Japan
Deeper and More Prolonged: September Tankan Preview
September 19, 2008

By Takehiro Sato | Tokyo

Recession Is Now the Consensus View – but How Long and Deep Will it Be?

The consensus has already formed that Japan is in a recession, and the question now is how long and severe will it be? As regards to severity, the focus in this Tankan is whether large manufacturers see the business conditions DI turn negative and revise down their capex plans (in June, these two areas were not as bad as we feared). For capex in particular, plans tend not to be revised much in the September Tankan, since the survey comes before 1H results, and so the negative impression would be all the greater, depending on how much the plans are revised down. In the end, we believe that the market will refocus on the risk that Japan’s recession may be longer and deeper than the consensus envisions.

Forecast for Business Conditions DIs

Energy prices, which have held back the Tankan headline number, have been correcting more sharply of late with the deepening financial turmoil, but we think the earliest that this could contribute to the headline is the December survey. There is no sign of a near-term pick-up in the Tankan headline currently, with the sharp rise in energy prices through the summer fresh in the memory and the turmoil in the overseas financial markets spilling over into Japan. Private-sector surveys such as the Reuters Tankan and the QUICK Tankan point to corporate mindsets becoming increasingly cautious amid the run-up in energy prices through the summer, and we forecast that the headline number for the large manufacturers’ DI will drop to -1. We expect a cumulative drop from the peak in 2006 of 26 points, rendering comparisons with the soft patch in 2004 largely meaningless. (At the moment the usual practice is for economists to publish BoJ Tankan forecasts immediately after the Reuters Tankan figures, but normally there is a gap between the two announcements of more than ten days. Meanwhile, survey responses from the companies are likely to keep coming in after the official deadline in mid-September. This means that in highly volatile times such as now, responses about the outlook can change with the prevailing market environment.) The outlook DI is also likely to worsen at a sharper rate than the drop in the June survey. However, note that the outlook DI tends to come out weaker than the current DI in the case of manufacturing.

Incidentally, a rough estimate of BoJ Tankan forecasts based on Reuters Tankan data gets us to figures of -7 for manufacturing (down by 12ppt from the June Tankan) and +7 for non-manufacturing (down by 3ppt). We avoid using these results as our actual forecasts since data for production, inventories, exports, share prices and corporate earnings must be weighed.

Worsening terms of trade due to soaring input costs play a huge part in the mindset of small- and medium-sized enterprises, so the DI for SMEs will likely get closer to the pace of the decline for the big firms. The Economy Watchers Survey has already made clear the significant deterioration in grass roots sentiment.

Forecasts for F3/09 Management Plan Revisions

(1) Sales and profit targets: In the June Tankan, large companies (all industries) were looking for growth in sales (+3.6%) and declining recurring profits (-7.0%) in F3/09, having revised down profit expectations by about 7pp from an outlook for flat growth in the March survey. Since the September Tankan does not reflect interim results, it is not normal to see substantial changes to full-year forecasts at this point, though 1H forecasts can be reviewed in light of April-June results. So we do not expect revision of sales and profit plans to be a major focus this time.

However, contrary to the consensus expectation for a short, shallow recession, recent industrial production is already being cut in line with the average pattern in recessions since the 1970s. Using a constant assumption for sales prices, manufacturing industry sales would drop some 2-3%, assuming only average levels of output cuts. Meanwhile, prime cost reductions stemming from the recent falls in energy and raw materials prices would not show up until next fiscal year at the earliest, so negative gearing will remain in effect for now. As a result, we expect business plans to be revised down sharply in the next-but-one Tankan (December) which reflects interim results, and eventually large companies are likely to be forecasting recurring profit declines of about 20% (MoF corporate statistics basis, excluding financials). In other words, negative news flow for corporate earnings is poised to continue at least until late October/November, when 1H results and full-year guidance are available.

Our exchange rate assumption underlying the corporate earnings outlook above is JPY103/USD. If the yen were to weaken on average by JPY5 against the dollar for the year, about 3pp would be added to the profit outlook. In this respect, the relative calm of the yen/dollar rate amid the financial turmoil is reassuring. Meanwhile, the average oil price assumption is US$115/bbl (note that this is not our forecast). A 10% drop in energy prices would improve the profit outlook by roughly 3pp. If energy quotes drop back further, therefore, the upward revision risk would predominate.

(2) Forecasts for F3/09 capex plan revisions: Full-year capex plans are unlikely to be significantly revised in the September Tankan for the same reasons discussed above for sales/profits. Even in past recessions, the revisions to capex plans of large firms in the September Tankan were smaller than in the December Tankan. That said, we are tracking whether companies will be more guarded on capital investment than at this stage in the past because of the tougher lending stance taken by banks and the issue of securing liquidity in the banking system. We forecast that large companies will revise their capex plans by -0.5% (average for the past five years is +0.2%) and call for a year-on-year increase of 2.3% (including investment in land, excluding software spending), breaking down as +6.2% (revision rate -0.5%) for manufacturers and +0.1% (revision rate 0.0%) for non-manufacturers.

Note that the ‘Survey on Planned Capital Spending’ by the Development Bank of Japan, published on August 5 at a time when companies had disclosed plans to a certain extent, indicated that listed companies were projecting a surprisingly solid 4.1% increase. However, it may well be necessary to factor for the impact of the uncertainty in the global financial situation in September. Plans may also be revised to take account of the drop in profits in July-September, driven by shrinking sales margins. The MoF’s Corporate Statistics indicate that the recurring profits of large manufacturers in the April-June quarter fell by about 11.7%Y and have been dropping for four straight quarters, and also showed four consecutive quarters of negative growth for all companies in all industries. Every time corporate earnings on this measure have declined in two successive quarters in the past has been marked by a recession.

The worsening employment situation also has negative implications for capex. We have focused on the relationship between the job-offers/applicants ratio and the capex ratio in the past 30 years. This shows that as labor supply/demand eases and marginal labor productivity rises as currently, companies have less incentive to invest in capacity increases and labor saving.

A key question ahead is how far replacement demand in non-manufacturing industries, particularly transportation and electric power, can offset the stagnant capacity increases in the manufacturing sector, but overall we look for capex conditions to be hostile. The credit crunch is also becoming a problem for SME lending as banks’ tougher loan stance, especially for the real estate and construction industries, is putting pressure on the funding of small firms; this will likely weigh on capex.

Policy Implications

Consumer price increases have exceeded the bounds of an ‘understanding of price stability’ set by the BoJ policy board, but with the recession set to deepen, we are not changing our forecast for a rate cut. In the US too, the chances of a rate cut rather than a hike are rising, given the outlook for the credit crunch and cooling prices. Although the FOMC passed on a rate cut on September 16, our US economics team is forecasting that, like it did last year in August, the Fed will temporarily guide the effective FF rate below the target level, taking unofficial steps towards easing. And if there is an official rate cut, expectations for the BoJ could intensify, depending on market conditions. Following new swap facilities by the central banks to support provision of US dollar liquidity on September 18, there may even be concerted rate cuts by the G3 if the market turbulence requires such action.

On the political front, the timing of a Lower House break-up and a snap election could leave the Diet discussion and implementation of the supplementary budget in disarray, with fallout for policy measures to ease SME funding access. This would be adverse for both SMEs and the BoJ, in our view.

Monetary policy implications could change according to the make-up of the post-election government, but if Taro Aso, a proponent of fiscal spending, gets the nod, we believe that this could be supportive for the BoJ, as he has apparent sympathy with the goal of interest rate normalization, referring to the benefits for savers of higher interest rates. Yuriko Koike, a believer in the ‘rising tide’ (a reflation-type) policy, could be less well aligned with the bank’s aims. However, the new cabinet may have only a caretaker role until shortly after the general election. Given the political uncertainty, it would be natural to expect the BoJ to hold its fire for the time being, in readiness to act decisively if necessary.

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United States
The Slowdown Goes Global
September 19, 2008

By Richard Berner | New York

The slowdown that began in the US is going global.  It now appears that economies in much of the developed world are slipping towards significantly slower growth, if not outright technical recession.  Indeed, our global growth forecasts for both 2008 and 2009, at 4% and 3.5%, respectively, are each 0.1% lower than in July, when we did the last comprehensive update (see Global Forecast Snapshots, September 12, 2008).  These annual forecasts mask considerable near-term weakness: In the US, Canada, Europe, Japan and New Zealand, we expect a few quarters of essentially no growth.  In our view, the slowdown abroad still doesn’t portend a global recession, but the risks have clearly shifted to the downside.

The sources of that weakness will help determine the consequences: If, as many assume, the global slowdown has been primarily the result of the sharp escalation of energy and food prices between March and mid-July, then the equally sharp reversal of those prices should at least cushion the downturn and prevent recession.  We agree that the energy shock was one contributing factor, and lower energy prices clearly will help the oil-consuming countries, while lower food quotes will help the net food importers.  But soaring energy and food prices aren’t the only story behind the slowdown; far from it.  We think that the broader pickup in global inflation is a culprit.  As we noted two months ago:

“Higher inflation erodes discretionary income and thus undermines consumer spending.  That’s especially the case in emerging market economies where food and energy outlays account for half or more of consumer budgets, where those prices have pushed inflation up to double-digit rates, and where the soaring cost of government energy subsidies is forcing authorities to reduce them.  Moreover, high and rising inflation typically is associated with more volatility and uncertainty, which is the enemy of investment and growth.  In addition, higher inflation has triggered tighter monetary policies and weaker risky asset prices, which will depress growth in the short run.”  (See Global Forecast Risks: From Inflation Upside to Growth Downside, July 21, 2008)

The inflation surge, likewise, is more the result of several years of lax monetary policy and dwindling slack in the global economy, not just an artifact of soaring commodity quotes.  Indeed, the surge in commodity prices itself was the product of booming demand and limited growth in supply; equally, it is the global slowdown that is now promoting sharp declines in commodity prices − but not yet in inflation and inflation expectations.  Consequently, central banks aren’t likely to declare victory until the coming significant decline in headline inflation proves durable. 

Moreover, we believe that the continued tightening of global financial conditions − including the response to higher inflation by many emerging-market and developed-economy central banks − has also been a major factor behind the global slowdown, and that this tightening won’t reverse soon.  As a result, the slowdown likely will persist into 2009, will probably be somewhat deeper than many hope, and recovery will probably be tepid when it emerges later next year (see “A Different Type of Downturn,” The Global Monetary Analyst, September 3, 2008). 

Three consequences of this global slowdown are equally important.   First, the oil price-dollar connection is in my view primarily correlation, not causation.  Indeed, as I see it, moves in both oil prices and the dollar − up and down − are the product of a common third factor, namely the shift in relative non-US growth.  Thus, the presumed causal connection between oil prices and the dollar, and the claim that Fed ease promoted a weaker dollar and thus higher oil prices, are in my view exaggerated.  To be sure, monetary policy differences between the Fed and the ECB contributed to a stronger euro through mid-July.  In particular, the Fed’s dual mandate and relatively low inflation expectations gave it latitude to respond to the US financial crisis over the past year, while the ECB’s concerns about second-round effects from higher headline inflation biased it to tighten.  But growth differentials also underpinned those expectations and are now in the driver’s seat.  If supply, rather than demand, factors change in commodity markets – e.g., if OPEC cuts production – the dollar-oil correlation could erode or break down.

Second, the slowdown will continue to test EM economic resilience.  While lower commodity prices help consuming countries, they are producing a sharp reversal in the ‘terms of trade’ for commodity producers and in their currencies.  Simply put, lower commodity prices transfer income away from the producers and back towards the consumers.  For the EM world, that implies a mix of weaker growth, still-high inflation, and sinking currencies.  EM economies are stronger than in the past, which means currency crises are less likely.  But it does not rule out EM ‘recessions’; this is the first real business cycle EM economies have faced since the Asian financial crisis and is unlike the US-led one in 2001. 

Third, weakness outside the US will unmask the domestic weakness in the US economy and in US earnings by eroding support for US exports and earnings of US affiliates.   The debate now is by how much and what is in the price.  As I see it, barring a global recession, US net exports will turn from being a record-strong contributor to US growth to a slightly negative factor over the next year.  And weaker growth abroad is a key ingredient in our strategy team’s forecast of a 7% decline in S&P 500 EPS this year. 

There’s no mistaking the evidence for the global slowdown.   Following a strong first quarter performance, global growth slumped in the spring.  In Canada and Mexico, the slowdown most clearly echoes the weakness in US activity, with net exports now a significant drag on growth, and both production and employment beginning to show the strain.  Since the small net contraction in the first half of the year, Canadian consumer spending has been sluggish, and sliding commodity prices may erode incomes.  Manufacturing and production-based indicators have held up well but are at risk.  In Mexico, production has already begun to contract.  Elsewhere in Latin America, activity has remained remarkably resilient but is now at risk, and there are signs of softening.  Production and demand indicators are still on the rise in Brazil, Argentina, Peru and Venezuela.  However, in Chile and Columbia the pace of economic activity has already turned sluggish. 

In the UK, our baseline view involves a slowdown rather than a significant recession.  But risks are rising: We think there is ~50% chance of a technical recession and ~25% chance of an early-1990s-style recession.  GDP will likely contract in 3Q, and we expect a very sharp slowdown in residential investment, more de-stocking, and a 2H08 contraction in consumer spending.  In Europe, we expect the economy to have troughed over the summer, but recent data point to ongoing weakness.  German activity indicators have weakened noticeably, partly reflecting payback from an unusually strong 1Q.  In France, manufacturing activity is decelerating sharply, credit conditions are tightening, and housing is softening, while slipping industrial production and business surveys are now confirming the bleak outlook for the Italian economy.  In Spain, real house prices are declining, and the correction in the construction sector is still ongoing.  In contrast, the Dutch, Norwegian, and Finnish economies are outperforming the euro area, with the latter reflecting strong growth in resources, the CEE, and in Russia.  But some of the CEE economies are now at risk, with Poland and Czech likely to slow materially in the coming months and Hungary struggling to emerge from its slow-growth rut.  In Denmark and Sweden, tighter monetary policy is already taking its toll.

Turning to Asia, the prognosis for China’s economy will be pivotal.  Recent data point to broadening weakness in activity, courtesy of slower export gains.  Thus, the outlook for robust growth in China hinges critically on the sustainability of property investment growth.  With the easing in monetary policy, the authorities’ orientation has shifted to favor growth, and more ease is coming.  But China is not the whole story; growth has slowed in many other Asian economies as tighter monetary policy and diminished capital inflows slow economic activity.  Hong Kong, Korea and India are all cases in point.  The fears of a Korean financial crisis are overblown, but growth may slow dramatically.  Indian consumption and capital spending are both slowing; indeed, consumer durables outlays and automobile sales indicate that the household sector's debt-leveraged spending remains under pressure.  In Malaysia, export-oriented manufacturing (28% of the economy) has already fallen to low single-digits, and non-commodity exports such as electronics are also seeing downward pressures. Finally, the Japanese economy has been in a mild recession after peaking in Oct-Dec 2007. Our main scenario is for the economy to trough in Jan-Mar 2009, but political uncertainty will heighten risks of a prolonged and deeper downturn. 

A sea change for investors. Although we’ve expected this global growth shift for some time, it has come a bit later and seems more broadly-based than even we expected.  Both are important: The delayed start of the slowdown nurtured the sense among investors that global growth was more resilient than feared.  That encouraged them to double up on decoupling trades, especially as the global economy appeared to be holding up better than the US.  The breadth of the slowdown has shattered the conceit that EM economies and markets would be a safe haven from the developed world’s credit crisis.  In our view, the slowdown abroad still doesn’t portend a global recession, but the risks have clearly shifted. 

In a world where the US may now be the ‘best house in a bad neighborhood,’ the dollar likely will rally as investors anticipate that policies will shift towards ease abroad.  While it was long expected, this non-US slowdown is forcing significant portfolio reallocations and deleveraging by investors who are overweight in overseas markets, in carry trades, and in long energy/short financials.  Overshooting as those trades unwind will eventually create renewed opportunities for patient investors, but volatility and aggressive price action will continue to contribute to risk aversion for now. Government spending are also on the cards, we believe.

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