Israel
Israel: Trip Notes: Further Tightening on the Way
May 30, 2008

By Tevfik Aksoy | Istanbul

We visited Tel Aviv and Jerusalem to meet with Bank of Israel (BoI) officials as well as economists and market participants from local financial institutions. Our general view, which was partially confirmed by the BoI’s recent rate hike of 25bp, is that risks on inflation remain to the upside, as suggested by the recent CPI data, the ongoing rise in oil prices and limited stability in food prices, coupled with surprisingly strong domestic demand. Contrary to the BoI’s previous assessment, indicating a high risk of spillover to the Israeli economy from a sharp slowdown in US growth, both exports and domestic activity remained buoyant, at least so far this year. While this risk clearly remains, and is especially contingent on the duration of the challenges surrounding the US economy, we will continue to watch for some convincing evidence that GDP growth is being affected noticeably in order for the output gap to play a supportive role. We expect CPI inflation to exceed 5%Y in the coming months (against the 1-3% official target band), and we have recently revised our policy rate call by a further 25bp to a 4% terminal rate for 2008. In light of the recent data and our discussions in Israel, we believe that the upside risks to our 50bp call in the coming months might go even higher. That is, it would not be surprising to see the BoI continue to hike until inflation expectations improve.

Inflation Is Now Broad-Based

Inflation reached 4.7%Y in April, surprising both the market and the BoI, in our view. Contrary to the earlier stages of the year where food and energy prices were seen as the main drivers of inflation, April data suggested more broad-based inflation: the consumer price index – excluding energy, food and fruit & vegetables – rose by 2%Y, some 0.9pp more than the previous month. During our discussions with BoI officials, there was consensus that the inflation environment had deteriorated noticeably. Moreover, the officials attested to the fact that inflation expectations have worsened and that the BoI had to take action (either by hiking or with strong wording); we consider the recent hike of 25bp as an encouraging step forward.

Regarding the real exchange rate, the BoI officials were open about how striking the appreciation has been recently. Essentially, the real exchange rate had been following an appreciation trend since late 2005, but the dramatic move since mid-2007 seems to call for additional scrutiny, especially considering the stagnant picture on the productivity front and rising wages

Growth Remains Strong, but Some Leveling Off Is Expected

The GDP data for 1Q08, which pointed to a seasonally adjusted and annualized 5.4%Y growth, were clearly a surprise to the market analysts, as well as to the BoI officials. The inflating factor of import taxes on GDP growth had been pointed out (excluding this, the GDP growth rate eases to 4.2%Y) by various contacts. However, there was no dispute that private consumption growth of 14.1%Y and export growth of 12.6%Y were indicative of strong domestic demand and lack of a noticeable impact of the appreciation of the shekel on competitiveness. In fact, the officials attested to the fact that the main driver of Israel’s exports is the world demand for the high-tech sector (in particular, that of the US) and not the real exchange rate. On that note, both BoI officials and local economists had been content with the resilience of demand for the high-tech products and services in the US, despite the overall weakness. On the other hand, imports are much more dependent on the level of the shekel: the BoI believes that it might take 1-2 quarters for the changes in the policy rate to affect the real exchange rate. Hence, it might take a while for the delayed impact of the ILS appreciation on imports to be seen in full. However, the officials continue to believe that the economy cannot sustain the ongoing momentum as is (we agree) and that the US slowdown is likely to result in a slowdown in growth later this year.

Unemployment at its Lowest Level Since 1996

With 1Q unemployment data coming out at a seasonally adjusted 6.3%, there seems to be further evidence of tight labor market conditions since the data pointed to the lowest unemployment rate since 2Q96. While there is an argument that a reason behind the decline in the unemployment rate was the weaker labor force participation rate, we are not fully convinced, given the rise in wages.

Remarkable Performance on Tourism

Meanwhile, the tourist arrival data had been remarkable this year, with the total number heading to a record high. Besides the positive impact of this on the balance of payments, the vibrant tourism sector essentially creates job opportunities for the uneducated segment of the population (where unemployment is the highest).

A Somewhat Mixed Picture on Growth and Inflation

Economists at local banks had various divergences in forecasts, but in broad terms there seemed to be consensus in general macro conditions. For instance, there was consensus among economists that inflation will ease to within the 1-3% band in 2009, while 2008 might witness persistently high inflation outside the target band. Forecasts ranged around 4% for 2008 and 1-2% for 2009.

The growth story was somewhat mixed, with a common view of more than 4% real growth this year that is expected to slow down in 2009 (either sharply or gradually, depending on assumptions), on the back of a stronger currency, weaker exports, delayed impact of the US slowdown, higher BoI rate and weaker private consumption. Especially in 2009, some economists expect knock-on effects of slower exports growth on fixed capital formation (lower machinery and equipment orders), leading to a decline in overall demand with a lack of support from wealth effects.

As attested to by April inflation data, the inflation of the recent past seemed to be more broad-based. As one economist pointed out, the deviation of inflation forecasts from the actual data (expectations consistently underestimating the actual figures) had not only stemmed from the Shekel-housing price link, but also related to an overall demand-pull inflation, a view with which we concur.

Regarding the policy rate, local economists diverged with their expectations for 2009 in a sense that some expected a hike and some expected a marginal decline. This was essentially a reflection of the view regarding their growth outlook. On the other hand, they seemed to all expect the ongoing hikes to continue by a further 25-50bp this year.

Fiscal Picture Seems Benign for the Time Being

The fiscal picture was generally seen as benign and under control as the realizations so far this year had been in line with the budget deficit target of 1.6% of GDP for 2008. This had clearly given the BoI comfort so far, and we got the impression that the fiscal matters might not be an issue until later this year. However, both the BoI officials and economists we met gave the heads-up for the July-August 2008 period when the budget discussions for 2009 would commence. Our sense is that the future path of fiscal policy might become a source of partial concern, given the fact that 2010 is an election year, which might make 2009 a candidate for looser fiscal policy. In addition, tax revenue growth might decline noticeably, in case the expected slowdown in GDP growth materializes next year, leading to a noticeable budget deficit. We believe that weaker performance on the privatization front (the pipeline is rather empty), less-than-ideal conditions to borrow from abroad and a widening in the budget deficit might automatically suggest rising risks of increased issuance in domestic markets.

A Close Call Between a 25bp and a 50bp Hike?

Looking forward, we expect the BoI to raise rates by another 25bp at its June 26 meeting, followed by an additional 25bp in 3Q. At that point, the BoI could keep rates unchanged for a while. The risk to this view would be prolonged strength in private consumption and overall demand pressure on prices, as well as a continuation of broad-based inflation that could force the BoI to hike more. We expect the policy rate to rise gradually to 4.50% at some point in 2009, parallel to our expectation of a tightening in the US fed funds rate.

Japan
Buy Japan on Inflation?
May 30, 2008

By Takehiro Sato | Tokyo

Foreign Investors Are Becoming Constructive on Japanese Equities

The Japanese stock market has held firm since late March and outperformed the European and Asian markets despite negative micro (corporate earnings) and macro (economic data) news flow. We have also heard some positive feedback about Japanese stocks from foreign investors recently. These investors think that Japan is best-positioned to benefit from inflation as the economy moves from deflation to inflation. Textbook economics teaches correlation between stock prices and inflation as well as an inflation-hedging function for stocks. Investors hence are inclined to purchase stocks during inflation.

Yet, we have a solid argument against this stance. It is true that demand-pull inflation can help corporate earnings and stock prices, since the volume effect more than offsets the reduction in corporate margins. However, Japan has not experienced an upturn in domestic demand recently, and is exhibiting modest stagflationary conditions, with cost-push inflation narrowing both corporate margins and the volume effect. Real wages have stalled due to price increases and corporate profits are heading lower. These trends should keep investors away from stocks. Which view is correct?

Reasons for Buying Japan

Our Japan equity strategist expects instability through early July followed by improved fundamentals and a TOPIX upturn toward 1,600 points by year-end on the basis that “a lag exists between a temporary rebound and a rebound based on fundamentals data, and the market could trade near bottom levels during the transition period” (see Japan Strategy: Outlines of a Market Rebound Emerging, May 2, 2008). Meanwhile, we advise a cautious stance for a somewhat longer period (though predicting the stock market is not an economist’s job).

We attribute the firmness of the Japanese stock market to foreign investors raising their asset allocation. Investors are looking for reasons to expand their exposure to Japan after underperforming the index thus far in 2008, with steep underweight positions for Japan since last year. This explains equity investors’ rising concerns for Japan’s long-term interest rate trend. The sharp rise of the long-term rate in late April had a substantial impact on foreign investors and generated extensive inquiries our way. Recent market comments by our equity sales teams have also made quite an impression on us, maintaining that the upswing in long-term interest rates is lifting stock prices. Such comments are asserting that the steepening of the yield curve that occurs with higher long-term interest rates strengthens bank earnings, and signals that investors should purchase bank stocks and other Japanese stocks.

Yet, the cause-effect dynamic is the reverse. Healthy curve steepening occurs when stronger corporate and personal capital demand boosts loan volume to a level where banks make a decent profit. Loan value is actually increasing at a moderate pace of 1%Y, with support from refinancing demand at regional public entities. However, banks are taking a stricter lending stance mainly toward small businesses and are unlikely to achieve robust loan growth.

Bond portfolio managers at Japanese banks are amused by this logic. The underlying implication of this justification for purchasing Japanese stocks is that investors want to expand their presence, and that the reason may not be important. The stock market hence could retain recent firmness compared to overseas markets in the very near term. What will happen after that?

Rising Energy Prices and Negative Income Transfer

From an economist’s perspective, we focus on how negative income transfer arising from US$130+ crude oil prices affects the stock market. Japan and other East Asian countries have broadly similar trade structures that involve exporting automobiles, IT goods and capital goods and importing energy and food products. We think that East Asia has sustained healthy economic activity, despite US$100+ oil prices, with support from positive income transfers from oil-producing countries such as kickbacks through plant and large development project orders, and energy subsidy measures that restrict gasoline prices.

What comes next? The BoJ reports income transfers from consumption countries to resource countries (trading gain/loss basis) at just under US$500 billion in 2006 (nearly JPY50 trillion at 1990 prices), with a large portion from Japan and other East Asian countries. We estimate that East Asia could transfer JPY100 trillion in income to the Middle East, Russia, Latin America and other resource countries in 2008 if the crude oil price, which is now double the 2006 price (average of around US$66 WTI) stays at the current level for the rest of the year. Besides Japan, higher energy prices inflict the most damage on East Asian countries, with poor energy efficiency and a reliance on subsidy measures.

Another concern with the crude oil price soaring above US$130 is an upturn in saving rates in resource countries receiving the income transfers (due to the saturation of demand for investment and consumption). Investment shortages for resource countries could lead to global investment shortfalls. Perfect efficiency in trade and financial markets would obviously facilitate re-investment of surplus savings from oil-producing countries in the financial markets of major countries and thereby continue driving global economic growth. Yet, markets encounter a variety of friction in the real world that creates a time lag in the spillover effect and prevents perfect efficiency. Subsidy measures in East Asian countries, meanwhile, are reaching the limits of fiscal support.

Japan does not provide subsidies for energy consumption, similar to other advanced economies, but has a cap on electricity rate increases under the fuel-cost adjustment program that restricts disorderly spikes in final prices. However, the authorities might lift the cap to assist electric power firms since crude oil prices above US$130 are cutting into margins under the cap system. Energy rates hence could rise sharply in Japan, along the lines of Korea.

Trading Losses Equivalent to 5% Consumption Tax Hike

Next, we take a closer look at recent economic conditions in the context of the above-mentioned income transfer. Japan reported a healthy 3.3% annual real GDP growth rate in Jan-Mar 2008, putting it alongside Germany, which reported surprisingly robust 6% growth for the same quarter, as a growth engine. Yet, the economy does not seem to be growing at this pace. This discrepancy stems from real income growth measured by real GNI or real GDI (distribution-side indicators for the national economy) that is well below the real GDP growth rate at less than 1% saar. We attribute this weakness to an outflow of real income (purchasing power) with the setback in trading terms, which we call trading gains/losses. Japan incurred trading losses at an annual rate of JPY26 trillion in Jan-Mar 2008. The outflow totaled JPY6.8 trillion even after counting gains from overseas dividends, interest income and other income sources. The level of the trading loss on its own constitutes a 13% consumption tax, and the impact has been equivalent to a 5pp increase in the consumption tax rate over the past year. While our European equities strategy team is recommending that investors should increase their exposure to Japan as a potential leading beneficiary of global inflation, we in Japan are not as bullish, considering the massive negative income transfer. However, Japan is likely to continue receiving favorable attention from a relative performance standpoint rather than absolute performance, if this view takes hold.

Japan is not the only economy that is confronting a major downturn in trading income. The US economy recorded modest trading gains in 2006, but this income deteriorated in Oct-Dec 2007. Recent crude oil price trends suggest that similar conditions are prevailing in the latest April-Jun quarter. China’s trading income as of 2006 had not dropped significantly, given the relatively low reliance on crude oil. Yet, the sharp rise in coal prices is possibly having an impact.

View of Long-Term Interest Rates in Modest Stagflation

Investors are closely monitoring Japan’s long-term interest rate as a factor explaining stock prices, along with stock price trends as mentioned above. They interpret the recent upswing of the long-term interest rate as a psychological symbol that deflation has ended. Yet, this logic has some contradictions.

We think that rising inflation has contributed to long-term interest rate gains to some extent, but we see correlation with overseas rate increases on a backlash to the flight to quality during the March panic and growing speculation about a suspension of US rate cuts as a stronger factor. The former occurred from an unwinding of arbitrage positions aimed at credit preservation by major investment banks concerned about hedge fund counterparty risk amid heightened global credit risk. Aggressive unwinding of arbitrage positions by relative value hedge funds that had been purchasing cheap bonds caused a heavy sell-off of 15-year floating-rate notes, CPI-linkers and other undervalued bonds, and investors moved to higher liquidity JGBs, short-term bonds and cash. This disruption pushed the 10-year rate to the 1.2% level at one point. The current long-term rate reflects an exhaustion of the flight to quality as financial market concerns retreated after the Bear Stearns bailout on March 16-17.

The latter refers to level correction for the US long-term rate with the pullback of speculation about additional Fed rate cuts, given the retreat of financial market concerns. Japan’s long-term interest rate actually moves in correlation with the US market, similar to stock prices, rather than following Japanese economic data. This dynamic is evident from the downturn in Japan’s long-term rate when the US rate drops on weak US economic data, despite the prospect of stronger upward pressure on consumer prices from rising crude oil prices.

While Japan’s long-term rate might be partially discounting for an inflationary risk premium, the inflation factor clearly does not explain the entire increase. For example, the anticipated inflation rate implied by CPI-linker prices has improved from the negative level in March but peaked recently at 0.3%. This suggests that investors are only discounting for an average 0.3% inflation rate, including a consumption tax hike, over the next 10 years. (Yet, market-conditions factors are restricting linkers’ price actions, and it might be unreasonable to assume that 0.3% is the anticipated inflation rate.)

How should investors interpret Japan’s long-term interest rate level amid growing signs of modest stagflation? Japan’s core CPI is likely to stay in the mid to upper 1% range during F3/09-3/10 with rising energy and food product prices. The real interest rate is nearly 0%, assuming a nominal rate below 2%. Does the nominal interest rate need a level correction?

Interest Rate Levels Not Enough to Assess the Extent of Monetary Accommodation

In this regard, the nominal interest rate does not necessarily rise in line with prices even in an inflationary environment. The US long-term rate offers a real-world example as it trades below headline inflation in the 4% range and suggests a negative long-term rate in real terms. We think this example highlights the importance of making a comprehensive assessment of related factors to determine whether the monetary environment is truly accommodative. Monetary conditions might not be accommodative even with very low nominal and real interest rates due to other factors, and vice versa. Other factors include trading terms and income allocation conditions, credit spread trends in financial markets and banks’ lending attitudes.

Trading terms and income allocation conditions are fairly weak, as explained. Downward pressure on trading gains from higher energy and primary product prices is hurting the purchasing power of households and companies more than indicated by GDP headline numbers. Credit spreads and bank lending stances are also creating resistance. Although credit spreads have stabilized with the retreat of excessive financial worries, the BoJ survey shows that banks are clamping down on lending to small businesses, and this trend is constricting SME liquidity. We do not find evidence of genuinely accommodative monetary conditions, despite low nominal and real rates. The reality could be the opposite.

We conclude that rising inflation is not enough to lift long-term interest rates in this environment. Japan’s distorted inflation – with an extreme reliance on energy and food product prices – is undermining real purchasing power.

Stickiness and Downward Rigidity of Nominal Wages

Finally, we point out the upside scenario under cost-push inflation. One possibility is that sustained central bank support for the real economy could reduce real interest rates further and foster a recovery in asset markets. Interest rates might emerge as a stimulatory factor at some point in this case. Lower real rates would boost economic activity by strengthening financial markets rather than the real economy.

Recovery of real wages offers another scenario. Wages are generally stickier and exhibit more downward rigidity than prices. Nominal wage hikes hence trail inflation. However, real wages could modestly recover if inflation settles down, since nominal wage gains lag any price decline. This dynamic actually played a role in overcoming the sharp recession after the second oil shock in the early 1980s. Yet, both of these are narrow-path scenarios at this stage.