Europe
The Economy Is Cooling
September 28, 2007

By Eric Chaney | London

There is a wide gap between volatile financial markets (such as the currency market) and the slow, measured reaction of the real economy to financial storms. Yet, listening carefully to the company managers surveyed over the last two weeks by economic institutes such as Ifo, Insee, Isae and their peers, we perceive growing evidence that the euro area economy is actually cooling. Even if we continue to believe that 3Q GDP may surprise on the upside, a mirror image of weak results in the previous period, the underlying trend is unambiguous: production slowed in September; demand, although still growing above trend, is decelerating and expected to decelerate further; and the inventory shortage is no longer a stimulus. As a result, companies are scaling down short-term production plans more neatly than they have done over the last six months. After almost two years of above-trend growth, euro area GDP is likely to grow more slowly than its potential rate, and the risk of at least a growth recession is serious. Policy makers, starting with the ECB, should pay attention to this inflexion point, because the news is coming from companies themselves, not from politicians trying to influence the ECB.

Production took a hit in Italy and Germany

The current production indicator slipped to 0.8 standard deviations (s.d.) above trend from 0.9. We would not give much weight to this very marginal change if it had not originated in two of the large euro area economies, Germany and Italy, where this indicator dropped by 0.5 s.d. Only a sharp rise of the Dutch indicator, which could be related to the end of the maintenance period in large refineries, prevented the overall index from falling more heavily. Our models suggest that this coincident indicator should decline further in each of the next six months.

Demand is robust but now slowing …

The demand indicator lost one-tenth of s.d. to 1.2, more than recouping the improvement reported in August. The correction was concentrated in Italy, where domestic orders fell heavily. By contrast, demand reported by German manufacturers did not weaken significantly: the indicator stood at 1.9 s.d., below the 2.4 mark reached last December, but still comfortably above trend. Our interpretation is that overseas demand for capital goods but also domestic demand from the capital goods sector is structurally strong and exceeding production capacity. German companies’ relative specialisation in this hot sector makes them less sensitive to the cyclical slowdown.

… and companies do not feel comfortable about production plans

However, even German companies seem to believe that red-hot demand is not sustainable. Production plans for the next three months, an indicator that is central in our models because it synthesises all the public and private information company managers have access to, fell by 0.5 s.d. in Germany, dropping below one standard deviation for the first time since February. Overall, thanks to more robust expectations in France and Italy, the euro area index fell by only 0.2 s.d., to 0.6, half of the level reached at the November 2006 peak. Since inventories were reported as significantly less insufficient than in previous months, it is sensible that companies are now trimming production plans in a context of slowing demand.

The Surprise Gap dropped into negative territory

For the first time since November 2005 (when it was a false alert), the Surprise Gap Index moved into negative territory, indicating that companies produced less than they had planned to do three months ago. This is not a recession signal: at -0.11, the index is still above the deceleration line (-0.26) that is indicating a high probability of growth slowing significantly below trend, on our estimates. Yet, the message of this reversal indicator is important: despite very cautious production planning and a significant capacity constraint in the capital goods sector, companies overshot their plans every single month since December 2005, at least until now. This implies that risks to GDP growth have moved from positive to negative.

Cooling, not hard landing

Overall, the ‘orderly slowdown’ scenario that we saw coming in July (Euroland Business Cycle Watch: Toward an Orderly Slowdown, July 27, 2007) is materialising. The slowdown should be more pronounced than we had expected then: our early GDP indicator for the third quarter dropped from 0.40% to 0.36% and its first shot at 4Q GDP growth is 0.46%, which is below trend. The money market crisis and the flattening of the yield curve that it has caused, together with a significant slowdown in the construction sector, were responsible for the downward revision. That the financial turmoil should have an impact on the real economy via a shift of the credit supply curve is important, because it might call for a kind of policy reaction different from what the ECB has done so far (temporary injection of liquidity), if confirmed and amplified.

Policy implication: A rate cut cannot be excluded

In plain English, if our analysis of the business cycle trend is correct (i.e., GDP growth could fall below trend for a couple of quarters), the ECB might have to consider a rate cut as a possible option. However, the most likely result is that the Council will opt for the status quo, as long as the probability of a hard landing remains as low as our indicators are suggesting: our Compass model, although shifting towards the western part of the map (risk of recession), is still in the grey zone.

 

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Japan
Modest Pick-up Alert
September 28, 2007

By Takehiro Sato | New York

Summer slowdown has been steeper than foreseen, but there are encouraging signs of late

The slowdown in Japan’s economy this summer that we originally foresaw has proved to be deeper than we expected, exacerbated by the global financial turmoil triggered by the US subprime meltdown. We even entertained the possibility that negative growth in real GDP in April-June could be repeated in July-September due to feeble consumption. However, the customs cleared trade balance data for August was unexpectedly strong, and there is now a chance that GDP in July-September could pick up, driven by overseas demand, with net foreign demand making a positive GDP contribution of an annualized 1% or more. Manufacturing industry has already been improving clearly from the summer, with industrial production data for August showing a sizable rise in output. In this light, while conscious that our timing may be a bit early, we are willing to risk forecasting that the economy will pull out of its summer doldrums.

Making the case for consumption to pick up

We cannot relax our guard for the time being. Even if the economy moves out of its summer inertia, the outlook is still for feeble consumption in July-September. July was a slow month for spending to start with due to bad weather, and this has been compounded by the bringing forward of department store sales campaigns into June. Consumption of summer goods perked up in a roasting August, but with temperatures remaining uncomfortably high in September, sales of autumn clothing have suffered, and it looks reasonably clear that consumption in the quarter overall is going to be unimpressive. Housing investment is also extremely weak. With condominium developers deliberately restricting supply to the market in urban areas where housing prices are now rising and home-buying sentiment among households weakening, revision of the Building Standards Act has depressed annualized housing starts in July and August far below one million units, which is unusually low. The effect of housing starts data will obviously appear in GDP-based residential investment. This environment creates the danger that corporate and household spending sentiment will not recover very much even after the summer.

Nevertheless, there are a number of reasons to foresee encouraging signs for consumption heading into October-December. Three are outlined below:

1) Personal consumption in July-September has been dampened by increases in residents’ tax from June. But since personal residents’ tax increases go hand in hand with earlier income tax cuts in January, the marginal impact of the higher residents’ tax burden will wear off in October-December. Of course, the outlook beyond is nothing to write home about, since the effect of scrapping special tax breaks remains, but there is a risk of misreading the outlook by assuming that the impact of residents’ tax hikes will go on.

2) Large manufacturing companies since the July-September quarter have been shifting into a mode of production increase, particularly for digital electronic appliances, eying the peak in demand next year in April-June. Automakers too are on track to pull back by the end of the year most of the output lost when the Chuetsu offshore earthquake interrupted parts supplies and forced them to cut back production lines to four business days in July. In this environment, it is possible that we will see a virtuous cycle, in some areas anyway, in which the expanding income formation power of large manufacturing firms feeds increases in income (mainly non-regular wages) and eventually consumption. We cannot be unreservedly optimistic, naturally, with sentiment at small businesses in a number of surveys and grass roots sentiment in the Economy Watchers Survey still notably weak. But for large manufacturers at least, pessimism should not be overdone.

3) Summer-like temperatures carrying over into September appear set to hit consumption further in the July-September quarter. The meteorologists expect autumn temperatures to arrive in October, and as the weather normalizes autumn goods consumption and demand for fall excursions should be primed.

Though having a solid grounding, these factors are not necessarily convincing enough to confidently predict at this point that consumption will pick up. However, we also think that overlooking small shifts in consumption just because wages remain stagnant could mean missing valuable investment opportunities. Given the rising uncertainty for the US economy, there is some risk in doing so, but we would like to make the call that the summer slowdown is probably over at this rather early point in order not to miss the bus.

Market implications

We have been in New York for our Japan Equity Conference this week, and the expectations of US investors for Japan’s economy and stock market are pitifully low. When views point entirely in the same direction, however, it sometimes signals that all the bad news has been discounted and that the market is near its bottom. There is a saying in the market that “a bull market begins in despair and breeds on skepticism”. The reality is that US investors do not view Japan with despair, but they have been stung by the poor relative performance of the Japanese market and are uniformly unable to find catalysts for a rally, in part because of the impasse for reform created by political uncertainty. If the hypothesis above is reasonable, however, it may be wise to be prepared for a level correction in Japanese equities.

Regarding the political situation, the Fukuda cabinet may be heavily swayed by the old guard LDP, and we must watch with a critical eye for backsliding on policy ahead of the general election. PM Fukuda himself, however, despite his aloof bearing and behavior, is extremely tough. His new cabinet might be able to exercise an unexpected degree of leadership in the face of resistance from the bureaucrats and within the LDP. Expectations for the new group are pretty low to start with, and such a cabinet might prove more effective than most expect according to the historical pattern (like Obuchi’s cabinet, and quite unlike Abe’s). The current cabinet does appear in large part to have been formed with an eye on the coming general election, but we see some potential for its performance to be a positive surprise.

Risks

The primary risk to our scenario is that with wages remaining anemic, the consumption recovery in October-December will fail to match our expectations. The Monthly Labor Survey showed that total cash earnings were sluggish in the most recent data for July, owing to measly bonuses at small and medium-sized firms. A feature of the current leveling off for the economy has been the lagging performance of smaller firms, but with large companies doing better from July-September and macro supply and demand for labor heading towards equilibrium, we can cautiously look for sentiment to catch up to a degree at these small enterprises.

Another risk is that despite the prospect of a pick-up in manufacturing performance from the July-September quarter, the picture could change if US consumption takes a nosedive. The Fed’s decisive policy response is helping restore some composure to financial markets in the US, but we think that there is likely to be future fallout from the subprime issue in the US economy, and are watching warily for changes in the production and shipment trend for digital electronic goods. Support for our scenario comes from extremely solid demand patterns in Asia and Europe, however.

 

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Currencies
Belated Verbal Intervention from the ECB?
September 28, 2007

By Stephen Jen & Luca Bindelli | London

Summary and conclusions

While EUR/USD has just set a record high, the EUR TWI (trade-weighted index) is nowhere near its record high and, in real terms, is only approaching the level last seen in late 2004, when the Euroland economy was a lot weaker.  These observations, coupled with the fact that the ECB seems very focused on containing inflationary risks, suggest to us that the ECB could have a surprising amount of tolerance for a higher EUR/USD.  Where EUR/USD goes from here should thus be driven more by policies rather than verbal or actual intervention, we suspect.  

The USD depreciation last week was exaggerated

The depreciation in the dollar in the past two weeks was not surprising to us.  What was remarkable was the speed of the decline.  Our view is that the Fed’s front-loading of rate cuts was the main reason for the sharp sell-off in the dollar, and that, in the weeks ahead, the dollar is unlikely to continue to decline at the same speed as it has over the past week unless the Fed cuts another 50bp on October 30-31, 2007.  The reason for this is as follows.  When we announced our latest forecasts two weeks ago, we had assumed that the Fed would be ‘gradualist’ in its delivery of monetary stimulus.  In that scenario, the dollar should weaken with the US economy.  As the US economy slows, the rest of the world (RoW) should also feel some spill-over effects, which should, in turn, temper the dollar’s decline.  However, the Fed surprised us last Tuesday by front-loading the rate cuts, and the currency markets had trouble pricing in the real economic slowdown and the prospective impact on the Euroland economy. 

In other words, rate differentials and rate expectations were more important in pushing down the dollar than relative growth, which we think should also be USD-negative, but just not as negative.  In fact, in the weeks ahead, we may indeed see the ‘growth story’ becoming more important than the ‘interest rate story’, as the US economy, and the Euroland economy, start to show softness.  Investors have so far ignored the weak ZEW and Ifo surveys but, over time, we believe that investors will question whether the ECB is done with rate hikes and whether its next move could be a cut.  This mere possibility will help contain EUR/USD, in our view.   

USD selling and buying opportunities

EUR/USD is likely to be over-valued, in our view.  However, we don’t think that the time is ripe for investors to sell these currencies, as the dollar could weaken further in the months ahead, offering better levels from which the USD could rally when the US economy recovers.  If we believe that this is a mid-cycle event in the US, then investors should be flexible about their posture regarding the dollar: short it now, but be ready to buy it back when the US economy bottoms. 

The ECB could be tardy in talking down EUR/USD

In the meantime, EUR/USD’s trajectory (both the level and the speed) will be a function of the ECB.  Guessing when the ECB will commence verbal intervention and actual intervention in the currency markets is very difficult.  But it is something that we, as investors and analysts, need to think about.  Our inclination is that there is a higher chance that the ECB will be tardy in commencing ‘serious’ verbal intervention or actual intervention to cap EUR/USD.  There are several reasons behind this view:

Reason 1.  The EUR index value is not that high yet.  Though we believe that EUR/USD is overvalued, the ECB may not have the same view.  In fact, we believe that the ECB is likely to attach great importance to the real TWI of the EUR in forming a judgment on when and how to intervene, as our colleagues Eric Chaney and Elga Bartsch have also pointed out.    While the real EUR TWI has indeed drifted higher so far this year, it is still below the level reached in late 2004, when the Euroland economy was much weaker than it is now:  GDP growth in 2H04 was only 0.3% on a quarter-on-quarter basis.  In short, our guess is that the ECB may be less alarmed about EUR/USD now than it was back in late 2004.     

Not only is the EUR no more expensive, on a real index basis, than it was in late 2004, but its rate of growth has been declining so far this year.    The growth rate of the real index value of the EUR is really not that high by historical standards if we extend the time series far back enough.  Thus, not just the level, but the speed of the rise in the EUR TWI may not seem to be a problem to the ECB.  

Much of this muted effect on EUR TWI, despite a sharply higher EUR/USD, is due to the ‘ballast effect’, which we have discussed before.  The more integrated the European Union (not the EMU) is, the less damaging the ‘sting’ from a sharply higher EUR/USD. 

Reason 2.  Euroland economy not seen by the ECB as vulnerable to a US slowdown.  The modest 2Q07 GDP growth figure was most probably an aberration (reflecting unseasonably good weather that boosted construction activity in 1Q07), and growth should regain momentum in 3Q07 and 4Q07, or at least this is the opinion of the Governing Council of the ECB.  At the same time, inflation is expected by both the ECB and our European Economics team to approach 2.5% or so by year-end, before reverting back down towards the 2.0% target.  This profile is already a bit ‘high’ for a strict inflation-targeter like the ECB.  Further, M3 growth accelerated further to almost 12% in July (from 9.3% in 2006 and around 10% in 1Q07).  Also, growth in private loans has not shown signs of deceleration.  Whether the ECB will raise rates further is still difficult to tell, particularly with the persistent dislocations in the money markets, but it does not seem to be close to cutting rates.  Such a policy stance stands in stark contrast to that of the Fed.

Reason 3.  The monetary trajectories in the US and Euroland don’t support a hawkish position on EUR/USD.  In our view, verbal intervention should be conducted only when the ECB is willing to, eventually, conduct actual intervention.  We believe that this is the only way for verbal intervention to be credible.  In a recent speech, Mr Lorenzo Bini-Smaghi emphasised the importance of consistency between monetary and intervention policies for the latter to be successful.  Back in 2001, the ECB did indeed follow up a series of verbal interventions with actual interventions, but the situation is quite different now.  The US is just re-entering a soft patch and may be six months away from reaching its cyclical trough.  The aforementioned divergence in the monetary paths between the Fed and the ECB would then not support actual intervention by the ECB.  In short, we don’t think that the pre-conditions have been met for the ECB to turn too hawkish on EUR/USD.  If the ECB is not ‘pre-emptive’ on interest rates, it is not likely to be ‘pre-emptive’ on exchange rates, either. 

This is not to say that some ECB officials would not complain about the rapid ascent of EUR/USD.  Our point here is that there will likely be no attempt made to cap the level of EUR/USD, simply because the EUR is not a problem for the economy, yet, and the preconditions for successful intervention have not yet been met. 

The upcoming G7 meeting

At the upcoming G7 meeting on October 19, 2007, in Washington, D.C., we expect European representatives (particularly those from the national governments) to raise the issue of exchange rates in general.  But we are likely to hear two messages.  First, the focus of comments from European officials is likely to be the USD and the JPY, not the EUR.  In other words, the weakness of other currencies, rather than the strength of the EUR, will be Europe’s main concern.  However, there is really not much that can be done about the weakness of the USD and the JPY, in our view, given that the US and Japan are the two soft spots in the world at this point.  Second, the ECB, in contrast to the government representatives, will likely be relatively silent.  Without the ECB being ‘on board’ with Europe adopting a more hawkish stance on exchange rates, we are afraid that it will be difficult for progress to be made on this issue. 

Bottom line

Despite the sharp rise in EUR/USD in the past week, we suspect that the ECB will be tardy in embarking on verbal intervention.  Where EUR/USD goes from here will be more of a function of monetary and economic trajectories, rather than verbal intervention, in our opinion. 

 

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Currencies
Dollar Peggers to Stretch the ‘Impossible Trinity'
September 28, 2007

By Stephen Jen | London

Summary and conclusions

The combination of the Fed’s rate cut(s) and a declining dollar will likely prove to be good for many emerging markets, almost too good in some cases.  In particular, many of the countries that have ‘sticky’ exchange rates – those that are either hard-pegged to the dollar like Hong Kong and the GCC countries or those that are not very flexible vis-à-vis the dollar (such as the CNY) – will be pressured to mimic the Fed’s monetary policy to preserve the de facto currency peg, when the domestic conditions demand a tighter monetary policy stance.  In this note, I argue that (1) pressures will continue to mount that could lead to revaluations against the dollar in some GCC countries; (2) Hong Kong’s stock market has no choice but to go up; (3) the pace of appreciation of the Chinese CNY may accelerate; and (4) whether the USD pegs in the GCC countries are dismantled should not have a direct impact on the dollar in general, though the psychological effects would likely be USD-negative. 

The ‘Impossible Trinity’

In economics, simultaneously targeting an exchange rate and maintaining an independent monetary policy, with an open capital account, is considered an ‘impossible trinity’.  Two of these three objectives can be achieved, but not all three at the same time.  If the countries that are pegged to the US dollar have business cycles that are in sync with that of the US, the appropriate monetary policies in these countries should be similar to those of the US, and changes in the Fed’s policy should not really cause complications.  However, if these countries diverge from the US economy’s business cycle, then monetary policy that is good for the US will not be appropriate for these countries.  But because of the need to keep the USD pegs, these countries cannot deviate significantly from the Fed’s policies.  Here lies the ‘trilemma’.

Countries elect to have dollar pegs often because their economies are tightly linked to the US.  So these policy inconsistencies should be rare, by design.  Saudi Arabia and the UAE, for example, have had USD pegs since June 1986 and January 1978, respectively, and, for the most part, dollar pegs have worked well for them as the sole nominal anchor for inflation control.  Similarly, before July 2005, China had had a de facto dollar peg for 11 years (since January 1994), for exactly the same reason. 

  But both the GCC countries and China are increasingly de-coupling from the US.  For the GCC countries, the large, and likely permanent, rise in oil prices since 2002 (oil prices were around US$20 a barrel in late 2001) has fuelled a large increase in infrastructural spending and investment in the GCC countries.  This change from cyclical and mean-reverting swings in oil prices to a very large and permanent terms of trade shock will have significant implications for the GCC countries’ exchange rate and monetary policies going forward, for their existing currency pegs, coupled with severe sterilization limitations, are no longer restraining inflation.  In any case, the GCC countries now confront the ‘Impossible Trinity’ of keeping their currencies from appreciating, keeping inflationary pressures contained while the Fed is cutting rates and fighting the porous capital account.  As a result, inflationary pressures have mounted.  My colleague Serhan Cevik has written extensively on this issue.

Similarly, China is increasingly de-coupling from the US, as its investment demand and exports to the world (not just to the US) have continued to grow strongly, despite the deceleration in the US.  In fact, it was Beijing’s realisation back in 2004 that China would eventually need its own independent monetary policy that ultimately led to its decision on July 21, 2005 to dismantle the de facto USD peg. 

In a way, the GCC countries are now more in sync with China than with the US.  (Perhaps the GCC should peg to the CNY one day.)  Further, the policy challenges arising from large balance of payments surpluses and under-developed financial markets are similar. 

My thoughts

In a de-coupled global economy, Fed rate cuts could cause significant complications for some economies.  There are some trading opportunities investors may want to consider.  I have the following thoughts: 

Thought 1.  Some GCC members’ USD pegs may be stressed.  As explained above, the ‘Impossible Trinity’ will indeed likely prove to be impossible for some GCC countries.  The monetary authorities will need to choose between permitting inflation to drift higher, or contemplate realigning the peg.  With the FFR at 4.75%, the cash rate gaps range from 4.1% in Oman to 6.25% in Kuwait for the GCC countries.  However, if the Fed eases by another 50bp, as our US economists believe it will by 1H08, pressures on this ‘trilemma’ will mount further, unless oil prices fall meaningfully.  It is important to note that these countries have several options:  (i) make no change to the parity of the exchange rate regime, and further tighten exchange rate controls and investment spending, (ii) abandon the dollar peg and adopt a basket peg; or (iii) revalue their currencies but still maintain a dollar peg, at different parities.  Of these three options, I think, realistically, the choices are between (i) and (iii) for most of these GCC countries.  While Kuwait did choose option (ii) on May 20, 2007, that was partly because, until 2003, Kuwait had a basket peg, with the USD having a heavy weight in the basket.  Thus, in a way, Kuwait reverted back to the exchange rate regime with which it is most familiar.  Of the rest of the GCC membership, all the countries have had dollar pegs for a long time.  Further, between options (i) and (iii), I think that there is a more than 50:50 probability that most of the GCC countries will not revalue their exchange rates and will try to tolerate slightly higher inflation for some time.  However, from a risk-reward perspective, the risk of them choosing option (iii) is not low, and the probability is rising as the Fed eases further while oil prices stay high.  Incidentally, the negative relationship between oil prices and the dollar further exerts policy pressures on the GCC countries. 

Thought 2.  Hong Kong’s equity market has every reason to keep rallying.  HK’s demand is powered by China, but its monetary policy is set by the Fed.  The economic de-coupling between the US and China will have the logical impact on HK’s equity markets.  The HSI has risen by 33% year-to-date and 51% over the past year.  From the low during the credit crisis on August 16, 2007, it has rallied by nearly 30%.  In a way, whether or not it is already a bubble, the HSI will continue to have policy reasons to head higher, due to this ‘Impossible Trinity’. 

Thought 3.  The pace of appreciation of the CNY may accelerate.  Our year-end forecast for USD/CNY is 7.30, reflecting our view that a slowing US economy will likely rekindle political angst about China’s RMB policy.  Further, the combination of rate cuts by the Fed and overheating pressures in China suggests that the economic justifications for a faster RMB glide path are now even more compelling than before.  While a strong CNY will not solve the complicated problems Beijing confronts, the RMB is one more avenue through which China could help rein in excess investment. 

Thought 4.  It is important to keep in mind that the issue at hand is about inflation control, not about whether the dollar is a good or a bad currency.  Bloomberg reported on September 20, 2007 that “Scrapping the (Saudi) currency peg may prompt other countries in the Middle East to follow suit and reduce their dollar reserves, further undermining the US currency.”  I am not sure I agree with this statement.  First, Kuwait abandoned the dollar peg on May 20, 2007, but nothing happened to the dollar.  China abandoned the USD peg in July 2005 and not much happened to the dollar.  Second, the weights in the prospective basket pegs may not be correlated with the currency compositions of the foreign asset holdings of these countries.  The GCC members are unlikely to have 100% of their foreign assets in dollars, despite the dollar peg.  If and when they move to a basket peg, it is not clear at all that they will reduce their dollar holdings.  Third, if they re-peg at different parities, they would still need to intervene by buying dollars.  Depending on the capital inflows, they might even need to buy more dollars than before.  In short, the de-pegging story may have a negative psychological effect on the dollar, but should not, in theory, drive the dollar lower. 

Bottom line

In an environment where the rest of the world’s economy may be de-coupling from the US business cycle, Fed rate cuts may be good for the US, but bad for countries whose currencies are pegged to the dollar.  The ‘Impossible Trinity’ should lead to several interesting trading opportunities.

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