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Global
A Deeper US Recession Goes Global October 07, 2008 By Richard Berner | New York The US Forecast at a Glance
Source: Morgan Stanley Research E = Morgan Stanley Research Estimates
Global Forecast at a Glance
Source: Morgan Stanley Research E = Morgan Stanley Research Estimates Indeed, the recession now threatens to go global, with industrial economies on the brink, and trade and financial shocks threatening the developing world. We now expect that the industrial economies will be flat in 2009, with significant slowdowns underway in all G10 economies. And while outright contraction is unlikely in any EM economy, the combination of external shocks and tighter monetary policies have promoted a dramatic slowing in most EM economies, but especially in Latin America. Our expectation for just 2.7% global growth in 2009 is three quarters of a point lower than only a month ago. These shocks are disinflationary, giving policymakers latitude to respond with easier monetary and other policies to cushion the blow. Our baseline US forecast has long represented the most likely in a distribution of outcomes, but skewed toward downside risks and a ‘tail’ risk of a more severe recession. The logic of adverse feedback loops from credit to the economy is now part of the standard forecast, but only now are analysts and investors becoming aware of the risks. Indeed, our research and that of the IMF suggests that episodes of financial turmoil are likely to be associated with deeper and longer recessions; they typically involve 2-3 times greater cumulative output losses and tend to endure 2-4 times as long than downturns that do not coincide with a financial crisis (see “Of Disasters, Recessions, Crunches and Busts”, The Global Monetary Analyst, August 13, 2008, and “Financial Stress and Economic Downturns”, World Economic Outlook, October 6, 2008). A second feedback loop involves spreading weakness beyond housing to consumer and capital spending, and from a global slowdown to US exports, that will promote further and more intense declines in employment, in turn pressuring income, consumers and their lenders (see Vicious Circles, September 29, 2008). Now the bear case for a deeper recession has become our baseline, with US GDP now likely to contract by 1% or more in the year ending in Q2 09 and the jobless rate rising past 7%. Incoming Income growth, moreover, looks like it is slipping fast. With the decline in nonfarm payrolls accelerating to 159,000 in September and becoming more broadly based, the workweek falling to a record low 33.6 hours, and average hourly earnings growth slowing to 0.2%, private wage and salary income likely declined. Moreover, manufacturing output, which has until recently been supported by exports and IT output, is starting to slide. The plunge in the September ISM business survey, with overall orders sliding and the export orders index hitting a two-year low, signals that a manufacturing recession is underway. Most important, the dislocations in money and credit markets have intensified over the past month, with the potential to impair severely credit availability for consumers and businesses alike if not soon reversed. In money markets, the breakdown in the interbank lending market — evident in the widening of spot 3-month Libor-OIS spreads to 289 bp — threatens mortgage and business finance, as Libor rates are a benchmark for many loans. Despite the heroic efforts of global central banks to flood the financial system with liquidity, bank fears of counterparty risk have resulted in what can only be described as panicky hoarding of cash. Commercial paper markets are less dysfunctional. But the $115 billion runoff in financial paper over the latest two weeks testifies to the inability of some intermediaries to roll over maturing paper, and concerns about nonfinancial companies’ ability to finance themselves in the commercial paper market are rising. Our own survey evidence points to a significant further tightening in financial conditions in the past two months (see The Credit Crunch: Getting Worse, October 3, 2008). These pressures are the result of the ongoing deleveraging of the financial system as losses mount, recently intensified by the demise of a major investment bank and the growing fears of counterparty risk that followed. The TARP was designed to slow that deleveraging process by using reverse auctions to allow leveraged lenders to sell impaired assets and free up balance sheet capacity at prices high enough to be attractive to them but not so high as to disadvantage the taxpayer. The Treasury will have enormous latitude to manage that process and to use warrants for taxpayers and distressed investors to make such bids more attractive. But there are many questions to settle before the process gets going, implementation is likely at least weeks away, and help for markets will lag further. The good news: The Treasury appears to be ready to implement purchases of MBS authorized in the GSE conservatorship plan; officials are contemplating the use of additional backstops for counterparty risk; and, as discussed below, additional monetary ease appears imminent. Meanwhile, the financial crisis is accelerating globally, making what seemed like a mild slowdown a few weeks ago potentially far more serious (for comparison, see The Slowdown Goes Global, September 17, 2008). Courtesy primarily of trade and financial shocks, technical recessions have already overtaken over many of the industrial economies. Their export growth is slowing and a downturn in capital spending is a risk, especially in Understandably, inflation concerns are fading as growth slows, operating rates fall, slack emerges in labor markets, and sellers cut prices in order to retain market share. For example, US operating rates through September have declined by an estimated 340 basis points from their peak, are now below their long-term average, and are likely to decline significantly further. Commodity prices have plunged and inflation expectations have receded from recent peaks, and we expect further declines as growth slows. Already, diffusion indexes of prices paid like those in the ISM survey have moderated sharply, to 53.5 from the 91.5 peak in June. The slowing globally is not uniform, however, and that will influence the eagerness of central bankers to reverse course and ease monetary policy. With markets and the economy at risk, monetary policy will turn to ease soon, with the Fed in the lead. The spreading credit crunch, the deterioration in the economy, and the threat of more downside risks argue for prompt action. Although it may appear to be largely symbolic, given that the funds rate has traded well below the official 2% target, we think that the Fed will ease monetary policy by 50 bp on or before the October 28-29 FOMC meeting, and by another 50 bp at the December meeting. With the ECB having decided against a cut last week, coordinated action is unlikely, but concerted moves are probable by several G10 central banks. Here's an overview of the upcoming regular monetary policy meetings in the G10 and our current expectations for the rate decisions. This week, the RBA, the BoJ and the BoE all have meetings scheduled, and with or without a Fed cut, our economists’ central view is for a 50 bp cut in Australia and a 25 bp cut in the UK, while the BoJ is expected to stay firmly on hold. The last column gives our economists’ assessment of whether and, if so, how a Fed move in the near future would change their current rate forecast. We'll update this as things develop. It is clear from recent sharp declines in equity prices in response to deteriorating economic news that neither a
China
Unscathed by Crisis; Not Immune to Downturn October 07, 2008 By Qing Wang, Denise Yam, CFA & Steven Zhang | Hong Kong Unscathed by Global Financial Crisis The financial crisis that is engulfing the major industrialized economies has inflicted enormous damage on the financial systems in these countries. The repercussion impact has already been felt strongly by many EM economies in the form of capital outflows, tight domestic liquidity and depreciation pressures on their currencies. First, Second, the domestic banking system is still awash with liquidity created by the rapid FX reserve accumulation that stems primarily from persistent current account surpluses. Third, thanks to capital account controls, the cross-border capital flows between Fourth, the financial linkage among sectors (i.e., households, firms and government) within the economy is intermediated primarily by the traditional commercial banks and thus is quite unsophisticated, especially when compared with the highly securitized financial markets in the Fifth, the respective balance sheets of households and the government are strong. The debt levels for households and the government are low at only 13% and 33% of GDP, respectively. Moreover, the banks are well capitalized and awash with liquidity, with the loan-deposit ratio only at 65%, one of the lowest in the NJA region. Not Immune to Global Economic Downturn The impact of the global financial crisis and economic downturn on With the US and EU accounting for about 40% of China’s total exports, China’s exports are sensitive to weaker demand in industrialized countries in general and the US and EU in particular. Our Lackluster exports in Inflation Risk to Subside Markedly Inflation risk in Past experiences in CPI inflation has indeed declined substantially in recent months, and this trend will likely continue, given the outlook for much weaker exports in 2009. Moreover, PPI inflation – which has been persistently high – may have already peaked. The latest September PMI reading for input prices registered a sharp decline. International commodities prices have well come off their peaks. If commodities prices were to stay at their current levels, they would constitute an important disinflationary force for Policy Response: Translating Balance Sheet Strength into Economic Resilience A substantial improvement in the inflation outlook should help to ease the lingering concerns about the inflationary consequences of an expansionary macroeconomic policy. The strong balance sheet for the economy in general and the government in particular lay the foundation for a potentially powerful policy response to boost growth. There is ample room for maneuvering in all three types of policy responses: monetary, fiscal and structural. On the monetary policy front, it would entail unwinding of the tightening policy measures that have been implemented since 2007, including the 162bp interest rate hike, 850bp hike of the ratio for required reserves (RRR) and the stringent administrative bank lending quota. An appropriate policy response should help to insulate On the fiscal policy front, both revenue and expenditure policies could be contemplated. The key revenue measures will likely include raising the minimum threshold for personal income tax (e.g., from Rmb2,000 per month to Rmb3,000 per month) and broadening out the implementation of VAT tax conversion from production-based to consumption-based. Under a consumption-based VAT scheme, VAT taxpayers will be allowed to deduct their capex on machinery and equipment in calculating the VAT base. Our preliminary estimate suggests that the implementation of such a scheme could yield tax savings for enterprises to the tune of 0.5-1.0% of GDP. Besides the revenue measures, the government could also increase its capex spending – especially on infrastructure projects – to help directly boost domestic demand, as was the case during the economic downturns in 1997-98 and 2001-02. More important, government capex tends to serve as ‘seed money’ to catalyze investment from non-government sources such that when exports are down, overall fixed-asset investment tends to pick up the slack. It should be noted that the ultimate capacity of fiscal spending to boost growth is determined by the government debt level instead of the magnitude of the current fiscal surplus or deficit. In view of the relatively low level of public debt in On the structural policy front, the most meaningful policy change will likely occur in the property sector, in our view. We expect potential policy responses to be aimed at boosting housing demand by easing the stringent mortgage lending rules, lowering the mortgage interest rates and rolling back other austere measures imposed on the property sector. These measures, together with a welcome correction in property prices, should increase housing affordability, improve sentiment and revive property sales and investment, in our opinion. In this context, further boosting fiscal spending to increase the supply of affordable housing will likely be another major policy initiative in the authorities’ efforts to strike a balance between supporting economic growth and the social objective of improving housing affordability for low- and middle-income households (see China Economics: Can the Property Sector Be Counted on as the Engine of Growth? September 2). Strengthening protection of farmers’ entitlement to their land will likely be another important structural policy change that could have a profound long-term impact. The authorities are expected to announce such a major policy change at the conclusion of the CCPCC 3rd plenum to be held October 9-12. This policy change will help boost consumer confidence among rural households in the short run and encourage investment and improve productivity in the agricultural sector in the longer term, in our view. Revised Forecasts Factoring in further deterioration in external demand and potential policy responses, we have lowered our GDP growth forecast to 8.2% from 9.0% and our CPI inflation expectation to 2.5% from 4.0% for 2009. We also made a slight downward revision to our 2008 forecasts of GDP growth from 10% to 9.8% and CPI inflation from 7.0% to 6.5%, mainly to reflect the latest developments. The downward revision in the GDP growth forecast for 2009 reflects the following considerations: First, we expect the contribution of net exports to growth to contract to only 0.4 percentage points (ppt) from over 2ppt in 2006-07. We envisage export growth to decline markedly in 2009 to only about 8% in US dollar terms and import growth to drop along with export growth, reflecting the high imports content of exports as well as the generally subdued international commodities prices in 2009. Second, we expect fixed-asset investment growth to decelerate to 9.5% from nearly 12% in 2007, as weaker performance in exports-related manufacturing and property sectors will likely be only partly offset by acceleration in the growth of public sector-led capex spending (e.g., infrastructure projects). We expect the scale of public sector-led capex spending to hinge on the developments in the property sector: weaker-than-expected investment in property sector will likely induce a larger-than-expected public investment program. Moreover, the change from production-based to consumption-based VAT will, ceteris paribus, be positive to capex spending on machinery and equipment in the manufacturing sector, in our opinion. Third, the deceleration in consumption growth will be less dramatic than that in investment. Chinese households are underleveraged and their consumption is not particularly sensitive to monetary and financing conditions. While employment and wage growth will likely slow – especially in the exports-oriented sectors in a cyclical downturn – the secular trend for consumption expansion remains largely intact, in our view. Moreover, the new labor law that became effective at the beginning of the year may have weakened the positive correlation between output and employment on the margin, such that we may not see as dramatic a slowdown in wage growth as in previous downturns. In this context, we expect more moderation in the growth of consumer discretionary than staples, as the former tend to be sensitive to consumer sentiment, which is unlikely to turn upbeat in 2009. We envisage both the GDP growth rate and CPI inflation to drop sharply in the coming quarters and to bottom in 1Q09 and start to stage a tentative recovery in 2Q09, as the effect of stimulating policy package kicks in. This quarterly profile for Policy Calls Through 2009 We expect a decisive policy shift toward boosting growth in the coming months. The following could be key components of the pro-growth package, in our view. On the monetary policy front, we expect four to five cuts in base interest rates (both lending and deposit rates), namely a cumulative 108-135bp reduction assuming a 27bp cut per move, in the remainder of the year and over the course of 2009. We expect these consecutive rate cuts to ensure that the one-year base deposit rate stays at a non-negative level when the inflation rate drops. We also expect the administratively enforced bank lending quota to be raised in 4Q after the 5% increase in July, such that overall bank lending growth will likely reach 16% in 2008. The bank lending expansion would entail multiple RRR cuts over the course of 2009, in our view. The appreciation of the renminbi exchange rate against the US dollar will likely remain slow through 2009. The persistence of a large trade surplus – as envisaged in our forecasts – and the absence of large capital flows due to capital account controls would suggest that any meaningful depreciation is unlikely to be sustained. We expect expansionary fiscal policy – including both tax cuts and expenditure increases – to contribute 1-3ppt of GDP growth, depending on the property sector developments. Risks The risk to our forecasts under the ‘imported soft landing’ baseline scenario is broadly balanced, in our view. The primary downside risks stem from a potential meltdown in The upside surprise to our baseline forecasts will probably come from a better-than-expected export performance, in our view.
Latin America
The End of Abundance October 07, 2008 By Gray Newman, Luis Arcentales, Daniel Volberg & Boris Segura | New York, Marcelo Carvalho | Brazil The remarkable bout of above-trend global growth is ending and, with it, the era of abundance that has characterized Globe Skirts Recession Rate Our global economics team now expects global growth to limp to 2.7% in 2009, skirting an outright global recession. Our We are slashing our 2009 growth projections for At the beginning of the year, indeed since September 2007, we began to warn that the upcoming cycle would likely end What’s Different This Time? First, we have seen little of the excesses common in past upturns in the region. The abundance of the past five years has not produced the ballooning trade and current account deficits fueled by consumer spending seen in the past in Second, Latin Pressure Points While As we have seen in recent weeks around the globe in both developed and developing economies, the credit crunch can uncover pressure points that threaten to intensify a period of weakness in economic activity. While the financial wizardry found in Latin America does not approach what we have seen in the developed world, the region is hardly immune – especially, I suspect, in countries such as And our review of Latin America’s 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 you look at Brazil or Peru 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, March 3, 2008). In turn, the uptick in growth as well as commodity pries has been largely responsible for the region’s improved fiscal stance. Without the support of strong growth and robust commodity prices, We are reducing our GDP forecast for Marcelo notes that trade financing has shrunk by 50% in the second half of September relative to the first half and car financing is getting tighter, with significant increases in financing rates and shortening of tenors during the month of September. Meanwhile, the latest FGV survey of consumer intentions to purchase durable goods has fallen to the lowest mark in two years. And talk is already spreading of a slowing in private investment, particularly in sectors such as auto parts, where the For all the talk of important infrastructure opportunities in And while we expect growth in It should be of little surprise that we expect The backdrop for the Mexican consumer is also deteriorating. Formal employment growth has come to a near-standstill, running just above 1% annualized into August. Meanwhile, banks are turning more cautious towards extending credit to the consumer as they face rising NPLs on credit cards. Lastly, while annual inflation began to ease in September, inflation angst among consumers appears to be riding high. Indeed, consumer confidence has plunged to historically low levels, with the pace of the deterioration comparable to that suffered during the 2001 recession. While there is hope that the government’s ambitious infrastructure program can help offset the With growth coming to a standstill, we expect
Regional Round-Up We are cutting our numbers for growth around the region – Argentina growth in 2009 goes to 1.6% from 4.7% previously, while Venezuela slips to 2.0% from 5.1%, Colombia to 2.0% from 3.4% and Peru to 4.0% from 5.5%. Chile’s growth slips to 1.9% in 2009 from 3.2%, but we believe that its macro policies have put the public sector on solid footing to deal with an imminent global cyclical downturn and potential dislocations in global financial markets. In contrast, Venezuela is likely to find much weaker oil prices combined with strong public spending ahead of the November regional races to put pressure on the fiscal accounts. Indeed, we now expect that the authorities will engineer a devaluation of the Bolivar Fuerte to 2.65 by the end of 2009 (2.15 previously) in response to a deteriorating fiscal outlook and the erosion in competitiveness that is hindering non-oil tradables production. In Bottom Line As the globe flirts with a recession in 2009, look for winners and losers as
United States
The Credit Crunch: Getting Worse October 07, 2008 By Richard Berner | New York Is the credit crunch squeezing Corporate America? The short answer: Yes. After seeing the dislocations in unsecured interbank lending and commercial paper markets over the past three weeks, the answer seems obvious. Libor-OIS spreads at the three-month maturity have widened by nearly 200 basis points, while rates on one-month financial and asset-backed commercial paper and on lower-rated nonfinancial paper have jumped by 200 bp or more. And on a 90-minute call organized by the National Association of Corporate Treasurers, borrowers reported that the cost of new credit lines is skyrocketing. Small wonder: Credit lines are options or insurance policies to provide the right to access cash, and with the old options coming in the money, the sellers of such protection are now charging higher premiums. Looking for corroborative evidence, we asked our equity industry analysts this week to confirm that companies under their coverage were experiencing tighter lending standards and were changing their behavior as a result. Three out of five reported that these companies had more trouble accessing credit over the past two months than previously. And 14% said companies have begun restricting credit to their customers. Given recent market dislocations, we guess that these proportions have jumped in the past three weeks. Our canvass confirms to us that this most severe credit crunch in a generation threatens a serious recession. This survey isn’t the first time we’ve inquired about credit conditions, of course. Each month we canvass the same group of analysts to compile the Morgan Stanley Business Condition Index (MSBCI). In the September MSBCI survey, our credit conditions index fell sharply to levels not seen since March of this year. And the generally difficult credit environment was evident in the fact that not a single industry analyst reported easier financing conditions over the past three months (see Business Conditions: Record Low, September 18, 2008). But this crunch is different. The current market dislocations reflect massive precautionary demands for dollar-denominated funding from Moreover, it’s not just lenders who are hoarding cash; borrowers are too: Anticipating trouble, 64% of respondents to our survey indicated that companies they follow had drawn down credit lines in the past two months, and one-third of those have fully drawn their lines. Analysts cover several companies; of the 461 companies in the sample, analysts said that 91 or 20% of them had drawn on their credit lines, and of those, 15 companies or 16% had drawn them fully. Given that some of this information is derived from 10-Q filings, it is worth noting again that these proportions probably have recently jumped. Eight percent of analysts said their companies were concerned enough about access to cash that they changed cash management strategies. In other words, these companies are fearful that the receivables that go into processing lockboxes will be delayed as the pipeline gets clogged. Our analysts typically cover large-cap companies that have strong balance sheets and big cash reserves. Other evidence strongly hints that small companies are also being hammered. The early-September NFIB survey, a small business poll, shows that smaller companies had nearly as much trouble getting access to credit as at the peak of the last severe crunch in 1990. In our view, the implications for the financial system, the banks and the Fed are clear: (1) Reintermediation of the banking system will require banks to raise even more capital as their loan books grow. (2) Banks’ ROAs will be depressed for longer, as line drawdowns are priced at yesterday’s looser lending standards. (3) Constrained balance sheets will encourage bankers to tighten lending standards for corporates and consumers alike; and the new, unexpected loans will strain balance sheet capacity. (4) The resulting reduced borrowing availability will boost loan losses. (5) Finally, in addition to flooding the financial markets with liquidity, the Fed seems likely to ease monetary policy further by cutting the official Federal funds rate target in coming days, even before the regularly-scheduled FOMC meeting at month end. The spreading credit crunch, the deterioration in the economy — evident in consumer retrenchment, in business surveys, in accelerating job loss, and in renewed slippage in housing demand — and the threat of more downside argue for prompt action. Beyond monetary policy, to break the adverse feedback loop from credit to the economy and back, removing troubled securities and loans from bank balance sheets will help to restore confidence, free up loan capacity, and allow recapitalization of the banking and financial system. That is the aim of the legislation now pending in Congress at this writing. However, this “tough love” comes with a cost: more bank failures. During this phase, bank analyst Betsy Graseck recommends investing in banks with relatively strong capital and relatively low tail risk in the loan book. These should have lower earnings volatility, less dilution, and a higher probability of being able to get through the cycle with increasing market share.
United States
Review and Preview October 07, 2008 By Ted Wieseman | New York Another crazy week ended with Treasury yields much lower across the board. There was a huge rally on Monday in response to the collapse in stocks after the House initially rejected the EESA plan. These gains were mostly reversed as investors grew confident that the bill would ultimately pass, as it did Friday. But by Friday’s close the market had rallied to new highs beyond Monday’s levels on turmoil in the short-term markets and fears that this could lead to a severe credit crunch with potentially major further negative impacts on an economy, which the week’s economic data left little doubt is already in recession even with the EESA passage. Money markets and financing markets came under stress to varying extents across different instruments and terms through the week, and concerns about companies’ ability to finance themselves in the commercial paper market rose. But the greatest immediate concern was focused on the interbank lending market, which at week-end could only be described as broken, as central banks across the globe continued to flood the financial system with liquidity, only to be met with what at this point seems to be an almost insatiable demand by banks to hold on to cash. Clearly, such a situation has potentially critical consequences for credit availability to businesses and consumers if confidence isn’t soon restored somehow. There were at least some incipient signs of hope Friday after severe and worsening stresses through most of the week, with forwards indicating that spot Libor might set somewhat lower Monday after rising every day during the week to new extremes above expected fed funds, and forward Libor/OIS spreads also seeing decent improvement to end the week, which helped short-end swap spreads to pull back partially from record wides hit Thursday. While these were rare positive signs heading into the upcoming week, the situation remains severe, and further substantial improvement will likely be needed before investors can have any confidence about the outlook for broader markets and the economy. Fed funds has already been trading well below the official 2% target for a couple weeks now, so an official rate cut from the Fed would be almost symbolic at this point. Still, we think that such a move, coming on top of the EESA passage, could help to provide some desperately needed confidence in the financial system, so we continue to look for a 50bp Fed rate cut in coming days. Other steps by the Fed are also a good possibility, from further expansions of current programs like the TAF to potentially some new programs, a variety of which are likely being discussed by policymakers. As of the 3:00 close Friday, Treasury yields were 19-42bp lower on the week, and there was a meaningful further rally in late trading Friday evening. The 2-year yield fell 42bp to 1.64%, 5-year 34bp to 2.675%, 10-year 19bp to 3.64% and 30-year 24bp to 4.11%. Even as Treasuries have rallied sharply in recent weeks – the 5-year yield has fallen nearly 30bp in the past three weeks – mortgage rates have actually risen as spreads have widened out, partly on disappointment that it is taking the Treasury so long to start its planned open market agency MBS purchases. With energy prices down sharply – November oil plunged US$13 a barrel to US$94 and November gasoline US$0.39 a gallon to US$2.23 – and nominals rallying strongly, TIPS naturally underperformed, but relative performance was oddly mixed across the curve. There were a lot of weird dislocations across the Treasury market in cash and futures, amid very illiquid trading conditions, so TIPS’ oddities were just part of the general strangeness. The 5-year TIPS yield fell 20bp to 1.64%, while the 10-year yield rose 12bp to 2.19% (so as poor as the nominal 10-year’s relative performance on the curve was, the 10-year TIPS was even worse), and the 20-year yield rose 4bp to 2.49%. This left the benchmark 10-year inflation breakeven down another 31bp at a new cycle low of just 1.45%. We doubt there are many people who really believe that CPI inflation is only going to average 1.45% over the next 10 years. There were heavy liquidity injections across the globe by central banks in dollars and other currencies through the week that in the There were at least some signs of hope Friday as we closed out a painful week, however. Forwards were suggesting that 3-month Libor could set 10bp lower at 4.23% Monday (though these forwards have not been very accurate recently and have been regularly underestimating actual Libor settings), as the passage of the EESA appeared to provide a confidence boost and investors’ hopes rose that the Fed would come in and do something, even if they weren’t sure exactly what the Fed should or could do to help the situation. Forward Libor/OIS spreads also saw an encouraging narrowing move Friday, even with a major dovish repricing of the Fed on the week that saw the low-rate Jan 09 fed funds contract gain 25bp to 1.40%. The Dec 08 eurodollar futures contract gained 20bp to 3.10% – with the gain more than accounted for by a big rally Friday – which left the forward Libor/OIS spread to December only a few basis points wider on the week at a bit below 170bp after being a good bit wider at Thursday’s high. Beyond December, forward spreads fell. The Mar 09 eurodollar contract gained 45.5bp to 2.48% and the Jun 09 contract 51.5bp to 2.545%, lowering the forward Libor/OIS spreads to those dates about 17bp to near 100bp and 10bp to 90bp, respectively. After hitting a record of 165bp Thursday, this improvement helped the benchmark 2-year swap spread narrow to 152bp Friday, though this was still up 9bp on the week and left the 2-year swap rate at almost double the 2-year Treasury yield. Money markets and financing markets weren’t nearly as bad as the interbank market was, but they were definitely strained to varying extents. In the money markets, flight to safety into Treasuries at times seemed to be easing but was in full force by Friday’s close. The 3-month bill’s bond equivalent yield fell 40bp on the week to 0.47% and the 4-week 3bp to 0.09%. Agency money market debt – at this point effectively as government guaranteed as T-bills – at least saw good gains on the week, even if spreads over Treasuries remained enormous. And the agencies were able to issue very heavy volumes of discount notes at these comparatively elevated yield levels, so demand for this paper from money managers was solid. Conditions were more iffy in money market debt perceived to be of somewhat lower credit quality. Even low-risk muni debt continued to struggle. As of Thursday, the SEC 7-day yield on the Vanguard New York Tax Exempt Money Market Fund was still at an extraordinary 5.74%, though this was at least down from a peak of 6.01% hit Tuesday at quarter-end. In the commercial paper market, Fed data indicated that highly rated non-financial companies continued to be able to fund themselves at low rates, with the AA non-financial 30-day yield averaging 2.01% Thursday according to the Fed’s figures, down modestly on the week. Spreads for lower-rated paper remained extraordinarily wide, however, with the average A2/P2 30-day yield at 4.94% Thursday, though this at least was down a good bit from the high of 5.96% hit Monday. Yields on financial paper remained elevated even for higher-rated issuers, with the average 30-day yield for AA financial CP at 3.12% Thursday. Even with substantial support from the Fed – banks had bought more than 20% of outstanding issues through the Fed’s recently introduced lending facility as of Wednesday – the average 30-day ABCP yield was at 4.08% Thursday. An unusually high share of new issuance remained overnight, particularly ahead of quarter-end, and this apparently encouraged some companies to seek out alternative sources of financing, as the amount of outstanding CP saw a record decline in the latest week. Meanwhile, overnight financing rates for high-quality collateral collapsed over the course of the week both on the flight to safety and the flood of cash that helped to drive the fed funds rate and short T-bill yields so low. On Friday, the average overnight general collateral Treasury collateral repo rate was just 0.07%, while agencies averaged 0.20% and mortgages 0.25%. Financing for lower-quality collateral remained difficult, term repo activity remained light, and there were widespread repo fails through the week in specific Treasury securities, though this situation seemed to be getting cleaned up to some extent Friday. Risk markets performed miserably on the week, with a big intraday sell-off in stocks that left them down modestly on the day Friday after the EESA passed, a particularly discouraging way to end a gloomy week. On the week, the S&P 500 fell 9.4%. Financials did comparatively well – the BKX banks stock index only fell marginally – and it was the cyclicals that really took a beating as global recession fears rose. Credit performed poorly, but not as badly as stocks. The now off-the-run series 10 investment grade CDX index widened 26bp on the week to 189bp (the new series 11 debuted Thursday and was trading near 170bp late Friday). The high yield index was 69bp wider at an all-time wide of 849bp through Thursday, but was outperforming Friday afternoon and holding little changed. Bank funding pressures contributed to big losses in the leveraged loan LCDX index, which hit a record wide of 624bp at Thursday’s close before showing some small improvement Friday. The EESA passage seemingly would be positive for commercial real estate debt, but the CMBX market didn’t trade that way, with the AAA index widening 38bp to 187bp, the junior AAA 96bp to 537bp, and the AA 159bp to 754bp. The subprime ABX market was more enthusiastic about the bill. The AAA index fell 1.36 points to 50.93, but all the lower-rated indices rallied, with the AA up 0.65 point to 12.57, a four-month high. Economic data released over the past week continued to indicate that the economy was already in recession even before the impact of the intensified financial crisis of recent weeks. As this worsening credit crunch hits the economy, we expect the recession to deepen substantially further in coming quarters from the 0.6% decline in GDP we expect in 3Q. Note, though, that the modest decline we see in 3Q will likely be substantially boosted by a sizable contribution from inventories and a still significant, but rapidly fading, contribution from net exports. We see final domestic demand (GDP excluding inventories and trade) falling nearly 3% in 3Q. Non-farm payrolls fell 159,000 in September, the ninth straight decline and the biggest in more than five years. Job losses were broadly based, with particular weakness in manufacturing (-51,000), retail trade (-40,000), construction (-35,000) and finance (-17,000). Healthcare (+21,000) remained the only area of relative strength. Other details of the report were also weak. The unemployment rate was steady at 6.1% after surging last month. The average workweek fell to a record low 33.6 hours, which combined with the drop in payrolls led to a 0.5% plunge in total hours worked. Average hourly earnings growth slowed to +0.2%, which combined with the decline in hours worked led aggregate weekly payrolls, a proxy for total wage and salary income, to fall by 0.3%. Consumer spending looks to have fallen for the first time in 17 years and fallen substantially. With real personal spending a weaker-than-expected 0.0% in August and both July (-0.5%) and June (-0.2%) revised down deeper into negative territory, real PCE was already down at a 2.9% annual rate in the three months through August. And terrible motor vehicle sales results point to no improvement in September. Overall sales tumbled to a 12.5 million unit annual rate in September from 13.7 million in August, moving just below the prior low in July to hit a new 16-year low. And there were widespread anecdotal reports in the press of prospective auto buyers being unable to obtain financing for purchases as the month progressed and the credit crunch intensified. We’ll get more key early information on September consumer spending when most major retailers report their monthly sales results on Thursday, and the numbers are likely to be ugly. As a result, we see 3Q consumption on track for a contraction of 2.6%. The ISM surveys for September were somewhat mixed, with previously relatively resilient manufacturing collapsing but non-manufacturing activity holding up much better but still showing close to no growth. The manufacturing ISM index plunged 6.4 points in September, its biggest drop in 25 years, to 43.5, its lowest level since the 2001 recession. Weakness among the key components was severe. Orders (38.8 versus 48.3), production (40.8 versus 52.1) and employment (41.8 versus 49.7) all hit their lowest levels in about seven years and all plunged to deeply below the 50-breakeven level. The drop in the composite index would have been even larger if not for a gain in the supplier deliveries index (52.5 versus 50.3). This likely just reflected temporary disruptions caused by the hurricanes. The prices paid gauge continued to moderate quickly, plunging to 53.5 from 77.0 in August and the 91.5 peak in June. A number of energy, metal and food items were reported down in price. This month, the manufacturing sector had been supported by robust exports even as domestic demand had stagnated. But with domestic demand weakening significantly further in recent months and the export picture dimming – the export orders index hit a two-year low – the previous resilience of the factory sector appears to be ending. Meanwhile, the non-manufacturing ISM composite index fell a half point in September to 50.2, a level consistent with stagnation. Business activity (52.1 versus 51.6) and orders (50.8 versus 49.7) showed small improvement and were in slightly positive territory, but employment (44.2 versus 45.4) sank further. Ten sectors reported growth in September, led by miscellaneous services, mining, education and farming, and eight contractions, led by entertainment, real estate, government and finance. The prices paid index remained surprisingly elevated, falling only three points to 70.0, as non-manufacturing companies still reported upside in a variety of energy and energy-related items and metals, for which manufacturers have already noted price cuts. The economic data calendar is light in the upcoming week, with Thursday’s chain store sales reports the most important releases. Investors will be on high alert for emergency Fed action, and we think that the Fed is likely to deliver at some point over the course of the week with a 50bp rate cut. Fed Chairman Bernanke will speak Tuesday afternoon, and if the Fed hasn’t cut by then, investors will look for signs of when it might plan to move or other steps it could be planning. Other than the chain store sales report and the regular weekly claims figures, the only major data release due out in the coming week is the trade balance Friday. We expect the trade gap to widen by more than a billion dollars in August to US$53.5 billion, with exports falling 2.1% and imports 0.9%. On the export side, factory shipment figures point to weakness in capital goods, while falling commodity prices indicate declines in industrial materials and food. On the import side, there is likely to be a sizable pullback in petroleum products as prices plunged. But royalty payments for the Olympic broadcast rights should sharply boost services, autos likely rose as North American assemblies rebounded, and port data point to some upside in other goods. |
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