A Darker US Outlook
March 11, 2008
By Richard Berner and David Greenlaw | New York
The US economic outlook continues to darken, and we're downgrading our US forecast for 2008 and 2009. Measured on a Q4/Q4 basis, we now expect real growth of 0.7% in 2008 and 2.9% in 2009; last month we expected 1.3% and 3.2%, respectively (the new year-over-year forecasts are 1.1% and 2.2%, vs. 1.3% and 2.7% previously). In our view, the recession we’ve expected since December is now more fully evident. The economic debate is now shifting to how deep and long it will be and what will be the shape of the ensuing recovery. | 2007E | 2008E | 2009E | Real GDP (YoY) | 2.2% | 1.1% | 2.2% | Inflation (CPI) | 2.9 | 3.7 | 2.5 | Unit Labor Costs | 3.1 | 2.2 | 0.9 | After-Tax “Economic” Profits | 3.2 | -6.1 | 5.9 | After-Tax “Book” Profits | 4.6 | -6.6 | 4.4 |
Source: Morgan Stanley Research E = Morgan Stanley Research Estimates Courtesy of aggressive monetary and fiscal stimulus and support from overseas growth, we still think the recession will be mild and short. But we’re now more pessimistic about the pace of recovery into 2009. The main culprits: a deepening credit crunch, the supply shock of higher energy and food prices, and growing consumer caution in the face of declining household wealth. As a result, we now expect the Fed to cut the federal funds rate by 75 bp to 2¼% at the March 18 FOMC meeting; previously we thought the FOMC would trim the rate by 50bp. We continue to think that the FOMC will reduce the funds rate in April by another 50 bp; together with the more aggressive March move, that would take it to 1.75%. We believe that this sub-2% level will represent the trough in short-term rates for this cycle, and that the Fed will keep such rates low for much of 2008. But there is a growing perception that even aggressive monetary ease and fiscal stimulus may not be sufficient to counter the depressing effects of a deepening credit crunch. And relying mainly on monetary policy to soften the blow may rekindle inflation. Consequently, Congress, the Administration, the Fed and other regulators are considering an array of policy responses designed to alleviate the burden on troubled homeowners from falling home prices and rising foreclosures and forestall or at least cushion an economic downturn. Even if they are not enacted this year, however, the debate over such remedies may add volatility to the yield curve and the rate outlook, as market participants may see them as a substitute for aggressive monetary ease. We also continue to expect a seesaw pattern of growth induced by the one-time stimulus from tax rebates this year. The resulting uncertainty over the sustainability of any recovery from recession will challenge investors and policymakers alike. Incoming data in our view reinforce the near-term recession call, but we still expect that it will be mild, amounting to only a ¾% annualized decline in the first half of 2008. Nonfarm private payrolls declined for a third straight month in February, and the decline intensified in the latest month. Indeed, with February’s plunge of 101,000, each monthly decline in the past three has been bigger than the last, suggesting that recession may have begun in December. Moreover, the weakness over the past three months has been broadly based; a diffusion index of private payrolls shows that less than 47% of reporting industries reported job gains over that span, the lowest level since 2003. To be sure, growing government employment is an offset. Coupled with pressure on real wages, however, the declines in private jobs and hours have depressed real income gains, with little prospect of improvement. So it’s hardly surprising that motor vehicle sales and retailing results are soft, suggesting that real consumer spending was essentially flat for a third straight month. Meanwhile, declines in nonresidential and government construction spending seem to have joined the ongoing collapse in residential building, as overall construction spending plunged 1.7% in January, the biggest drop in 14 years (see “Recession Claims its Next Victim: Commercial Construction,” February 19, 2008). And judging by recent orders and shipments data, business equipment and software outlays are declining at a 6% annual rate in the first quarter. The upshot: We expect that domestic final demand contracted by about 1¼% annualized in the current quarter, and that the deterioration will probably intensify in the spring. Ongoing contributions to growth amounting to about a full percentage point from net exports are preventing a deeper contraction in US output or GDP, but the downside risks still predominate. Three factors are responsible for those risks and – because they are unlikely to fade soon – for a more anemic recovery later in 2008 and into 2009. First, the credit crunch is intensifying. Losses are mounting, some financial markets remain dislocated, and lenders continue to tighten standards and credit availability. We now estimate that mortgage losses may reach $400 billion over the next two years. The methodology is detailed in David Greenlaw et al., “Leveraged Losses: Lessons from the Mortgage Market Meltdown,” US Monetary Policy Forum Conference, February 29, 2008. Rising losses will erode lender capital and thus promote further deleveraging of lender balance sheets as capital ratios shrink. We think that the combination of capital constraints and “reintermediation” of the banking system will keep financial conditions restrictive. In turn, this financial restraint will limit housing demand and extend the ongoing vicious circle of decline in housing activity. Weakening demand boosts the excess in housing supply over demand, manifest in nearly 10 months’ supply of new, 1-family homes. That imbalance is depressing home prices, and would-be buyers are loath to step up while prices are falling. Falling home prices, in turn, intensify the deterioration in mortgage credit quality, increasing lender risk aversion and financial restraint. Real home prices now seem likely to decline by a cumulative 15% by early 2009, restraining household wealth and consumer spending. The risk is that these developments will trigger an ‘adverse feedback loop’ that spills over into the rest of the economy. Indeed, credit spreads have widened for corporate, household and municipal borrowing to new cycle highs, and lenders have grown more cautious. Liquidity is dwindling as evidenced in wider Libor-OIS and swap spreads, which in turn are benchmarks for pricing most loans. This restraint intensifies the housing downturn, pressures consumers, and weakens capital spending. It may also harm state and local government investment outlays. The second restraining factor is that higher energy and food prices, driven primarily by supply factors, are eroding consumer discretionary spending power. Rather than falling or even stabilizing as our energy team has expected, crude quotes have climbed roughly $13/bbl higher than the team thought they would be for the first quarter. Retail gasoline prices (all grades) have moved back to $3.22/gallon, and even at current crude quotes, pump prices may rise towards $3.50/gal. by the traditional Memorial Day peak; each penny increase drains $1.3 billion in consumer purchasing power. What’s more, food prices continue to escalate; even if the pace moderates to 4-5% this year from 2007’s 4.9% as we expect, the increases may cost consumers $50 billion in lost purchasing power. Put differently, we recently boosted our headline CPI inflation forecast from 2.2% to 3% (see “Higher US Inflation, Not Stagflation,” February 22, 2008). We now expect headline inflation to hover near 4% through midyear. That increase roughly translates into a 3/4 percentage point reduction in real income growth. Finally, we think that the recent plunge in consumer sentiment evinces lasting consumer caution, grounded in falling home prices, shrinking real incomes, and rising uncertainty about the economy, and that in turn implies a more subdued spending prognosis. For example, the University of Michigan index of consumer sentiment tumbled in late February to a level comparable to early 1992, when the unemployment rate was 7.4% and rising and gasoline (in 2008 prices) cost $1.60/gallon. Because of that more uncertain climate, we think that the fiscal stimulus measures the President signed into law will produce less bang for the buck than we thought a month ago. Specifically, last month we expected consumers to spend 40% of the forthcoming tax rebates; now we expect that they will spend only 20%. (A University of Michigan canvass reported last week suggests that 28% of all consumers that expect to receive a rebate plan to spend the money within the next year.) So-called liquidity-constrained consumers may well spend a bigger share of the rebates than will others, but as access to credit dwindles, consumers may conserve cash for necessities. In any case, we continue to think that the benefits from such stimulus will be transitory, and that a growth “payback” is likely in Q4 2008 and early in 2009 (see “Playing the Double-Dip Recovery,” February 4, 2008). Moreover, our long-standing view is that spending would likely grow more slowly than income over the forecast horizon, and with the likely longer-term path for household wealth and income somewhat more constrained, we now project a more moderate trajectory for consumer spending in 2009. Against that backdrop, we now see the Fed pursuing a slightly more accommodative path for monetary policy than just a week ago. The latest commentary from Fed Chairman Bernanke and Vice-Chairman Kohn emphasizes downside risks to the economy, an appraisal we share. The expansion of the Term Auction Facility (TAF) and additional RP actions taken Friday reduce only slightly the chance of continued aggressive action. (The TAF promotes a collateral switch – with the Fed providing financing for “bad” collateral and offsetting the impact on their balance sheet by holding fewer T-bills. The increase in the size of the TAF to $100 B should help to absorb some of the financing pressures in markets in which the underlying credit has issues. In addition, the T-bills that are being liquidated are in high demand in the market. It seems clear that the original announcement of the TAF back in December helped to rein in term Libor-OIS spreads and bolster market confidence. The Fed probably hopes that last week’s announcement will accomplish these same objectives. The announcement of the 28-day term RP pool is an attempt to provide increased liquidity to primary dealers who cannot access the TAF. The major difference is that the collateral used for open market operations is confined to Treasuries, agency debt and agency MBS as opposed to the far broader range of securities and loans that can be posted in the TAF operations.) Most importantly, the FOMC isn't offering new policy guidance and appears unwilling to disappoint fragile market expectations. To be sure, many Fed officials are determined not to repeat the mistakes of 2003 by leaving rates too low for too long. And some cite 2% as a floor below which they don't want to go. From our standpoint, that means officials will likely reverse course on monetary policy much faster than they did in 2003-05. But such a reversal is obviously conditional on the outlook, and with the outlook soft for now, such a reversal is likely in 2009-10, not this year. What might be among the unconventional remedies for the credit crunch? There is no simple answer, so a variety of tools may be considered. The most promising of these is reform and expansion of the Federal Housing Administration (FHA) to help troubled borrowers to refinance mortgages into new loans federally insured under FHA. The use of warrants or some form of option (‘negative amortization certificate’) that gives the taxpayer and lenders some equity upside likely will be a feature of any reform proposal. But the climate for legislative action is difficult because it’s an election year; campaigning leaves relatively few legislative days to move these proposals, and both parties sense opportunity to score political gains from the crisis. Resistance from industry is a second roadblock that bars the more ambitious proposals. To be sure, there is legitimate opposition to some of those proposals because they involve significant moral hazard by putting taxpayer funds at risk, and the framers need to find the balance between moral hazard and risks to the economy (see “If Monetary Policy Can’t Do the Job, Then What?” March 3, 2008). Despite those difficulties, Fed officials seem willing to embrace unconventional tools as a means to take the burden of combating the credit crunch off monetary policy. Chairman Bernanke last week urged lenders to find ways to reduce debt for struggling homeowners, and in the past has suggested a combination of carrots and sticks to do that. New York Fed President Geithner also argued that “carefully designed, targeted programs in cooperation with the private sector can play an important role in resolving the various constraints that are now impeding economically viable mortgage restructurings.” Although the Treasury yield curve from 2s to 10s has steepened by 100 bp to 200 bp since the beginning of the year, more steepening may be forthcoming. Markets are already priced for the trough in short-term rates that we foresee by April. But given the dreary outlook, market participants are convinced that the Fed won’t raise rates any time soon. Thus, the steepening we expect will mostly come from a rise in longer-term rates as inflation stays high. But as noted above, we also believe that the debate over possible use of unconventional tools to address the credit crunch will add volatility to the curve and the rate outlook, because their use may persuade market participants that the Fed will be able to raise rates sooner and by more than they currently expect.
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Review and Preview
March 11, 2008
By Ted Wieseman | New York
The Treasury curve saw a big further steepening move over the past week as the front end posted significant gains and the long end sizable losses. The week was filled with key economic news that continued to suggest that the economy is currently in recession – a big loss in private sector payrolls (the third straight decline), recessionary results for both ISM surveys, sluggish (if somewhat better than expected) auto and chain store sales, and the biggest monthly decline in construction spending in 14 years, with the weakness spreading beyond housing into non-residential and government building. These data were largely ignored, however, as investors remained focused on increasing turmoil across various markets (a solid rebound in munis after their horrendous showing the prior week the only notable exception) – swaps, MBS, credit, FX, stocks, LIBOR, leveraged loans, commercial real estate, subprime mortgages, commodities – that reached a peak in an extremely ugly day Thursday. So, even when Friday’s poor employment report capped the week’s soft data run, modest recoveries across markets after Thursday’s near meltdown remained investors’ focus and helped to calm the nerves at the end of another tumultuous week. The Fed’s better-late-than-never announcement that it would significantly raise the size of the upcoming TAF auctions, after the initial surprising announcement that the sizes would be held steady, as well as conduct sizable term repos (allowing non-bank primary dealers unable to use the TAF better access to term funding) was a key driver of the stabilization across various markets Friday, based both on the direct positive of increased term liquidity injections and also the market’s belief that the announcement presaged a more aggressive fed funds rate response at the upcoming FOMC meeting, if not sooner. In our view, Friday’s Fed announcement certainly does not rule out the possibility of a reduction in the official fed funds target before the March 18 FOMC meeting, but it probably makes such a move somewhat less likely. On the week, sizable front-end gains and back-end losses drove the curve to new peaks, with 2s-30s rising 24bp to 303bp, a near four-year high. The 2-year yield fell 12bp 1.52% and the 5-year 7bp to 2.43%, while the 10-year yield rose 2bp to 3.55%, and the 30-year 12bp to 4.54%. Surging commodity prices and generally rising inflation fears that have led increasing numbers of investors to seek inflation protection (though generally in inflation swaps space rather than directly in TIPS) drove another very strong week for the TIPS markets, with the 5-year yield falling 15bp to -0.17%, the 10-year 6bp to 0.98%, and the 20-year 5bp to 1.68%. Note that there’s a 5-year TIPS auction coming up next month. While a Treasury security can’t actually have a negative coupon (the mechanics of trying to get investors to actually send the Treasury money every six months would be pretty absurd), it can have a zero coupon. The TIPS with the closest maturity to the upcoming April 2013 issue (the July 2013, an old 10-year) is yielding only 0.17%, so if there’s a continuation of recent trends through April, the new 5-year TIPS could actually be a zero coupon security. For a good part of the week, the Treasury market was a little noted sideshow during bouts of turmoil across various other key markets that were at their worst in a nasty trading session Thursday before the Fed’s announcements on stepped up liquidity injections restored some calm. In the interest rate space, the MBS and swaps market remained under severe pressure. The benchmark 5-year swap spread blew out to an all-time wide of 114.75bp Thursday before moderating a bit to end the week at 108.5bp, a 20.5bp surge on the week. The benchmark 10-year spread rose 15.25bp on the week to 86.25bp. As bad as the swaps market deterioration was, the badly struggling MBS market actually significantly underperformed it, in what our MBS desk described as the worst week they had ever seen in their market. Even after a nearly half-point improvement Friday, on the week MBS underperformed the awful swaps performance by almost a point and a half. In addition to this turmoil in interest rate markets, key risk markets also were hit hard to varying degrees. A brief period of relative stability in credit turned into a near freefall Thursday before some renewed stabilization Friday that still resulted in significant losses on the week. In late trading Friday, the 5-year investment grade CDX index was 16bp wider on the week at 181bp, and the HiVol index, with its relatively higher concentration of issues in the underperfoming financial sector, 57bp wider at 394bp. Through Thursday, the high yield index was 41bp wider on the week at 762bp, and the index was trading down slightly Friday. Stocks had a tough week, with the S&P 500 ending down nearly 3%, but credit continues to trade significantly weaker than equities. The commercial mortgage CMBX market had a terrible week, pointing to increasing risk of significant write-downs of commercial real estate holdings. The AAA CMBX index widened 49bp on the week to 261bp, the AJ (junior AAA) 154bp to 701bp, and the AA 181bp to 857bp. The subprime ABX market, which had been trending softer recently, but only gradually, also fell hard, so yet more subprime write-downs may be coming. The AAA ABX index fell 6.62 points on the week to 53.42 and the AA index 4.88 points to 21.08. The main bright spot amid this carnage was the muni bond market, which staged a sizable rebound over the course of the week after what had been a near freefall late the prior week. The leveraged loan market also held in reasonably well, with the LCDX index only 6bp wider on the week at 479bp through midday Friday. There was a significant dovish repricing of the near-term Fed view, with the market now pricing in more than 75bp of easing at the upcoming FOMC meeting (or some chance of intermeeting action), but there was no change in the expected trough funds target of 1.75%. Binary options were pointing to the market pricing slightly greater than a 50% chance of a 75bp or larger cut and a nearly 25% chance of 100bp. On the week, the April fed funds contract gained 9.5bp to 2.235%, May 9bp to 1.895%, July 5bp to 1.77%, and low rate September 4.5bp to 1.725%. In the face of this significant Fed repricing and the quickly approaching rate cut at the March 18 FOMC meeting, term LIBOR barely budged most of the week as stresses in the banking system intensified before finally seeing a decent improvement Friday. This kept LIBOR/expected fed funds spreads extraordinarily high and eventually convinced the Fed on Friday to announce significant additional measures to try to address the situation. On the week, 3-month LIBOR fell 12bp to 2.94%. The 3-month LIBOR/3-month OIS spread hit an 11-week high of 82bp on Thursday, which had represented a 44bp increase since the end of January, before moderating to 78bp Friday, up 1bp on the week. In response, the Fed announced Friday that it was raising the sizes of the March 10 and March 24 TAF 28-day TAF auctions to at least US$50 billion each (it “will increase these auction sizes further if conditions warrant”) from US$30 billion. That initial US$30 billion number would have merely rolled over the maturing February operations and injected no new liquidity; at the time, this was a disappointing decision when it was announced on February 29, given that the major renewed deterioration in the LIBOR market was already well underway at that point. TAF auctions will continue “for at least the next six months unless evolving market conditions clearly indicate that such auctions are no longer necessary”. In addition to the bigger and longer-lasting TAF auctions, the Fed introduced another measure to address one key shortcoming of the TAF, that it is only available to banks. In order to expand more term funding to the entire primary dealer community, the Fed will also “initiate a series of term repurchase transactions that are expected to cumulate to US$100 billion”. The term repos will have the same 28-day terms as the TAF auctions. Note, though, that Fed repos will continue to accept a much narrower range of collateral than the TAF – only Treasuries, agencies and agency mortgages. Still, given the severe recent pressures on the MBS market, the ability to finance these positions with the Fed for a specified term could be a significant source of support, and the first 28-day repo, a US$15 billion operation conducted Friday, accepted only MBS collateral. Early indications pointed to a slightly positive response to the Fed’s stepped up efforts; they were for about a 7bp further decline in 3-month LIBOR Monday, and forward LIBOR/OIS spreads through the next few quarters narrowed a couple of basis points. The key round of early economic data for February – a third straight decline in private sector payrolls and at an accelerating pace, both ISM surveys in contractionary territory below 50, and motor vehicle and chain store sales results, though a bit better than expected, suggesting that real consumption was close to stalled for a third straight month – continued to suggest that the economy is currently in a recession and also provided some confirmation for our initial estimate that November marked the peak of the prior expansion. Non-farm payrolls fell 63,000 in February on top of a 22,000 drop in January. The February result was boosted by a 38,000 jump in government jobs after little change in January; private sector payrolls plunged 101,000, a third straight drop, each bigger than the last, suggesting that recession may have begun in December. Weakness was concentrated in manufacturing (-52,000), construction (-39,000), retail trade (-34,000) and business services (-20,000). The unemployment rate dipped a tenth to 4.8%, but only because of a drop in the labor force; household survey employment plunged 255,000. The average workweek was steady at 33.7 hours, resulting in a 0.1% decline in total hours worked. Average hourly earnings gained 0.3%, leaving aggregate weekly payrolls up 0.2%, pointing to negligible growth in real income in February. The two ISM surveys moved in opposite directions in February, but both were below the 50-breakeven level. The manufacturing ISM’s composite diffusion index fell 2.4 points in February to 48.3, more than reversing January’s surprising rebound to hit a five-year low. All five components declined, with the biggest drop seen in the production index (50.7 versus 55.2), which reversed most of a strange surge in January. The orders (49.1 versus 49.5) and employment (46.0 versus 47.1) gauges posted smaller declines, but for the former this still left it at its second lowest reading since the Iraq invasion and the latter its lowest reading since June 2003. The prices paid index (75.5 versus 76.0) was little changed at a very high level. A variety of metals and chemicals led the up in price list. After the collapse posted in January, the non-manufacturing ISM rebounded in February, but remained in contractionary territory, with the composite index gaining 4.7 points to 49.3 after plunging 8.6 points last month. The business activity index (50.8 versus 41.9) was the biggest contributor to the upside. Orders (49.6 versus 43.5) and employment (46.9 versus 43.9) posted significant but smaller gains and remained below 50. The prices paid index fell 3 points to a still very high level of 67.9. Various energy items, metals and office supplies were listed up in price. Early indicators for February consumer spending, through somewhat better than expected, remained soft. After plunging 5.4% in January, unit sales of motor vehicles were unchanged at a depressed 15.3 million unit annual rate. Meanwhile, chain store sales results taken as a whole were still soft, but better than expected, though significantly mixed by sector, with further weakness at clothing and department stores, improvement at the discounters and continued solid results by the clubs. Incorporating these results, we look for overall retail sales to dip 0.1% in February and ex auto sales to rise 0.2%. Incorporating these forecasts into our estimate of broader consumption, we see real spending in February raising a marginal 0.1% after two flat months. This would leave overall 1Q consumption on pace for a rise of only 0.7%. Other data bearing on 1Q GDP released the past week were marginally negative overall, and we cut our first quarter growth forecast to -0.4% from -0.2%. Weak construction spending results were the main negative. Construction spending plunged 1.7% in January, the biggest drop in 14 years, as weakness in non-residential and government spending has joined the ongoing collapse in residential building. Overall residential spending plunged 3.0%, with the key single-family and multi-family new homebuilding construction components combining for a 4.6% plunge, for a 43% annualized drop in the past four months. We continue to see residential investment plunging at a 32% annual rate in 1Q, with the predominant new homebuilding component down 43%. Business construction now appears to be joining the downturn in the residential sector. Non-residential spending fell 1.2%, the biggest drop in two-and-a-half years. The employment report suggested that this weakness extended into February, with non-residential construction payrolls down 9,000, their third fall in the past four months. We now see the structures component of business investment falling 3% in 1Q, down from our prior +1% forecast, after very strong 16% growth for all of 2007 on a 4Q/4Q basis. The deterioration in state and local tax revenues also appears to be leading to belt tightening in municipal construction. Government spending dipped 0.2% in January on top of a 1.6% drop in December. We cut our forecast for overall 1Q government spending to +1.9% from +2.3% (the rebound in state and local government payrolls in February and upward revisions to prior months provided a bit of an offset to the drop in construction). A steep drop in state and local construction spending should contribute to a flat reading for overall state and local spending in the first quarter. Meanwhile, the factory orders report pointed to a slightly larger decline in the equipment and software component of business investment. Non-defense capital goods shipments were adjusted down slightly in both January (0.0% versus +0.1) and December (+1.6% versus +1.7%) from the advance estimates in the durables report. Incorporating this result, we cut our forecast for 1Q equipment and software investment a few tenths to -6%. But this was offset by a 1.3% surge in overall factory inventories in January, with durables unrevised at +0.6% and non-durables gaining a record 2.3%. However, unit inventories of autos in January, which BEA released along with the official February motor vehicle sales results, fell 2.3%, much weaker than we expected, given the steep drop in sales in the month. Combining the manufacturing upside and autos downside, we continue to see inventories as a neutral factor for 1Q growth, with the combined impact of the downside in business investment implied by the construction spending report and capital goods shipments revisions and in government spending from the construction figures leading us to trim our overall GDP forecast to -0.4% to -0.2%. Note that this forecast incorporates another huge positive contribution from net exports of nearly a full percentage point. The January trade report due out on Tuesday will be a key report in helping to firm up that estimate. The Fed moves into its traditional pre-FOMC meeting quiet period next week, so we likely won’t be hearing much from Fed officials. Fed Chairman Bernanke does speak Friday, but his remarks on ‘Fostering Sustainable Homeownership’ are likely to steer clear of anything market moving so close to the March 18 meeting. Key economic data releases due out in the coming week include the trade balance Tuesday, Treasury budget Wednesday, retail sales Thursday and CPI Friday: * We look for the trade deficit to widen marginally in January to US$59.0 billion, with exports up 0.8% and imports up 0.7%. On the export side, a huge rise in semiconductor shipments points to strength in high-tech capital goods, while higher prices should support upside in food and industrial materials. Food export prices in particular posted their biggest monthly increase on record in January. On the import side, all of the gain is expected to be accounted for by continued upside in energy products. Another month of weakness in growth in inbound cargo at the key West Coast ports suggests that sluggish domestic demand continues to restrain non-energy imports. * We expect the federal government to report a US$170 billion budget deficit for February, much bigger than the US$120 billion deficit recorded a year ago, though partly as a result of calendar distortions. Individual tax refunds are likely to be much higher this February than last, resulting in a sharp fall-off in net tax receipts. Also, corporate tax refunds are running unusually high this year. Meanwhile, with March 1 falling on a Saturday, a sizable batch of early March payments were shifted into February, leading to a significant boost in spending compared with a year ago. We still look for the budget deficit to reach US$400 billion for the fiscal year as a whole. * We forecast a 0.1% decline in overall retail sales in February but a 0.2% rise excluding autos. Even though unit sales of motor vehicles were steady in February, we look for a fall-off in the auto dealer component of retail sales due to a more severe seasonal adjustment factor. Otherwise, the chain store results pointed to a modest gain in the general merchandise component along with a healthy advance in the pharmacy sector. However, results for apparel outlets were soft, and we look for a pullback in this category. Also, we expect some price-related moderation in gas station sales. * We look for a 0.2% rise in the February consumer price index, overall and excluding food and energy. Headline CPI is expected to show a bit of moderation this month, reflecting some slippage in gasoline prices (primarily during the early part of the month) and a decline in the price of milk. Still, quotes for just about every other food item continue to move higher, and with gasoline prices poised for some significant elevation during March, any flattening out in the headline CPI for February is likely to prove short-lived. Meanwhile, the core is expected to be up 0.23% on an unrounded basis, implying that we see some upside risk to our +0.2% estimate. On a year-on-year basis, we see the core just barely rounding down to +2.4%.
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In Search of the Slowdown
March 11, 2008
By Gray Newman and Luis Arcentales | New York
Although abundance continues to bring robust growth for most of Latin America, Mexico decided in early March that a fiscal stimulus package was in order. It’s probably not a coincidence that the two countries announcing stimulus packages last week were Mexico and Chile; after all, economic activity in both countries is running well below their peers in Latin America. No sooner had Mexico announced its stimulus package than we began to hear two very different reactions to what the plan stood for and what it would accomplish. The responses to the stimulus plan tell us a great deal about how investors are viewing Mexico today as the US enters a recession. While we have some sympathy with the two competing schools of thought, we believe that both are flawed. Slowdowners versus De-linkers The slowdown camp, populated with investors who are trying to time the next move of Mexico’s central bank, took one look at the stimulus announcement and concluded that the economy must be slowing much more rapidly than the authorities have so far admitted. Why else, they argue, would the authorities need to come out with a stimulus package? If fiscal stimulus is needed, the slowdown camp reasons, a bit of monetary stimulus from Banco de Mexico cannot be far behind. Meanwhile, the de-linking camp holds out hope that the stimulus package will help Mexico’s economy to de-couple from the US. After all, the de-linkers argue, the March 3 stimulus package is just the latest sign that the administration is committed to helping to boost Mexico’s domestic economy. The stimulus plan comes on top of the most ambitious investment budget in 20 years, with total investment promoted by the public sector nearing US$50 billion (5% of GDP) in 2008 alone. In Search of the Slowdown Smoking Gun We have a great deal of sympathy for the slowdown camp’s view that Mexico’s economy is set to decelerate in 2008. We have long argued that the link between the Mexican economy and the US is alive and that it cuts both ways. Of course, a nuanced view is in order. Mexican exporters have taken the first steps to reduce their dependence on the US. Last year, as the US economy began to falter, Mexican exports to the rest of the world grew by 28% compared with a pace of only 5% to the US. That lopsided shift in demand has helped to offset the slowdown in US demand for Mexico’s manufactured products. While non-US-bound exports accounted for just under one-fifth of all Mexican exports, the rapid growth meant that its contribution to export growth nearly equaled that of all US-bound shipments. Meanwhile, with services rather than manufacturing now the key driver of growth and employment in Mexico, the economy is likely to be less vulnerable to weaker US demand than it was during the 2001 US downturn (which followed a manufacturing-led upturn in Mexico). Still, despite all of the nuances, it is hard to avoid the conclusion that Mexico’s economy will slow in 2008. Given the normal lags between the US and Mexican manufacturing cycles and given the downturn in US manufacturing to date, there appears to be more downside for Mexico’s economy. After all, after a brief bout of relief with January’s ISM data, February’s downturn in the US ISM manufacturing survey – to the lowest levels since the initial Iraq invasion in 2003 and, before that, early 2002 as the US economy was just coming out of recession – suggests that there is more difficult news ahead for Mexico. Indeed, until the tumbling of forecasts in the past few weeks, we had long been considered to be overly pessimistic on Mexico’s growth prospects for 2008. We spent much of last year explaining to local businesses why we expected not only 2007 to disappoint relative to 2006’s growth burst, but why we also saw further weakness in 2008. Just three months ago, our 2.6% forecast for 2008 growth put us near the bottom of consensus forecasts; today, that same forecast puts us just slightly below the latest consensus of 2.8%. But while we have sympathy for the slowdown camp, we think that it is exaggerating the case of the slowdown and misreading its importance to Banco de Mexico. We highlight three problems with the commonly held views of many in the slowdown camp: First, while we think that Mexico’s economy is likely to weaken in 2008, we are seeing no signs of a rapid deceleration. In fact, we are seeing some signs of a turn-up at the beginning of the year. Looking for the slowdown smoking gun? You are unlikely to find it. Retail activity has remained fairly robust – January retail sales were up 8.0%, hardly changed from 8.7% in the fourth quarter. Meanwhile, consumer goods import demand data, which had been weakening in the second half of last year, showed an important improvement in January – even once we exclude soaring gasoline purchases. While Mexico’s new consumer confidence survey was down 2.5% in February relative to a year ago, the survey actually posted a modest upturn in seasonally adjusted terms after nearly six months of uninterrupted declines. The weakest sign in the new year was the January remittances report, which showed a 5.9% drop – the sharpest fall since the beginning of the monthly series in 1995. But recall that remittances accounted for less than 2.7% of GDP in 2007 – hardly a major driver of consumption. Second, some softening in demand in Mexico is likely to do little to prompt Banco de Mexico to cut rates, since demand pressures were never the problem driving inflation in the first place. What has been driving Mexican headline and core inflation higher has largely been a series of external supply-driven shocks, particularly among commodities, which have fed through to processed food. Banco de Mexico has argued that it has seen no meaningful demand pressure on inflation in 2007 even before the first signs of slowing in consumption and external demand began to emerge in the fourth quarter. Unless domestic demand plummets in 2008 – which is not embedded in our forecast of 2.6% GDP growth nor in the central bank’s forecast range of 2.75-3.25% – Banco de Mexico is unlikely to find much room to cut rates promptly or aggressively. Finally, Mexico’s inflation dynamic is likely to face more of the same during much of 2008: pressure from commodity prices feeding through to processed foods. While we expect some softness in commodity prices later in the year, the pipeline is likely to remain challenging for consumer inflation during most of the year. And with headline expected to bump back over 4% in the coming months, Banco de Mexico is likely to remain watching for any signs that the uptick in a broad range of food items is putting pressure on wages or on pricing decisions elsewhere in the economy. Indeed, February’s above-expectations inflation reading showed a first taste of what we expect up until mid-year: higher commodity prices (in February seen in grain seed oil prices) more than offset the bout of produce price deflation. Debunking the De-linkers We also differ with the de-linking camp. The latest fiscal program is modest at best and likely to dwarfed by the cyclical pressures from the US. Taken at face value, the fiscal package is worth US$5.6 billion or 0.6% of GDP. Looking at the details, however, shows that the fiscal boost is unlikely to move the growth needle by any meaningful amount: First, it is worth noting that only US$1.2 billion is made up of tax relief, mainly in the form of discounts of employers’ contributions to the Social Security Institute and temporary discounts to corporate taxes. Second, nearly half of the US$1.2 billion in tax relief does not represent a reduction in taxes, but simply a delay in the payment. Importantly, the tax relief is modest compared with the important increase in taxes, courtesy of the fiscal reform approved last September, which businesses are expected to pay in 2008 – to the tune of US$10 billion. Third, the Mexican plan is unlike the high-powered fiscal boost implemented in the US, which involves handing money back via tax rebates to lower-income households – which have the highest propensity to consume – and also investment tax incentives for businesses (see Dick Berner’s Upping the Ante on Stimulus, January 28, 2008). While Mexico’s plan also provides for some reduction in electricity tariffs, this comes after businesses have seen their electricity bills steadily increase so far in 2008. While the benefits from Mexico’s already announced National Infrastructure Plan are likely to be felt in 2008 and beyond, much of the public sector’s budgetary investment, which could top US$35 billion this year, is being reassigned from current spending. A portion of the funding is coming from the tax revenue gains expected from the fiscal reform approved last year. Building up Mexico’s infrastructure is critical for the country’s long-term growth perspective. And shifting spending from current spending to investment projects can improve Mexico’s long-term growth prospects. But it is not clear if shifting spending from one area (current) to another (investment) will necessarily add much in terms of stronger GDP growth in 2008. Quite simply, if funds are being spent to build bridges in rural areas and boost Pemex’s energy infrastructure instead of funding bureaucrats’ spending habits, the geographical distribution of GDP may change, but not necessarily the size of GDP in 2008. Bottom Line We expect Mexico’s economy to be tested in 2008 as the US recession unfolds. Our US economics team continues to review its GDP forecast and warns of more weakness ahead. That clearly puts downside risk to our Mexican forecasts in 2008. But we subscribe neither to the camp arguing that the slowdown will be brutal and force Banco de Mexico’s hand to begin to cut interest rates soon, nor to those who argue that Mexico’s fiscal efforts can fully offset the weakening growth dynamic from the US. We would advise caution if investors begin to swing too far to either of these camps.
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Fuelling the ZAR and CPIX
March 11, 2008
By Michael Kafe & Andrea Masia | South Africa
A Higher Oil Price Profile ... Our US and European colleagues have again revised their oil price forecasts for 2008-10. For the first time ever, we now admit that oil prices are likely to hover above the US$100/bl mark for most of this year, decline to some US$84/bl by mid-2009 and rise again to US$94/bl by the end of 2010. This new profile calls for a review of our inflation, current account, currency and GDP growth forecasts. ... Lifts the Inflation Trajectory ... With regards to inflation, the new oil price profile lifts CPIX by some 0.2-0.3pp for most of 2008. We also took the opportunity to make adjustments to our electricity price profile to fully reflect the impact of the electricity tax that was introduced last month. (In the February 2008 Budget, Finance Minister Manuel imposed a 2c/kWh electricity consumption tax. However, we did not make adjustments to our CPIX profile because we were unable to establish the exact cost of electricity to consumers at the time. Thankfully, the National Energy Regulator has published detailed information in this regard.) We estimate that the 2c/Kwh tax will raise the average cost of electricity for domestic consumers from 45.3c/kWh to 47.3c/kWh, an increase of some 4.4%. Sticking to the regulator’s recommended municipality electricity tariff increase of 12% for this year and adding an extra 4.4pp in taxes takes us to 16.4%. We round this up to 17%. For 2009, we assume a 15% increase. Incorporating all these changes into our CPIX grid and allowing for a weaker currency suggests that targeted inflation will now close the year at 7.1%Y (previously 6.6%Y), and fall back within the 3-6% target range only in 2Q09 (5.7%Y). For 4Q08, our quarterly average reading now comes in at 7.4%Y – almost 1.5pp higher than the SARB’s January 31, 2008 forecast of some 5.9%Y. We now expect CPIX to average 5.6%Y in 2009 (previously 5.4%). We still expect core CPIX to reach 6% by August 2008, and remain above the 6% level for the rest of the year, making it difficult for the SARB to cut rates anytime this year. In fact, the risk is that the SARB may hike rates at the April MPC meeting. ... Fuels the Current Account Gap ... Since 2006, we have pointed out on numerous occasions that higher commodity prices are not necessarily a good thing for South Africa, given the country’s inability to take advantage of the commodity price boom to boost exports, thanks to inadequate mining infrastructure, a poor product distribution network, labor unrest and recent power outages. On the other hand, South Africa’s oil imports have almost doubled from 12.5% of the country’s import bill in 2003 to 24% at the end of last year, and are showing no signs of letting up. At the moment, it would appear as though the marginal benefit from higher commodity export revenues is more than offset by the marginal cost of landing oil, hence the visible trade gap. In fact, data published by Statistics South Africa show that, despite the huge rally in commodities over the past two years, mining production in South Africa fell 1.5%Y in 2006 and a further 0.1%Y in 2007. Another key feature of South Africa’s external trade account is the high level of capital imports (more than two-fifths of the country’s import bill). While it has been our view that the government’s massive capital infrastructure program should keep the level of capital imports high in the next 3-5 years – given the high import penetration ratios of these projects – we have nevertheless cautioned on a number of occasions that such imports are likely to be back-loaded, given the well-documented capacity constraints in the public sector. This could change: in its 2008 Budget, the National Treasury made significant expenditure allocations to the two key parastatals Transnet and Eskom. Encouragingly, Eskom has already initiated the contracting-out of power grids to private sector companies. At the same time, it has promised to fast-track its own base-load capacity build. This raises the possibility that, contrary to our earlier expectations, we could see some front-loading of capital imports. We estimate that, ceteris paribus, the upward revisions to our oil price profile should combine with the fast-forwarding of some capital imports to lift the country’s current account deficit from an estimated 7.1% of GDP in 2007 to 7.5% of GDP in 2008 (7.2% previously), 7.6% of GDP in 2009 (7.4% previously) and 7.8% in 2010. ... and Hurts Currency Prospects We have had a bearish outlook on the rand since 2H07. Unfortunately, it took the better part of half a year to see the call come through, but it eventually did in 1Q08 as market complacency gave way to an objective focus on the country’s fundamentals. Not only was the 15% correction in the currency quick and vicious, it has also taken us above our year-end target of 7.60. We believe that, although the recent move appears stretched and may well be overdone, the rand will remain a structurally weak currency this year. Current account funding pressures will likely surface over the course of the year as portfolio equity inflows dry up in the face of weaker GDP growth prospects. We also believe that portfolio bond investors (so-called ‘carry-players’) are unlikely to pick up the slack if 2H08 CPIX falls a lot slower than the market currently believes (as we expect). Such a dry-up in capital inflows will no doubt hurt the currency. One must also remember that wage negotiations are likely to be tougher this year than they were in 2007, given that inflation is likely to peak at a much higher level than previously thought. For the first time in many years, we believe that the prospects of double-digit wage settlements can no longer be dismissed as ‘a thing of the past’. Wage negotiations typically begin in April, and could extend until the end of 3Q; any man-hours lost during this period will shave domestic GDP growth expectations further, with negative implications for both foreign direct investment and portfolio equity inflows. We are also of the opinion that rising political uncertainty in the run-up to African National Congress President Jacob Zuma’s trial in August 2008 could hurt sentiment and encourage foreign investors to adopt a wait-and-see attitude towards South Africa. Finally, our US colleagues are looking for a 9% appreciation in the dollar from EURUS$1.54 to EURUS$1.40 by year-end. Ceteris paribus, this should put further pressure on US$ZAR during 2H08. Against this background of a likely dollar recovery, rising domestic inflation and current account deficits, potentially lower GDP growth rates, political uncertainty, possible labor unrest and a potential dry-up in capital inflows, we are inclined to raise our US$ZAR forecast to 8.20 by the end of this year (previously 7.60), and 8.70 by end-2009 (previously 8.10). We would therefore regard any short-term pullback in US$ZAR as an opportunity to reinstate long US$ positions.
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Credit Market Developments: It’s Not Just Their Problem
March 11, 2008
By Chetan Ahya | Singapore
Sharing the Pain – Globalization Works Both Ways At the first signs of the credit problems in the US and Europe 6-8 months ago, it appeared that the trend might not affect India’s financial markets and real economy significantly. However, things are changing quickly. The Asian credit market has also been feeling the heat. This is reflected in a sharp rise in Asian dollar bond yields. We believe that this, coupled with a slowdown in portfolio equity inflows, private equity inflows and real estate investments, will weigh adversely on India’s growth outlook. For the last 3-4 years, India’s growth acceleration trend has benefited more from the globalization of capital markets than from the globalization of trade. This trend now appears to be reversing. How Do Credit Market Developments Matter for India The renewed stress in the US and European credit markets has been transmitted to Asian credit markets. This is reflected in the sharp rise in the credit default swap (CDS) rate, which measures perceived credit risk. The average CDS rate in AXJ, as measured by Bloomberg’s iTraxx Asia ex-Japan Index, which comprises 70 equally weighted entities, has increased from 48bp as of early July 2007 to 285bp currently. The average CDS for non-investment grade bonds has shot up to 592bp currently from 216bp as of end-September 2007, while that for investment grade has increased to 171bp from 40bp as of end-September 2007. The Indian paper has suffered a similar fate, with CDS rates rising to 200-480bp from the lows of 60-100bp in July 2007. If this trend continues, foreign capital-raising will become difficult. Capital Inflows Could Slow Significantly We believe that a sustained favourable global risk appetite trend has been at the heart of India’s current growth acceleration cycle – average GDP growth accelerated to 9.3% during the last three financial years (F2006, F2007 and F2008) from an average of 6.2% in F2003 and F2004. We believe that one of the key drivers of India’s virtuous growth cycle has been large capital inflows, providing a major liquidity infusion and pushing up domestic demand. Indeed, over the last 12 months, we estimate that India received US$106 billion (close to 10% of GDP) of capital inflows. Out of this, US$40-45 billion is foreign debt, about US$30 billion were equity market-related inflows, about US$13-15 billion was net foreign direct investment, or FDI (a significant part of which were private equity and real estate investments), and the balance was other hybrid inflows. In our view, a significant part of the non-debt inflows could also have been funded by way of debt leveraging in the international market. Recent credit market developments are making it difficult for global financial institutions to raise wholesale funds. This in turn is reflected in the ability of these institutions to lend to companies. Already many of the Asian and Indian companies are withdrawing their foreign currency bond issuances. Similarly, property companies are finding it very difficult to get access to foreign debt as well as equity capital. We believe that capital inflows into India could slow to US$30-40 billion over the next 12 months compared with US$106 billion in the last 12 months, unless there is a dramatic turnaround in the global credit market environment. Why India Could Be More Affected in the Region We believe that India will be one of the most affected countries in the region by the recent global credit market developments. First, unlike the rest of the region, India runs a current account deficit, and its large balance of payments surplus has been driven by capital inflows. Most other countries in the region have large current account surpluses. Second, India has had a strong credit cycle over the last four years. It has been a beneficiary of a virtuous cycle of large capital inflows – a major liquidity infusion – pushing up domestic demand. India’s credit growth has averaged 29% over the last three years. The country has also been an exception in the region, pursuing loose, pro-cyclical fiscal policies with a combined centre plus state government fiscal deficit (including off-budget liabilities) at an average rate of 7.7% of GDP over the last four years. Risk Aversion in Domestic Banking Sector Also Increasing In addition to the trend in the global credit markets, India has witnessed a rise in credit spreads in the domestic banking sector. Credit spreads are widening for corporate sector borrowing as well as for household loans. Corporate sector borrowing costs are rising in the domestic market, with the spread for one-year AAA rated companies over the corresponding maturity government bond yield increasing to 250bp from the bottom of close to 100-130bp in early January 2008. The spread on one-year A rated paper has increased to 310bp currently. Similarly, banking sector spreads on household loans have increased significantly. Financial Market Implications We believe that capital access for capex and household spending will become more constrained over the next few months, affecting aggregate domestic demand and GDP growth. We estimate that GDP growth will slow to 7% during the quarter ending December 2008 from 8.9% during the quarter ended September 2007. In our view, the downside risk to our below-consensus estimates has increased. Morgan Stanley strategist Ridham Desai believes that the key sectors affected by this trend are (i) banks with large international operations, (ii) property and (iii) capital goods and construction. In general, he expects that companies with floating-rate foreign exchange liabilities, asset side exposure to equities and sub-par fixed income securities will likely surprise negatively. Hence, financials and industrials are the main underweight positions in his model portfolio.
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