Assuming that the US economy follows a U-shaped trajectory in 2008 (a mild and shallow recession in 1H, followed by a recovery in 2H), USD/JPY has a good chance of selling off in 1H, but rising in 2H. A year of two tales for the US economy should have important cyclical implications for USD/JPY. In addition to the external shocks arising from the US business cycle, the JPY will also be perturbed by four policy-induced growth shocks made in Japan, which should enhance the U-shaped trajectory we see for the JPY crosses this year. We reiterate our call for USD/JPY to trade down to 103 by June, then back up to 110 by year-end. An economic slowdown in the US and Japan and a general risk-averse financial environment should be positive for the JPY in 1H, while the opposite should be negative for the JPY, as Japanese investors resume pushing down their ‘home bias’ in 2H. The external demand shock from the US will hurt Japan Japan is likely to be a ‘higher-beta’ economy vis-à-vis the US than others. First, Japan is still quite exposed to the demand from the US, which accounts for some 20% of Japan’s overall exports. In 2001, when the US fell into a capex-led recession, the contractions in Japan’s exports (down 5%Y in 2001) and its GDP growth (0.2%Y) were instantaneous. Japan was tightly coupled to the US back then, and will probably be so this time around too – in the opinion of Sato-san. Not only is it still exposed to external demand from the US, unlike most other countries, Japan has extremely limited scope to deploy Keynesian countermeasures to deal with the collateral damage from a US recession. The BoJ is the only central bank in the world that has not yet ‘fully re-loaded’. In addition, the policy rate is so abnormally low that the BoJ will be rather reluctant to ease. Given the circumstances, however, the BoJ is struggling to justify further monetary tightening. Though CPI inflation has finally turned positive again (0.6% in November), this recent rise in prices reflected higher energy costs, i.e., cost-push rather than demand-pull. Not only has there been no sign of a wage-price spiral, if anything wages remain stagnant as the structural changes in the labour market have weakened the bargaining power of workers; this also implies that, when hit by an energy or input price shock, companies could pass on the cost to the workers in order to preserve their margin. As a result, real wages fall in response to an energy shock. Our Japan economist Sato-san suspects that the next move by the BoJ could very well be a rate cut rather than a rate hike, particularly if the Nikkei enters a bear market. At the same time, a large fiscal stimulus is also out of the question: Japan’s fiscal position is still too weak to allow it to contemplate large fiscal stimulus packages. Although Japan’s primary surplus has shrunk down to a little less than 1% of GDP from -4.1% in 2001, its overall government deficit is still very large at 3.4% of GDP in 2007, even though it has come down from a cycle-high of 8.8% of GDP back in 2002. Interest payments on Japan’s stock of debt remain daunting. Even if Japan achieves its ambitious goal of reaching a primary balance by 2011, its stock of debt – which has just reached 182% of GDP – is not likely to stabilise in the foreseeable future. This is not a solid platform from which to launch a fiscal stimulus package. Finally, unlike most other countries, the JPY is unlikely to act as an automatic stabiliser in a recession: the JPY tends to strengthen when the going gets tough in Japan, which further exacerbates the slowdown. It is unlikely to be different this time. Four domestic shocks, driven by (good) policies My colleagues in Japan (T. Sato and R. Feldman) have made these observations in their recent write-ups. Essentially, three policy-induced shocks will retard domestic demand growth, even though all three policies are sensible, and a fourth policy-induced shock will help undermine capital outflows. In fact, our Japan team is looking for growth to be around 1.0% (+0.9% for the calendar year and +1.1% for the fiscal year), which is down from 1.8% in 2007 and lower than the 2008 forecast by consensus (1.5%), the BoJ (2.1%) and the government (2.0%). Domestic shock 1. A tightening in the construction code. The Japanese Ministry of Land, Infrastructure and Transport (MLIT) tightened the building code in June 2007 in response to architects who cheated in their earthquake-resistance designs and calculations. For builders, this has dramatically complicated applications for building permits. Construction of condos is likely to be weak until at least late 2008, shaving off 0.3% from overall GDP growth. Domestic shock 2. A reduction in the loan guarantee for SMEs (small and medium-size enterprises) by METI. SMEs account for 70% of the workforce in Japan and 57% of total value-added. METI used to provide a 100% guarantee on bank loans taken out by SMEs. But this was reduced to 80% in October last year. This will further burden the SMEs. Our colleague Sato-san discusses this extensively in Credit Crunch Coming, January 7, 2008. Domestic shock 3. A tightening in consumer loan regulations. The first enforcement in January 2007 imposed more severe penalties on illegal lending by non-bank entities. The second enforcement took place in December 2007. The final implementation will take place by mid-2009, which will impose a ceiling on the lending rates of 20%. This legislation was initially intended to curb the number of borrowers with multiple debt, but as Sato-san discusses, this may also impact the SMEs. (Please see Sato-san’s note for further details.) Domestic shock 4. The FSA’s higher disclosure requirement on mutual fund investments. While the first three domestic shocks will adversely affect Japan’s GDP growth, this fourth policy shock will temporarily discourage retail capital outflows from Japan. The ‘Financial Instruments and Exchange Law’ took effect at the end of September. These regulatory changes are essentially aimed at offering more detailed explanations on the ITF products to investors, i.e., bringing transparency to the marketplace. While there is no reduction in the product classes that can be sold, ITFs have significantly curtailed their offering of mutual fund products as a result of cumbersome disclosure procedures. The Investment Trust flows experienced a sharp contraction in outflows in October as a direct result of this regulation by the FSA. Thus, what is essentially a very sensible regulation has somehow led to a distortion in the JPY market. USD/JPY to yo-yo As we argued in The Dollar Smiles in a Recession (December 10, 2007), the world entering the ‘winter quadrant’ should be positive for the JPY (and the CHF). As the JPY strengthens toward 100, the MoF will not likely respond. The MoF’s stance on the JPY is essentially a reflection of the general public’s view, which has, in fact, been changing. For decades, there was a clear preference for a competitive JPY. A merchantilist bias was prevalent. However, with the sharp rise in oil and food prices, and the significant loss in purchasing power overseas, popular opinion is now split on whether a weak JPY is good or bad for Japan. This ambivalence will likely translate into a MoF that will refrain from conducting unilateral interventions to support USD/JPY. If USD/JPY does indeed approach 103 by June, as we believe, this issue of MoF interventions will be discussed by investors. However, as soon as the global economy reasserts itself, which we suspect could take place in 3Q, and investors’ risk-taking appetite returns, we believe that the JPY will weaken again. The pent-up appetite among Japanese investors for foreign assets is immense – an argument we have made in the past. Capital outflows will resume, as Japan’s financial ‘home bias’ is reduced from what is currently extraordinarily distorted levels. Bottom line We reiterate our tactical call that USD/JPY should be sold in 1H. The global economic slowdown and general risk-aversion should assist the JPY’s ascent. But when the world recovers, this trade should be reversed as the structural decline in Japan’s financial ‘home bias’ should resume.
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How Much Assets Could SWFs Farm Out?
January 11, 2008
By Stephen Jen | London
Summary and conclusions Sovereign wealth funds (SWFs) will outsource part of the management of their assets to external fund managers. In this note, we guesstimate that, in the aggregate, SWFs could farm out US$150 billion worth of capital in the next two years and, thereafter, roughly US$200 billion every year for the next decade. What we know about SWFs’ use of external managers While it is well-known that all SWFs farm out part of their assets to external managers, hard and specific data on this are scant. We first document the only comprehensive set of data we could find on this for, unsurprisingly, Norway’s Government Pension Fund – Global (GPF). In addition, we augment our view by examining what a large developed sovereign pension fund (SPF) has done in terms of out-placement of capital. We use Canada’s CDQ (Caisse de depot et Placement du Québec) as an example. Norway’s GPF is widely recognised as one of the most transparent SWFs in the world. It publishes on its website specific data on its out-placement of funds to external investors. The GPF was established in 1990, but the first transfer into the fund took place in 1996. The GPF began with roughly a 40-60 split between external and internal management. But as the fund matured and the Norges Bank built up its own infrastructure to undertake systematic fund-management activities, the external/internal management balance gradually shifted to around 20% and 80%, respectively, i.e., 20% of the assets under management (AUM) are now managed by external managers. Over this period, total AUM also grew rapidly, reflecting the sharp rise in oil and gas prices during this period. As of end-3Q07, Norway’s GPF had NOK 1.93 trillion (or US$358 billion) under management. However, the capital out-placement ratio for equities has been significantly higher than that for bonds. We make the following observations. 1. AUM shifting from bonds to equities. As the GPF matured, its bond-equity split shifted from 100% bonds and 0% equities to 40% bonds and 60% equities. This evolution is very consistent with the strategic aim of SWFs to raise their exposure to ‘risky’ assets, i.e., assets that promise higher expected returns, albeit with higher variance. Readers should keep this trend in mind when thinking about the issue of capital out-placement. 2. Equities require more outsourcing. Investment in equities is intrinsically a bit more involved, from an institutional perspective. The various stocks and companies need to be covered by numerous specialists, whereas bond products are simply fewer. Further, it arguably takes longer to train specialists in some sectors for equities, and therefore the ‘fixed costs’ are higher to build up this type of human capital and, correspondingly, staff turnover would be more costly. In short, the sheer demand for personnel is just different for running equity or bond portfolios. It therefore makes sense for ‘young’ funds to outsource a bigger portion of the equity investment to external specialists. But as a fund builds expertise and its infrastructure in covering equities, the portion of investment that is outsourced should decline, as it has in the case of Norway’s GPF. 3. Beta versus alpha. Alpha tends to be outsourced for diversification purposes, while beta is kept in-house to keep management costs low. This is a general rule that applies to most funds, and it is no different for SWFs/SPFs. This could be why, for Norway’s bond investment, the part that is outsourced actually rose from zero at the start of the fund to more than 10% now. Further, as SWFs/SPFs build up their ‘alternative investments’, which include private equity and hedge funds, further out-placement of capital with external managers in these categories is both sensible and likely. We also examined the case of Canada’s CDQ, and found that this large and developed SPF still has more than 10% placed with external fund managers. Calculating the likely size of out-placement by SWFs Based on the observations made above, and duly noting that SWFs vary in style, we guess that 10-20% of the AUM may be farmed out by ‘mature’ SWFs, and even more by ‘young’ SWFs. An added advantage – which applies to funds that prefer not to be as transparent as Norway’s GPF is – is that farming out helps to cover up their footprints in the financial markets. For this reason, we assume that SWFs will on average start out with 20% of management outsourced. Though this figure is higher than that for Canada’s CDQ, it is substantially lower than the starting level of Norway’s GPF. Total AUM by SWFs at this moment are around US$2.88 trillion, according to our estimate. But most of these funds have been fully invested, and only the newer funds among these will have a ‘stock’ (as opposed to ‘flow’) impact on external fund managers. China will need to place part of its US$70 billion or so of liquid funds of the CIC to external fund mangers. The management of part of the SWFs of Korea, Russia, Chile and Libya will need to be outsourced. Adding the prospective SWFs such as the ones in Taiwan, Brazil and, most importantly, Japan, more than US$700 billion in new SWFs may need to be considered. 20% (or US$150 billion) of this may be outsourced. This is the ‘stock’ change. Once the assets of the new SWFs are allocated, the assets of all SWFs will grow rapidly over time, and part of the incremental asset growth will also need to be placed with external managers. This is the ‘flow’ change. We calculate that, in the next five years, total assets under management by SWFs will, on average, grow by US$1 trillion a year. 20% of this incremental growth will be US$200 billion. Bottom line It is likely that SWFs, in the aggregate, may out-place 20% or so of its assets with external investors. The new SWFs that are being established may place US$150 billion or so of funds with external managers. Going forward, as the AUM of all SWFs grow over time, another US$200 billion may be placed with external managers annually over the coming five years.
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Explaining the SIBOR Plunge
January 11, 2008
By Deyi Tan | Singapore, Chetan Ahya | Singapore
What’s new? 3-month SIBOR has held at about 1.8% for the third consecutive day, dropping about 60bp from the 2.375% prevailing at the start of the year. Similarly, long rates have also fallen, with the 10Y bond yield dropping from 2.68% to 2.35% in the same period, and the yield curve has flattened slightly with the 10Y-3M spread declining from 95bp in mid-December to 70bp currently. The decline in SIBOR appears counter-intuitive, particularly when the central bank has embarked on a tighter monetary policy stance in its semi-annual October-07 review. Also, inflation has yet to peak and seem likely to track around 6% in 1H08, in our view. Explaining the SIBOR decline We believe that the movement in SIBOR could be reflecting the central bank’s challenge in managing the different corners of the ‘impossible trinity’. Under the impossible trinity framework, monetary policy makers – in an open economy – have to decide which of the other two corners of the ‘impossible trinity’ (i.e. exchange rate or interest rate) it wants to retain control over. Monetary policy makers in Singapore have traditionally chosen to have tighter control on the exchange rate rather than interest rate. This means that domestic interest rates such as SIBOR are determined by global interest rates, currency expectations and MAS sterilization operations. It appears now that MAS is letting liquidity drive down the SIBOR rates. Though this is slightly counter-intuitive, given that inflation has yet to peak, we believe that there are several reasons that could explain the SIBOR plunge: 1) Fed futures pricing: On the back of weaker US data such as manufacturing ISM & payrolls and Bernanke’s speech overnight, which was more dovish than expected, Fed futures have (since the start of this year) began to price in more aggressive Fed ease, just about fully pricing in a cut to 3% at the June meeting. This is lower than our US economists, Richard Berner and David Greenlaw’s, expectation of 3.5% by 2Q08. Additionally, Fed futures are now pricing in an 88% chance of 50bp cut at the January 30-31 meeting, compared to the 25bp cut they were pricing in at end-December 2007. 2) Currency appreciation: A confluence of factors is contributing to SGD appreciation pressures. As we mentioned previously, rate cuts in the US and more cuts to come are threatening to put pressure on US$ weakness. Also, as of now, still relatively dichotomous economic momentum between the developed economies such as US, which are at the epicentre of the credit crunch, and economies such as Singapore, which are at the periphery of the credit problem but would be impacted via trade and financial market linkages spillover, are leading to a weak US$ and still strong flows into Singapore. Liquidity inflows, as measured by the FX accretion, have picked up in recent months. Dec-07 12-month and 3-month FX accretion now stand at 10.4% and 13.5% of GDP, respectively. Additionally, a more marked currency appreciation in other Asian currencies such as RMB and rumours of more to come amid inflationary pressures have also increased S$NEER appreciation pressures. As a result, the trade-weighted SG$NEER, which is managed within a policy bandwidth, continues to test the boundaries, tracking at the upper policy band. 3) Uncovered interest rate parity (UIRP) rule: With the SG$NEER testing the upper boundaries, given liquidity flows, MAS needs to sell SGD and buy USD to prevent the S$NEER from overshooting the upper band. This will inject liquidity into the system. MAS can accelerate its sterilization operations to absorb the liquidity which will hold SIBOR rates up. However, as a part of these flows are likely less stable in nature, we believe that MAS has allowed liquidity to drive down interest rates to reduce the returns on the currency and ease appreciation pressures on the SG$NEER. Facing a policy dilemma Indeed, the need to manage SG$NEER within its boundaries meant letting go of the third corner of the ‘impossible trinity’ and allowing SIBOR to be driven down by liquidity. This SIBOR plunge is not without precedent (see Asia Pacific Economics: US$1 Trillion Excess Liquidity Tide – Triggering Policy Surprises? May 10, 2007). Recall that in 1H07, excess liquidity triggered policy shifts in several Asian countries. SIBOR also declined from 3.4% as at February 2007 to a low of 2.3% by May 2007 amid the liquidity tide as the SG$NEER was tracking persistently near/at the upper band. Inflation was not a concern back then. However, the SIBOR decline now poses a policy dilemma, given that inflation is running at its highest level since the exchange rate policy was adopted in 1981, the oil shock years of 1980s notwithstanding. Going forward, inflation likely has more to run and could go closer to 6% in 1H08 amid the 18-25% revision of the public housing annual values (see Singapore: Revision of HDB Annual Values: A Better Reflection of Cost-Push Pressures in the Economy, November 13, 2007), the lagged impact from property reflation, high capacity utilization, transport fare revision, electricity tariffs revision and food & oil prices. Where will SIBOR go next? We estimate where SIBOR could go based on the UIRP framework, which suggests that the difference between global and domestic interest rates is equal to expected currency appreciation (see equation below). iUS – iSingapore =Expected Appreciation of SG$ against the US$ Where iUS = US interest rate & iSingapore = Singapore interest rate In our base case, our fed funds target rate (FFTR) expectations and SGD currency futures at this point are implying that SIBOR would back up to 2.5% by end-2008 as global growth rebounds in 2H08 and the US Federal Reserve starts raising rates in 4Q08. However, there are several moving parts to our SIBOR forecasts, and risks to our forecasts would arise from changes in expectations regarding the US economic outlook and Fed easing, as well as the pace of appreciation of other Asian currencies. All things being equal, risks to our FFTR forecasts and hence our SIBOR forecasts could be to the downside, particularly in light of Bernanke’s speech overnight.
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Business Conditions: Record Low
January 11, 2008
By Shital Patel and Richard Berner | New York
The Morgan Stanley Business Conditions Index hit an all-time low in early January, declining three points to 28%. Our canvass of industry analysts has never been tested in a recession, of course, because we started the survey and the index in June 2002. But a comparison over that period with other business indicators corroborates the evident weakness in business conditions consistent with at least a mild recession. The questions now are how deep and how long the recession will be. Fed Chairman Ben Bernanke this week signalled heightened concerns about the outlook, and we now expect the Fed to cut the funds rate by 50 bp at the January 29/30 FOMC meeting rather than 25 basis points as we were previously expecting. But given the lags in monetary policy, that won’t affect the economy for some time. Unfortunately, the way we read our survey results, the bottom of the downturn, let alone recovery, is not yet on the horizon. Our business conditions expectations index fell 10 points to an historical low of 25%, while advance bookings are contracting. Hiring plans remained weak, with only 26% of the groups planning to increase payrolls over the next three months. In contrast, plans to increase capital spending over the next three months jumped 25 points to a near-record high of 61%. We think this surprise is anomalous. Survey results also suggest a worse growth-cum-inflation mix that feels like stagflation. The pricing conditions index increased eight points to 71%, last reached in December 2005. The breadth of this downturn tells the story: Business conditions deteriorated over the past month for a staggering 50% of groups and improved for an inconsequential 3%. Conditions deteriorated for nearly all sectors, but remained unchanged in healthcare and utilities. Expectations for business conditions over the next six months are notably worse. Fully 68% of analysts expect conditions to deteriorate, up from 59% last month. Weakness is expected in all sectors. While Wall Street is beginning to accept the reality of a recession or at the very least an economic slowdown, Street earnings forecasts have remained stubbornly high. S&P 500 consensus earnings estimates for 2008 have increased compared to last month from 14.0% to 15.3%, while 2007 estimates were revised down slightly to 1.9% from 3.7%. The good news is that our own analysts are taking recession risks more seriously than a month ago and folding the scenario into their estimates. Compared to early December, 2008 earnings estimates have come down to 10.9% from 13.5%. There is evidence, moreover, that other Street analysts may be following suit. Bill Smith from our US equity strategy team notes downgrades in the consensus FY2 earnings revision factor in some non-financial groups including industrials, telecom, and tech within the past month. Downward revision estimates still have a long way to go. According to our analysts, 37% expect margins to expand in 2008 at companies under their coverage, compared to consensus Street expectations of 80%. As we noted last month, to get to 10.9% earnings growth, analysts continue to expect extremely high revenue growth which isn’t likely given our economic outlook. In fact, 68% of analysts still believe there are downside risks to earnings estimates, virtually unchanged from last month. Of these, 58% believe the risk is from worse domestic results, 15% from worse domestic and foreign growth, 15% from margin compression, and 11% from worse than expected growth abroad. Only 32% of analysts see upside risks to earnings estimates. Also, fewer analysts than before believe the dollar has helped earnings: 37% believe the dollar has contributed to bottom line results, down from 48% in early December. Credit availability continues to be a concern. Our credit conditions index, which looks at the ability to get financing compared to three months ago, remained unchanged at a weak 28% in January. Over the past month, lending standards continued to tighten. This month is the fifth month that roughly half of the groups which fall into the ‘borrower’ category (~80% of sample) have faced sequentially tighter lending standards. Of the lenders, three-fourths have tightened standards, up significantly from 33% in December. There is no doubt that the MSBCI is deep in recession territory. Now we wait to see whether there are any signals of a bottom. A sustained upturn in the headline index can’t happen until analysts start reporting that conditions are at least not getting worse. Getting better lies off in the future. SPECIAL ELECTION QUESTIONS. With the 2008 presidential election process in full swing, we asked analysts two special questions about the elections and business. The results were predictable. First, we asked analysts whether the uncertainty over the election outcome is causing companies under their coverage to delay hiring and/or capital spending plans. Only 11% of the groups are delaying spending, including managed care, household and personal care products, and aerospace and defense. In addition, 82% of analysts believe that companies under their coverage perceive that the environment for their businesses would be more favorable with a Republican Administration.
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