The Peril of Underestimating Risks
June 19, 2007
By Serhan Cevik | London
The correction in financial markets is a sign of normalization. After the sell-off in the US bond market that pushed yields sharply higher around the world, financial markets have stabilized, thanks to the abundance of liquidity and the strength of economic fundamentals. However, the adjustment in expectations (and especially in the long end of the yield curve) may not be over, considering the fact that just a few weeks ago the US bond market was pricing the start of monetary easing over the course of this year. With the US economy holding up much better than expectations and the rest of the world growing at a rapid pace, the focus has moved, once again, onto underlying inflation risks and the direction of interest rates (see Richard Berner’s analysis, Repricing the Outlook, June 11, 2007). Like other emerging markets, Israel, too, has come under pressure, experiencing corrections in the exchange rate and bond prices. The shekel, for example, depreciated as much as 7.2% against the dollar and the 10-year bond yield differential widened from flat to 46bp vis-à-vis the US. However, following the global stabilization pattern, the shekel is now 2% stronger and the yield differential is a mere 10bp wider than the tightest reading. Although we still believe in the shekel’s fundamental strength, interest rates in Israel are not in synch with strengthening domestic demand and emerging inflationary pressures.
The shekel’s appreciation is no longer enough to curb inflation pressures. The consumer price index was unchanged last month, a bit lower than our projection for a 0.1% increase but higher than the consensus estimate for a 0.2% decline. As a result, the year-on-year inflation rate remained at -1.3%, still dramatically lower than 3.5% a year ago. But we all know that the overwhelming factor driving inflation from above the central bank’s target range into deflationary territory has been the shekel’s appreciation that pushed exchange rate-linked prices lower. The housing sector, for instance, with its long-standing habit of dollar-based contracts, posted a 1.6% drop so far this year and 5.3% over the past 12 months, contributing to the wave of deflation. However, as we have long argued, this is just a technical phenomenon, not ‘real’ deflation stemming from economic weakness. Indeed, if we look beyond the headline figure, there are clear signs of higher inflation in the Israeli economy — hidden behind the veil of currency appreciation. According to the Bank of Israel’s calculations, the annual inflation rate of CPI components influenced by exchange rate movements was -4.6%, whereas ‘domestic’ prices unaffected by the shekel’s appreciation recorded a 4% increase. Moreover, the behavior of dollar-denominated prices has also started becoming inflationary. For example, housing prices declined by 1.6% in the first five months, while the shekel appreciated by 4.7% against the dollar. In other words, even dollar-based prices are now on the rise — an unsurprising development, in our view, given the strength of domestic demand. The narrowing output gap will become one of the key factors determining inflation. After expanding at an annualized rate of 6.3% in the first quarter, Israel’s economy shows no sign of slowdown. If anything, it is highly likely to record even stronger readings in the remainder of the year, as domestic demand gains momentum. One of the leading engines of growth is private consumption, and the consumer confidence index increased by 5 points in May to the highest level in the past five years, thanks largely to sustained improvements in the labor market. The unemployment rate already declined from 10.9% in 2003 to 7.7% this year — the lowest reading in the past ten years, while real wage growth accelerated to 2.9% in the first quarter. Therefore, it was not surprising to see a sustained increase in consumer spending (reaching an annualized rate of 11.8% in the first three months of the year). It may be early to flag an episode of overheating, but the Israeli economy is certainly expanding at a rate that keeps narrowing the output gap, especially as we witness a slowdown in productivity growth (see The Gapology of Interest Rates, June 11, 2007). Interest rates at current levels underestimate inflation risks, in our view. Although fundamental improvements should keep supporting the shekel’s valuation (below 4.10 against the dollar), the deflationary power of currency appreciation is coming to an end and ‘domestic’ factors will become far more influential over inflation dynamics. As a consequence, with the stabilization of the exchange rate and above-potential growth in domestic demand, we expect a steady increase in inflation. Considering the lagged transmission of monetary easing — 200bp since last October — the risks to growth and inflation are on the upside. This is why we think that interest rates at current levels underestimate inflation risks (arising from domestic factors as well as global developments like higher energy and food prices). In addition, thanks to technical (but temporary) deflation, Israel has decoupled from the rest of the world, as the difference between domestic and market capitalization-weighted world interest rates declined from 160bp in May 2006 to -80bp this month. We are not obsessed with interest rate differentials, but pricing perfection not just in economics but also in geopolitical affairs sets the stage for higher volatility.
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Reforms? Yes; De-coupling? No
June 19, 2007
By Gray Newman and Daniel Volberg | New York, New York
In early June, a bout of risk reduction sped through emerging markets, weakening currencies that had been rallying for months or in some cases for years. Mexico’s peso was among the casualties — moving from 10.71 to 11.02 in the first half of June. Yet no sooner had markets begun to prepare for uncertainty over the impact of an uptick in US growth on inflation and higher Treasury yields, than a series of data releases suggested that US inflation might not be the problem that some had feared. With that, the prospect for peso strength has re-emerged. After all, the Mexican peso rally — from 10.95 in mid-February to 10.70 at the end of May — had faced resistance only once global risk reduction had reappeared. And despite the February through May rally, the peso’s gains had been modest over the past 12, 18 or 24 months. While Colombia’s currency had gained 21% and the Brazilian Real had moved by 22% during the past 18 months, the Mexican peso was largely flat in the 18 months ending at its recent peak in late May. Indeed, in the 18 months leading up to end-May, the peso had actually weakened by 1%. And so, Mexico peso bulls argue that as risk appetite returns, the peso can rally and perhaps even begin to make up for the rally that the currency had missed in 2005 and 2006. We are not as upbeat, for two reasons: The link cuts both ways
First, it should come as little surprise that investors have distinguished between the Mexican peso and other Latin and emerging market currencies. Within emerging markets, no country has stronger links with the US economy than Mexico. Last year, the US purchased 85% of all of Mexico’s exports; no other country in emerging markets came close. And the link between Mexico and the US is not just a matter of US demand for Mexican manufactured goods; US demand for Mexican labor in 2006 helped fuel nearly US$25 billion in remittances that were sent back to Mexico from workers in the US. At nearly 3% of GDP, remittance flows outstripped both foreign direct investment and tourism revenues last year. Perhaps most worrisome, in a reversal from the normal pattern, in late 2006 and through the first four months of 2007, remittance flows began to slow just as Mexico’s economy lost steam. Indeed, in the six months ending April 2007, remittances grew just 3.1%, a far cry from the 24.4% gain over the same period a year earlier. That removes what has normally been a robust countercyclical inflow that helps to temper the downturns in Mexico (see “Mexico: The End of Abundant Remittances?” Global Economic Forum, April, 17, 2007). With questions surfacing in the past 18 months over the strength of the US economy, it is hardly surprising that the currency of the economy with the strongest US links within emerging markets has fared poorly. Indeed, Mexico is likely to earn the distinction this year as the slowest-growing economy in emerging markets if our forecast of 3.3% GDP growth holds. No commodity gains
Second, Mexico is virtually alone among Latin American economies in its failure to benefit from the boom in commodity prices, oil prices excluded. And even in the case of oil, production declines have partially offset the upturn in prices in recent years. For example, last year the public sector’s oil windfall amounted to M$108.4 billion (1.2% of GDP) thanks to soaring prices which averaged US$53 per barrel, fully US$16.5 above the budget estimate (US$36.5). But oil exports last year averaged 1.794 mbpd, a shortfall of 4% compared to the original budget estimate of 1.868 mbpd. Unlike the rest of Latin America, oil and other non-manufacturing exports simply don’t account for much of Mexico’s export mix. Oil exports in the 12 months ending in April 2007 represented only 8% of Mexico’s merchandise exports. In contrast, commodity exports (broadly defined as non-manufacturing exports) account for nearly half of all exports for Brazil and for between 60% and 90% of exports in most of the rest of Latin America. Accordingly, we have been fairly bearish on the prospects for the Mexican peso. We have repeatedly run our models looking at the relationship between the Mexican peso and growth, between interest rates in Mexico as well as differentials with the US, and between inflation differentials with the US and other variables, only to continue to find projected values for the Mexican peso between 11.00 and 11.40 for 2007. Until now, we have been on the weak end of the range. Peso revisions
Today, however, we are modifying our peso forecast, moving it to 11.00 from 11.40 for the end of 2007 and to 11.10 from 11.60 for the end of 2008. The reason? Our expectation that Mexico’s new administration is likely to accomplish more on the reform front than we had expected when it first took office. When the administration first took office in December 2006, we were skeptical about its ability to advance on the reform front. The authorities appeared to have been caught off-guard and panicked when the corn-tortilla price crisis arose in January, they suffered defeat when the Senate rejected the president’s nominee for the board of the central bank, and they were only able to secure a watered-down version of public worker pension reform. The concessions granted in order to get the pension reform passed, we feared, were especially telling. The reform was not innovative: after all, the move from a pay-as-you-go to a fully funded system had already been accomplished ten years ago in a sweeping reform of pensions for the entire private sector. What was at stake was simply to bring public workers into a similar arrangement. And the political maneuvering was not that daunting — two major political parties had supported the move and the negotiations mainly centered on working with two union leaders, both of which had showed a willingness to support the reform. It was surprising then that the administration agreed to such a modest form of the reform — one which allowed all current workers to opt out of the new system and hence reducing the savings from the reform. We concluded that the public workers pension reform was a sign of the weakness of any political pact between the administration and its centrist opposition. On that front, we have now changed our view. We now believe that the authorities deliberately accepted a weakened pension reform in order to ensure its passage, use it as a showcase of the administration’s willingness to compromise and be able to build some political momentum to help with the next reform. We suspect that by negotiating a compromise on the pension reform, the authorities are in stronger shape today to present a fiscal reform in the coming weeks. As with the pension reform, we expect that the authorities will be conservative with the fiscal reform in order to ensure passage. A move to a single A credit rating would likely require revenues totaling four or five percentage points of GDP: that does not seem to be what the fiscal reform will provide. In contrast, however, a modest reform garnering 0.8% to 1.2% of GDP initially, with 2% or more over the course of the next five years as tax efficiencies kick in, seems likely, and should be enough for another upgrade in Mexico’s country rating to just one notch below the single A range. The reform appears set to address four issues: boosting tax revenues, attacking tax evasion, increasing the reliance on tax collection from the states as opposed to the federal government, and introducing a new level of scrutiny and transparency in public spending. We remain concerned, however, that while boosting Mexico’s public finances is a necessary condition in order to be able to fund the pressing needs in the country’s infrastructure and human capital, a reform of public finances is in itself insufficient. Mexico needs to ensure that the increased public finances are used appropriately (see “Mexico: An Abundance of Reforms?” This Week in Latin America, February 19, 2007). Bottom line
Mexico remains linked to the US and that link cuts both ways. In a period of strong US growth, Mexico also benefited. But more recently, a sluggish US economy has taken its toll — with the usual lags — on Mexico as well. Given our expectations that the US economy will grow just under 2.5%, we expect Mexico’s economy to continue to lag that of other emerging markets. The US link is also likely to weigh on the Mexican peso. Thanks to the prospects for modest reforms, we’ve tempered our cautious stance on the peso, but we do not see a significant, sustainable upside to the Mexican peso from current levels.
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Key for Summer Rate Hike: June Tankan Preview
June 19, 2007
By Takehiro Sato | London
Tankan likely to reconfirm healthy corporate sentiment and capex activity The headline result dropped in the March Tankan on concerns about the decline in global stock prices just before the survey period and the US economy. Our main interest in the June Tankan is whether the headline result improves amid a rapid pullback in uncertainty about the US economy. Although the Reuters Tankan, a leading indicator, is somewhat sluggish at this point, our model suggests that the headline result could remain firm. The manufacturing environment is not particularly healthy, with declining automobile exports and high inventories for IT products, but a firm headline result is likely to bolster investor confidence in the sustainability of economic growth. We currently think this could happen. Although investors are concerned about the resilience of capex, given some weaker data flow, such as machinery orders, against the backdrop of an ongoing discrepancy between the healthy corporate sector and sluggish household sector, we expect the June Tankan to clarify firm capex similar to the recent MoF Corporate Statistics data. The general trend in our economist industry has become that the BoJ Tankan forecast is announced sooner after the Reuters Tankan, but this time there will again be a gap of over ten days between the two. Sudden changes in the market environment could alter corporate sentiment over the next 10 days while the BoJ is conducting its survey. We hence might have to revise our forecast to reflect near-term stock and currency market trends. Key reference data releases prior to the Tankan are the Business Outlook Survey (June 20) and May Index of Industrial Production (June 28). Business conditions DI outlook We project +23 and +21 for the business conditions DIs for large manufacturers and large non-manufacturers, flat from March levels in large manufacturing and a 1ppt decline in large non-manufacturing. The main factors supporting our outlook for firm manufacturing sentiment are 1) past production activity, such as inventory and shipment trends from one quarter or more earlier, has a larger impact on corporate sentiment than the latest output results in our model, 2) continued steep yen depreciation in real effective terms is propping up exports, and 3) lower breakeven points thanks to the fixed cost cuts are enabling companies to generate profits with only modest sales growth. In large non-manufacturing, we expect a fall in retail industries DI to weigh on the non-manufacturing sentiment as a whole. Meanwhile, the outlook assessment DIs should again turn more cautious. The outlook assessment DIs often weaken as the current condition DIs climb. This time as well, we think that the outlook assessments for large manufacturers will come in at +21, 2ppt behind the current assessments. However, this stance does not have strong negative implications. Our rough estimates based on Reuters Tankan DIs suggested 2ppt and 1ppt declines for manufacturers and non-manufacturers respectively from the March Tankan. However, the result varies depending on whether we use the quarterly average or the end of quarter data as an explanatory variable, so we avoid using these results as our official forecast. Forecasts of management plans in F3/08 1) Sales and profits targets: Large enterprises (all industries) projected +1.6% YoY sales and -0.6% recurring profits for F3/08 in the March Tankan, taking a cautious stance as expected. We expect companies to retain this conservative stance in the June Tankan judging from January-March results, and are not counting on robust profit outlooks. However, there has been some positive news. Our updated economic forecast (from June 11) envisions +2.4% nominal growth in F3/08 for the first gain exceeding 2% in 11 years since F3/97. Japan’s return to a normal nominal growth rate after a lengthy period of being at the lowest level among OECD countries suggests that a new phase of sales growth driving higher profits (instead of relying on restructuring savings) is arriving. We think that double-digit profit growth is within reach in F3/08, considering revisions to conservative initial plans over the past two years. Yet the June Tankan is unlikely to offer clear evidence of this potential. 2) F3/08 capex plans: Large enterprises make their largest upward revisions to capex plans from the March to June Tankan reports since few companies have finalized plans prior to the end of the previous fiscal year when the March survey occurs, while many present clear plans based on previous-year results and business outlooks for the new fiscal year by the June survey. Average plan revision rates in the June Tankan for the past four years since F3/04 are +3.9% for large enterprises (+6.8% for manufacturers and +2.3% for non-manufacturers). We project a +3.5% overall revision rate for large enterprises (+4.2% for manufacturers and +3.1% for non-manufacturers), which is less than the average, in light of somewhat cautious outlooks for domestic capex from major manufacturing industries in other surveys, such as Nikkei’s capex trends survey. Based on the projected revision rates, we expect the capex plans of large enterprises (all industries) to target +10.0% YoY growth (+10.8% for manufacturers and +9.6% for non-manufacturers) in F3/08. Our outlook for slower momentum from manufacturing capex reflects pricing and orders dips with semiconductor, LCD and other IT-related investment demand entering a lull. Although domestic automotive capex plans should remain high relative to weaker domestic and overseas sales trends, we do not envision the robust activity seen last year. Non-manufacturers, meanwhile, should match the F3/07 revision rate, given growing capex demand in a wide range of services industries, including industrial infrastructure (electric power and transportation) and corporate/personal services. Policy and market implications The June Tankan might provide a strong indication of where monetary policy is headed in the summer. The BoJ should conclude in its interim assessment of the Outlook Report at the next MPM on July 11-12 that the economy is proceeding in line with its scenario if capex plans are generally upbeat, even if the headline result stalls somewhat. While the BoJ is likely to postpone a rate hike at the July meeting for political reasons such as deference to the ruling parties prior to the Upper House election, this outcome would further strengthen expectations for a rate hike at the August meeting (August 22-23). In fact, there is risk that the BoJ hastily proceeds with rate normalization despite weak prices, since it seemingly assumes that not lifting the policy rate when the economy is on track with its scenario could lead to a loss of confidence within the framework of semi-annual Outlook Reports and interim assessments. The June Tankan Survey should be an important milestone of whether the BoJ continues its aggressive normalization campaign. As for the market implications, overseas investors in Japanese stocks have some doubts about the BoJ’s push for tighter monetary policy on the basis of preventing a future bubble while prices are still declining. Investors might sour toward the Japanese market if the BoJ steadily moves ahead with tightening without providing a sufficient explanation.
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