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India
2009 Growth Outlook: Still in a Coupled World December 19, 2008 By Chetan Ahya (Singapore) and Tanvee Gupta (India)| Capital Inflows Remain a Key Driver for Growth Outlook India’s potential growth has been steadily rising, driven by improving demographics (a rising proportion of working-age population), reforms (creating a platform for the working-age population to operate productively), and globalization (creating job opportunities). However, we believe that over the past few years, India’s GDP growth accelerated significantly relative to its potential growth. India’s GDP growth accelerated to an average of 9.3% during the three years ended March 2008, compared with averages of 6.6% and 6.0% in the preceding three and five years, respectively. The most important driver of this acceleration in growth above potential was the sharp rise in capital inflows over the past five years. India received an average of US$10 billion per annum over 2000-2002. During 2003-2005, capital inflows more than doubled, to an average of US$21.3 billion, followed by increases to US$38.5 billion in 2006 and to US$98.3 billion in 2007. We believe that higher capital flows have been the anchor of a self-fulfilling virtuous cycle of an appreciating exchange rate, lower interest rates, and strong domestic demand growth. Unfortunately, capital inflows into India have less to do with India's long-term fundamentals, in our view. The trend for capital inflows into emerging markets has been dependent on global risk appetite, which, in turn, has been driven by the liquidity and growth environment in the developed world. As per IIF estimates, capital inflows into emerging markets increased to US$782 billion in 2007 from US$113 billion in 2002. The trend in India has been very similar. Indeed, just as the global growth environment has deteriorated, India has witnessed capital outflows. As per our estimates since early July, India has witnessed net capital outflows of ~US$8-10 billion. The sudden systemic stop in capital inflows at a time when the country is running a current account deficit has meant a large balance of payments deficit. We estimate that India's balance of payments deficit was US$35-40 billion over the last five months. With the domestic banking system already witnessing tight liquidity conditions, foreign exchange outflows have resulted in a disruptive spike in the cost of capital. Policy rate cuts and liquidity measures cannot prevent a sharp slowdown in the growth of domestic demand. We believe that measures initiated by the central bank are unlikely to bring down the cost of capital in a meaningful manner before domestic demand and underlying credit demand decelerate sharply. Unprecedented External Demand Shock Underway India's export growth averaged 24.8% over the last three years, driven by strong global growth. However, over the last three months export growth has decelerated sharply. While until recently strong demand from emerging markets ensured that export growth remained healthy, over the last three months disruptions in these economies have been evident. Apart from the weakening of demand, exports have also been affected by the lack of foreign trade credit and by inventory liquidation. India's exports declined by 12.1% YoY in October 2008, compared with 10.4% in September and 26.9% in August. While we expect some improvement in the second half of 2009, exports are likely to be unusually weak over the next six months. We are now expecting exports to decline by 5.3% YoY in 2009. Industrial Recession Ahead While deceleration in GDP growth may not appear as severe, industrial production, which matters for the listed corporate sector, is likely to witness a deeper slowdown. Industrial production decelerated to an average of 4.5% for the three months ended September 2008 from a peak of 13.6% in the quarter ended January 2007. Further weakness in domestic demand owing to the rise in the cost of capital and sharp deterioration in external demand will likely result in industrial production declining for a few months between November 2008 and June 2009. This will be the worst industrial sector performance since the 1991 cycle. Weaker 2009, Gradual Recovery in 2010 Building in weaker domestic as well as external demand, we expect GDP growth for 2009 to be 5.3%. We then expect GDP growth to recover in 2010 in line with our global forecasts. We believe the improvement in domestic demand in 2010 will be restrained by the fact that the banking sector will likely remain impaired because of large increases in non-performing loans in 2009. We expect a slight improvement in external and domestic demand. We forecast 2010 GDP growth to be 6.4%. Aggressive Monetary Easing but Limited Fiscal Stimulus We are anticipating monetary policy easing to continue through 2009. We are now expecting the repo rate (the key policy rate) to be reduced to 5.25% by the end of 2009. Most of this reduction will probably be front-loaded, with the repo rate likely to be at 5.5% by March 2009. We also expect the central bank to supplement the rate cuts with additional liquidity-support measures. However, we are less optimistic on the fiscal policy response. We believe that in an environment of global deleveraging and risk aversion, the private sector is unlikely to respond effectively to monetary easing, and therefore a counter-cyclical fiscal policy assumes an important role. However, the Indian government has been running pro-cyclical fiscal policies over the last few years. In F2009, we estimate that the fiscal deficit including off-budget liabilities will be 9.9% of GDP, one of the highest amongst large economies in the world. Public debt to GDP after including off-budget liabilities is estimated to increase 95.9% as of March 2009. Hence, we see no scope for an aggressive fiscal policy response. We believe the government could try to increase infrastructure spending through bilateral investment agreements with Japan and/or Middle Eastern countries, but the implementation of such an investment program is unlikely to be quick enough to provide growth support in 2009. Risks to Our Base-Case View Our economics team currently estimates global growth of 0.9% in 2009 and 3.3% in 2010. Our global economics team has added bull and bear scenarios to the base case (see “The Good, the Bad, and the Ugly” in this publication). Based on this framework for the global growth outlook, we see bull scenario growth for India at 6.3% in 2009 and 7.5% in 2010, and the bear case at 4.3% in 2009 and 5.3% in 2010. In the bear case, we are assuming continued risk aversion in the global financial markets and therefore a sustained adverse trend in capital inflows and a sharper fall in exports. In the bull case, we are assuming a recovery in capital inflows and export growth. We assume the political environment to be a neutral factor. However, the outcome of general elections scheduled for May 2009 could also bring upside or downside risks to our base-case outlook.
Japan
Reshaping Our Cautious Profile December 19, 2008 By Takehiro Sato and Takeshi Yamaguchi | Tokyo Our main scenario for 2009 foresees the worst recession of the post-WW2 era. Even in the bull case, we estimate negative growth in 2009 and tepid recovery in 2010. Acute negative feedback from the financial markets is worse than we foresaw. Given the breadth and depth of manufacturing production cutbacks, we foresee maximum recession momentum in Oct-Dec 2008 and Jan-Mar 2009. With extra damage from technical factors such as the lower base effect, out of necessity we sharply lower our outlook for 2009. We also think recovery in 2010 will be slow. Given the overwhelming uncertainty, we also look at what might happen if conditions proved better or worse than in our base case scenario. Outline of Our Growth Outlook: Three Cases (%)
e = Morgan Stanley Research estimates Source: Morgan Stanley Research
Our base scenario for 2009 GDP is -2% (versus -1.1% previously), the same as 1998 when the Japanese economy was on the verge of financial meltdown. Even in the bull case, we estimate -1.2%, while -3% in the bear case would be by far the worst of the post-WW2 era. We see corporate earnings (F2010, parent) at -20% in the base case, -10% in the bull, and -40% in the bear. While we then expect growth to scrape back into positive territory in 2010 (+0.2% in the base case), we foresee weak recovery momentum, and even in the bull case we only estimate a rise of +1%, which is below the growth potential. The bear case assumes a second straight year of negative growth at -1%. Visibility on underlying factors for corporate earnings for 2010 such as the input cost is very poor, but assuming rising input costs with a pickup in the global economy, we do not expect profit growth to match possible gains in sales. For prices, we forecast average annual declines in 2009 in both base and bear cases, and with a possible backlash from the previous year in 2009 2H, we expect the core CPI to dip by more than -1% YoY, falling through the existing bottom of the late 1990s (-1.0%). We anticipate an expansionary bias in Japan’s macro policies, faced with broadly based economic deterioration. That said, there is not much room for maneuver in either fiscal or monetary policy, so we anticipate limited traction from these sources. Details about the base case. We expect the downturn to climax towards Jan-Mar 2009 as overall demand retreats both domestically and overseas, and we do not anticipate much sense of recovery throughout 2009. Once into 2010 we expect the economy to pick up gradually albeit with a patchy start, but we expect momentum to be weak due to soft recovery overseas. Overall we only anticipate growth scraping into positive territory at +0.2%. Yet as costs come down, we expect corporate earnings to do better than companies’ extremely conservative initial guidance, while still falling 20%. We foresee equity market disappointment with cautious guidance in Apr-May 2009. The high yen leads us to expect price changes to turn negative again, and we foresee both consumer and domestic corporate goods inflation turning negative from 2009 2H, exacerbated by a backlash to 2008 commodity inflation and a wider output gap. We also expect the major correction in asset prices in the past year to squeeze prices in general. Recovery triggers are 1) better terms of trade from lower input costs and 2) pent-up demand as households and companies tire of extreme penny-pinching. In 1), lower resource/energy prices curb trading losses and aid recovery in household and corporate real purchasing power. In 2), as at end-1998, we expect pent-up demand to start trickling out from both companies and households by about Oct-Dec 2009, a year from the event risk of Sep 2008. Yet there is lingering downside risk too – domestically, from tougher construction rules following the housing shock of 2007 and a repeat of such events. The revised Architect Code Law in question takes effect in May 2009. Bull case for 2009-10: We foresee recovery to a sub-trend growth rate of +1% in 2010. Yet lower costs put corporate earnings (-10%) ahead of the base scenario. With limited scope for self-sustaining recovery in domestic demand, realization hinges on a bull scenario for overseas. Namely, macro policy efforts by overseas authorities and swift implementation of measures to create a healthier financial system (securing transparency of asset prices and separation from bank balance sheets). Bear case for 2009-10: The 2009 bear case foresees a -3% drop in GDP and a deflation spiral. Capex falls at a 2-digit rate and consumption reaches new depths of weakness. In 2010, the downward spiral tails off somewhat but growth stays negative at -1%. Corporate earnings undershoot guidance, falling 40% due to top-line shrinkage. We would envisage this scenario if overseas economies deteriorated even further and Japan also saw an all-out credit crunch by financial institutions concerned about capital shortages. More demands on monetary policy. Despite expansionary fiscal policy, the sheer size of government liabilities demands a restrictive stance and inevitably places a burden on monetary policy. Specifically, we expect easing along the following lines depending on how badly the economy deteriorates: 1) quantitative easing without ZIRP (+ unsterilized FX intervention), 2) rate cuts, 3) quantitative easing with ZIRP (+ unsterilized FX intervention), 4) increase in Rimban (JGB outright buying) value, 5) further relaxation of eligible collateral criteria (shares, CMBS), 6) CP (ABS, ABCP) and CMBS purchases, 7) CMT, CPI-linker purchases, 8) buying up of equities as during 2002-04. As such, monetary policy is likely to take the place of fiscal policy to assist corporate funding.
Currencies
2009 Dollar Outlook December 19, 2008 By Stephen Jen & Spyros Andreopoulos | London In 2009, assuming that the global economy finds a trough by summer, we see the dollar rallying further into the trough, but underperforming most other currencies as the world recovers in 2H. The swings in the global business cycle will likely be the dominant driver for the dollar. Other factors such as US government debt sustainability and the US inflation outlook associated with the Fed’s QE (quantitative easing) operations will likely be secondary considerations, mainly because we believe that US Treasuries will remain well-supported and a flare-up in inflation is not a probable risk. There is no official change to our forecast and we continue to look for EUR/USD to dip to 1.10 by 2Q, before recovering to 1.20 by end-2009. USD/JPY will likely exhibit a similar U-shaped trajectory, dropping to 85 by 2Q before rising to 100 by end-2009. Most EM currencies will likely experience intense depreciation pressures vis-à-vis the USD in 1H. Differentiation at the EM country level will likely be unproductive in the sell-off phase. But in the recovery phase, country-specific factors will likely drive a wedge between the currencies of the ‘good’ from the ‘bad’ economies. Resurrecting our ‘four seasons’ framework. In thinking about how currencies might be affected by large swings in the global business cycle, it is important to consider both the real economy and the financial side (the buoyancy of global equity markets). In other words, exchange rates are not only functions of relative economic growth, but are also sensitive to general levels of risk appetite, which are correlated with the buoyancy of world equity markets. Since financial markets tend to be ‘forward-looking’ and anticipatory, when the world plunges into a recession, earnings forecasts are cut, risk-taking curtailed, and equity prices decline ahead of the actual contraction in economic activities. To help us think about the implications for currencies, we first calculated the historical correlations between various currencies (vis-à-vis the dollar) relative to economic growth and the equity markets. Different currencies tend to perform best in different ‘seasons’, or ‘comfort zones.’ We suggest that high-beta currencies such as many of the AXJ currencies belong to summer or the spring quadrants, while the currencies of large capital-surplus countries, such as JPY and CHF, should be in ‘winter’ or ‘fall’. By and large, simple correlations of exchange rate performance relative to global growth and global financial market buoyancy are consistent with these broad prejudices. The distance of these currency cells from the origin denotes the size of the elasticities. We believe that EUR and CHF should underperform the dollar as we enter the ‘winter’ quadrant, due to European and Swiss banks’ exposure to Eastern Europe. JPY, on the other hand, could be supported by acute repatriation flows as we head into ‘winter’. Call 1 — The dollar to strengthen first, and weaken later. At the turn of each year, there is a temptation for analysts like ourselves to make one call on the dollar for the entire calendar year (i.e., a strong or weak dollar ‘year’). However, more often than not, currencies don’t change trends on January 1. 2008 is a good example: The dollar did not begin to show strength until May against AXJ currencies and until July against the EUR. In the first few months of 2008, the dollar was extraordinarily weak. For 2009, we see the opposite trends: dollar strength in the first months, followed by possible dollar weakness in 2H. We see the world toggling through ‘winter’ and ‘spring’ in 2009, with a risk that ‘winter’ may last longer than 1H, and ‘summer’ may come in 2010 or later. Thus, we will be buying dollars and JPY into 1H, but with a view to flip our positions some time in 2Q in anticipation of a global economic recovery. Call 2 — EM currencies will be stressed in 1H. The global EM currency ‘moment’ is not over, in our view. In fact, the process is roughly halfway complete. We see weaker Latam currencies in 1H09. Pressures on AXJ currencies will likely persist, as these countries’ exports collapse and their central banks cut interest rates. We believe that even the CNY will be allowed to weaken against the dollar in coming months. Eastern European currencies may come under intense balance of payments pressures. While Russia especially deserves investors’ full attention, the familiar structural fragilities of EE will expose the broad region to possible discrete changes in the RUB, in our view. When the global economy bottoms, we would be keen to buy back KRW, BRL and MXN. Our view on the commodity currencies (AUD, NZD, CAD) is broadly similar to that on the EM currencies. Call 3 — We remain bearish on the EUR in 1H. Though the EUR is no longer overvalued, it is still over-rated and over-owned, in our view. The sell-off from 1.60 to the high 1.20s merely puts EUR/USD closer to its fair value: EUR/USD was massively overvalued at 1.60. The EUR is no longer expensive, but it is not cheap. Further, the only reason why the dollar could have rallied so sharply since July was its hegemonic reserve currency status. The fragmentation of the European sovereign bond markets helps preserve the superior reserve status of the dollar. Finally, the negative feedback from possible fractures in EE could cause material damage to the EMU, and weigh on EUR. Two main risks to our dollar view. The two key risks to the dollar are inflation and an unsustainable federal debt profile. The Fed’s QE operations need an exit strategy. The latest talk of the Fed issuing its own debt may be one way the Fed could unwind its balance sheet in time to stabilise inflation expectations. The dollar’s performance will be driven by inflation expectations, in our view. Similarly, the super-sized US fiscal deficits will be a risk for the dollar, though our central case view is that US Treasuries are more likely to be a preferred safe haven asset in a global recession relative to other sovereign debt..
Euroland
Testing Times December 19, 2008 By Elga Barstch | London Showing the euro’s macro mettle: The current downturn marks the first full-blown recession since the start of monetary union. And it’s in these testing times that the euro area’s mettle is likely to be shown. For the full year 2009 we see GDP down 1.0%: Our base case calls for contracting activity to eventually give way to a muted recovery around midyear. Clearly, there are some unique pressure points in the euro area, as the currency union is not matched by a political union and most economic policy decisions, other than monetary policy, are still taken at the national level. Note that this heterogeneous policy approach could also be beneficial in an environment of a high level of uncertainty about the outlook and of divergent opinions about what policy options are best to follow. In addition, the pros and cons of E(M)U membership will likely be debated both inside and outside the euro area. The current consensus seems to be that the chances of EMU break-up have increased on the back of the current turmoil. We disagree. In fact, we think that the opposite might be the case and some countries could be fast-tracked towards EMU membership. Here we discuss the challenges facing Europe in 2009 and conclude that EMU will likely pass this first real test of its macroeconomic policy framework. As a result, we expect the economy to recover from mid-year onwards. Dramatic cut in production lies ahead Getting the policy response right Possibility of reduced policy effectiveness We expect a trough in the refi rate of 1.5% to be reached in early 2009, slightly below the 2% we had pencilled in before. But the uncertainty around our main scenario is considerably higher than usual. We would therefore not rule out that the ECB will need to push policy rates to a new low. In any case, the ECB will likely aim to maintain a medium-term perspective and thus keep a firm eye on its exit strategy, given that the current trouble partly has its roots in the ECB allowing a major bubble to develop by leaving interest rates too low for too long during the last easing cycle. Hence, if the ECB deems that additional interest rate cuts are needed, it could well be keen to reverse them again as soon as possible. Similarly, the effectiveness of any expansionary fiscal policy stance depends on the reaction of the private sector, notably the saving behaviour of private households and, to a lesser extent, non-financial corporates. Next year, fiscal policy should turn expansionary for the first time since 2001, we estimate. Currently, we count around €65 billion of discretionary measures, equivalent to 0.7% of GDP. More is on the way as we write. Thus, we would not be surprised if the deficit eventually reached, or even exceeded, the 3% mark in 2009. Bigger budget deficits, however, do not automatically guarantee stronger domestic demand. Higher spending by the government could be offset by lower private sector spending and higher savings. For a region historically plagued by big government budgets, it is thus essential to ensure that the fiscal measures remain temporary in order to avoid that the private sector becomes concerned about the long-term sustainability of government debt levels. Ideally, the measures would therefore come with a sell-by date. Alternatively, they could involve a front-loading of long-term spending plans on items such as infrastructure, research and development. Mind the coming country rotation within the euro area Postcards from the edge of EMU Similar pressures were also felt further afield in Central and Eastern Europe. In many respects, it is reminiscent of the tensions felt in the European Exchange Rate Mechanism (ERM), in particular in the early 1990s. Dislocations at the fringe of the euro area also have important repercussions on the euro area itself. Not only is the euro area much more open than the US – with exports of goods and services accounting for 22% of GDP, compared to 12% – but more than a third of these exports are destined for other European countries, of which Central and Eastern Europe account for a further third. In addition to direct exports being dented by the global recession, foreign affiliate sales of euro area multi-national companies will likely also feel the pinch. Unfortunately, there aren’t any data available at the euro area level. But as a rough guide, foreign affiliate sales can total as much as 210% of exports in the case of Germany, 98% in the case of France and as little as 38% in the case of Italy. Investment spending will likely take the hardest hit Some support should come from falling consumer price inflation, which will likely fall markedly and should trough around the 1% mark in July, before starting to rise rapidly again in the second half on the back of flip-flopping base effects. This sharp fall in headline inflation should not be mistaken for the start of a deflationary demise à la Japonaise though. Instead, the falls in energy and food prices, which are the main drivers behind this development, should be seen as a factor supporting real demand growth. The ECB will look through these massive swings in headline inflation caused by base effects, we believe. In our view, investors should do so too. Bottom line Our surprise: EM-Umbrella
Malaysia
Testing the Resilience of Malaysia’s Trade Surplus December 19, 2008 By Deyi Tan, Chetan Ahya | Singapore & Shweta Singh | Mumbai Trade Linkages and Pressure Points As we highlighted in ASEAN Economics: Setting the Context and Calibrating the Risks, December 11, 2008, we rank ASEAN’s macro vulnerability based on a framework of: 1) who is most addicted to risk-capital liquidity; 2) who is most exposed to trade and asset market linkages; 3) who has the ability and wherewithal to undertake policy responses; and 4) Idiosyncratic domestic factors such as political conditions. Specifically, on the transmission mechanism of trade linkages, we rank Malaysia as the second-most vulnerable to global macro deterioration within ASEAN, given its export share (percentage of GDP) and current account balance. The openness of the economy is one factor, and pressure points stem from the following, in our view: Commodity exposure: Malaysia is the largest net commodity exporter within ASEAN. Mineral fuels (petroleum, coal and gas – 17%) and animal oils and fats (crude palm oil – 9%) constituted 26% of exports (4Q trailing sum) as of September 2008. The rise in the price of Tapis crude oil and crude palm oil from US$35/bbl and US$500/ton, respectively, in 1Q04 to US$124/bbl and US$923/ton in September 2008 gave the commodity-related trade surplus a boost from 11% of GDP to 14.9%. However, the price effect will now work in reverse, with commodity prices retreating markedly from their highs in July, and monthly trade data are beginning to reflect that. Holding volumes constant, we estimate that every US$10/bbl decline in oil prices and CPO prices will shave 0.7% and 0.5% of GDP off the trade balance, respectively. Electronics exposure: Electronics is another area of weakness. Items such as electrical machinery (21%), data processing machines (9.2%) and telcoms (7.4%) constitute about 38% of exports. However, Malaysia’s electronics exporters have seen one of the weaker growth rates in the region, and have been losing global market share in the past few years. The non-commodity trade surplus (4Q trailing sum) was just 3.7% of GDP in September 2008, at a time when the total trade surplus was 18.6% of GDP. With the US ISM New Orders leading indicator falling to a new low since the 1980s, we will see more weakness on that front. As it is, electronics exports fell 5.8%Y (3MMA) in October 2008. As a benchmark, electronics exports declined 24.5%Y (3MMA) at the trough in September 2001. Stress-Testing Malaysia’s Trade Balance These factors have raised the question as to whether Malaysia’s trade surplus could possibly turn negative in 2009. We believe that this is unlikely. First, in volume terms, Malaysia is still a net commodity exporter. Commodity prices could fall, but the zero-bound to prices means that the positive buffer on the commodity front would still be present. Second, the impact of the global spillover onto exports tends to cause imports to slow down on the back of lesser intermediate imports (for export purposes) and weaker domestic demand. This offsets the negative impact of slower exports on the trade balance. We carried out scenario analyses to stress-test the extent to which the trade surplus could fall under various conditions and whether a trade deficit could indeed occur. Our assumptions and conclusions are as follows: Scenario 1: We assumed that the average price for Tapis crude oil and CPO in 2009 and 2010 will hover close to current levels of US$46/bbl and US$490/ton, respectively, at US$40/bbl and US$400/ton. We further assumed that non-commodity trade (excluding mineral fuels and edible oils) will follow a momentum trajectory similar to 2001, with growth troughing in 2Q09. In this scenario, the trade surplus (custom basis) will fall from around RM126 billion in 2008 to RM73 billion in 2009, and RM69 billion in 2010. Scenario 2: We assumed that the average price for Tapis crude oil and CPO in 2009 and 2010 will stay at US$40/bbl and US$400/ton, respectively. The trough in US ISM New Orders (3MMA) in 2001 of 39.9 corresponded to the 20.5%Y (3MMA) decline in non-commodity exports. With US ISM New Orders now tracking at a low of 33 (3MMA), we assume that non-commodity exports will decline to around 30% at the trough in 2Q09 but follow a recovery path similar to 2001. In this scenario, the trade balance will fall to around RM74 billion in 2009 and RM72 billion in 2010. Scenario 3: We assumed that the average price for Tapis crude and CPO in 2009 and 2010 will reach 2001 levels of US$20/bbl and US$250/ton, respectively; US$250/ton is at the lower end of the breakeven range of US$250-350/ton for CPO. For non-commodity trade, the magnitude of decline is the same as in scenario 2. However, we assumed that it would be an elongated L-shape trajectory, and we extended the duration of the trade trough through to 2010. In this scenario, the trade balance will fall to around RM61 billion in 2009 and RM64 billion in 2010. Narrowing Trade Surplus to Impact Growth While we think that a trade deficit situation is unlikely in 2009, we do expect the trade surplus (BoP, USD terms) to narrow from 20.6% of GDP in 2008 to 17.1% in 2009 on the back of commodity price effect and slower global trade. This would undermine the first two of the three legs in Malaysia’s growth model of trade – commodity resources and fiscal pump-priming. We expect Malaysia’s GDP growth to decelerate to 0.5%Y for 2009 from 5.5%Y in 2008.
United States
A Deeper Slump Triggers Aggressive Policy Responses December 19, 2008 By Richard Berner and 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)
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.
Global
2009 Global Economic Outlook December 19, 2008 By Richard Berner (New York) and Joachim Fels (London)| The financial crisis will continue to play out in 2009, with serious repercussions for the global growth and inflation prognosis. Downside risks prevail for both, so that deflation is a bigger risk than inflation. We expect just 0.9% global growth in the coming year, matching the weakest year on record (1982). But with policymakers resolved to do whatever it takes to end the crisis, recovery seems likely. The issue will be how long it will take to stabilize credit markets and thus economic activity. Our best guess is that the credit markets are beginning to improve, but the process will not be speedy. As a result, recovery will be slow in coming and moderate at best in 2010. This is the final issue of the Global Economic Forum for 2008. We will resume regular publication on Monday, January 5, 2009.
Latin America
Sliding in 2009 December 19, 2008 By Gray Newman, Luis Arcentales, Daniel Volberg, Boris Segura (New York) and Marcelo Carvalho (Sao Paulo)| The era of abundance – five years of strong global growth that prompted a sharp 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. We are cutting our forecasts for a second time since October; no country in the region is likely to be unscathed in 2009. 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 from 3.5% to 1.5%. 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. 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. 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. We expect to see a modest sequential recovery in late 2009, but I 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 (Exhibit 1). My own bias is that the risks remain to the downside of our forecasts. Country Details In Mexico, where exports accounts for nearly one-third of GDP, the US slowdown has already produced a decline in industrial activity five months long (and counting) through September, and more pain seems on the cards. And 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 the third quarter, which even considering calendar effects represents a marked slowdown from 6.7% and 11.2% in the second and first quarters, respectively. And the combination of mounting job losses, tighter credit – as banks struggle with rising credit card nonperforming loans (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) due to a dramatic income shock from falling commodity prices and the loss of an undervalued exchange rate. Daniel calculates that out of the 2.2 million formal jobs created in the 2003–07 period, 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 in growth could occur. In Brazil, Marcelo Carvalho warns Brazil is likely already to be in a recession that began in 4Q08. He expects 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. 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 devaluation 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 our 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 200 basis points 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. 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 a modest 1.5% over the course of next year. One Positive Element, Two Cautious Elements Positive: Starting points matter – The region appears to be in better shape than in the past to manage a downturn in the global economy. The risks that a downturn in growth leads to a major financial crisis in the region’s largest economies are 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. We have seen little of the excesses common in past upturns in Latin America — no ballooning trade and current account deficits fueled by consumer spending; no widening fiscal deficits; no central banks burning through reserves trying to prop up overvalued currencies. Cautious: Leaning against the wind – Much more limited space to engage in counter-cyclical policy. Fiscal stimulus is likely to require an important increase in debt financing precisely at a moment in which investor appetite for emerging market obligations appears to be waning, implying a risk of crowding out the private sector and countering any attempts by the monetary authorities to ease interest rates. Among the region’s major economies, only Chile can allow for significant fiscal easing without debt financing. If the downturn is prolonged, we are concerned that investors may have underestimated the risks associated with increased debt issuance. 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, for three reasons. First, Latin America’s central banks have lagged their counterparts around the world in easing monetary policy, stemming in part from the region’s unfortunate past as the epicenter of hyperinflation. Second, the level of financial intermediation and the role of credit in most of Latin America are still extremely limited, which 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 credit quality. Cautious: Policy slippage or even reversals – this is perhaps the greatest risk in Latin America, and throughout emerging markets. We would not be surprised to see regulatory creep throughout the region that could lead to de facto, even if not de jure, nationalization. We are concerned with “translation risks” as the policy remedies being deployed in the developed world are adopted (and adapted) in Latin America and emerging markets. And the longer that downturn in activity continues, the greater the risk of further slippage. Bottom Line It is hard to handicap the severity and the duration of the current downturn in Latin America — so much depends on your global assumptions. But there are elements for celebration and elements 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 fear 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.
UK
A Pessimistic and an Optimistic Case December 19, 2008 By David Miles and Melanie Baker | London For the past year or so, growth in the UK has been weakening, and quarterly output growth turned negative in 3Q for the first time in more than 15 years. Credit conditions have tightened markedly and global growth has slowed sharply. Our central forecast for calendar year 2009 GDP growth is for an outright contraction (the first since 1991) of 1.0%, and we continue to see the balance of risks to that central forecast as skewed to the downside. The prolonged tightening in credit conditions seems unlikely to suddenly dissipate in 2009. Employment levels are likely to contract. The risk of ‘negative feedback loops’ developing in the UK economy remains present. Asset price falls (including housing), the slowing economy and rising unemployment make banks less willing to lend, and households and corporates less willing to spend, all worsening the outlook for the real economy. However, we remain cautiously optimistic that we can avoid a deep and prolonged recession in the UK. This is largely due to three factors: 1) Massive monetary (and substantial near-term fiscal) policy stimulus, which is likely to prevent household demand falling precipitously and which encourages a lengthy period of balance sheet and savings adjustment rather than a short, sharp one. 2) A determination by the UK authorities to get credit markets functioning and revive the flow of lending. 3) The recent large depreciation in sterling, which is likely to boost net exports and offset some of the effect of slower growth in the UK export markets. The pessimistic case: Sharply higher household savings. The household saving rate could follow a profile similar to that of the early 1990s. Then, the household saving rate increased from around 4% at the end of the 1980s to about 12% by 1992. If a rise in the saving rate on that scale were to happen now, consumer spending would fall very sharply for a couple of years. We have constructed a scenario along these lines where, alongside a very sharp decline in consumption, we mix in three years of contraction in fixed investment (both residential and business investment contract in 2008, 2009 and 2010). On such a scenario, the unemployment rate reaches a 15-year high, with unemployment rising 1.2 million peak to trough (compared to around 1 million in the early 1990s). In this scenario, UK GDP contracts by almost 3% in 2009. The key to whether this scenario materialises is consumer spending and saving behaviour. If the household savings rate, which is exceptionally low, follows a trajectory similar to the recession of the early 1990s, it will be rising sharply at a time when global growth is well below trend, so that reductions in domestic consumption are not offset by much stronger growth in exports. In that scenario, a very sharp and protracted fall in output will be inevitable. There are many good reasons for households to want to build up their savings over the next couple of years. These include: offsetting the hit to wealth created over the past year by falling house and equity prices; greater uncertainty about job prospects; and a reduced ability to smooth consumption by borrowing. While our central case is that households will prefer to raise their savings rate gradually, there are some reasons to expect this to happen rapidly, despite the weak economic backdrop: 1. The baby boom generation is nearing retirement and many households’ pension plans will have been hit by the decline in property and equities. If unwilling to significantly defer their retirement plans, households may ramp up sharply their rate of voluntary contributions to pension schemes. 2. A large number of households are likely to be in negative equity (or very close to it) by the middle of 2009. Many of those households may wish to increase their savings and need to do so rapidly to lower their mortgage relative to the value of their property, making it easier to obtain a new mortgage or to retain a mortgage on relatively favourable terms. Some households will have been holding off selling a property despite a desire to move, given conditions in the housing and mortgage market. A rise in the number of forced sellers might see such capital injections increase. 3. Households may expect deposit rates to fall sharply, given cuts in the policy interest rate, so that it makes sense to ‘lock-in’ higher fixed savings deposit rates now. The optimistic case: Positive supply-side effects. In this scenario, households significantly increase their supply of labour, boosting potential output. The ‘lost’ output from the period of sub-trend growth is not permanent. That is because the supply side of the economy might not have been damaged significantly by the credit crunch (an optimistic view, since it assumes that the severe damage to the financial system we are seeing does no lasting damage to productive capacity). This could imply that the recovery is significantly more vigorous than many expect (and is ultimately sustainable). So, if growth in 2008 and 2009 is substantially sub-trend (as we expect) – creating 3-4% of spare capacity if trend growth is unchanged – then a bounce-back to trend over the following two years means cumulatively growth would need to be 3-4% above trend in those years. The point here is that a couple of years of growth approaching 5% in 2010 and 2011 – which now looks wildly optimistic – is actually what is implied by a return to an unchanging underlying trend four years or so down the road. Of course, this assumes that the trend level of output has not been damaged by the credit crunch. Whether that is so depends on how supply potential evolves. Supply-side responses to some of the huge shocks we have seen may be both pro-growth and supportive of corporate profits. Those huge shocks include: 1) A big fall in equity values; 2) A big fall in house values; 3) A perception by many households that their debt is too big relative to their income; and 4) A potential overhang of some types of residential properties, meaning that construction investment will be very low for some years. Factors 1) and 2) lower household wealth. With household wealth a lot lower, we should expect two things: higher household saving and higher labour supply. (Factor 3 generates a similar response.) Higher saving is a negative for growth in the near term (because we can’t expect other components of spending to adjust up to offset it). But the impact of more labour supply – as people need to work more to replace nasty shocks to wealth – is ultimately a clear positive for economic activity and for corporate profits. It means the capital-labour ratio is lower (boosting the return to capital, reducing real wages, and encouraging more investment). Factor 4) implies that residential construction will be much reduced, maybe for many years. The resources used there will be available elsewhere, and land prices are likely to be lower than they otherwise would have been. Those are not negative factors for the (ex-construction) corporate sector.
Asia Pacific
Disruptive Growth Shock in 2009 December 19, 2008 By Chetan Ahya (Singapore) and Sumeet Kariwala (India)| Reflecting the weaker global environment, we expect GDP growth in AXJ to be 5.3% in 2009, which will be very close to the 2001 low. We concede that the risks to our estimates are to the downside. We believe the economies in the AXJ region are likely to be affected in two ways: 1) Risk aversion in global financial markets transmitting to a higher cost of capital in the region: The sharp drop in capital inflows and increased contagion from global financial markets has been passed on to most AXJ countries in the form of rising cost of capital (both equity and debt). While most countries have started cutting rates, the cost of borrowing for consumers and the corporate sector remains high. To analyze the adverse impact of rising risk aversion in the global financial market, we group the region's economies into three buckets (moderate, high, and maximum impact) based on their dependence on credit growth to drive economic growth and the position of their current account balances. The "Trouble Zone", which includes India, Korea and Indonesia (accounting for 35% of the region's GDP) has experienced strong credit growth and has current accounts in deficit. As a result, their economies are likely to suffer the most from the global financial market contagion. Sudden systemic halts in capital inflows at a time when their current accounts are in deficit have pushed their overall balance of payments into large deficits. With their banking systems already facing tight liquidity, the balance of payments deficit and foreign exchange outflows have caused a disruptive rise in the cost of capital over the last four months. We believe these economies will face large dislocations in their financial systems, which will affect their ability to revive quickly. They face the risk of non-performing loans rising as the growth cycle turns down. While Singapore and Hong Kong are likely to be less affected than the trouble zone economies, we believe they will still suffer from a deleveraging trend, as both have had a strong credit growth cycle, and Singapore also had a property cycle. China, Taiwan and Malaysia did not have a strong credit growth cycle and run current account surpluses. They are likely to suffer less financial system dislocation than the other two groups. 2) External demand shock: AXJ's exports have grown 19.3% YTD in 2008, driven by what we call the rest of the world, or ROW (world excluding US, Europe, and Asia). This group primarily includes emerging market economies. Exports to ROW have grown 31.2% YTD in 2008 compared with 5.6% and 16.2% in exports to the US and Europe, respectively. However, a further slowdown in the US and Europe and a sharp slowdown in ROW are beginning to emerge in the form of a sharp deceleration in AXJ exports. Disruptions in the trade credit market and counterparty concerns have added to the demand slowdown. We believe that the region’s exports will likely cross the lows of 2001 in this cycle. The follow-through impact on the region's business capex cycle is likely to be severe. Many countries in the region have built large production capacities to feed global export demand. A sharp slowdown in exports could cause a major dislocation in the balance sheets of regional companies, and corporate investment demand will likely be hit hard. While many countries in the region had the support of private sector construction and real estate investment in 2008, we believe this spending will decelerate sharply in 2009 as the supply of domestic and international risk capital continues to shrink. The external demand shock will hurt Singapore, Hong Kong, Malaysia, Taiwan and China the most considering their high levels of exports to GDP and large current account surpluses. Having said that, we believe that these countries will suffer less dislocation in their financial systems relative to countries with strong credit growth cycles and current account deficits. Key Economic Indicators
Source: CEIC, Morgan Stanley Research. E = Morgan Stanley Research estimates Offsetting Benefits from Falling Commodity Prices Strong global growth pushed commodity prices, particularly crude oil prices, to new highs by the middle of 2008. As a net importer of commodities, the AXJ region suffered from a negative terms-of-trade shock. The net commodities trade deficit shot up to 9.0% of GDP annualized during the three months ended June 2008 from 6.2% during the three months ended June 2007. However, with the sharp fall in commodity prices over the last four months, we expect the commodities trade deficit to narrow sharply. The fall in commodities prices has also helped the regional inflation rate to peak, removing the hesitation amongst the AXJ central banks to respond with loose monetary policy. Similarly, a reduced subsidy burden, particularly on food and energy, should create room to pursue loose fiscal policy. How Strong Can Monetary and Fiscal Response Be? While most central banks have already responded by cutting policy rates and/or injecting liquidity, we believe these moves will be blunted to some extent by the risk aversion contagion from global financial markets. These liquidity measures will be less effective, particularly in trouble zone countries like India, Korea and Indonesia. While countries with current account surpluses (Singapore, Hong Kong, China, Taiwan and Malaysia) should have tighter control over their domestic cost of capital, they are also likely to suffer partially from contagion reflected in reduced access to risk capital from global financial markets. However, we believe some of these current account surplus countries will likely get more bang for the buck from a strong fiscal policy response. China recently announced an aggressive economic stimulus package of Rmb 4 trillion (US$586 bn, about 16% of 2008 GDP) to boost domestic demand. About Rmb 400 billion will be spent in 4Q08 and the balance by end-2010. Even Taiwan, like China with relatively low public debt to GDP, has the ability to initiate a strong fiscal policy response. Our Taiwan economist, Sharon Lam, expects the Taiwanese government to spend 1.5-2% of GDP on infrastructure and tax cuts. Looking for a Slow Recovery in 2010 Our US and European economics teams expect a tepid recovery in 2010, with GDP growth in their economies accelerating to 2.0% and 1.2%, respectively. Similarly, our global team estimates 2010 growth of 3.3% compared with 0.9% in 2009. In turn, we expect AXJ GDP growth to recover to 6.8% in 2010. This recovery in the region assumes improvement in both the availability of risk capital and external demand, reflecting the global growth trend. Risks to Our Base Case View Our global economics team adds two scenarios to their base case forecasts: In the “ugly,” or bear, scenario, global activity contracts by 0.8% in 2009 and recovers by only 1.3% in 2010 as economic headwinds dominate policy stimulus. In contrast, the “good,” or bull scenario assumes 2.3% growth next year and 4.3% in 2010, as a comprehensive and massive range of policy actions overwhelm the downturn. Based on this framework, our bull case scenario for AXJ growth is 6.7% in 2009 and 7.6% in 2010; our bear case assumes growth of 3.2% in 2009 and 4.9% in 2010. China: Getting Worse Before Getting Better (Qing Wang) We think 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. Further growth deceleration is expected in 1H09, and deflation is a distinct possibility. The effect of massive policy stimulus implemented since October 2008, together with a tepid recovery in G3 economies, is expected to help the Chinese economy regain some growth momentum in 2H09. We construct two alternative scenarios – the bear (featuring 5% GDP growth) and bull (9% GDP growth) cases – to highlight both the downside and upside risks to the 2009 outlook under our base case (7.5% GDP growth). Real estate investment will be the biggest swing factor among the scenarios, in our view. Hong Kong: Hit By Foreign Trade, Credit and Asset Market Linkages (Denise Yam) The sharp correction in the asset markets and the tightening in credit conditions are taking their toll on Hong Kong’s economy. Weakening global demand and significant depreciation in regional currencies are set to hurt Hong Kong’s trade outlook. Barring monthly fluctuations, year-on-year trade growth has slowed to mid-single-digits in recent months, but we forecast this to plunge to a 5% contraction in 2009. The HKMA has taken aggressive steps in liquidity assistance and injections into the interbank market to ensure a lower cost of funds to financial institutions. The government is guaranteeing loans to SMEs to help ease the credit crunch. Unfortunately, dwindling fiscal revenues from land sales, stamp duties and direct taxes will likely result in a sizeable deficit in the current fiscal year, limiting policy options on the fiscal front to support the economy. We construct two alternative scenarios – the bear (featuring 4% GDP contraction) and bull (0.5% GDP growth) cases – to highlight both the downside and upside risks to the 2009 outlook under our base case (2.8% GDP growth). India: Capital Inflows – A Critical Macro Link (Chetan Ahya) Over the last three years, large capital inflows have been the anchor of the self-fulfilling virtuous cycle of higher capital flows – an appreciating exchange rate, lower interest rates and strong domestic demand growth. However, a reversal in capital inflows since 2Q08 has resulted in a sharp rise in the cost of capital and deceleration in domestic demand (consumption as well as investment). Our base case assumes a major decline in capital inflows in 2009 and a gradual recovery in 2010, in line with the global growth trend. The second growth driver, though less important than the first, is external demand. We expect export growth to be -5.3% in 2009 compared to 12.7% in 2008. We believe that the monetary policy measures will help but cannot fill the gap created by a reversal in capital inflows and weaker exports. On the fiscal policy front, considering that current public debt to GDP is already high at close to 77% of GDP, there is limited scope for an aggressive fiscal policy response. Indonesia: Anchored by Commodity Cycle (Chetan Ahya) Indonesia’s economy has been fuelled by credit, which is funded by capital flows and elevated commodity prices. Amid deleveraging, risk-aversion and declining commodity prices, Indonesia finds itself engulfed in the twin macro problems of a current account deficit and tightening liquidity. The resulting rise in the interbank rate will likely hurt the local banking sector and force a sharp slowdown in domestic demand. Moreover, the vulnerability of the currency from declining commodity prices and its impact on trade balance as well as a relatively open capital account could lead to further tightening in liquidity conditions as the central bank intervenes to buy rupiah and sell US$. We expect growth at 2.5% in 2009 and 4.5% in 2010. Risk appetite, the availability of risk capital and the extent of currency and commodity price swings pose risks in either direction. We note that policy responses to cushion the cycle are hindered as the monetary policy tool becomes less effective in the deleveraging cycle and fiscal responses are similarly curtailed by higher funding costs. Korea – More Downside from Domestic Demand than External (Sharon Lam) While everyone is focusing more on export and construction, we see the biggest downside from consumption due to household deleveraging, wealth destruction and currency depreciation. We believe that Korea’s export growth will perform relatively better than other exporters because of much stronger competitiveness after sharp KRW depreciation. Since exporters’ earnings in KRW terms are not deteriorating as much as the deadline and while deflation is deterred by its currency, we believe that bankruptcy rates will not be as high as the market fears. Meanwhile, we expect another 100bp cut in interest rates to bring the policy rate to a historical low at 3% before mid-2009, and fiscal policies to continue to focus on construction and SME sectors. The biggest downside risks remain with domestic liquidity problems if foreigners continue to sell Korean bonds, thereby squeezing already tight wholesale funding sources. At the same time, the dollar shortage problem will re-emerge if a majority of ship orders are cancelled and therefore shipbuilders cannot meet their external debt payments with trade credits. The upside risk depends on the effectiveness of China’s stimulus measures as Korea’s growth is heavily related to China’s fixed asset investment. Malaysia – Three-Legged Growth Model Giving Way (Deyi Tan/Chetan Ahya) Manufacturing has already taken a hit from trade deceleration. The public sector economy now also seems likely to slow. Fiscal pump-priming has softened amid a less-expansionary budget, higher resource costs and political uncertainty. Despite the government rebalancing spending towards grass-root levels, consumer resilience will be tested in the face of weakening sentiment. Elevated commodity prices had provided a strong income effect that filtered down to the rural community, given the segmented market structure in agricultural commodity production. However, the reversal in commodity prices amid global demand destruction now undermines this support. We expect GDP growth to slow to 0.5% in 2009 and 4.2% in 2010, with the fiscal deficit standing at -4.8% of GDP and policy rates reaching 1% by end-2009. Trade and asset market linkages pose the key risks in our bull-bear framework. Singapore: A High-Beta Economy (Deyi Tan/Chetan Ahya) For an economy strongly leveraged on exports, the important issue is whether continued policy efforts have enabled Singapore exporters to outperform on a relative scale. However, Singapore exporters have underperformed compared to regional counterparts, particularly in electronics, as they are lagging in technology and there is an absence of strong home-grown brands. Domestic demand is unlikely to fill the void as the export-oriented strategy means that even domestic demand has become less domestic in nature. In our base case, we expect -2.5%Y growth in 2009 and a tepid recovery to 3.2% in 2010. In terms of policy responses, we believe that fiscal stimulus of 2-3% of GDP would be required to cushion the slowdown. Monetary policy will continue to be guided within a zero appreciation stance, with downward adjustments of the bandwidth mid-point during policy reviews. Similar to Malaysia, trade and asset market linkages are key risks in our bull and bear scenarios. Taiwan: Too Focused on Tech Exports (Sharon Lam) Taiwan cannot escape the global recession as its economy is too focused on tech exports. We expect negative year-on-year GDP growth to extend to 1Q09. However, we do not expect overall negative GDP growth for 2009 since the proactive government supportive measures will start to kick in at the beginning of 2009, which we estimate could boost GDP growth by 2pp next year. We expect CBC to stay ahead of other central banks in the region and cut its interest rate by another 100bp before mid-2009, while fiscal policies will focus on tax reforms. The biggest downside risk could come from any delay in policy execution next year, and further loss of competitiveness to Koreans due to currency. Upside risk depends on global tech demand; however, even if it recovers, it will be very mild, in our view. Thailand: Idiosyncratic Domestic Risks (Chetan Ahya) Within ASEAN, Thailand’s sensitivity to changes in global macro conditions is relatively lower. Its trade and asset market linkages are among the lowest. Moreover, tightening credit conditions have less impact since Thailand’s credit cycle had been subdued due to weak domestic sentiment, given political conditions. The absence of excesses both in terms of capex and consumption means that a boom-bust scenario is also less likely, in our view. However, domestic political developments are a risk in our bull-bear framework. We expect growth at 1.5%Y in 2009 and 3.5%Y in 2010 in our base case. In terms of policy responses, fiscal pump-priming is likely to be hindered by execution capability in light of political conditions. The monetary policy tool could be more effective in this regard.
Japan
How Japan Got Financial Reform Right – Eventually December 19, 2008 By Robert Feldman | Tokyo A Brief History: Japan’s Three False Starts Japan made three false starts on financial reform, before finally succeeding in 2002-04. The eventual success depended on actions that cumulated through the three false starts. The first false start came from late 1992 through early 1994. As growth collapsed in 1992-93, the nation focused on traditional monetary and fiscal policies. The Bank of Japan cut rates, and the government implemented major fiscal stimulus. However, hopes for revival were dashed by structural weaknesses in the financial system and the corporate sector, and by a sharp bout of yen strength in 1993-94. Very little was done on structural reform. Substantial worries about the financial system emerged. As the stock market tumbled, investors questioned bank capitalization. A first attempt at resolution was made, with the Cooperative Credit Purchase Corporation (CCPC), but it was not actively used. The second false start came from mid-1995 through mid-1996. A blockbuster fiscal package, more aggressive rate cuts by the BoJ, and a deregulation drive temporarily stoked public works and business investment. But when Prime Minister Hashimoto took over in January 1996, the market saw fiscal austerity coming. The combination of spending cuts, tax hikes, and the Asian crisis in mid-1997 ended Japan’s second try at reform. Indeed, financial system worries deepened. The problems of housing loan companies (jusen) were highlighted. A Housing Loan Administration Corporation was formed under the Deposit Insurance Corporation in 1996, to dispose of bad assets of the jusen. In addition, the DIC expanded its deposit insurance program. In structural reform, this second period saw some progress. The amendment of the Anti-Monopoly Law paved the way for a subsequent corporate M&A boom. Also, the government created the Council on Economic and Fiscal Policy to be the highest body for making and integrating economic policy across ministries. The third false start came in 1997-99. The banking panic of 1997 triggered another massive fiscal package (about 3% of GDP), focused on guarantees for small business borrowing. After the failures of several large financial institutions in November, there was a major rethink of financial crisis management methods, including money market liquidity support. The BoJ launched a major expansion of base money and its balance sheet. Unfortunately, the linkage between monetary policy and nominal GDP had collapsed. The extra money printing had little effect. Moreover, while pushing hard on quantity, the BoJ moved to a “near-zero rate” policy only in March 1999. The very depth of the financial crisis prompted a deeper look at structural woes. PM Obuchi commissioned the Economic Strategy Council (ESC) to write a new blueprint for growth strategy. Subsequently, the Mori government pushed the “e-Japan” program, to increase broadband connectivity. Financial sector measures focused on capital injections to the banks. The conditionality on the public funds injections to banks was severe. Recipients have to pay significant dividends to the government, and there were cuts of total compensation (by 20-30% from peak levels). However, there was little new reform on accurate assessment of bad loans. The Real Thing: Financial reform in 2002-04 As the economy weakened in 2001, BoJ cut rates first on March 1, and then moved to the zero interest rate policy (ZIRP) on March 22. Simultaneously, BoJ announced the shift to quantitative easing, and committed to maintain extremely easy monetary conditions until core consumer price changes sustainably returned to positive territory. PM Koizumi took over in April 2001. During the first period of the Koizumi government, April 2001 to September 2002, the metabolism of economic reform policies accelerated, but financial reform continued at the same pace as the Obuchi/Mori years. Conditions changed suddenly at end-September 2002. Koizumi sent a strong signal by naming Heizo Takenaka as financial affairs minister. Within a month, the “Takenaka Plan” for cleanup of financial institutions was formulated, and aggressive actions began. In particular, the Financial Services Agency, now under Takenaka, tightened its methods of checking the classification of bad loans by banks, and insisted on a uniform approach. Another turning point came in May 2003, when the government took harsh action on a large troubled bank. Takenaka and Koizumi ejected 140 senior managers as a condition for financial assistance. Confidence returned to the financial system almost immediately. Finally, the government created a new private-sector-staffed workout entity, the Industrial Revitalization Corporation of Japan (IRCJ). It began operations in May 2003. There was tacit encouragement from the FSA for financial institutions to take troubled borrowers to the IRCJ, which then used special powers to enforce cooperation among creditors, based on realistic revival plans. The IRCJ was a huge success. It completed its task and closed shop well before the 5-year deadline, and even returned a small profit to the taxpayer. From History to Roadmap Japan’s bitter history of financial sector reform suggests a model of financial reform, with five key factors (See Exhibit 2). These factors are: (1) an economic growth strategy, formed with macro, micro, and global economic trends in mind. (2) A safety net to aid those hurt by economic reforms, but also avoid moral hazard. (3) Capital injections to restore confidence in financial institutions, but with adequate conditionality on stockholders, employees, and management. (4) Public support to put moral pressure on everyone involved. (5) Strict asset assessment, to gain confidence of depositors and investors. Moreover, not only must all factors be present, they must be present at the same time. For investors to judge the progress and likely success of other countries in financial reform, careful attention to these five factors is necessary. As Will Rogers said, “History does not repeat itself, but it rhymes.”
Global
The Fed Lady Sings December 19, 2008 By Joachim Fels | London ZIRP official now. The FOMC’s decision to lower the official fed funds target from 1% all the way to 0-0.25% merely confirms what the Fed has already been practicing, as the effective funds rate has been trading near zero for a while. However, according to Dave Greenlaw, the FOMC action and statement still send a strong message by committing to keep the policy rate low “for some time” and by stating that the Fed “will employ all available tools”, including the possibility of buying Treasuries. Clearly, the Fed’s goal is to push interest rates lower across the entire yield and credit risk curve in order to prevent a depression. What about the others? With zero interest rate policy (ZIRP) and quantitative easing (QE) in the US now firmly established, global investors’ focus is likely to shift to the potential for additional monetary policy actions in other countries and to governments’ fiscal stimulus plans that either have already been announced or are still in the pipeline. It’s worth highlighting a few developments on these fronts. The Fed isn’t the only one ZIRPing. Two other central banks – the Swiss National Bank (SNB) and the Bank of Japan (BoJ) – are at or close to ZIRP already: • Last week, the SNB reduced its official target range to 0-1% and stated that it was aiming at the middle of that range. It is important to note that the SNB targets three-month Libor, while other central banks typically target the overnight rate. In order to bring three-month Libor down, the SNB has held its overnight repo rate down at virtually zero (0.02% as of yesterday) since late November and has thus virtually adopted ZIRP already. A further reduction in the three-month Libor target to 0-0.5% in 1Q09 appears likely to us. • In Japan, where ZIRP was first devised at the start of this decade, the BoJ currently maintains a target of 0.3% for the overnight rate and our Japan team expects a reduction of the target to zero, probably in two steps, during the first quarter. Combining QE with currency intervention. While the Fed is likely to focus its QE efforts on buying MBS and Agency debt, and possibly Treasuries, both the SNB and the BoJ may choose to implement QE partly through unsterilised currency intervention, i.e., buying foreign currency without offsetting the impact on their balance sheet through open-market sales of other assets. The reasoning behind this is that for small open economies like Switzerland, the exchange rate is a more important driver of the economy than mortgage rates or other interest rates, and in the case of Japan, currency intervention might help to stem the recent sharp appreciation of the yen. ECB not ZIRPy, but LIRPy. Meanwhile, the ECB appears to be far more reluctant to go anywhere near ZIRP. This holds especially for the euro area, where ECB President Trichet in an interview this week indicated that there is a limit to lowering the interest rate further from the current 2.5% level and Bundesbank President Weber more explicitly mentioned that he would be uncomfortable with lowering the refi rate below 2% for more than a short while. However, notwithstanding these reservations, we think that the downdraft in economic indicators and a possible further rally in the euro against many currencies including the dollar will eventually force the ECB’s hand, taking the refi rate down another 100bp to 1.5% during 1Q09 and thus to a new low, and we expect the low interest rate policy (LIRP) to be maintained for most of 2009. Increasing focus on fiscal stimulus. Finally, with monetary policy having exploited most (though not all) options, attention is likely to shift to further fiscal policy action in the coming weeks and months. While many governments have already announced stimulus programmes, the big unknown is the size and composition of the incoming Obama administration’s fiscal package. Bottom line: The Fed is super-aggressive, now having officially adopted ZIRP and QE. Japan and Switzerland are ZIRPing too and may resort to unsterilised currency intervention as a variant of QE. The ECB is unlikely to go to ZIRP, but weak economic data and a rallying euro should bring significantly lower rates and thus LIRP. And fiscal policy is becoming more proactive too in most countries, with major news pending on the Obama fiscal stimulus package. With all this actual and prospective policy action, we continue to believe that deflation and depression will be avoided. And we wouldn’t be surprised if, when we all come back early next year, the debate shifts to the timing and likely size of an economic rebound in 2009 and a surge of inflation in the years after. More on this in the next issue of this publication, which we will resume on January 7.
China
Outlook for 2009: Getting Worse Before Getting Better December 19, 2008 By Qing Wang; Denise Yam, Steven Zhang and Katherine Tai | Hong Kong More Economic Pain Likely in the Near Term The triple whammy of 1) a cooling down in real estate investment, 2) a massive de-stocking of raw material inputs after the collapse of international commodity prices, and 3) a slowdown in external demand should continue to weigh on China’s economy through the first half of 2009. We would characterize the country’s economic outlook for the new year as ‘getting worse before getting better,’ laying the foundation for a firmer recovery in 2010. We expect growth to slow further in 1H09, and we see deflation as a distinct possibility. The effect of the massive policy stimulus implemented since October 2008, together with a tepid recovery in G3 economies, should help the Chinese economy regain some growth momentum in 2H09. We forecast GDP growth to slow to 7.5% in 2009 from 9.4% in 2008: An outright decline in private real estate investment and much weaker exports should be partly offset by a sharp increase in government-driven investment, especially in the infrastructure sector. Risks: We construct two alternative scenarios, a bear case featuring 5% GDP growth and a bull case assuming 9% growth, to highlight the downside and upside risks to the 2009 outlook under our base case (7.5% GDP growth). Real estate investment will be the biggest swing factor among the scenarios, in our view. The package of tighter macroeconomic policies that China implemented from late 2007 through 4Q08 has hit the property sector particularly hard. As a consequence, real estate investment has slowed substantially, reducing demand for key construction materials, such as steel, cement, and aluminum, and housing-related consumer durable goods. While much attention has been paid to the synchronized recessions in G3 economies and their knock-on impact on China’s external demand, we think the biggest swing factor in gauging the growth outlook in 2009 is real estate investment in China. Given the gloomy outlook for G3 economies, China’s external demand in 2009 will almost surely be very weak. The rapid economic deceleration in 2008 has been primarily attributable to the slowdown in real estate investment rather than to 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. Investment implications. Although economic expansion driven by the public sector should help achieve headline GDP growth and job creation targets and thus limit the extreme downside risk of an outright hard landing, we do not expect it to deliver nearly as strong corporate earnings growth as when the same level of headline GDP growth is fueled by buoyant private-sector spending. The public-sector-driven growth will likely occur in a relatively ‘job-rich’ but ‘profit-deficient’ macroeconomic environment where bonds tend to be favored over equities. Within the equity space, sectors and companies with high earnings visibility and/or those exposed to government-supported capital spending will likely outperform. 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 shock in terms of trade. From the demand side, decelerating exports — which are expected to continue slowing amid a synchronized recession in G3 economies — have 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 positive supply shock, it is ‘good’ deflation; if it is due to negative demand shock, it is ‘bad’ deflation. Our best judgment is that the potential deflation in 1H09 will likely belong to the former category. 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, preemptive monetary policy response. We have lowered our CPI forecast for 2009 from 1.5% to -0.8%. We forecast headline CPI deflation at -0.9% YoY in 1H09 and -0.7% YoY in 2H09. The easing in deflationary pressures that we are projecting in 2H09 reflects our assumption that the policy stimulus will be able to arrest the decline in price levels. The Policy Outlook The Chinese authorities have made delivering economic growth a top priority by adopting a campaign-style approach to policy execution. On the fiscal policy front, the Rmb 4 trillion stimulus package, of which Rmb 1.18tn will be funded out of the central government budget, is unlikely to be the only stimulus package for the entire year, in our view. On the monetary policy front, given the high risk of deflation, we expect that benchmark interest rates will be cut aggressively – by a further 162 basis points – over the course of 2009. The rate cuts will most probably be front-loaded in 1H09 because of the need to prevent deflationary expectations from becoming entrenched. While the authorities may engineer a modest depreciation of the renminbi against the US dollar in the near term, we believe the renminbi’s trend appreciation over the longer term remains intact in view of China’s strong balance of payments position. We see a broadly stable renminbi exchange rate against the dollar as the main reason for the outperformance of the Chinese stock market since August compared with its emerging market peers. We expect this to remain an important factor underpinning the relative performance of Chinese stocks.
UK
Near-Term Outlook: Revising 4Q Lower; More to Come from the MPC December 19, 2008 By Melanie Baker, CFA & David Miles | London Summary and Conclusions Very weak incoming data suggest that 4Q GDP growth is likely to be weaker than we had expected. We lower our 4Q real GDP growth forecast (to -1.2%Q from -0.7%Q), which has a knock-on effect on our annual forecast for 2009 (-1.0% from -0.6%). We now think that the Bank of England will probably cut rates again in 1Q. Incoming Data Consistent with Very Weak 4Q We have lowered our 4Q GDP forecast to -1.2%Q from -0.7%Q (leaving our 2009 GDP forecast at -1.0% after -0.6%). Surveys such as the CBI industrial trends survey (manufacturing), distributive trades survey (retail) and PMIs as well as Bank of England Agents scores for consumer services turnover, investment intentions and manufacturing output have all weakened further so far in 4Q, and have weakened very sharply in some cases. In addition, actual industrial production fell 1.6% in October. If production were to hold steady in November and December (we think further falls are more likely), this would leave that component of GDP alone down 2.1%Q in 4Q (enough to lower our 4Q GDP forecast to -0.9% from -0.7%). On consumer spending, survey indicators (though not official retail sales) are consistent with a sharp contraction, as are car sales (private car registrations were down a whopping 45%Y in November). MPC Leaves the Door Open for Further Rate Cuts Following the release of the MPC minutes for the December meeting, on balance we think that a further rate cut in January or February looks likely (probably January). The MPC appears to have finished its ‘unfinished business’ from the November rate cut (where it felt that more than 200bp in rate cuts might be needed, but cut only 150bp). At least part of the 100bp rate cut in December was in response to incoming news since the November rate cut. Further, according to the minutes, the Committee agreed that “a cut of at least 100 basis points was needed” [our italics]. On the face of it, this would suggest that further rate cuts in January were the most likely outcome, and this is now our central case (50bp cut). However, we think that this will be a relatively close-run thing (much more so than many seem to expect). The MPC discussed a number of reasons against a larger rate cut: 1) Going further could cause an excessive fall in the exchange rate; 2) An unexpectedly large cut could also undermine confidence in the economy; 3) Given the uncertainty inherent in the transmission mechanism, it was difficult to be certain that rates needed to be cut by more or faster than that; and 4) Substantial measures on financial system support and fiscal policy had been taken. These would take time to have an impact but would support demand in 2009. Further, the MPC noted the importance to the outlook of bank lending, but agreed that the policy rate was not the right policy instrument to tackle supply constraints in the credit market. Arguments 1) and 2) are related to how unexpected a larger rate cut would have been at the beginning of December. Given that markets have moved to price in further cuts, those arguments would presumably not be enough to dissuade the MPC from cutting rates again in January. However, the remainder of the arguments will still hold in the New Year. On balance, we think that January is a very close call. The MPC has voted to cut rates 300bp since the start of October alone, and much of this seems to have been passed onto a large proportion of mortgage holders. However, given that the market appears to have priced in more rate cuts, when the MPC comes to its decision in January, it may be reluctant to disappoint the market and risk upward movements in market rates, given the economic outlook. Further, the MPC has shown a determination to avoid the worst outcomes for the UK economy and, if the incoming information point to a further sharp deterioration in the outlook in 1Q, it seems very likely to take further policy action (whether through cutting interest rates or other measures). The next key data releases on that front are probably lending and credit conditions data right at the start of next year. We think that the very weak data on production and sharp deterioration in labour market data should be enough to persuade the MPC to cut rates again. We certainly do not think it is a ‘done deal’ that the Bank of England follows the Fed and cuts rates to near zero. For one, the structure of the mortgage market is very different such that the Bank of England does not need to lower medium-to-long term interest rates in order to boost the consumer. The 300bp cuts already done should have a decent impact on household incomes (we estimate about 1% of GDP) since a significant proportion of those cuts seems to have been passed on to those on variable rate mortgages. The Bank of England has already taken additional ‘unconventional steps’ to support lending and the economy (e.g., the SLS). We do not necessarily need to get to zero interest rates to see more such steps. RPI and Policy Rate Changes RPI inflation is very sensitive to the path of policy rates that we assume. We show four profiles below for RPI inflation to illustrate this. We change nothing other than the interest rate assumption and only let this mechanically feed through into the mortgage interest rate component (i.e., we assume that it is fully reflected in standard variable mortgage rates but does not affect the inflation profile through other components): 1) The Bank of England cuts rates another 50bp, then starts taking back rate cuts in late 2009 and raising rates in 2010 back to 4.00%. 2) The Bank of England keeps rates on hold for a while then starts taking back rate cuts in late 2009 and raising rates in 2010 (as we had it before). 3) The Bank of England cuts rates to 0.5% and keeps them there. 4) The Bank of England cuts rates to 0.5% and then rapidly increases rates from the beginning of 2010 back to 4.00%.
A Pessimistic and an Optimistic Case for the UK Economy The following is an extract from the UK Investment Perspectives publication (December 11, 2008) adjusted to include changes to the base scenario. For the past year or so, economic growth in the UK has been weakening – quarterly output growth turned negative in 3Q for the first time in more than 15 years. Credit conditions have tightened markedly and global growth has slowed sharply. Our central forecast for calendar year 2009 GDP growth is for an outright contraction (the first since 1991) of 1.0%, and we continue to see the balance of risks to that central forecast as skewed to the downside. The prolonged tightening in credit conditions seems unlikely to suddenly dissipate in 2009. Employment levels are likely to contract. The risk of ‘negative feedback loops’ developing in the UK economy remains present – asset price falls (including housing), the slowing economy and rising unemployment make banks less willing to lend, and households and corporates less willing to spend, all worsening the outlook for the real economy. However, we remain cautiously optimistic that we can avoid a deep and prolonged recession in the UK. This is largely due to three factors: 1) Massive monetary (and substantial near-term fiscal) policy stimulus, which is likely to prevent household demand falling precipitously and which encourages a lengthy period of balance sheet and savings adjustment rather than a short, sharp one. 2) A determination by the UK authorities to get credit markets functioning and revive the flow of lending. 3) The recent large depreciation in sterling, which is likely to boost net exports and offset some of the effect of slower growth in the UK export markets. The Pessimistic Case: Sharply Higher Household Savings However, the household saving rate could, instead, follow a profile similar to that of the early 1990s. Then, the household saving rate increased from around 4% at the end of the 1980s to about 12% by 1992. If a rise in the saving rate on that scale were to happen now, consumer spending would fall very sharply for a couple of years. We have constructed a scenario along these lines where, alongside a very sharp decline in consumption, we mix in three years of contraction in fixed investment (both residential and business investment contract in 2008, 2009 and 2010). On such a scenario, the unemployment rate reaches a 15-year high, with unemployment rising 1.2 million peak to trough (compared to around 1 million in the early 1990s). In this scenario, UK GDP contracts by almost 3% in 2009. The key to whether this scenario materialises is consumer spending and saving behaviour. If the household savings rate, which is exceptionally low, follows a trajectory similar to that in the recession of the early 1990s, it will be rising sharply and at a time when global growth is well below trend, so that reductions in domestic consumption are not offset by much stronger growth in exports. In that scenario, a very sharp and protracted fall in output will be inevitable. There are many good reasons for households to want to build up their savings over the next couple of years. These include: offsetting the hit to wealth created over the past year by falling house and equity prices; greater uncertainty about job prospects; and a reduced ability to smooth consumption by borrowing. While our central case is that households will prefer to raise their savings rate gradually, there are some reasons to expect this to happen rapidly, despite the weak economic backdrop: 1. The baby boom generation is nearing retirement and many households’ pension plans will have been hit by the decline in property and equities. If unwilling to significantly defer their retirement plans, households may ramp up sharply their rate of voluntary contributions to pension schemes. 2. A large number of households are likely to be in negative equity (or very close to it) by the middle of 2009. Many of those households may wish to increase their savings and need to do so rapidly to lower their mortgage relative to the value of their property, making it easier to obtain a new mortgage or to retain a mortgage on relatively favourable terms. Some households will have been holding off selling a property despite a desire to move home, given conditions in the housing and mortgage market. A rise in the number of forced sellers might see such capital injections increase. 3. Households may expect deposit rates to fall sharply, given cuts in the policy interest rate, so that it makes sense to ‘lock-in’ higher fixed savings deposit rates now. The Optimistic Case: Positive Supply-Side Effects In this scenario, households significantly increase their supply of labour, boosting potential output. The ‘lost’ output from the period of sub-trend growth is not permanent. That is because the supply side of the economy might not have been damaged significantly by the credit crunch (an optimistic view, since it assumes that the severe damage to the financial system we are seeing does no lasting damage to productive capacity). This could imply that the recovery is significantly more vigorous than many expect (and is ultimately sustainable). So, if growth in 2008 and 2009 is substantially sub-trend (as we expect) – creating 3-4% of spare capacity if trend growth is unchanged – then a bounce-back to trend over the following two years means cumulatively growth would need to be 3-4% above trend in those years. The point here is that a couple of years of growth approaching 5% in 2010 and 2011 – which now looks wildly optimistic – is actually what is implied by a return to an unchanging underlying trend four years or so down the road. Of course, this assumes that the trend level of output has not been damaged by the credit crunch. Whether that is so depends on how supply potential evolves. Supply-side responses to some of the huge shocks we have seen may be both pro-growth and supportive of corporate profits. Those huge shocks include: 1) A big fall in equity values; 2) A big fall in house values; 3) A perception by many households that their debt is too big relative to their income; and 4) A potential overhang of some types of residential properties, meaning that construction investment will be very low for some years. Factors 1) and 2) lower household wealth. With household wealth a lot lower, we should expect two things: higher household saving and higher labour supply. (Factor 3 generates a similar response.) Higher saving is a negative for growth in the near term (because we can’t expect other components of spending to adjust up to offset it). But the impact of more labour supply – as people need to work more to replace nasty shocks to wealth – is ultimately a clear positive for economic activity and for corporate profits. It means the capital-labour ratio is lower (boosting the return to capital, reducing real wages and encouraging more investment). Factor 4) implies that residential construction will be much reduced, maybe for many years. The resources used there will be available elsewhere, and land prices are likely to be lower than they otherwise would have been. Those are not negative factors for the (ex-construction) corporate sector.
United States
High Noon for State and Local Budgets December 19, 2008 By Richard Berner | New York State and local budget shortfalls are once again forcing significant spending cuts, in turn prompting fears that such fiscal restraint will push the economy deeper into recession. Those fears always surface in time of economic stress. In 2001, a tide of state and local red ink raised concerns about such “pro-cyclical” fiscal actions, but then they seemed overblown (see “Day of Reckoning for State Budgets?” Global Economic Forum, November 21, 2001). Unfortunately, the problems this time are more serious for three reasons. First, the recession is likely to be the most severe in thirty years. Second, the credit crunch has grown more intense. And finally, the recession has unmasked longer-term imbalances in state and local budgets, such as rapid growth in healthcare and pension obligations that are incompletely funded or simply pay-as-you-go. The interplay among those three factors threatens to produce real fiscal drag. The recession is hammering state and local government budgets as never before: Revenues are tumbling and are likely to get worse. According to the Rockefeller Institute of Government, of the 42 states for which data are available, total tax revenue in the third quarter was flat compared with a year ago (see http://www.rockinst.org). There’s deeper trouble ahead, because about two-thirds of state tax revenues come from sales and income levies − including on capital gains − and both are falling. It’s worse for counties and municipalities. Falling home prices and homeownership make it politically difficult to increase assessed values or millage over time, and thus threaten to erode the two-thirds of tax revenue from property levies. Fewer home sales and lower values, in fact, will promote that erosion more quickly, and reduce real estate transfer and mortgage recording taxes and fees. By mid 2009, we expect that state and local tax receipts will decline by at least 4% from a year earlier. Outlays are still rising briskly, but some are beyond local officials’ control. About 22% of total current outlays are benefits, primarily Medicaid, which provides health and long-term care assistance to nearly 60 million low-income, elderly and disabled people. Nationwide, states pay for 43% of Medicaid outlays and must cut eligibility and raise copayments to realize savings. But recessions stymie those cost savings, as the jobless lose employer-sponsored health coverage or fall into poverty. Education and public safety account for another 58% of current outlays, and cutting those services is also difficult. With state and local budgets now hemorrhaging red ink, we expect that even current operations budget gaps (excluding construction outlays) will rise at least to 1% of GDP. And because virtually all states have some kind of constitutional balanced budget rule, these upcoming deficits are forcing many state officials to engage in “pro-cyclical” fiscal belt-tightening, cutting spending in the face of recession. Those mooted cuts will become reality in 2009-10 budgets. As if that weren’t bad enough, the credit crunch is also hurting state and local outlays because officials can’t fund operations in anticipation of tax receipts, let alone infrastructure projects. The credit seizure has dislocated the municipal bond market for roughly a year. Cautious investors who are in deleveraging mode have demanded bigger concessions to buy muni debt as their confidence in the ability of monoline insurers to backstop the market eroded and liquidity evaporated. More recently, investors have bet that deteriorating credit quality would increase the chance of default (for a discussion of CDS pricing see Credit Derivatives Insights: Munis vs. Corporates in Recession: CDS Considerations, October 24, 2008). With credit both scarce and dear, issuers are postponing projects and cutting current outlays as they expect further bleeding in receipts. More ominously, the problems in state and local budgets are more than cyclical; the recession is merely unmasking gaping holes that good times papered over. Unfunded or partly-funded mandates like Medicaid and educational directives have grown more quickly than the revenue base even in good times. State and local pension and healthcare obligations are rising rapidly, but many of those promises were inadequately funded. In good times, state pension funds appeared to be 95% funded at the end of 2007. Using data from Wilshire Associates, the funding gap for 116 funds might have been only $96 billion. However, the Wilshire report follows state practice of using a rate to discount liabilities close to the assumed rate of return. In addition, the market downturn this year has crushed asset values, opening up a funding gap that could reach $700 billion even with that discount rate assumption, and more without it. A GAO report highlights the fact that long-term state and local healthcare promises may blow their deficits up to 5% of GDP by 2050 (see United Stated Government Accountability Office, “State and Local Fiscal Challenges: Rising Health Care Costs Drive Long-term and Immediate Pressures,” November 19, 2008). Finally, infrastructure is deteriorating and the needs for repair are accelerating. The good news, at least for now, is that relief is on the way, as the incoming Obama Administration will offer two significant elements needed to assist states and localities. First and most immediately, the Federal government will likely shoulder some of the Medicaid burden. Temporarily increasing the FMAP (Federal Medical Assistance Percentage) would offer relatively quick relief to strapped state governments. Second, the President-elect has begun to outline a massive infrastructure program that will offer medium-term stimulus as well as financing relief to state and local governments for projects on their books. No one should expect that such stimulus will kick in quickly, because the spendout rates from infrastructure authorizations are typically slow. That is unavoidable and necessary: Although state governors have identified $136 billion in ‘shovel-ready’ projects, prioritizing projects and ensuring they are done right will pay dividends. A third ingredient that would restore a semblance of normality to the muni market might also be helpful. With liquidity low and investors eager to buy protection on many issuers, issuance has been exorbitantly expensive or otherwise problematic. Specifically, as the Fed and Treasury have done for commercial paper and asset-backed securities, a TALF-like facility and a backstop for muni debt would help these governments regain access to funding. At present, however, neither the Fed nor the Treasury seems eager to step in. The crisis undermining state and local government finances does have a longer-term benefit: It may create the stress and thus the opportunity to reform long-term budgets and finally put them on a sustainable path. However, difficult as they are, the economics pale by comparison with the politics. Major changes to retirement and healthcare plans are needed soon. Real leadership at all levels of government and a sense of shared sacrifice will be required. Ultimately, those corrective actions could be catalysts for unleashing opportunity in the muni market.
Global
Risks to the Global Outlook: The Good, the Bad and the Ugly December 19, 2008 By Richard Berner (New York) and Joachim Fels (London)| Cutting Forecasts; Downside Risks Remain We are sharply cutting our outlook for global growth and inflation in 2009 for the sixth time in seven months, this time to 0.9% and 2.6%, respectively, from 1.7% and 3.9% in November. And the 2010 recovery is likely to be moderate, despite unprecedented global policy stimulus. Our baseline view takes growth back up to 3.3% in 2010, with inflation at 3.7%. If that outlook is realized, global growth in 2009-10 would be the second weakest in the post-war period, barely stronger than in the deep 1982-83 downturn. Global Forecast at a Glance
E = Morgan Stanley Research estimates Source: Morgan Stanley Research More importantly, downside risks persist as a global credit crunch and falling asset prices ripple through the economy. Indeed, incoming data around the globe indicate plunging economic activity and prices in October and November, pointing to a severe global recession and a real deflation scare. Courtesy of globalization, this recession has spread quickly, undermining any cushion of support from abroad for the US economy or vice-versa and intensifying the adverse feedback loops. Given the strength of economic headwinds, even ultra-aggressive policies seem unlikely to promote a vigorous rebound soon. If the risks still point to the downside, why not simply cut our estimates to the point where those threats are balanced? There must be a better way to assess the balance of risks than by extrapolating the evolution of our forecasts from month to month. A Framework for Assessing Risks to the Outlook We think there is a better way: Assess and quantify the risks to the outlook systematically in advance. In this note, we provide a framework to meet that goal, thus providing investors and our colleagues with a sense of forward-looking plausible risk scenarios around a baseline (see The Method to Our Madness below for details on the methods, on specific risks, and on regional differences). Globally, we believe that there are five key drivers of risk: First, the extent of deleveraging by leveraged lenders remains uncertain, and further write-downs and provisioning will intensify the credit crunch in several developed economies. The extent of further declines in asset values, especially in real estate, will deepen those risks, especially for US consumers (see “Perfect Consumer Storm to Last at Least Until Mid-2009”, Investment Perspectives, November 20, 2008). Second, many central banks have eased monetary policy aggressively and quantitatively, but it is unclear whether and when such policies will get traction. To be sure, there are recent signs of a revival in liquidity and money growth (see “More Action, Some Traction”, The Global Monetary Analyst, December 3, 2008). However, monetary policy in many EM economies remains restrictive. Third, officials, notably the incoming Obama Administration, are considering a massive step up in fiscal stimulus, with an undetermined amount in infrastructure outlays and tax cuts. The timing, size, and economic effectiveness of such policy actions are likely to remain unclear for a while. Next, swings in currencies, commodity prices and risk premiums matter for the outlook in many EM economies (see Latin America: Shocking the Consensus, September 22, 2008). Finally, the extent of the real estate downturn in China is a critical risk factor for that pivotal economy (see Outlook for 2009: Getting Worse Before Getting Better, December 9, 2008). The upside and downside results from those scenarios provide a very different perspective compared with the baseline. In our ‘ugly’ scenario, global activity contracts by 0.8% in 2009 and recovers by only 1.3% in 2010 as economic headwinds dominate policy stimulus. Given that we think of global recession as growth below 2.5%, the ugly scenario would border on something even worse than the most severe recession in the postwar period. In contrast, the ‘good’ scenario involves 2.3% growth next year and 4.4% in 2010, as a massive range of policy actions overwhelm the downturn. Unfortunately, the good-ugly comparison reveals that the downside risks outweigh the upside odds. The margin is not large in 2009, where growth in the bear case falls short by 1.7 percentage points of the baseline, compared with a 1.4 percentage point gap between the good outcome and the baseline. But the downside margin of risk widens in 2010 to 2 to 1 (the ugly outcome is 2 percentage points below the baseline, while the good outcome is only 1 percentage point above the baseline). Policy Paradox: Near-Term Downside Risks Promote Recovery in All Scenarios Two factors skew the distribution of risks to the downside. First, while ‘tail’ risks (low-probability, high-impact events) lie outside the range of plausible outcomes, they shape the continuum of risks within that range. In our view, depression and deflation – defined as periods of two years (or more) of declining output and prices – are today bigger tail risks than the return of a global boom and inflation. Second, the credit crunch is powerful, and policies have been reactive rather than preemptive. As a result, deleveraging, risk aversion, and the near-term cyclical dynamics of recession are likely to offset policy stimulus for now. Depression and deflation are important tail risks because, if left unchecked, the credit crunch could trigger severe consumer and business retrenchment. But they are highly unlikely for two reasons. For one, we see some economic excesses outside of real estate as more limited than in past periods, as a result of more limited global connectivity and supply-chain management. Most important, we believe that misguided policies deepened the Great Depression and Japan’s crisis, and we have learned three lessons from those events. First, aggressively use macro policies to buy time for other steps to take effect. Second, implement policies to stabilize the financial system and attack the root of the credit crunch. Finally, adopt measures to reduce the imbalances that triggered the downturn (see “Neither the Great Depression Nor Japan”, The Global Monetary Analyst, November 19, 2008). Indeed, we believe under all our scenarios that aggressive policy will eventually gain the upper hand. That holds even in the ugly scenario for 2010. A premise of our risk analysis framework is that the policy responses and policy traction are critical determinants of the outlook in 2010: Put simply, the weaker 2009 proves to be, the more aggressive will be the policy response, including that from officials who have thus far been laggards. Inflation Risks: Counterintuitive Skew Finally, the risks to inflation are – somewhat counter-intuitively – tilted in the other direction from those to growth. Normally, massive economic slack would be associated with higher deflation risks. Make no mistake, our baseline and near-term scenarios encompass sharp declines in inflation outcomes globally. However, four factors make deflation unlikely: First, the current inflation decline largely represents a reversal of the inflation spike of early 2008, rather than the beginning of a new era. Second, we think that companies will quickly cut excess capacity to balance supply with demand. Third, some of the emerging global declines in goods prices are clearly declines in relative prices, not prices generally. This shift in the ‘terms of trade’ benefits consumers and most businesses, even in commodity-producing countries. The vital element to keep in mind is that the Fed and other central banks are easing aggressively and in some cases now quantitatively to influence inflation expectations. Indeed, now there are three important factors that lead to upside asymmetry for inflation risks around the baseline. First, we believe that low oil prices will sow the seeds for higher prices down the road. Supply cutbacks should put a floor under prices at $30 or so, and when demand rebounds, supply will be slow to come back on line. Moreover, in developed economies, there is a risk, albeit a small one, that policy stimulus will overstay its welcome, eventually (beyond 2010 in our view) leading to renewed inflation concerns. Finally, in developing economies, poor growth outcomes in the short term are leading to further currency weakness, pushing up inflation at least over our two-year time horizon. Regional Risks: Developing Economies Are Higher Beta These risk drivers can differentiate economic (and earnings) risks across regions. While the US economy is at the center of the deleveraging dynamic, and thus likely will experience the deepest recession, the dispersion of risks for emerging market economies is wider than for the developed world. That’s appropriate because EM economies are more highly leveraged to global growth through trade, capital flows and commodity prices. In addition, many EM policymakers are still concerned about inflation risks following sizable currency declines. Delayed policy responses will increase downside risks to growth in both EM and developed economies like Europe and Japan. As noted earlier, the risks for inflation in the developing economies are skewed to the upside around a near-term declining baseline. In contrast with GDP, where the risks are slightly tilted to the downside, for inflation the upside in the bull case is higher than the downside in the bear case. That reflects two factors: First, supply constraints in oil and other commodities limit the downside in the ugly scenario and push commodity prices even higher in the bull scenario. Second, in the bear scenario, falling exchange rates offset declines in EM inflation from other sources. In turn, such dynamics support our LatAm and Asia EM teams’ case that EM central banks have less latitude than the G7 to ease monetary policy. Over the long term, that issue will fade in importance as these countries develop further, become less dependent on commodities and external sources of growth, and their markets become more flexible. But for now, it perversely will boost inflation risks around the baseline. The Method to Our Madness A Framework for Assessing Risks to the Outlook To assess risks, we analyze the impact on growth and inflation of a handful of critical, plausible alternative scenarios. Until now, our assessment of the width, skew, and fatness of the tails of the distribution around our baseline forecast has been subjective. Here, we adopt a more systematic approach by looking to key drivers in each region and to the most important common global factors that could cause change. Plausibility is defined to cover outcomes roughly one standard deviation from the mean in either direction. Our methodology involves shocking key drivers of risk for each economy or region and aggregating the resulting upside and downside scenarios into consistent global outcomes. For the US, those drivers involve different paths for home prices, different rates of loss among lenders, and more or less aggressive policy actions and their effectiveness. For Europe and Japan, policy actions are critical; for China, it is the performance of real estate. For Latin America, the shocks come through currencies (and the response through interest rates), commodity prices, and risk premiums. Considering variation in commodity prices as a risk driver complicates risk analysis for two reasons. First, the weakness in demand that has promoted the recent collapse in commodity quotes is clearly bad news for emerging-market commodity producers. However, it is a welcome cushion for the perfect storm now battering the American consumer and by extension other consuming countries. As a result, these massive changes in the “terms of trade” are bane to some but boon to others, and their consequences for global risks must be netted from that interplay. Second, it is critical to assess the source of the change in commodity prices: Today’s plunge is primarily the result of weak demand, so it would be misleading to look at the drop as a new source of global stimulus. Conversely, if it results from increased supply, the effects on global growth likely will be positive. Indeed, we estimate that if an increase in supply allowed crude quotes to decline to $30/bbl, global growth would be roughly 0.5 percentage points stronger than in the ugly scenario (or -0.3% rather than -0.8%), and global inflation would decline by 0.3 percentage points (to 1.5% rather than 1.8%). In what follows, we outline region-by-region risks and risk drivers: United States – Our baseline outlook assumes that home prices (FHFA purchase-only home price index) decline by another 10% for a peak-to-trough total of 18%, and uses MS large-cap bank analyst Betsy Graseck’s estimate of $1.4 trillion in cumulative losses for the US financial system. We assume a $500 billion fiscal stimulus package spread over three years. The bear case assumes that home prices will decline by an additional 7%, that cumulative losses total $1.7 trillion, and that monetary and fiscal policy efforts take four months longer to be effective. Moreover, we assume that consumers save 10% more of the tax cut than otherwise. The bull case assumes home prices decline by only an additional 5%, cum losses amount to $1.3 trillion, the fiscal stimulus is $700 billion, and monetary and fiscal policies begin to get traction in the spring of 2009. Euro Area – Our bear case (30% subjective probability) incorporates a domestic demand crunch caused by several factors. First, a noticeable reduction in the availability of credit to the non-financial private sector, rather than our baseline assumption of a gradual tightening in credit conditions and credit availability in line with a typical recession. Second, instead of easing slightly as in our baseline, the household saving rate could start to rise noticeably. Third, faced with a sharp deterioration in budget dynamics, governments might find it more expensive to fund themselves and private investment projects could be crowded out. Fourth, effective funding costs might go up considerably compared to our baseline of an ECB refi rate cut to 1.5% and a gradual easing in the Euribor/OIS spreads. In our bull scenario (10% probability), financial conditions become noticeably more favorable, fiscal policy achieves major multiplier effects, global growth surprises on the upside, and commodity prices on the downside. The sharp fall in many activity indicators in recent months would be seen as a sign of a proactive corporate sector that was fast to slash production, managed its supply-chain efficiently and made full use of the flexibility of temporary staffing. United Kingdom – Our bear scenario assumes that the low household saving rate follows a trajectory similar to the recession of the early 1990s, rising sharply at a time when global growth is well below trend, so that reductions in domestic consumption are not offset by stronger growth in exports. A sharp and protracted fall in output would be inevitable. This risk is not our main forecast because we are not seeing the sharp rise in interest rates that helped drive the household saving rate up dramatically in the early 1990s. A more benign path than our base case is one where the "lost" output from 2008 and 2009 is not permanent because the supply side is not damaged by the credit crunch and activity bounces back strongly in 2010 to trend. It seems optimistic to assume that the severe damage to the financial system does no lasting damage to productive capacity. Japan – The main downside risks to our base case are a political crisis and protracted policy gridlock after the snap elections, and a policy-induced slump of construction investment (again) just like the housing shock in 2007. Our bull scenario envisages a sharp improvement of terms of trade, which could reduce the outflow of real purchasing power and unleash pent-up consumer demand. New Zealand – The key drivers for the bear scenario are (i) even weaker growth in trading partner economies, damaging export prospects further, and (ii) a sustained decline in house prices, which would prolong the recession. China – Despite much attention paid to the G3 recession, we think the biggest swing factor for 2009 growth is real estate investment. Our base case (65% subjective probability) envisages a 6% decline in real estate investment by the private sector in 2009. If real estate investment were to contract by 30%, the impact would be so large that even the current fiscal stimulus package would not make up for the growth shortfall. We estimate that GDP growth would drop to 5%, tantamount to an outright hard landing. Under this bear case scenario (25% probability), consumption growth would likely be significantly lower as both employment and income growth would suffer. Our bull case (10% probability) envisages a larger contribution of net exports to growth because of less-deep-than-expected recessions in G3, as well as flat instead of reduced real estate investment. We estimate that GDP growth could reach 9.0% under this bull case, provided that the fiscal stimulus package would not be scaled back. Korea – While many are focusing more on export and construction, we see consumption as the biggest downside risk due to household de-leveraging, wealth destruction and currency depreciation. Our bear case assumes domestic liquidity problems as foreigners continue to sell Korean bonds, squeezing wholesale funding further. The dollar shortage could re-emerge if a majority of ship orders are cancelled and shipbuilders cannot meet their external debt payment with trade credits. The upside risk depends on the effectiveness of China's stimulus measures as Korea's growth is heavily related to China's fixed asset investment. Taiwan – The biggest downside risks stem from any delay in monetary and fiscal policy execution next year and further loss of competitiveness to Korea due to currency appreciation vis-à-vis the Korean won. The main upside risk depends on global demand for Taiwan’s technology exports. Russia, Kazakhstan, Ukraine – For the former Soviet Union commodity prices remain the key external driver of risk scenarios. Russia and to a lesser extent Kazakhstan have temporary scope to cushion the downturn with fiscal expansion, but through much of the region monetary policy will have to be further tightened into the slowdown given the risks of deposit flight from fragile banking systems. IMF programs are likely to defend currency pegs in the Baltics, at the expense of a deep contraction, but to drive further depreciation in Ukraine. The sharp recovery in steel and oil prices seen in our central case scenario would bring rapid relief in the CIS in 2010. Central Europe – Downside risks to growth and inflation dominate even after our recent downgrades. Open economies exposed to the auto sector (Hungary, Czech) are particularly at risk from a growth standpoint. Rates are being lowered everywhere, but the strength of the monetary transmission channel has weakened in the last few years due to increased loans in foreign currency, especially in Poland, Hungary and Romania. Fiscal policy does not have much scope to cushion the blow, and fiscal positions are set to deteriorate in 2009 on the back of lower growth. In Hungary in particular, the fiscal squeeze associated with the recently approved IMF package will provide an extra blow to consumers, in addition to slower credit and export growth. Israel – The Bank of Israel’s pre-emptive policy easing and the government’s planned fiscal stimulus package should limit downside risks to some extent. However, an even sharper than expected decline in exports and easing domestic demand present downside risks. The absence of a housing bubble and sound fiscal policies are mitigating risks to a large extent, but upcoming elections might result in some policy slippage. Turkey – The main risk rests with external financing, particularly the ability of the private sector to roll over debt. The expected decline in current account deficit and the funding from a possible IMF stand-by arrangement are likely to help close the potential financing gap. Protracted weakness in global markets may cause local depositors to switch back to foreign currency deposits, resulting in a noticeable depreciation in the currency. But the central bank has started to ease monetary policy and there will be limited support for small to medium sized enterprises that could prevent a recession. South Africa – Risks are asymmetrically skewed towards the bear case of weak GDP growth and sticky inflation. Continued weak global growth prospects and a commensurate dearth in capital flows would keep the currency on the back foot, given the huge current account deficit. A recovery in global growth through 2010 would likely see oil prices rise sharply enough to prevent the SARB from cutting rates aggressively, thereby capping domestic growth prospects. United Arab Emirates – The risks to near-term outlook are driven by: (i) the oil markets; (ii) the domestic real estate sector; and (iii) the availability of foreign financing. Although both fiscal and external accounts are expected to remain balanced at oil prices of about $40 per barrel, continued weakness in oil markets may lead to further output cuts, an adverse effect on oil sector growth, more moderate growth in public investments, and lower exports of services to neighboring oil-producing countries. Latin America – Although we now expect Latin America to contract by 0.4% in 2009, we are concerned that the downside risks still dominate. The good news is that the starting point for Latin America has improved from the past: the region does not suffer from the same kind of current account imbalances or fiscal shortfalls as in the past. However, we are concerned that policy makers have less room to engage in counter-cyclical fiscal and monetary policy to temper the blow of the downturn. For the bear case, we assumed the nominal exchange rate depreciates by two times the 10-year standard deviation of the real effective exchange rate. We used a standard set of “bear case” commodity prices from our colleagues on the commodity research team as additional inputs. For the risk premium (spread over US Treasuries), we used the 10-year average. We then estimated implied interest rates and GDP growth (for more details see “Latin America: Shocking the Consensus”, This Week in Latin America, September 22, 2008). For the bull case, we have largely used the previous “base case” before our first revisions downward in October 2008 (see “Latin America: The End of Abundance”, This Week in Latin America, October 6, 2008). |
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