Buy Japan on Inflation? (Part II)
June 26, 2008
By Takehiro Sato | Tokyo
Real Interest in Japan, as We Anticipated
As expected, we experienced real interest in Japan for the first time since 2005 when we visited the US early in the month. Investors’ response to offers of meetings was markedly more enthusiastic than for our previous visit in January, and in many cases a senior class of investor was seeking a first-hand view. Among these US investors, it is the global investors who have shied away from Japanese equities in the past two years that are the most bullish. They have noted the strong recent performance of Japanese stocks and now seem to be trying to increase asset allocation weightings for Japan, having reduced their exposure last year. The biggest bears on Japan, conversely, are the fund managers who specialize in Japanese equities. We cannot draw precise distinctions for investor categories, but generally it seems that many hedge funds are bullish and the real money managers, if anything, are tending to be cautious. Even the ‘bulls’, however, are not showing strong conviction that raising Japan weightings is the way to go, though they seem willing to get on board for the time being, even so. The bears have seen their performance suffer while maintaining underweight positions, but appear unsure that increasing exposure to Japan is wise this late in the day. The Focus Is Japan’s Inflation The investors we met would ask us without fail about Japan’s inflation outlook. When it comes to inflation, the view was nearly unanimous that what matters is not whether it’s ‘good inflation’ or ‘bad inflation’, but simply whether the decade of deflation can be put to rest. This came up repeatedly, and investigation revealed that this is the pitch investors are hearing from other brokerages recommending Japanese stocks. Recently, both inside and outside our firm, we are frequently being confronted with the view that inflation in Japan can be the touchstone for a recovery in domestic demand. I have been a consistent skeptic on this topic, and expect to remain one (see Buy Japan on Inflation? May 29, 2008). We earlier reversed the bearish view of inflation held up until March, and now are probably among the most bullish in the market about inflation, but see this simply as a case of cost-push inflation. Assuming current levels for oil price and yen rates, we forecast that the inflation rate for the Japan-style core CPI will reach 2% within this year, and might even hit 2.5% in April 2009 as the effect of fuel tax abatement disappears, but we think that the US-style core index (which excludes food and energy) will barely scrape above zero this year. So, it is mainly food and energy where inflation is expected. Looking at income distribution, we estimate that trading losses (the amount of real income flowing outside Japan due to deterioration in terms of trade) resulting from the transfer of purchasing power overseas because of rising energy and food prices will reach about JPY34 trillion annualized in the April-June quarter, some JPY8 trillion more than the figure from January-March. This is the equivalent of slapping another 4% on the consumption tax. In less than the last six months, then, Japan’s economy has been exposed to a shock of this magnitude, which makes this hardly the time to be bullish on domestic demand. With inflation for primary goods on the rise, the risk instead is that as weak domestic demand is coupled with a slowdown in Asia, which has driven Japan’s exports, the economy may drop into recession. Inflation as an Argument for Reflation A widespread view shared by proponents of reflation for Japan’s economy is that inflation encourages front-loaded consumption behavior, and would thus stimulate domestic demand. Or perhaps the gut sense that, having experienced ten years of deflation, the important thing for Japan is restoring inflation in any shape or form is gaining ground. We respond with this counter-argument. According to Ministry of Internal Affairs & Communications data, consumer prices for items purchased more than 15 times a year (mostly foodstuffs) rose 2.4%Y in April. Meanwhile, prices for items purchased less frequently than once every two years (mostly consumer durables) declined 0.9%Y. I am highly skeptical as to whether food price inflation can trigger front-loaded consumption behavior, as food is generally not an area where consumers hoard. Besides, real income which underpins consumption is damaged by rising prices, and is flowing overseas at an accelerating rate from a macro perspective, as above. If prices of durable goods were to turn up, on the other hand, it would signify secondary inflation, and this could foster expectations for rising prices among the public and lead to a general front-loading of consumption. The reality, however, is that durable goods prices are still dropping as rising input costs for raw materials are being soaked up in the manufacturing process, and an imminent turnaround looks unlikely. For example, the possibility of cost transference to automobile prices has been widely mooted in the wake of huge steel price increases negotiated with automakers by major steel producers, but with domestic demand for autos in the doldrums, it is doubtful if consumers will ultimately swallow price hikes. Productivity Gains Have the Potential to Paint a Rosier Picture? The idea that cost-push inflation can lead to a reflation story appears to rest on the belief that expanding corporate margins fed by price hikes can allow depressed real wage levels to recover. However, for non-durable goods we cannot expect a powerful volume boost from a consumption spurt even if prices rise, and if sales volumes are slumping corporate earnings would presumably come under pressure. The household survey data for January-March in fact show that real expenditure on items for which prices have risen (mayonnaise, canned seafood, bread, instant noodles) fell across the board. By contrast, real spending levels for durables (TVs, portable music and video players, PCs) showed an increase as prices continued to drop. The leap year may have pushed up consumption of durables in this quarter, but to discern a trend we must wait for April-June figures. Our forecast, by the way, is for GDP-based real consumption in April-June to be flat sequentially at best, in reaction to the brisk previous quarter. To maintain consumption levels in real terms, even under inflation, real wage levels will need to rise as a result of a productivity improvement that is commensurate with increases in input costs, and this is not likely to happen in a short span of one or two years. It is even possible that the brunt of consumption adjustment still lies ahead, and that this adjustment process has simply been slowed down in the face of the current supply shock. It would be too pessimistic to entirely discount the prospect of a new productivity revolution in Japan, however. Japan has a track record of responding to past oil crises by revolutionizing productivity. Yet even it still took three years (February 1980 to February 1983) to pull out of recession after overcoming the repercussions of the second oil crisis in the early 1980s, for example. Market Implications As we discuss below, high oil prices are a threat to Japan in the same way as they are to the US and countries in Asia, but we are firmly in line with the view that the Japanese stock market is in a relatively good position due to differences in energy efficiency and energy policy, as well as a relatively low rate of inflation. Moreover, our Japanese equity strategy team argues that the Japanese market could outperform due to a lack of downside risk from a valuation perspective. From a macro standpoint, we think that downside risk to valuations is limited because the top-down decline of 5.5%Y that we estimated for corporate earnings when formulating our economic outlook in May has now skewed upwards due to a weaker yen (our assumption as of May was for a F3/09 average of JPY103/US$). These could justify a relative performance trade buying Japan and selling Asia. At the same time, after touching on 1.9% in mid-June, more recently long-term interest rates have been looking at levels of around 1.7% as expectations of a rate hike in Japan to follow the ECB and others have retreated, with US long-term rates easing alongside a more cautious outlook for the US economy and statements from the BoJ Governor after the June MPM referring to a sense of stability . Perhaps in concert with this, expectations of reflation have currently gone quiet in the Japanese stock market, too. On the outlook for long-term rates, we see potential for revived market expectations of a BoJ rate hike between now and July-September as growth in the Japan-style core CPI rate accelerates to the upper 1% level, and for rates to have another stab at the 2% barrier, not breached for the past 10 years. Still, amid mounting risk of a global recession, towards the end of the business year we expect long-term rates to settle in the upper 1% level. Right now, stock market participants are paying increasing attention to long-term interest rates, with those who subscribe to a reflation scenario appearing to envision a positive correlation between long-term rates and share prices, mindful of the plunge in government bonds in 2003. At that time, first share prices soared, and then long-term interest rates followed. We do not question the logic of this causal association. Yet, the market at the moment seems to be hoping for a rise in share prices fuelled by growth in long-term rates, prompting reactions of either hope or concern from the stock market with every rise and fall in interest rates, which seems to turn the causal association on its head. Normally, it is only when corporate demand for funds rises and companies are able to make good on their obligations and pay back interest on borrowings that banks earn fair margins on lending and ultimately can return these in their deposit interest rates. This is where we take issue with the recent argument, whose tone is that a steepening curve will improve banks’ net interest margins. Moreover, on the idea that if nominal interest rates are constant, real interest rates will generally come down as a result of inflation – in other words, the degree of monetary easing will intensify – we would note that interest rate levels alone do not determine the extent of monetary easing or tightening. As we discuss later in relation to the US, even when interest rate levels are low, there are cases where a stricter stance on lending by commercial banks is putting pressure on the monetary environment to the same or an even greater degree than in past recessions. In Japan, too, the approach to lending to SMEs is becoming more cautious, and companies are also talking of an increasing tightening of their financial positions. Risk Factors The biggest risk factors for now are ongoing elevation of the crude oil price and deterioration of the US economy. The former constitutes a relatively serious threat for Asia, where energy efficiency is comparatively poor. According to the BoJ’s Outlook Report in April, trading losses in Asian countries had already worsened more than in Japan as of 2006, but even then Asian growth remained high because spending on subsidies for energy prices artificially dampened the sensitivity of domestic demand to the oil price. However, with the oil price now at the US$130/bbl level, the sustainability of such subsidizing policies is under threat. Our global economics team estimates that at the current oil price, subsidies amount to more than 2% of China’s GDP, over 3% in India, nearly 4% in Indonesia and 6-7% in Malaysia, in all cases making it increasingly difficult to maintain these policies. In fact, on June 19, China moved to cut some of its subsidies relating to gasoline, diesel and other fuels. If such measures to rein in subsidies served to raise the sensitivity of economies to the oil price and led in the medium term to checks on the oil price itself, that would be welcome. However, the transitional process will bring pain. There are already signs of slowing exports to Asia from real Japanese exports for April-May, and there is an increased risk of a negative net contribution of external demand to real GDP for April-June. Asia is becoming a risk factor for a country like Japan that relies on external demand. Regarding the second risk factor of the US economy, although the declaration of an effective injection of public funds in mid-March gave the financial markets a small breathing space, given a tighter approach to lending by financial institutions and stagnating employment, we think that the real deterioration of the economy is only just beginning. In other words, despite the break provided for disposal of legacy assets via marking down of subprime-related securitized instruments, there are signs of growth in default rates on corporate bonds and loans, while the delinquency rate on loans to individuals, which had already risen to a level in line with past recessions, looks set to advance still further as financial institutions tighten their lending standards. In particular, there seems to be a rush at the moment to take out loans using the slack offered by housing loan collateral where the use is not designated (HELOC, a sort of commitment line to individuals), apparently ahead of tighter lending frameworks at banks and others. However, as the lines narrow going forward, we expect growth in balances to come to a sharp halt. The US economy is basking momentarily in the effects of efforts to stimulate consumption by reducing taxes – amounting to a total of JPY106.7 billion in the household account alone. However, although this is warding off recession for now, with growth in gasoline prices also kicking in from October-December, when the effects of the tax cuts should fade, a double dip seems a strong possibility to us. Our US economics team holds such a view, and has cut its forecast for real GDP to +0.9% for 2009. We think that the only event that could overturn this cautious view on the economic outlook would be a steep fall in the oil price. A fall in the oil price would probably be accompanied by recovery in confidence in the dollar, and if the oil price did actually settle at a more affordable level, the outlook for the world economy in general, not just Japan, would sharply become brighter. If policy measures by individual countries – increased Saudi Arabian output, reduced energy subsidies in China – restored calm to overheated markets, then that would of course be welcome, but at the moment this seems like wishful thinking.
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The Double-Digit Inflation Club
June 26, 2008
By Joachim Fels & Manoj Pradhan | London
Resurrecting Marxism. Marx (Groucho, not Karl) once quipped that he would not want to belong to any club that would accept him as a member. The same probably holds true for most members of a club that we invented on our weekly internal Morgan Stanley global economics call last week – the double-digit inflation club (‘DDIC’). Sparking our decision to found this imaginary club was the fact that the number of countries with double-digit rates of consumer price inflation in our coverage universe had more than doubled from only three to seven within the last couple of months. Russia, Ukraine and Vietnam, which have had double-digit inflation for a while, were recently joined by South Africa, Turkey, Indonesia and India – yet another illustration of the rising global inflation pressures that we have been highlighting for some time now. Plenty of clubbers! Like all new club founders, we were eager to expand, so our team looked for potential entrants among economies that we do not regularly cover. Of course, we expected to find some more, but we were flabbergasted to see how many countries around the globe actually have inflation running in the double-digits. Before you hold your breath, we found around 50 countries with double-digit inflation rates. And we probably missed some more where data are hard to come by. Thus, with the United Nations (a much more established and esteemed, but less exclusive, club) listing 192 member states currently, more than one in four countries in the world are currently plagued by double-digit inflation! A few points are worth noting about the characteristics of this group: • Almost exclusively EM. DDIC members on our list, with the sole exception of Iceland, are all considered to be emerging market (EM) economies. There are several reasons why EM economies may be more prone to high inflation than advanced economies. First, many EM countries still have relatively weak institutions and central banks that are not (or not fully) independent in an environment of pro-growth oriented policies. Second, most commodity producers are EM economies, and the surge in commodity prices has led to inflationary booms in some of these countries. Third, oil and food typically have a larger share in EM consumer baskets, and surging prices for these products thus have a bigger influence on total inflation. Fourth, a combination of fast income growth and fixed exchange rates in many EM countries will naturally produce higher inflation there than in slower-growing developed countries (among themselves, economists call this the Balassa-Samuelson effect). Last but not least, with many EM economies linking their currencies to the dollar, the Fed’s aggressive rate cuts in response to the credit crisis have led to a very loose monetary policy stance in these economies, fuelling inflation pressures. • Three billion consumers affected. While our list of DDIC members includes many small countries (by population size), it also includes six of the ten most populous nations on the planet, namely India, Indonesia, Pakistan, Bangladesh, Nigeria and Russia. All club members together account for no less than 42% of world population. In other words, close to three billion consumers are currently experiencing double-digit rates of price increases! • A fairly equal distribution. The DDIC club membership is fairly diverse, not only economically but also geographically. About a dozen members each come from Africa and Latin America/the Caribbean. Asia and Central and Eastern Europe including the former Soviet republics have around ten members each, and the Middle East at least five. Thus, inflation is rampant at double-digit rates in each of the major EM regions. Two implications of high inflation rates around the globe are worth highlighting here: More tightening in EM ahead, but… First, in many high-inflation EM economies, central banks have embarked, or are likely to embark, on raising interest rates and tightening monetary policy through other measures. For details of our interest rate forecasts, see The Global Monetary Analyst, June 25 – our regular table is on page 17 and do also refer to our country economists’ commentaries in the Central Bank Watch section. However, it is important to note that the extent of the tightening in many countries will be constrained by the desire of the authorities to prevent any of what they consider to be excessive currency appreciation. Given the overall very easy stance of global monetary policy that we have highlighted in previous work, a massive global tightening of monetary policy is thus unlikely, especially if the Fed keeps interest rates low for a considerable period, as our US economists believe. Sustained high inflation damages long-run growth. Second, the longer inflation remains high, the more damaging it will be for longer-term economic growth prospects. The main reason is that high inflation rates usually go hand in hand with a higher variability of inflation, which raises uncertainty and can thus reduce investment spending. Empirical work by, among others, Robert Barro and Stanley Fischer (though conducted more than a decade ago) suggests that, controlling for other factors that influence growth, inflation has a dampening impact on long-run growth, especially at very high inflation rates. The experience since the publication of Barro’s (1996) and Fischer’s (1993) studies would tend to support this conclusion, as the decline in global inflation over the past 15 years or so coincided with an acceleration of economic growth. Thus, there is plenty of reason to worry about the continuation of the bull story for emerging markets, especially in those countries that have seen a sharp acceleration in inflation, are unable or unwilling to tighten policy sufficiently, and are commodity consumers rather than producers. For the full directory of countries, please see The Global Monetary Analyst, June 25.
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Hedging Inflation Risks: Opportunities and Pitfalls in US Products
June 26, 2008
By Richard Berner, Jim Caron & George Goncalves | New York
Inflation risks have risen globally and investors want protection. Small wonder: Inflation exceeds 10% in around 50 economies, mostly emerging markets, and more seem likely to join the “Double-Digit Club” soon, especially as officials reduce energy subsidies. In the industrial economies, inflation is above target for most of the inflation-targeting central banks, and concerns about inflation have either taken equal billing with or supplanted recession worries. Risky-asset markets, understandably, have sold off hard, with the MSCI All-Country World Index off 8.7% in the past month. The debate now is whether the current episode is another inflation scare, a cyclical pickup in inflation that could last a while, or, more ominously, the beginning of a more prolonged period of higher inflation. In our view, global inflation has been brewing for some time and central banks seem unlikely to snuff it out soon. So while its impact will vary across regions and markets, rising inflation won’t evaporate quickly, and investors should consider these developments as a regime shift. But traditional inflation products, such as inflation breakevens (BEIs), haven’t paid off; they have only fluctuated in a range since March, and distant forwards − designed to extract longer-term inflation expectations − have actually declined. How should investors profit from and protect against rising inflation risks? The answer: Buy inflation volatility. Even if inflation fails to rise significantly, or if the rise is merely cyclical rather than a regime change, investors in products that take advantage of rising uncertainty over inflation may benefit from such hedges. Choosing the right products to monetize rising inflation concerns is critical. Even though inflation volatility has risen over the past few months, we prefer owning products with imbedded optionality that may still rise in value with rising uncertainty about inflation. For example, one can buy call options on inflation swaps either outright or in cap format. Such a position benefits both from a rise in the level of inflation and from a rise in volatility derived from increased inflation uncertainty. Or, one may prefer to express an inflation hedge based on the propensity for back-end yields to rise rather than attaching their view directly to CPI. In that case, one can buy caps on US 10-year swap rates struck out-of-the-money. These positions can be used to hedge rising inflation, with the downside limited to the cost of the option and the added benefit of being long volatility driven by inflation uncertainty (for specific trade recommendations, refer to The New Inflation Regime: Profiting From and Protecting Against Rising Inflation Risks, June 13, 2008). Criticism of inflation metrics is overblown. Some investors believe that the shortcomings in US price indexes account for the failure of CPI-based products such as TIPS to be a good inflation hedge. Indeed, “inflation is everywhere except in the CPI” is a common refrain − paraphrasing Nobel-prize-winning economist Robert Solow, who famously observed in 1987: “You can see the computer age everywhere but in the productivity statistics.” Those criticisms, articulated at length by Pimco’s Bill Gross, center on 1) hedonic quality adjustments, 2) calculations of housing costs via owners’ equivalent rent (OER), and 3) geometric weighting/product substitution (for Bill’s latest, see “Hmmmmm?”, Investment Outlook, June 2008). They also seem to reflect the idea that price increases in energy, food, commodities, imports and medical care − all the things that are rising in price − aren’t accurately reflected in the CPI. The curse of Arthur Burns in this view has returned with a vengeance (see “The Curse of Arthur Burns,’ Global Economic Forum, October 22, 2004)! We think that such concerns are grossly overblown (Bill, forgive us the pun). Statisticians make hedonic or quality adjustments to about one-third of the components in the CPI by weight in the index, but the biggest component so adjusted is the notorious OER measure itself. In that case, hedonics actually boost the CPI, because they allow for the depreciation of the housing stock, which gives the consumer less shelter bang for the buck, so to speak. On net, careful study of the effect of hedonics suggests that the impact amounts to 0.005 percent (see David S. Johnson, Stephen B. Reed, and Kenneth J. Stewart, “Price Measurement Since the 1996 Boskin Report,” Monthly Labor Review, May 2006). The OER may be a flawed measure of housing costs but it is superior to the composite that it replaced in 1983. And suggestions to replace it with measures of home prices in today’s context seem downright bizarre: With home prices by some metrics falling by 14%+, such substitution would trim headline inflation by about 400 bp − effectively to zero. Likewise, the impact of geometric weighting and substitution of new products for old is comparatively small (see David E. Lebow and Jeremy D. Rudd, “Measurement Error in the Consumer Price Index: Where Do We Stand?” Journal of Economic Literature, March 2003, pp. 159-201). To be sure, some inflation drivers − such as energy, food, commodity and import prices − may show up in the CPI with a lag and/or boost it by less than feared. For example, the spring rise in gasoline prices only matched recent seasonal patterns through March. Now it’s payback time; energy quotes are rising faster than typically, so they will boost upcoming inflation prints disproportionately. Food is a smaller share of the average budget than most consumers think, but it is likely to boost overall inflation by nearly 100 bp this year. And import prices are beginning to outstrip their domestic counterparts, either squeezing margins or boosting prices as domestic sellers pass them through. In short, these factors will show up in rising CPI-based inflation, and investors should take heed. Inflation metrics do matter, however. To gauge whether longer-term inflation fears are rising, the choice of a particular BEI measure will influence the results. Ten-year TIPs spreads have risen by about 30 bp since mid-March, but are little changed over the past 15 months. Likewise, market participants commonly use measures of distant forward (5y5y) BEIs (e.g., USGG5Y5Y Index) that have barely changed over the past 15 months, frustrating investors who wanted to profit from their increase. But 5y5y BEIs as the Fed computes them from smoothed yield curves have risen by a not-insignificant 30 bp over the same time frame (see Refet S. Gurkaynak, Brian Sack, and Jonathan H. Wright, "The TIPS Yield Curve and Inflation Compensation," Finance and Economics Discussion Series (FEDS) paper 2008-05). Most analysts think that the Fed measure better expresses inflation expectations, because it is less affected by liquidity differences between TIPS and on-the-run nominal securities. For investors, there may be opportunity to hedge if the more commonly-used measure catches up. In contrast, other measures of inflation expectations have recently caught officials’ and investors’ attention. The University of Michigan’s consumer canvass suggests that 5-10 year median inflation expectations jumped to 3.4% in May and early June, a 13-year high. The surge in energy prices clearly accounted for much of the recent escalation; it also lifted 1-year median inflation expectations to 5.1% − a 26-year high. With little slack in the economy, officials cannot be sure that inflation will remain low, and the Fed response was swift and made their resolve clear. Fed Chairman Bernanke noted that “the Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.” To quantify the extent to which the near-term jump in inflation expectations also lifted the longer-term measure, it is useful to calculate a distant forward measure from the term structure of this survey, in this case a 1y7.5y measure of expectations. Such a calculation shows that longer-term measures of consumer inflation expectations have moved up from recent lows, but have been essentially stable at 3.1% over the past 15 months. On that measure, it might appear that the Fed should not worry about inflation expectations drifting dangerously higher. Fed Needs to Be Vigilant We are not so sure. In our view, there is legitimate reason to be vigilant, in part because the median level of expectations is not the whole story. Critically, the variance around it also matters, and we think that rising inflation uncertainty means that the regime change has arrived. Three important pieces of evidence buttress that claim: First, Treasury-market term premiums have risen at the 10-year maturity (by 50 bp for a zero-coupon calculation since mid March). While some of the rise undoubtedly reflects the reduced fears of systemic risk and more volatile real rates since then, a portion of the increase likely reflects higher inflation uncertainty. Second and related, although TIPS breakeven inflation protection has been range bound, it has recently become more volatile, commensurate with the rise in Treasury-market term premia. Given that over the long haul the variance in market-based inflation expectations has historically tracked consumer-based inflation expectations, this increase in volatility is important. Finally, the variance of both short- and longer-term surveyed inflation measures has also moved up significantly. While the variance of 5-10 year inflation expectations over the past decade averaged just 9 bp, or just one-fourth its average over the 1990-97 period, it has recently risen to 14 bp. A further rise in consumer-based inflation volatility could eventually lead to a viral jump in market measures of inflation, in turn promoting a further rise in inflation uncertainty. This rise should push up prices of inflation products based on options. The bottom line for us is that inflation uncertainty has just begun to rise, reinforcing our view that hedging inflation risks with volatility products remains attractive, even though some of this shift is in the price. Indeed, a combination of such products with more traditional positions in BEIs can prove a profitable way to hedge against an inflation increase − whether it occurs or not.
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