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Japan
Sharpest Fall Since 1974: December Tankan Preview December 03, 2008 By Takehiro Sato | Tokyo Depth and Trajectory of the Downturn Is Without Recent Parallel The December Tankan will be very different from the September survey, given the transformation of global financial markets since mid-September and reworking of business plans in light of 1H results. We expect the headline to plunge by double-digits, negative growth in the capex plans of large companies and recurring profits to drop 30% for major downward revisions as already signaled by company guidance in the interim reporting season. Recent industrial production data for October make clear that the depth and scope of the downturn will exceed that of the post-IT bubble at the start of the decade, and rival the first oil shock at the start of the 1970s. The Tankan will serve to confirm the depth and trajectory of the current recession. Forecast for Business Conditions DIs We expect the headline (business conditions DI for large manufacturers) to record the second-largest drop on record, slipping 23pt from -3 in September to -26 in December. This would almost match the 26pt drop between the June (+8) and September (-18) surveys in 1974, when the first such data were available. In terms of level, however, there have been worse readings at several points, e.g., -38 after the IT bubble (December 2001-March 2002), -51 at the time of the Asian Financial Crisis (December 1998), -43 after the land price bubble (December 1993-March 1994), and -57 during the first oil shock (June 1975). So, compared with past recessions, our forecast does not come across as unduly bearish. We look for the outlook DI to worsen further to -29. The outlook DI tends to comes out weaker than the current DI for manufacturing, but this time we see a danger that in the absence of any signs of recovery in January-March, the headline number in the next Tankan (March) will show further deterioration. Incidentally, a rough estimate of BoJ Tankan forecasts based on Reuters Tankan data announced on December 2 gives us figures of -21 for manufacturing (down 18pt from the September Tankan) and -3 for non-manufacturing (down 4pt). We avoid using these results as our actual forecasts since data for production, inventories, exports, share prices and corporate earnings must be weighed. (At the moment the usual practice is for economists to publish BoJ Tankan forecasts immediately after the Reuters Tankan figures, but normally there is a gap between the two announcements of more than ten days. Meanwhile, survey responses from the companies are likely to keep coming in after the official deadline in late November (November 27). This means that in highly volatile times such as currently, responses about the outlook can change with the prevailing market environment.) We expect the drop in the DI for SMEs to rival the pace of the declines in 1975 and 1998, in light of grassroots sentiment highlighted by the Economy Watchers Survey and Shoko Chukin Bank’s Business Survey Index for Small and Medium-Size Enterprises, in which the former is the worst on record and the latter at 10-year lows in terms of levels. Forecasts for F3/09 Management Plan Revisions 1) Sales and profit targets: In the September Tankan, large companies (all industries) were looking for recurring profits to drop by single-digits at 9.4% in F3/09. We expect the December survey to point to a decline of 25-30%, reflecting revised corporate guidance after interim earnings results. (Company guidance is provided on a consolidated basis, whereas sales and corporate profits in the Tankan are parent-based. So Tankan-based corporate profits tend to show lower growth than the consolidated figures.) Note that we are also expecting a 30% decline this term, on the MoF’s corporate statistics basis (large firms, excluding financials; parent entities). However, industrial production has recently been falling away more sharply than on average in recession since the 1970s and by more than in the wake of the IT bubble. Production is plunging almost as steeply as during the first oil shock in 1974, and the gap between peak and the nearest trough in December survey forecasts is more than 15%. Assuming another cut of about 5% in January-March, we must be steeled for a massive 20% drop in overall industrial output in the current downturn. Even using a constant assumption for sales prices, manufacturing industry sales would drop nearly 10%. Meanwhile, the benefit (improved terms of trade) from prime cost reductions due to the pullback in energy and raw materials prices would not show up until F3/10 at the earliest, so negative gearing will remain in effect for now. The sales assumption above suggests that our forecast for profits to decline 30% is not pessimistic, and could even be somewhat rosy. We believe that negative news flow will continue until late April when ultra-conservative guidance for F3/10 comes out. Our exchange rate assumption underlying the corporate earnings outlook above is an average of JPY99/USD for F3/09. If the yen were to weaken by JPY5 against the dollar on average for the year, about 3% points would be added to the profit outlook. Our average oil price assumption, meanwhile, is US$94/bbl (note that this is not our forecast). A 10% drop in energy prices would improve the profit outlook by roughly 3pp. 2) Forecasts for F3/09 capex plan revisions: We expect full-year capex plans to be revised significantly in the December Tankan, for the reasons discussed above for sales/profits. Capex is likely to track well below the average for the past five years, in a fragile economy hampered by liquidity constraints. Some degree of replacement demand is coming up in non-manufacturing industries such as electric power, but will not be enough to compensate for reduced investment in capacity expansion by manufacturers. Specifically, we forecast that the revision rate for large companies will be -3.0% (the average for the past five years is +1.1%), leaving these firms projecting a 1.4%Y decline (including land, excluding software), comprising -0.3% for manufacturing (revised down 5.7%) and -2.0% for non-manufacturing (revised down 1.3%). Note that the Nikkei Shimbun’s Survey of Capital Investment (November 24), which post-dates the global financial turmoil of September/October, showed listed companies still projecting year-on-year growth with a 2.4% increase in F3/09 capex. However, we believe that these plans are under review, given the severity of the economy’s decline since October, and see potential for downward revisions in the March and June Tankan surveys. The stricter lending stance by banks is now pushing some firms out of business in the construction/real estate industries due to funding problems. We expect corporate financing to get tighter ahead of the end of December and March, and fear an upswing in bankruptcies that spreads beyond these areas. Given the liquidity constraints still present, we are not hopeful that capex will pick up significantly in F3/11. Policy Implications The BoJ put together a package of financing assistance for companies facing tighter conditions in the run-up to year-end and fiscal year-end at an emergency meeting on December 2. The bank reintroduced a lending facility, which accepts corporate debt obligations as eligible collateral (as applied temporarily between December 1998 and April 1999), but unconventional measures such as purchasing commercial paper have not been included, and we suspect that the impact will be modest. Governor Masaaki Shirakawa seems determined to use interest rates as the mechanism to facilitate funding distribution in the market, and extremely reluctant to invoke unconventional measures. However, the downward momentum in the economy in October-December 2008 and January-March 2009 goes beyond the IT bubble aftermath early in the decade and rivals the first oil shock early in the 1970s. In the past, the BoJ has tended to find itself forced into more extensive monetary easing than first intended after modest and belated initial steps taken reactively in response to the economy and the market. We believe that as the downturn deepens and pressure from the markets is ratcheted up, the bank will not only have to revert to ZIRP (the zero interest rate policy), but also to adopt unconventional measures such as outright purchasing of private-sector debt and stocks.
United States
The Capex Recession Goes Global December 03, 2008 By Richard Berner | New York A deep US capital-spending recession is now under way that could easily rival the bust of 2001-2. The earlier slump was severe and long: Real equipment and software spending contracted by 12.3% between the end of 2000 and the trough in 1Q03. There are critical differences: While that earlier downturn was the product of capex excesses, especially in IT, this one is rooted in the financial excesses and credit crunch that lie at the heart of the current global downturn. But the two episodes have key elements in common. Perhaps most important, globalization then and now means that even America’s premier capital goods companies have nowhere to hide. In 2001-2, these global players were exposed to the global tech and telecom bust. Today, the forces are broader: Courtesy of the steepest global recession in at least two decades, these companies confront a capex slump that is truly global in scope. Moreover, the end of US investment tax incentives enacted as part of last January’s economic stimulus package will accentuate the capex downturn. Following moderate declines averaging 3.8% annualized in each of the first three quarters of 2008, incoming data point to a significant deterioration in investment outlays for equipment and software in the current quarter. Nondefense capital goods shipments excluding aircraft plunged 2.4% in October and have tumbled at an 11.3% annual rate in the past three months. Moreover, bookings for nondefense capital goods ex aircraft – the key gauge of equipment capex demand – slumped 4.0% in October and sagged at a vertiginous 32.3% annual rate in the past three months; that’s their worst three-month plunge since the last recession in 2001. No category was spared in October: Declines in machinery (-6.8%) and high tech (-2.4%) orders paced the slide. Those data and declines in IT production put investment in equipment and software on pace for an estimated 16% annualized decline this quarter, and more sharp declines are likely. Partly as a result, we are tracking 4Q GDP at -5% (down from our last published estimate of -3.5%) − the worst quarterly result since 1980. Four headwinds are promoting this capex slump. First, the economic ‘accelerator’ is working in reverse, reflecting the effects of slower growth over the past year and now outright declines in overall output. The ‘flexible accelerator’ model of investment implies that business investment will respond with a lag to changes in the desired stock of capital in relation to output. As a result, a deceleration in the growth of economic activity – such as that over the past three years from the housing recession – will depress growth in investment. And outright declines in output will intensify the process. Managers will tend to extrapolate a slowdown in business activity into dimmer expectations of future growth, lower perceived returns from investing, and a reduced need to invest. Such ‘accelerator’ or ‘decelerator’ effects typically kick in over several months, and this one arrived right on schedule starting more than a year ago. Until the economy re-accelerates, therefore, capital spending is at risk. Tumbling operating rates are also depressing capital spending, especially in traditional industries where lingering excess capacity cries out for consolidation. Magnified recently by Hurricane Ike and the Boeing strike, overall industry utilization rates declined to 76.4% in October, or some 500bp below their peak the year before. Even in disciplined industries, falling operating rates have always been a death knell for investment spending in Smokestack America. When excess capacity appears, pricing power dwindles, margins shrink, and companies try to absorb the excess. Often it takes a while. In the past, such excesses followed a capital-spending boom triggered by strong economic fundamentals that then deteriorated just as the new capacity came on line. This time, because operating rates have hinted at excess capacity in many Old Economy industries for years, companies have shown relative restraint. But when demand was buoyant, these companies tried to hang on or invest in new processes in the hope that they could cut costs, improve quality and gain market share. Unfortunately, global competition undermined that strategy in many cases. As a result, operating rates in lumber, iron and steel, furniture, motor vehicles and parts, textiles and apparel, paper, and chemicals are all close to or below the lows of the 2000-1 and/or 1990-91 recessions. Utilization rates in fabricated metals, construction materials, machinery and plastics are declining rapidly. These industries account for fully 44% of industrial output and two-thirds of manufacturing capex. Some of these companies flinched from rationalizing capacity in the expansion, but recession likely will force their hand. A third, related force depressing capital spending is sinking profitability. Capex discipline enabled companies significantly to boost margins in the expansion, and the resulting surge in corporate profits and cash flow meant they did not need to borrow for capex, inventories or working capital. Now, recessionary pressure on margins and corporate cash flow is a significant obstacle to capital outlays, especially when access to external financing is limited to nonexistent. Indeed, the companies most likely to buy low-tech equipment are under significant operating and financial stress, the more so recently because the dollar’s rebound and sinking operating rates have robbed them of pricing power. Finally, the credit crunch almost certainly will squeeze capital spending. Such outlays aren’t as credit-sensitive as housing or big-ticket consumer durables, and the lags between changes in financial conditions and changes in capex may be longer. Moreover, the analysis is complex, as gauging the interplay of higher costs and diminished availability of credit is difficult. But the impact has clearly been negative in the past, and today seems likely to follow that pattern. Beyond equipment, which accounts for two-thirds of US investment outlays, commercial capex is also at risk. To the four headwinds noted above one must add the recent increases in office and industrial vacancy rates and the slippage in commercial rents, especially in mall and other retail space. Prices for existing properties are still quite elevated in relation to cash flow (‘cap rates’ are still below historical norms), and NCREIF data show that returns (income plus capital) have slipped close to zero or have turned down – both typical warning signs of a coming bust in commercial construction. The global recession is magnifying the impact of those factors on US capital spending in three ways: Weaker US exports are hurting overall US output, intensifying the reverse accelerator and depressing operating rates. Weaker global capex demand is trimming the demand for US exports of capital goods. And the downturn abroad is intensifying the global pressure on US profits and cash flow. The feedback loop from US weakness to global growth also is increasing downside risks to capital spending. Our global economics team sees plenty of evidence for capex weakness. In Europe, Elga Bartsch notes a very sharp fall (10% from the April peak) in domestic order demand inflow to German capital goods producers, and capital goods producers across the euro area are slashing their output plans aggressively. The declines actually began during the third quarter across many countries. Melanie Baker points out that agents surveyed by the Bank of England have pared capex plans in the wake of increased uncertainty about the outlook and tighter financial conditions. UK contacts also reported some slowing of Middle and Far Eastern demand for capital goods, reflecting lower oil prices, the global effects of the credit crunch, and overcapacity in some sectors. And Pasquale Diana notes a sharp slowing in Eastern European capex. In Mexico, our LatAm team observes that the outlook for capex is darkening as export demand dries up. Details of the most recent October manufacturing surveys paint a worrisome picture. The index of manufacturers that feel this is an auspicious time to invest plunged to 14.2, a historically low level and 30.9 points below a year earlier, while the industrial orders gauge dipped to 48.5, the second month below the 50 “neutral” threshold. Meanwhile, annual growth in capital goods imports slowed to 13.4% in October, off from 24.9% in the third quarter. Evidence from FDI corroborates the deteriorating industrial backdrop: Inflows into manufacturing are down 42% annualized compared to 2007. The slowdown has spread across Asia as well. Takehiro Sato notes that Japanese core machinery orders fell 10.4% Q/Q in the summer quarter, the largest drop in 10 years. Gerard Minack notes that the Australian mining investment boom is not over as many of these are long-tail projects, and the pipeline, for now, is bulging, but a number of project cancellations or delays were announced over the past month. The sharp declines in Australian commercial loan approvals and in business sentiment indicators both augur a capex downturn. While Chetan Ahya and Qing Wang have not yet seen a sharp slowdown for the ASEAN region and China, the fundamentals look grim. There has been a significant rise in the cost of capital in India, Indonesia and Korea, and capital inflows to the region have slowed sharply. The property sector has been hit as excess capacity and funding challenges for property companies take their toll. Moreover, export growth is plummeting, and slowdowns in Asian exports always tend to promote a parallel slowdown in manufacturing capex. Hence, it is likely that fixed investments in the region will touch the 2001 lows despite the pending fiscal stimulus. Three pieces of corporate news bolster that appraisal: Chinese officials reportedly are delaying new airline orders for 2009-10. STMicro has massively cut its revenue forecast to -12 to -18% from flat to -8% previously. Morgan Stanley Analyst Theepan Jothilingam from our European Oil and Gas team notes that the energy industry is clearly reassessing capex outlays in response to lower oil prices. National oil companies including Petrobras, Saudi Aramco, and Royal Dutch Shell are slashing spending and delaying projects (see Capex Spotting 2: Now for the Downstream, November 19, 2008) For battered risky asset markets, there are two opposing implications of the capex recession. Near term, weakness in capital spending may intensify recession fears and pressure risk appetite. As the recession matures, however, investors may regard capex weakness as a sign of capital discipline that should boost future returns. In fact, US capital spending discipline in the recent expansion implies that there are fewer excesses to work off today than in past recessions (see “Capital Discipline, Returns and Productivity”, Global Economic Forum, November 4, 2002). That discipline should pay off in the back half of 2009, when we expect the housing recession to end and the economy to re-accelerate. Downside risks to our global growth scenario and the capex outlook predominate. A deeper global recession would hurt capital goods producers in the three ways described above: Weaker US exports would hurt US and global capex demand, and global weakness would also intensify the global pressure on US profits and cash flow. The feedback loop to global growth would increase downside risks. Contrariwise, repairing funding and credit markets would be an important first step towards global recovery, including in investment spending. The good news: Capital-spending discipline had sustained pent-up demand for US capital spending in the expansion, and an economic recovery may bring a capex rebound more quickly than in the past. |