France
The ‘Negative Quarters’ Are Still on Their Way
November 18, 2008

By Carlos Caceres | London

The Economic Slowdown in France Is Continuing

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 France are still rising, although at a clearly decelerating rate. Indeed, real house prices reached a standstill in 2Q08, and are likely to have entered negative territory in 3Q08. Nominal house prices will certainly follow suit. Overall, we would expect to see house prices falling in France throughout 2009, albeit moderately. In fact, construction investment has barely moved from its long-run average (and that of the euro area as a whole), and house prices in France do not seem to be really misaligned from fundamentals (see, for example, European Economics: Financial Innovation and European and Housing and Mortgage Markets, July 18, 2007).

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 France enjoys relatively low levels of debt compared to its European counterparts, and compared to the French corporate sector. In this sense, the household sector could prove to be relatively more resilient to the tightening of credit conditions than the corporate sector. However, slowing employment growth will likely erode real disposable income growth, despite the expected fall in headline inflation. Overall, we think that private consumption will reach a standstill (i.e., zero growth) in 2009, and then grow by close to 1% in 2010.

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.

Important Disclosure Information at the end of this Forum

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 South Africa, as 33% of its exports are destined for Europe, compared with 29% to Asia and 13% to the US. We believe that we could be entering a stage where the impact of a further leftward shift in the European (and global) demand curve for South African exports more than offsets the quantity appeal from price attractiveness. Such concerns around export penetration, combined with the sharp fall in commodity export prices, have compelled us to lower our forecasts of export growth from 3.7%Y to 2.2%Y in 2008, and from 6.8%Y to 4.7%Y in 2009. At the same time, the import bill has remained relatively high, as strong growth in imports of agricultural commodities, chemicals and machinery have taken up some of the slack in oil imports. It is worth noting, however, that oil imports are likely to rise somewhat in coming months as one of the major local refineries has been shut down for unscheduled maintenance, following the destruction of its main processing unit by fire. We therefore look for a near-term deterioration in the external trade balance, with commensurate downside risks to overall GDP growth.

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 South Africa. First, using a rolling 12-month moving average, we estimate that commodities account for some 64% of South Africa’s exports, and just 22% of imports (mainly oil). This means that, ceteris paribus, for South Africa to benefit from any downturn in the commodity cycle, oil prices need to fall off thrice as much as the drop in prices of commodity exports such as platinum, gold, steel, coal, etc. This is unlikely, in our view. So far, oil prices have fallen by 64%, while platinum – the country’s largest export earner – is down 62%. Thankfully, gold prices have only fallen by 25% so far, and while this is no doubt a positive development, one should remember that gold accounts for only 7% of South Africa’s exports. Unless production volumes are stepped up significantly, the relative gain here will be marginal. So far this year, gold production volumes have fallen 13.2%.

Inelastic Near-Term Demand for Capital Imports

Second, we believe that in the run-up to the 2010 FIFA World Cup (and beyond), South Africa’s demand for capital imports will become increasingly price-inelastic, given the fixed commitments of such projects. In fact, apart from projects under the leadership of the Airports Company of South Africa, where import intensities may be close to peaking on selected projects, we believe that most of the other capital projects (e.g., Gautrain, Transnet, Eskom, etc.) are still at a stage where the key inputs (cement and steel) can be sourced mainly from local suppliers. As these projects mature, however, their import requirements are likely to rise. This should continue to exert pressure on the balance of payments.

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$17.5 billion in foreign exchange deposits (including advances to foreign banks) at a time where there is a global squeeze in cross-border capital flows). It is not surprising, then, that the country is currently faced with challenges on its external payments balance. In such an environment, one would expect the currency to remain weak as it fulfils its role as the main shock absorber. We therefore stick to our view that US$ZAR will likely close this year around 10.00, and depreciate further to 10.80 at end-2009 and 11.40 at end-2010.

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 South Africa continues to be cost-push, we may be entering a phase where weak demand-pull pressures – both global and local – provide meaningful offset to cost-push inflation. This is a view already shared by a number of local investors that we visited earlier this week, and could conceivably become an important argument in the SARB’s decision function going forward. Added to this is the fact that oil prices have fallen significantly to just over US$50/bbl presently. As we highlighted in our scenario analysis last month (see South Africa Chartbook: November – Macro Cracks Widening, October 30, 2008), were oil prices to fall below US$50/barrel, while the currency remains broadly in line with our view, one could conceivably see inflation fall back within the target range by 3Q09. Such a development could well provide adequate justification for the SARB to initiate the easing cycle much earlier than our central assumption that policy easing would only commence in August. For now, however, we stick to our base case, as we believe that the risks to our currency forecast are to the upside. One must also remember that the oil futures curve has now gone from backwardation into a relatively steep contango, suggesting that oil prices may be bottoming around current levels, and could in fact rise somewhat in 2009/10 as tight supply conditions reassert themselves. At this stage, therefore, we believe that the Philips curve is flat enough to ensure that tepid demand does not fully offset the powerful forces of supply-side inflation.

Important Disclosure Information at the end of this Forum

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 China have so far not been allowed to run a fiscal deficit, it is safe to say that the general government fiscal stimulus is at least as large as the central government fiscal stimulus (i.e., Rmb1.18 trillion).

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 China is about 1-1.5x. Factoring in the multiplier effect, we estimate that the fiscal stimulus package could contribute 2-3pp to GDP growth, ceteris paribus, if only the Rmb1.18 trillion fiscal stimulus from the central government is taken into account. If, however, local government is allowed to run a fiscal deficit to be financed by issuing local government bonds and, in the meantime, new capital from the private sector can be raised, the size of the package and the attendant impact on GDP growth will be larger. For instance, if the local government is allowed to issue Rmb150 billion in debt and meanwhile an additional Rmb50 billion can be mobilized from the private sector (e.g., from SOEs), the broadly defined fiscal stimulus package would amount to Rmb790 billion (i.e., 2.7% of GDP). The impact on GDP growth would be 2.7-4.0pp.

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 China Need to Sell Part of Nearly US$2tn Official FX Reserve Assets to Fund This Stimulus Package?

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 Beijing, Shanghai, Jiangsu, Zhejiang, Guangdong and HeNan announced their respective stimulus plans for the local economies in the next two years, as did several key ministries including the Ministry of Railway, Ministry of Communication and Ministry of Housing. We would expect more announcements from both provincial governments and various ministries in the coming weeks.

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.

Important Disclosure Information at the end of this Forum

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 US recession goes global in a big way.  Though the nominal trade deficit narrowed a good bit in September, a plunge in real exports sent the real trade gap substantially wider.  And while we’re still a week away from data covering the survey period for the November employment report, a terrible weekly claims report suggested that the severe deterioration in the labor market portrayed by the October report probably got even worse this month. 

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 US recession going global, the previous major support to US growth from strong exports is disappearing rapidly.  The trade deficit narrowed to US$56.5 billion in September from US$59.1 billion in August, with both exports (-6.0%) and imports (-5.6%) plunging.  Much of the drop in exports came from a collapse in aircraft on strike disruptions.  Food, industrial materials (largely a price-related drop in fuel oil), consumer goods and ex aircraft capital goods also fell sharply.  The majority of the drop in imports reflected a price-driven plunge in petroleum products.  Consumer goods also fell sharply and autos were weak, while service imports reversed an August spike resulting from Olympics broadcast rights payments.  With much of the drop in imports price-related, the real goods trade deficit widened by nearly US$3 billion, with real exports collapsing 7.8% and imports falling 3.6%.  At this point, we see net exports only adding a few tenths to 4Q GDP growth after boosting growth by an average 1.6pp per quarter from 2Q07 through 3Q08. 

The economic calendar is fairly busy in the upcoming week, and the first round of regional manufacturing surveys for November – Empire State Monday and Philly Fed Thursday – will help set initial expectations for the ISM after it plunged to its lowest level since 1982 last month.  Initial jobless claims this week will cover the survey period for the November employment report, and if the terrible results seen in the last report – initial claims at their highest level since 2001 and continuing since 1983 – are extended, we could be looking at initial expectations for November non-farm payrolls being for a drop in excess of 300,000.  Other data releases due out include industrial production Monday, PPI Tuesday, CPI and housing starts Wednesday and leading indicators Thursday:

* 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.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.