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EMEA
CEEMEA: More Growth Cuts November 18, 2008 By Oliver Weeks, Pasquale Diana, Mohamed Jaber | London, Tevfik Aksoy | Istanbul, Michael Kafe & Andrea Masia | Johannesburg Given sharp new cuts to our global growth forecasts (see Beyond a Deeper Recession: Tepid Recovery, Joachim Fels and Richard Berner, November 10, 2008), and further deterioration in commodity and funding markets, we have made significant further cuts to our growth expectations for the CEEMEA region. Across the region, our growth forecast falls from 5.5% in 2008 to 1.8% in 2009, with The largest downgrade to our forecast downgrades in Central Europe is in Hungary, where a combination of tighter pro-cyclical fiscal tightening and a significantly more challenging credit environment will result in a severe recession, in our view. Admittedly, we think that risks remain tilted to the downside, but they are hard to quantify now. Elsewhere, we have revised down growth (the From a central banking standpoint, the implication of our recent downgrades to growth and CPI is that a massive easing cycle is about to start – and it has already begun in some countries (the • In the • In • In • In We have cut growth forecasts significantly across the former For For Weak global demand to cap SA exports and GDP: In South Africa, recent economic data on retail trade, manufacturing value-add and mining production point to significantly weaker 2H08 activity than our central forecasts had suggested; this, together with continued GDP downgrades by our European, American and Asian counterparts, has prompted us to trim our GDP estimates further. For 2008, we now expect GDP to come in at 3.3% (3.7% previously), before falling off a further percentage point to 2.3% in 2009 (2.5% previously). Although it is still early days, recent surveys and incoming data suggest that, so far, the manufacturing sector’s response to the weaker currency is unimpressive – presumably because of a sharp fall-off in global demand. Indeed, recent indicators in a number of developed countries – such as the outsized decline in October US payrolls & vehicle sales, and the vertiginous drop in German manufacturing orders – suggest that economic activity is contracting sharply in the industrialized countries. That our European colleagues now anticipate a longer recession in Europe (-0.6%Y in 2009 versus 0.2%Y previously) is important for SARB to overlook technical dip in 3Q09 inflation: Given our prognosis of a weak rand, we believe that the SARB will find it difficult to cut interest rates as early as the market expects, despite the fact that the economy is slowing sharply. One must remember that, for a sole mandate, inflation-targeting central bank, it is always inflation first, and growth second. After allowing for a R1.30 decline in the December regulated price of petrol as suggested by the latest mark-to-market pricing from the Department of Minerals and Energy, our inflation forecasts now show that CPI could, on a pure technical basis, dip below the upper end of the 3-6% inflation target band in August 2009, thanks to base effects from the spike in oil prices this year. However, it quickly rises above 6% again in 4Q09, as the positive base effects fall out of the wash. Indeed, it is only after 2Q10 that CPI falls sustainably within the target band, closing the year at around 5.6%Y. We believe that the latter reading is uncomfortably close to the upper end of the target band for the SARB to front-load aggressive policy easing as expected by the market. We expand on our views on Compared to the most recent revision in October (see Strong Headwinds from the West: Slow Growth Ahead, October 9, 2008), we revised down our 2008 forecast to 2.3% from 2.7%. We made a similar but more sizeable revision to our 2009 GDP growth forecast by slashing it to 1.9% from 2.5%. Our 2010 real GDP growth forecast stands at 4.6%, which foresees a modest recovery in private consumption and investment spending, as well as a pick-up in exports. However, the pace and timing of the recovery is likely to be dominated by the improvement in global markets, rather than Industrial production continues to disappoint: In September, the IP growth rate eased to -5.5%Y, bringing the average growth rate to -2% in 3Q. The slowdown in production had been visible in almost all sectors, especially in certain groups such as textiles (major employer). However, over the past few months, the industrial heavyweights – such as machinery and equipment, motor vehicles and other transportation equipment, as well as electrical machinery – received their share of the slowdown. The recent IP growth data deviated significantly from our forecast of -2%Y, and based on the outlook for exports, as well as domestic consumption prospects, we have revised down our 2008 growth forecast. In fact, we expect to witness a negative headline growth rate in 3Q08, which might improve marginally in 4Q08 if government spending and a possible improvement in the contribution of net exports outweigh the slowdown in private consumption. Meanwhile, capacity utilization data continued to display a weak picture in 3Q, as the long religious holiday was extended by some car manufacturers when the plants were shut down for production temporarily as a result of weak sales and inventory build-up. At this juncture, we do not expect the capacity usage rate to show any signs of revival until year-end, and the upcoming religious holiday in early December is unlikely to help the picture. On the sales front, the gloomy news on the global economy, rising unemployment and the deteriorating outlook for job security was illustrated by a noticeable decline in consumer confidence and expectations. Nevertheless, more concretely, we have witnessed a continued and sharper decline in passenger car/light commercial vehicle sales, possibly signaling the upcoming weakness in growth. Since most of the car sales depend heavily on consumer loans, we do not expect a pick-up in the sector in the near term, with interest rates at their highest levels in years. Monetary easing unlikely to be a panacea for some time: Unlike various central banks, the CBT is not going to ease monetary policy, in our view. Looking forward, we expect the double-digit inflation rate to linger until 2Q09 in the absence of an appreciation in the currency and/or a marked decline in local natural gas/gasoline and/or electricity tariffs. This, coupled with the pressure on the currency, is likely to force the CBT to preserve its cautious stance. Hence, we maintain our view that no rate cuts will materialize in 2008, and we have recently revised the timing of our first rate cut call to 2Q09 from 1Q09, while maintaining the 150bp total. However, as indicated by the CBT governor during the presentation of the Inflation Report, we would expect the de facto policy rate to become the CBT’s lending rate rather than the borrowing rate, which is 300bp higher than the 16.75% policy rate (current borrowing rate). While the base rate or the borrowing rate might remain unchanged in the next 3-6-month period, the de facto policy rate could fall, which would still mean that the monetary policy rate remains tight. In any case, even the envisaged rate cut in 2009 might not prove effective in inducing spending, since both real and nominal interest rates will still be considered high. UAE: Revising Our Near-Term Outlook While we continue to believe that the UAE’s economy remains fundamentally sound, we are revising our macroeconomic forecasts in line with recent changes to our global economic outlook. Real GDP growth is expected to grow at a slower pace in 2009, with inflation decreasing further than we had previously estimated. We now project that real GDP will grow by about 3.8% in 2009 and 4.7% in 2010, about 2pp lower than our most recent estimates (see UAE: Weathering the Crunch, October 8, 2008). A number of factors have affected our decision to revise our previous forecasts downward. First, recent oil market developments – including lower market estimates of global oil demand and announced OPEC production cuts – have led us to lower our 2009 projections of oil GDP growth from 4.5% to 1.5%. Second, the sharper slowdown in global growth that we are currently projecting for 2009 is expected to have a negative impact on the non-oil sector, including manufacturing (e.g., aluminum and petrochemical production) and trade services, which are now projected to grow at a lower rate next year. Third, the continued weakness in real estate markets is likely to contribute to a further slowdown in the growth of construction and real estate services. Fourth, domestic demand is also expected to increase at a more moderate pace as: (i) investments in the oil sector are phased over time; and (ii) the feasibility of some of the large real estate projects is re-evaluated in response to reduced access to international capital markets and higher funding costs. However, we do not expect any significant reduction in spending on infrastructure, especially in
France
The ‘Negative Quarters’ Are Still on Their Way November 18, 2008 By Carlos Caceres | London The Economic Slowdown in The French economy is experiencing a significant deceleration, which we think is likely to continue in the next couple of quarters. Abated by a strong currency and high input prices in the last couple of quarters, an already weakened French economy will now face the prospects of a serious ‘credit crunch’ combined with a European and global slowdown (see Euroland Economics: Cutting Forecasts Further, November 10, 2008). The French economy managed to escape a ‘technical recession’ in 3Q08, but we think that it will likely experience a few consecutive quarters of negative growth in the near future. On our main case scenario, real GDP is likely to fall by around 0.2% in 2009, and it will likely grow by 1.0% in 2010 (significantly below-trend), according to our forecasts. The Horizon Looks Gloomy for Corporate Investment The expected further tightening of credit conditions will likely take its toll on the corporate sector. This does not bode well for corporate investment. Profits in the non-financial corporations were already squeezed in previous quarters by the surge in oil prices and a strong euro. This is likely to have already led to a significant downward revision in companies’ investment plans. Looking ahead, we believe that the prospects of a serious ‘credit crunch’ are likely to further exacerbate this process. Indeed, we think that investment will likely be the weakest link during this economic downturn. On our forecasts, fixed investment should experience a noticeable contraction (-2.1%) in 2009, and then grow by a mere 0.3% in 2010. Further, we think that the manufacturing sector has already entered what could turn out to be a deep and prolonged recession (see, for example, Euroland Business Cycle Watch: Manufacturing Recession Deepening, September 29, 2008). Construction Will Also Experience a Noticeable Downturn The construction sector is also experiencing a significant slowdown. Housing starts are already falling sharply, and business confidence in the construction sector is at its lowest level since 1997. Indeed, we think that construction (housing) investment will likely accompany corporate investment deep into negative territory next year. Construction investment could actually record a contraction during two consecutive years, according to our forecasts. House Prices Are Likely to Fall, Albeit Moderately House prices in Private Consumption Slowing, but Should Remain Afloat Private consumption will certainly be affected by the economic downturn, yet we think that consumption growth is likely to remain in positive territory both in 2009 and 2010. Indeed, the household sector in Fiscal Balance Likely to Exceed 3% This Year and Next Currently, we expect the government response in terms of fiscal policy to be relatively muted. Indeed, with the budget deficit already at 2.7% of GDP in 2007, we think that there is limited scope for counter-cyclical fiscal measures. However, given the magnitude of the slowdown on our forecasts, we would not be surprised to see fiscal policy turning slightly expansionary in the next couple of years. Overall, we think that the budget balance is likely to deteriorate noticeably, with the deficit exceeding 3.0% of GDP this year and next, and falling back below this ‘ceiling’ only in 2010. Risks to Growth Are Still Skewed to the Downside. Paraphrasing J-C Trichet at the November 6 press conference, “we are living in a different universe since mid-September”. Indeed, there is a greater uncertainty regarding the outlook for the French (and European) economy in the next couple of years. In particular, the money market dislocations could prove longer-lasting than we currently expect, the ‘credit crunch’ could amplify significantly in the coming quarters, and the response from the authorities could turn out to be more muted than we anticipate. Therefore, taking these risks into account, we consider two alternative scenarios for the French economy: a bear case with GDP growth falling 0.9% in 2009, and a rather timid recovery in 2010, and also a bull case scenario with GDP growth in positive territory both in 2009 and in 2010, although well below-trend. Indeed, our bear case scenario is close to the situation observed following the ERM crisis, when the French economy saw its real GDP falling 0.8% in 1993.
South Africa
Further Growth Downgrades November 18, 2008 By Michael Kafe & Andrea Masia | Johannesburg Introduction For the second time in as many months, our global economics team has been forced to take cognizance of the deteriorating global environment, and make the necessary adjustments to our growth, inflation and currency forecasts. We have further downgraded our global growth forecast from 2.5% in 2009 to 1.7%, and expect 2010 to come in at 3.6% (see Beyond a Deeper Recession: Tepid Recovery, Joachim Fels and Richard Berner, November 10, 2008). On the back of these weaker GDP estimates, we expect global demand pressures to subside significantly, with global inflation now likely to come in around 3.8% in 2009 (4.6% previously), before recovering to 4.2% in 2010. Weak Global Demand to Cap SA Exports and GDP In South Africa, recent economic data on retail trade, manufacturing value-add and mining production point to significantly weaker 2H08 activity than our central forecasts had suggested; this, together with continued GDP downgrades by our European, American and Asian counterparts, has prompted us to trim our GDP estimates further. For 2008, we now expect GDP to come in at 3.3% (3.7% previously), before falling off a further percentage point to 2.3% in 2009 (2.5% previously). Although it is still early days, recent surveys and incoming data suggest that, so far, the manufacturing sector’s response to the weaker currency is unimpressive – presumably because of a sharp fall-off in global demand. Indeed, recent indicators in a number of developed countries – such as the outsized decline in October US payrolls & vehicle sales, and the vertiginous drop in German manufacturing orders – suggest that economic activity is contracting sharply in the industrialized countries. That our European colleagues now anticipate a longer recession in Europe (-0.6%Y in 2009 versus 0.2%Y previously) is important for Unfavorable International Terms of Trade Also, we continue to maintain a bearish outlook on the rand, as we believe that the downturn in commodity prices will be net negative for Inelastic Near-Term Demand for Capital Imports Second, we believe that in the run-up to the 2010 FIFA World Cup (and beyond), In short, we believe that, this time around, the adjustment of export and import volumes to currency weakness could be uncharacteristically muted. Funding Constraints on the Balance of Payments Third, while we welcome the fact that the government is doing its utmost to source international capital (e.g., it is helping Eskom to source some US$5 billion from the World Bank, and a further US$500 million from the African Development Bank (ADB)), it is not clear that it will be able to raise enough capital to fully fund the huge deficit on the current account. For example, assuming that Eskom’s program with the World Bank is structured as a single bullet payment of US$5 billion rather than tranches of, say, US$1 billion per year for five years, the full inflow would amount to some R50 billion. Add to this US$500 million (R5 billion) from the ADB and the expected inflow of R22.5 billion from the partial sale of Vodacom to Vodafone (UK) and one gets a total of some R80 billion. This is still less than half of our current account estimate of some -R200 billion in 2008/9. Further, recent data from the SARB show that 3Q08 portfolio outflows were as much as R33.8 billion (i.e., higher than our initial forecast of R21 billion outflows); also, commercial banks have now liquidated up to a third of their foreign exchange deposits over the past 12 months (leaving them with only US$17.5 billion in foreign exchange deposits (including advances to foreign banks) at a time where there is a global squeeze in cross-border capital flows). It is not surprising, then, that the country is currently faced with challenges on its external payments balance. In such an environment, one would expect the currency to remain weak as it fulfils its role as the main shock absorber. We therefore stick to our view that SARB to Overlook Technical Dip in 3Q09 Inflation Given our prognosis of a weak rand, we believe that the SARB will find it difficult to cut interest rates as early as the market expects, despite the fact that the economy is slowing sharply. One must remember that, for a sole mandate, inflation-targeting central bank, it is always inflation first, and growth second. After allowing for a R1.30 decline in the December regulated price of petrol as suggested by the latest mark-to-market pricing from the Department of Minerals and Energy, our inflation forecasts now show that CPI could, on a pure technical basis, dip below the upper end of the 3-6% inflation target band in August 2009, thanks to base effects from the spike in oil prices this year. However, it quickly rises above 6% again in 4Q09, as the positive base effects fall out of the wash. Indeed, it is only after 2Q10 that CPI falls sustainably within the target band, closing the year at around 5.6%Y. We believe that the latter reading is uncomfortably close to the upper end of the target band for the SARB to front-load aggressive policy easing as expected by the market. Low Oil Price and Weaker Demand-Pull Pressures Present Risks to Policy Outlook We acknowledge that, although the source of inflation in
China
A Q&A on the Fiscal Package November 18, 2008 By Qing Wang, Steven Zhang & Katherine Tai | Hong Kong Q1: What’s New about the Fiscal Stimulus Package? A: The Chinese authorities announced on November 9 that the future policy mix will feature “proactive fiscal and appropriately loose monetary policies” (see China Economics: An Aggressive Stimulus Package Announced, November 9). In this context, a Rmb4 trillion stimulus package for 2009-10 was also announced. At a joint press conference held last Friday by the NDRC, MoF and PBoC, the authorities further clarified that the central government would provide Rmb1.18 billion of the Rmb4 trillion package. Q2: What’s the Hurry? A: The authorities have been preparing a pro-growth policy package since this summer in the context of preparing for the Central Economic Work Conference – the annual event that determines the economic policy stance and agenda for the coming year – to be held in the last week of November. Two special considerations appear to have made the authorities decide to announce the key parameters of the policy package earlier than originally planned. First, since Chinese President Hu was going to attend the G20 summit in Washington on Saturday, November 15, by announcing this aggressive pro-growth policy package, Chinese authorities may have wanted to project an image of a ‘responsible stake holder’ amid a global financial crisis in front of their G20 counterparts. Second, underlying economic activity has been deteriorating rapidly – as reflected in the sharp decline in the growth rates of industrial valued-added and power usage – and warrants a prompt and strong policy response to arrest this trend, before larger and more permanent damage is done to the economy. Q3: Is This Rmb4 Trillion Stimulus Package for Real? A: The question is far from as straightforward as it appears. Indeed, there has been much discussion about the true size of the fiscal stimulus package since it was announced. We find that much of debate has actually reflected considerable confusion over three related but different concepts: a) the ‘general government fiscal stimulus’, which refers to additional net spending directly out of the general government budget (including both central and local government); b) the ‘capital-catalyzing effect’, which refers to the total amount of funds that can potentially be mobilized and spent on the designated projects under the spending plan; and c) the ‘macroeconomic effect’, which refers to the impact of that spending on headline GDP growth through the fiscal multiplier effect. The general government fiscal stimulus effect is the combined effect of both central and local government fiscal stimulus. Based on the clarification by officials at the press conference, the central government fiscal stimulus package is worth Rmb1.18 trillion over the next two years (i.e., Rmb590 billion or about 2% of GDP per year). However, the size of the local government fiscal stimulus package is yet to be determined. At the press conference, the NDRC official hinted that some local governments may be allowed to run a deficit to be financed by debt issuance subject to approval from the central government. Since the local governments in The macroeconomic effect is a function of the general government fiscal stimulus effect, the new capital mobilized from the private sector and the magnitude of the fiscal multiplier. The new capital mobilized from the private sector refers to the amount of additional funds that may otherwise be saved instead of being spent. By its nature, this new capital should be treated as part of broadly defined fiscal stimulus, in our view. For example, an SOE does not plan to make any investment in 2009 for reasons completely unrelated to the current economic situation. However, given that pro-growth has become a top policy priority, this SOE may decide to make investment in response to the call from policymakers. The investment undertaken by this SOE is of quasi-fiscal nature and should be treated as part of the fiscal stimulus, in our view. This quasi-fiscal stimulus made by SOEs will likely help to explain the bulk of the upside surprise – if any – to the impact of the stimulus package. According to academic research, the fiscal multiplier in We note that the ‘general government fiscal stimulus’ and the ‘macroeconomic effect’ are distinctly different to the ‘capital-catalyzing effect’. According to the NDRC official, the Rmb1.18 billion pledged by the central government as the ‘seed money’ can help raise Rmb4.0 trillion (i.e., Rmb2 trillion or about 7% of GDP per year) in total capital that can be spent on designated projects under the spending plan. In this light, it is inaccurate to label the Rmb4 trillion package as fiscal stimulus. It should instead be considered as the amount of total capital potentially raised as a result of implementation of the general government fiscal stimulus package which, in its current form, only includes the Rmb1.18 trillion committed by the central government. We think to gauge the incremental investment amount reflected in the fiscal stimulus plan by comparing it to the original investment plan under the 11th Five-year Plan is meaningless, as the so-called Five-year Plan is just an indicative reference and by no means a hard target for either the investment amount or sectoral allocation. In practice, the actual investment execution is very different from the original plan. Q4: How Will This Rmb4 Trillion Package Be Funded? A: The authorities did not explain how it will be funded. The Rmb1.18 trillion committed by the central government will likely be raised through issuance of special government bonds of Rmb590 billion per year. This is in line with our earlier estimate of the potential amount of bond issuance of Rmb400-600 billion in 2009 (see China Economics: How Much Can Be Expected from Fiscal Stimulus, November 4). In light of its strong fiscal position (i.e., government debt level of only about 25% of GDP), the Chinese government should have little difficulty in issuing this amount of bonds at low cost. In general, funding in this context should not be an issue of concern, in our view. Chinese banks are still flush with liquidity and their funding costs are on the decline, as interest rates will be cut aggressively in the coming quarters, in our view. In this context, if the government is to co-finance a quarter or third of the investment projects, the banks should be quite willing to provide the rest of the financing need, in our view. Q5: Does A: Absolutely no. Domestic liquidity is abundant, as indicated by the very low loan-deposit ratio in the banking system (i.e., about 65%). The central bank can simply lower the still very high RRR or cut back the scale of its sterilized intervention (through issuing less PBoC bills) to provide the liquidity support, with absolutely no need to draw down its FX reserves. To the extent that the stimulus package will boost domestic demand and thus imports, it will lead to a smaller trade surplus and hence less rapid accumulation of FX reserves. But this type of impact will likely be quite marginal, given that Chinese producers who are suffering from overcapacity should be able to meet the bulk of the demand increase as a result of the stimulus package, negating the need for increasing imports. Q6: How Will This Stimulus Package Change Your Outlook for the Chinese Economy? A: We recently downgraded our GDP growth forecast for 2009 from 8.2% to 7.5%, despite the announcement of this fiscal stimulus package (see China Economics: Further Growth Forecast Downgrade amid a Deeper Global Recession, November 10). This is because we have already factored in the impact of the potential fiscal stimulus package. Without this stimulus package, the economy would likely head towards a hard landing (e.g., 5%) in 2009. With this fiscal package, the risk of a hard landing scenario (i.e., below 7% growth) has diminished substantially, in our view. That said, the economy will likely continue to decelerate over the next three quarters before bottoming out by mid-2009 and staging a modest recovery in 2H09, as external demand starts to improve and the effect of the pro-growth policy kicks in. Q7: What’s Next? A: The authorities are expected to hold the annual Central Economic Work Conference in the last week of this month. We would expect more details to be provided about the stimulus plan. Over the course of last week, local governments of several economically advanced provinces including Q8: What’s the Bottom Line? A: We think that, at this juncture, debating whether the Rmb4 trillion package is incremental or how it is going to be funded is of second-order importance (though we have spent much time on this subject). The key is that the government’s policy stance has shifted decisively toward pro-growth by adopting a campaign-style approach. It is clear that the authorities want to bring growth to a desired level using all means at their disposal. If this current policy package were to prove insufficient, we have no doubt that it will be augmented. The question is, what is the magic number – i.e., the desired level of GDP growth for 2009? We think that growth of 8-9% is what the authorities really want to achieve, but if it were to turn out to be 7-8%, it would also be considered acceptable. So, if one has strong conviction that the market has priced in a too low a growth scenario, then the market is underestimating the ultimate impact of the authorities’ policy response, in our view.
United States
Review and Preview November 18, 2008 By Ted Wieseman | New York Treasuries posted good 5-year-led gains over the past week as risk markets performed terribly, with a meltdown in the subprime and commercial real estate markets following the announcement that the original purpose of the TARP to buy these assets was being abandoned of particular note, and economic data remained terrible. The refunding auctions that were a major focus through the holiday-shortened week were mixed, with the revived 3-year note receiving a surprisingly warm reception, the 10-year doing okay, and the bond reopening tailing badly (but subsequently recovering in a good rebound Friday). It was a light week for economic data, but the bad news continued in what was released. The October retail sales report was one of the worst in history, confirming that the sharp decline in consumption in 3Q has extended in a substantial way into 4Q. We cut our 4Q consumption estimate to -2.4% from -2.0% after an expected downward revision in 3Q to -3.3%. At this point it looks like the total drop in real consumer spending in the year through 2Q09 could end up being the worst one-year decline on record. Combined with what will likely be a more negative inventory contribution after an upside surprise in September retail inventories, 4Q GDP appears at this early point on track for a decline near 4%. A significant contributor to the likely steep deterioration in overall growth is the ongoing collapse in previously robust exports as the On the week, benchmark yields fell 3-22bp, led by the 5-year. The 2-year yield fell 10bp to 1.24%, 5-year 22bp to 2.34%, old 10-year 12bp to 3.66% and 30-year (which had the most problems with the new supply) 3bp to 4.21%. The 3-year was actually the best performer through the week after its Monday debut, rallying from the 1.80% auction award to close at 1.55% Friday. This issue never really found solid sponsorship during its previous revival from 2003 to 2007, so its initially very positive reception was surprising. It remains to be seen if the enthusiasm can be sustained in the face of US$25 billion a month of new supply. Meanwhile, the new 10-year rallied slightly from the 3.78% award at Wednesday’s auction to close the week at 3.74%, while the 30-year made it back to near Thursday’s pre-auction levels Friday after tailing nearly 10bp to 4.31% at the auction. TIPS had a mostly positive but oddly mixed week despite a further collapse in energy prices. The 5-year yield plunged 20bp to 2.45% and the 20-year 13bp to 2.82%, but the 10-year yield rose 6bp to 2.89%. Liquidity in TIPS, as in most other markets at this point, is so poor that relative performance overall and within the sector is being largely driven by where there happen to be flows and what direction they’re in rather than any sort of fundamental considerations. Mortgages bounced around a fair amount during the week, but current coupon yields held pretty close to the 5.5% level they’ve been hanging around since the big rally the first few days of the month. The Monthly Treasury Statement showed that the Treasury has been buying roughly US$1 billion every trading day, helping significantly to keep this part of the market supported. Agencies, on the other hand, continued to perform terribly, with spreads over LIBOR at the longer end blowing out to more record wides at more than 100bp over LIBOR, continuing effectively to shut the debt markets to the agencies except at the very short end, where demand for agency money market debt has remained strong. It was a rough week for risk markets, and while a 6% plunge in stocks attracted most of the headlines, the meltdown in subprime and commercial real estate was more worrisome. The subprime ABX and commercial mortgage CMBX market had been trading poorly for several weeks as no progress was being made in moving ahead with TARP purchases of distressed assets, suggesting that they might have already moved a long way towards discounting that these purchases would never happen. This definitely turned out not to be the case by a long shot, however, as these markets collapsed after Treasury Secretary Paulson confirmed Wednesday that the original purpose of the TARP was being abandoned and that there would be no purchases of real estate debt. Losses in the CMBX market were particularly severe, with all the indices gapping to a series of record wides. The AAA index widened 145bp on the week to 412bp, junior AAA 306bp to 1,332bp, AA 298bp to 1,695bp, A 336bp to 2,220bp, BBB 418bp to 3,196bp, BBB- 408bp to 3,628bp and BB 555bp to 4,548bp. This market saw a decent temporary rally after the TARP was first proposed, but current levels are now drastically worse than before the plan was even floated. Relative to the closes on September 17, the day before the TARP proposal was announced, the AAA CMBX index has now widened 206bp, junior AAA 716bp, AA 823bp, A 926bp, BBB 1,149bp, BBB- 1,154bp, and BB 1,258bp. This market probably would have been better off if the distressed asset purchase plan had never even been proposed instead of having the rug pulled out from under it with the Treasury’s recent actions. As badly beaten down as the subprime ABX market already was, it had less room to plunge further, but additional losses for the week were still severe across all indices – AAA (35.85 versus 39.70), AA (7.15 versus 9.41), A (5.74 versus 6.91), BBB (4.06 versus 4.74) and BBB- (4.09 versus 4.82). Since end-September, the AAA ABX index has now fallen 29% and the AA 40%, which could lead to another round of brutal marks this quarter for banks on their remaining subprime exposure if prices don’t recover by year-end. The recent collapse in the leveraged loan LCDX index is likely to add to banks’ 4Q pain, with the index widening 84bp on the week to 948bp through midday Friday, up from 545bp at the end of September. Amid the weakness in stocks, subprime, commercial real estate and leveraged loans, credit held in relatively well. In late trading Friday, the investment grade CDX index was 16bp wider on the week at 204bp. Through Thursday, the high yield index was 36bp wider at 1,159bp, but the index was trading down nearly a point late Friday. On top of the weakness in risk markets centered on the commercial real estate and subprime meltdown, additional negative signs for the financial system came from some back-tracking in term interbank lending rates that was extrapolated forward to a substantial extent in futures markets. Through Wednesday, 3-month LIBOR had set lower for 23 consecutive days, plunging from the 4.82% October 10 peak to 2.13%. But this reversed course Thursday and Friday, with 3-month LIBOR setting Friday at 2.24%. This was still a net 5bp improvement on the week that brought the spot 3-month LIBOR/3-month OIS (a measure of the average expected fed funds rate over the next three months) spread down a similar amount to 173bp. Futures markets, however, took the reversal in the long-standing declining trend quite badly, sending forward LIBOR/OIS spreads substantially higher, as the Dec 08 eurodollar contract lost 26bp on the week to 2.295%, Mar 09 21bp to 2.145%, Jun 09 14bp to 2.165%, and Sep 09 3.5bp to 2.225%. This boosted the forward LIBOR/OIS spread to December by about 30bp to 175bp, March 26bp to 141bp, June 21bp to 127bp and September 15bp to 101bp. The market now doesn’t see the terrible damage done by the Lehman collapse being reversed until December 2009, when LIBOR/OIS spreads are finally priced to return to pre-Lehman levels near 80bp (which, it’s almost hard to believe now, actually seemed quite elevated at the time just a couple months back). Retail sales plunged 2.8% in October, with auto dealers’ receipts falling 5.5% as unit auto sales hit a 25-year low and ex auto sales plummeting a record 2.2%. Though much of the drop in ex auto sales was driven by a largely price-related 12.7% decline at gas stations, weakness was broadly based. Sizable drops were seen in most discretionary categories, including clothing (-1.4%), general merchandise (-0.4%), furniture (-2.5%), electronics and appliances (-2.3%), and sports, books, and music stores (-1.6%). The key retail control component plunged 2.3%, adding to a very weak start for 4Q consumption after the plunge in 3Q. We see 3Q consumption being revised down to -3.3% from -3.1% and now see 4Q running at -2.4%, down from our prior forecast of -2.0%. Indeed, we see growth in real consumption in the year through 2Q09 coming very close to the post-war record full-year decline of -1.5% posted in 4Q74. Meanwhile, the business inventories report had a mixed impact on 3Q and 4Q growth. Ex auto retail inventories rose 0.4% in September, much higher than BEA assumed in preparing the advance GDP estimate. This more than offset the likely downward revision to consumption, to lead us to boost our expectation to the revision to 3Q GDP to -0.7% from -0.8% (versus the advance estimate of -0.3%). This points to an offsetting weaker inventory contribution in 4Q, however, to add to the worsening trajectory for 4Q consumption. As a result, we cut our 4Q GDP estimate to -3.9% from -3.5%. While the trade report for September didn’t have any further impact on our GDP forecasts, it did highlight an important reason why 4Q is likely to be so weak – with the The economic calendar is fairly busy in the upcoming week, and the first round of regional manufacturing surveys for November – * We look for only a modest 0.5% recovery in October IP following the plunge seen in September (-2.8%). In fact, the bulk of the expected upside reflects a hurricane-related rebound in oil refining and drilling. Most other sectors are expected to show further declines, mirroring the weakness in the manufacturing sector that was evident in the latest employment report. * We forecast a 2.1% plunge in the overall producer price index in October and a 0.2% decline excluding food and energy. A 20% plunge in wholesale quotes for gasoline is expected to contribute to a record decline in the headline PPI for October (note: the data stretch back to the late 1940s). The natural gas and electricity categories are also likely to post declines. And softness in beef and dairy prices is expected to lead to further deceleration in the food component. Meanwhile, the PPI survey of motor vehicle prices transitions to the new model year every October. This can sometimes lead to some very sharp swings in car and truck prices. This time around, we suspect that a decline in the motor vehicle category will help to restrain the core. * We look for the consumer price index to plunge 1.0% in October overall and rise 0.1% excluding food and energy. The energy component is expected to post a double-digit decline, leading to an all-time record drop in the headline CPI for October (note: the current record is -0.9% recorded in July 1949). Also, food prices appear to have softened significantly in October following a long string of elevated readings. Elsewhere, industry surveys point to an unusually large fall-off in hotel rates. Finally, we expect further weakness in key categories such as motor vehicles and apparel. * We forecast October housing starts of 775,000 units annualized. The October labor market report showed a further fall-off in hours worked within the construction sector, pointing to a continued decline in starts. We look for about a 5% dip in October. While starts are expected to drop by another 15% or so over the next 6-9 months, the level of new homebuilding activity is already so low that the inventory of unsold residences is shrinking at an accelerated pace. Thus, there finally appears to be some light at the end of the tunnel. * The index of leading economic indicators is likely to fall 0.3% in October, resuming sinking following a small rebound last month from its biggest two-month drop in 18 years in July and August. This month will likely see a huge negative contribution from stock prices and smaller, but still sizable, subtractions from consumer confidence and supplier deliveries. The main positive offset should be a surge in the real money supply, but only because of plunging inflation. The steep yield curve will also provide a boost. |