Latin America
Sliding in 2009
December 11, 2008

By Gray Newman, Luis Arcentales, Daniel Volberg, Boris Segura | New York & Marcelo Carvalho | Sao Paulo

The era of abundance – the five-year bout of above-trend global growth that prompted a remarkable upturn in Latin America – is over. It is startling how quickly it has ended. Less than six months ago, commodity prices were still soaring, many of the largest economies in the region were roaring and exchange rates were gaining ground to levels not seen in decades. Now, all of the focus is on the severity and duration of the downturn. 

Indeed, our global economics team has cut the outlook for the global economy for the sixth time in seven months, with global growth for 2009 being slashed almost in half to 0.9% from 1.7% (see Risks to the Global Outlook: The Good, the Bad and the Ugly, December 9, 2008). As part of our global team’s exercise, we are also revisiting our outlook for Latin America. When we first revised our outlook for the region in early October, we slashed Latin America’s growth prospects for 2009 to 1.5% from 3.5% (see “Latin America: The End of Abundance”, EM Economist, October 10, 2008). At the time, some thought that our call that Mexico’s economy would post no growth in 2009 was overly pessimistic; the same view was leveled at our call for Brazilian growth to slump to 2.0% next year. 

In light of the severity of the downturn and the persistence of downside risks to the global economy, we are cutting our Latin American forecasts for a second time. We now expect the region to contract by 0.4% in 2009, the most severe downturn since 1983. We see Mexico contracting by 1.5% in 2009, Brazil’s growth to average zero and Argentina to suffer from a 2.2% decline. No country in the region is likely to be left unscathed in 2009. We expect the Mexican peso to regain some lost ground, but still to end 2009 near 12.80 versus our previous estimate of 11.60. We see the Brazilian real ending next year at 2.70 versus our previous forecast of 2.30 and Argentina’s peso to weaken to 4.50 versus our previous assumption of 3.35. 

Country Details

In some countries, the case for a contraction is easier to make: Take Mexico, for example, where export demand accounts for nearly one-third of GDP. The slowdown in the US has already produced a five-month-long decline in industrial activity through September, and more pain seems in the cards. November’s ISM index – which plunged to its lowest level since 1982 – is an ominous sign of what to expect in the coming months in Mexico. Luis Arcentales notes that the slowdown in the economy has not been limited to industrial production, as consumption has also shifted to a lower gear. Mexico’s retail chamber, ANTAD, reported sales growth of just 3.0% in October, below the already weak 4.3% in 3Q, which even considering calendar effects represents a marked slowdown from 6.7% in 2Q and 11.2% in 1Q. Further, the combination of mounting job losses, tighter credit – as banks struggle with rising credit card NPLs – and still elevated inflation are likely to continue testing the resilience of Mexico’s consumer. Not surprisingly, consumer confidence stands at historically low levels.    

In Argentina, Daniel Volberg is calling for a contraction in activity (-2.2% in 2009), as the economy undergoes a dramatic negative income shock from falling commodity prices and the loss of an undervalued exchange rate. After all, Daniel calculates that out of the 2.2 million formal jobs created in 2003-07, roughly one million were tied to sectors that benefitted from a weak currency. Add to that the deterioration in business confidence as the authorities continue to adopt heterodox measures, and the case for an even greater downturn to growth cannot be ruled out. 

In Brazil, Marcelo Carvalho warns that Brazil is likely already to be in a recession that began in 4Q08. He expects that investment will be hit the hardest among GDP components, as capital expenditure plans are cut back sharply, and move into negative terrain next year after growing at a double-digit pace this year. As the economy sinks into recession territory, the central bank may choose to partially accommodate the inflation-target overshooting. Marcelo argues that the central bank is not in a rush to slash rates aggressively soon, but will eventually resume cutting rates at some point in 2009 (see “Brazil: Growth Pressure Points”, EM Economist, December 5, 2008). 

In the Andean region, Boris Segura now expects Venezuelan GDP to contract by 1% in 2009 compared with a previous forecast of 2% growth, as oil prices remain soft. He also now sees a larger depreciation of the currency, to 2.85 in 2009 versus 2.65 previously, given the pressures on the fiscal accounts from lower oil prices. Meanwhile, he expects Colombia to feel the knock-on effects from Venezuela’s move to recession and is trimming his 2009 GDP forecast for Colombia to 1.5% from 2% earlier. While Colombia has very little room for counter-cyclical fiscal policy, we expect an easing in monetary policy with 200bp of cuts in 2009. If there is a bright spot in the Andean region, Boris’s candidate is Peru, where he sees growth close at 4%.

Meanwhile, Chile’s prudent set of macro policies has put the country on solid footing to deal with the downturn and potential dislocations in financial markets, argues Luis Arcentales (see “Chile: Time to Shine”, EM Economist, November 28, 2008). Whether we focus on Chile’s ample ammunition – record international reserves and fiscal assets of near 15 percentage points of GDP – or its ability to deliver it effectively, the country seems to be in an enviable position to conduct counter-cyclical fiscal policy and engineer a normal cyclical downturn, even if the globe turns out to be less hospitable than we currently expect. Accordingly, we see Chile expanding at a modest 1.5% over the course of 2009.

One Positive Element, Two Cautious Elements

Despite all the attention that our new forecasts may prompt, we still have a difficult time handicapping either the duration or the magnitude of the downturn. We expect to see a modest sequential recovery in late 2009, but would be the first to admit that the downturn could last longer or the region could rebound more quickly. Indeed, along with our global team, we have developed two scenarios to complement our call: a bull scenario and a bear scenario. Our own bias is that the risks remain to the downside of our forecasts, but if nothing else, we hope we have learned the importance of humility after a year as tumultuous as 2008. 

But while it remains difficult to handicap the length or the severity of the current downturn, we would argue that there are three characteristics of the region on the eve of 2009 that are worthy of investor attention. One of the three characteristics is unambiguously positive; the other two should give room for pause and explain why we still retain a bias towards greater caution.

Starting Points Matter

Faced with an uncertain global downturn, starting points matter. We have seen little of the excesses common in past upturns in Latin America. The abundance of the past five years has not produced the ballooning trade and current account deficits fueled by consumer spending that we have seen in Latin America’s past and elsewhere today in other emerging economies. Nor is Latin America home to widening fiscal deficits that plague other emerging economies.  Nor have we watched as central banks burn through reserves trying to prop up woefully overvalued currencies.

Mexico does not look like the Mexico of 1994 when the current account ballooned and was on its way to 8% of GDP. Nor does Chile resemble the Chile of 1998, as the Asian Financial Crisis lapped up on its shores and when the current account imbalance was nearly as large. Nor does Brazil have the same imbalance as the Brazil of early 2001. We have begun to see some growth in current account imbalances this year, but the region’s adjustment process on the fiscal and on the current account side is likely to be much less painful than it was in past downturns. In short, Latin America appears to be in better shape than in the past to deal with a downturn in the global economy. The risk that a downturn in growth leads to major financial turmoil in the region’s largest economies is lower today than in the past. With the trio of massive reserve accumulation, current account improvement and better fiscal results, Latin America has its house in better order today than in decades. This is the good news.

Leaning Against the Wind

Latin America is starting from a much improved state, but we are concerned that it will suffer – along with many other emerging economies – from much more limited space to engage in counter-cyclical policy. While governments in developed economies have embarked on an important counter-cyclical fiscal mission, fiscal stimulus is likely to require an important increase in debt financing, precisely at a moment when investor appetite for emerging market obligations appears to be waning. Indeed, among the major economies in Latin America, only one – Chile – can allow for significant fiscal easing without recurring on debt financing. For the rest of Latin America (and apart from tapping some stabilization funds), fiscal stimulus will require a significant increase in debt financing (see “Latin America: Shocking the Fiscal Abundance Story”, EM Economist, October 3, 2008). What limited space there is to increase sovereign issuance in the region – beyond what is available from the IFIs – runs the risk of crowding out the private sector and countering any attempts by the monetary authorities to ease interest rates.

If the downturn is prolonged, we are concerned that investors may have underestimated the risks associated with increased debt issuance. A great deal of attention has been given to the reduction in external debt in emerging economies. Brazil, for example, is often highlighted as the poster child of the improving state of emerging markets: after all, it now has international reserves that cover nearly three times its public external debt and cover nearly all public and private external obligations. However, we estimate that Brazil’s overall budget deficit of nearly 2% of GDP would widen to nearly 5% of GDP simply with a return to trend growth and a less favorable external environment. Recall that Brazil’s public sector’s gross debt stock (domestic and external) stands at nearly 56% of GDP, with more than one-quarter coming due in less than a year – higher than any of the other major economies in Latin America.

Not only is room for counter-cyclical fiscal policy limited, but we also argue that counter-cyclical monetary policy is unlikely to provide an important stimulus in the region. Our rationale for limited effectiveness of monetary policy in the region is three-fold:

•           First, it is not a coincidence that Latin America’s central banks have lagged their counterparts around the world in easing monetary policy. Latin America’s resistance to easing interest rates stems in part from the region’s unfortunate past, as the epicenter of hyperinflation. While we expect to see some easing in monetary policy – we expect, for example, Banco de Mexico to ease policy rates by 175bp in 2009 beginning in 1Q – we do not expect to see a dramatic reduction in line with what our developed world economists are expecting. Indeed, in Brazil there remains a debate about how soon the central bank can begin cutting: our Brazil economist, Marcelo Carvalho, does not expect easing until late in 2009. Central banks throughout the region remain concerned, rightly or wrongly, that currency pass-through may rear its head and produce a greater bout of inflation and contaminate expectations.

•           Second, the level of financial intermediation and the role of credit in the most of Latin America are still extremely limited. While the effectiveness of monetary policy is not limited to the credit channel, the under-intermediated state of most Latin economies is likely to limit the traction of monetary policy. 

•           Third, it is difficult to imagine that credit growth will play a meaningful role in boosting economic activity even as monetary policy is eased, given the sharp declines that we envision in consumer and business confidence, the weakness in labor markets and the risks to the quality of the loan portfolio. In some countries, credit growth already appears to be suffering, as caution from financial intermediaries’ international headquarters appears to be taking its toll. We are not arguing that there is no role for monetary policy to play in 2009. We expect to see some easing, but for it to be modest compared with the reduction in interest rates in the developed world. Further, we would underscore the modest impact it is likely to have given the under-intermediated nature of most of the economies in the region.

Policy Slippage

Perhaps the greatest risk in Latin America, and throughout emerging markets, is not simply that policymakers have less room to deploy counter-cyclical policy, but that policy slippage or even reversals take place.  While we have already seen one case in which the privately managed pension fund system was effectively nationalized, we would not be surprised to see regulatory creep throughout the region that could lead to de facto, even if not de jure, nationalization. In Mexico, for example, congress has begun to investigate privately administered pension funds that were formed in 1997, as part of the transition from a pay-as-you-go pension system towards a fully funded defined contributions scheme. Although most of the debate in Mexico has so far centered on the commissions charged by some of the pension fund administrators, there is a risk that the political debate could broaden after workers receive their end-year statements early next year, ahead of February 2009 when congress reconvenes. It is difficult today to be confident that once the laws governing the pension system are re-opened, the final changes will be limited to a reduction in commissions. This may be the case, but our concern is that the range of policy options being debated is likely to widen, thus increasing the risk of policy slippage or reversal.

It is too early to argue that policy slippage or policy reversals will take place in the region. But we are concerned with ‘translation risks’, as the policy remedies being deployed in the developing world are adopted (and adapted) in Latin America and emerging markets. There seems to be little doubt that the state will play a much greater role in the functioning of the economy in the US, particularly in the financial system. Whatever the merits of greater state control, the risks that such policies give rise to onerous regulations in Latin America are real. And the longer that downturn activity continues, the greater the risk of further slippage. Although the region has suffered past downturns in 1998 or 2001 without important policy reversal, we expect this downturn to contain greater risk of damage on the policy front. First, we expect the downturn in 2009 to be substantially deeper than the downturns in 1998-99 or 2001-02. Second, the financial sector origins of the current downturn and the dramatic policy response required in the developed world are likely to set the stage for a more interventionist policy stance in Latin America as well as throughout emerging markets.

Bottom Line

It is hard to handicap the severity and the duration of the current downturn in Latin America – so much depends on one’s global assumptions. But there are elements for celebration and for caution when looking at the outlook for Latin America in 2009. The good news is that the region enters the downturn in better shape and less over-extended than at anytime in the past quarter of a century. The reasons for caution, however, should not be ignored. The room to engage in counter-cyclical policy is likely to be limited, and we are concerned that the risks of policy slippage or outright reversal are real.

Five years of abundance dealt Latin America an enviable hand. But too often policymakers and investors confused the heady cyclical uptick with the emergence of more sustainable growth. The downturn underway is likely to test the region’s policy resolve and serve as the ultimate guide to whether the region chooses the path to sustainable growth.

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Japan
Lowering Base-Case Outlook to the 1998 Post-War Nadir
December 11, 2008

By Takehiro Sato & Takeshi Yamaguchi | Tokyo

Slashing Our Outlook, Taking a Bleaker View of the Negative Feedback Loop

The adverse feedback to the real economy from the financial market is worse than we envisaged, both internally and externally. Domestically, the broadening and deepening output cuts in manufacturing industry force us to lower GDP forecasts for the October-December and January-March 2009 quarters, when the momentum of the recession will peak. This has the technical effect of lowering the base effect for 2009. The second set of preliminary GDP figures for July-September 2008 has also been revised down. Overseas, our global team has reduced forecasts by another notch for both developed and developing economies (for details, see Richard Berner and Joachim Fels’ Global Economics: The Good, The Bad and the Ugly, December 9, 2008). These changes require a further downward revision of our 2009 forecast for Japan. Reflecting the uncertain outlook, we have also quantified upside and downside scenarios relative to our base case.

Recession to Match the Worst Post-War, with Negative Growth of 2% in 2009 Even in the Base Case

Our base case calls for negative GDP growth of 2.0% (previous forecast:-1.1%) in 2009 (-1.3% in F3/10), which matches the contraction in 1998 at the time of Japan’s financial crisis. Our bull case is -1.2% (-0.7% for F3/10), and our bear case calls for the worst recession since the war, with GDP at -3% (-2.5% for F3/10). For corporate earnings (parent company basis), our base case is for -20% in F3/10 (previous forecast: -5%), with the bull case at -10% and the bear case at -40%.

Our base case calls for the economy to eke out growth of 0.2% in 2010 (+0.5% for F3/11), with a fragile recovery; the bull case is for +1% in 2010 (+1.5%), still short of the growth potential, and the bear case is for a second consecutive year of negative growth at -1% (-0.4%). For corporate earnings in 2010, the conditions for energy prices and exchange rates are opaque, but assuming that costs would rise as the global economy picks up, we expect profits to struggle even if sales recover.

For prices, our 2009 outlook is negative on average in all three cases. The second half of 2009 will be vulnerable to a reactive drop relative to the year earlier, and we expect core CPI deflation to exceed 1%, outpacing even the trough from 2001 (-1.1%). For macro policies, we anticipate a strong expansionary bias in Japan as well, in the face of overall economic deterioration. However, with limited room to maneuver in both fiscal and monetary policy, we do not see much that can propel the economy forward.

Base case

As demand in Japan and overseas drops back, we expect the downturn to climax towards January-March 2009, and then foresee the economy bumping along the bottom from April-June for the rest of the year without a sense of recovery. Into 2010, we expect a gradual pick-up, patchy at first, with momentum fragile amid a still tentative recovery overseas. We expect the economy to just barely evade negative growth, expanding by about 0.2%. For corporate profits, we have some hope that lower costs will limit the decline to 20%, which would probably be slightly better than the incoming ultra-conservative guidance from the companies. However, we anticipate disappointment in the markets during April-May 2009 at the conservative nature of this guidance. On prices, we foresee a slide into deflation from the second half of 2009, as both consumer and domestic corporate prices suffer a reaction to commodities inflation a year earlier and the deflation gap widens. A sharp correction in asset prices over the preceding year would also exert downward pressure on general prices.

Potential catalysts for a recovery under these conditions are (1) improvement in corporate terms of trade due to falling input costs, and (2) pent-up demand emerging as households and companies tire of belt-tightening. On the first, the drop in resource and energy prices restricts trading losses and will help the real purchasing power of consumers and companies to rebound. On the second, we are looking for some measure of demand to filter through from October-December 2009, roughly a year after the onset of event risk in September 2008, mirroring the pattern seen in Japan’s economy at the end of 1998.

Yet downside risk is also latent. We are concerned about the potential for renewed event risk similar to the housing shock of 2007, triggered by tougher regulation of building standards. The law in question is the revised Architect Code effective from May 2009. We also highlight stricter regulation elsewhere – such as the revised Installment Sales Law (timing undecided) and Housing Defect Liability Law (from October) – as a potential risk for the economy in 2009.

Bull Case

As noted upfront, even our bull case envisions negative growth of 1.2% in 2009 (-0.7% for F3/10). We assume a return to growth of +1% in 2010 (+1.5% for F3/11), but only a fragile recovery with the economy still short of its potential growth rate. Corporate earnings would fall by only 10% in F3/10, supported by falling costs. Given the limited potential for an autonomous rebound in domestic demand, this upside scenario would require a bullish story for overseas economies. While the implication that Japan is not responsible for its own economy may be unpalatable, it is a simple fact that Japan’s economy has continued to rely too much on external demand in the last five years. Stabilization for the economy and financial system (prudence policy) from swift macro policy action (creating asset price transparency and removing non-performing assets from banks’ balance sheets) by fiscal and monetary authorities overseas would be the key to unlocking this scenario, in our view.

Bear Case

In our bear case, the economy shrinks 3% in 2009 (-2.5% in F3/10) in the grip of a deflationary spiral. Capex drops by double-digits, and personal consumption also slips further. In 2010 the negative spiral would be less tightly wound, but still we envision a further contraction of 1% (-0.4% for F3/11). Plummeting top lines send corporate profits in F3/10 down 40%, matching or exceeding the declines possibly built into company guidance. In this bear scenario, we assume that overseas economies fare worse than anticipated, but also that lending in Japan is reined in to a greater extent due, for example, to concerns about capital shortages at financial institutions.

Policy Implications: Greater Strain on Monetary Policy, Accelerating the Timing of ZIRP

The high level of government debt imposes limits on how far fiscal expansion can be taken, and monetary policy will inevitably come under greater stress. Specifically, we expect the following measures in response to the degree of economic deterioration: (1) quantitative easing without ZIRP (zero interest rates) (+unsterilized intervention); (2) rate cuts; (3) quantitative easing with zero interest rates (+unsterilized intervention); (4) increase in rinban operations value (outright JGB purchasing); (5) further broadening of eligible collateral (to include stocks, CMBS); (6) outright purchasing of CP (ABS, ABCP) and CMBS; (7) outright purchasing of CMT and inflation-indexed bonds; and (8) outright purchasing of stocks. Steps (1) and (3) could be the result of aggressive unsterilized intervention to counter the advance of the yen.

BoJ Governor Masaaki Shirakawa stresses the maintenance of short-term money market functions and seems reluctant to invoke more potent measures at this point. However, in the past the BoJ has tended to find itself forced into extensive monetary easing after modest and belated initial steps. We believe that ultimately monetary policy will take on more of the character of fiscal policy, under pressure from the markets. We envisage two further rate cuts to get us back to ZIRP (zero interest rate policy) in the January-March quarter of 2009, a quarter earlier than our previous outlook. In our base case, ZIRP is jettisoned in July-September 2010.

Long-Term Interest Rate Outlook

The JGB market has been underperforming relative to the global drop in long-term yields. We attribute this to (1) the minimal leeway for additional rate cuts, (2) a drop in JGB market liquidity due to tighter financing, (3) concerns about supply/demand deterioration due to increased issuance, and (4) profit-taking by banks and rebalancing by pension funds triggered by falling stock prices. However, the first two of these factors should fade as the BoJ adopts a more aggressive easing stance ahead. Concerns about supply and demand will continue, but the key determinant of the JGB market trend is the fundamentals of the economy, not supply and demand. We expect the 10-year benchmark index yield to test the 1% level in mid-2009.

Macro Implications of Political Risk and Fiscal Expansion

The cabinet’s support rating has fallen to over 20% as policy drifts over Diet submission of the second supplemental budget, with the PM’s ability to bring cohesion to the ruling parties now being questioned. But with the economy and markets in difficult straits, another leadership election would risk alienating the electorate, and we expect the current line-up to carry on at least until around March when the initial budget for F3/10 should be finalized. At the same time, this implies a comparatively high chance of Diet dissolution and a general election around April-May 2009, when the budget and budget-related bills would be about to take effect. Given the current state of the economy and markets, we could not rule out a power handover if there is an election then.

Post-election, we think the likely patterns are (1) a DPJ government in sole power, (2) a coalition between the conservative wing of the LDP and left wing of the DPJ, or (3) a coalition between the reformist wing of the LDP and right wing of the DPJ. In the event of either (1) or (2), there could be a 180-degree shift in the direction of looser fiscal policy with the goal of equilibrium in the primary balance by F3/12 shelved and a freeze on ‘thick bone’ spending cap policies. In the event of (3), a reform agenda would be pursued. However, it is hardly realistic to suppose that with both developed and emerging countries headed for massive fiscal stimulus, Japan alone would continue to pursue a path of fiscal contraction. The high level of government debt would still be a hindrance, but even in the event of (3), we would expect policy to change over time in the direction of fiscal expansion.

In Japan’s case, since there is a current account surplus despite huge government debt, government funding is sustainable in macro terms. And with ongoing balance sheet shrinkage round the world (deleveraging), we believe that repayment of corporate and household debt is very likely to increase the savings-investment balance further. Deleveraging by the private sector has indeed been the mechanism that has enabled government funding in the asset price deflation since the 1990s. This mechanism could become more prominent with the return of debt deflation Japan is experiencing. Given this, we do not believe that Japan faces a potential debt crisis like some emerging countries. This is Japan’s competitive edge, but, at the same time, a weakness that can lead to a lack of fiscal discipline.

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Taiwan
How Bad Can it Get?
December 11, 2008

By Sharon Lam & Katherine Tai | Hong Kong

Summary and Conclusions

The Taiwanese economy is already in recession. Although not supported by seasonally adjusted quarter-on-quarter GDP data, which is required to officially classify if an economy is in recession, Taiwan posted negative year-on-year growth in 3Q08, and we expect negative growth to extend another two quarters into 1Q09. Whether this is technically a recession or not does not matter – it certainly feels like a recession, as the macro conditions are deteriorating quickly. It is certainly too late to prevent a recession from happening now, but we should not forget the Taiwanese government’s proactive measures, which should help to limit the downside risks.

In our base case, we are revising down our 2009 GDP forecasts again to 0.5% from 1.5% as the current decline in domestic demand has turned out to have come earlier and be more severe than expected, mainly due to business closures and job losses brought about by the collapse in exports. We see growth momentum as the worst in 1Q09, but that will be followed by a solid recovery, as the effects of the stimulus measures kick in. We forecast 2010 GDP growth to return to the trend average of 4%. 

We expect the Central Bank of China, Taiwan (CBC) to cut its policy rate by another 100bp to bring the rediscount rate to 1.75% before mid-2009. In fact, we believe that the CBC will cut its rate rather aggressively by at least 50bp at its coming MPC meeting scheduled for December 11. If that happens, there could be downside risks to our rate cut forecasts. Meanwhile, the government has already announced a series of fiscal stimulus efforts that may boost GDP growth by 2pp in 2009. In fact, we feel that our base case could be too conservative, if the supportive measures are implemented successfully. 

2008 in Retrospect

Taiwan started off 2008 with a lot of hope, as did we. We have been expressing increasing confidence in the economy since mid-2007, based on strong currency, wealth and liquidity, and policy changes to be brought about by the new government. It worked well until the issue of global deleveraging came after mid-2008. Real GDP growth, posting 5.4% in 1H08, was significantly higher than the 10-year trend average of 4%. We were also advocating for Taiwan’s exports to perform better than market expectations, as we argued that emerging markets would support the tech demand; this call worked in January-August when export growth registered much stronger-than-expected growth of +17%Y, despite weak demand from developed markets. Our currency call was solid, as the TWD was indeed the second-best performing currency in non-Japan Asia after the RMB. Meanwhile, the new government carried out the policy changes as promised in its election agenda. Weekend chartered flights between Taiwan and Mainland China began in July, and the corporate investment caps in China were removed. Dialogue across the Strait has become much more frequent and constructive, and it was heightened when the chairman of China’s Association for Relations Across Taiwan Straits visited Taiwan for the first time in November.

As good as it got, President Ma and his new administration faced their first challenge after the inauguration in May from rising inflation that dampened sentiment, although Taiwan managed to keep inflation as the lowest in the region. The hopes of a re-rating were then dashed with the global credit crunch, which not only severely affected the worldwide banking system but also triggered the global recession that is now underway. The government then became proactive in delivering stimulus measures, hopefully to bring Taiwan out of recession, but the measures were not enough to deal with the financial torrents that swept through global financial markets so swiftly. Taiwan’s GDP growth contracted sharply to -1%Y in 3Q08, registering the first contraction since SARS in 2003, and marking the weakest gain since the prior downturn in 2001, as exports collapsed before domestic demand was able to respond to policy changes. 

Why Is Our Base Case Not Negative?

We have been challenged recently on why our 2009 GDP forecast is not negative. It is interesting that the market does not look at consensus anymore, but rather tends to use the most bearish forecast on the Street as a benchmark. As we explained in Mild Recession but Negative Growth Not Likely, November 11, 2008, we think the ‘net export’ contribution to GDP growth will remain positive (at least by 2pp), given domestic demand weaknesses dragging down on imports. 

More importantly, we should not forget or ignore the efforts that have been put forward by the government in supporting the economy. The demand destruction in this cycle could be unprecedented, but so are the post-bubble responses from the government. Since October, the Taiwanese government has announced a series of fiscal stimulus including the shopping coupons (TWD 83 billion) and infrastructure spending (TWD 100 billion per year in the next four years), which we estimate will bring 0.3pp and 1.2pp to GDP growth in 2009, respectively. Other measures include reduction in the inheritance tax and higher deductibles for personal income tax. Along with a further 100bp interest rate cut expected within the next six months, we expect the government’s stimulus measures to boost 2009 GDP growth by 2pp.  Added to the 2pp contribution from net exports, GDP growth in 2009 could easily be +4%.

In other words, the plunge in domestic demand would have to be bigger than 4pp to pull 2009 GDP growth into negative territory, i.e., a magnitude similar to the recession in 2001. It is possible that domestic demand could contract as much as in 2001, but we do not see too high a likelihood of this since there has not been much over-consumption and over-capacity in this cycle, while policy responses have been much faster. As a result, if the stimulus measures are implemented successfully next year, we see upside risks to our base case scenario.

We forecast inflation to average 0% in 2009 with months of CPI growth that could dip into the negative. However, we are reluctant to call this as deflation in Taiwan, as we see it as more of a reversal of the imported commodity inflation – i.e., a high base effect from 2008 – rather than any sustained decline in consumer prices. Meanwhile, the trend of production relocation to China that has resulted in cheaper products, which was a main reason for the deflation in 2002-03, has already matured. Moreover, we believe that the forthcoming rate cuts and a low interest rate level to begin with should limit the downside to prices.

We look for a stable TWD/USD exchange rate next year to average at the mid-33 level. The TWD has outperformed most emerging market currencies this year and was the second-best performing currency in non-Japan Asia after China. The main reason that the TWD outperformed this year was the unwinding in carry trades, as the TWD was a base for borrowing, as in the case of JPY, but certainly at a much lower magnitude. However, the impact from a reversal in risk appetite will likely fade next year, and so the performance gap between the TWD and other emerging market currencies should narrow. 

Upside Risks and Bull Case GDP at 3.2% for 2009

Given Taiwan’s heavy dependence on export growth, we believe that the major upside risk will come from external sources, namely an earlier-than-expected recovery in global demand. On the other hand, domestic demand in Taiwan has been a lingering confidence problem and therefore will likely require more structural reforms, but we believe that the recent policies have to focus more on getting Taiwan out of a recession first, and therefore sentiment is unlikely to revive without an export recovery first. In our bull case scenario, global GDP growth will reach 2.3%, which is still a recession similar to the one in 2001 but better than 1991 and 1982. In this case, we expect Taiwan’s exports to drop only 5% instead of the -13% in the base case.

Faster export recovery alone is not enough to bring Taiwan’s growth to more solid territory; it needs to be coupled with more aggressive tax reforms (i.e., a significant and early implementation of tax rate cuts on both corporate and personal income in 2009 that should amount to at least 3% of GDP).  We understand that tax reforms require more consideration, given the impact on the fiscal position of an economy with 23 million people. If aggressive tax rate cuts are deemed not feasible, we would expect to see tax rebates to deal with the cyclical difficulties. Meanwhile, we continue to expect more stimulus measures to help stabilize the property market.

Under this bull case scenario with a more visible export recovery and aggressive tax reforms, we expect Taiwan’s GDP growth to be 3.2% in 2009 – this would still be the lowest since the 2001 recession. We then forecast 2010 growth at 5%, which is above trend. We expect inflation to average 1.5% in 2009, as commodity prices will rebound with a faster global recovery, and so we expect smaller rate cuts or even a rate pause to keep the CBC’s rediscount rate at 2.25% at the lowest. A positive interest rate gap between the TWD and USD will be maintained, and we will see a slightly stronger TWD/USD to average 32 next year before dropping to below 30 in 2010.

Downside Risks and Bear Case GDP at -2.5% for 2009

A further collapse in exports is often cited as the biggest downside risk, but the impact is not that straightforward. No matter how much exports decline, imports will only decline even more, as those for export production use will drop in proportion to exports while those for domestic use are also under pressure. Therefore, the net export contribution to GDP growth should remain positive, as we mentioned earlier. 

Nevertheless, the collapse in exports is likely to have a ripple effect on domestic demand through business closures and unemployment. In both September and October, the number of dissolved companies more than doubled from a year ago. The number of factory closures is also rising sharply and only looks set to soar further. Meanwhile, labor market conditions are deteriorating rapidly. The seasonally adjusted jobless rate went up 0.4% just within two months, with the latest October reading at a four-year high of 4.3%. Given that the jobless rate is always a lagging indicator, we expect that the peak will not be reached until after mid-2009 at close to 5%. However, we do not expect the jobless rate to be as high as the previous peak posted in 2002 of 5.4%, since back then it was a recession that was met with an accelerating trend of production relocation to China, and the latter factor is missing in this cycle.

If exports tumble more than expected and bankruptcies continue to soar, we believe that the government may focus on setting up bad banks or even bailouts, which would shift resources away from productive uses that can generate demand. Without proper stimulus measures, we can expect the economy to dip into the negative zone. In our bear case, we expect export growth to drop at a record -25% and GDP at -2.5% in 2009, while capex and private consumption will contract 20% and 1.5%, respectively. Taiwan’s November exports plunged -23%, and this is only the start of demand destruction in the world, in our view; so, the bear case, although unprecedented, is not entirely impossible; indeed, our global team has bear case 2009 GDP growth at -0.8%. Nevertheless, we assign a small probability to our bear case, as we continue to stress that the infrastructure stimulus plans announced by governments around the world should have a positive impact on aggregate demand in 2009. The TWD will certainly depreciate more under this scenario, but we also doubt if the USD strength can continue, as it is at the center of the problem with sky-rocketing debt. Thus, we believe that the weakest point of TWD/USD will be only 34.5. We do not see interest rates going to 0%, even under the most bearish case, since Taiwan does not have a liquidity problem, and so there is no need to risk trapping itself at a 0% interest rate.

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China
Outlook for 2009: Getting Worse Before Getting Better
December 11, 2008

By Qing Wang, Denise Yam, CFA, Steven Zhang & Katherine Tai | Hong Kong

Where Did We Get it Right or Wrong for 2008?

It is time for a year-end reflection. In early December 2007, we put forward a four-season framework to describe potential scenarios in 2008 (see China Economics: Journey into Autumn: An Imported Soft Landing in ’08, December 4, 2007). We believe that it remains a useful framework to explain the economic and policy developments over the past year. Let’s revisit the key elements of this framework.

Back in late 2007, we believed that there would be two types of uncertainty facing the Chinese economy in 2008: 1) whether an external slowdown in the wake of the US subprime turmoil would be significant enough to effectively disinflate the Chinese economy; and 2) whether the macroeconomic tightening policy launched by the Chinese authorities would be followed through consistently to cool off domestic demand sufficiently and thus effect disinflation.

Along the two dimensions of uncertainty, we envisaged four potential scenarios in 2008: 1) Autumn featured a combination of external downturn and policy muddling-through that would likely bring about ‘an imported soft landing’; 2) Summer featured a combination of no meaningful external downturn and policy muddling-through that would result in ‘overheating’; 3) Spring featured a combination of no external downturn and a large revaluation of the exchange rate that would help achieve a ‘policy-induced soft landing’; and 4) Winter featured a combination of external downturn and aggressive domestic tightening that would lead to ‘an outright hard landing’.

Autumn, or ‘imported soft landing’, was our baseline scenario for 2008. This scenario hinged on two key calls: 1) a US-led global downturn that would slow the rapid expansion of China’s exports and thereby help the economy to cool off; and 2) a muddling-through style for macroeconomic management in that as external demand weakened, domestic policy tightening would not be followed through consistently and would even be eased over the course of the year. Our policy call therefore featured three ‘no’s’: no campaign-style administrative tightening, no large one-off revaluation of the renminbi exchange rate and no interest rate hike.

In discussing the market implications, we argued in our December 4, 2007 note that “under our baseline scenario of an imported soft landing…While this growth rebalancing should be positive to the equity market over the medium term (i.e., 1-3 years), the stock market performance will likely be moderately negative in the near term (i.e., 6-12 months). Specifically, low-valued and low-margin export-oriented sectors (e.g., textiles) may be hard-hit, as firms in those sectors may attempt to hold on to their market shares by squeezing their profit margins in order to remain competitive. At the same time, domestic market-oriented sectors – especially those exposed to capex spending supported by the government – should do relatively well, as government increases in spending shore up domestic demand, offsetting weakening external demand”.

With the benefit of hindsight, we believe that we got it right in terms of the direction and trajectory of the economy in 2008; however, the economy has evolved in a more volatile fashion than we initially anticipated. This is particularly the case for the overshoot in the inflation rate in 1Q08 and the ongoing rapid deceleration in growth in 4Q08. While the former has been reflected in the late stage of an international commodity price bubble, the latter has been exacerbated by the intensification of global financial market deleveraging since September. In a similar vein, while the course of policy action has been broadly in line with our ‘three no’s’ call, policy responses lately (i.e., drastic interest rate cuts and strong fiscal stimulus in October-November) have been more aggressive than we originally envisaged, but we believe that they are warranted by the rapid deterioration in underlying activity.

When it comes to broad market implications, our calls have been wrong: China’s stock market performance, similar to that of its many emerging market peers, was very poor over the past year instead of being “moderately negative in the near term (i.e., 6-12 months)”, as we had predicted. While the export-oriented sectors have indeed been hit hard but the domestic market-oriented sectors – especially those exposed to capex spending supported by the government – did relatively well after the official announcement of the fiscal stimulus package, this outcome has materialized against the backdrop of a severe broad-based stock market correction.

Causes of the Slowdown: A Triple-Whammy Impact

A substantial economic slowdown is underway in 2H08. The slowdown is apparent in the rather sharp fall in the growth rates of industrial value-added and power usage since September 2008. Is this part of the ‘imported soft landing’ that we envisaged all along? Or could it be a ‘domestic-made hard landing’, a risk that we initially flagged in early September? (see China Economics: Can the Property Sector Be Counted on as the Engine of Growth? September 2, 2008).

We believe that three factors have caused the rather sharp slowdown of the economy, including (in order of importance): a) the cooling-down in real estate investment; b) a massive destocking of raw material inputs in the immediate aftermath of the sharp correction of international commodity prices; and c) the slowdown in external demand.

The most important component of China’s macroeconomic tightening policy package that was launched in late 2007 is the austere measures imposed on the property sector, in our view. The property sector has been hit hard and, as a consequence, real estate investment has slowed substantially, diminishing demand for key construction materials, such as steel, cement and aluminum and housing-related consumer durable goods.

The slowdown in production of key materials has been exacerbated by a sudden sharp correction in commodity prices, as the global financial turmoil in general and the deleveraging in particular have intensified since September, leading to a massive destocking of raw material inputs. Many Chinese enterprises have been building up their inventories of key commodity inputs on the expectation that commodity prices will remain high and even continue to rise. Destocking is a key reason for the near-freefall in the production of key materials in 3Q, in our view (see China Economics: Sharper-than-Expected Slowdown in 3Q08 on Destocking, October 20, 2008).

Weakening external demand is not the primary reason for the sharp deterioration in underlying economic activity since late summer, as deceleration in exports has been gradual and taking place since mid-2007.

These three factors have dealt the economy a triple-whammy impact since 3Q: on the back of a gradual deceleration in exports, the policy-induced sharp slowdown in real estate investment growth was exacerbated by a massive destocking, which in turn was triggered by the sharp correction of international commodity prices in the aftermath of intensification of global deleveraging.

It would have been an ‘imported soft landing’ in action had there not been the heavy-handed tightening measures against the property sector, in our view. The policy-induced decline in real estate investment growth gives rise to risks of a ‘domestic-made hard landing’. Against this backdrop, the authorities made a drastic change in their policy orientation in 4Q08 by implementing expansionary monetary and fiscal policies, as well as by rolling back a majority of the austere measures imposed on the property sector (see China Economics: An Aggressive Stimulus Package Announced, November 9, 2008).

Growth Outlook: Fasten Your Seatbelts

While the triple-whammy impact that caused the rather sharp economic slowdown in 4Q08 is unlikely to maintain its full force throughout 2009, its impact will likely continue to be felt though 1H09, in our view. In particular, a sharp deceleration in China’s exports has just started. In this context, we believe that China’s economic outlook for 2009 is best characterized as ‘getting worse before getting better’, laying the foundation for a firmer recovery in 2010. Thus, market participants should fasten their seatbelts and be prepared for a bumpy ride in the quarters immediately ahead.

We forecast that China’s GDP growth in 2009 will be around 7.5%. This is our baseline scenario under which we envisage the impact of a significant outright decline in private real estate investment and much weaker exports will be partly offset by a strong increase in government-driven investment, especially in the infrastructure sector (see China Economics: Further Growth Forecast Downgrade Amid a Deeper Global Recession, November 10, 2008). We expect further growth deceleration and deflation (to be discussed in detail) in 1H09. The effect of massive policy stimulus implemented since October, together with a tepid recovery in the G3 economies, should help the economy regain some growth momentum in 2H09. Here’s why:

First, the policy response is much faster this time around than the response during the Asian Financial Crisis and should help to avert a prolonged growth decline in China, in our view. When the financial crisis broke out in July 1997, the authorities initially underestimated the knock-on impact on China and did not make their first interest rate cut until October 1997 and did not implement the first fiscal stimulus package until mid-1998. As a consequence, power usage growth – a high-frequency indicator of underlying economic activity – did not bottom out until mid-1998 when the first fiscal stimulus package was executed (see China Economics: How Much Can Be Expected from Fiscal Stimulus? November 4, 2008). The policy response this time around is clearly faster, and we expect that the effect will start to be apparent by mid-2009.

Second, the size of policy stimulus will be substantially larger. The key is that the government’s policy stance has shifted decisively toward pro-growth by adopting a campaign-style approach. We believe it is clear that the authorities want to bring growth to a desired level with all means at their disposal. And the policymakers’ capacity to implement expansionary fiscal and monetary policies is much stronger. If this current policy package were to prove insufficient, we have no doubt that it would be augmented (see China Economics: A Q&A on the Fiscal Stimulus Package, November 16, 2008 and China Economics: 108bps Rate Cut and More to Come, November 26, 2008).

Third, among the three factors that constitute the triple-whammy impact, since many of the austere measures imposed on the property sector have been rolled back in recent months and there has been a welcome correction in property prices, we expect housing affordability to increase, sentiment to improve and property sales to stabilize by mid-year 2009.

Fourth, with commodity prices likely staying at low levels for the near future, our best judgment is that the input destocking of raw materials will likely run its course in 1H09.

Fifth, improvement in external demand should also contribute to a modest recovery in 2H09, in our view. Our colleagues Dick Berner and Joachim Fels think that the unprecedented monetary and fiscal policy actions should begin to pull the G3 economies out of recession during 2H09 (see Global Economics: Beyond a Deeper Recession: Tepid Recovery, November 10, 2008 and Global Economics: Risks to the Global Outlook: The Good, the Bad and the Ugly, December 9, 2008).

Inflation Outlook: A Perfect Storm for Deflation

A confluence of factors points to a high risk of deflation in 2009. From the supply side, the bursting of the international commodity price bubble, triggered by intensification of the global financial deleveraging since September, has caused the prices of raw materials imported by China to decline sharply, representing a powerful positive terms of trade shock. From the demand side, while the austere policy tightening implemented since late 2007 has reined in the rapid expansion of money and credit growth, decelerating exports – which are expected to continue amid a synchronized recession in the G3 economies – have also started to exacerbate the problem of production overcapacity, limiting Chinese producers’ pricing power.

Therefore, despite still relatively high CPI and PPI readings at this time, we believe that a perfect storm for deflation is gathering strength under the surface. It is likely to bring about a deflationary impulse in 1H09 that could morph into persistent deflation in 2H09 and beyond, barring an aggressive policy response up front. Deflation is not always a bad thing. If it is due to a positive supply shock, it is ‘good’ deflation; if it is due to a negative demand shock, it is ‘bad’ deflation. Our best judgment is that the potential deflation that is expected to emerge in 1H09 will likely belong to the former. However, the challenge is to prevent deflationary expectations from getting entrenched, turning ‘good’ into ‘bad’ deflation, as the latter carries far more serious consequences. This necessitates a strong, pre-emptive monetary policy response.

We have revised our CPI forecast for 2009 down to -0.8% from 1.5%. We forecast headline CPI deflation at -0.9%Y in 1H09 and -0.7%Y in 2H09. The expected easing in deflationary pressures in 2H09 in our forecasts reflects the effect of policy stimulus that will likely be able to arrest the decline in price levels. This highlights the risks to our forecasts. If policy responses are weaker or occur later than we expect, deflation could become more serious, in our view (see China Economics: A Perfect Storm for Deflation, December 3, 2008).

Risks: The Bear and Bull Cases

We construct two alternative scenarios – bear and bull cases – to highlight both the downside and upside risks to the 2009 outlook for the Chinese economy under our baseline scenario.

Even though much attention has been paid to the synchronized recessions in the G3 economies and their knock-on impact on China’s external demand, we believe that the biggest swing factor in gauging the growth outlook in 2009 is real estate investment in China. Given the gloomy outlook for the G3 economies, China’s external demand in 2009 will almost surely be very weak. As we have pointed out earlier, the rapid economic deceleration so far this year is primarily attributable to the slowdown in real estate investment instead of weak exports. Under our baseline scenario for 2009, we envisage a significant decline of 6% (in real terms) in real estate investment carried out by the private sector.

However, if real estate investment were to contract by 30% in 2009, the impact would be so big that even the fiscal stimulus package in its current form and size would not be able to make up for the growth shortfall, in our view. We estimate that GDP growth would drop to 5% if this happened. This would be tantamount to an outright hard landing, in our view. Under this bear case scenario, consumption growth would likely be significantly lower than under the baseline scenario, as both employment and income growth would also suffer a setback. This bear case scenario could materialize if property prices decline continuously throughout 2009, as it would likely reinforce a buyers’ strike and destroy the investment appetite of real estate developers on a nationwide scale.

A potential upside surprise to our baseline growth forecasts may stem from a larger contribution of net exports to growth if the recessions in the G3 economies are not as deep as expected and if real estate investment remains flat and doesn’t decline. Moreover, a better export performance may also induce somewhat faster investment growth in the manufacturing sector. We estimate that China’s GDP growth could reach 9.0% under this bull case scenario, provided that the fiscal stimulus package is not scaled back because of better-than-originally-expected conditions.

We assign a subjective 65% probability to our base case, 25% to our bear case and 10% to our bull case. Real estate investment is the biggest swing factor among the scenarios. We have argued that there is not a serious nationwide house price bubble (see again China Economics: Can the Property Sector Be Counted on as the Engine of Growth?). Further, we attribute the slow property sales and price correction to the austere measures taken against the property sector, resulting in a nationwide credit crunch for this sector. It has been less than two months since the government decided to roll back these austere measures, so considerable uncertainty remains about when these policy changes could turn sentiment around. Our best judgment is that while real estate investment will likely register an outright decline from the levels of 2007-08, the probability of a massive collapse in real estate investment on a nationwide scale is small. We expect that further property sector-boosting policy measures will likely be implemented in the coming months.

The Policy Outlook

The authorities have made delivering economic growth a top policy priority by adopting a campaign-style policy execution approach. On the fiscal policy front, the RMB4 trillion stimulus package, of which RMB1.18 trillion will be funded out of the central government budget, is unlikely to be the first and only stimulus package for the entire year, in our view. On the monetary policy front, in view of the high risk of deflation, we expect that benchmark interest rates will be cut aggressively by an additional 162bp over the course of 2009. The rate cuts will most probably be front-loaded in 1H09 due to the need to prevent deflationary expectations from becoming entrenched.

The Chinese authorities appear to have started to resort to depreciation of the renminbi exchange rate as a policy tool to help the export industry. Our colleague, Stephen Jen, believes that China may allow modest and temporary (5-10%) depreciation of the renminbi against the US dollar (see Currency Economics: Changing My Call on the Chinese RMB, December 2, 2008). In this context, sustained renminbi depreciation against the USD that would reverse the appreciation course in the past three years is unlikely, in our view (see China Economics: A New Renminbi Regime? November 24, 2008). We expect that the authorities will take additional measures (e.g., VAT rebate) to help the exporters.

Investment Implications

While public sector-driven growth will help achieve headline GDP growth and job creation targets and thus limit the extreme downside risk of an outright hard landing, it will not be able to deliver nearly as strong corporate earnings growth as when the same level of headline GDP growth is fueled by buoyant private sector spending. We believe that the public sector-driven growth will be a relatively ‘job-rich’ but ‘profit-deficient’ macroeconomic environment in which bonds tend to be favored over equities. Within the equity space, sectors/companies with high earnings visibility and/or those exposed to government-supported capex will likely outperform.

The initial deflationary impulse due to positive supply shocks will bring about cost savings, especially in the sectors whose inputs are energy- and raw materials-intensive. However, with sticky wages, persistent deflation would cause real wages to rise, profit margins to fall and employment to be cut back, which may set off a deflationary cycle. A deflationary environment generally favors bond holders (or creditors) over equity investors (or debtors).

While the authorities may engineer a modest depreciation of the renminbi against the USD in the near term, we believe that the renminbi’s trend appreciation over the longer term remains intact, in view of China’s strong balance-of-payment positions. This view can be expressed in a pair trading strategy: long USD/CNY at the short end but short USD/CNY at the long end of the forward curve, in our view.

A broadly stable renminbi exchange rate against the USD has been the main reason for the ‘outperformance’ of the Chinese stock market since August compared with EM peers. Looking ahead, we believe that it will likely continue to be an important factor underpinning the performance of China’s stock market.

When the overall economic outlook becomes less uncertain sometime in the later part of 2009, we think that the profitability and quality of the investment projects that have been carried out under the campaign-style stimulus plan may become an issue of concern, as market participants start to focus on longer-term risks.

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United States
A Deeper Slump Triggers Aggressive Policy Responses
December 11, 2008

By Richard Berner & David Greenlaw | New York

Incoming data point to a deeper US recession than we thought a month ago, one rivaling the 1981-82 slump for depth and duration.  Measured by the decline in real GDP from its peak in the spring of 2008, we now expect a 2.6% decline in output through spring 2009, compared with the 2% decline we thought likely last month.  Thus, we are cutting our 2009 and 2010 forecasts again; we see real GDP contracting by 1.9% in 2009 versus 1.3% a month ago, and growing 2% in 2010 versus 2.1% last month.  The downturn would be deeper still, in our view, were it not for an ultra-aggressive combination of monetary and fiscal stimulus that will soon move into high gear.  Authorities are pulling out all the stops: Quantitative easing by the Fed and the largest-ever fiscal stimulus package likely will promote stability in the economy late in 2009 and a moderate recovery in 2010.

US Forecast at a Glance

(Year-over-year percent change)

	2008E	2009E	2010E
Real GDP	1.2%	-1.9%	2.0%
Inflation (CPI)	3.8	-0.3	3.1
Unit Labor Costs	0.8	2.4	1.2
After-Tax “Economic” Profits	-5.0	-25.2	4.4
After-Tax “Book” Profits	-12.0	-18.3	7.6

Source: Morgan Stanley Research   E = Morgan Stanley Research Estimates

 

The economy fell off a cliff in October and November, as the full force of an intensifying credit crunch hit domestic demand and the global downturn began to depress exports.  While a plunge in energy quotes cushioned the blow, consumers still face a perfect storm: Wealth is plunging, with falling home prices and the worst single-year equity market decline since 1931.  The credit crunch has denied consumers access to credit; banks in November reported that they are less willing to lend to consumers than any time since credit controls were imposed briefly in 1980.  And capped by a horrendous loss of 553,000 nonfarm payroll jobs in November, and a revised average monthly loss of 419,000 in the past three months, consumers are losing support for labor income at the fastest rate since 1982 (see “Perfect Consumer Storm to Last at Least Until Mid-2009”, Investment Perspectives, November 20, 2008).  It’s hardly surprising that vehicle and retail sales have continued to slide, despite more than a $2/gallon plunge in gasoline prices. 

Worse, the economy is losing ground on all fronts.  Capital spending is turning down sharply, evidenced by the 35.5% annualized slide in nondefense capital goods orders in the three months ended in October.  Real merchandise exports collapsed by 7.8% in September (including the impact of the Boeing strike on deliveries), with more bad news expected in coming months as the global recession spreads.  The deepening credit crunch has tightened lending standards and credit availability further, so the three-year-old housing crash has yet to find a bottom.  In all, we estimate that output plunged at a 4.5% annual rate in the two quarters ending in 1Q09, which would be the third sharpest six-month decline since 1947.

Against that backdrop, deflation fears have risen, courtesy of plunging commodity prices, crumbling inflation expectations, a soaring dollar, and the onset of a potentially severe global recession.  Indeed, a yawning US “output gap” and emerging slack abroad will quickly reverse the global inflation surge that appeared earlier this year.  But deflation remains a ‘tail’ risk, primarily because the Fed is engaged in massive, targeted quantitative easing that will put a floor under inflation expectations and ultimately inflation itself.

Quantitative easing began a few months ago when the Fed ceased sterilizing the effect on its balance sheet and bank reserves of the numerous market support programs and liquidity facilities that continue to be implemented. As a result, the size of the Fed’s balance sheet has ballooned from about $900 billion as of mid-September to more than $2 trillion at present.  Measures that have already been announced imply that the balance sheet will approach $3 trillion over the course of the next several of months.  This balance sheet expansion has led to a corresponding elevation in excess bank reserves. 

However, as noted in our recent analysis, the sharp spike in reserves and the monetary base has triggered only a very modest pickup in money supply growth to this point (see Revenge of the Ms, November 18, 2008).  The lesson from the Japan experience is that it will probably take some time for banks to stop hoarding the excess cash.  We suggest monitoring the weekly money supply figures to determine if QE is getting some traction via an expansion of bank credit.  In the end, we suspect that QE – and particularly the targeted QE that the Fed has adopted by focusing its actions on mortgage rates and consumer credit availability – will act to reinforce the support coming from government capital injections and other types of fiscal stimulus. But a significant improvement in the intermediation of credit will not occur overnight.

The Fed has other tools at its disposal, including a commitment to keep rates low and monetizing the coming fiscal stimulus by buying Treasuries. However, we detect considerable reluctance among Fed policymakers to precommit to an extremely accommodative stance for a specified length of time. After all, isn’t that what helped to get us into this mess in the first place? Any such commitment would likely be conditional on inflation and economic performance.  Moreover, we believe that the market misread Chairman Bernanke’s recent reference to the possibility of buying long-term Treasury debt.  Treasury yields are already so low that the impact of a Fed purchase program would be minimal.  Instead, policymakers can get a lot more bang for the buck by buying up the mortgage market – where spreads to Treasuries have been historically wide.  As he did back in 2002 when he made the helicopter reference that earned him a famous nickname, Mr. Bernanke was merely offering an example of the types of actions that the central bank can deploy when they run out of room on the fed funds rate.  The most important message is that the Fed has plenty of ammunition left and there is no limit to any future expansion of the central bank's balance sheet.

Moreover, massive fiscal stimulus is coming.  We anticipate that the incoming Obama Administration will quickly sign a multi-year plan that could total $750 billion.  It likely will include short-term help for the unemployed and state and local governments, medium-term tax cuts, and significantly stepped up longer-term infrastructure outlays.  Indeed, President-elect Obama vowed on Saturday to create and implement the largest public works construction program since the initiation of the interstate highway system a half century ago as part of his stimulus plan.  From the perspective of adding stimulus, the important point about infrastructure outlays is that the ‘spendout’ rates are slow.  For example, a $500 billion infrastructure plan might involve $100 billion in first-year outlays, and could take up to a decade to implement; the highways system took nearly forty years.  Thus, although the President-elect and state governors have identified $136 billion in ‘shovel-ready’ projects, many of which are needed and long-overdue, as sources of immediate stimulus they may fall short of the mark.

Our point is that the structure of stimulus matters as much as size; the issue is bang for the buck.  For example, we believe that a reduction in the payroll tax would be more potent than many other stimulus options.  It would help to both stimulate demand and reduce the cost of labor.  Officials could implement a six-month suspension of the payroll tax quickly and inject $425 billion into the economy.  We estimate that a temporary suspension of the payroll tax – together with other measures currently being discussed in Washington – would provide a powerful dose of stimulus far beyond the magnitude associated with the Reagan tax cuts of the early 1980s and the Bush tax cuts of 2001 and 2003.  Politics are an obstacle, however; many view a reduction in the payroll tax as a “raid on the social security trust fund.”  While we think this is sheer nonsense, we recognize that the hurdles are high, and lawmakers may have to look elsewhere (see Fiscal Stimulus: Make it Bigger – and Better, December 8, 2009). 

Investors looking at our monthly updates may be tired of hearing that the risks to our outlook still point to the downside.  If so, why not simply cut our estimates to the point where those threats are balanced?  There is a better way to assess the balance of risks than by extrapolating the evolution of our forecasts from month to month.  We are now attempting to assess and quantify the risks to the outlook systematically in advance.  We provide a framework to meet that goal, thus providing investors and our colleagues with plausible risk scenarios around a baseline (see Risks to the Global Outlook: The Good, the Bad and the Ugly, December 9, 2008).  The risks around the baseline do still point to the downside; in the ugly scenario we see the US economy contracting by 2.9%, or a full percentage point below the baseline, while in the good scenario it declines by “only” 1.2%.

We think markets have digested a lot of bad economic news, but they have not completely moved beyond it.  Ten-year US yields plunged to record lows over the past week, courtesy of hopes for targeted QE and fears of deflation.  Yet crosscurrents affecting Treasury yields may surface: For now, the combination of a deeper recession, lingering deflation fears, and hopes for Fed purchases of Treasury debt may cap yields, even at today’s low levels.  However, the Treasury will issue a huge volume of supply even with no additional stimulus plan, and that volume will only grow, putting upward pressure on yields.  On net, we think Treasury yields now seem likely to consolidate, but will rise over the course of 2009. 

Likewise, equities have rallied sharply on the hope that aggressive stimulus will shorten the recession, but near-term earnings and economic disappointments will be hurdles to further gains.  In addition, sequencing matters: Until credit markets consistently improve, rallies in equities seem likely to be short lived.

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