South Africa
Worrisome Core CPIX Jump
March 03, 2008

By Michael Kafe, CFA & Andrea Masia | South Africa

Summary

Data released from Statistics South Africa showed that CPIX rose 1.2%M to register an 8.8%Y rate, which was higher than our and market expectations of 8.4%Y. Of the 1.2%M increase in the January reading, 0.5pp was attributable to food, while medical costs added another 0.5pp. Non-alcoholic beverages and housing made up the remaining 0.2pp. Quite importantly, there was a significant acceleration in core CPIX (CPIX excluding food and petrol prices) to 5.6%Y from 5.0%Y in December. Our model suggests that this latter measure of inflation could reach 6% as early as this August. In our opinion, the material deterioration strengthens our out-of-consensus conviction that interest rates are unlikely to be cut anytime this year. In fact, the risk is that policy rates could be raised again this year, in our view.

It’s Not Over Till Food Says So

Food prices surprised to the upside at 1.4%M. Although we expected a seasonal snap-back of 1.2%M, the broad-based increase of all components within the food index provided sufficient impetus to push food inflation back to the high levels experienced in 3Q07. Looking forward, we expect a resumption in the deceleration of food inflation witnessed prior to the January reading, as copious amounts of summer rain and forecasts of improved harvests continue to hold near-term grain futures prices steady. Globally, however, food prices – particularly wheat and rice – are experiencing renewed upward pressure; given the high degree of openness of the South African economy, it is difficult to see how South Africa can sustainably decouple from the rest of the world. We must also point out that there is a huge divergence between near-term and longer-dated grain futures prices, confirming our view that any moderation in food prices would be short-lived. This viewpoint is of course contrary to the SARB’s view that there is “…a general expectation of some moderation in food price inflation during the course of this year” (see MPC Statement, January 31, 2008).

No More Deflation in Clothing and Footwear

Another source of upside surprise in the January CPIX print was the revisions made to the clothing and footwear sub-indices (4.1% of index). According to Statistics South Africa, these items were measured in the past irrespective of whether they were sold at a discounted or regular price. A decision has however been taken to exclude sale items and replace them with the next best regularly priced substitute. The data on clothing and footwear have been back-dated to January 2007, but no changes were made to the historical headline CPIX series.

The revisions have taken the average monthly reading of the sub-index from -0.6% in 2007 to +0.6%. For January 2008, the reading came in flat, versus our expectation of a -0.5%M print. Looking forward, it appears that a key source of disinflationary pressure has now been compromised.  

Medical, Energy and Other Costs

Elsewhere, medical expenses rose by a seasonal 4.4%M. We expected a reading of at least 5%M, given the recent indications of sharp increases in the cost of private healthcare.

Fuel and power posted a 0.4%M print versus our 0%M forecast. The increase here is very confusing, given that paraffin prices declined by 9c/litre on the month, while electricity costs remained unchanged.

Similarly, running costs within the vehicle component increased by 0.2%M against our expectation of a flat reading as petrol prices remained unchanged that month.

Worrisome Jump in Core CPIX to Prevent Rate Cuts

For some time now, we have been expressing our concern that core CPIX would breach 5%Y in January, and head towards 6% by year-end -– a key driver of our out-of-consensus call that the SARB is unlikely to be cutting rates towards the end of the year.

Unfortunately, the January reading came in at a whopping 5.6%Y versus our 5.2%Y forecast, and is likely to reach 5.8% in February – the last reading that will be available to the SARB as it goes into the April MPC meeting – before falling back to the 5.3-5.5% range between March and June, thanks mainly to positive base effects. Quite importantly, however, we now expect core CPIX to reach 6% by August 2008, and to remain above 6% for the remainder of the year. This will no doubt make it difficult for the SARB to justify any rate cuts this year. We expect the easing cycle to commence only in the middle of 2009.

Looking Forward

Today’s reading has again lifted the CPIX trajectory by some 0.3 pp over the next 11 months. What’s more, after incorporating the current mark-to-market in domestic petrol prices, and recent upward revisions to oil prices by our US and European colleagues, we now have a double-peak in CPIX at 9.4% in both February and March. Once again, contrary to the SARB’s January 31, 2008 inflation profile, we do not expect CPIX to fall back below target anytime this year. In fact, our December 2008 forecast now comes in at some 6.5%Y. We look for a return to target no earlier than 2Q09.

We believe that the perfect storm of higher oil prices, a weaker currency, deteriorating inflation expectations and resurgent food prices will keep South Africa’s inflation and interest rate risks skewed to the upside this year. Although the MPC has made it clear that it is unwilling to raise rates any further, we believe that the probability of a policy rethink is non-zero.

 

United States
Dollar Smile Becoming Fixed
March 03, 2008

By Stephen Jen | London

Summary and Conclusions

The dollar is vulnerable.

We have had mixed views about the dollar for 2008: bullish against the EUR and GBP, but bearish against many of the EM currencies.  In the first two months of the year, the dollar hovered in a range, but is now beginning to weaken once more across the board, against both EM and European currencies, and low as well as high-yield currencies.  We believe that this recent depreciation in the dollar is justified by the economic fundamentals, despite the fact that we have had a constructive view on the dollar against the EUR.  Reality has so far turned out to be different from what we had assumed at the end of last year. Three differences stand out.  First, the Fed has been hyper-proactive.  This has helped to contain investor fear and limit the downside risk to the US economy.  Second, the world outside the US continues to show resilience rather than weakness; however temporary, this could be interpreted by most investors as supportive of the economic de-coupling view of the world and negative for the dollar.  Third, as a result of the above two points, the Fed may face a more intense dilemma over growth and inflation than other central banks.  In other words, the Fed’s aggressive actions mean that it may be seen to have a higher risk of making a policy mistake than other central banks. 

Until the rest of the world starts to feel the impact of the slowing US, and if investors move into a ‘fear mode’ again, the dollar may stay on its back-foot for a bit longer.  

Is the ‘Dollar Smile’ Idea Still Valid?

If we had been told, at the beginning of the year, that the US would be on the precipice of falling into a recession, that the Fed would cut rates more aggressively than at any point in the post-WWII period, but that Euroland and Asia would somehow remain resilient, i.e., de-coupled from the US, most of us would have guessed that EUR/USD would be much higher than 1.50.  My point is that the ‘Dollar Smile’ has worked in the past few weeks, as fear-motivated capital flows balanced out the negative interest rate carry for the dollar.

We are not abandoning the ‘Dollar Smile’ framework, but recognise that the different policy and economic fundamentals than we had assumed have made the ‘Dollar Smile’ rather ‘fixed’, and conditions will need to change to make it smile again.  Specifically, while we still believe that fear will return as the US and the world’s economic fundamentals deteriorate, i.e., the ‘Dollar Smile’ should work again some time in the future, the lag between a slowing US and a slowing Euroland will likely be long enough that EUR/USD could stay higher than we had thought. 

Here are some developments that have taken place in the last few weeks that are not dollar-supportive.

• Development 1.  A hyper-proactive Fed is not positive for the dollar.   In addition to eroding the dollar’s yield premium (the dollar is now close to CHF in 3M yield − our US economists are looking for the fed feds rate to be cut to 2.00% by June and 3M LIBOR to fall to 2.35%, lower than the SNB 3M LIBOR target of 2.75%), an active Fed has helped to stabilise investor sentiment and therefore has moderated the safe-haven flows that are supportive of the dollar.  In terms of the real FFR (deflated by the headline CPI), this is already quite an aggressive easing cycle, compared to the other eight recessions since the mid-1950s.   In fact, in the six months prior to the onset of the eight recessions since WWII, the Fed was less aggressive than it has been in the past six months.  Further, the total decline in the real FFR so far (3.60%) is more than the average size of the reduction in the real FFR across these eight previous recessions (about 2.5%).  As we pointed out in A Hyper-Proactive Fed and the Dollar Smile (January 31, 2008), such a Fed stance, all else being equal, should not be supportive of the dollar.  In fact, in the event that the Fed succeeds in moderating the economic slowdown, this would be the worst-case scenario for the dollar, as the yield deficit is not offset by safe-haven flows.  Fed Chairman Bernanke’s testimony on February 27, 2008 and Vice Chairman Don Kohn’s speech on February 26, 2008 were reminders to the market that the Fed will not hesitate to ease further if the economic outlook deteriorates. 

• Development 2.  The rest of the world appears to be resilient, for now.  A slowing US economy always affects the rest of the world (RoW) with a delay.  For Euroland, historically, the delay has been 1-2 quarters.  Possibly due to the fog of uncertainty, investors may be attaching more weight to current data and not projecting forward the impending slowdown in Euroland.  While the list of concerns on investors’ minds has not changed in the last two months, the macro data from around the world last week were, on balance, on the strong side, suggesting that the world might de-couple from the US, at least temporarily.  If the world keeps growing despite a faltering US, the dollar should not enjoy a strong safe-haven bid.  Risk capital already began to return to some EM markets last week and global equities seem to be forming a tentative bottom.  We are still early in the recession process, but the latest twist of data and the subtle shift in investors’ mood are remarkable. 

• Development 3.  Stagflation fear is likely to put more pressure on the Fed than on other central banks.  We are not believers in stagflation in the US.  However, stagflation fear is compelling, as US growth is indeed decelerating and inflation accelerating.  Investors have limited patience hearing our recitation that, in most of the recessions, inflation remained high well into the slowdown, and only declined after the recession was over. (Take a look at how US CPI evolved during the recessions of 1990-91 and 2001.  In the earlier episode, inflation actually accelerated during the recession.  It did not decline until after the recession was over.  In the ensuing two years, CPI inflation actually fell by around 3%.  In the 2001 episode, while inflation did not accelerate into the recession, it remained high half-way into the recession.  Similar to the 1991 experience, inflation also declined substantially in the year or so after the recession ended.)  But even if stagflation – sustained inflation coupled with sustained economic stagnation – does not materialise, if the Fed is successful at averting a recession, then inflation could very well become a genuine threat.  (In fact, we have said several times before that, by the end of the year, inflation will likely be the number one worry in the US.)  The dollar, therefore, could reflect investors’ concern about how the Fed will deal with this dilemma.  While the ECB, BoE and BoJ may eventually face similar dilemmas, they are not yet at that point. 

My Thoughts

The dollar will be vulnerable against the EUR in the coming weeks, and against many EM currencies in the coming years.  While there is certainly scope for investors to establish fresh speculative dollar shorts against the EUR and GBP, I remain troubled by the already high valuation of these currencies.  Therefore, I continue to see the EUR and GBP ending the year significantly lower than their values at the start of the year.

Here are some thoughts I have on some unsettled issues related to the discussion on the dollar:

1. Broad-based uncertainty makes it difficult to get the dollar call right.  The fate of the dollar is dependent on a number of variables, and there is considerable uncertainty attached to each of the key assumptions.  The first is the US economy.  Whether or not it will fall into a recession is still not yet clear, even though it is certainly slowing rapidly.  The hyper-proactive Fed has made this call on the US economy less certain.  Then there is the assumption on market sentiment: will the sense of fear intensify enough to trigger safe-haven flows supporting the USD, CHF and JPY?  The third question is the timing and the magnitude of the response of the rest of the world to the slowdown/recession in the US.  The key is for us to understand how each of these key variables turn out, and to be ready to draw different conclusions about the dollar, using a consistent framework.  Earlier this year, we warned about the risk of another spike in the EUR, but did not feel confident enough to alter the forecast for 1Q, mainly because the call on investor sentiment was too difficult to make.

2. Recession in the US = lower inflation, with a delay.   I fully recognise that globalisation may no longer be disinflationary and the downward trend in global inflation may be bottoming.  However, if the US falls into a recession, I am fairly confident that inflation will decline.  On average across the eight US recessions since the 1950s, inflation has evolved, in both absolute and de-trended terms.  Even if we consider the de-trended series, which is the more ‘stringent’ of the two and the one that better highlights the cyclical aspect of the debate, we see that inflation in the US declined during the year following recessions.  The Fed and the dollar will likely still be punished because of the fear of stagflation, but my opinion is that there will be no stagflation.

3. The right policies to deal with food price inflation?   I find it curious that investors accept, as a matter of fact, that countries should tighten monetary policy and revalue their currencies in response to food price inflation.  To me, food price inflation is intimately linked to the rise in oil and energy prices.  Demand for biofuels has diverted a significant supply of soft commodities away from the traditional consumers.  Thus, this is more of a global supply shock, and less of a local demand shock.  Further, the rise in per capita incomes in some developing countries may indeed have contributed to a change in taste and raised the demand for some meats, but it is far from clear that the right policy response is to raise interest rates because Chinese people like pork.  Such a change in taste is a relative price argument, not an inflation argument.  Finally, if what we are dealing with is indeed more of a global supply shock, I don’t see how the whole world could pursue currency revaluations to resolve this problem. 

4. Vicious circle between a weak dollar and high oil and commodity prices.  Since 2002, as measured by the difference between USD and SDR (Special Drawing Rights)  prices of commodities, 29.5% of the rise in oil and commodity prices is due purely to the numeraire effect from a falling dollar.  Thus, as the dollar weakens, the prices of these internationally traded goods rise automatically, hurting the USD, which in turn pushes commodity prices higher. (After a generation of a positive relationship, after 2002, the dollar and oil prices have had a negative relationship.  There are several reasons for this, all of which we’ve discussed in the past.  First is the numeraire effect.  Second, oil exporters have been aggressively diversifying their export receipts into the EUR and GBP, away from the dollar.  Third, there is a perceived difference in how the Fed and the ECB might react to a rise in oil prices.  The changes in the expected interest rate policies may also explain the negative correlation between the dollar and oil prices, particularly during recent years, when carry trades dominated the currency markets.   Fourth, given that much of Asia is still soft-linked to the dollar, a decline in the dollar enhances Asia’s economic activities and in turn boosts its demand for energy products.)  Oil, gold, the EUR and many other internationally traded assets are at historical or multi-year highs; a part of the reason is that the international unit of account is at a record low.  This process could generate extreme overshoots in multiple asset prices. 

5. Threat of coordinated intervention?  I have written previously about the rising risk of coordinated intervention (see Waiting for Coordinated Interventions? November 1, 2007),  that any currency intervention would likely be coordinated, and a prerequisite for such an event would be that the Fed and the ECB’s policy inclination are in sync.  As it stands now, it does not look as if this condition will be met any time soon.   We believe that the extremely overvalued EUR will eventually weigh on the Euroland economy and that Euroland will start to slow more meaningfully in the coming weeks.  However, until this happens, the risk of coordinated intervention does not seem to be high, meaning that coordinated intervention will likely not rescue the dollar any time soon.  The other consideration is Germany’s strength.  The tolerance of Euroland for a strong EUR will be determined by Germany – the country that is most reliant on exports – and not by the likes of Italy or Spain, which are already slowing.  Global demand for capital goods from Germany remains very robust, and this could keep German exporters relatively insensitive to the strong EUR for some time.  Though I don’t think that coordinated intervention is likely anytime soon, I think that the G7 should consider taking more dramatic action against a falling dollar, as it is starting to complicate policy making (point 4 above) in several respects, which I will discuss on another occasion. 

6. GCC dollar peggers to blink.   With temporary global economic de-coupling, oil prices have stayed high (and could rise further), despite the US economic slowdown.  The FFR is low, and is likely to fall further, as Chairman Bernanke made clear in his testimony this week.  The divergence between oil prices and the FFR, combined with the depreciating dollar, will exert considerable pressure on the GCC dollar pegs.  Inflation in the GCC countries continues to rise.  Qatar’s inflation reached 13.7% in 4Q, and Saudi Arabia’s inflation surged past the 7% mark in January, up from 6.5% in December.  The UAE’s inflation was 9.3% in 2006.  Inflation in December was 8.3% in Oman and 6.2% in Kuwait.  With the exception of Bahrain, inflation continues to rise in all the GCC countries.  Asset price inflation helps the haves, but goods price inflation hurts the have-nots.  Over time, asset and goods price inflation will create social pressures and tensions between the haves and the have-nots.  This is not a regime that is sustainable.  My own guess is that the pegs of the GCC countries are more brittle than the HKD peg. 

Bottom Line

The dollar will be vulnerable in the coming weeks.  The combination of a hyper-proactive Fed, stabilising risk-taking appetite and apparent economic resilience in much of the rest of the world is not supportive of the dollar.  The ‘Dollar Smile’ has become rather fixed, and we see the over-valued EUR/USD possibly staying higher for longer, particularly during the coming weeks before the US slowdown undermines growth elsewhere.  We are open to broad-based downside risks to the USD in the near term, but maintain our year-end biases in favour of the USD, relative to the EUR and GBP, but against the dollar relative to many EM currencies, particularly the AXJ currencies.

Malaysia
A Safe Haven in a Stagflation-type Environment
March 03, 2008

By Deyi Tan & Chetan Ahya | Singapore

A Growth Model Leveraged on Commodity Resources and Pump-priming

Malaysia has a growth model that is leveraged on commodity resources. While not a member of OPEC, it is the fourth-largest producer of oil within the Asia Pacific region, with a comfortable oil balance (production less consumption) of 4.2% of GDP (2006), which is larger than Indonesia’s 0.3% of GDP. It is also the second-largest producer of crude palm oil, which has seen prices accelerate as biodiesels become fashionable in the light of high oil prices. Indeed, since 2004, prices of its main commodities have increased, specifically by 194% for Tapis crude oil, 158% for tin, 111% for crude palm oil, 97% for rubber and 30% for natural gas. Correspondingly, commodity-related revenue that has flowed into government coffers has also risen from 21% of government revenue in 2000 to 37% in 2006 (3.6% of GDP in 2000 and 7.9% in 2006). Solid revenue support from its commodity base is likely an important reason why the government has typically been able to play a strong role in pump-priming the economy, either in the form of subsidy provision in food and oil or through public capex outlays. The latter has consistently accounted for a high 44-71% share of annual fixed capex expenditure.

Twin Engines Are Up and Running for 2008

We believe that the twin engines of Malaysia’s growth model, namely commodity prices and willingness to pump-prime, are well-positioned for 2008. Limited recoupling in EM, which accounts for most of the incremental demand in energy amid OPEC’s US$80/bbl glass floor for oil prices, could ensure a stream of revenue to support Malaysia’s fiscal growth strategy. Additionally, with general elections due on March 8, the government has also displayed higher willingness to pump-prime. In this regard, we note that three near-term catalysts ensure that Malaysia’s growth prospects remain relatively defensive at a time when it matters most in 1H08.

1) Election stimulus: The government typically pursues an expansionary fiscal policy in the run-up to elections. In the elections since 1986 (with the exception of the 2004 period of fiscal consolidation), budget balances have expanded from an average of -2.1% of GDP (4Q trailing sum) in the three quarters preceding the election to -3.2% of GDP in the election quarter. Similarly, this time, the fiscal deficit has widened from -1.3% of GDP in 2Q06 to -5.7% in 3Q07 as central government spending increased from 22.5% of GDP in 2Q06 to 26.3% in 3Q07. More specifically, the infrastructure project of Ipoh-Padang Besar electrified double-tracking railway, which had been placed on hold after Badawi took over the helm from Mahathir, has now been revived. Letters of award worth about RM3.7 billion have been given out and are expected to start soon. The project, worth a total of RM12.5 billion (2% of GDP), is one of the largest infrastructure projects to date and is expected to be completed in five years. 

2) Policy-driven income increase: In a similar vein, the 7.5-35% increase in civil service wage for the first time since 1992 for the one million or so civil servants (effective July 2007) will increase spending power by an estimate of 1.2% of GDP.  Additionally, the measure to allow withdrawals from EPF accounts for mortgage repayments since January 2008 will potentially increase disposable income by 7%. Though wage data for Malaysia are patchy, anecdotal information suggest that unionized employees in the financial sector could potentially negotiate for a 20-30% increase in wages. Better spending power is evident in autos (+19%Y, 3MMA in December 2007), consumer imports (+4.2%Y, 3MMA in December 2007) and private consumption data (+11.1%Y in 4Q07).

3) Commodity supercycle filters down: Buoyant commodity prices are supporting the hard and soft commodities (mineral fuels and edible oils) which constitute about 20% of total exports and 76% of the trade surplus as at December 2007. Indeed, edible oils and petroleum products have lifted the related trade surplus to 11.9% of GDP as at December 2007 from a low of 7.6% of GDP as at March 2002. We believe that this has positively spilled over to the income levels of the agricultural population, which constitute about 14% of employment. Indeed, agricultural employment has registered the fastest pace of growth at 8.2%Y versus 2.0%Y for total employment as at September 2007. Additionally, our industrials and conglomerates analyst, Fordy Widjaja, notes that a shortage of plantation workers is also likely to have lent a boost to rural wages. 

Equity Market Implications: Relative Safe Haven in Stagflationary-type Environment?

With a global macro environment of lower growth and higher inflation, we believe that the Malaysia growth model offers a degree of defence in terms of domestic demand strength, which is also at the same time less eroded by inflation pressures due to subsidies. Indeed, the Malaysia market has outperformed the US by 20% and the rest of the emerging markets by 14% since October 2007. We believe that the strength of domestic demand is likely to be a reason for the relative outperformance, and this is likely to remain supportive. Additionally, from a macroeconomic perspective, sectors such as infrastructure construction could also benefit from the fiscal pump-priming.

Short-term Risks − Subsidy System a Tad Stretched?

Malaysia’s oil reserves will run dry in 2021 and undermine the current model of using commodity revenue to subsidise growth. As it is, amid the high commodity costs, the system of fuel subsidy provision is appearing to be a tad stretched. The fuel subsidy burden likely ran up to US$12.4 billion (~7% of GDP) for 2007, and if the government were to raise fuel prices after elections are held, it would lead to a one-time payback from the private consumer. Fuel prices are the second lowest within ASEAN5, and the consumer has been buffered from escalating energy quotes since March 2006 when domestic fuel prices were last changed by 18-24%. With crude oil prices running at close to US$100/bbl, we estimate that fuel subsidy rates are likely standing at 34-50% for gasoline, diesel and LPG − close to the levels seen when fuel prices were last changed. An increase in fuel price of 10-30%, if it happens, would sap discretionary spending power by 0.4-1.3 percentage points, ceteris paribus. In terms of the inflation impact, it could add 0.9-2.6 percentage points to CPI.

Long-term Risks − Economy Outside of Commodity and Construction Pump-priming Losing Shine

Beyond the cyclical short term, we are also less sanguine about Malaysia’s structural prospects. Its natural resource endowment and the leverage of that to finance investment and subsidizing growth have allowed the economy to grow with reasonable momentum. This has likely lessened the urgency to improve the competitiveness of the economy outside of commodity and construction pump-priming. Indeed, we note that Malaysia’s export sector likely suffered, not only from cyclical pressures but also structural pressures. Export growth has been dragged down by weak electronics performance and, at 2.7%Y, export momentum is one of the lowest in the region for 2007. Malaysia has been losing market shares in key export segments. Integrated circuits and telecommunications equipment have seen their global market share decline from 8.0% and 4.5%, respectively, in early 2000 to 6.5% and 2.6%, respectively, in 2006 − at a time when Singapore has improved its global share in higher value-added production such as integrated circuits from 11.2% to 17.3%.

Additionally, the government’s efforts to move further up the value-added chain have been hampered by its lopsided focus on infrastructure hardware – which contributes relatively little to long-run competitiveness – rather than human-capital software. Its standards of the education system have fallen behind the government’s policy aspiration of economy upgrading. Policies such as the National Economic Policy (NEP), which give privileges to the bumiputras, have also led to a brain drain, compounding the problem of talent-pool shortage.

Malaysia has 13 years before its oil runs dry in 2021. Concerted government efforts to improve overall competitiveness would be essential to grow the economy beyond the medium term, in our view.