United States
Business Conditions: Sustainable Improvement or False Dawn?
June 16, 2008

By Richard Berner & David Cho | New York

Building on May’s increase, business conditions improved further in early June, with the Morgan Stanley Business Conditions Index rising seven points to 43%. While the index remained below the 50% threshold separating growth from contraction, this month is the second straight rise, netting to a 15-point gain from April’s low. What’s more, the June reading is the highest since October 2007, and even a 3-month moving average of this volatile indicator rose to a 2008 high. This good news seems to confirm better-than-expected recent data on retail sales, capital goods orders, exports, and nonresidential construction.

Does this bullish combination suggest that the US economy is finally and sustainably on the mend? We strongly doubt it. Although there’s no mistaking the strength of recent data, all our analytics point to further weakness and suggest that this two-month improvement is just another false dawn. Here’s why.

The Case for Improvement

The macro case for improvement certainly has merit; after all, significant monetary and fiscal stimulus is in place, and they may now be overwhelming the headwinds facing the economy. And the vitality of global growth, which has long fueled an improvement in US export performance, seems so far intact. Bulls examining details of the June MSBCI canvass could cite several corroborative details. Echoing the narrowing in corporate credit spreads, our credit conditions index jumped 12 points to 45%, or the highest reading since the credit crisis began last summer. Our expectations index − a gauge of analysts’ sentiment − jumped 7 points to a 2008 high.

There’s more: Hiring plans doubled in June to include more than one-third of respondents, while capex plans increased to 50% − the highest level since January. Likewise, advance bookings held steady in June over 50%, and analysts have turned more positive on margins and earnings. Whereas in May, 46% of analysts expected margins to shrink at companies they cover, in June that share shrank to 30%. And while in May analysts expecting downside risks to earnings outnumbered those anticipating upside by nearly three to one (73% versus 27%), in June that proportion was almost evenly split (44% now look for upside risks versus 56% who see downside).

Energy and Materials Mask Weakness Elsewhere

Nonetheless, we think the case for renewed weakness is stronger. Among the headwinds: higher energy prices, an ongoing housing downturn, falling home prices and tighter financial conditions (see “The Double-Dip Supply Shock,” Investment Perspectives, June 12, 2008). The housing downturn is well advanced, but some of those forces − such as the most recent escalation of energy quotes − have yet to hit consumers, let alone business conditions. Indeed, consumers seem now to be defending their life styles with a combination of tax rebates and previously-arranged home equity and other lines of credit. None of these sources of wherewithal is sustainable. By design, the rebates are one-time boosts to income. And lenders are growing increasingly reluctant to extend new credit.

Moreover, there’s less to the breadth of the upswing in the aggregate MSBCI than meets the eye. Energy and materials producers are on a tear, not surprisingly, as conditions improved dramatically in those groupings. But except for IT, their strength comes at the expense of many other industry groupings that are energy and materials consumers. Conditions worsened significantly in consumer discretionary, financials, industrials, healthcare, and utilities. Expectations deteriorated in those industries as well as in telecommunications services and utilities.

That dichotomy widened the gap between our two major industry subindexes. All the June improvement came in the manufacturing subindex, which jumped 14 points to 61% (not seasonally adjusted), while the services subindex slipped two points to 29%. Likewise, bookings improved in materials, energy and IT, but deteriorated elsewhere. Hiring improved in energy and showed steady growth in healthcare, IT and materials, but worsened elsewhere. Hiring plans improved in energy, healthcare, IT and materials, but deteriorated modestly in others. Capex plans improved in those same industries, as well as utilities and consumer staples, while they deteriorated sharply in most others.

The pricing conditions index rose to a record high 75% in June, reflecting rising energy, commodity and import prices. A record two-thirds of respondents said that companies under their coverage raised prices, and 46% said they raised them by 3% or more. Sellers in energy, materials, consumer discretionary and healthcare all raised prices significantly. Prices declined in IT and telecommunication services.

Earnings Expectations versus Reality

Earnings optimism is broader based: Analysts expect margins to expand in energy, materials, utilities, healthcare and IT. Some of that likely stems from current pricing power: 53% of analysts reported in June that companies under their coverage raised prices as fast as or faster than their costs. In our experience, such analyst optimism typically outpaces reality, although a sluggish economy has narrowed the gap. More importantly, with the economy turning sluggish and operating rates slipping, such pricing power seems unlikely to last. That will put pressure on margins. Indeed, the quality of those earnings is becoming more dispersed, with sharp increases in the number of analysts reporting better or worse quality, and far fewer reporting no change.

For their part, market participants should heed the Hobson’s choice in this report, given today’s rising inflation concerns. If the improvement in business conditions is sustainable, earnings expectations might be realized, but concerns about inflation would likely escalate, in turn fueling expectations of Fed tightening and pushing up bond yields still further. Conversely, if the improvement fizzles, as we expect, there’s much more downside to earnings compared with today’s elevated expectations. Either way, risky assets may suffer.

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Currencies
A Monumental Petro-Wealth Transfer
June 16, 2008

By Stephen Jen | London

Summary and Conclusions

We are witnessing a monumental transfer of wealth to oil exporters, which may last beyond our generation.  There will be important geopolitical and security implications.  In this note, we highlight some of the economic and financial implications of this wealth transfer. 

The Size of the Wealth Transfer

High and rising oil prices are the crux of many macro issues that are important to investors today.  The outlook of the global economy, inflation and monetary reactions are all predicated on the trajectory of oil prices; none of these issues is close to being resolved, because the outlook for oil prices is so uncertain.  High oil prices also lead to large wealth transfers from the world to the oil exporters.  While this notion is well recognised, we provide some broad figures for your consideration. 

Saudi Arabia, at today’s oil prices, is enjoying oil export receipts of some US$1 billion a day.  Total daily oil export receipts are roughly US$2.0-2.5 billion for the GCC, non-GCC OPEC and non-OPEC exporters. 

If oil prices don’t retreat back to the low double-digit levels, oil exporters will enjoy a massive wealth transfer from the rest of the world.  As a rough calculation of the size of this transfer, we compute the market value of the proven oil reserves in the various groups of oil exporters. 

At US$120 a barrel, the six GCC countries have US$58 trillion worth of proven oil reserves.  If oil prices continue to rise, obviously the proven reserve valuations increase commensurately.  At today’s oil price of US$135 a barrel, the stock of the GCC’s oil wealth is around US$65 trillion.  (This averages out to roughly US$4 million per citizen, or US$20 million for a family of four, though in practice the oil wealth will not likely be distributed in this way.)  As a reference for comparison, the world’s total public equity market capitalisation is around US$50 trillion. 

Economic and Financial Implications

There are several important economic and financial implications from such a wealth transfer: 

•           Implication 1.  High growth and high inflation.   Large balance of payments (BoP) and fiscal surpluses have led to high growth in domestic demand in the GCC.  The rapid build-up of aggregate supply, however, has been compromised by infrastructural constraints – mainly housing, as inward migration of foreign workers has been large.  Inflation, therefore, has roots in demand as well as supply.  As a result, inflation should not be dealt with via interest rates alone.  In most of the six GCC countries, CPI inflation is now double-digits: 14.8% in Qatar, 11.6% in the UAE, 11.5% in Oman, 10.4% in Saudi Arabia, 10.1% in Kuwait and 2.7% in Bahrain.  Policymakers have been trying to develop ‘downstream’ sectors related to oil and gas, so as to ‘broaden’ the hydrocarbon industry.  (This has been a policy objection throughout the GCC, but in Saudi Arabia, six cities will be created to centre on various ‘downstream’ industries related to oil.)  At the same time, policies are being put in place to encourage the development of private companies in the non-oil sectors to add to the family companies that have already thrived in these economies. 

•           Implication 2.  Pressure on the currency pegs.   As we have written in the past (see Delay in GCC’s Monetary Union Raises Reval Risk, February 7, 2008, and A Managed Float Is the Ultimate Goal for the GCC, November 21, 2007), we believe China’s move from a pegged regime to one that permits greater monetary independence might serve as a blueprint for the GCC.  Caught in the policy ‘trilemma’, the GCC will be unable to tame demand-oriented inflation unless interest rates can be raised to positive levels.  The sustainability of the current pegged regime is a function of social and political tolerance for the divergence between the ‘haves’ and the ‘have-nots’.  Negative real interest rates fuel asset price inflation as well as goods price inflation – the former helps the ‘haves’ while the latter hurts the ‘have-nots’.  So far, GCC governments have tried to offset the impact of goods price inflation through transfers and subsidies on various products.  Public sector salaries have been raised significantly to compensate for high and rising inflationary pressures.  They have also tried to ease inflationary pressures through postponement of public projects, allowing more building materials to be channeled to the private residential sector. 

•           Implication 3.  SWFs as the primary vehicle for capital expatriation.  OPEC’s C/A surplus is likely to exceed US$500 billion this year.  Much of this savings surplus, as well as capital inflows, will be expatriated through SWFs.  Our calculations show that oil-exporting SWFs now have about US$2.3 trillion in assets under management, and that this figure could exceed US$3.3 trillion by 2010.  In contrast to two or three years ago, when the world’s savings deficit was concentrated in the US and the US C/A deficit absorbed some 80% of the world’s C/A surpluses, right now the world’s C/A surpluses are much more concentrated, with the oil exporters and China being the main surplus countries.  The oil exporters are already highly reliant on SWFs as the main channel through which capital can be sent back out to the foreign financial markets. 

•           Implication 4.  Depressing global real interest rates.   The world still suffers from a problem of excess savings, in our opinion.  As the US C/A deficit shrank (now below 5% of GDP, and expected to reach only 4.5% of GDP by year-end), the trajectories of the C/A surpluses of oil-exporting countries and China are fairly robust.  This combination of a sharp decline in the US savings deficit and large savings surpluses in several parts of the world, including oil exporters, suggest that the world’s real interest rates should fall to equilibrate the world’s savings and investment.  The G10 10Y real interest rate has just set a generational low of 1.35% – roughly half as high as the potential growth rate of the G10 economies.  Another way to understand the low real yield is that the marginal propensity to consume is lower for the oil exporters than it is for the oil importers, despite the large spending on infrastructure by the former.  As wealth is transferred from the latter to the former, the world’s interest rate should fall.  Yet, another way of thinking about the low yields in the world is that SWFs could have invested their new proceeds in relatively safe sovereign bonds, waiting to deploy the capital into risky space when the global economic conditions improve. 

Thoughts on the GCC Currency Pegs

We believe that most GCC governments are still committed to the USD pegs for the time being, and the reiteration of this commitment by Saudi Arabia, the UAE and Qatar last week during Secretary Paulson’s tour of these countries is credible.  Most of the GCC countries emphasise ‘supply-driven’ inflation, and have the view that as long as growth holds up, a bit of inflation would be tolerable for now.  However, over the medium term, the GCC’s dollar pegs will almost certainly be replaced by more flexible regimes, with or without a monetary union.  We believe that there is meaningful risk of one or more GCC countries adjusting their pegs beyond 2008. 

Bottom Line

We are witnessing the beginning of a monumental transfer of wealth to oil-exporting countries that may last beyond our generation.  Saudi Arabia is earning more than US$1 billion a day from its oil exports, and the GCC hold some US$65 trillion worth of oil reserves, most of which will one day be consumed and the GCC will have converted oil into paper assets of this amount.  There are geopolitical, economic and financial consequences from this wealth transfer.

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Emerging Markets
Central Europe: FX Loans Give Central Banks Plenty to Worry About
June 16, 2008

By Pasquale Diana | London

Stabilization, but no credit crunch in Central Europe yet. The global credit crunch is well underway, taking a heavy toll on debt-laden economies (the US, UK, Spain) and driving down house prices. This note looks at credit dynamics in Central Europe (we look here at the Czech Republic, Hungary, Poland and Romania), a region where large investments of foreign-owned banks in underdeveloped banking sectors have resulted in fast loan growth over recent years. The available data thus far suggest stabilization of credit growth, but no sharp slowdown yet, either in the household or the corporate sector. At most, we are seeing stabilization of growth at very high rates. However, the headline numbers do not tell the whole story. Looking at the details, it appears clear that in some countries most new loans, especially to households, are FX-denominated. These borrowers, attracted by lower interest rates and monthly repayments of FX-denominated loans, are not naturally hedged, and are therefore exposed to currency fluctuations.

Romania and Hungary stand out as clear macro risks. Fast expansion of FX-denominated loans is particularly pronounced in Hungary and Romania, where they now account for around 60% and 55% of total household loans, respectively (but the share is steadily rising), and for nearly all of new mortgages. To be sure, FX lending has expanded very quickly in other countries in Eastern Europe that we do not specifically look at in this note (the Baltics, Bulgaria). However, at least in the Baltics we are seeing some clear signs of slowdown of credit growth. And unlike the Baltics and Bulgaria, neither Hungary nor Romania has a currency board or pegs. Having floating exchange rates allows the economies to adjust, but also leaves borrowers exposed to currency swings.

Looking at a range of vulnerability indicators, Romania and (to a lesser extent) Hungary do not fare well. They have sizeable current account deficits, financed only in part by FDI inflows. This leaves FX borrowing (and in Hungary’s case, bond purchases by foreigners) as the main source of C/A financing. As seen, credit growth is still robust in both, and a large portion of that is made up of FX loans. In Romania’s case, wage growth close to 20% and high growth and inflation point to significant dangers of overheating. In Poland, fast credit growth is a clear concern, though we note that FX loan growth has already eased and the size of external imbalances and the quality of funding do not look worrying yet.

To the extent that borrowers are making a choice between an FX loan and a local currency loan and taking exchange rate risk into account, there should be no great cause for panic. However, central banks across the region have sounded increasingly concerned about the accumulation of FX liabilities on the household side, pointing out that neither commercial banks nor their clients (borrowers) might have adequately accounted for all risks. Recently, for example, the National Bank of Hungary has warned banks and borrowers against excessive JPY loans. And in Romania, the NBR raised the minimum reserve requirement ratio on FX liabilities (to 40%) two years ago and recently adopted additional prudential rules for unhedged FX borrowers. These measures have not had much effect, so far.

We think that there are three macro dimensions of why the expansion of FX loans in the region matters:

•           First, financing of external imbalances. In countries where these FX loans represent the main source of funding for wide external imbalances, a credit crunch affecting Western European banks would likely dry up funds available to their eastern European affiliates. Given lack of financing, the C/A imbalances would reduce sharply (as is happening in the Baltics), as consumption and import growth are hurt by the credit squeeze. At the same time, these currencies would be severely hurt by the funding pressures on the BoP – this would intensify credit problems by increasing mortgage repayments, and trigger an even sharper credit retrenchment; it would also fuel inflation, which is well outside central banks’ comfort zones across the region. For this reason, we think that both the National Bank of Hungary and the National Bank of Romania will raise rate aggressively and intervene in the FX market in order to avoid excessive FX corrections (these are ‘NBH/NBR puts’ so to speak).

•           Asset prices at risk of correction. A severe credit crunch would put significant downward pressure on house prices, assuming (as we believe) that increased credit availability was instrumental in explaining the sharp house price growth seen in parts of the region over recent years. In effect, the demand side of the housing equation will weaken sharply – and asset prices would adjust as a consequence. Broadly, this is what has happened in the Baltics, where house prices are already reported down 10-20% from the peak.

•           Third, efficacy of monetary policy is reduced. A more medium-term issue, but nevertheless a central one for monetary authorities: the expansion of FX loans means that the traditional credit channel is fast losing its efficacy. Indeed, for those that borrow in CHF, EUR or JPY (Hungary) or CHF or EUR (Romania), it is monetary policy decisions taken elsewhere that matter. Moreover, in a situation where the central bank hikes rates to cool down the economy (and strengthen the currency), an undesirable side-effect is that even more FX borrowing is encouraged, as the domestic-foreign rate differential widens further and borrowers incorporate currency gains into their expectations – thus finding it even more advantageous to borrow in FX and play the ‘carry trade’.

Outlook: Credit Growth Will Likely Moderate, Not Collapse

Credit intermediation in these countries remains low by international standards (private sector credit is over 140% of GDP in the euro area, versus 40-50% in Central Europe), so it is plausible to assume that, in the medium term, credit growth as a share of total GDP will rise towards Western European levels as real incomes catch up. In the near term, we use the recently published senior loan officer surveys to gauge likely developments in credit. The evidence is not uniform:

•           In Hungary, loan officers reported that increased competition for new business is motivating banks to launch new, riskier products, and they expect to further ease credit standards for household loans (FX housing loans in particular), despite a slight deterioration in portfolio quality. In the corporate sector, banks expect somewhat tighter credit conditions. As the NBH noted, these results stand in contrast to similar surveys carried out in the euro area and the US, which show a clear trend towards tighter household lending conditions in those countries.

•           In Poland, loan officers expect tighter credit standards in granting housing loans and, for the first time in the history of the survey, expect tighter conditions for granting consumer loans. In contrast, they expect a slight easing of lending policy towards corporates.

While elsewhere in the region we do not have similar surveys, our recent visit to Romania indicates similar dynamics as in Hungary: namely, while credit growth might have peaked, it is unlikely that it will slow down markedly, as banks continue to aggressively compete for new customers and credit intermediation is still low. Our base case scenario is that credit growth should moderate slightly in the region, but a crash is unlikely. The main risk is that a severe crunch in Western Europe forces parent banks to cut funding aggressively to subsidiaries in Central Europe. If that were the case, growth would be hurt quite severely across the region, and countries where consumers are already facing weak disposable income growth, such as Hungary, would probably enter into recession. A credit slowdown in Romania and Poland, countries where growth is primarily driven by consumption and investment, would help to correct external imbalances. Provided the credit slowdown is not severe (unlike the ongoing crunch in the Baltics), this would be a somewhat reassuring development in Romania, where the current account deficit has only recently begun to stabilize, but remains substantial by regional standards.

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