United States
Downside Risks for Corporate Profits
March 18, 2008

By Richard Berner | Mexico

Like the downturn in the economy, investors recognize that a domestic earnings recession is now underway.  Statistically, of course, the criteria for an economic recession haven’t been met; for example, the economy has yet to post even one quarter of contraction, nor have published monthly indicators except employment begun to contract.  But S&P operating earnings plunged by 30.8% over the four quarters of 2007, courtesy of losses at financial services companies, and earnings excluding financials decelerated sharply.  Domestic earnings measured in the National Income and Product Accounts (NIPAs), which declined by 4.6% from a year ago in the third quarter of 2007, probably weakened further in the final quarter of last year and the first quarter of 2008. 

Investors nonetheless are hoping that a resilient global economy means a mild and short earnings downturn followed by a hearty recovery.  That’s not illogical, and so far, double-digit earnings gains at US affiliates, which account for about a third of overall profits, have helped to keep earnings growth (measured in the NIPAs) in positive territory.  We estimate that after-tax “economic” profits rose by 5.7% from a year ago in the fourth quarter, and that earnings from abroad rose by about 20%.  Can it continue? 

As I see it, the short answer is no.  The US economic outlook has darkened, and the combination of operating leverage working in reverse, rising costs, dwindling pricing power, and deteriorating credit quality will squeeze domestic profit margins.  Despite a solid contribution from the translation effect of a weaker dollar, slower overseas growth seems likely to tame the overseas earnings boom.  Here’s why.

First let’s look at the top line.   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.  Indeed, the risk is that mounting financial losses, lender caution, and rising credit costs will trigger an ‘adverse feedback loop’ that spills over into the rest of the economy.  Although February brought inflation relief in the form of flat consumer prices, the recent run-up in crude energy and food quotes, driven primarily by supply factors, has yet to show up at retail and will further erode consumer discretionary spending power.  The upshot is that even with higher consumer inflation, nominal GDP (i.e., top-line output) will probably decelerate to 2.8% this year from 5% in 2007 (see “A Darker US Outlook,” Investment Perspectives, March 13, 2008).  That alone will slow earnings growth. 

But the real story is the analytics of margins: In my view, the combination of slower growth and high operating and financial leverage in Corporate America made a contraction in earnings unavoidable even if the economy skirts recession.  Lower marginal but higher fixed costs have increased operating leverage.  Corporate America’s ability to exploit that leverage propelled earnings to record levels when growth was healthy.  Strong increments to revenue went straight to the bottom line.  Financing the boom with debt  and buying back stock increased financial leverage and, of course, raised earnings per share.  Our strategy team estimates that corporate buybacks may have added 250 bp to S&P earnings gains in 2006 and 300 bp in 2007 (see “The Earnings Recession,” Global Economic Forum, December 3, 2007). 

But leverage — both operating and financial — works both ways.  Slower growth means that operating leverage is working in reverse, with decreases in revenue going right to the bottom line.  In addition, slower growth has trimmed operating rates, reducing pricing power.  In manufacturing, for example, operating rates have declined by a percentage point over the past year.  Not only does that mean slower top-line growth, but the loss of pricing power drops straight to the bottom line.  Thus, rising costs for energy, materials, commodities, and imported goods are no longer being passed through to prices but instead are pressuring margins.  Moreover, higher financial leverage boosted debt service in relation to cash flow, and now investors demand higher premiums to take on escalating credit risks, squeezing profits margins further. 

Strength of Overseas Earnings to Be Challenged

The offsetting good news from overseas is therefore critical.  Growth abroad — and the higher oil prices that come with it — are powerful engines for US earnings.  The leverage factor in this case could be as high as 5 to 1; that is, a percentage point improvement in global growth would yield an extra 5 percentage points of US earnings growth.  According to Macroeconomic Advisers, global nominal GDP excluding the US rose by 7.8% over the past year, and measured in the NIPAs, earnings of US affiliates abroad jumped by nearly 20% over that period.  Such earnings amounted to a record 31.5% of overall earnings in the third quarter of 2007; S&P measures show a similar share.  Importantly, that’s double the share of twenty years ago – the last time strong global growth consistently contributed to growth in the US.  Consequently, the global impact on earnings today has doubled over the past two decades as US direct investment has spread abroad.  Moreover, we think that for the first time in two decades, stronger global growth will consistently lift US growth through improved US net exports.  Empirical work has long supported the idea that improving growth is several times more powerful for exports than a similar-sized percentage-point change in relative prices.  That boosted US earnings last year, but if growth abroad slows as I expect, that source of support will fade. 

In contrast, the weaker dollar, if sustained, could support US earnings through two channels.  First, it is already translating US companies’ overseas results in euros or yen into more dollars.  On a broad, trade-weighted basis, the dollar has declined by 10.8% from a year ago, and our empirical work suggests that such a decline would boost US earnings from abroad by at least 3% and as much as 6%, boosting overall earnings by 150 bp.  It’s reasonable to expect those effects to continue through 2008.  In addition, a weaker dollar at the margin will help US companies recapture market share.  The 8.8% gain in real US exports in the year ending in January is encouraging in that regard.  Unfortunately, these earnings tailwinds won’t offset the decline in domestically-sourced profits.  In fact, it’s noteworthy that even with a third of overall earnings still growing, we still expect a 6.1% year-over-year decline in overall economic profits in 2008.

Vicious Circle for Transatlantic Earnings

There’s also a darker side to earnings from abroad.  I worry about the potential for a vicious circle in transatlantic earnings.  The US earnings downturn is already spilling over into weaker earnings abroad, especially in Europe.  NIPA data show that US earnings remitted abroad in last year’s third quarter declined by 7% from Q3 2006.  No doubt such weakness was a factor in our European strategy team’s recent earnings downgrade; they expect a 16% plunge in European earnings this year compared with the consensus forecast of a 7% increase.  The impact of the US earnings downturn on Europe likely will be significant: US direct investment data suggest that about 2/3 of our payments abroad go to Europe.  Such payments, which are earnings of US affiliates of foreign companies, crashed in the last recession — from a peak of $66 billion in Q1 2000 to a loss of $24 billion in Q4 2001.  And for European companies the strength of the euro is a massive headwind: A 13% appreciation of the euro has magnified the earnings downturn in euros for European companies’ US affiliates.  Together with tighter financial conditions, I’m concerned that weak earnings at European companies could contribute to a sharp deceleration in capital spending and in European growth.  That would complete the circle, because it would also hurt US earnings abroad.  About half of those overseas earnings originate in Europe. 

Against this backdrop, what’s really perplexing is that Wall Street analysts don’t think that a weak 2008 will cast doubt on the vigor of next year’s results.  On the contrary, in what I think is fundamentally flawed logic, they have maintained the level of their 2009 estimates where they were, so that downward revisions to 2008 earnings actually boost the 2009 growth rate.  Street estimates for 2009 S&P 500 earnings growth have been revised up to 15.5% from 14.7% at the beginning of January (for details, see “Business Conditions: Bouncing Along the Bottom,” Global Economic Forum, March 14, 2008).  By comparison, we expect a 5.9% increase in 2009 after-tax economic profits that would leave the level below that in 2007.

The market implications of these developments are complex, because at some point markets will stop going down on bad news — when it has been fully discounted.  A mild earnings recession is probably in the price, but a tepid upturn is not, with consequent downside risks to equities and credit.  Such a dispirited earnings environment probably would raise more questions about credit quality, widen credit spreads, and continue to affect stock prices.  Lower interest rates reflect risk aversion and a weaker economy, so they won’t promote multiple expansion until signs of economic recovery and an end to margin compression are visible.  Thus, for now at least, earnings disappointments likely will be bad news for investors.

Earnings risks are pointed to the downside and likely have consequences for the economic outlook.  A deeper recession, especially one that spreads abroad, would promote a much more serious profit squeeze.  The resulting tightening in financial conditions and limits on cash flow would likely depress capital spending and hiring.  But leverage does work both ways, and renewed growth ultimately will help margins and earnings expand again.  The timing is the key uncertainty: I have less conviction whether that will happen in 2009 or beyond.

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United States
Business Conditions Bouncing Along the Bottom
March 18, 2008

By Shital Patel and Richard Berner | New York, New York

As we suspected it would be, the rebound in the MSBCI in February was mostly reversed in March, falling five points to 32%.  We see few if any signs of improvement: Credit conditions and forward-looking indicators, including the advance bookings index and business conditions expectations index in our survey, continued to deteriorate in early March.  Hiring plans deteriorated noticeably, with only 13% of the groups planning on expanding payrolls and fully one-fourth planning to cut payrolls.

The MSBCI has proved to be a good leading indicator: Since it first plunged to 30% last August, consensus GDP estimates for 2008 have nearly halved from 2.9% to 1.5%, according to the Blue Chip Economic Indicators.  Our own GDP estimates have come down from 2.6% to 1.1% as of March 10.  Consistent with our recession call, we believe the MSBCI will continue to bounce along the bottom through at least mid-year before showing any noticeable signs of improvement.

A key reason: Credit conditions continue to deteriorate.  Survey results echo what’s plainly evident in financial markets and in lender anecdotes.  Our credit conditions index, which looks at the ability to get financing compared to three months ago, fell seven points to 26% in March, the second-lowest reading in the nearly six-year history of the question.  Over the past month, lending standards tightened significantly.  Seventy percent of the groups which fall into the ‘borrower’ category (about 80% of sample) have faced sequentially tighter lending standards.  Of the lenders (only 8% of sample), two-thirds have tightened standards, down from 75% in February.

Other surveys have been mixed.  On the positive side, the National Federation of Independent Business’ small business optimism index edged up to 92.9 from last month’s reading of 91.8, which was the lowest level since January 1991.  However, according to NFIB Chief Economist William Dunkelberg, survey results suggested the economy was “stronger-than-perceived.”  Small businesses are still not feeling the full impact of the credit crunch: The net percent of business owners reporting loans harder to get in recent months stood at 5% in February versus the 2007 average of 6%.  He also noted that labor markets remained tight for owners trying to hire new workers.  Other surveys were weaker.  The ISM manufacturing index hit a nearly 5-year low of 48.3 last month and the ISM nonmanufacturing index hit an all-time low of 44.6 in January, but rebounded to a still-low 49.3 in February.

Earnings quality lower.  This month, we asked analysts some questions about the 4Q07 earnings season.  Earnings quality deteriorated: 31% of analysts reported that earnings quality is worse compared to a year ago, up from 25% in November.  Only 5% noted that earnings quality was better.  By quality we mean earnings growth came from either higher sales or lower costs.  According to our strategy team, 60.4% of companies reported 4Q07 earnings above expectations, down slightly from 62.1% in 3Q07.  Our survey results suggest that of the companies that beat expectations, half had higher top-line growth, while 18% had lower costs.  This compares to 36% with higher top-line growth and 38% lower costs in the last earnings season.

MS analysts have been slashing 2008 earnings estimates, nearly halving them from 13.5% in early January to 7.0% this month.  That’s a move in the right direction, although we think estimates could still be revised lower — our own forecast for 2008 after-tax “book” profits (measured in the National Income Accounts) is for a decline of 6.6%.

More analysts see upside risks to 2008 estimates.  Thirty-eight percent of analysts believe there are upside risks to their 2008 earnings estimates, up from 31% last month and the highest percentage since May 2007.  Of these, 36% believe the risk is from better domestic results, 29% from margin expansion, 21% from better domestic and foreign growth, and 14% from better-than-expected growth abroad.  Sixty-two percent of analysts see downside risks to earnings estimates, mostly from weaker domestic results.  Some of the new optimism may arise from the translation effects of a weak dollar.  The dollar has been in the headlines again, with the yen and the euro strengthening.  Thirteen percent of respondents noted that the dollar contributed 3 percentage points or more to bottom line results at their companies, while 31% believe the weaker dollar has contributed 1-3 percentage points.

Leading indicators remain weak, but there are two major disconnects.  First, while the March survey showed more analysts who believe there are upside risks to their earnings estimates, they expect business conditions to remain weak over the next six months.  Our business conditions expectations index fell five points to 28% in early March, with only 15% of groups expecting conditions to improve (mostly in materials and energy).  Second, the advance bookings index plunged 21 points to 29%, the lowest reading since April 2003.  Only three groups reported that advance bookings over the next 1-6 months are up compared to the previous three months.  We find this second disconnect especially surprising considering 27% of analysts believe domestic and/or foreign growth could surprise to the upside.

Inflation and pricing power.  Our pricing conditions index, which looks at the change in prices charged compared to a year ago, edged down two points to 63% in March.  While this is 13 points off the high of 76% posted in November 2005, it is still well above the 53% posted in August of last year; that was the most recent trough.  In fact, this pricing diffusion index has remained at or above the 50% threshold since September 2003 (prior to that there were lingering fears of “disinflation” or even outright deflation).  A retreating pricing conditions index supports our call that year-over-year CPI inflation rates will moderate from 4.0% in 4Q07 to 3.0% in 4Q08.

While nearly half of the industries covered in this survey were able to increase prices compared to a year ago, higher costs have been squeezing margins over the past three months.  Fully 43% of groups noted that material and/or labor costs have increased faster than prices charged, compared to 37% in January.  Expectations for 2008 margins have come down quite a bit: This month, roughly one-quarter of the respondents expect margins to expand, down from 38% in February, and 36% of respondents expect margins to shrink, mostly in the consumer discretionary, industrials, and financials sectors.  With recession underway, this margin compression augurs poorly for earnings.

 

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Chile
Can’t Beat the Real Thing!
March 18, 2008

By Luis Arcentales | New York

With Latam watchers torn about the extent of the pain that the ongoing US slump will bring to the region, it is important to ask which countries are more vulnerable to a turn in external conditions, which have played a central role in the robust growth of the past five years (see “Latin America: Growing Disconnect, Growing Risk”, This Week in Latin America, March 3, 2008).  The ‘insurance’ purchased in the form of rapid international reserve accumulation could indeed make the region more resilient to a worsening external environment, as could an export base with limited exposure to commodities.  By these two metrics, Chile does not seem to be in the most comfortable position, with commodities accounting for over 70% of total exports (30% of GDP) and international reserves of US$16.9 billion which, at 10% of GDP, are the smallest as a share of GDP of any major Latin American economy aside from Mexico’s (starting May 2003, Banco de Mexico put in place a rules-based mechanism of daily US dollar auctions to reduce international reserve accumulation).

Unlike any other country in the region, however, Chile has taken advantage of the past few years of abundance to build a war chest that not only allows it plenty of room to conduct counter-cyclical fiscal policy, but which seems sensible from a financial standpoint as well.  Record-high levels of international reserves in Brazil, Colombia or Argentina say little about the strength of their fiscal position and how much ammunition these countries have saved for a rainy day.  On this front, Chile is the real thing. 

Saving for a Rainy Day in the Right Way

Soaring copper prices in a context of the structural budget surplus framework in place since 2001 has allowed Chile to produce massive fiscal surpluses.  Last year, Chile’s public sector posted a surplus of 8.7% of GDP – the largest in two decades since data are available. Chile’s fiscal prudence, in turn, has allowed for significant reduction in public indebtedness and rapid accumulation of assets, which at the end of 2007 stood at US$20.9 billion, split between the Economic & Social Stabilization Fund (FEES, US$14.0 billion), the Pension Reserve Fund (US$1.5 billion) and Treasury deposits (US$5.4 billion). Indeed, Chile’s government is now a net creditor to the tune of 11% points of GDP (see “Chile: Conserving Abundance”, EM Economist, February 15, 2008).  Just as Chile has avoided the temptation of super-charging its economy by opening the fiscal spigot in recent years, Chile’s ample savings in its stabilization fund shield its budget from a sudden drop in commodity prices or a cyclical downshift. 

Not only has Chile’s adherence to fiscal prudence generated ample savings, but we would argue that Chile’s strategy is also financially sound from two separate perspectives.  First and foremost, it makes sense for Chile to transform its copper wealth – which based on Codelco’s copper reserves of 77 million tons, we estimate to be around US$1.3 trillion at current copper prices – into financial assets which, over the long term, tend to offer superior returns.  Second, the government is planning to diversify the holdings of the FEES – where most government assets currently reside and which is fully allocated to fixed-income instruments – which should provide superior risk-adjusted outcomes going forward.

Chile faces a choice between leaving its copper underground while waiting for it to appreciate or extracting it and turning it into financial wealth, in a similar way as our colleagues Stephen Jen and Luca Bindelli have argued about the GCC countries and oil (see GCC: Transforming Oil into Financial Wealth, November 15, 2007).  After all, excluding fiscal revenues derived from state-owned Codelco – which produces about a third of Chile’s copper output and holds half the country’s reserves – central government accounts would still have ended in surplus territory in each of the past three years, thanks to record receipts from private mining companies and strong activity-linked VAT and income tax collections. Thus, the issue at hand is on whether financial assets offer superior returns to those of copper.

Chile is doing the right thing by turning its copper abundance into financial wealth as financial assets offer superior risk-adjusted returns than copper in the long term, in our view.  Over the past century, the value of equities has risen nearly 400 times, trumping returns from bonds, money market and oil (see Norges Bank Deputy Governor Knut Kjaer’s presentation, From Oil to Equities, November 2006).  If we look back at data since 1980 – which include the popping of the TMT bubble and the five-fold increase in copper since 2002 – we find that equities offered superior total returns than copper.  And returns are only one side of the coin: once we add the volatility of returns into the equation, we find that copper is by far the least compelling asset class. 

And authorities have laid out a superior diversification strategy with it set to be in place by year-end.   The Finance Committee within Chile’s Finance Ministry has recommended the allocation of 15% of the FEES assets into equities and 20% into corporate bonds, which we consider to be a major step in the right direction. At the end of 2007, the FEES had 68% of its assets in sovereign debt, 4% in agencies and the remainder in bank deposits, all administered by the central bank (40% in US dollars, 40% in euros and 10% in yen).    Using monthly data since 1980, we find that the portfolio recommended by the Finance Committee would offer superior risk-adjusted returns than any single asset class and even better than the current asset allocation of the FEES. 

Importantly, the increase in the risk profile of the FEES seems like a sensible strategy, in our view, in a context in which its assets are unlikely to be needed to shore up the government’s budget anytime soon.   Copper markets are set to remain in deficit this year and next, keeping prices well supported around US$3.50 per pound, according to our Metals & Mining team (see Global Commodity Update: Supply in Crisis, February 15, 2008).  Even against a backdrop of near-record-high copper, Chile’s 2008 budget incorporates a reference copper price of just US$1.37 per pound, leaving an ample cushion for copper to retrench – even as higher costs such as energy and water continue to put pressure on miners’ margins and thus point to higher equilibrium long-term prices – and still generate a fiscal surplus. 

A conservative, gradual diversification approach seems sensible, in our view, to further consolidate popular support for Chile’s prudent fiscal management approach.  With government popularity near historical lows, consumer confidence at the lowest level since 2003 and prospects for only moderate growth this year, pressures to spend appear to be mounting.  Against this backdrop, the authorities seem to grasp that the FEES’ 2009 performance will be an important political and popular test; thus, a small, conservative allocation to riskier assets in the first year seems like a well-suited strategy. 

Should Chile Be Saving at All?

While Chile’s fiscal prudence should pay off as it allows fiscal policy to better smooth out the impact of business cycle fluctuations, it is reasonable to ask if a developing country should be accumulating assets at a rapid rate – in Chile’s case at US$21 billion (13% of GDP) at the end of 2007 and rising.  Without going into the merits that saving today brings to avoiding a pro-cyclical fiscal stance in an environment of record-high copper quotes, we offer some thoughts on two important areas, namely education and infrastructure needs.

First, while surveys suggest that Chile is among the most competitive economies in the world, its education system is comparably poor.  The 2008 budget already allocates historically high spending levels to education, and the authorities have begun to tackle some of the system’s deficiencies.  However, research by the OECD suggests that Chile’s educational shortfalls are not necessarily caused by lack of funds but, instead, by the inefficiency of the spending.  Indeed, the OECD points out that given its level of spending, Chile’s educational outcomes could improve by 16% if it were to deliver educational services as the best achievers among OECD countries do. 

Second, Chile does not appear to have significant shortfalls on the infrastructure front. In a recent report, researchers at the World Economic Forum noted that Chile has the highest-quality infrastructure network in the region, with port quality almost matching that of Germany.  There seems to be some room for improvement on roads and energy; in the latter area, significant investment is pouring in, which is expected to go a long way towards alleviating today’s tight situation by the end of next year. Moreover, Chile’s stable macroeconomic backdrop and legal framework make it the most attractive destination for private investment in infrastructure, according to the WEF. 

Bottom Line

Unlike any other country in the region, Chile has taken advantage of the past few years of abundance to save for a rainy day.   Indeed, Chile is in an enviable position to efficiently conduct counter-cyclical fiscal policy, both relative to its Latin American neighbors and relative to its own history, with a war chest amounting to 13 percentage points of GDP at the end of 2007.  Importantly, for Chile, transforming its copper wealth into financial assets is a sensible financial strategy, given the better risk-adjusted long-term return profile provided by stocks and bonds.  And with the assets saved for a rainy day unlikely to be needed to shore up the government’s budget anytime soon, authorities are planning to diversify their holdings into stocks and corporate bonds by year-end. 

Rapidly rising levels of international reserves from Brazil to Colombia and Argentina may make these countries more resilient to the coming global downturn; however, record reserves say little about the strength of their fiscal position and how much ammunition these countries have saved for a rainy day.  On this front, Chile remains the real thing. 

 

 

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Colombia
Light at the End of the Tunnel
March 18, 2008

By Boris Segura | New York

Even as the US Fed cuts rates, Colombia’s central bank is still facing the prospect of hiking its overnight rate.   After three years of uninterrupted success in meeting its inflation target, Banco de la Republica struggles with the fact that it missed its target in 2007 and is seemingly destined not to reach it again this year. The central bank’s challenge is compounded by not having been able to reach its ultimate goal of price stability, unlike other countries in the world.

Banco de la Republica has been proactive in its conduct of monetary policy, as it has hiked its intervention rate by 375bp, starting April 2006, to 9.75%, even when inflation was on a downward trend. However, the monetary authorities, probably sensing domestic demand pressures in the pipeline, preemptively began a tightening campaign back then. The intervention rate, deflated by 12-month ahead inflation expectations, is certainly high and second only to Brazil in the region. The authorities even raised reserve requirements on bank deposits last May.

We think that the central bank is near the end of its monetary tightening campaign. We expect one final hike by Banco de la Republica to 10%, probably reinforced with an increase of reserve requirements on bank deposits, in 2H08.

Recent Inflation Trends

Inflation figures for the first two months of 2008 have been disappointing, taking year-on-year headline inflation to a four-year high. However, as has been the case in most of Latin America, food prices have led the way. Besides the usual culprits (imported foodstuff), there has been some unusual price action in non-tradable perishable foodstuff (potato, vegetables, etc.). Inflation ex-food has thus stayed flat for most of the past year, inside the inflation target band.

However, if you look at non-tradable inflation and exclude food and regulated prices, it has been stubbornly outside the target but is likely to come down slightly during 2H08, along with what we expect to be a decelerating economy throughout this year. This measure gauges inflation most likely caused by aggregate demand pressures.

We are revising our year-end inflation forecast to 5.6% from 5.1%, given the (worse than expected) first two inflation releases of the year and the expected evolution of the main inflation categories going forward. We are assuming some relief in food inflation and in non-tradable inflation excluding food and regulated prices; if these trends do not materialize, we might end the year with a 6%+ inflation print.

Base effects are likely to cause inflation to head down somewhat during 2Q08, thereby keeping Banco de la Republica on hold for the rest of the current half of the year. Inflation is likely to pick up again in 3Q, so we suspect the central bank to be back in the picture again, via another rate hike supplemented with an increase in reserve requirements on bank deposits. This course of action would be mostly a signal by the central bank to anchor inflation expectations, as we expect aggregate demand to show clearer signs of deceleration by then.

Main Factors Affecting Inflation During the Remainder of 2008

The single most important factor that will influence inflation for the remainder of the year is the pace of deceleration of aggregate demand. We witnessed a deceleration of the Colombian economy throughout 2007; the GDP release for 4Q07, due out at the end of the month, is going to show a further deceleration. Admittedly, this slowdown is coming from record-high levels, as staff at Banco de la Republica points out, but it is likely that aggregate demand pressures on inflation will dissipate by 2H08. We expect Colombia’s economy to converge towards its potential GDP growth of 5.5% throughout 2008. In the meantime, we expect the central bank to be on the look out for a possible contamination of inflation expectations, which have drifted higher.

Until now, there is some evidence of an actual deceleration in several indicators, coming from very high levels in 2006.  For example, real retail sales (excluding fuel) have slowed from rates of growth of 16-18% during 2H06 to 6% at the end of 2007. Something similar happens in the case of industrial production, as it is coming down from growth levels of 15-17% to 8% during the same period. The slowdown in domestic credit is less noticeable, particularly in the case of corporate credit, but during our recent visit to Bogota, we were told that banks are tightening the screws on new lending. In other words, the economy is decelerating indeed but probably needs to slow some more to make Banco de la Republica comfortable with a decision to halt its rate hikes.

We sense some unease within Banco de la Republica regarding growth overseas, particularly in the US, and its impact on export demand. Although export growth does not show signs of abating, the central bank is worried about the US economy taking a sharper downturn, as well as some softening in Venezuelan demand for Colombian products. This is a major uncertainty on export demand and thus on GDP growth.

There is no help coming from the fiscal side. 2007 probably saw the best in terms of Colombia’s fiscal performance, which is set to deteriorate in 2008. In particular, primary expenditure by the central government is set to grow by 18.5% this year, hardly a tight fiscal stance needed to reduce Colombia’s twin (fiscal and current account) deficits.

Banco de la Republica’s Challenges

For 2008, only 17% of the analysts surveyed by the central bank thought that it was possible to reach the inflation target. We suspect that this percentage came down further after the first two inflation releases of the year.

The first challenge Banco de la Republica faces is to decide when to stop hiking its intervention rate. We argue that this is a hard call, but that the central bank is not quite ready to stop; it is only to pause for the rest of the semester. This is so because Banco de la Republica would like to make sure that the economy is decelerating at a rate consistent with a dissipation of aggregate demand pressures on inflation. But it wouldn’t like to run the risk of over-tightening monetary policy either, in the face of a severe food shock that’s driving headline inflation up.

The other challenge Banco de la Republica is likely to face is the (lack of) credibility of its inflation target. What should it do? It is too risky to give up on the target so early in 2008, particularly after missing the previous year’s target, and despite the high likelihood of not reaching it again. The central bank needs to anchor inflation expectations, which have remained surprisingly well behaved throughout this episode.

Therefore, in the meantime, we are likely to start fielding questions from investors such as: should Banco de la Republica drop its inflation target? Should it define a new target? Should it target a different inflation measure? We don’t have easy answers for these questions, but an interesting resolution for the central bank is to emphasize the longer-term nature of its ultimate inflation target (3%), and insist on the reasons why it has not been able to make progress over the last 14 months.

Bottom Line

We contend that Banco de la Republica is near the end of its monetary tightening campaign.  It has been aggressive hiking its intervention rates, but has also been facing strong headwinds in terms of a severe food price shock and inflationary pressures coming from sturdy domestic demand.

We expect the economy to keep decelerating throughout 2008, so as to bring some relief to the monetary authorities.   However, this development won’t be enough for inflation to converge to Banco de la Republica’s target.

Instead of keep hiking its intervention rate ad infinitum, we are of the view that Banco de la Republica will be wary of going for an inflation overkill, particularly when it has doubts about the extent of deceleration of economic activity abroad.

We thus expect one more hike by Banco de la Republica in 2H08 to 10%, probably supplemented with an increase in reserve requirements on bank deposits. Still, it will have a lot of explaining to do so that its inflation-targeting regime keeps inflation expectations in the economy well anchored.

 

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United States
Review and Preview
March 18, 2008

By Ted Wieseman | New York

Treasuries posted big long end-led gains over the past week and a significant bull flattening of the curve, as a brief bout of optimism on Tuesday following yet another unconventional policy response from the Fed turned sharply in the other direction over the rest of the week, especially following the Fed’s Friday bailout of Bear Stearns, which just Monday had vehemently denied that it was facing any liquidity problems.  The Fed’s new Term Securities Lending Facility (TSLF) should help dealers finance positions in illiquid private label mortgage securities and probably increase confidence that funding issues won’t arise in struggling agency MBS, but there’s no good reason at this point to believe that it will be any more effective than the various other, largely futile, unconventional policy measures attempted to this point or the already substantial, and soon to be more so, rate cuts in arresting the ongoing meltdown in the broad financial system.  The more conventional policy response should continue to be aggressive at this week’s FOMC meeting.  After the renewed deterioration following Tuesday’s bounce across various markets that culminated with a particularly ugly trading day Friday after the Bear Stearns rescue plan was announced, a 75bp rate cut at the FOMC meeting appears very likely and 100bp can’t be ruled out. 

Economic data released over the past week were slightly positive overall for the outlook for 1Q growth, with a better-than-expected trade report and upside in wholesale and retail inventories offsetting weakness in retail sales to lead us to marginally raise our 1Q GDP forecast to -0.2% from -0.5%.  This was of little importance, however, compared to the growing downside risks to our baseline outlook of a mild first half recession followed by a short burst of growth in 3Q as fiscal stimulus hits, then a deceleration to several quarters of sluggish but positive growth, before a sharp cyclical pick-up over the balance of 2009.  With just the brief, though at least for a day substantial, reprieve following the Fed’s Tuesday TSLF announcement, which also included an announcement that the ECB and SNB are rejoining the TAF operations (though this had no lasting impact on extremely elevated LIBOR/OIS spreads), the pressures on the banking and broader financial system reintensified as various markets resumed significant and, in many cases, illiquid and disorderly turmoil − credit, stocks, MBS, commercial mortgages, leveraged loans, interbank lending, FX; even trading in off-the-run Treasuries is becoming increasingly difficult.  And while it certainly may not end up being reflected in any meaningful way in real economies, the bouts of significant weakness seen across many Asian stock markets during the week were at least worrisome at a time when non-Japan Asia, of course led by China, is the key engine of global growth while the US sputters, with exports at this point about the US economy’s only significant source of support.

On the week, benchmark Treasury coupon yields fell 9-19bp, led by the long end, with 2s-30s falling 10bp to 293bp.  Though this was a relatively minor move after the huge steepening seen since the turmoil began last summer and the curve did steepen significantly in Friday’s huge rally off the lows hit Thursday, bull flatteners in a recession are still never a positive sign, reflective as they are of market expectations of a more protracted downturn.  The 2-year yield fell 9bp on the week to 1.43%, the 5-year 9bp to 2.34%, the 10-year 12bp to 3.425%, and the 30-year 19bp to 4.35%.  The major outperformance of TIPS seen over the prior few weeks saw a big reversal on the week, mostly on Friday after the surprisingly benign unchanged readings for headline and core CPI in February.  On the week, the 5-year TIPS yield rose 9bp to -0.08% and the 10-year 3bp to 1.00%.  Friday’s events caused a mass rush into cash, sending the 4-week bill’s bond equivalent yield plunging 39bp on the day and 50bp on the week to 1.17%.  The 3-month bill rallied 30bp on the week to 1.16%.  This wasn’t reflected in the repo market, however, with Treasury general collateral repo averaging 2.75% Friday, up from 2.03% Thursday and 2.45% at the end of the prior week, as the Bear Stearns situation might have been contributing to some dislocations.

Most major markets followed similar patterns through the week − rough Monday, big rebound Tuesday following the Fed’s announcements, renewed deterioration Wednesday and Thursday, and then major weakness Friday − to end on net modestly worse for the week as a whole but with a very negative trajectory coming out of Friday.  Treasuries followed an inverse pattern as flight-to-safety trades and more fundamentally based reassessments of the impact of market developments on the economic outlook swung back and forth.  Intraday volatility was very high across many markets as trading liquidity appears to be broadly suffering.  In the interest rate space, swaps were a stand-out performer relative to most other markets.  The benchmark 5-year spread narrowed about 16bp on the week to 92.5bp, after seeing only a marginal widening after Tuesday, and the benchmark 10-year spread narrowed 15bp to 81bp, building slightly on a big Tuesday move through the rest of the week.  Agency MBS continued to show extraordinary intraday and day-to-day volatility.  Big further underperformance versus swaps continued Monday and into early on Tuesday, followed by a huge rally the rest of the day Tuesday and into the first part of Wednesday after the Fed’s TSLF announcement eased fears that funding issues, which have not been a significant problem to this point for agency MBS, could develop.  Significant renewed worsening then followed through the second part of the day Wednesday, continuing into Thursday and Friday.  Net underperformance to swaps on the week ended up being relatively small, but the trajectory over the second half of the week was much worse.  If this continues, in our view, a strong case would remain for the Fed to begin sizable, permanent direct purchases of agency MBS securities, which is perfectly within its legal right to do, even though for some time it has confined its permanent open-market purchases only to Treasuries.  The blowout in MBS spreads has had a significant, direct impact in short-circuiting the Fed’s attempts to stimulate the economy through rate cuts − according to Freddie Mac’s national survey, the average 30-year fixed mortgage rate has risen 65bp in the past seven weeks and is now almost unchanged from when the Fed began cutting rates in September − and as illiquid as this market has become, direct Fed intervention could have a major, immediate positive effect. 

Key risk markets followed similar trajectories through the week.  As of late Friday trading, the 5-year investment grade CDX index was 13bp wider on the week at 191bp, just off the all-time closing wide of 193bp hit Monday.  The high yield index was 2bp tighter on the week at 757bp through Thursday’s close, but the index was trading down about a half point Friday afternoon.  The S&P 500 ended the week down only 0.4%, but it dropped 2.5% following Tuesday’s huge rally.  The potential for significant commercial mortgage real estate write-downs continued to rise as the CMBX market worsened on the week.  In a reversal of recent trends, though, the higher-rated indices held in relatively well, while the low-rated indices were crushed.  The AAA index widened 2bp on the week to 263bp, the AJ index 9bp to 710bp, and the AA index 70bp to 927bp, all holding below all-time wides hit Monday (of 277bp, 753bp and 928bp, respectively).  The A, BBB, BBB- and BB indices, however, all took major losses on the week to end at all-time wides.  Through midday Friday, the leveraged loan LCDX index was 13bp wider on the week at 479bp following a 27bp worsening after Tuesday.  Given that the Fed’s TSLF plan could provide significant direct support to AAA rated private label MBS securities, including subprime, as long as it’s not on review for downgrade, the one market you might have thought would be able to buck the post-Tuesday reversal would be the AAA rated ABX subprime index.  But not only did this index fail to sustain a Tuesday rally, with the on-the-run AAA index falling 1.33 points on the week to a new all-time low of 52.09, it didn’t even see much of a rally to begin with on Tuesday, ticking up a meager half point. 

After initially moving Tuesday to price a closer call between a 50bp and 75bp rate cut Tuesday and upping the expected funds rate trough to 2% from 1.75%, there was a huge reversal in Fed pricing the rest of the week, the majority coming Friday following the severe market deterioration and surge in general systemic fears that followed the Bear Stearns announcement, that left futures at week-end pricing a good chance of a 100bp cut at Tuesday’s meeting and, for the first time, a 1.50% trough.  The April fed funds contract gained 11.5bp on the week to 2.12%.  It’s not clear exactly what this might be implying about Tuesday’s meeting and what it might be saying about the potential for intermeeting action later this month or in April, but lightly trading binary options were pointing to about a 75% chance of at least a 75bp rate cut and a 25% chance of 100bp.  Meanwhile, the May fed funds contract gained 9.5bp to 1.80%, July 13.5bp to 1.635%, and low-rate October 17.5bp to 1.55%.  A 17.5bp drop in 3-month LIBOR on the week to 2.76% didn’t keep pace with the near-term Fed repricing, sending the 3-month LIBOR/3-month OIS spread up 5bp on the week to 82bp, a four-month high, after a huge reversal from what had been initially a very positive reaction to Tuesday’s Fed announcements that sent this spread down to 60bp.  The extraordinarily elevated and rising LIBOR/OIS spreads remain a key symptom of the intensifying stresses on the banking system.  Eurodollar futures gains were long end-led, in line with the Treasury curve move.  The reds (Mar 09 to Dec 09) gained 26.5 to 28bp, resulting in a modest further scaling back in rate hiking expectations next year off the expected trough in rates in the second half, with the Sep 08/Sep 09 spread falling 6.5 to 49bp and the Dec/Dec spread 3.5 to 71bp. 

Worsening downside risks to the medium-to-longer-term outlook from the worsening financial turmoil were the week’s key economic developments, but incoming data did point to a slightly smaller decline in first quarter growth.  A better-than-expected trade report and upside in wholesale and retail inventories offset a weak retail sales report to lead us to boost our 1Q GDP forecast slightly to -0.2% from -0.5%.

The trade deficit widened slightly to US$58.2 billion in January from US$57.9 billion in December, with exports up 1.6% and imports 1.3%, both gains mostly a result of higher prices.  On the export side, food rose sharply as food export prices posted a record increase, and industrial materials also posted a good gain on upside in gasoline and gold.  On the negative side, recently surging capital goods exports pulled back somewhat as aircraft corrected from a record high and there was little change ex aircraft.  The gain in imports was more than accounted for by another surge in petroleum products to another record high.  In line with weak domestic demand, consumer goods imports fell sharply, while capital goods were little changed for a third straight month.  The results for the overall trade balance were in line with our forecast that net exports will add 0.9pp, the economy’s only real source of strength at this point.  Meanwhile, the surprising softness in capital goods exports, which we expect to be reversed in the coming months, led us to raise our estimate of business investment in equipment and software in 1Q to -4.5% from -6%.

Also positive for 1Q growth − but negative for 2Q − were upside surprises in inventories, with wholesale inventories jumping 0.8% and retail ex auto inventories gaining 0.4%.  We now see inventories adding 0.4pp to 1Q GDP growth instead of being neutral.

On the negative side was a continued sharp slowdown in consumer spending.  Retail sales plunged 0.6% in February as auto dealers’ receipts fell 1.9%, much weaker than the flat unit sales results, and ex auto sales declined 0.2%.  Weakness in ex auto sales was concentrated in food stores, restaurants and partially price-related downside at gas stations.  Housing-related categories − furniture, electronics and appliances and building materials − also remained soft.  Meanwhile, general merchandise posted a modest gain led by club stores, in line with the chain store sales results, and clothing stores also posted a small increase, a much better result than implied by company reports.  The key retail control category fell 0.2% in February.  Combining this worse-than-expected result with the positive implications of the lower-than-expected February CPI inflation result, we cut our forecast for 1Q real consumption to +0.3% from +0.6%.

Market developments, including any further news on Bear Stearns’ situation, will likely be the main focus in the upcoming week, which will be cut short by the Good Friday holiday and preceding early close on Thursday.  Otherwise, the FOMC meeting Tuesday is clearly the key event on the calendar.  Following the Fed’s TSLF and TAF announcements Tuesday and initially strongly positive market response, it had appeared that odds might be shifting back towards only a 50bp rate cut.  But after the renewed deterioration through the rest of the week and the particularly ugly end to the week across markets on Friday following the Bear Stearns intervention, a 75bp rate cut now seems quite likely.  A 100bp cut seems unlikely but possible at this point, though a lot could still happen over the weekend and in trading Monday and Tuesday to alter perceptions of how aggressive a Fed response is warranted.  With downside risks to the economic outlook substantial and rising, Fed policy is clearly focused almost entirely for now on fighting those risks, leaving potential upside risks to inflation to be dealt with later.  Still, the surprisingly benign February CPI report likely does provide policymakers more comfort at the margin as they think about how aggressively to act Tuesday.  On the other hand, concerns about the collapse of the dollar may be rising.  A measured, orderly decline in the dollar was likely considered a meaningful net positive by policymakers for some time.  But the rising risk that the decline could continue accelerating and turn disorderly clearly is not a welcome development, and policymakers could have some concerns about exacerbating the situation with increasingly aggressive rate cuts.

The economic data calendar in the coming week is fairly light.  The Empire State manufacturing survey Monday and Philly Fed Thursday will set initial expectations for the March ISM, while initial jobless claims this week will cover the survey period for the March employment report and help guide early forecasts for payrolls.  Other notable releases due out include industrial production Monday, producer price index and housing starts Tuesday, and leading indicators Thursday:

* Following three consecutive monthly upticks, we expected to dip 0.1% in February.  Outside of a modest rebound in motor vehicle output, the softness in production appears to have been broadly based.  The sharpest declines are expected in categories such as wood products, furniture, apparel and printing.  Finally, the volatile utility category is expected to post only a modest weather-related gain.

* We look for a 0.3% rise in the overall PPI in February and a 0.2% gain ex food and energy.  Both the food and energy categories are expected to post far more modest gains than seen in January, which should lead to some moderation in the headline PPI for February.  The core is also expected to show a somewhat more modest advance than seen last month, highlighting the fact that at least a portion of the rise seen in January was likely due to inadequate seasonal adjustment.  However, the tobacco component represents a possible wildcard this month.  There were reports of a jump in cigarette prices at the wholesale stage last month, but this was not captured in the PPI data.  And it‘s worth noting that the tobacco component now accounts for a sizeable 6% of the core PPI.

* We expect housing starts to fall to a 0.95 million unit annual rate in February.  The labor market data for February pointed to a further decline in residential construction activity.  So, starts are expected to slip below the 1 million unit pace for the first time since 1991.  Indeed, we continue to believe that a significant further pullback in homebuilding will be necessary to bring the inventory of unsold new residences into better alignment with demand.  In fact, we look for an additional 20-25% decline in starts over the balance of the year.

* Based on currently available components, the index of leading economic indicators is likely to fall 0.1% in February, which would be its fifth straight monthly decline – a run not seen since the July to November 1990 interval (note: the 1990-91 recession began in July 1990).  The biggest negative contributors are likely to be jobless claims, supplier deliveries and consumer confidence.  A sharp rise in the money supply and a steeper yield curve should provide some positive offset.

 

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