Perfect Storm for the American Consumer
November 12, 2007
By Richard Berner | New York
Serious pressures are mounting on the US consumer on five fronts: Job growth is slowing, surging energy and food quotes are draining purchasing power, adjustable rate mortgages are resetting, lending standards are tightening, and housing wealth will likely decline. Do these dark clouds finally and ominously herald the perfect consumer storm?
More than eight years ago, I described a “golden age” for the US consumer. Arguing that consumers’ health was enhanced by strong job and core income gains and improving balance sheets, I saw few clouds on the horizon (see “A ‘Golden Age’ for The US Consumer,” Global Economic Forum, April 14, 1999). And when storms arrived — a bursting equity bubble, the recession of 2001, the terrorist attacks on 9/11, a jobless recovery, a six-year surge in energy prices, and a long housing recession — our call regarding the American consumer’s resilience held up well. Annualized growth in real consumer spending during that period averaged 3.4%, essentially equal to the average of the past 50 years, and such outlays never contracted on a quarterly basis. That was then. In my view, consumers now face their toughest challenge since the recession of 2001, promoting at best sluggish growth for a while. Our baseline forecast shows a tepid 1.4% annualized rise in consumer spending over the three quarters ending next June (see “The Credit Recession,” Investment Perspectives, November 8, 2007). I believe fears about some of these tests individually are overblown, and others will prove temporary. But consumers are vulnerable to shocks, and a more protracted combination of these trials could trigger outright consumer retrenchment. For a summary gauge of consumer health, one apparently need look no further than the University of Michigan’s early November canvass of consumer sentiment. The index sank to 75%, nearly matching the post-Katrina low in September 2005, which in turn was the lowest reading since 1992. The five headwinds noted are evident in the details. Seven and nine percent of respondents, respectively, reported that tight credit and an uncertain outlook made it a bad time to buy durables (four- and 15-year highs). Almost one-third reported that high prices were making them worse off. And two anecdotes suggest that consumer woes are spreading to upper-income shoppers: High-end retailers reported sales declines in October, and a New York auction of a Van Gogh painting failed to attract a single bid. Nonetheless, to assess their impact, it’s important to dimension the extent of each of these challenges. That’s hard in some cases, like lending standards, that defy quantification. And the interplay among the last three — the “ARM squeeze,” declining housing wealth, and tighter consumer lending standards — could be a triple threat to so-called “liquidity-constrained” consumers, and I don’t want to overlook that possibility. First, and most important, job gains are slowing, limiting the gains in spendable income. True, nonfarm payrolls this year have risen by 125,000 per month, capped by a 166,000 gain in October. But that is down from a 189,000 pace in 2006. Moreover, payroll data overstate the pace; the government’s preliminary estimate of the annual benchmark revision to payrolls points to a downward adjustment equal to about 25,000 per month beginning around mid-2006. In addition, early warning indicators of employment are flashing caution: The number of self-employed has declined by 155,000 in each of the past three months, and the number at work part-time for economic reasons rose by 59,000 in October. A bright spot: Analysts responding to our business conditions canvass do expect a hiring pickup in the next few months (see “Business Conditions: Signaling a Recession?” Global Economic Forum, November 9, 2007). Yet it appears that wage growth may be cooling: Measured by average hourly earnings, by a new experimental series covering all private industry workers, or by the employment cost index, wages for production workers and for all civilian workers have decelerated to about a 3% rate during the past three months. Nominal wage and salary growth likely decelerated to a 5% annual rate in the three months ended in October, down from 6.4% over the past year. Second, the combination of surging energy and food quotes likely will drain more than $70 billion from that advance in nominal purchasing power in the last three months of 2007, and will correspondingly further depress spending. The recent jump in refined product and crude oil prices probably isn’t over. For example, wholesale gasoline quotes rose by 18% in the past four weeks to levels not seen since the post-Katrina surge in 2005, and crude is hovering just below $100/bbl. The surge reflects low inventories, limits on OPEC supply, and renewed geopolitical tensions, and it may take nationwide gasoline prices to $3.25/gallon or beyond before it ends. We think that these hikes will prove temporary as the demand-supply balance eases (see “Oil Overshoot,” Global Economic Forum, October 19, 2007). The bad news is that there is no sign of relief visible, and the surge comes at just the wrong time for consumers. Soaring food prices also threaten consumer budgets and headline inflation. Courtesy of a drought in Australia and strong demand for ethanol in the US, overall food prices are rising — at a 4.4% rate in the year ended in September — and could feed through to inflation expectations. The jump in animal feed quotes has led to higher beef and poultry prices following flat to declining prices last year. A California freeze earlier this year also hiked citrus quotes and damaged orchards. Earlier this year it appeared that the inflation and budget threat from soaring food prices might be transitory and overblown. The impact of the California freeze faded somewhat. Persistently higher feed prices triggered lower beef quotes as ranchers brought more of their herds to slaughter when profitability slipped. Record corn plantings triggered a plunge in wholesale corn quotes. But strong demand has brought grain and soybean prices up again, and farmers may see “beans in the ‘teens” again soon. It appears that rising dairy, sugar and grain prices will filter through to retail food prices into the spring. Next, let’s look at the ARM squeeze. Pessimists have long argued that as a large volume of adjustable rate mortgages begin to reset, the drain on consumer discretionary spending power would be crippling. Fed Chairman Bernanke last week noted: Indeed, on average from now until the end of next year, nearly 450,000 subprime mortgages per quarter are scheduled to undergo their first interest rate reset. Relative to past years, avoiding the payment shock of an interest rate reset by refinancing the mortgage will be much more difficult, as home prices have flattened out or declined, thereby reducing homeowners' equity, and lending terms have tightened. Should the rate of foreclosure rise proportionately, communities as well as individual borrowers would be hurt because concentrations of foreclosures tend to reduce property values in surrounding areas. A sharp increase in foreclosed properties for sale could also weaken the already struggling housing market and thus, potentially, the broader economy. Beyond just subprime debt, the Mortgage Bankers Association estimates that between $1.1 and $1.5 trillion of adjustable rate mortgages (or about 10% of the overall mortgage market) will reset in 2007. Resets will be painful for certain borrowers, but we estimate that in the aggregate they will add only about $15 billion to household debt service in 2007 — representing less than 0.2% of personal income. The impact of ARM resets will rise further in 2008, to perhaps 0.4% of household disposable income. That is consistent with the results of the careful study released earlier this year by Christopher Cagan. He estimates that the difference between initial monthly payments and the payments when the loans are fully reset averages $42 billion per year over the next few years (see Christopher L. Cagan, “Mortgage Payment Reset: The Issue and the Impact,” First American CoreLogic, Inc., March 19, 2007). As Chairman Bernanke noted, however, resets aren’t the whole story. Some loans — and not just subprime loans — are likely to face the double whammy of a significant reset while simultaneously having insufficient equity to permit a sale or refinance. Cagan’s analysis suggests that as a result, over the next six years or more, lenders will foreclose on about 1.1 million of such loans amounting to losses of about $112 billion, or about 1.1% of mortgage debt outstanding. Teaser-rate and subprime mortgages originated in the past three years are most vulnerable; Cagan estimates that 32% of teaser loans (including Pay Option and similar ARMs), 7% of market-rate adjustable loans, and 12% of subprime loans will default due to reset. However, it is critical to know who are the borrowers in such cases. Revealingly, Cagan estimates that 11.1% of the properties purchased or most recently refinanced with adjustable-rate first mortgages in 2005 have negative equity, while a whopping 23.9% of such borrowers in 2006 have negative equity. Some of these borrowers, seeing the coming deceleration in home prices, probably cashed out as much equity as they could and ran with the proceeds, never even making the first payment. That kind of fraud suggests much more pressure on the lender than on the consumer. But while lenders may bear much of the loss, consumers will feel their pain through the lending channel: Not surprisingly, against this backdrop, lenders have further tightened lending standards, which will constitute a major headwind for the would-be extractor of home equity to finance spending. According to the Fed’s November Survey of Senior Loan Officers at banks, nearly half of mortgage lenders and one-fifth of corporate lenders tightened standards recently. And the nonagency mortgage-backed securities market remains dislocated. While we believe that fears of a full-scale credit crunch are overblown, mortgage credit availability is already tighter than in the 1990 credit crunch period. Still, affordability is the main issue for housing demand, and the outlook for housing wealth and income are the main issues for consumer spending. We’ve long thought that the coming deceleration in housing wealth would prompt consumers to boost the share of saving and reduce the proportion of spending out of current income. Because homebuilders have not responded aggressively enough to cut production and eliminate the mismatch between housing supply and demand, we now think that real home prices will decline by 10% nationwide over the next year. Based on rules of thumb like those in the Fed’s econometric models and those we use, such a hit to wealth (about $1.5 trillion, or 2.5% of overall household net worth) might promote a $75-100 billion decline in consumer spending, or about ¾% to 1% of the total. That’s essentially what we’ve built in to our forecasts. Clearly, a bigger hit to wealth could trigger a bigger spending pullback, especially in combination with the four other headwinds mentioned above. For investors, it’s important to note that some, but not all of these risks are in the price. Risky assets remain exposed, as significant economic weakness – but not recession – seems to be in the price of most asset classes. Equity markets seem fully priced for consumer weakness, but not retrenchment. Treasuries are rich across the maturity spectrum but may get richer still, and the yield curve likely will continue to steepen — bullishly for now, fueled by credit turmoil, expectations of a weak economy, and significantly easier monetary policy. But rising energy quotes will boost headline inflation, adding a likely whiff of stagflation. Together with rising term premiums, that could promote a near-term bearish steepening of the yield curve. Risks to the consumer are rising, and the risk of outright US recession is higher now than at any time in the past six years: Housing is in sharp decline, consumers are vulnerable, and companies may cut capital spending and liquidate inventories. A strong contribution from global growth is still a huge positive, but spillovers from US weakness to trading partners may hobble that lone source of strength. These pressures could last longer or be more intense than I expect. And even if the economy skirts overall recession, corporate earnings will likely decline.
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Business Conditions: Signalling a Recession?
November 12, 2007
By Shital Patel & Richard Berner | New York
As expected, the improvement in the Morgan Stanley Business Conditions Index was short-lived. The MSBCI plunged 23 points to 30% in early November, the record low last seen in August. While we do not have enough history to see how the MSBCI behaved during previous cycles, the index has certainly hit dangerously low — perhaps even recessionary — levels. Over the past month, credit conditions have worsened, and the S&P 500 has begun pricing in economic weakness, sinking 5.7%. Add in oil prices climbing dangerously close to $100/barrel, and the question changes from when the MSBCI will recover to if it will happen, at least over the next six months. It is also important to note that the weakness is not only due to housing-related factors — our survey sample no longer includes homebuilders and mortgage finance companies. There is no doubt that lending standards have tightened over the past few months. According to the Fed’s Senior Loan Officer Survey released on Monday, November 5, domestic banks tightened lending standards on C&I loans to large firms over the prior three months. Our own credit conditions index declined five points to 30% — not quite at September’s low of 22%, but still the third-lowest reading in the index’s five-year history. Financing has been more difficult to obtain in the past three months, mainly for the consumer discretionary, energy, and IT sectors. We also asked analysts how lending standards have changed over the past month. Of the 80% of our sample that are borrowers, 53% faced tighter standards, up from 47% in October but down from 72% in September. Not surprisingly, the auto industry was among those reporting significantly tighter standards. While credit conditions are undeniably weak, they seem to be recovering from their early-September lows. However, a weaker dollar is an offset to tougher credit conditions. Since January, the dollar on a trade-weighted basis has declined by 10.7% against a broad basket of currencies (16.1% vs. major currencies). This month we asked analysts, on a year-over-year basis, how much the declining dollar has contributed to bottom line results at their companies. Surprisingly, 28% of analysts reported that the dollar contributed 1-3 percentage points to earnings, down from 33% in August, while another 28% said it only contributed 0-1 percentage point, down from 31%. The dollar has added 3 percentage points or more to earnings at the biotechnology and software companies. The dollar negatively affected earnings at the wireless services and IT services companies who may rely on services purchased abroad. Financial conditions have a lagged impact, so the weak dollar could continue to help companies in coming months. For the 82% of the S&P 500 market cap that has reported so far, year-over-year operating earnings came in at –2.8%, 0.5 percentage point below expectations and down from 9.6% growth in 2Q. The good news is that the quality of the earnings “beat” was high. Of the analysts whose companies beat expectations, a full 74% reported that companies either reported higher top-line growth or had lower costs. Also, 63% of analysts reported that earnings quality is unchanged compared to a year ago, up from 59% in August. Earnings quality is worse for only 25% of the companies, up slightly from 23% during the last earnings season. We also surveyed analysts about the risk to their earnings estimates. Only 28% of analysts see upside risks to earnings; of these nearly half (45%) are optimistic about growth abroad, up from only 21% in August. This fits our US strategy team’s bifurcating market thesis — analysts are becoming more aware of the importance and strength of foreign markets. Still, a full 73% expect risks to the downside, up from 64% in August and 28% in May. Of these, 63% believe that domestic growth may be weaker than expected and 26% fear a combination of weaker domestic and foreign growth. Given weak business conditions and downside risks to earnings estimates, Street analysts seem to be pretty upbeat. While the bottom-up consensus estimate for 4Q S&P 500 earnings growth is only 4.4%, consensus ex financials is still at 12.4%. It seems that the ex-financials estimate has a way to go considering it stood at 13.6% at the beginning of August. Other survey details were mixed. On the negative side, the breadth of responses tilted toward weakness. Half of the analysts noted that business conditions deteriorated over the past month, while only 8% reported improvement, the lowest percentage in the history of the survey. The materials and energy sectors were the only groups that improved. Our manufacturing and services sub-indexes also declined notably in early November. The manufacturing index declined 24 points to 34%, while the services index dropped 28 points to 24%. Our gloomy analysts also expect weak business conditions to continue over the next six months. The business conditions expectations index plunged 19 points to 28%, the lowest level in the nearly two year history of the question. Not surprisingly, consumer discretionary companies are expecting weakness, as well as companies in financials, IT, and industrials. Not all results of the survey were pessimistic. The advance bookings index edged up two points to 52%. Also, hiring and capex plans improved; 35% of the groups have plans to step up hiring over the next three months, up from 21% last month and the highest percentage in six months. Industrials and IT companies expect to increase payrolls in the near future. Capex plans also improved in November as 55% of sectors plan to increase spending over the next three months, the highest level since July. In a weakening economic environment, companies have managed to retain pricing power, as the pricing conditions index dipped only three points to 63%. A full 53% of groups were able to increase prices from a year ago. In fact, 28% were able to raise prices by 3% or more, mostly in the energy, health care, and industrials sectors.
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Review and Preview
November 12, 2007
By Ted Wieseman/David Greenlaw | New York
The Treasury curve saw a huge steepening move over the past week as the front end surged higher on a combination of flight-to-safety from reintensifying turmoil in risk markets and continued worries about further write-downs in the financial sector, and a sizable dovish repricing of the Fed. And the Fed repricing itself was clearly driven by the financial market turmoil and not by either economic data or Fedspeak. A heavy calendar of Fed speakers, including Chairman Bernanke, uniformly reiterated the message of the October 31 FOMC statement – downside risks to growth and upside risks to inflation continue to be seen as balanced, suggesting no inclination at this point to cut rates again at the upcoming FOMC meeting. Futures markets, however, moved to fully price in a 25bp rate cut on December 11 – and another 50bp beyond that next year – betting either that renewed turmoil in markets would significantly shift the Fed’s thinking on the case for further easing in December or that the market could force the Fed into another cut in December as it appears to some extent to have been able to do in October. Market turmoil in the past week was most focused on weakness in stocks, credit and subprime mortgages, but there were also indications of a contagion from the meltdown in the subprime mortgage market into the commercial mortgage market, where default swaps performed terribly. Asset-backed CP worsened a bit on the week but did far better than these other closely watched markets. A light calendar of economic data was mostly ignored. Upside surprises in the wholesale trade and international trade reports pointed to a significant further upward revision to 3Q GDP growth, which we now see being revised up to +5.3% from +3.9%, compared with our +4.2% estimate coming into the week. We continue to see 4Q GDP slowing sharply to +0.9%, but with a somewhat stronger mix of final demand and inventories than we were previously estimating. On the week, 2s-30s spiked 21bp to +117bp and 2s-10s 15bp to +80bp, both highs since the first part of 2005, with the 2-year yield plunging 21bp to 3.43% and the 5-year yield 16bp to 3.76%, while the 10-year yield fell 6bp to 4.23% and the long bond yield was unchanged at 4.60%. TIPS continued to perform very well, as it looks like the ongoing upside in energy prices should provide enough of a boost to headline CPI in November and December to offset the significant drag on the non-seasonally adjusted core in those months from Christmas discounting and lead to atypical increases in the NSA CPI index. The benchmark 5-year inflation breakeven rose 5bp on the week to 2.35% and the 10-year 3bp to 2.42%, both near multi-month highs. While things didn’t reach nearly the extremes seen during the worst of the August mess, the flight-to-safety was also extreme at the very short end. The 4-week bill yield plunged another 31bp on the week on top of a 25bp decline the prior week to 3.41%, and the overnight general collateral Treasury repo rate moved well through the funds target over the course of the week, averaging 3.77% Friday. A significantly more dovish medium-term Fed path was priced into futures markets. In the near term, the January fed funds contract gained 7.5bp to 4.255%, fully pricing in a 25bp rate cut to 4.25% at the December FOMC meeting, and the February contract gained 9.5bp to 4.07%, pricing a high probability of another 25bp cut to 4% at the January meeting. Shorter-end eurodollar futures gains (small losses began with the June 11 contract) were led by a 13.5bp rally by the June 08 contract to 4.00%, a 14.5bp gain by the now low-rate Sep 08 contract to 3.895%, and a 13.5bp rally by the Dec 08 contract to 3.90%, pricing at least a 3.75% trough in the funds target next year, if not lower. While this meaningful Fed repricing clearly indicated that there was a fundamental element to the week’s Treasury rally, there was also a clear flight-to-safety element, as seen in a further blowing out in swap spreads. The benchmark 2-year spread rose 11bp on the week to 83bp, a more than seven-year high. The benchmark 10-year spread rose 6bp to 74.75bp, still a bit below the highs seen during August. Clearly, renewed market turmoil dominated investor focus on the week, and things were grim just about across the board. At the time of the early bond market close, the S&P 500 was down 3.2% on the week, erasing all of the gains seen since early September, when the market started rallying ahead of the first rate cut. Credit spreads continued moving much wider. The 5-year HiVol CDX index widened another 23bp on the week to 207bp, for a 49bp deterioration over the past two weeks, while the broader IG index widened 7bp to 77bp for an 18bp two-week sell-off. The high yield index was 22bp worse on the week at 481bp at Thursday’s close, and the index was trading down more than a half point at midday Friday. The leveraged loan market as reflected in the LCDX index, which had previously also been showing signs of improvement, continued its recent renewed deterioration, with the LCDX index 48bp wider on the week at 343bp through midday Friday. The subprime mortgage market was in intensifying disarray, with the highest-rated ABX indices posting huge drops on the week. The AAA ABX index plunged 10.24 points to 69.93 and the AA 9.18 points to 40.21. Just a month ago these indices were trading in the mid-90s and mid-80s, respectively. To the extent that financial firms are using the ABX market to value their subprime mortgage exposure, this accelerating collapse has worrying possible implications for further future write-downs. The ABX meltdown has also begun to spread in a major way into the commercial mortgage market. The CMBX market had a horrendous week, with the losses led by the higher-rated indices, as in ABX. The current series AAA CMBX index widened 32bp on the week to 79bp, and the AJ index (‘junior’ AAA), widened 145bp to 277bp. Relative to the turmoil in these other markets, asset-backed CP, which was such a focus of concern in August and early September, was a relative oasis of stability, though there was some mild deterioration, with term yields backing up a bit from the lows hit the prior week (the average 30-day yield through Thursday was up 7bp on the week to 4.81%, according to Fed data) and our desk noting a shift back towards a higher concentration of overnight from term funding over the course of the week. The past week’s economic data calendar was light. The most noteworthy releases were the wholesale and international trade reports for September, which filled in more of the missing data that the BEA had to plug in estimates for in producing the advance estimate of 3Q growth. Results for both these reports surprised significantly to the upside relative to the BEA’s assumptions, adding to previously reported positive surprises in the construction spending and factory orders reports for September. In the wholesale trade report, inventories surged 0.8% in September. Notably, this jump was not a result of weak activity – sales surged 1.3%, causing the I/S ratio to dip a tenth to an all-time low of 1.10. The BEA assumed that wholesale inventories would be unchanged in September, and August (+0.7% versus +0.1%) was revised much higher, pointing to a big upward revision to 3Q growth. Meanwhile, the September international trade report was also much better than expected. The nominal trade gap (-US$56.5 billion versus -US$56.8 billion) in September narrowed slightly from a downwardly revised August to its lowest level in two-and-a-half years as exports jumped another 1.1% and imports rose 0.6%. This was a significantly better result than the BEA assumed in preparing the 3Q GDP report. The 0.6% gain in imports was significantly less than expected. The main surprise was a slight decline in petroleum products, where we had expected a good gain based on weekly Energy Department figures. Natural gas was also down sharply, while other materials imports were little changed, leaving the sizable industrial supplies and materials grouping down 0.7%. The major source of upside in overall imports was capital goods, which jumped 1.9% – a positive indicator for domestic investment. Exports posted a surprising 1.1% gain that was again in large part attributable to continued explosive growth in food exports, which rose 9.4% in September for an astounding +134% annualized gain over the past three months. Industrial materials and consumer goods also saw good upside. The only notable negative was capital goods, which fell 1.0% – a positive indicator for domestic investment, given the sharp rise in capital goods shipments in September. Combining the upside in wholesale inventories and international trade, we now see 3Q GDP growth being revised up to +5.3% from +3.9%, up from our estimate coming into the week of +4.2%, which was based on upside surprises in the September construction spending and factory orders reports. Looking to 4Q, a significantly larger expected add from inventories in 3Q – we see the inventory contribution being boosted to +1.2pp from +0.4pp – points to an offsetting larger drag in 4Q. On the other side, the real goods trade deficit in September was little changed, a significantly better starting point for 4Q net exports than we had been assuming. At this point, we see net exports adding another half point to 4Q growth on top of gains of greater than a full percentage point in 2Q and post-revision most likely in 3Q. In addition, the positive capital goods imports/exports mix in September provided a more positive ramp for domestic investment in 4Q. We boosted our equipment and software investment forecast to +5% from +3.5%. Combining the expected larger drag from inventories in 4Q with the larger expected boost from net exports and capital spending, we continue to forecast a +0.9% rise in 4Q GDP, but with a stronger final sales/inventory mix. Beyond financial market developments, which are clearly moving in the wrong direction again in a significant way, the only real near-term trigger we see that could prompt a fundamentally based rate cut in December would be significant weakness in the November employment report, which will be released just a few days ahead of the December 11 FOMC meeting. Trends had been looking somewhat worrisome on that front recently, but a significant improvement in the latest jobless claims report eased fears about that key upcoming report quite a bit. Initial jobless claims fell 13,000 to 317,000 in the week of November 3, moderating after three weeks of elevated readings. The Labor Department said that about 3,000 claims this week were attributable to the California fires (since the seasonal factor was very small this week, the impact on the seasonally adjusted number was about the same), so the underlying improvement was a bit better. Continuing claims in the week of October 27 dipped 4,000 to 2.579 million after having hit a two-month high the prior week. We’re still a couple weeks away from figures covering the survey period for the November employment report, but clearly this latest improvement points to a lower risk of a weak result for November payrolls. The bond market is closed Monday in observance of Sunday’s Veterans’ Day holiday (though the stock market continues its tradition of not closing in recognition of this holiday), but the data calendar in the upcoming week will be quite busy for the final four days of the week. In addition to the data, Fed Chairman Bernanke will be speaking on FOMC communications on Wednesday morning. The Fed has been discussing this issue for some time, with indications that it is moving towards increasing the frequency of the publication of its forecasts (which are currently only released semi-annually in the Monetary Policy Report) and also lengthening the forecast horizon. Key data releases due out in the coming week include the budget deficit and pending home sales Tuesday, retail sales, PPI and business inventories Wednesday, CPI and the Philly Fed and Empire State surveys Thursday, and IP Friday: * We expect the federal government’s budget deficit to widen modestly in October to US$53 billion from US$49 billion in the same month a year ago. A calendar shift helped to boost both receipts and outlays by about US$5 billion, and thus was a neutral factor for the overall deficit. Underlying growth in revenues appears to have been solid in October, as withheld income and payroll taxes posted about a +10% yr/yr gain. We continue to look for a US$200 billion deficit in the current fiscal year (or 1.4% of GDP), up from US$163 billion (1.2% of GDP) in FY2007. * We look for overall retail sales to be flat in October but ex auto sales to rise 0.2%. The auto company reports imply a slight decline in dealer sales during October following two months of solid gains. Otherwise, chain store results were sluggish, with some strength at discounters and clubs offset by softness at department stores and apparel outlets. Thus, we look for a fractional rise in the general merchandise component and a further decline in apparel, where unusually mild weather appeared to have a further negative impact. Meanwhile, the service station category showed a much sharper advance in September than implied by our price-based model, and we suspect that the October report may show some payback in this component and/or a downward revision to September. * We forecast a 0.3% decline in the October producer price index, overall and excluding food and energy. A slight pullback in energy prices together with some softening in quotes for milk and beef should help hold down the headline PPI. However, the main issue this month will be the impact of the annual changeover to new model year pricing in the motor vehicle sector. This occurs every October and is often associated with an unusually large swing in the core PPI. For example, the core PPI fell 0.5% in October 2006 – one of the largest declines on record. We believe that the seasonal adjustment factors will again overcompensate for the change in vehicle prices, leading to a pullback in the car and light truck components. Excluding motor vehicles, we look for a 0.3% rise in the core. * We look for a 0.4% rise in business inventories in September. The manufacturing and wholesale sectors posted above-trend gains. So, even with an anticipated decline in auto dealer stockpiles, overall inventories should show a decent gain. The I/S ratio is expected to hold at 1.27. * We forecast a 0.2% rise in the October consumer price index, overall and excluding food and energy. Gasoline prices didn’t start to climb until late in the month, so the energy category is expected to show only a modest rise in October. Also, the food component should post a smaller advance than in prior months because of a flattening out in quotes for milk and beef. Meanwhile, the core is expected to be close to trend, with a further climb in hotel rates partially offset by a pullback in the apparel category. Note that our estimate for the core on an unrounded basis is +0.17%. Finally, the year-on-year reading for the core is expected to just barely round up to +2.2%, up from +2.1% in September and August. * We expect overall industrial production to be flat in October, with a 0.2% dip in the key manufacturing gauge offset by a decent gain in utility output, as the unusually warm weather kept air conditioners running later than normal. The employment report indicated that the softness in factory output should be broadly based, with notable weakness likely in chemicals, textiles and apparel, food, furniture, and electrical equipment and appliances. Finally, motor vehicle assemblies appear to have been little changed following sharp declines the prior two months.
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Showdown on Pensions, or Is it on Reforms?
November 12, 2007
By Eric Chaney | London
From November 13 and probably for several days, bicycles and scooters will become fashionable in large French cities. Industrial action called by most unions in large state-owned companies (e.g., SNCF, RATP, EDF) will paralyse the traffic of trains and metros and could cause power shortages. Unions are trying to derail the reform of the super-generous pension schemes employees of these companies are still enjoying, on top of lifetime employment. In some cases, these benefits are nothing other than an extraordinary rent extracted from taxpayers: drivers of high-speed trains, for instance, may retire at 55 with a full pension. All put together, the ‘special pension schemes’ as they are called in France are now running large cash shortfalls, around €6 billion per year, and are thus massively subsidised by tax payers. While Prime Minister Juppé had failed in reforming these regimes in the autumn of 1995 – with the benefit of hindsight, this episode cost him his political career – Nicolas Sarkozy made clear during his electoral campaign that he would do the job. He also warned unions in advance that, if he won the presidential contest, he would have the democratic legitimacy to implement the reform. Here we are. After failed negotiations between the management of the concerned companies, unions have opted for an open confrontation with the government. Since the financial markets have in mind a very negative view of French social relations, several days of strikes might have a negative impact on the relative price of French assets, compared to their euro area peers. Yet, I believe that, if this were to happen, it would be a buying opportunity. Why the public opinion is supporting the reform The major difference compared with 1995 is that, this time, the railways worker strike is not popular, for two reasons. First, being taken hostage by employees of state-controlled companies who do not even have to fear for their jobs is unpalatable. Second, wage-earners in all other sectors, including civil servants, had to accept in-depth reforms of their own pension benefits. This was done in two stages, first in 1995 for the private sector, and in 2005 for the public sector. All employees have to contribute during 40 years (to be progressively extended to 42 and beyond, depending on demographic developments) to get a full pension. In addition, pensions are not indexed to wages anymore, but, instead, to prices, which is equivalent to a 25% cut in the present value of pensions at the age of retirement, assuming a 20-year retirement period and a 1.5pp gap between wage and price inflation. Only railway, metro, and employees of several other state-controlled entities (including to Opera ballerinas and MPs) are still benefiting from a lower contributing period and faster-growing pension rates. There is thus in the population a deep sentiment that this is unfair treatment, especially so among retirees. No wonder then that, on October 18, a poll by BVA found that 57% of the polled persons found the reform justified, versus only 32% having a negative view. There is too much at stake for Sarkozy to give up Unions have understood the threat and are divided about the best strategy: going for a long-haul battle, ‘like in 1995’, in order to derail the whole reform train, or asking for compensation. The more leftist unions are of course calling for the first option and ask for a renegotiation of all the pension systems, knowing probably that this would send the budget deficit to 5% of GDP or even more, and thus would not be consistent with EMU membership. More moderate unions, including the ex-communist CGT, are probably seeking the highest possible compensation but, in reality, know that the reform is on track. I had a long debate on the BBC with a professor of political science at the LSE and a senior member of one of the large French unions. In my post-debate chat with the latter, I understood that this particular union was desperately waiting for some kind of cash compensation in order to swallow the bitter pill. This is indeed reasonable, for deep political reasons. President Sarkozy was elected – with more than 53% of the votes – to make things change in France, starting with the most unfair features of an inefficient welfare system. Too much is at stake for M. Sarkozy and his Prime Minister Francois Fillon (who masterminded the 2005 reform) to give up: if the pension reform is withdrawn, then not one single other reform will succeed, in my view. Supported by the population and risking his own political future, Nicolas Sarkozy can afford a few days, maybe a week of transportation disruption: this would probably make the strike increasingly unpopular and would then reduce the bargaining power of reformist unions. Reforms will have a cost… However, at some point, the government (or the management of state-owned companies) will have to make an offer to end the conflict. My view is that there will be almost no room for a compromise on the backbone of the reform, i.e., the contributing period and the indexation of pensions. By contrast, there is ground for compensation, for negotiating the transition period, etc. This will have a budgetary cost, unavoidably. Given that the French public deficit is already likely to rise next year, not far from 3.0% of GDP on our forecasts, this would certainly raise eyebrows in Brussels and Frankfurt. The French government is likely to ignore the warnings from the EU Commission and other federal bodies, I believe. …but it is the long-term net benefit that matters The French authorities are likely to argue that what really matters is the net impact of the reform on the French economy and public finances. Since in the long term the reform should save €6 billion (at constant prices) or 0.3% of GDP per year, there is a lot of leeway to offer some sweeteners in order to end the conflict and move on to the next reform, namely the labour market. Investors should take the long-term view There is nevertheless a risk: excessively generous sweeteners would not only reduce the long-term benefit of the reform but also increase incentives to resist future reforms, a typical moral hazard case. Because the French economy is entering in a cyclical soft patch, as indicated by the drop of manufacturing production in September and Insee surveys and because other constituencies (students for instance) are jumping on the railways strike bandwagon, some MPs might suggest to the government to water down its reforms or to use fiscal sweeteners more liberally. This would be a mistake that I do not think the government is ready to make. Once again, too much is at stake for the president, and political conditions have never been so good for reforms since the beginning of the Fifth Republic. Therefore, if some investors sell French stocks at the sight of large demonstrations in Paris streets on their CNN screen, I believe that long-term investors should seize this opportunity to buy, at least on a relative basis.
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Reassessing Macro Sensitivity to Higher Oil Prices
November 12, 2007
By Chetan Ahya | Singapore
Crude oil prices have shot up 51% to US$96 in the last five months. The sharp increase has again brought the discussion on India’s macro sensitivity to oil prices into focus. In this note, we analyze India’s dependence on oil as a source of energy, the trend in the government’s domestic pricing policy for petroleum products and the sensitivity of India’s macro economy to oil price movements. I. India’s dependence on oil as a source of energy Share of oil in energy consumption is relatively low…
India’s share of oil in overall energy consumption is lower than that for most emerging markets. Oil meets about 30% of India’s commercial energy requirements. Coal is the predominant source of energy (55% of total) due to its easy availability. According to the Planning Commission of India, coal reserves are expected to last for over 50 years at current levels of production, and hence coal will continue to remain a key source of energy for the country. The balance is accounted for by natural gas (8.1%) and nuclear & hydro power (6.9%).
….but share of world oil consumption is high
Despite oil having a low share in overall energy consumption, India is one of the leading consumers of oil in the emerging world owing to the relatively larger size of the economy. India’s oil consumption has increased to 2.6 million barrels per day (3.1% share in global oil consumption) in 2006 from 1.6 million barrels per day (2.3% share) in 1995. Over the past 10 years, India’s oil consumption has grown at an average 4.3% per annum, versus 7.5% for China and 1.3% for other major emerging markets. India’s efficiency of oil usage, as measured by oil intensity (primary oil consumption per unit of GDP), is higher than the world average and marginally higher than that for top emerging countries. Dependence on imported oil is high
India’s proven reserves of oil and oil production have remained largely stable over the last decade. As a result, increasing oil consumption has meant greater reliance on crude oil imports for India. India imports about 72% of its crude oil and petroleum products requirement, up from 44% in 1995. Crude oil accounted for about 25% of India’s total imports in F2007 (5.3% of GDP). India’s overall oil balance (crude oil and petroleum product imports less exports) is one of the worst in the region. The government continues to control prices of petroleum products
Domestic prices of oil products (other than industrial products such as naphtha and aviation turbine fuel) historically have been directly or indirectly controlled by the government. For a brief period between April 2002 and April 2004 (when crude oil prices were US$24-35/bbl), oil companies could independently determine the price of diesel and gasoline. Currently, although public sector oil companies are supposed to collectively fix prices of crude oil and petroleum products based on so-called import parity pricing, in practice all price changes are decided by the government. Controlled petroleum product sales account for around 64% of total sales on a volume basis and 80% on a value basis. II. Sensitivity of India’s economy to oil prices
The typical macro impact of oil price movements
The government’s involvement in domestic oil pricing means that movements in oil prices can have a less- or greater-than-proportionate impact on key macro indicators such as inflation, consumption and growth. If the government were to allow domestic oil prices to be completely market-determined, we estimate that the typical macro impact would be as follows:
(a) Inflation, private consumption and growth: If crude prices were to rise or fall by 10% (for the full year), it would result in a change in wholesale price inflation by 0.6-0.7pp if the government were to pass the full decrease/increase onto consumers (a cascading effect of a similar amount would also be felt). Our estimates show that a US$5/bbl change in average crude oil prices would result in a 0.15pp change in GDP growth, if the full benefit/cost were passed to consumers, which is not happening currently. If consumer prices remain unchanged, we estimate that the government (including public sector oil companies) burden would decline/rise by around US$2.5 billion (0.3% of GDP).
(b) External balance and liquidity: A US$5/bbl change in crude oil prices would result in India’s import bill and current account deficit falling/rising by about US$2.8 billion per annum (or 0.3% of GDP). Oil price sensitivity in the current cycle
Unlike in past cycles, the macro balance sheet is now relatively well positioned to absorb the oil shock in the current cycle. For instance, in 2001-2, as oil prices shot up, the balance of payments situation worsened, adversely impacting the exchange rate. As a result, the central bank was forced to tighten monetary policy to limit depreciation of the exchange rate. Two key factors have helped to withstand the oil shock. First, the balance of payments surplus has been strong in the current cycle as higher oil price payments have been offset by higher exports and large capital inflows. Second, the government has taken a greater role in domestic pricing than in previous cycles, thus cushioning domestic demand. Large gap between required market-determined price and actual price
Oil products can be grouped into three baskets: (a) industrial products, where prices are largely market-determined and tend to move in line with import parity prices; (b) oil products used for cooking by the lower- and middle-income population, including LPG (liquefied petroleum gas) and kerosene; and (c) products where the government partially passes the burden of higher international prices onto consumers. This is essentially the case for gasoline and diesel. Traditionally, the government has been using these products for cross-subsidizing kerosene and LPG. The government also levies a high level of taxes on these products. Politically, the government is more sensitive to increases in the diesel price as diesel is used by truck operators for transport of mass items of consumption. Hence, domestic diesel prices tend to be lower than gasoline prices. Our estimates indicate that the current weighted average realization of oil products in the domestic market implies an average crude oil price of US$54/bbl (WTI), versus the current international market price of US$96/bbl. The gap between the required fully marked-to-market price of petroleum products and the current domestic prices of these products is covered by (a) passing the burden onto (largely government-owned) oil companies, both upstream and downstream; (b) increasing the fiscal burden by way of reduction in indirect taxes on petroleum products; and (c) issuing bonds to oil companies to compensate for the lack of recovery (which the government treats as an off-budget liability, i.e., this part of the subsidy burden is not taken into account for presenting annual budget deficit estimates). What if oil prices stay close to US$100/bbl through to the financial year-end?
We expect the government to announce about a 5% increase in domestic prices in the next two weeks. That would still leave the actual price well below that warranted by the current market price. In our view, if crude prices (WTI) average about US$83.5/bbl in F2008 (YE March) and the government does not resort to any further price increases, the overall oil subsidy burden will rise to 1.9% of GDP, with 42% being borne by the government in the form of direct subsidy and issuance of oil bonds. The balance (58%) will likely be borne by the oil companies. Hence, higher oil prices are unlikely to result in a proportionately negative impact on inflation, private consumption and growth. In addition to an increase in the off-budget fiscal deficit, the current account deficit for F2008 would also be at 1.5%, compared with our current estimate of 0.9%.
Bottom line
GDP growth in the near term will likely see only a minor negative impact. In the near term, higher crude oil prices would only mean an expansionary fiscal policy. However, we believe that growth may be impacted meaningfully if crude oil prices stay close to current levels beyond the next six months.
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No Surprises in 2008 Budget
November 12, 2007
By Michael Kafe, CFA | Johannesburg
Background
The Government of Nigeria published its 2008 Budget on November 7, 2007. Outside of what seems to us to be a rather optimistic 2008 GDP growth forecast, there were no major surprises relative to the forecasts we put out in Nigeria: Looking Up, June 15, 2007. The Budget was predicated on anticipated crude oil production volumes of 2.45 million barrels per day, an average oil price of US$53.83/barrel, joint venture cash calls of US$4.97 billion, an exchange rate of N117/US$, an inflation rate of 8.5% and a GDP growth rate of as much as 11%Y. Overview of the 2007 Budget In a brief overview, the president indicated that, although oil prices far exceeded baseline projections for 2007 (the 2007 Budget was based on crude oil production volumes of 2.5 million barrels per day and a benchmark oil price of US$40/barrel), revenues came in N796 billion short of their projected levels, thanks to production disruptions in the Niger Delta. However, the hole was plugged, mainly by monthly drawdowns on the excess crude account, among others. Budgeted revenues For the 2008 Budget, oil revenues are expected to contribute 80% of receipts, while non-oil revenues rake in the remaining 20%. On the revenue line, the government expects N2.03 trillion (in line with Morgan Stanley’s forecast of N2.04 trillion), split between the Federation Account (N1.87 billion) and the Excess Crude and Other account (N160 billion). The latter two compare with our forecasts of N1.8 trillion and N240 billion. We had expected the government to stack a little bit more money away in the Excess Crude account than it appears willing to. Budgeted expenditure With regards to expenditure, the government has pencilled in a N2,450 billion estimate, slightly lower than our forecast of N2,559 billion. This is split between statutory departments such as the national Judicial Council, the Niger Delta Development Commission and the Universal Basic Education Commission (N187.6 billion), domestic debt service costs (N306.2 billion) and foreign debt service costs (N66 billion), while the remainder is spent by Ministries, Departments and Agencies (MDAs). At N1,890 billion, the allocation to MDAs comes in below our forecast of N2,082 billion, thanks in large measure to a lower-than-expected allocation to capital projects. As mentioned in Nigeria: IMF Review Says Naira Undervalued, October 26, 2007, the new administration has put several capital and infrastructure projects on hold, pending comprehensive strategic and technical reassessment of projects. This suggests that – as with most public-sector projects – the actual roll-out of the multi-year projects announced in the 2007 Budget could be back-loaded. Positively, however, we are quite pleased that, despite the civil service salary adjustments, total recurrent expenditure by MDAs is still in line with our estimate – in fact, it is slightly lower. The government committed to a range of public-sector projects, ranging from a N94.4 billion transportation project, through a N90 billion agricultural and water resources project to N110 billion for its Millennium Development Goals (MDGs). In addition, N210 billion has been allocated to education, N138 billion to health-sector projects and N140 billion to education. Fiscal deficit is well-contained Given these revenue and expenditure projections, the government expects a fiscal deficit of N0.5 trillion or some 2.5% of GDP. This is very similar to last year’s 2.3%-of-GDP deficit, and is in line with our forecast. Nigeria’s domestic debt stock is expected to reach N1.9 trillion by the end of this year – an increase of N285 billion, while foreign debt remains flat at US$3 billion (N357 billion) – down from US$32 billion in 2005 – thanks mainly to debt forgiveness under the Paris Club arrangement. On the whole, Nigeria’s debt ratio is expected to remain well below 20% of GDP for the foreseeable future. Unlike South Africa, the government of Nigeria sees no material benefit from either restructuring or prepaying its external debts; hence we believe that the spread of South Africa’s debt-to-GDP ratio over Nigeria’s, which we expect to fall from 800bp this year to 300bp by 2010, could be eliminated by 2015. Will the real GDP growth rate please stand up While the Budget assumptions are based on a rather optimistic 11% GDP growth rate for 2008 (from 5.6% in 2006 and Morgan Stanley’s forecast of 6% for this year), the government does not quite indicate how it expects to achieve this jump. We notice, however, that the fourth paragraph of the Budget Speech indicates that “Based on current trends, real GDP growth for 2007-2008 is set to average 7% per annum.” The latter forecast is exactly in line with Morgan Stanley’s June 15, 2007 estimate of 7%. We are therefore inclined to believe that the 11% growth assumption on which the 2008 Budget was based may either have been a nominal specification or, quite frankly, a misprint. Conclusion On the whole, we believe that the Budget was positive. The containment of the fiscal deficit well below Maastricht recommendations is no doubt welcome, as is the curtailment in total public debt. We appreciate that the cutback in capital expenditure could be reversed once proper due diligence is completed on the numerous projects that the government hopes to bring on-stream. Importantly, the assumption of a stronger currency also confirms our view that the authorities must have indeed resolved not to stand in the way of currency strength.
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Fasten the Seatbelt: An Update
November 12, 2007
By Qing Wang | Hong Kong
Summary and conclusions
The renminbi appreciation against the US dollar has speeded up significantly over the past three weeks (see China Economics: Fasten the Seatbelt, October 22, where we last discussed this subject). The CNY/USD rate dropped from 7.51 on October 22 to 7.42 on November 9, or a renminbi appreciation of 1.25%, the greatest strengthening in any three-week period since the renminbi revaluation on July 22, 2005. Against this backdrop, speculation has intensified that China may modify the exchange rate regime further (e.g., through a ‘one-off’ revaluation or band widening).
Acceleration in the renminbi’s strengthening was a key component of the mini-tightening cycle I envisaged. I think that our FX strategy team’s expectation that the CNY/USD rate will fall to 7.30 by end-December is certainly achievable. For 2008, I expect the Chinese authorities to maintain their gradual appreciation strategy but at a faster pace than in 2007. I assign a low probability to another ‘one-off’ revaluation. The policy measure of widening the band is not impossible, but would be largely symbolic, in my opinion, especially if it were to be implemented in the near term.
A period of a sharp drop in the CNY/USD rate tends to be followed by a pullback as the authorities want to create the appearance of two-way volatility. Since I believe that the authorities’ policy objective of allowing a faster renminbi appreciation to address external (e.g., sizeable trade surpluses) and internal (e.g., high inflation) imbalances is firmly in place, any such pullback should be quite brief and thus create opportunities to add to positions that are positively sensitive to renminbi appreciation.
Have you fastened your seatbelt?
The CNY/USD rate dropped from 7.51 on October 22 to 7.42 on November 9, or a renminbi appreciation of 1.25%, the fastest pace in any three-week period since the renminbi revaluation on July 22, 2005. To put the last three weeks’ developments into perspective, the renminbi appreciated against the US dollar by only 3.4% for the entire year of 2006! This marked acceleration of renminbi appreciation appears to have also exacerbated the broad-based selling pressures on the US dollar, as it may have created the perception that even the PBoC – the largest sovereign buyer of US dollars – has finally given up on the greenback.
The accelerated appreciation suggests that renminbi appreciation has indeed featured importantly in the mini-tightening cycle that I envisaged (see China Economics: Runaway Monetary Growth Points to a Mini-tightening Cycle in the Coming Months, October 14).
What to expect going forward?
I expect that the momentum of faster appreciation will be maintained for the remainder of the year, especially against the backdrop of a weakening US dollar and in view of the upcoming political events that may put the renminbi exchange rate issue under the spotlight again. Our FX strategy team’s forecast of the CNY/USD rate dropping to 7.30 by end-2007 is now well within reach, in my view. For 2008, I expect the Chinese authorities to keep to the gradual appreciation strategy but to allow a faster pace of strengthening than in 2007.
In this context, speculation that China may make further modifications to the exchange rate regime (e.g., a ‘one-off’ revaluation or band widening) has intensified, as I expected. However, I maintain my call that there is a very low probability of another discrete adjustment in the exchange rate this year and less than a 20% probability for next year.
In addition to my arguments in previous notes, I believe that for the Chinese authorities to make such a bold move as a more-than-10% revaluation, one of the following two conditions would need to be met: i) domestic CPI inflation moves out of control (i.e., headline CPI is above 8% for a protracted period); or ii) such a sizeable revaluation would produce an international political gain vis-à-vis China’s major trading partners (e.g., the US and EU) that would be sufficient to make the currency move worthwhile.
However, neither condition will likely be met in 2008, in my view. First, I believe that there is no basis for sustained high inflation in China, and the currently high inflation is set to moderate over 2008 (see China Economics: ‘An Era of Inflation’ Dawns for China? Not So Early, September 11). Second, I do not believe that any meaningfully large political gain (as a result of China allowing a large renminbi revaluation) would be achievable until after the US presidential election cycle (i.e., January 2009).
A band-widening is possible but would be largely symbolic, especially if it were to be carried out in the near term, in my view. The official intra-day trading band for the USD/CNY rate was widened from +/-0.3% to +/-0.5% on May 18, just before the second US-China Strategic Economic Dialogue (SED) took place (see China Economics: Band Widening ≠ Faster Renminbi Appreciation, May 21). Some have suggested that China may widen the band again in the run-up to the third SED meeting that is to take place around mid-December.
While I would not rule this out completely, I believe that: a) the probability of a near-term band widening is small; and b) such a band-widening, if it were to occur, would be largely symbolic, especially if it were to be carried out in the near term. Since the band was widened on May 18, the USD/CNY spot rate has still been traded well within the former narrower +/-0.3% band, with the old band having been tested only twice since the band-widening. In other words, even the former band has not been used fully, let alone the new band. Therefore, there is really no practical need to widen the trading band at this time. On the other hand, before the old band was widened on May 18, it was also far from being fully used. This is why, I think, a band-widening is not impossible; however, even if there were one, it would be largely a symbolic move.
Risks and market implications
Past experience suggests that a period of a sharp fall in the USD/CNY rate tends to be followed by a pullback as the authorities want to give the impression of two-way volatility. Although I expect the accelerated appreciation to be sustained for the remainder of the year, it is unlikely to be a straight downward path towards year-end. I think that the authorities may attempt to engineer a pullback in the USD/CNY rate in the coming days. However, since I believe that the authorities’ policy objective of allowing faster renminbi appreciation to deal with external (e.g., sizeable trade surpluses) and internal (e.g., high inflation) imbalances is firmly in place, any such pullback should be quite brief and thus create opportunities to add to positions that are positively sensitive to renminbi appreciation.
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