the biggest two-month gain in over two years. Non-defense capital goods ex aircraft shipments were also revised up in both April (+1.0% versus +0.7%) and March (+1.6% versus +1.5%), pointing to stronger investment spending in 2Q. And overall factory inventories rose a larger-than-expected 0.5% in April, with the non-durables component (+0.5%) posting its biggest rise since last June, supporting expectations that a return to modest inventory building after the outright liquidation in 1Q will add substantially to 2Q growth. The inventory story received further support from another robust wholesale trade report. Wholesale inventories ticked up 0.3% in April after a slightly upwardly revised 0.4% rise in March, while sales jumped another 1.3% on top of an upwardly revised 2.1% surge in March. The April inventory gain was in line with our expectations, but the March revision pointed to a slight upward adjustment to 1Q growth. Meanwhile, decent chain store sales results for May — certainly at least compared to the dismal April numbers, even if they weren’t all that impressive taken by themselves — suggested that the peaking out in gasoline prices is helping to stabilize consumer spending growth after the recent soft patch. Based on the details of the chain store sales results, we boosted our estimates for the general merchandise and clothing store components of the May retail sales report, which we expect to post decent rebounds after significant declines in April. This led us to boost our overall May retail sales forecast marginally to +0.8% overall/+1.0% ex autos from +0.7%/+0.9%. We continue to see the key retail control component gaining +1.1% (which will be a much less impressive gain in real terms, given the expected surge in May headline inflation) and still forecast 2Q real consumption growth of +2.0% after the 4%+ gains in 4Q06 and 1Q. We had been worried about downside risks to that +2.0% forecast before the chain store sales numbers, given the series of record highs set for gas prices through much of the month, but we’re now feeling more comfortable that a more severe consumer retrenchment will be avoided. Finally, the key driver of the stronger growth outlook for 2Q was a much better-than-expected foreign trade report that pointed to a significant positive contribution to second quarter GDP from net exports. The trade deficit narrowed to US$58.5 billion in April from US$62.4 billion in March, as exports ticked up 0.2% and imports plunged 1.9%. Exports were restrained by softness in capital goods that was surprising in light of sharp high-tech-led gains in capital good shipments and industry data pointing to strength in overseas aircraft deliveries. Meanwhile, the import drop was led by a sharp pullback in consumer goods. The volatile drugs category reversed a spike posted last month, but other consumer goods imports were also surprisingly soft, given port data and Asian export figures. The real goods trade deficit plunged to US$54.9 billion in April from US$59.6 billion in March, an even bigger move than the narrowing in the nominal deficit. This April level was well below the 1Q average of US$57.7 billion, and, even assuming a decent widening over May and June, points to a significant positive contribution from trade to 2Q growth. We boosted our estimate of the net exports contribution to 2Q GDP from zero to +0.7pp. Partly offsetting this, the capital goods imports and exports details were slightly negative for second quarter investment, offsetting the positive implications of the upward revisions to capital goods shipments in the factory orders report. Capital spending still appears on track for a big pick-up in 2Q, however — we look for a 10% gain in overall business investment, with the equipment and software component up 8%. Based on the soft import numbers, we also slightly reduced our May and June inventory assumptions, offsetting the upside seen in the April data. We still see inventories adding a substantial +0.9pp to 2Q growth though. This all netted to an upward revision to our 2Q GDP forecast to +4.1% from the +3.4% estimate we entered the week with. In addition, a slightly narrower 1Q trade deficit combined with the upward revision to March wholesale inventories pointed to a small upward revision to first quarter GDP. We look for an upward adjustment to +0.8% from +0.6%. This would leave first half growth running at +2.5% annualized — a much better measure of the current underlying trend than either the depressed 1Q result or strong 2Q reversal. We expect to see a slight pick-up from that pace in the second half before a return to near what we believe is the long-term sustainable trend of +3% in 2008. After the relative lull of the past week, the economic calendar is quite busy in the coming week. Data focus will be on CPI Friday and retail sales Wednesday. The Fed calendar is active, with a number of speakers, including Chairman Bernanke Friday on “The Credit Channel of Monetary Policy”, as well as the release on Wednesday of the Beige Book prepared for the upcoming June 27-28 FOMC meeting. On the supply calendar, an US$8 billion reopening of the 10-year note will be auctioned Tuesday. Other data releases due out include the Treasury budget Tuesday, business inventories Wednesday, PPI Thursday, and IP, the Empire State survey, current account balance, and University of Michigan survey Friday: * We expect the federal government to post a US$68 billion budget deficit in May, up sharply from US$43 billion the prior year, with revenues falling 13% year on year and spending unchanged. The expected weakness in revenues mostly reflects quicker processing of April tax returns that sharply boosted April non-withheld tax receipts at the expense of May (but with solid combined growth over the two months of about 12%). Meanwhile, spending last May was boosted by non-cash adjustments to the valuation of student and housing loans. We continue to forecast a budget deficit for all of FY2007 of US$170 billion, down significantly from US$248 billion in FY2006. * We look for a 0.8% gain in overall retail sales in May and a 1.0% rise excluding autos. Based on the unit sales results, the auto dealer category is expected to be little changed this month. However, a very sharp price-related jump in the gas station component should help push up headline sales in May. Meanwhile, the chain store sales results pointed to rebounds in some of the key discretionary sectors, such as general merchandise and apparel, but some softness in the drug store component. Excluding auto dealers and gas stations, sales are expected to be up 0.5%. Based on this estimate, we continue to see real consumer spending tracking near +2.0% in 2Q. * Based on the previously reported results for the manufacturing (+0.5%) and wholesale (+0.3%) sectors and an expected marginal gain in retail based on an anticipated decline in autos, we look for overall business inventories to post a modest 0.3% gain in April, which would still be the largest rise in seven months after the sharp inventory correction over 4Q and 1Q07. The I/S ratio should dip to 1.27, matching the lowest reading seen in nearly a year. * We look for the producer price index to surge 0.7% overall in May but tick up 0.1% excluding food and energy. A rise in energy prices that just about matches the outsized gains seen the past three months should lead to some significant further elevation in the headline reading. Meanwhile, a rebound in drug prices should be largely offset by an expected dip in the volatile motor vehicle components, leading to another benign core reading, though a bit higher than the back-to-back unchanged results seen the prior two months. * We forecast a 0.7% rise in the headline consumer price index in May and a 0.3% gain excluding food and energy. Another sharp climb in gasoline prices is expected to help lead to one of the largest advances in headline CPI seen in many years. In fact, since 1990, it would be exceeded only by the post-Katrina spike of +1.2% registered in September 2005. Meanwhile, we look for the core to post a mild rebound following a pair of below-trend results in March and April. Hotel rates are expected to post a further gain following on the heels of the bizarre fall-off seen back in March. Also, modest rebounds are expected in categories such as apparel and airfares. On a year-on-year basis, the core is expected to tick back up to +2.4% (after rounding down to +2.3% in April). * We look for a 0.1% dip in industrial production in May. The labor market data suggest that the underlying pace of activity in the factory sector paused in May following on the heels of sharp gains in each of the prior two months. Although motor vehicle assemblies posted a further advance, and output appeared to rise sharply in the aerospace sector, there appeared to be some offsetting pullbacks in categories such as primary metals, textiles, furniture and printing. Moreover, there appear to have been some major disruptions at oil refineries during the month. The net of these various cross-currents is expected to be a fractional rise in the manufacturing component of IP. Finally, mild weather seems to have helped to trigger a modest pullback in the utility component.
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Reformists Get a Large Majority at the Lower House
June 11, 2007
By Eric Chaney | from Paris
President Sarkozy’s party, the UMP, and its close allies are likely to win between 380 and 460 of the 577 seats in the National Assembly (median estimate: 420), according to first round exit polls. This is broadly in line with pre-poll estimates and, if confirmed at the second round, would give a very strong majority to the new President and to his reformist platform. The second round will take place next Sunday. As a reminder, the French electoral system is a two-round first-pass-the post system. In most cases there are only two candidates left for the second round. The current cabinet is likely to be broadly unchanged, although some departments could benefit from more junior ministers. François Fillon (who won his seat at the first round) will remain Prime Minister; Jean-Louis Borloo (also elected) will keep his portfolio as Minister of Economy and Employment. The National Assembly will convene in July and will have to vote on several bills already in the hands of the Conseil d’Etat (the constitutional watch dog). Several will have an impact on the economy and public finances. The most important ones in my view are: 1. Interest on housing loans will become deductible from taxable income, including loans contracted up to five years ago. There will be a cap on this tax break (probably €1,500). 2. Overtime worked will become partially income tax and payroll tax free (details not yet sorted out). 3. The total amount of direct taxes paid by any households will be capped to 50% of taxable income. 4. Universities will be given the option of becoming autonomous, the exact content of autonomy not being fully clarified at this stage (Will it include financial autonomy?) Taken together, these first measures should have a fiscal cost worth between 0.3% and 0.5% of GDP, on a gross annual basis. Their impact on potential growth is debatable. By making home ownership easier, the first measure listed above will increase aggregate households’ collateral and thus could increase their credit and thus stimulate consumption. It could also give some oxygen to the housing construction sector, which is starting to feel the pain of higher interest rates. However, it is unlikely to stimulate long-term growth. The reduction of taxes on overtime hours is tantamount to a reduction of the marginal cost of labour (on an hourly basis, not on a per capita one), which should reduce tax for unskilled workers, and this could increase the input of labour in the overall economy and thus potential GDP. On the other hand, the tax deductibility of interest on existing loans amounts to no more than a fiscal stimulus that will increase the budget deficit without enhancing potential growth. The 2008 budgets (state and welfare funds such as healthcare, now both controlled by Minister of Budget Eric Woerth) are likely to include several important spending cuts, such as reductions in the number of civil servants (half of those retiring will not be replaced) and cuts in healthcare spending. Hence, the net fiscal stimulus next year is likely to be modest, and could even be negative, as PM Fillon suggested in his post-election comment. The next wave of reforms will deal with more structural issues. Atop my list is the reform of the job contract, which, if consistent with Nicolas Sarkozy’s platform, should make layoffs easier and more transparent, and the job-seeking process more effective. Overall, I take the outcome of the first round as favourable for the process of reforms and the potential growth of the French economy. I will revisit the reform process in a more detailed note in the next few days.
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The Gapology of Interest Rates
June 11, 2007
By Serhan Cevik | from Doha
The output gap — domestic as well as global — will determine the trajectory of interest rates. For a country that was once accustomed to inflation in excess of 400%, having interest rates 175bp below the US policy rate certainly presents an unprecedented situation. It may have indeed sounded absurd even a year ago, as eternally bearish residents kept expecting a weaker currency and higher interest rates, but it is, albeit excessive, not surprising, in our view. With the shekel’s appreciation — driving exchange rate-linked prices lower — Israel experienced a wave of deflation that pushed the annual inflation rate from 3.8% in April 2006 to -1.3% this year. This shift in inflation dynamics also allowed the Bank of Israel to alter the course of monetary policy and cut short-term interest rates by 200bp in the past eight months. However, we believe that the policy stance has moved below neutrality and is now out of synch with underlying economic conditions. Although the shekel’s appreciation over the past year reflected fundamental improvements in the economy, the exchange rate pass-through effect is fast becoming less influential over inflation dynamics. Therefore, we need to focus on the lagged effect of accommodative monetary conditions and the behaviour of domestic demand (which has already led to higher inflation excluding the currency factor). In other words, going forward, not the shekel’s valuation, but the output gap — domestic as well as global — will be far more important in determining the trajectory of inflation and interest rates. We may keep getting deflationary readings, but inflation will certainly move higher. We do not expect significant changes in the behavior of inflation in the near future, thanks to strong base effects and the shekel’s relative strength. However, this is simply a temporary phenomenon, in our opinion, influencing prices sensitive to exchange rate movements. For example, housing prices — already experiencing a 6.2% drop over the past year — will continue to be a source of (technical) deflation, albeit at a rapidly diminishing intensity as currency appreciation comes to an end and booming demand pushes dollar-denominated prices higher. Hence, as the shekel stabilizes at its new equilibrium, inflation will move within the target range over the coming year. Indeed, the Israeli economy already has ‘hidden inflation’ — behind the cloud of the shekel’s strength. Consumer price inflation excluding the exchange rate pass-through effect is running above the target range, while deflationary readings in exchange rate-sensitive components push the headline rate lower. And this is exactly why we have argued against further monetary easing. Domestic demand is increasing at an above-trend pace, while productivity growth decelerates. Apart from a brief slowdown during the war in Lebanon last summer, the Israeli economy has remained on a robust growth path, expanding at an average rate of 5% in the past three years. And the latest figures show no sign of deviation from this new trend, as real GDP growth reached an annualized rate of 6.3% in the first quarter of this year. However, there are two important changes in growth dynamics. First, after lagging behind the export engine, private consumption has gained a more prominent role in the composition of economic activity by increasing at an annualized rate of 11.8% in the first quarter. This is certainly not unexpected, given historically low interest rates and improvements in the labour market. For example, the unemployment rate declined from 10.9% of the civilian workforce in 2003 to 7.7% in the first quarter of this year. This is actually the lowest jobless rate in the past ten years, thanks to an annualized employment growth of 5.5%, and confirms the broadening of economic gains. The other critical development we need to focus on is productivity growth. The signs of deceleration in labour productivity growth — already apparent in the second half of last year — have become more pronounced in recent months. Albeit cyclical, it is enough to push unit labour costs higher at a time when the rise in domestic demand leads to the narrowing of the output gap. The balance of supply and demand in the economy is becoming more inflationary. The output gap — the difference between actual and potential growth rates — is an important indicator, but its estimation is difficult, especially in an economy like Israel experiencing structural changes. Nevertheless, even with measurement errors, the behaviour of the output gap provides valuable information about the state of the economy and underlying inflation pressures. And our estimates (as well as the central bank’s calculations) suggest that the Israeli economy will soon have a ‘positive’ output gap, if not already. Judging from the divergence between ‘domestic’ and ‘imported’ inflation rates, it seems that inflation pressures are already here, but simply hidden by the shekel’s appreciation for the time being. Furthermore, the evolution of the global output gap has become, at least neutral and probably inflationary. Therefore, considering the lagged transmission of interest rate cuts in the past eight months, the risks to Israel’s inflation outlook are now on the upside. Although ‘gapology’ is not an exact science and suffers from measurement errors, the current monetary policy stance in Israel is undeniably expansionary when the economy needs no more stimulus.
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A Big Bang Theory of Convergence
June 11, 2007
By Serhan Cevik | London
Turkey must leave behind its historical baggage to achieve economic convergence. After enduring decades of political instability and boom-bust economic cycles, Turkey has enjoyed an extraordinary period of political tranquility and economic normalization in the past four years. Supported by the strength of global conditions, prudent policies and structural reforms led to an acceleration in real GDP growth from 3.6% a year between 1990 and 2002 to 7.4% and disinflation from 71.7% to the single-digit territory. Even slow-moving socioeconomic indicators (such as poverty rates and income distribution) showed substantial improvements. Although Turkey, with its per capita income standing at just 30% of the European average, has a long way to go, economic stabilization and financial rationalization already set the stage for what could potentially become the longest boom in history. Indeed, fiscal consolidation — lowering public-sector debt from 93% of GDP in 2002 to 60.7% last year — let the private sector take the lead in driving the economy to a higher growth path. As the contribution of business investment spending increased from a mere 0.5% between 1990 and 2002 to 4.5% in the last four years, Turkey experienced an unprecedented surge in total factor productivity growth that could, if it remains intact, keep bringing sustainable gains. However, recent events have shaken our confidence in Turkey’s ability to leave behind its historical baggage and anachronistic institutions that present the most significant threat to convergence. The ghosts of the past threaten to polarize Turkish society. The military’s venture into politics and the Constitutional Court’s decision to annul the presidential election process have left us with a Pandora’s box — full of institutional risks that we would not have expected to surface in a country negotiating to become a member of the EU. Indeed, in the midst of an election period, we are still witnessing the emergence of new risks that are causing institutional uncertainties and political fragmentation in Turkey. But what is really behind this sudden burst of agitation? One theory is the clash between religion and secularism that compels the ‘secular establishment’ to take an ‘unwavering’ stance. Though this line of reasoning has obvious appeals, we find it ignores a range of issues that exist underneath these fault lines. Opinion polls show that Turkish society stands firmly against a regime based on religious principles. Furthermore, the great majority of Turks does not see a major threat to secularism and dismisses the so-called clash between religion and secularism as an illusion (see The Litmus Test for Liberal Democracy, April 9, 2007). Indeed, in our view, it is not religious fundamentalism but isolationist nationalism that is the real threat to Turkey’s globalization and convergence towards liberal democracy. In other words, interest groups — representing the country’s statist past built on ‘managed democracy’ and closed economy — are resisting greater openness and changes in the structure of incentives. Unfortunately, such an institutionalized inertia threatens to keep Turkey away from Europe and even to polarize society. The tension is not about the regime, but arises from Turkey’s structural transformation. Several years ago, at the beginning of Turkey’s stabilization attempts, we published a report (Challenging Statism and Crony Capitalism, January 11, 2002) arguing that archaic institutions are at the heart of political fragilities and economic problems. Despite significant progress since then, the internalization of reforms is still far from complete. After all, the state had been the ultimate distributor of income and wealth for a long time and created rent-seeking generations — through state-owned enterprises, administrative measures, subsidy schemes and interest payments. In turn, such institutional arrangements reinforced the culture of ‘clientalist’ relations, which resist institutional modernization. Put differently, today’s tensions are not about a threat to the secular regime, but arise from Turkey’s structural transformation that comes with distributional consequences as well as efficiency gains. This is why there is so much opposition to privatization and foreign investment (even into not so ‘strategic’ sectors). Likewise, the so-called ‘inflation lobby’ has struggled against normalization that removes a major source of income and creates overdue pressure to innovate. Of course, the latest developments are political in nature and reflect the resistance to updating long-held positions on issues like Cyprus, Armenia, Kurds and cosmopolitan democracy (see Finding Common Sense, August 15, 2006). After the coming elections, Turkey needs a ‘big bang’ approach to convergence. Election uncertainty may be high, but there is really no ambiguity about Turkey’s choices, in our view. Just as the 2002 elections represented a turning point for economic normalization, Turkey needs, once again, a new opening to accelerate institutional modernization. The path to liberal democracy and market economy is of course never smooth or without occasional setbacks, but Turkey is now facing a defining moment — a choice between yet another generation lost to the vicious circle of institutional inertia and political paralysis or continuing to close the democratic deficit and keep the economy on a welfare-enhancing trend. Countries, like many other things, move in and out of fashion. Turkey, with its great potential, is now in fashion and has a unique opportunity to build a brighter future
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SWFs – Save the World Funds
June 11, 2007
By Robert Alan Feldman | Tokyo
Big bucks in SWFs My colleagues Stephen Jen and David Miles have written extensively on the growing importance of sovereign wealth funds (SWFs). They estimated that such funds will grow to US$17.5 trillion in aggregate size by 2017, and that the higher risk appetite of such funds might push bond yields up and equity risk premia down significantly.[1][1] There is another side of the SWF phenomenon, however, which has yet to be explored. This aspect is the potential to harness such funds to help solve some of the world’s most vexing problems, such as pollution, energy sustainability and poverty alleviation. It all comes down to how they invest their assets. In this sense, there is a connection between the growing SWFs and the TEDI (Technology, Environment, and Development Initiative) idea that I introduced in March, 2003.[2][2] The development dilemma: Growth versus suffocation The successful SWFs (and precursors such as national commodity funds, or domestic counterparts such as development authorities) are those which have separated the management of national wealth from political considerations. The essence of success is concentration of investments on economic value, and insulation from political use of funds. Unsuccessful institutions are those where politics have intervened, and which are not subject to disclosure or accountability. While independence, disclosure and accountability are essential for proper performance of such funds, there are also economic externalities that will inevitably affect SWF asset allocations. Indeed, as Stephen has pointed out, the two main sources of funds for the SWFs have been oil exporting countries and Asian exporters. That is, the funds are the direct results of globalization and its effect on the demand/supply balance in energy. The externality is pollution. Thus the dilemma: It is unjust to refuse today’s developing economies the opportunity to raise living standards because of the effect of growth on the environment, especially while the developed countries enjoy high living standards. On the other hand, realizing the growth potential of the developing world will — with today’s technology — destroy the planet for everyone. Is there a way out? I think there is. SWFs, if wisely structured, may hold the key. SWF + TEDI The key to solving this dilemma is to put the concepts of the SWF and the TEDI together. Because SWFs are by their nature sovereign, they are owned by the people of their nations, and thus inevitably have a public character. By ‘public’, I mean that they must serve the common needs of a number of owners, which in turn means internalizing economic externalities. Among these externalities are energy and environmental sustainability, along with poverty alleviation. Hence, it is only natural that the SWF investment guidelines instruct that funds be allocated in part to address economic externalities. The innovator’s dilemma But why should the SWFs — especially the oil money — be interested in a fund that would develop alternative energy sources and potentially lower the value of fossil fuel energy reserves that these countries now own? The answer lies in the effect of technology advance on resource values. At today’s oil prices, there is accelerating investment in alternative technologies. The higher oil prices go, the more such investment will accelerate. At some point, a breakthrough will occur. The old, carbon-based energy technologies will wane, and the new, environmentally friendly ones will wax. Successful companies are those that actively invest in technologies that can disrupt the markets they currently control.[3][3] SWFs, in order to serve the long-term needs of their owners, must take this lesson to heart. To paraphrase the American proverb, since you can’t lick ’em, you better join ’em. Rational behavior for the SWFs, therefore, is to invest aggressively in disruptive energy and environment technologies, and thus to own the tools that will bring sustainable economies. To this end, a share of SWF assets should arguably be allocated to technology, environment and development projects that help ensure sustainability. What share? A surprisingly small one, I think. After all, if SWF assets grow to US$17.5 trillion in value over the next ten years, a mere 10% would allow US$1,750 billion for such investments. How big are the required investments? Perhaps history gives a guide, however imperfect. The Manhattan Project, perhaps the most ambitious Big Science project in history, cost about US$23 billion in 2006 dollars.[4][4] Thus, a 10% allocation of SWF assets over the next ten years would allow the equivalent of 76 Manhattan Projects. Moreover, there is no contribution in this figure of US$1,750 billion from the non-SWF countries — who should also contribute. Leadership The real stumbling block is not science, but politics. As the G-8 Summit showed, there is much attention to the goals of environmental and energy security, but less agreement on the particulars — even crucial particulars like whether to set numerical targets. Fortunately, Japan and Europe seem to be creating a ‘coalition of the willing’ to accelerate energy and environmental policy action. If the growing power of SWFs can be harnessed to the issue, then the outlook for the markets — not to mention for the planet — would improve.
[1][1]See How Big Could Sovereign Wealth Funds Be in 2015? by Stephen Jen, and Sovereign Wealth Funds and Bond and Equity Prices, by Stephen Jen and David Miles, Morgan Stanley, May 3, 2007 and May 31, 2007, respectively. [2][2]See Replacing Pessimism – A CRIC Cycle Approach, by Robert Alan Feldman, Morgan Stanley, March 27, 2003. [3][3]See The Innovator’s Dilemma, by Clayton Christensen, Harvard Business School Press, 1997. [4][4]According to Bureau of Labor Statistics data, the average level of the consumer price index for 1942-45 was 17.3, and the level for 2006 was 201.6. Since the Manhattan Project is estimated to have cost US$2 billion in current dollars, the 2006 could would be about US$23 billion. (=2 * (201.6/17.3).
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