Morgan Stanley - Global Economic Forum

Japan
Fukui May Linger Past His Sell-by Date
January 14, 2008

By Takehiro Sato | Tokyo

Key message

The 2008 recession call made by our US economics team is becoming the consensus, and the market view on Japan’s economy, where we moved early to cut our forecasts sharply, now also appears to be becoming more downbeat. In this context, the market is starting to become sensitive to the possibility that there will be a rate cut in Japan too. However, political turmoil due to the upper and lower house stand-off has thrown succession plans for the BoJ’s leadership into confusion, and it is now possible that incumbent governor Toshihiko Fukui’s influence will linger some time beyond his expiration date of March 19, as a result of political compromise. If so, delays in moving to a new leadership would probably mean that even if there is a rate cut, it will not come so quickly.

What’s new

The terms of the current governor and deputy governors are approaching expiration, but the chances of an uncontested selection process for their successors are slim, and our originally whimsical scenario that these seats may be left vacant is becoming more realistic. Some elements of the Democratic Party of Japan (DPJ) are already saying that the selection should be a matter for the next cabinet, and that therefore the reshuffle should be postponed to beyond a general election. This opens the possibility that Fukui will either be reappointed for a time, or retain a role in policy enforcement as an executive director even if he steps down. Our reasons are outlined below. Scenarios differ depending on whether the Diet is in session or not when the term of office expires on March 19.

First, if the lower house is dissolved and the Diet closes down, in the event that agreement of both houses cannot be obtained, the cabinet could appoint a governor and deputy governors without the approval of the Diet. But then if these appointments are not endorsed by the new Diet after the general election, the cabinet would have to axe these appointees swiftly (according to the BoJ Law, article 23, clause 5-6). It is easy to imagine that no strong candidates would be willing to put their names forward with this threat hanging over them, in which case a natural outcome would be to reappoint the current leadership provisionally. Also, if the next leadership team is decided and the Diet gives approval, there is the possibility that the incumbents could step down voluntarily before their terms expire, falling on their swords in traditional Japanese manner.

What would happen if there is a vacuum at the BoJ even though the Diet is in session? Here the procedures are somewhat involved. Since the current BoJ Law makes no provision for this eventuality, nifty moves would be needed to keep the policy board functioning. This might take the form of the current governors stepping down, and then taking up positions as executive directors. (Another possibility is the policy board member being elected from the six standing executive directors.) Diet approval would not be needed to become an executive director, and the Minster of Finance could make such appointments based on the recommendation of the policy board (BoJ Law, article 23, clause 3). The newly appointed directors could then be co-opted onto the policy board in the normal line of business. These proceedings were characterized as the view of the Cabinet Legislation Bureau in the House of Councillors Financial Affairs Committee last November as “a theoretical possibility that is not ruled out” (source: Bloomberg). The BoJ Law provides that the executive directors may take the governor’s duty when the governorship is vacant (article 22, clause 5). (The process differs legally when pertaining to ‘vacancies’ and ‘unable to perform duties’. The latter indicates cases where the board chairperson becomes unable to carry out his/her duties, including from overseas business. The Board chose Miyako Suda under such an ‘unable to perform’. However, the leadership chairperson is chosen by other board members when the top position is a ‘vacancy’.)

The policy board chairperson is chosen by the other members (BoJ Law, article 16, clause 3). In this case, it should be theoretically possible to elect a newly added executive director as the chairperson of the policy board, and so Fukui could carry on in this role even after stepping down as governor by becoming an executive director until the governor’s post is filled. This is simply a theoretical possibility, and not a stratagem that the government would be likely to embrace eagerly, but is worth keeping in mind should a vacancy in the governorship leave the policy board chair open. It would nevertheless be a global embarrassment for Japan if it cannot find a governor to attend major international get-togethers such as G7 meetings which can only be attended by the MoF Minister, Vice Minister and Governor of the BoJ. A G7 meeting in Washington is coming up in late April, for example. As one market participant, we are eager to see a swift appointment of a new governor and deputy governors, as a delay raises uncertainty about policy scenarios.

Where we differ

The risk of an impasse for the BoJ reshuffle is already widely recognized in the markets, but these two scenarios above, though imperfect, are possible ways around the problem. They would mean, however, that Governor Fukui retains influence for a time even after stepping down, either as the provisional governor or cloaked as an executive director.

Next catalysts

To divine the future course of policy, we hone in on the interim assessment of last year’s October Outlook Report, due in the January Monthly Report (January 22). This is likely to indicate that the economy is trending less robustly than the BoJ forecast made in October. This tenor is already observable in the downgrading of the basic outlook in the December BoJ Monthly, and in the cautious wording of Deputy Governor Toshiro Muto’s speech on January 10. If a new governor is decided by April, it is even possible that in the next Outlook Report in April the basic scenario for the economy and prices and the policy approach of normalization of policy rates will be revised according to the new broom’s policy leanings. We cannot push this possibility very hard at this moment, however, given the demands of character and initiative that would be required of a new governor willing to jump straight in and revise the Outlook Report in April, especially amid the current uncertainty over the personnel issue.

Policy implications

The economic outlook at home and abroad is getting bleaker, but it is still likely that monetary policy would remain gridlocked should Governor Fukui continue to wield influence until a new governor is decided after a general election. This means that in a situation which calls for lower interest rates, there might be delays in making the necessary moves because of a reluctance to depart from the path towards normalized interest rates that Governor Fukui has embarked upon. The framework for basing policy on ‘two pillars’ may also need to be reviewed flexibly according to the condition of the economy and asset markets, and we also see a need to rethink the positioning of the ‘understanding of price stability’ as a policy tool, which has become obscure. If the handover to new BoJ leadership is delayed, however, any departure from the current framework, if any, could well be delayed beyond the middle of the year.

Risks

If the general election is advanced to February, the likelihood that the handover process will stall diminishes. Also, if the DPJ agrees to the elevation of the presumptive successor Deputy Governor Muto, there would be no vacuum. We rate both as unlikely, however. In the former case, the critical importance of time-limited budget-related bills (sunset bills) could lead to political trading between the government and opposition parties that brings forward the dissolution of the lower house to around the end of the fiscal year, but the general election would probably slip into April. There could be a leadership vacuum at the BoJ for nearly two months if this happens. In the latter case, the decision would probably rest with DPJ honcho Ichiro Ozawa. He will not commit himself on the governorship question, but the DPJ opposed the deputy governor Muto and Iwata’s nomination five years ago and is unlikely to meekly accept the appointment of a former top MoF bureaucrat.

United States
Review and Preview
January 14, 2008

By Ted Wieseman & David Greenlaw | New York

The Treasury curve posted another major steepening move over the past week on big front-end gains and small back-end losses as Fed Chairman Bernanke confirmed market expectations for a 50bp rate cut at the upcoming FOMC meeting. Indeed, the Chairman even hinted at the possibility of an inter-meeting rate cut with his statement that “the Committee must remain exceptionally alert and flexible”. We certainly wouldn’t rule out an inter-meeting cut, but think that it’s pretty unlikely.

We don’t see a near-term data release that would provide a clear trigger for such a move. And stabilization in credit markets over the second half of the week – in response first to comments by Berkshire Hathaway that it was actively discussing buying or otherwise supporting a major bond insurer and then to news of the buyout of Countrywide by Bank of America – would seem to remove the need for an urgent response to what at midweek had appeared to be an increasingly disorderly collapse in credit markets. The market, on the other hand, sees an immediate cut as a good possibility. By the end of the week, a reasonably high chance was being priced into futures markets that the Fed would cut the funds target by 50bp as early as Monday and then cut another 25bp at the January 29-30 FOMC meeting, though just a 50bp cut at the meeting was still priced as the modestly more likely outcome. It was a light week for economic data, but key reports were weak. Most notable were even worse-than-expected chain store sales results for December, which pointed to a negative retail sales report on Tuesday, the key release in the upcoming week’s very busy economic calendar. While the soft December comes too late in the quarter to prevent 4Q07 as a whole from still posting a solid gain in consumer spending, it clearly provides a poor starting point for what we expect will be a much worse 1Q for the consumer. Meanwhile, the November trade report was much worse than expected and suggested that net exports will provide only marginal support to 4Q growth after being a major positive in 2Q and 3Q. We expect that exports will be a major support to the economy during the mild recession we forecast for the first half of this year, so the soft results for November coming after the big pullback in the ISM export orders index in December is worrisome. Mostly as a result of the trade surprise, we cut our 4Q07 GDP forecast to +1.2% from +1.7%.

At this early point, the trajectory for 1Q GDP appears to be slightly worse than our -0.8% forecast.

On the week, 2s-10s steepened 9bp to 122bp and 2s-30s 17bp to 180bp, both highs since December 2004, as the 2-year yield fell 14bp to 2.59%, the 5-year 9bp to 3.07% and the 10-year 5bp to 3.81%, while the long bond yield rose 3bp to 4.39%. A much more dovish Fed path was priced into futures markets through the first half of this year, with a more moderate adjustment beyond that. In the very short term, the January fed funds contract gained 4.5bp to 4.10% and the February contract 18.5bp to 3.65%, pricing in roughly a 40% chance that the FOMC will cut the funds target to 3.75% Monday and then to 3.50% at the January 29-30 FOMC meeting. The April contract gained 29bp to 3.315%, pricing a further cut to 3.25% at the March FOMC meeting, the May contract rose 34.5bp to 3.06%, pricing a move to 3% at the April meeting, and the July contract rallied 34bp to 2.875%, pricing a toss up on whether the funds target will be 2.75% or 3% after the June meeting. If not by June, the move to 2.75% is seen as coming shortly thereafter and then a final cut to 2.50% by late 2008 or early 2009, with the Sep 08 eurodollar futures contract gaining 25.5bp to 2.955% and the low-rate Dec 08 contract 18bp to 2.90%. Gains beyond that were significantly smaller, with the 2009 contracts rising 11-13.5bp and the 2010 contracts 12-14bp. Given the strong language coming from the Fed Chairman, it’s no surprise that investors are pricing such an aggressive near-term Fed path. We’re more stuck by how pessimistic investors are about the how successful the Fed’s actions will be in getting the economy back on track in 2009 and beyond. The Dec 09 eurodollar futures contract at only 3.305% and the Dec 10 contract at 3.925% point to significant pessimism about the possibility for a decent cyclical rebound from the expected 2008 recession. The 5-year TIPS yield at just 0.84% sends an even more dire message about market expectations for the prospects of a post-recession rebound.

Stocks ended the week a bit worse after rebounding off their midweek lows, with the S&P 500 down 0.8% on the week. The week’s much bigger story in risk markets was credit. The credit markets seemed to on the verge of an increasingly panicked rout through late Wednesday before staging a solid rebound off the lows following the Berkshire Hathaway and Countrywide news. In late trading Friday, the 5-year HiVol CDX index was trading 9bp wider at the week at 240bp and the broader investment grade index 8bp wider at 97bp, but this represented a big improvement from the all-time wides hit Wednesday afternoon just before the Berkshire Hathaway interview on CNBC of 278bp and 107bp, respectively. Meanwhile, money markets continued to show signs of improvement. 3-month LIBOR fell sharply on the week to 4.26% from 4.62%. The more important improvement relative to expected fed funds was significant, but much more modest given how big the Fed repricing was, with the 3-month LIBOR/3-month OIS spread falling 12bp to 62bp. This represents a big improvement from the 100+bp levels seen in early December before the TAF program began, but is still above even levels in the mid-40s hit in late October, not to mention more normal levels near 8bp. Meanwhile, significant improvement continued in the asset-backed commercial paper market. The amount of ABCP outstanding rose for a second straight week after a prior string of 20 straight declines. This could be a key development in prompting further improvement in LIBOR/OIS spreads to the extent that banks become more comfortable that demands are fading to pull asset-backed securities backed by off-balance sheet ABCP programs on balance sheet or otherwise provide support to these programs. Term ABCP yields also fell substantially on the week and tightened versus LIBOR, while our desk noted a significant pick-up in term activity relative to overnight post-Bernanke.

It was a very light week for economic news, but the key data that were released were negative. Most notable were even worse chain store sales results for December than already weak expectations, with particularly terrible numbers from department stores and clothing retailers. Incorporating these results, we cut our retail sales forecast to -0.2% overall and -0.5% ex-autos from our preliminary estimate of -0.1% and -0.3%, respectively. We also trimmed our estimate for the key retail control to -0.4% from -0.2%. This had a marginally negative impact on our outlook for 4Q GDP growth, though our 4Q consumption estimate is still rounding up to +2.9%, in large part thanks to the surge in November retail sales, which looks likely to be at least partly unwound in December. Clearly a negative consumption number in December would provide a much softer starting point for 1Q. We expect 1Q consumption growth to be little better than unchanged at this point.

A much bigger negative for the 4Q growth outlook was a far worse than expected November trade report. The trade deficit widened to a more than one-year high of US$63.1 billion in November from US$57.8 billion in October as imports surged 3.0% and exports rose only 0.4%. The bulk of the import gain was accounted for by petroleum products, mostly a result of higher prices, but real petroleum imports also rose sharply. Consumer goods imports also posted a big gain, in line with a pick-up in West Coast port activity after several sluggish months. Almost all of the export gain was accounted for by a good gain in services, which lifted the services surplus to a record high. Goods exports were little changed, as upside in food and petroleum products was offset by drops in non-energy industrial materials and a sharp pullback in aircraft from October’s record high. Even with much of the worsening in the nominal trade gap coming from higher prices, the real goods deficit still widened a couple billion dollars, much worse than the slight narrowing we had anticipated. We now see net exports only adding 0.1pp to 4Q GDP growth.

Meanwhile, the underlying details on capital goods exports and imports overall were in line with our assumptions, and had no impact on our investment forecasts. We see 4Q equipment and software investment falling 1.7% and overall business investment rising 4.6% thanks to a 19% spike in structures investment, based on extremely robust trends in private non-residential construction spending in November. The significant drop in non-residential construction employment in December, however, suggests that support from that sector is quickly fading moving into 2008.

The much worse-than-expected results for November exports coming after the sharp drop in the ISM export orders index for December provided another hint that the global outlook may not be as robust as is widely believed. We’re still assuming that exports will be a big positive contributor to US growth in the first half of 2008, helping to keep the likely recession mild. Risks on that front certainly seem to be rising, however.

Combining our slightly lower consumer spending estimate and the significantly lower estimate for net exports with a small positive offset from a slightly higher-than-expected wholesale inventory result for November, we cut our 4Q GDP forecast to +1.2% from +1.7%. However, the worse starting point for 1Q consumption we now see from a weaker December retail sales report and a likely slightly bigger inventory drag after incorporating the small 4Q wholesale upside suggest that 1Q growth is probably starting off running somewhat weaker than our -0.8% forecast. Note also that that -0.8% forecast builds in a 1.2 percentage point positive contribution from net exports, which would require substantial improvement in the upcoming monthly trade results – about a US$1 billion narrowing in the real deficit each month from December through March – after the much worse-than-expected November outcome.

The economic calendar in the upcoming week is packed. The most notable economic release will be retail sales on Tuesday, which we expect to add to previously released data suggesting the economy may have slipped into recession in December. The inflation numbers – CPI Wednesday and PPI Tuesday – will attract some attention, but they are of limited importance at this point. For all the lip service the FOMC may continue to pay towards its vigilance over inflation, when push comes to shove, we think that it is very unlikely that it will hesitate to cut rates aggressively – including the now highly likely 50bp rate cut at the upcoming FOMC meeting – if the economy continues to fall into recession, regardless of what the incoming inflation data show. Chairman Bernanke will be testifying on the economic outlook Thursday, but his prepared remarks will likely be quite similar to the message delivered Thursday.

The Budget Committee members will likely be most interested in trying to get the Chairman to support their various fiscal stimulus plans, so the Q&A probably won’t provide any significant new information either. In addition to the retail sales and inflation reports, data due out include the Empire State manufacturing survey and business inventories Tuesday, industrial production Wednesday, housing starts, the Philly Fed survey and jobless claims (where we look for a big rise in initial claims to reverse the past week’s drop that we think was fully a result of seasonal adjustment problems) Thursday, and leading indicators and Michigan consumer confidence Friday:

*We forecast a 0.2% drop in overall December retail sales and a 0.5% decline ex-autos. Unit sales of motor vehicles point to a modest gain in the auto dealer category. However, we believe that seasonal adjustment quirks contributed to the surprising spike in November non-auto sales, and thus we look for some significant offsetting declines across a broad range of categories in the December report. In fact, our translation of the chain store results implies sizable pullbacks in key categories such as apparel, general merchandise and pharmacies. The only notable gain is expected to be a modest price-related uptick in gas station sales.

*We look for a 0.1% decline in the overall producer price index in December and a 0.1% rise ex-food and energy. A modest pullback in wholesale gasoline prices following the near-record surge in November should be partially offset by a jump in quotes for food. Also, the volatile motor vehicle category is expected to flatten out following an unusually large jump in November. This should help to lead to only a fractional rise in the core measure.

*We expect weakness in retail inventories – with unit figures pointing to a significant drop in autos and ex-autos also likely to be soft on the surge in November ex-auto retail sales – to partly offset big gains at the manufacturing and wholesale level, leading to a small 0.3% gain in overall inventories in November. The I/S ratio should fall two-tenths to an all-time low of 1.24.

*We look for the December consumer price index to rise 0.2%, overall and ex-food and energy. The energy category is expected to post a far more modest gain than seen in recent months. This should help contain the headline result in December. Meanwhile, we expect the core to post a trend-like rise, with a rebound in hotel rates and a further climb in airfares being partially offset by some softness in motor vehicle prices. The risks this month appear to be slightly tilted to the upside since our unrounded estimate for the core is +0.21%. Finally, on a year-on-year basis, we look for the core to tick up again this month (to +2.4%).

*We forecast a 0.1% rise in December industrial production. The employment report pointed to significant weakness in the manufacturing sector, with relatively sharp declines in both employment and hours worked. However, some of the sectors that have the highest weightings in the Fed’s calculation – such as food, chemicals and aerospace – held up reasonably well. Moreover, motor vehicle production came in higher than implied by the original assembly plans, and thus we look for a modest positive contribution from the auto sector. All of this should add up to a fractional rise in the key manufacturing component of IP. Finally, electricity output is likely to register a partial rebound following some weather-related softness in prior months, but this should be about offset by a dip in oil drilling.

*We expect December housing starts to fall to a 1.15 million unit annual rate. The inventory of unsold new homes remains quite elevated and the labor market data showed considerable weakness in the construction sector during December. So, we look for a further 3% decline in starts this month. Moreover, we expect starts to decline by an additional 25% over the course of 2008, bottoming in the 850,000-900,000 unit range late in the year.