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United States
Global Support for US Growth Is Ending August 06, 2008 By Richard Berner | New York Two years ago, we thought strong global growth would be a key prop for an otherwise-weak Now, however, the party’s over. Spillovers from the The evidence for the global slowdown is mounting. While there are some exceptions, there’s no mistaking the slowing growth in Asia, Europe, and In Europe, slipping export growth and rising energy prices have combined to undermine business confidence even in resilient In Modest benefit from lower oil prices. If sustained, our team expects that the recent $20/bbl drop in oil prices will lessen both inflation and growth concerns in many economies. GDP effects range from as little as 0.3% in Slower global growth will hobble US exports and overseas earnings. We think global growth has been by far the strongest factor supporting the boom in US exports and overseas earnings, so the coming global slowdown will likely reverse this strength. We disagree with those who attribute the upturn in But we think global growth far outweighs the currency effect. Three factors matter in that regard. First, in a globalized world companies price to local markets, so the “pass-through” from exchange-rate changes to US import prices and to the prices of US exports in overseas markets is much less than 100% (see “Is a Weaker Dollar Inflationary”, Global Economic Forum, November 16, 2007). For example, in the past three years, dollar-denominated prices for US exports of consumer and capital goods excluding IT products rose by 6.6% and 9.8%, respectively. But in Second, most empirical estimates put the sensitivity of exports and imports to relative price changes at less than one, while their sensitivity to demand or output is one or, in the case of imports, more than one. Finally, the idea that “translation” effects of exchange rate changes on earnings are 1:1 is a myth. That’s because Corporate America doesn’t allow the currency chips to fall where they may; pricing to local markets is facilitated by hedging currency risks with either futures or options. In addition, just as at home, the effects of slower growth on earnings abroad will be magnified by declining operating leverage. We expect a mild Implications for US equity markets and US policy makers. US earnings are likely to decline by more than analysts expect – and more than is priced into equity markets. For example, we estimate that a 10 percentage-point drop in overseas earnings will trim 350 bp from overall Despite slower growth, market participants are unlikely to get help from the Fed. To be sure, the fundamentals are weakening, and the Fed tightening now in the price through year-end will probably ebb. But inflation risks haven’t faded completely; indeed, “core” inflation by almost any metric is moving higher. Moreover, the Fed’s extension last week of its liquidity facilities until January is a more targeted set of tools for maintaining the functioning of money markets than would be further monetary ease. Thus, while officials probably see the risks between growth and inflation as more balanced than at the last FOMC meeting in June, we think the Fed will be on hold for the foreseeable future.
Mexico
More Hikes Coming August 06, 2008 By Gray Newman & Luis Arcentales | New York Despite the recent easing in agricultural and energy commodity prices, the worst bout of price hikes is still ahead for Perhaps nowhere does the central bank see greater risk of pent-up price hikes than in While the central bank is not forecasting a 50% increase in gasoline prices (nor are we), the recent increase in the pace of gasoline price hikes in mid-July and early August highlights the risk to inflation. Indeed, the central bank explicitly stated that much of the larger-than-expected hike in the inflation path (89bp on average, up from a previous estimate of 50bp) came from concerns about a more rapid reduction in subsidies on the gas and gasoline front. Faced with the risks of significantly higher inflation in the months ahead, we now expect Banco de Mexico to hike its reference rate by an additional 75bp, bringing the overnight rate to 8.75% by end-2008. We had previously expected the central bank’s hiking cycle to end at 8% after two 25bp hikes (see “ Cushion Not to Hike? There should be little doubt that Banco de Mexico is set to continue to hike interest rates. While the authorities have shied away from characterizing the two tightening moves in June and July as part of a tightening cycle, it is almost unimaginable that the central bank would maintain interest rates unchanged after revising upward its inflation path as dramatically as it did on July 30 with the release of its quarterly inflation report. Some might argue that the new path gives the central bank ample room to live with higher inflation in the short term without hiking. After all, the new path assumes that an uptick in inflation in the near term is consistent with a return of inflation to near the 3% target by end-2010. We believe that this view represents a misreading of the central bank’s new inflation path. The pessimistic inflation path − a kind of worst-case scenario prepared by the central bank − should not be seen as acquiescence of higher inflation. Instead, the path was chosen in late July after concerns arose that the pattern of constant upward revisions to the inflation path (in January, in April and then again in July) risked damaging the central bank’s credibility. Ultimately, we believe that the central bank’s message is that there is a risk of a greater-than-expected spike to inflation. If it materializes, the uptick should be short-lived and represents a one-off adjustment to prices. If, for any reason, the uptick begins to morph into a homegrown problem via higher wages or deteriorating expectations, the central bank stands ready to act to ensure that its goal of 3% inflation is not jeopardized. However, by presenting a disconcertingly high inflation path, along with somewhat more dovish language in the recent inflation report, the central bank may have created some confusion. One, Two or Three? The real question, in our view, is the magnitude of the hikes to come following the two 25bp hikes in June and July. We doubt that the central bank has a preconceived notion of how many more hikes will be necessary, but it is probably working with the idea that one or two more hikes may be sufficient. After all, Banco de Mexico showed significant hesitation to begin tightening in June, and even then was extremely careful not to suggest that a tightening cycle had begun. Recall that the June decision came after the central bank had warned for months that Looking for more signs that the central bank’s working assumption is that only a few more hikes are needed? One needs to look no further than the concluding paragraphs of its quarterly inflation report released on July 30, where it argues that it sees (however imperfectly) a “significant moderation” in the factors that had provoked the greatest global inflation problem in decades. Banco de Mexico highlights both the recent softening in commodity prices and weaker global demand to argue that the inflation outlook is likely to improve. While the report was not claiming victory, the central bank’s tone that it could see beyond the worst of inflation was read by many as suggesting that few additional hikes would be needed. In contrast, we expect Banco de Mexico to end up hiking by more than most market participants currently expect. Why our more hawkish forecast? After all, we agree with the central bank that most of the price hikes in We also fear that Banxico’s newly announced inflation path represents an additional factor that could push wage settlements higher in the months to come. While the central bank is right to argue that a weakening labor market should help to temper wage hikes, we suspect that Indeed, in recent weeks − even before Banxico released its new inflation path − we have seen an important uptick in wage settlements. Both Pemex and FSTSE (public workers union) workers obtained 4.8% wage hikes. While the magnitude of the hike may not look alarming in and of itself, it does represent a significant uptick from past negotiations. In 2005 and again in 2006, Pemex granted a 4.1% wage hike, followed by a 4.25% in 2007. This year’s negotiation not only represents a break from a relatively stable trend line from Pemex in recent years, but is also significantly above the average public worker wage hike (4.2%) in 1H08. Moreover, public wage agreements often become the new benchmark for private companies. We suspect that many unions will argue that Banxico’s 5.5-6% end-2008 inflation forecast requires wage hikes of 6% or more in order to catch up with rising inflation. Ultimately, we expect wage settlements to remain under control and for inflation to begin to revert by early 2009 − and so we only call for 75bp of additional hikes. But we suspect that the fallout on expectations and wage negotiating stances from higher inflation in the coming months will lead to a further deterioration in the “balance of risks” so carefully monitored by the central bank. As a result, we expect Banxico’s hand to be forced and produce at least three hikes of 25bp in August, September and October. Indeed, we cannot rule out a hike of 50bp in the coming months if we see an unusually large jump in medium-term expectations. The Oil Price Forecast Feud There are two unknowns in both our and Banxico’s inflation forecasts. The first is the risk of ‘abundance in overdrive’. Although we expect the global economy to slow, we are concerned that the path to slower growth may be bumpy and interrupted by stimulus attempts. This, in turn, means that the recent softening in commodity prices may be a bit premature and that inflation shocks may persist longer than the central bank is counting on (see “Emerging Markets: Latin Hawks versus Global Doves”, EM Economist, July 25, 2008). The second risk to our inflation forecast is changes in At present, the finance ministry’s stated policy is to move gasoline prices in line with inflation − but there is no hard and fast rule preventing an adjustment. There has been some confusion on this matter because of a new revenue bill passed last year that provides for a 5.5% tax on gasoline to be sent to the states. The tax earmarked for the states is being introduced gradually over 18 months and has added about two centavos to gasoline prices each month since the start of the year. In contrast, in the first three months of the year, the federal government did not add any additional tariff adjustment to the price of gasoline other than the state tax. In April, May and June, the federal government gradually increased gasoline prices above and beyond the state tax, producing annualized gasoline price increase of roughly 5% in 1H08. However, since mid-July, just as Banxico was reviewing its inflation path for the rest of the year, the finance ministry upped the pace of gasoline price increases. The two hikes in mid-July and early August now are pushing gasoline prices up at an annualized rate of roughly 12%. It is well known that the finance ministry does not like the current subsidized state of gasoline prices. At the pace seen in 1H08, the cost to the public finances was at an annual run rate of roughly US$20 billion or just under 2% of GDP, as Bottom Line Softening global demand and easing commodity prices are bringing some relief to inflation watchers around the world and in |