Review and Preview
February 18, 2008
By Ted Wieseman | New York
The Treasury curve saw yet another big steepening move the past week.
The front end was supported by a strong flight-to-quality bid from weakness in various markets – severely dislocated auction-rate securities becoming the latest focus of investor anxiety to add to the growing list of distressed or completely broken markets – as well as a belief that worsening market conditions would lead to more Fed easing. Heavy mortgage selling pressures, mixed economic data, continued sizable curve steepening trade flows and limited interest in the longer end at such low rates pressured the intermediate and longer ends of the market. After the major and broadly based weakness across risk markets – stocks, credit, commercial mortgages, leveraged loans – the prior week, trends in the latest week were more mixed. Credit spreads continued to blow out to new wides, but stocks rose slightly on the week. The leveraged loan LCDX and commercial mortgage CMBX markets that have become an increasing source of concern were mixed on the week – some worsening in the former, little overall change in the latter – but in both cases at least there were signs of some stabilization after the near freefall they had seen over the prior couple of weeks. But the severe disruptions in the auction-rate security markets, muni debt primarily but also student loans to a smaller extent, still kept investor anxieties sharply elevated and consequently kept a strong bid in the front end of the Treasury market, on top of the continued support from heavy investor demand for curve steepening positions. This was partly a flight to safety, but a further dovish repricing of the Fed indicated that investors also expected the latest market disruptions to have a real negative economic impact as well, or at least a bad enough impact on general market functioning to prompt a Fed response. Interbank lending markets also saw a further worsening, with the spread of 3-month LIBOR over the expected average fed funds rate over the next three months rising to its highest level in almost a month. These worsening dislocations came as worries continued to shift from subprime mortgages to leveraged loans and commercial real estate as the next potential major sources of future write-downs and ongoing balance sheet pressures. Amid the primary focus on these various market developments, economic data released the past week were mixed. The retail sales, trade balance and business inventories reports taken together pointed to slightly less bad GDP growth in 4Q07 and 1Q08. We now expect 4Q GDP growth to be revised up to +0.8% from +0.6% instead of revised down to +0.5%, and we see 1Q running at -0.5%, a bit better than our original forecast of -0.7%. Looking forward, however, surveys and more high-frequency data released the past week – both the Michigan and ABC consumer confidence surveys, the Empire State manufacturing survey, and the 4-week average of initial jobless claims – were ugly, and we continue to see our recession call as being well on track. On the week, the Treasury curve saw another big steepening move, with 2s-10s rising 15bp to 187bp and 2s-30s 18bp to 268bp, though there was a decent pullback Friday from new peaks since the summer 2004 hit on Thursday. The 2-year yield fell 2bp to 1.91%, while the 5-year yield rose 6bp to 2.76%, the 10-year 12bp to 2.78%, and the 30-year 16bp to 4.59%. A surge in energy prices supported the shorter end of the TIPS market, but the long end performed badly, with the 10-year TIPS yield up 13bp to 1.48%. Key risk markets that had previously been the key market focus before a shift in the latest week towards anxieties about the severe problems in the auction-rate securities market were mixed on the week. At the time of the early bond market close, the S&P 500 was trading up a bit less than 1% on the week. Credit spreads had moved to new wides again, however, with the 5-year investment grade CDX index another 17bp wider on the week at 146bp in midday trading Friday. The high yield index was doing relatively better – it was a minor 7bp tighter on the week through Thursday, but the index was trading down about a half point Friday. As of midday Friday, the leveraged loan LCDX index was another 17bp wider on the week at an all-time wide of 534bp, though this was at least a significant slowing in the rate of deterioration from the 208bp widening that had been seen year-to-date through the end of the prior week. The commercial mortgage CMBX market also stabilized after having been in near freefall over the prior week-and-a-half, with mixed results across the various indices. The AAA index tightened 10bp on the week to 214bp after having widened a whopping 82bp the prior week. The AJ (junior AAA) and AA indices widened slightly further, but at a much slower pace than the prior recent deterioration, while the lowest-rated indices tightened a bit. Despite little new coming from Fed Chairman Bernanke’s Congressional testimony, there was a significant further dovish repricing of the Fed. There was a further move towards pricing out an intermeeting rate cut as the February fed funds contract fell 4.5bp to 4.96%, but the April contract gained 1bp to 2.415%, May 4bp to 2.225%, July 6bp to 2.04% and August 8bp to 1.93%. In the interbank lending markets, the significant worsening seen the prior week was extended in the latest week. Three-month LIBOR dipped 2bp on the week to 3.07%, not keeping pace with the more dovish expected Fed path, causing the 3-month LIBOR/3-month OIS spread to rise to 54bp from 51bp at the end of the prior week and 36bp two weeks ago. The worsening problems in the leverage loan markets and sell-off in the CMBX market, and their implications for additional bank write-downs and balance sheet pressures, appear to be significant contributors to this recent deterioration. And investors are not expecting any improvement any time soon. The Mar 08 eurodollar futures contract lost 4bp on the week, June 08 5.5bp and Sep 08 1.5bp, significantly underperforming overlapping fed funds futures contracts, and indicating that investors do not expect any meaningful improvement in LIBOR/expected fed funds spreads through most of this year. Eurodollar losses reached as high as 30-30.5bp for the Mar 12 to June 13 contracts. Hard data on consumer spending and trade released over the past week pointed to slightly stronger growth in 4Q07 and a smaller decline in early 1Q08, but more forward-looking and high-frequency indicators were looking grim, and we remain confident that our recession call is on track. Retail sales rose 0.3% in January, overall and excluding autos. Auto dealers’ receipts posted a 0.6% increase, contrasting with the big decline in unit sales. Meanwhile, most of the upside in ex-auto sales came from a surprising surge by gas stations (+2.0%), given the flattening out in gasoline prices. Excluding autos and gas, sales ticked up 0.1%. While chain store sales results were weak, they were sequentially improved from December against a tough year-ago comp, and this was reflected in particular in upside at clothing stores (+1.4%) and also in a small gain in general merchandise (+0.1%). The key retail control grouping rose 0.4%, slightly higher than we expected, pointing to marginally stronger consumption in 1Q than we previously estimated. We now see 1Q consumption running at +0.7% instead of +0.6%. Meanwhile, retail control in December (-0.1%) was unrevised, but November (+1.4% versus +1.6%) was adjusted a bit lower, pointing to a downward revision to 4Q consumption to +1.8% from +2.0%. The trade deficit narrowed to US$58.8 billion in December from US$63.1 billion in November, with exports rising 1.5% and imports falling 1.1%. Almost all of the export gain was accounted for by capital goods, and the majority of this upside was in aircraft, which surged to another record-high. High-tech capital goods exports were also strong. The biggest contributor to the import decline was a sharp fall in autos as North American assemblies slowed. Consumer goods, non-energy industrial materials and food were also down significantly and capital goods were little changed. This weakness offset a surprising jump in petroleum products to another record-high, mostly as a result of higher prices, contrasting with other data showing declining oil import prices in the month. The December trade deficit was significantly smaller than BEA assumed in preparing the advance estimate of 4Q growth, and the better end to 2007 provided a stronger starting point for trade in 1Q08. We now see the trade contribution to 4Q GDP growth being adjusted up to a substantial +0.8pp from +0.4pp. And we boosted our 1Q estimate to +0.6pp from +0.3pp, though this was partly offset by the negative implications of the poor mix of December capital goods imports (weak) and exports (strong) for domestic investment. Finally on 4Q07 and 1Q08 GDP, retail ex-auto inventories rose 0.7% in December, a bit stronger than BEA assumed, pointing to a smaller inventory drag in 4Q, but with an offsetting negative in 1Q. Combining the impacts of the retail sales, trade and inventory numbers, we now expect 4Q GDP growth to be revised up to +0.8% from +0.6% instead of revised down to +0.5%. And we now see 1Q GDP tracking at -0.5%, up slightly from our original -0.7% forecast. Beyond these slightly positive adjustments to the 4Q07 and 1Q08 growth outlook, some survey and higher-frequency data released over the past week were grim. The University of Michigan consumer confidence index fell nine points in the first part of February to 69.6, the lowest reading since 1993, tracking a similar recent collapse in the ABC News/ Washington Post weekly poll. The current conditions and expectations gauges both fell nine points to 85.4 and 59.4, respectively. That was the lowest reading for expectations – a component of the index of leading economic indicators – since the beginning of 1992. Meanwhile, the industrial production report showed manufacturing output stagnating in January and the factory sector capacity utilization continuing to grind lower, with negative implications for business pricing power, and the first look at the manufacturing sector in February pointed to a further deterioration. The headline index in the Empire State manufacturing survey plunged 21 points in February to -11.72, the worst reading since the 2001 recession (aside from a few bad months surrounding the Iraq invasion in 2003). Results weren’t as bad on an underlying basis, but still soft, with an ISM-comparable weighted average of the key activity measures falling to 48.1 from 50.9 on weakness in shipments, orders and employment. That was the worst outcome on this basis in five years and down sharply from the recent high of 57.4 hit in October. We’ll get another early read on February manufacturing conditions on Thursday with the release of the Philadelphia Fed survey. Finally, initial jobless claims pulled back a bit in the week of February 9, one week ahead of the reference period for the February employment report, but the 4-week average rose to the highest level since the aftermath of Hurricane Katrina in 2005. There’s a fairly light economic calendar in the upcoming holiday-shortened week. The CPI report is out unusually late this month for some reason on Wednesday. While this report will certainly attract significant market attention, not many people seriously believe that the Fed is going to be in any way restrained in continuing to cut rates if the economy continues to deteriorate, regardless of the protestations of some Fed officials to the contrary. Also on Wednesday, the FOMC minutes from the January 29-30 meeting will be released. With Fed Chairman Bernanke’s semi-annual monetary policy testimony coming unusually late this time (on February 27 and 28), the minutes will provide an early look at the Fed’s revised economic forecasts as well as probably provide some sense of how much more the FOMC thinks it may have to do after front-loading 125bp of rate cuts in one week last month. We suspect that the FOMC thinks that it is closer to the trough in rates than the market does, given the chairman’s remarks in his testimony Thursday that he expects a period of sluggish growth, but at this point doesn’t see an outright recession, in the first half of this year, followed by a pick-up in the second half as fiscal stimulus and the delayed impact of already implemented monetary policy stimulus are felt. Other than CPI, key data releases due out include housing starts Wednesday and leading indicators Thursday: * We look for the consumer price index to rise 0.2% in January, overall and ex-food and energy. Gasoline prices edged only slightly higher in January (but appear likely to show a decline in February). Meanwhile, the seasonal adjustment factors do not appear to fully compensate for the typical start of the year rise in prices in the healthcare sector, and airfares likely continued to climb as the carriers pass along the impact of prior fuel price hikes. Our unrounded estimate for the core is +0.21%, implying that we see slight upside risk to our estimate. On a year-on-year basis, we expect the core to hold at +2.4%. * We expect January housing starts to be little changed at a 1.00 million unit annual rate. Favorable weather and a temporary bounceback in the volatile multi-family category following a near-record 40% plunge in December should provide some support this month. We expect only a fractional dip (-0.5%) in the overall pace of January starts. Looking ahead, we continue to expect a further 25% drop in starts relative to the current pace but look for activity to bottom out around the end of 2008. * Based on currently available components, the index of leading economic indicators should be flat in January after three straight declines, with a big drop in stock prices offset by positive contributions from jobless claims, consumer confidence and money supply.
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A Mild Counter-Cyclical Budget
February 18, 2008
By Deyi Tan | Singapore
What’s new? The 2008 Budget was announced last Friday with an emphasis on long and short-term objectives. In a nutshell, the long-term objectives were a reiteration of long-standing government policy, broadly along the following lines: a) Diversifying economic growth drivers and staying competitive: Tax deductions and allowances will be increased to incentivise research and development spending by corporates. Concessionary tax rates are given to promote Islamic finance, insurance and maritime financing. Real estate duty is abolished in a bid to spur the private wealth management industry. Some 20,000 square metres of office space is to be freed up by 1Q09 and another S$1 billion of government projects deferred to ease construction bottlenecks. b) Improving the hardware and software of the economy: S$50 billion is committed to land transport infrastructure from now until 2020. The number of subsidized university places, university and polytechnic bursary quantums and spending on continuing Education and Training (CET) will be increased. c) Improving retirement and healthcare adequacy: Tax relief is broadened to encourage Central Provident Fund (CPF pension) Minimum-sum and Medisave Account top-ups. Life bonuses (a one-off bonus) will be given for the first few cohorts of CPF members joining the newly announced annuities scheme. Government spending on healthcare facilities will also be increased. Fiscal stance is counter-cyclical Yet, beyond the longer-term policy reiterations, what is likely to be of greater market interest are the short-term objectives or the potential fiscal stimulus the Budget could provide in light of the recent economic and asset market developments, aggressive reflationary actions by the US and the expansionary fiscal policies of ASEAN neighbours such as Malaysia and Thailand. On that point, the government expects to run a small fiscal deficit of S$800 million (-0.3% of GDP) in FY2008 after a surplus of 2.7% of GDP in FY2007. This is on the back of operating revenue of S$39.8 billion, net investment income of S$2.2 billion and total expenditure & special transfers of S$42.9 billion, Specifically for FY2008, the increase in special transfers is the biggest contributor to the expansionary fiscal stance, accounting about 64% of the increase in government expenditure. Special transfers of S$5.4 billion (2.1% of GDP) announced for FY2008 is the largest since FY2001 (S$5.3 billion and 3.5% of GDP). Short-term fiscal stimulus is likely mild Indeed, to deal with the immediate issue of rising cost-push pressures from the commodity supercycle, property reflation and GST hike and as part of the government’s efforts to redistribute budget surpluses, some of the fiscal measures the government has announced are the following. First, growth dividends (cash payouts), the quantum depending on income and annual values of homes and varying between S$100 and S$400, will be paid out in two instalments in April and October 2008. This is expected to cost S$865 million. Second, as part of the GST offset package announced in FY2007, S$450 million worth of GST credits would be disbursed. Third, the government is making top-ups to Post-Secondary Education and Medisave Accounts. Fourth, the government is increasing the monthly payouts for the Public Assistance Scheme (for those unable to work) from S$290 to S$330. It will also increase the Singapore Allowance for government pensioners. The latter is expected to cost an additional US$3 million a year. Fifth, there will be an income tax rebate of 20% (capped at S$2,000) for all resident taxpayers for YA 2008. This is expected to cost the government S$380 million (the first three measures are Special Transfers). These surplus redistribution measures and inflation-offsets will affect the household balance sheet positively at the margin. However, the increase in such public expenditure (e.g., growth dividends, GST credits and 20% income tax rebates) that goes directly towards strengthening household balance sheets is not what makes up the bulk of the special transfers increase. 46% of the increase in special transfers is channeled towards CPF accounts or other funds that might not be required for immediate expenses and where the short-term stimulus to the economy is correspondingly lower. Additionally, another 40% of the increase in special transfers is channeled towards funds such as the National Research Foundation, which support the longer-term policy initiatives of the government, rather than serving as an immediate fiscal boost to the economy. More generally, though the fiscal stance has typically been anti-cyclical, with lower fiscal balances in periods of slower economic growth, the Singapore government in our view is not as much a proponent of Keynesian pump-priming as its ASEAN neighbours. It typically prefers to use public spending as a means to the end of spurring more private sector-led activities or achieving long-term policy goals such as retirement and healthcare adequacy rather than as an end in itself. Indeed, its belief in fiscal prudence can be seen from the fact that the government is constitutionally required to run balanced budgets in each five-year term and that use of investment income from past government surpluses is still limited to 50% or less of realized income gains. Still expecting limited recoupling in the economy We expect the fiscal stimulus from the FY2008 Budget to be mild. Having said that, however, this does not undermine our view that there will be limited recoupling of the Singapore economy with the developed world. Indeed, in Who Has the Best Domestic Demand Dynamics in ASEAN? September 28, 2007, we already noted that while the wherewithal to engage in fiscal pump-priming is high, the government is unlikely to engage in strong fiscal stimulus measures, given its typically prudent approach. Our limited recoupling view continues to be predicated upon the broad-based construction capex boom in residential, commercial, retail and infrastructure amid the high capacity utilization rates as excesses from the 1996 bubble are purged. This will reduce the sensitivity of the capex cycle to the export cycle, to which it has traditionally been linked.
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