Latin America
No Hurry in 2009
January 06, 2009

By Gray Newman | New York

The New Year is only days old and already I am hearing hope expressed about the prospects for Latin America and, indeed, emerging markets in 2009. After all, while the data releases that economists pore over are likely to show a severe break in the growth dynamic in Latin America in the coming weeks and months, investors are rightly focused on the direction for 2009. This is hardly the time for ‘rearview mirror’ economics, the optimists argue. Their argument is threefold: it centers on relevance, policy stimulus and Latin America’s starting point.

The Case for Optimism

First, short of an outright depression, asset prices in the region have already overshot most scenarios of a downturn in economic activity. Economists who spend time analyzing every detail of the latest weak retail sales or industrial production release are engaging in a classic error of the profession: they may end up with an accurate description of the present (or the recent past) state of the economy, but their analysis is largely irrelevant. Indeed, irrelevance soon gives way to irritation among investors who have watched their portfolios suffer only to be told after the decline that the era of abundance is now in question.

Second, the optimists point out that policy stimulus has been massive and swift and that more is set to come, as the new administration takes office in Washington this month.  One of the advantages to the fact that the epicenter of the globe’s current downturn is in the developed world, and particularly in the US financial system, is that the policy response has been timely and forceful. Moreover, the ground is fertile for policy stimulus to gain traction. Some in the optimist camp argue that the sharp downturn in global activity during 4Q08 was exaggerated by a run-down in inventories which widened the gap between production – which in many cases came to a halt – and consumption. A forceful stimulus package could reverse this and lead to a sharp rebound in activity.

Finally, the optimists argue that Latin America is in better shape going into the current downturn than it has been in decades. Starting points matter, and the optimists note that we have seen little of the excesses common in past upturns in Latin America. The abundance of the past five years did not produce the ballooning trade and current account deficits fueled by consumer spending seen in Latin America’s past.  Nor is Latin America home to widening fiscal deficits that plague other emerging economies. Nor have Latin American central banks burned through reserves trying to prop up woefully overvalued currencies. In contrast, far from needing large inflows to finance severe current account or fiscal imbalances, the region is awash with international reserves and may be able to fund stimulus packages to complement the stimulus already underway in the developed world.

The Case for Agnosticism

I have a great deal of sympathy for much of what the optimists argue, but I end up in the camp of the agnostics at this juncture. Let me explain why: 

First, I wholeheartedly agree with the critique of ‘rearview mirror’ economics. Whether in forecasting or in driving, looking through a rearview mirror can be dangerous if it takes your attention away from what is ahead of you. And economists perform a disservice when their analysis is detached from the question of whether the finding is ‘in the price’. But I cannot help but comment on the irony of the recent critique of ‘rearview mirror’ economics: it comes after one of the most devastating example of ‘rearview mirror’ thinking in decades. During late 2007 and 1H08, as the evidence continued to mount that the turmoil which began in the US housing market was likely to spread around the globe and engulf emerging economies as well, many of the optimists today were advocates of ‘rearview mirror’ thinking and argued that there were no signs that the US downturn was having any impact on the emerging economies.

Second, I also agree with the optimists regarding the importance of starting points. Mexico today does not look like the Mexico I remember in 1994 when the current account ballooned and was on its way to 8% of GDP. Nor does Chile resemble the Chile of 1998 as the Asian Financial Crisis lapped up on its shores and when the current account imbalance was nearly as large. Nor does Brazil have the same imbalance as it did in early 2001. Latin America appears to be in better shape today than at any point in decades past to deal with a downturn in the global economy. Why then my agnosticism?

My agnosticism springs from the asymmetry of risks involved in calling a turning point. There is little to be gained from calling a downturn late, at least in the emerging markets world where downturns are usually sharp, unforgiving and rapid. Unable to divine the timing of a downturn with precision, I’d always be in favor of being early rather than late. (I’d distinguish being early from the perennial naysayers who have gained a following of late; they are not much better, in my view, than the ‘safe haven’ evangelists that continued to focus investor attention on the long-run prospects for emerging markets last year when the region was on the eve of the most severe cyclical downturn in decades.) In contrast, I have a much harder time making the case for calling the upturn early. When an upturn begins in Latin America, the recovery in economies, markets and currencies is usually measured in years, not months. The downside risks to an early call for an upturn are significant. In contrast, if one is late in calling the upturn by a few months, the losses are likely to pale compared to the multi-year gains from the turnaround. 

My job, as an economist, is to call turns in the business cycle – both up and down – as best I can. But I would be dishonest if I didn’t admit that there is a strategic element that I take into account when making a call. If I believe that I see an upturn coming, I will call it. But if I err, I would always prefer to err on the side of calling a downturn early and an upturn late. 

The Case for Caution

We are on the record calling for a modest recovery in late 2009 in Latin America. The magnitude of the downturn at the end of 2008 and in the first months of 2009, however, is likely to be severe enough that the activity on average in 2009 contracts from the levels seen in 2008. Indeed, we are forecasting that average GDP in 2009 contracts by 0.4%, the worst showing for the region since 1983 (see “Latin America: Sliding in 2009”, EM Economist, December 12, 2008). But I would be the first to admit that the downturn could last longer or the region could rebound more quickly. This agnosticism from my vantage point, however, argues in favor of remaining cautious, given the asymmetry of risks in calling the upturn. After all, if the global downturn lasts longer, the risks to Latin America grow. 

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

Not only is room for counter-cyclical fiscal policy limited, but I would also argue that counter-cyclical monetary policy is unlikely to provide an important stimulus in the region. While we expect to see some easing in monetary policy – we expect, for example, Banco de Mexico to ease policy rates by 175bp in 2009 beginning in 1Q and Brazil to move as well – we do not expect to see a dramatic reduction in line with what our developed world economists are expecting. And the impact of monetary easing is likely to be limited both due to the under-intermediated state of most Latin economies and as we expect monetary policy to have limited traction, given the sharp declines that we envision in consumer and business confidence and the weakness in labor markets. 

But perhaps the greatest risk in Latin America (and throughout emerging markets) is that policy slippage or even reversals take place. While we have already seen one case in which the privately managed pension fund system was effectively nationalized in Latin America, I would not be surprised to see regulatory creep throughout the region that could lead to de facto, even if not de jure, nationalization.

I am not arguing that significant policy slippage or policy reversals will take place in the region. But I am concerned that if the downturn lasts longer than our global economics team is calling for, we could see ‘translation risks’, as the policy remedies being deployed in the developing world are adopted (and adapted) in Latin America and emerging markets. There seems to be little doubt that the state will play a much greater role in the functioning of the economy in the US, particularly in the financial system. Whatever the merits of greater state control, the risks that such policies give rise to onerous regulations in Latin America should not be ignored.  The longer that downturn in activity continues, the greater the risk of further slippage.

Bottom Line

Now is not the time to turn bearish on Latin America: the time to act was a year ago. But I’d caution against chasing every possible sign of an upturn in either the real economy or the markets. There is simply too much that we do not yet know about the severity or the duration of the current downturn. Given the downside risks associated with being early in calling an upturn and the relatively modest costs of being late to the recovery, I would argue in favor of caution.

Five years of abundance dealt Latin America an enviable hand. Too often policymakers and investors confused the heady cyclical run-up with the emergence of more sustainable growth. The downturn underway, if it lasts long enough, could test the region’s policy resolve and serve as the ultimate guide to whether the region is on the path to sustainable growth. Why the hurry to make that call today?

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United States
Review and Preview
January 06, 2009

By Ted Wieseman | New York

After a huge and relentless flattening move from mid-November through Christmas, the Treasury curve saw a decent steepening the past week, as the front end posted decent gains while the long end gave back a small part of its enormous prior rally.  Off-the-run bonds, the highest-yielding part of the Treasury market, led the downside (though off-the-run 10s also were affected, as the bond and 10-year contracts performed terribly and cheapest-to-deliver off-the-runs traded accordingly), as shell-shocked investors appeared to be showing a little optimism going into 2009 and shifting some money out of super-low-yielding Treasuries – where the highest yields are still only around 3.25% even after the past week’s losses – and into stocks, which caught a solid bid over New Year after a poor showing for a week-and-a-half following the FOMC meeting, and credit, which slightly extended what had already been a strong post-FOMC rally.  However, it was another very quiet holiday week across all markets, and it thus would have taken very little in the way of asset reallocations to drive significant moves across markets, so we’ll probably have to wait until trading desks are fully staffed again in the coming week to see where we really stand moving into 2009.  Thin and sluggish trading conditions are certainly normal this time of year, but it seemed very unlikely a few months ago that we would make it through year-end in such a typically boring way without any obvious funding strains at all.  So, the Fed’s powerful shift towards quantitative easing that started in mid-September, which has sent excess bank reserves to astronomical levels near an US$800 billion daily average, around 500 times higher than normal, has notched one significant early victory in successfully moving the financial system smoothly through year-end.  It was a light week for economic data, but what was released was terrible.  The manufacturing ISM plunged to one of its worst-ever readings, as the combination of the badly deteriorating domestic economy, the impact of severely weakening global growth on exports and a worsening inventory overhang have sent the factory sector into a major downturn.  Consumers are also in a miserable mood as the labor market continues to deteriorate, with the Conference Board’s consumer confidence gauge hitting a record low.  Views of the labor market continued to worsen, which we expect to be reflected in another miserable employment report in the upcoming week. 

On the week, 2s-10s steepened 29bp after having flattened 125bp over the prior six weeks, with the 2-year yield dipping 1bp to 0.875% while the 3-year yield rose 7bp to 1.13%, 5-year 23bp to 1.73%, 10-year 28bp to 2.42% and 30-year 21bp to 2.815%.  To the extent that assets shifts were going on, they appeared to be futures-driven, as the bond contract plunged about six points on the week and the 10-year contract three points, all of the downside in both cases coming in major sell-offs on Wednesday and Friday.  There was a very slight easing of the squeeze at the short end, with the 4-week bill’s yield up 2bp to 0.02% and the 3-month 10bp to 0.09%, but the extent to which extraordinary demand for the safest short-term asset might be moderating probably will be clearer after we see the upcoming week’s bill auction results.  TIPS sold off about in line with nominals, a weak showing considering the sizable rebound in commodity prices on the week, with the 5-year yield up 26bp to 1.83%, 10-year 29bp to 2.25% and 20-year 32bp to 2.42%.  Mortgages and agencies performed poorly on the week, lagging the Treasury sell-off.  But with the Fed preparing to start purchasing US$500 billion in MBS, roughly US$4 billion on average a day on top of the Treasury’s US$1 billion buying, through the first half of the year, easily more than absorbing likely new supply, MBS yields should start moving lower again shortly.  The huge rally in agencies since the Fed began its purchases recently should also allow the agencies to continue ramping up their mortgage purchases again and adding to the MBS bid, and the Fed should be back in buying agencies in the coming week after taking a holiday break following the completion of US$15 billion of its initially planned US$100 billion in buying. 

Risk markets had a good week to move into 2009.  After initially rocketing off the November 20 lows and peaking after the FOMC meeting, stocks had been moving lower but caught a renewed bid in the latest week, with the S&P 500 rising 7% to move a couple of percent higher than the December 16 post-FOMC close.  Credit markets moved steadily higher post-FOMC while stocks were struggling, and this continued in the past week as stocks rebounded, though the gains were small, with the investment grade CDX index tightening 8bp for the week Friday afternoon to 199bp.  The subprime ABX and commercial mortgage CMBX markets also mostly posted small further gains – the AAA ABX index rose slightly to a two-month high of 39.09 from 38.88, though lower-rated indices were all unchanged, while all the CMBX indices were slightly better, with the AAA tightening 9bp to 525bp and the junior AAA 10bp to 1443bp.  The leveraged loan LCDX index, on the other hand, solidly extended its powerful recovery from the near collapse seen from mid-November to mid-December.  From November 14 to December 15, the LCDX index widened 1,329bp to 2,327bp, but after another nearly 200bp improvement to 1,296bp over the past week through midday Friday, it had reversed most of those losses, though it remained much weaker than the levels around 400bp it traded near from mid-June to mid-September. 

The manufacturing ISM composite index fell another four points in December to 36.2, a worse level than which has only been seen in a handful of months in the 1980, 1973-75 and 1948-49 recessions.  The key orders (22.7 versus 27.9), production (25.5 versus 31.5) and employment (29.9 versus 34.2) gauges all extended their recent collapses to fall deeply into recessionary territory.  These were record lows for orders and production and a 26-year low for employment.  Not a single industry group reported growth in overall activity, orders, production or employment.  Meanwhile, the prices paid index extended its extraordinary collapse, falling another 7.5 points to 18.0, a 60-year low after a 73.5-point plunge from the 30-year high hit in June.  Up until mid-year, the manufacturing sector was being supported by strength in exports even as domestic demand was slowing rapidly.  Domestic activity has now deteriorated into a severe contraction, and exports are showing major softness as the US recession goes global.  The export orders plunged to a record low (in the shorter 20-year history of this index) of 35.5 in December.  Before the recent collapse, the prior record low for this gauge was much higher at 43.7, hit during the Asia/Russia collapse in 1998.  The report highlighted comments from a machinery executive – “Europe has slowed down dramatically, while Asia – particularly China – has virtually shut down.”  An inventory overhang is also worsening.  The customers inventory index (a gauge of whether stockpiles are perceived to be too high or too low) rose two points to 57.0, a 14-year high.  This is likely to contribute to continued weakness in orders and production in coming months, as the manufacturing sector endures one of its worst downturns on record. 

The Conference Board’s measure of consumer confidence, which focuses on the labor market in its questions, fell 6.7 points in December to an all-time low of 38.0.  The current conditions index tumbled 13 points to 29.4, a low since 1992, after posting its worst one-year drop ever.  Views of the current labor market continued to worsen.  The percentage of respondents describing jobs as plentiful fell to just 6.2% from 8.7%, and the percentage describing jobs as hard to get jumped to 42.0% from 37.1%.  This was the most net negative view in 16 years.  Over time, this question matches up reasonably well with trends in the unemployment rate and is thus suggesting a rapid deterioration in the labor market. 

After the last two very quiet holiday weeks, the new year gets off to a busy start in the upcoming week.  A fairly busy data calendar will be highlighted by the delayed employment report on Friday.  Prior to that, motor vehicle sales on Monday and chain store sales results Thursday will provide early indications for December retail sales, which we expect to be depressed both by underlying weakness and what we expect will be a reversal of seasonal factors that appeared to overcompensate for the late Thanksgiving and artificially boost sales results in November.  It will be a very heavy week for supply, with a 10-year TIPS auction Tuesday, 3-year Wednesday and 10-year reopening Thursday.  TLG bank debt issuance will also likely resume in sizable volumes after the recent holiday lull.  Early January is normally a heavy period for corporate debt issuance in general, so companies for whom non-FDIC guaranteed debt can be issued on reasonable terms may be in the market as well in the coming week.  The minutes from the December 16 FOMC meeting will be released Tuesday, so we’ll get some more details behind the powerful statement the Fed issued after that meeting.  Other data releases due out include construction spending Monday and factory orders Tuesday:

* We forecast a 1.3% decline in November construction spending.  The housing starts data point to another very sharp fall-off in the residential category.  We also expect to see declines in the non-residential and public components in November.

* We look for motor vehicle sales to rise to a 10.5 million unit annual rate in December.  Tight financing conditions, the specter of a possible bankruptcy filing and deteriorating labor market conditions are all weighing on the industry.  However, gasoline prices have plummeted and company reports indicate that sales activity actually picked up a bit during the second half of the month.  So, we look for a slight uptick in the selling rate relative to the depressed 10.1 million unit sales pace seen in November.

* We forecast a 2.3% plunge in November factory orders.  Another sharp price-related drop in the non-durables component should combine with the previously reported aircraft-driven decline in durables to lead to a fifth straight sizable fall in overall factory orders.

* We look for a 450,000 decline in December non-farm payrolls.  Labor market conditions are deteriorating at a rapid clip, and we look for another sizeable drop in payrolls.  However, the pace of job losses is not expected to be quite as severe as in November because we suspect that the bulk of the weakness in holiday-related hiring was captured last month and that much of the impact of the recently announced auto plant shutdowns will not show up until the January report.  Also, weather conditions across much of the nation were relatively mild through the December survey period, and this should provide some modest support.  However, we look for some weakening in the government sector and acceleration in the pace of job losses within the financial services.  Meanwhile, the household survey is expected to show a flattening out of the labor force, which should help to push the unemployment rate up to 7% for the first time since mid-1993.  Finally, average hourly earnings are expected to continue to show some resilience this month.  However, it’s worth noting that we strongly suspect that much of the recent upside in wage rates is due to a compositional shift in the work force – not wage inflation.

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United States
A New Rate Outlook: QE and the Yield Curve
January 06, 2009

By Richard Berner & David Greenlaw | New York

QE aimed at capping rates: The Fed’s new program of ZIRP combined with aggressive quantitative easing (QE) has helped to flatten the Treasury yield curve, pushing 10-year note yields to 2%.  Moreover, mortgage rates have plunged and some important credit spreads have started to narrow.  We think that the Fed will stay in QE mode until the economy stabilizes and deflation risks ebb, likely late in 2009 or early 2010.  Those forces should cap 10-year yields at 2.5% during the next few months, and below 3.25% over the next year.

Aggressive program: The Fed has resolved to “employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability”.  The new actions in mid-December – cutting rates effectively to zero, conditionally committing to keep rates low for “some time”, and promising to buy longer-term securities, possibly including longer-term Treasuries – reflect that resolve and were all positive surprises for the bond market.  In repeating that it might buy Treasuries, the FOMC underscored its desire to target the level of yields.  So far, so good.  We still suspect that an evaluation of the potential benefits from purchasing long-term Treasury debt will show that other strategies would yield more bang for the buck.  However, there is no question that the Fed wants to get the level of long-term rates down across a variety of different asset classes.

Is it really QE? Fed officials have gone out of their way to say that their actions are not QE; they say they are targeting the asset side of their balance sheet, while QE uses an expansion of liabilities.  Moreover, while they agree inflation will fall, they are not worried about deflation.  The semantics don’t matter in our view because Fed operations are using both sides of the balance sheet.  QE involves the expansion of high-powered money – otherwise known as monetary base.  This should eventually trigger a pick-up in the growth of bank credit and the money supply. However, the Fed does not want the focus to be aimed at these types of quantity indicators.  Instead, officials indicate that they are trying to ease financial conditions and improve market functioning by financing a variety of securities directly on the asset side of their balance sheet.

Targeted QE uses both sides of the balance sheet: We call this ‘targeted QE’ because it combines elements of both orthodox QE and extensions as outlined in the Fed’s discussions of QE as early as 2002.  It includes funding specific assets on the Fed’s balance sheet or in special purpose vehicles (SPVs) to restore market functioning and bring rates down.  Examples: The Fed’s proposal to purchase US$600 billion of agency mortgage pass-throughs and agency debt and an unspecified amount of Treasuries; the Term Asset-Backed Securities Loan Facility (TALF) and Commercial Paper Funding Facility (CPFF), which are designed to support ABS and CP markets by financing those securities.  The Fed could sterilize such facilities through reserve-draining open market operations, but it has decided not to.  That’s what qualifies these actions as QE.

Splitting hairs: All this may seem academic, but the mid-December price action underscores the point that Fedspeak matters and the clearer the better.  We remain slightly puzzled by the Fed’s denial that it is doing QE, especially because some Fed officials think they have a communication problem.  The distinction may have something to do with longer-run planning around an exit strategy and with some of the problems that plagued Japan officials during their experience with QE.  The good news is that the intent of the Fed’s actions is clear.  Indeed, we’re not overly worried about deflation, primarily because the Fed is acting as if it is.  The current situation is obviously unprecedented, especially if one ignores the volatility around Y2K, which was highly technical and not reflective of any QE.  In any case, the Fed’s objectives and the tools it will use to achieve them are clear-cut at this point and no one should get too hung up on the terminology.

Exit strategy: It’s too soon to think about exit strategies from this massive commitment of Fed firepower when the focus is on avoiding deflation.  But when policy gets traction and the threat of deflation fades, that consideration will be more relevant.  Exiting QE and abandoning ZIRP will require a major adjustment in the bond market when the economy and prices show signs of life; assuming that begins late next year, yields may jump by 200bp over the course of 2010.

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