Shocking the Fiscal Abundance Story
September 30, 2008
By Gray Newman, Marcelo Carvalho, Luis Arcentales, CFA, Daniel Volberg & Boris Segura | New York
A year ago, it was relatively easy to turn cautious on Latin America and broader emerging economies. After all, it appeared that investors and Latin watchers were all on one side of the trade. Five years of above-trend global growth had produced one of the best growth records for Latin America (and emerging economies) in decades, and that, in turn, had swollen the ranks of emerging markets fans. Any doubt over just how widespread the optimism had become was dispelled in August 2007 when, after a brief bout of nervousness in July and early August, I began to hear talk that emerging markets were the new ‘safe haven’ (see “Emerging Markets: Emerging Questions”, EM Economist, August 31, 2007 and “Latin America: Will Abundance Slow?” EM Economist, September 14, 2007). Those three words – ‘new safe haven’ – sounded awfully like a new variant on ‘it’s different this time’.
Latin America, the ‘New Safe Haven’? To be fair, the ‘safe haven’ camp marshaled some powerful evidence. Unlike the past bouts of turmoil, this time the problem had not started with Latin America. More importantly, Latin America had a much stronger balance sheet than it did in 1998 when the Asian Financial Crisis reached the shores of the region or in 2001 in the aftermath of the tech bubble. And it was true that the abundance of the past five years had not produced the ballooning trade and current account deficits in the region fueled by consumer spending that had been common in the 1990s. Gone were the days of widening fiscal imbalances and central banks trying to prop up overvalued currencies by burning through billions of dollar reserves. Instead, debt buybacks were in vogue around Latam as reserves soared. The ‘safe haven’ camp may have been right on the region’s structural improvement, but the focus seemed irrelevant at best. Faced with a serious cyclical downturn, I worried that many believers in the ‘safe haven’ thesis would find their confidence called into question as the US slowdown morphed into a patch of below-trend global growth. Few things are more damaging for a macro specialist than to highlight the long-term structural story just months before a cyclical downturn. Cycles nearly always bite. During the past 12 months, there have been moments when both the ‘safe haven’ camp and its critics have felt vindicated. After all, the slowdown has proven slow in coming to Latin America. While Mexico, Chile and Colombia have experienced a slump, Brazil’s economy keeps posting robust results. When stronger-than-expected 2Q GDP (up 6.1%) was released earlier this month, Brazil’s statistical authorities noted that an alternative measure (quarter-over-quarter) pointed to a dramatic acceleration in the pace of growth relative to the start of the year. Peru has also continued to post strong reports, including an 8.3% uptick in monthly GDP in July. On the other hand, the relative resilience to date in Latin America’s real economies stands in sharp contrast to the downturn in Latin American markets, as investors have decided not to wait around to see if the region emerges largely unscathed. Structural Growth Gains? A year later, I am wondering whether now is the time to focus investors’ attention on the structural successes of the region and argue that the markets have moved too far relative to the likely performance of the region’s economies. I am not willing to champion the structural improvement over the cyclical risks, at least not yet, for two reasons. • First, the downturn in the region’s real economies is just now starting and is of uncertain duration. Our initial scenario work suggests that a one- or two-standard deviation shock to some of the key variables for the region could produce a much more pressing outcome than most market participants appear to be working with (see “Latin America: Shocking the Consensus”, EM Economist, September 26, 2008). • Second, and more worrisome, it is not clear how much of the heady growth or the fiscal progress is permanent and how much is simply the result of the strong inflows during the era of abundance. Our review of Latin America growth dynamics suggests that the principal drivers of better growth in the region have been a series of external factors reflected in favorable financial and credit conditions, strong global demand and a remarkable surge in the terms of trade. Indeed, whether one looks at Brazil, Mexico or Argentina, the bulk of the upturn in Latin America’s performance since 2003 has come from external factors − the hand that Latin America has been dealt (see “Latin America: Growing Disconnect, Growing Risk”, EM Economist, March 7, 2008). Structural Fiscal Progress? The fiscal strength of the region also appears to be more a by-product of abundance and less the result of a structural shift. At first glance, Latin America’s fiscal resolve appears to be impressive. While fiscal deficits still abound in emerging markets, there are no egregious examples in Latin America. The problem countries are elsewhere. Not only do the principal economies in Latin America distinguish themselves from other emerging economies, but Latin America’s fiscal stance appears to represent a break from the past when large fiscal deficits were more common. After seeing regional fiscal imbalances of 3-4% of GDP a decade ago, Latin America today is showing a largely balanced budget. Once adjusted for strong growth and unusually favorable commodity prices, however, Latin America’s fiscal improvement quickly fades. Indeed, our first attempt at building a regional fiscal model suggests that the structural fiscal stance of the region has deteriorated rapidly since 2005. A few words are needed in order to explain how we created our fiscal measure. We have taken the fiscal accounts for Brazil, Mexico, Argentina, Chile and Peru during the past decade and then adjusted the revenue stream for the uptick in real activity and the improvement in commodity prices above and beyond its historical average. In this exercise, we have contrasted the era of abundance (starting in 2003) with 10-year averages for each variable. Our results should be viewed as an exercise, not as a scenario. Whereas the actual fiscal balance compares actual revenues and actual expenditures, our ‘structural’ fiscal balance compares growth- and commodity price-adjusted revenues with actual spending. Our exercise is not designed to predict the size of the fiscal or budget balance if revenues had been lower. If they had, most governments would likely have tightened their belts and spent less (although this is not necessarily the case with Chile, where the authorities use their own calculation of ‘structural’ revenues to guide spending). Instead, our exercise is designed to measure the size of the fiscal windfall that the region has enjoyed in the era of abundance and hence to give some sense of the magnitude of the adjustment that could be needed. Spending the Windfall We estimate that the budget windfall by mid-2008 had reached close to 4% of GDP among five of Latam’s largest economies, or roughly US$112 billion. This means that if growth or commodity prices were to return to their 10-year averages, the fiscal deficit would be near 4.1% of GDP instead of the reported 0.1% deficit. In essence, the windfall represents the size of spending cuts that the region’s authorities would have to engineer in order to maintain the current fiscal balance. Alternatively, the gap could be filled by new taxes. In reality, the response would likely be some mixture of both, along with some fiscal slippage back to levels seen a decade ago. By definition, our exercise creates a gap when the drivers of fiscal revenues (be they GDP growth, commodity prices or other factors) enjoy a bout of abundance. This alone is not reason for concern. Look, for example, at Chile. Work by Daniel Volberg and Luis Arcentales suggests that Chile’s massive fiscal surplus, which reached 8.7% of GDP last year, would instead be a modest surplus closer to 1.8% of GDP today. The gap is not a problem in this case: if Chile saw revenues revert to historical or ‘structural’ levels, it would not have to do anything to keep its fiscal accounts in balance or even run a modest budget surplus. The problem is with the rest of the region excluding Chile. Marcelo Carvalho calculates that Brazil’s budget deficit today would be running nearly 3% of GDP larger than currently reported: closer to 5% of GDP rather than the official rate today of around 2%. The same holds true for Brazil’s primary surplus: rather than exceed 4% of GDP, by mid-2008 it would be running at just over 1% of GDP. Daniel Volberg calculates that Argentina’s budget balance would morph from a surplus of 1.1% of GDP last year to an 8.1% deficit, while Boris Segura finds that even the darling of many investors, Peru, would see its budget surplus shrink from 1.7% last year to a deficit of 2.6%, if growth and commodity prices returned to their 10-year averages. Bottom Line Across the region, from Mexico to Argentina, including Brazil and Peru, the abundance windfall has translated into a sharp rise in fiscal spending in recent years. Chile is the only country where the windfall produced a sharp rise in the budget surplus instead of in spending. It is too early to tell how long the downturn in global activity lasts and what the damage will be to the region. But much of the improvement in Latin America that was thought to be structural may turn out to be the result of the past five years of above-trend global growth. A year ago, it was time to turn cautionary when it seemed that the entire market had taken the other side on Latin America and emerging markets. Time will come when it is right to take the other side as investors show undue concern. My bias, however, is that we are not there yet. And the longer that growth disappoints, the greater the risk that the region’s track record on structural reform is shown to be lacking. Nothing would benefit the region more than to recognize those structural shortfalls and to act now.
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GDP Downgrades: How Bad Will the Cycle Get?
September 30, 2008
By Chetan Ahya and Deyi Tan | Singapore
Negative Feedback Loop Overwhelms When the subprime crisis began in July 2007, we argued that ASEAN would be able to soft-decouple. In 1H08, soft-decoupling panned out according to script. ASEAN grew 5.8%Y (versus +6.4%Y in 2H07) as the US, euro area and Japan rose 2.3%Y, 1.8%Y and 1.0%Y, respectively (versus +2.0%, +2.6% and +2.1% in 2H07). In a reversal of roles, the rest of the world (ROW) was in fact helping to support growth in the developed world. Net exports contributed 2.9pp to the 2.8% growth we saw in US GDP in 2Q08. However, the duration of the credit crunch in developed economies mattered in terms of how long this could be sustained for, due to the inevitable negative feedback loop to ROW through trade and financial market linkages. There have been a few false dawns since markets peaked in October 2007, but the unfolding of financial events in the US in the past two weeks, some 14 months since the crisis first began, shows that the bottom is likely still some way off. As a result, we are downgrading our ASEAN GDP forecasts to 5.4% from 5.6% for 2008 and to 4.1% from 5.1% for 2009 for the following reasons, each of which affects ASEAN economies to varying degrees: (1) Building in rising costs of risk capital and shrinking liquidity: The risk premia behavior in ASEAN is fast catching up with the rest of the world. Risk capital is becoming increasingly scarce and expensive, and major international bond issuances and international equity offerings have ground to a halt. The impact from slowing capital inflows will affect economies that have the twin problems of current account deficits and tight banking sector credit-deposit ratios (LDR). Within ASEAN, Indonesia – the largest economy in the region – falls into this category. Indonesia has had a strong credit cycle, with loan growth at 36%Y in September 2008. Now, a declining current account balance due to domestic demand that is too strong for comfort and retreating commodity prices, at a time of capital outflows, have led interbank rates to rise to 11.1% without matching policy rate hikes by Bank Indonesia (BI). Indeed, a disruptive rate move is already underway, and we believe that the central bank’s efforts to lock the currency within the 9,000-9,500 band are only exacerbating the liquidity tightening. Additionally, as we highlighted in Asia Pacific Economics: Shrinking Global Liquidity – Impact on AXJ, September 19, 2008, even economies with favorable current account balances such as Singapore and Malaysia are not immune to a reversal in liquidity trends and a rise in the cost of risk capital as foreign reserves decline. On the back of a lack of confidence regarding counterparty risks, the Bank of East Asia incident and a potential change in the central bank’s exchange rate policy in the October review, Sibor has also moved up 100bp in the past two weeks. Economies with large stocks of excess liquidity such as Singapore and Malaysia should face relatively lesser pain as the central banks can partly neutralize the abnormal stress in the system by unwinding the stock of excess liquidity. Yet, the negative impact on business capex and consumption from the rise in cost of funding will still be unavoidable, in our view. (2) Autonomous support to wane: Autonomous macro support is also likely to weaken going forward. Singapore has seen a broad-based construction boom (in retail, residential, commercial and infrastructure), and the committed nature of such investment is the reason why the construction sector remains in overdrive mode, although the correction in the property cycle has already begun. As with each property cycle, developers tend to oversupply during the up-cycle and undersupply in the down-cycle. Now, supply-side adjustments are under way as property launches have slowed. We expect the growth delta from construction activities to taper off in 2009. In Malaysia and Thailand, where there is a relatively larger public sector economy, we believe that the probability of active fiscal pump-priming is undermined by the lack of political stability for policy execution, even though Thailand has just announced an expansionary 2009 fiscal plan (-2.4% of GDP versus -1.8% for 2008). Indeed, for both economies, politics remains a wild card. A clear political end-game is not in sight, and we believe that political conditions should continue to muddle through, which would put a damper on market sentiment. Moreover, for Malaysia, the recently announced 2009 budget is, in fact, less expansionary, with the fiscal deficit expected to come to -3.6% of GDP (versus -4.8% in 2008). Not only is this so, but the government is also getting less ‘bang for its buck’ as part of the 4.4% increase in expenditure goes into accounting for the high resource costs in previously committed projects. Most important, we believe that a weak political environment could affect the execution of any government plan to increase investments. (3) Commodity price retreat – Boon or bane? Many EM economies are commodity producers, and rising commodity prices in 1H08 provided the income effect for ROW to support developed world growth. Similarly, in ASEAN, as export demand from the US dwindled to low-single-digit momentum of 0.6%Y, 3MMA for July 2008, ASEAN exports to economies outside of the US, Europe and Asia continued to grow at 39.9%Y, 3MMA, and this segment accounts for 21% of total exports. Moreover, ASEAN economies such as Malaysia and Indonesia are themselves commodity producers, with commodity trade balance running surpluses of 15.1% and 6.8% of GDP (1H08 annualized), respectively. This is likely why domestic demand there has remained resilient at 8.9%Y and 7.5%Y for 1H08, respectively. However, global demand destruction has now caught up with the commodity prices. The change in terms of trade for EM commodity producers suggests that the next leg of the slowdown could likely come from the EM space. The impact on ASEAN will come in terms of slowing end-demand from these export markets and for Malaysia and Indonesia, more directly also through the reversal of the positive spillover impact that high commodity prices had on the rural community. Economies such as Singapore and Thailand should benefit from the positive change in terms of trade. Yet, to the extent that commodity price movements are suggestive of a broad macro softening that has already taken place, the decline is overall a net negative and not a zero-sum game for ASEAN. Building More Growth Downside into 2009 Numbers We are marking to market and revising downwards our ASEAN GDP forecasts to 5.4% from 5.6% for 2008 and to 4.1% from 5.1% for 2009. Consensus is expecting 5.3%Y and 5.1%Y, respectively. Specifically, the most significant downward revisions are in economies with higher trade and financial market linkages such as Malaysia and Singapore. Not only is Singapore most exposed, given its trade openness, but asset market linkages are also highest here, given the government’s strategy to develop the financial industry post-1998. In terms of growth trajectory, in line with our global macro colleagues, we expect the growth cycle to bottom in 1H09, with a muted recovery in 2H09. Even with this downgrade, we believe that the risks to our growth forecasts are skewed toward the downside.
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Review and Preview
September 30, 2008
By Ted Wieseman | New York
Treasuries beyond the very short end bounced around a decent amount over the past week but didn’t end up much changed as investors largely focused on the political wrangling in Washington over the financial market bailout plan. Going into the weekend it seemed likely but not certain that a bill would be passed, but considerable uncertainty remained about the exact form any bill would take and how successful it might thus end up being, with particular concerns about how any government demands for equity stakes in participating firms would be structured. The potential flood of Treasury supply that might be required to fund the plan was a negative for the market, which had trouble taking down a record 5-year auction, though the huge 2-year sale went fine. On the other hand, flight to safety remained strong in the market as in by far the week’s most notable market activity the very short end – interbank, financing and money markets – were to varying extents in near-meltdown mode at midweek before showing some improvement Thursday and Friday. Even after some signs of life late in the week, these markets ended the week in bad shape, and it will be crucial that some stability be restored going forward to avoid potentially devastating impacts on the broader markets and the economy. Economic data were ignored through the week as investors focused on more pressing concerns, but the key data that were released – durable goods, home sales, jobless claims and a couple more regional manufacturing surveys – were terrible and didn’t leave a lot of doubt that the economy is already in recession. We cut our 3Q GDP forecast to 0.0% from +1.0%. Our base case had been modest contractions in GDP in 4Q08 and 1Q09, but the risk of a bigger and more protracted downturn is clearly becoming greater as the financial system seizes up and hoards liquidity to a probably unprecedented extent. On the week, benchmark Treasury coupon yields ended relatively narrowly mixed, considering the level of turmoil, with the 10-year for some reason performing terribly on the curve. Trading conditions in Treasuries and many other markets were extremely illiquid. The old 2-year Treasury yield fell 11bp to 2.01% (the new issue ended at 2.06% after being auctioned Wednesday at 2.115%) and the old 5-year yield dipped 2bp to 2.97% (the new issue closed at 3.01% after being auctioned Thursday, with a nearly 5bp tail, at 3.13%), while the 10-year yield rose 2bp to 3.825%, and the 30-year yield fell 2bp to 4.35%. Even with energy prices rising on the week − November oil gained US$4 a barrel to US$107 and October gasoline US$0.07 a gallon to US$2.67 – TIPS resumed with a vengeance the underperforming trend that’s been in place since early July after a brief bit of major outperformance when the bailout plan was first announced, and nominal Treasuries plunged, with the 5-year TIPS yield up 22bp to 1.84%, the 10-year 24bp to 2.07% and the 20-year 13bp to 2.45%. The inflation breakeven on the shortest-dated Jan 09 issue is now deeply in negative territory, but even the next maturing April 10 issue is trading with a slightly negative inflation breakeven, which is hard to make any fundamental sense of. Indeed, inflation swaps to April 2010 are nowhere near that level, but investors who might try to take advantage of that seeming arbitrage don’t have the luxury generally of using ‘hold to maturity’ valuations if they put on the trade and it continues moving further out of whack. As Treasury coupons and risk markets bounced around in comparatively constrained ranges and with relatively muted moves on the week, the short-term money, interbank and financing markets were the real focus as they appeared to be approaching a meltdown midweek before pressures eased up somewhat late in the week but remained intense. Some part of these extreme dislocations are certainly related to severe quarter-end balance sheet pressures – which resulted in terrible liquidity conditions through the week across various markets – but the extent to which these problems are more fundamental and last beyond the quarter-end turn remains unclear at this point and will be crucial for the state of markets and the economy going forward. If the basic underlying wiring of the financial system and by extension the economy continues to short circuit, the repercussions will be severe. Money markets saw some tentative signs of improvement towards week-end but remained badly strained. The 3-month bill’s bond equivalent yield fell 15bp on the week to 0.86% and the 4-week plunged 74bp to just 0.12%, but at least yields didn’t trade at negative levels as they did briefly during the prior week. One thing that makes these rock-bottom bill yields particularly amazing is that the Treasury has absolutely flooded the market with supply to an extent we’ve never seen anything even approaching before. On top of regular weekly bill issuance, where sizes are already elevated, an astounding US$300 billion in cash management bills were sold between September 17 and September 29 as part to the Special Financing Program the Treasury implemented to help the Fed with its balance sheet, and aside from some relatively minor concessions at some of the auctions, the market took all this paper down without any let-up in the pressure on short rates. Trends in agency money market paper – as effectively risk-free from a credit perspective as T-bills since the government’s GSE intervention – were mixed on the week. Rates on very short-term paper came down quite a bit, but 3-month yields ended Friday near 2.75%, up from 2.30% at the end of the prior week – a huge and rising premium over 3-month T-bills. On the positive side, the agencies were able to issue very large volumes of discount notes at these elevated yields late in the week, so money market investors were returning to this paper (balance sheet-constrained dealers certainly weren’t doing much buying) to a notable extent after there had been periods of heavy liquidation the prior week that caused the Fed to begin open-market purchases of agency discount notes. After the initial US$8 billion discount note pass by the Fed on September 19, an additional US$2 billion was bought in the latest week in an operation late in Tuesday’s trading session as agency market debt was having its worst problems Tuesday and Wednesday and then an additional US$4.5 billion late Friday as things were stabilizing. If conditions in a section of the money market that from a credit perspective is as effectively as risk-free as Treasuries saw such stress during the week, clearly other paper considered relatively higher risk was under even more strain. Even essentially risk-free state money market debt was seeing yields surging. For example, the SEC yield on the Vanguard New York Tax-Exempt Money Market Fund had risen to 5.00% Thursday from 2.76% at the end of prior week and 1.56% two weeks back. Relatively higher-risk commercial paper market came under a lot of strain. According to Fed data, through Thursday 83% of the week’s CP issuance had been with maturities of 1-4 days, about the same as the prior week, but up from 62% two weeks ago. There was so little term activity in some sectors of the CP market on Monday that the Fed was not able to provide a complete list of interest rates for the day. According to the Fed, yields on lower-rated A2/P2 non-financial CP remained sharply elevated at an average 5.50% for 30-day paper on Thursday and 6.00% for 90-day, enormous spreads over much calmer conditions for AA-rated non-financial paper, which was yielding 1.93% for 30-day and 2.23% for 90-day. Somewhat similar conditions prevailed in the financial sector, though the Fed’s introduction of the ‘asset-backed commercial paper money market mutual fund liquidity facility’ appeared to be providing substantial support to ABCP. According to the Fed’s figures, the average rate on Thursday was 3.14% for 30-day AA financial CP and 2.82% for 90-day. For ABCP, the average rates were 3.72% and 3.80%, respectively. Using the Fed’s facility, commercial banks had bought US$73 billion of ABCP from money market mutual funds as of Wednesday using non-recourse loans (meaning participating banks had no credit risk from the purchases) from the Fed at the discount rate, which represented 10% of the entire ABCP market and nearly a third of money market mutual fund holdings of ABCP. The interbank lending market was in turmoil at week-end, though the market was at least pricing that the situation would improve somewhat – though remain at badly stressed levels – over coming months. Hopefully, we will start to see some positive movement in the coming week once what has been a very rough quarter-end balance sheet squeeze is past. 3-month Libor surged another 55bp on the week to 3.76%, having now risen nearly 100bp in the past two weeks as the market, at the same time, has moved increasingly to price in imminent Fed rate cuts (or at least a continuation of the unofficial easing that has been in place recently, with fed funds averaging well below the 2% target over the past week). As a result, the 3-month Libor/3-month OIS spread – in our view, the best real-time gauge of bank balance sheet strains – spiked more than 80bp over the past week to an all-time high 208bp, which was nearly double the previous all-time high seen before this recent turmoil. Libor rates continue to be officially posted every day and remain key benchmark rates across a variety of floating-rate loans and bonds and swaps markets, so this back-up in rates has real and potentially substantial negative economic implications. But as far as a gauge of actual interbank lending, 3-month Libor is almost purely theoretical at this point, since there is almost no actual term interbank lending occurring. Indeed, the Fed is increasingly becoming the one of the only reliable sources of term money for financial institutions (the Home Loan Banks remain another key funding source), with the Fed’s balance sheet expanding by 22% in week through Wednesday – about matching the growth over the prior four years through the end of the prior week – as loans through a variety and growing list of programs surged. And if banks aren’t even willing to lend to each other for a few months at such extraordinary spreads over their expected overnight funding costs, the implications for their willingness to make loans to businesses and consumers are clear and frightening. There was one modest positive amid this turmoil, though, as the market did move late in the week to price a decent improvement in Libor/OIS spreads on a forward basis – though to still extremely high levels at least through the next year. After getting crushed through the first part of the week, the Dec 08 eurodollar futures contract reversed course Thursday and Friday to end the week with a 7.5bp sell-off to 3.30%. With substantially more Fed easing priced over the overlapping period – the January fed funds contract surged 26bp to 1.65% – the forward Libor/OIS spread to mid-December still jumped about 35bp on the week to near 165bp, but at least came down from Wednesday’s peaks above 190bp and was a good bit below spot levels. Even at such a high absolute level, it could be taken as a somewhat hopeful sign that the forward Libor/OIS spread to December is priced more than 40bp below spot levels, considering that balance sheet pressures, which have been so bad over this quarter-end, have been a major source of market anxiety for some time. The Mar 09 eurodollar contract gained 4.5bp on the week to 2.935% and the Jun 09 contract lost 4.5bp to 3.06%, which caused the forward Libor/OIS spreads to those dates to rise about 18bp to around 115bp and 100bp, but these also at least marked decent improvements from Wednesday’s extremes. Financing markets weren’t in nearly as bad shape as interbank or money markets – certainly at least not for collateral with recognizable prices like Treasuries, agencies and equities; funding less liquid assets is much more problematic – but was also strained. The average overnight Treasury general collateral repo rate averaged 0.94% Friday (but was trading at 0% at the end of the day) after averaging as low as 0.25% Wednesday. Agencies on Friday averaged 1.25% overnight and mortgages 1.50%, as spreads versus Treasuries came in quite a bit with help from the TSLF and all the T-bill supply. For a price, term repo could get done for high-quality collateral, but liquidity in term repo was thin. Almost all of the TSLF options the Fed sold covering the September 25 to October 2 period for the broad schedule 2 collateral were of course exercised given this situation, and it was actually a bit of a mystery why US$2 billion of the US$49 billion in options that were written weren’t exercised. Risk markets ended modestly softer on the week. Depending on your point of view, at various points through the week equity and credit markets could have been seen as either being oblivious to the breakdown in the short-term markets and whistling past the graveyard, or, alternatively, being wisely more forward-looking and rightly relatively calm about the situation in the belief that the financial support plan would settle markets down. The S&P 500 lost 3.3% on the week. Financials took a significant hit after their huge prior rebound, with the BKX banks stock index off 11%, but a lot of weakness was also seen in cyclicals as global growth worries continued. In late trading Friday, the investment grade CDX index was only a relatively muted 11bp wider on the week at 162bp. The high yield index was 58bp wider at 777bp through Thursday’s close, but the index was trading up slightly late Friday. If there wasn’t enough turmoil to worry about already, credit investors are going to have to deal with rolling into the new series 11 CDX indices in the upcoming week. The subprime ABX and commercial mortgage CMBX markets, which would seem to be among the most direct beneficiaries of the support plan, were able to extend to varying degrees the big rallies that greeted initial news of the plan. The AAA ABX index gained another 3.81 points on the week to 52.29 and the AA 1.15 points to 11.92. Additional upside in the CMBX market in the latest week was a lot smaller (though the rally the prior week was bigger), with the AAA index tightening 2bp to 149bp, the junior AAA 5bp to 441bp, and AA 25bp to 595bp. Investors were not paying much attention to economic data during the week, but a fairly light calendar was uniformly bad. Most notable was a very weak durable goods report that pointed to a substantial drop in equipment investment in 3Q. Also incorporating upside in durable goods inventories and a smaller expected contribution from net exports, we cut our 3Q GDP forecast to 0.0% from +1.0%. This would come after a surprising downward revision to 2Q to +2.8%. Though this was still a superficially solid result, the upside was entirely attributable to an enormous positive contribution from net exports; the domestic economy contracted slightly in 2Q. We see consumption falling 1.2%, business investment 6% and residential investment 14% in 3Q at this point, so even if overall GDP growth manages to stay out of negative territory temporarily, the private domestic economy is likely to post a substantial contraction. Meanwhile, home sales, especially for newly built homes, were down in August as mortgage rates spiked, and weakness in regional manufacturing surveys and jobless claims led us to cut our ISM forecast to 49.5 from 50.0 and employment forecast to -150,000 from -125,000. Durable goods orders plunged 4.5% in August. In line with company data, there was a sharp drop in aircraft bookings, but underlying orders also showed major weakness. Non-defense capital goods ex aircraft orders – the key core gauge of business capital spending – fell 2.0% after a much lower revised gain in July of just 0.4% versus the initially reported jump of +2.5%. August weakness was driven by a plunge in machinery orders. Core capital goods shipments were also soft, plunging 1.7% in August after a much lower revised gain in July (+0.4% versus +1.6%), pointing to a substantial drop in business investment in equipment and software in 3Q. We see overall business investment falling 6% in 3Q and the equipment and software component 9%. Inventories became more bloated, rising 0.7% in August, lifting the inventory/sales ratio to a seven-year high. This provided a partial offset to the weakness in investment, as we now see inventories adding 1.2pp to 3Q growth instead of +0.9pp. When we updated our August trade balance forecast, we reduced our forecast for the positive contribution from net exports to 3Q GDP to +0.8pp from +1.3pp. Taken together, these various adjustments reduced our overall GDP forecast a point to 0.0%. Home sales results were weak, though much more so for new than existing homes. Existing home sales fell 2.2% in August to a 4.91 million unit annual rate, extending what has been a roughly stable trend since late last year. Single-family home sales fell 1.4% to 4.35 million and have been similarly little changed on net since late 2007, while condo sales plunged 8.2% to 560,000, reversing what had been a modest recent rebound. The number of homes available for sale plunged 7.0%, dropping the months’ supply to 10.4 months. This is still way above more normal levels near six months and only modestly improved from the April peak of 11.2 months. Meanwhile, new home sales plunged 11.5% in August to a 460,000 unit annual rate, a low since 1991. This drop ended what had also been a recent stabilizing trend in these figures, though of shorter duration than for existing homes. Weakness was concentrated in the Northeast and West, with sales in the West plummeting to a 27-year low. Homes available for sale fell 4.4%, but with the sales pace declining much more, the months’ supply of unsold new homes jumped to 10.9 months from 10.3, just below the March peak of 11.2 months and way above a more normal level near six months. It’s possible that the spike in mortgage rates over the summer that has since been reversed may have contributed to this plunge in sales (though, if so, it apparently didn’t impact existing home sales nearly as much), so activity may rebound somewhat in coming months. Clearly market focus going in to the upcoming week will be the status of the financial system bailout bill and the details of the actual bill if it passes, as it still seems likely to in some form. If a bill passes, major attention will likely be on the specific language regarding equity warrant grants to the federal government by participating companies to judge how widespread participation in the plan might be. Pressures on short-term markets are unlikely to see meaningful improvement and could worsen until we, at least, get through quarter-end on Tuesday. So it will be very important to track developments in money, interbank and financing markets once we do get past September 30 to see if things start to function more normally, as severe quarter-end financial sector balance sheet pressures hopefully ease. Watch for some potential sticker shock Monday, though, as the 3-month Libor setting will cover the year-end turn for the first time and will likely set even higher as a result. If this September quarter-end winds up being an early warning for year-end, things could get very ugly in December. There is a lot of key economic data out in the coming week, but investors may not be ready yet to shift much focus back towards the rapidly deteriorating real economy. Data releases due out include personal income and spending Monday, Conference Board consumer confidence Tuesday, manufacturing ISM, construction spending and motor vehicle sales Wednesday, factory orders Thursday, and the employment report and non-manufacturing ISM Friday: * We forecast a 0.4% rise in August personal income and a 0.3% increase in spending. Distortions related to the tax stimulus rebate checks have contributed to some wild gyrations in income over the past several months. But these effects should be largely behind us at this point – especially with respect to the accounting for pre-tax income. The employment report showed a decline in payrolls combined with a slightly above-trend rise in wage rates, which points to a modest rise in overall income. A similar gain is expected in consumption, with the retail sales report showing an outright decline in retail control that should be more than offset by a rebound in motor vehicle sales. Finally, the core PCE price index is expected to be up 0.25%, with the year-on-year rate ticking up to +2.5%. * We expect the September ISM to fall to 49.5. Weak results from the Kansas City and Richmond Fed surveys after more mixed data from the Empire and Philly regional reports led us to cut our preliminary estimate. We now look for the national ISM to fall half a point from the 49.9 reading seen in August. A slowing global economy should lead to further gradual moderation in factory activity, but this effect should take some time to play out. Hurricane-related distortions may contribute to some elevation in vendor deliveries and boost the composite index this month relative to greater deterioration expected in other key components. Finally, the price index should continue its rapid retreat from the cycle peak seen back in June. * We look for a 1.1% decline in August construction spending. The housing starts data point to a continuation of the slide in residential activity. Meanwhile, the non-residential category finally showed some softening in July after registering a consistent string of upside surprises in prior months. We expect the latest weakening to continue in August. Also, the public category appears to be due for a pullback, given the deteriorating finances of state and local governments. * Industry reports indicate that motor vehicle sales held little changed in September at a 13.6 million unit annual rate after stepped up incentives helped spark a decent rebound in August (though to a still abysmal level) from the 16-year low sales pace hit in July. * The plunge in the durables component and a likely sizable price-related drop in non-durables should lead to a 3.5% fall in overall factory orders in August, which would be the biggest decline in a year. * We forecast a 150,000 decline in September non-farm payrolls. The combined effects of some underlying deterioration in labor market conditions and the distortions related to the hurricane season are expected to contribute to a steeper decline in payrolls than seen in recent months. Although the jobless claims data have been subject to considerable statistical noise in recent weeks, there does appear to have been some noticeable upward drift of late. Moreover, we are assuming a hurricane effect of -50,000 in September. The unemployment rate has moved higher in recent months, consistent with the loss of jobs seen in the more reliable payroll data. However, the 0.4 percentage point spike in the jobless rate last month seemed to overstate things a bit, so we look for a temporary partial retracement in September to 6.0% from 6.1%. Finally, the lagged effect of the recent rise in the federal minimum wage should provide some mild impetus for average hourly earnings, while hurricane effects could help push the average workweek a bit lower.
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Capital Inflows – A Critical Macro Link
September 30, 2008
By Chetan Ahya | Singapore & Tanvee Gupta | Mumbai
Capital Inflows – Key to India’s Recent Growth Acceleration Story India’s potential growth has been steadily rising, driven by improving demographics (rising share of working age population), reforms (create a platform for working age population to operate productively) and globalization (creates job opportunities). However, we believe that over the last few years, India’s GDP growth accelerated much higher than potential growth − an argument that we have belabored for a long time now. India’s GDP growth accelerated to an average of 9.3% during the three years ending March 2008 compared with an average of 6.6% in the preceding three years and 6.0% in the preceding five years. The most important driver for this acceleration in growth above potential was the sharp rise in capital inflows. Capital inflows have risen dramatically over the last five years. India received an average of US$10 billion per annum between 2000 and 2002. During 2003-05, capital inflows more than doubled to an average of US$21.3 billion, followed by an increase to US$38.5 billion in 2006 and to US$98.3 billion in 2007. We believe that capital flows have been the anchor of the self-fulfilling virtuous cycle of higher capital flows – an appreciating exchange rate – lower interest rates – strong domestic demand growth. Are Capital Inflows Dependent Only on the Fundamental Story of EMs? Very often we hear the argument from investors that capital inflows were drawn into India because of attractive growth opportunities and, therefore, this trend should continue unabated. However, this argument is not supported by actual trend for capital inflows in the past. Capital inflows into India have trended in line with overall EM capital inflows. The trend for capital inflows into EMs has been dependent on global risk appetite, which, in turn, has been driven by liquidity and the growth environment in the developed world. As per IIF estimates, capital inflows into EM increased to US$782 billion in 2007 from US$113 billion in 2002. The trend in India has been very similar. Indeed, during F2008 (12 months ending March 2008), India received US$108 billion in capital inflows. There are several key components to this capital inflow: US$29 billion were portfolio equity inflows, US$42 billion were debt borrowings, US$15.5 billion were net FDI and the balance was other inflows. Over the last few months, with the reversal in global risk appetite, we are seeing a sharp fall in capital inflows into India and EMs. As per our estimate, capital inflows on an annualized basis slowed to US$30-35 billion in April-August 2008. India has seen portfolio equity outflows of US$4.3 billion from April to August 2008, in line with the emerging markets. We believe that FDI inflows into India will also decline significantly following portfolio equity. We have observed in the past that FDI inflows into emerging markets and India tend to lag the portfolio inflows by a year. A large part of the rise in FDI inflows into India was in the form of private equity inflows, real estate and acquisition of equity stakes in Indian companies by multinationals. There has not been any significant increase in FDI into greenfield manufacturing activities in India. Hence, a large part of the FDI inflows should likely follow the mood of the capital markets. In our view, a significant part of the non-debt inflows could also have been funded by way of debt leveraging in the international market. Recent credit market developments are making it difficult for global financial institutions to raise wholesale funds. This, in turn, will be reflected in the ability of these institutions to lend to companies. Debt inflows into India have also slowed and should likely drop further. Global debt market deterioration should make it extremely difficult for the companies in India to raise the same magnitude of foreign debt capital at a reasonable rate. It is possible that many small- and medium-sized companies in India may not be able to raise debt at all from the international markets. The environment for the debt market is reflected in the sharp rise in the credit default swap rate (CDS), which measures perceived credit risk. The average CDS rate in AXJ, as measured by Bloomberg’s iTraxx Asia ex-Japan Index (which comprises 70 equally weighted entities), has increased from 48bp as of early July 2007 to 316bp currently. The average CDS for non-investment grade bonds has shot up to 693bp currently from 216bp at the end of September 2007. The average CDS for investment grade has increased to 177bp from 40bp at the end of September 2007. Indian paper has suffered a similar fate, with CDS rates rising to 250-770bp from the lows of 60-100bp in July 2007. Why India Could Be More Affected in the Region? In the current global financial market environment, countries with the twin macro-problems of a high current account deficit and tight banking sector liquidity would likely suffer a major deceleration in growth. In the Asia-Pacific region, Australia, Korea, India and Indonesia are part of this ‘twin-macro problem’. We believe that India would be the most affected after Australia. First, unlike the rest of the region, India runs a current account deficit, and its large balance of payments surplus has been driven by capital inflows. Most other countries in the region have large current account surpluses. Second, India has had a strong credit cycle over the last four years. It has been a beneficiary of a virtuous cycle of large capital inflows – major liquidity infusion – pushing up domestic demand. India’s credit growth has averaged 9.3% over the last three years. Risk-Aversion in Domestic Banking Sector Also Increasing The tight global liquidity environment is quickly transmitting into the domestic market. Risk premia behavior in the global financial markets is contagious. Apart from the tighter liquidity environment, banks are also suffering from higher credit costs, and we expect this trend to deteriorate further over the next 12 months. India has already seen a rise in credit spreads in the domestic banking sector. Credit spreads are widening for corporate sector borrowing as well as for household loans. Corporate sector borrowing costs are rising in the domestic market, with the spread for one-year AAA rated companies over the corresponding government bond yield increasing to 257bp from the bottom of 100-130bp in early January 2008. The spread on one-year A rated paper has increased to 339bp currently. Similarly, banking sector spreads on household loans have increased significantly. Anecdotal evidence suggests that banks are charging a high level of spreads for lending to low-income consumers for consumer durables and automobile purchases, SMEs and property companies. Is There Much Scope for Policy Response? We believe that there is not much scope for a quick policy response to a further slowdown in domestic demand. The government has already been running a pro-cyclical fiscal policy stance. Indeed, the burden of higher oil prices, the government’s announcement of a wage hike for its employees and the write-off of farm loans have pushed the government’s (center plus states) deficit, including off-budget items, to 10.2% of GDP in F2009 (YE March 2009). We don’t expect a quick monetary policy response either. We believe that the RBI is unlikely to cut policy rate until 2Q09. We think that the RBI would hesitate to cut policy rate until we see a deceleration in WPI inflation to the RBI’s comfort levels of 5% from the current 12.14%. Moreover, the RBI’s policy rate decision is also likely to be weighed against the weakening exchange rate (see Impossible Trinity Strikes Again, September 24, 2008). Further Domestic Demand Deceleration Is Inevitable Over the last 12 months, aggressive tightening in India’s monetary conditions has already slowed credit-funded consumption significantly. While investment growth peaked a few months back, as per our estimates, it still grew in line with overall GDP growth in 2Q08. We believe that the increased tightening in the global and domestic financial markets will further slow investment growth. We expect private corporate capex, which has been the key component of investment growth acceleration over the last two years, to be hit badly over the next 12 months. Building in a further deceleration in credit-funded consumption spending and, more importantly, in business capex, we are cutting our 2009 GDP growth estimate to 6.4% from 6.9% earlier. On a financial year basis, for F2010, we are expecting GDP growth to be at 6.5% from 7.0% estimated earlier. This compares with consensus estimate of 7.6% for F2010 (estimated as of early September 2008 as per Consensus Economics Inc.). Financial Market Implications Morgan Stanley strategist, Ridham Desai, believes that the key sectors affected by this macro trend are i) banks with large international operations, ii) property and iii) capital goods and construction. In general, we expect companies with floating-rate foreign exchange liabilities and asset-side exposure to equities and sub-par fixed income securities to likely surprise negatively. Financials and industrials are the main underweights in his model portfolio.
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