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China 2009 Outlook Downgrade: Getting much Worse Before Getting Better United States Review and Preview View GEF Archive

		The Global Economics Team

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The Chinese economy suffered a hard landing in 4Q08. We estimate that China’s GDP growth may have registered negative quarter-on-quarter growth of -1.7% in 4Q08 after a flat quarter in 3Q08 (on a seasonally adjusted, annualized basis). Specifically, while the growth rates of industrial production (value-added) and external trade (both exports and imports) plunged, inflation rates also declined sharply.

When discussing China’s economic outlook for 2009 in early December 2008, we argued that three factors had caused the sharp slowdown in the economy. These were (in order of importance): 1) the cooling in real estate investment; 2) a massive de-stocking of raw material inputs in the immediate aftermath of the collapse of international commodity prices; and 3) the slowdown in external demand (see Outlook for 2009: Getting Worse Before Getting Better, December 9, 2008). 

We think the freefall in activity in 4Q08 was mainly attributable to the massive destocking and severe disruption in trade finance (see China Chartbook: De-leveraging, De-stocking, Disinflation, January 2, 2009). In particular, the latter factor has contributed to a sharp contraction in trade flows due to already weakening external demand. While we were quick to identify the de-stocking as a key reason for the economic slowdown, we underestimated the severe consequences of the disruption in trade finance on trade flows in 4Q08 and the lingering shock impact on the confidence of private investors and households (see Sharper-Than-Expected Slowdown in 3Q08 on De-stocking, October 20, 2008).

We think the disruption in trade finance may have had a disproportionately large impact on Emerging Asia. Since the external trade carried out by Emerging Asia tends to concentrate on low-margin links in global valued-added supply chains, it is especially sensitive to the rising costs of trade finance and increased risk perceptions, in our view.

Two Inflection Points

The latest readings of key indicators have shown some signs that the sharp contraction in underlying economic activity may have eased somewhat in December. This makes some market observers wonder whether the economy is approaching an inflection point.

While an inflection point appears to be in sight, it will unlikely be the inflection point envisaged under our original ‘getting worse before getting better’ baseline scenario, in our view. Rather it could be a ‘technical rebound’ from the extreme lows after the undershooting, as de-stocking is expected to run its course and trade finance to normalize (at lower levels compared with pre-crisis highs) in the coming months.

A more meaningful inflection point – beyond which a recovery could be sustained – has yet to emerge, in our view. Such an inflection point will likely appear around mid-year as we believe that a sustainable recovery hinges on three factors: 1) the kick-in of the policy stimulus effect in China by mid-year; 2) stabilization of real estate investment; and 3) a tepid recovery in G3 economies by 4Q09.

Outlook Downgrade

We are downgrading our GDP growth forecast for China to 5.5% from 7.5% previously for 2009 and to 8.0% from 8.5% previously for 2010. This downgrade reflects two specific considerations. First, the shock impact of the economic hard landing in 4Q08 has substantially weakened the confidence of both entrepreneurs and households. While the Entrepreneur Expectation Indicator has fallen to the lowest level since 2000, consumer confidence took another dive in September 2008 after having been broadly stable since the beginning of 2008. In this context, anecdotal evidence suggests that job cuts in the manufacturing and construction industries among migrant workers have been substantial, while wage reductions in other sectors in urban areas have reportedly taken place.

Second, our global economics team recently further downgraded the GDP growth forecasts for the US and Euroland in 2009 to -2.4% (from -1.9% previously) and -1.6% (from -1.0% previously), respectively (see US Economics: Global Recession Aggravates the US Downturn, January 12, 2009 by Richard Berner and David Greenlaw; European Economics Chartbook: Cutting Euro Area Growth, Inflation and Interest Rate Forecasts, January 7, 2009 by Elga Bartsch and Carlos Caceres). With an unchanged outlook for the Japanese economy (i.e., -2.0% growth in 2009), these revisions suggest that the average G3 growth rate in 2009 will be about -2.0%. The battered confidence of investors, together with a more challenging external environment, indicates that private capex, especially in export-oriented sectors, will likely be very weak.

We are therefore marking down our growth forecasts for manufacturing investment (to 0% from 5% previously), real estate investment (to -12% from -6.0%), consumption (to 6.2% from 7.8% previously) and external trade (to -3.0% from +3.0% for exports and to -5.0% from -4.2% for imports). In our revised forecasts and in terms of contribution to growth, consumption will become a larger driver for growth in 2009, an important shift from the pattern in previous years. The contribution of net exports to growth is unchanged at zero because we expect the growth of imports will slow along with exports as domestic demand weakens. This is also partly a reflection of the import content of private manufacturing investment tending to be higher than that of public investment in infrastructure projects.

Getting Much Worse Before Getting Better During 2009

The economy will likely get much worse before getting better over the course of 2009. We expect much weaker headline GDP growth rates in the range of 3.0-3.5%Y in the next two quarters before the economy starts to accelerate from 3Q09 and peak at 9.6%Y by 4Q09.

Several factors help explain this rather dramatic profile of quarterly growth rates. At least three fundamental factors cause us to believe that the economy will get much worse in the quarters immediately ahead. First, the shock impact of the economic hard landing in 4Q08 will likely last well beyond 4Q08, as investors turn much more cautious and start to revisit their original capex plans for 2009.

Second, our global economics team forecasts the bulk of economic contraction in G3 economies in 2009 will take place in 1H09, suggesting a meaningful recovery in China’s exports will be unlikely until 2H09.

Third, while there are tentative signs from the latest data that property sales in a number of cities registered considerable improvement over the past few weeks, the broad downward trend of sales established since early 2008 points to further weakness in real estate investment in the months immediately ahead.

At least two fundamental factors lead us to attach a considerable probability to the economy picking up in 2H09. First, we expect the effect of the aggressive policy stimulus to start to show up in an improvement in indicators of real economic activity by mid-year. This view is reflected in the projected acceleration in quarter-on-quarter growth rates in 2H09. Bank lending – a key gauge of the strength of policy responses, be it fiscal or monetary – accelerated sharply in November-December 2008, after the administrative bank lending quota was abolished and the authorities called on the banks to support the government’s effort to revive the economy. It is highly likely that loan growth may have accelerated in January 2009 even from the pace in November-December 2008, in our view. Past experience indicates that bank lending tends to lead investment by five to seven months, suggesting that it takes time for easy credit conditions to translate into an improvement in real economic activity, ceteris paribus.

Second, our global economics team expects the growth rate of all G3 economies to bottom in 3Q09 and show a tepid recovery in 4Q09. Stabilization and improvement in the external environment would help boost confidence and bode well for a potential recovery in China’s export growth in 2H09.

Besides these economic factors, an important technical one helps explain why headline year-on-year growth rates could turn out to be very low in 1H09 and the potential rebound in 2H09 would only partly be able to offset the growth shortfall in 1H09. China has been consistently delivering rapid growth in past years. If a rapidly expanding economy like China comes to a sudden halt even for a couple of quarters (i.e., registering very low quarter-on-quarter growth rates), this would have a fairly large negative impact on the year-on-year growth rates in subsequent quarters even if the economy were to resume positive growth in these quarters.

Risks

We also revised our two alternative scenarios – bear and bull cases – to highlight both downside and upside risks to the 2009 outlook for the Chinese economy under our new baseline scenario. Notwithstanding the downgrade to our growth forecast, we continue to believe that the biggest swing factor in gauging the growth outlook in 2009 is real estate investment in China. Under our revised baseline scenario for 2009, we envisage a significant decline of 12% (in real terms) in real estate investment by the private sector.

If, however, real estate investment were to collapse and contract by 30% in 2009, the impact would be so big that even the fiscal stimulus package in its current form and size would not be able to make up for the growth shortfall, in our view. We estimate that GDP growth would drop to 3.5% in this event. Under this bear case scenario, consumption growth would likely be significantly lower than under the baseline case, as both employment and income growth would also suffer further setbacks. This bear-case scenario could materialize if property prices were to decline continuously throughout 2009, as it would likely reinforce the buyers’ strike and destroy the investment appetite of real estate developers on a nationwide scale.

A potential upside surprise to our baseline growth forecasts may stem from a larger contribution of net exports to growth if the recession in the G3 economies is not as deep as expected and if real estate investment registers only a modest decline. Moreover, a better export performance may also induce positive investment growth in manufacturing. We estimate that China’s GDP growth could reach 7.5% under this bull-case scenario.

We assign 65%, 15% and 15% subjective probabilities to the base, bear and bull cases, respectively. Real estate investment is the biggest swing factor among the scenarios. We have argued that there is not a serious nationwide house price bubble (see Can the Property Sector Be Counted on as the Engine of Growth? September 2, 2008). Further, we attribute the slow property sales and price correction to austere measures taken against the property sector that have resulted in a nationwide credit crunch for this sector. It has been less than three months since the government decided to roll back these austere measures, so considerable uncertainty remains regarding when these policy changes could turn sentiment around. Our best judgment is that, while real estate investment will likely register an outright decline from the levels in 2007-08, the probability of a massive collapse in real estate investment on a nationwide scale is small, especially if there were to be additional policy measures to boost this sector (to be discussed below).

Real Test in 2010

We forecast 8% GDP growth in 2010. We expect the year-on-year GDP growth rate to start to moderate – after peaking in 4Q09 – over the course of 2010 toward the 6-7%Y range by end-2010; we think that this will likely be the sustainable growth rate for China over the next decade, after the global economy pulls itself out of the potentially deepest recession since WWII in 2010. The deceleration in growth rates over the course of 2010 would reflect the recovery in exports and private investment being partly offset by a smaller fiscal policy stimulus.

We are still structurally positive on the Chinese economy over the long run. We believe that the four key secular themes – urbanization, industrialization, globalization and market-oriented economic liberalization – should continue to underpin reasonably strong growth in the long run. And the relative strength of the balance sheet of the economy (e.g., government, banking system, households) should help cushion the impact of the financial turmoil in the short run (see Unscathed from Crisis; Not Immune to Downturn, October 6, 2008).

It, however, goes without saying that there is tremendous uncertainty about the outlook for 2010 for the global economy in general and the Chinese economy in particular. First, it is still uncertain whether the G3 economies can successfully stage a decent recovery in 2010, as envisaged under our baseline scenario for the global economy (see Global Economics: Risks to the Global Outlook: The Good, the Bad and the Ugly by Richard Berner and Joachim Fels, December 8, 2008).

Second, in the event that the G3 economies were to fail to recover in 2010, this would require an even stronger fiscal policy response from China, if the objective were to deliver 7-8% growth per annum. For instance, if the fiscal deficit in 2009 were to be 3% of GDP, the size of the fiscal stimulus would be 3% of GDP (assuming a balanced budget position in 2008). However, if the same size of fiscal stimulus were to be delivered in 2010, this would entail a fiscal deficit of about 6% of GDP, in our view. At some point, the authorities would have to weigh the benefits of propping up growth through public spending against the attendant fiscal and efficiency costs.

Third, prolonged global economic recession could lead to rising protectionism abroad and deviation from the path of market-oriented reform inside China, which may in turn weaken market confidence and delay any meaningful economic recovery in 2010.

Policy Calls

The authorities have made the delivering of economic growth a top policy priority by adopting a campaign-style policy execution approach. If, as we envisage, year-on-year GDP growth is 3-4% in 1Q-2Q09, we would expect additional announcements of pro-growth policy measures. At the same time, we also think that the officially set growth target of 8% in 2009 will likely be adjusted downward to reflect the evolving reality.

On the fiscal policy front, we expect the underlying fiscal deficit of the general government (including both local and central governments) would reach about Rmb1 trillion (or about 3% of GDP) in 2009 and would likely comprise of three components: regular central government budget deficit, special construction bonds issued by the central government, and special bonds issued by the central government on behalf of local governments.

On the monetary policy front, in view of the high risk of deflation, we expect benchmark interest rates to be cut aggressively by an additional 108-135bp over the course of 2009 (see A Perfect Storm for Deflation, December 2, 2008). We expect that the rate cuts will likely be symmetric (i.e., both lending and deposits cut by the same magnitude) and most probably be front-loaded in 1H09 because of the need to prevent deflationary expectations from becoming entrenched. Moreover, further progress could be made toward interest rate liberalization in that commercial banks – which are being encouraged to increase lending to the SMEs and enterprises engaged in agricultural activity – may be given more latitude to reflect price risks through differentiated interest rates.

We stand by our call that the renminbi exchange rate against the US dollar will be broadly stable in the range of 6.80-6.85 throughout 2009 (see Stephen Jen’s Currency Economics: Changing My Call on the Chinese RMB, December 2, 2008). We expect the authorities to take additional measures (e.g., VAT rebate) to help the exporters.

There could be additional policy upside to the property sector, given its critical importance in determining the economic outlook, in our view. Potential policy changes include: a) official abandonment of the stricter rule for second home mortgages; b) allowing deduction of mortgage interest payments from personal income tax; and c) potential direct purchases by the government of commercial housing (at a discount from current prices) with a view to unlocking the buyers’ strike and thus facilitating the market clearance process and increasing the supply of affordable housing.

Implications

Despite the substantial downward revision in our growth rate forecasts, our views are largely unchanged concerning the investment implications from the perspective of economic fundamentals (see again Outlook for 2009: Getting Worse Before Getting Better, December 9, 2008). As a recap, we believe that, while public-sector-driven growth will help deliver reasonably good headline GDP growth and job creation targets, it will likely be unable to deliver nearly as strong corporate earnings growth than when the same level of headline GDP growth is fueled by buoyant private sector spending. The public sector growth will likely be in a relatively 'job-rich' but 'profit-deficient' macroeconomic environment, in which bonds tend to be favored over equities. Within the equity space, we believe that sectors/companies with high earning visibility and/or those exposed to government-supported capex program will likely outperform.

However, per our revised forecasts, the headline year-on-year growth rates in the ‘getting worse’ leg of the cycle would be quite low (i.e., 3-4%Y) compared to the ‘norm’ for China that people have become used to, and this could be a shock to market participants. As a consequence, this would likely also heighten uncertainty about China’s growth potential over the long run and trigger more critical and fresh looks at the robustness of the ‘China story’, which has underpinned much of the macro-driven investment flows into China.

United States
Review and Preview
January 20, 2009

By Ted Wieseman | New York

After a bit of a reversal over the holiday period and into the first week of the year, the past week’s price action suggested that the enormous bull-flattening trend seen from Halloween to Christmas Eve might be resuming in the Treasury market, as even after a partial 10-year-led bear-steepening reversal Friday, the market posted sizable long-end-led gains on the week.  It was a heavy week for economic data and the news was dismal overall.  The outlook for consumption looks much worse after an abysmal retail sales report, the industrial sector remains in freefall, and even with what appears likely to be a big inventory drawdown in 4Q, economy-wide I/S ratios are soaring as demand is collapsing even faster than production and imports.  On the positive side, but likely only temporarily given clear indications that the global economy is in increasingly terrible shape, the recent collapse in imports has outpaced the drop in exports, so net exports don’t seem likely to be the drag on 4Q growth that we previously assumed.  But even incorporating this upside, weaker outlooks for consumption, investment and inventories led us to cut our 4Q GDP forecast to -6.5% from -6.0%, which would be one of the worst quarters on record.  And deflation also continues, with sharp declines again in both CPI and PPI that drove the latter into negative territory on a year-on-year basis in December and will likely have the former there in January.  This miserable economic backdrop, however, ended up having only limited impact on the week’s trading activity.  Much focus instead turned back to renewed worries about the state of the financial system as bank earnings reporting season got off to the expected terrible start, and the Treasury, FDIC and Fed agreed to backstop losses at Bank of America tied to the Merrill Lynch acquisition after having previously made a similar arrangement with Citigroup.  On top of a collapse in bank stocks that accounted for much of a terrible week for the overall stock market, the renewed investor worries about banks brought to an end, at least for now, what had been a major improving trend in interbank rates and spreads over expected fed funds.  The other, more targeted aspect of the Fed’s quantitative easing policy also faltered as mortgages and agencies both traded poorly on the week despite heavy Fed buying.  So it appears that even though it was seemingly fully anticipated, the reality of the ongoing disaster that is the 4Q reporting season for banks has at least temporarily halted what had been a very positive previous trend of the Fed’s new policy approach gaining major traction.  We may have to wait until we get through earnings season – with the additional negative of what will almost certainly continue to be a steady run of terrible economic data – to see whether the prior improving trend can be reestablished. 

 

On the week, benchmark Treasury coupon yields fell 5-17bp, and the curve flattened, with the 2-year yield down 5bp to 0.71%, 3-year 8bp to 1.05%, 5-year 7bp to 1.46%, 10-year 11bp to 2.30% and 30-year 17bp to 2.89%.  The biggest declines in yields were actually posted by off-the-run bonds, which have been the highest-beta part of the curve on both the upside and downside so far this year.  It wasn’t much, but there were at least some small signs that the intense squeeze at the very short end might be easing.  The 4-week bill’s yield rose 3bp on the week to 0.05%, which, incredibly, was nearly a two-month high.  The 3-month bill’s yield also eased a bit, rising 5bp to 0.12%, and repo market conditions showed some signs of normalization, with the Treasury overnight general collateral repo rate averaging 0.19% Friday and 0.14% Thursday after having run barely above zero for some time.  TIPS ended mixed on the week.  The run of huge outperformance TIPS saw initially ended on Tuesday, a week after the much-stronger- than-expected 10-year TIPS auction.  But after giving back some relatively ground, a CPI report that didn’t match the direst expectations gave the shorter end in particular a good lift Friday.  For the week, the 5-year TIPS yield fell 16bp to 1.36%, 10-year 6bp to 0.53% and 20-year 9bp to 2.27%.  Though mixed by sector, with 5s and shorter maturities outperforming and the longer end lagging nominals somewhat, considering the backdrop of collapsing commodity prices, with February oil down 14%, and rallying nominals, it was a pretty strong week for TIPS.  Meanwhile, despite heavy buying by the Fed – US$23 billion in the five trading sessions through January 14 – mortgages performed poorly outright and especially on a relative basis over the past week.  After the initial sharp gains posted January 5-6 when Fed buying began, the MBS market had been very tightly range-bound for a week.  But the market sold off to the low end of the range Thursday and then broke below it on a further sell-off Friday.  At this point, as heavy as Fed buying has been (and decent-sized Treasury buying also continues), it has recently been more than offset by sizable selling by banks and money managers lightening positions after the big MBS rally since late November and by rising origination pressures.  At Friday’s close, 4% and 4.5% MBS yields were moving up toward 3 7/8% to 4% after having held near 3 3/4% through the first part of the week.  Heavy Fed buying of agencies also wasn’t enough to prevent underperformance in that sector.  The Fed bought a surprisingly large US$3.5 billion in 4 to 9-year paper Tuesday – its biggest purchase yet on a duration-adjusted basis – but agencies lagged on the week anyway, with 5-year and 10-year agencies lagging swaps by about 10bp.  TLG debt (FDIC-guaranteed bank bonds) also saw periods of underperformance, but less so than agencies, to the point that TLG debt for the first time moved to trade rich to agencies over the past week. 

 

It was a rough week for risk markets that helped support Treasuries.  Around the time of the early bond market close, the S&P 500 was down 6% on the week, and while the losses were broadly based, it was financials that led the downside, with the BKX banks stock index down 22% on the week as of early Friday afternoon to its lowest level since mid-1995.  Credit performed poorly also, but outperformed stocks, with the investment grade CDX index trading 10bp wider on the week at 212bp Friday afternoon.  In contrast to stocks, which were on pace for their worst close since December 1, the IG index was ending the week modestly better than the recent wide close of 220bp hit Wednesday.  High yield and leveraged loans both traded off significantly, the latter more so in a return to prior form.  Through Thursday’s close, the HY CDX index was 144bp wider at 1,317bp, though the index was trading slightly higher Friday.  Meanwhile, the leveraged loan LCDX index was 235bp wider on the week through midday Friday at 1,547bp.  On the positive side for the LCDX index, it did end the week on a positive note, tightening about 50bp Friday after having widened almost 500bp over the prior seven trading sessions.  This index has had a tendency recently to run hard in one direction or the other for a while, so perhaps Friday’s bounce marks the start of an improving phase.  It was another rough week for the commercial mortgage CMBX market also, with the AAA index 144bp wider on the week at 755bp through Thursday’s close, junior AAA 131bp at 1,678bp, and AA 165bp at 2,151bp.  The AAA subprime ABX index, though, was posting a partial rebound after taking a big hit the prior week in response to a movement in Congress towards allowing judges to restructure mortgages in bankruptcies.

 

In addition to the pounding that bank stocks took, renewed fears about financial system stability was also seen in worsening conditions in interbank markets after what had been a huge and sustained improving trend over the prior few months.  After peaking at 4.82% on October 10, 3-month Libor fell to a low 1.08% Wednesday before reversing course to fix Friday at 1.14%.  The January eurodollar futures contract settles Monday, and it closed the week at 1.18%, so more upside is expected in coming days.  Though a bit off the lows, there was still a good improvement in the spot 3-month Libor/OIS spread on the week, with a decline to 96bp from 108bp.  Forward rates, on the other hand, reversed course much more sharply late in the week to post significant increases for the week as a whole.  The forward spread to March rose about 13bp for the week to near 80bp, June 12bp to 69bp, September 11bp to 61bp and December 10bp to 63bp.  On the positive side, the market is still pricing in decent improvement over the first half of the year in these key real-time gauges of current and expected strains on bank balance sheets, but clearly cautiousness about how much improvement there will be this year is rising.  Rising pessimism about Libor/OIS spread narrowing led to a decent increase in shorter-end swap spreads on the week, where the Libor/Treasury repo rate differential is a relatively more important determinant of spreads.  The benchmark 2-year spread widened 7bp on the week to 61bp and 5-year 2.5bp to 54.5bp, though the 10-year dipped 1.5bp to 15bp and the 30-year was unchanged at -18bp. 

 

Data releases the past week bearing on GDP growth continued to be negative, leading us to cut our 4Q GDP forecast to -6.5% from -6.0%.  This would be the third worst quarter in the 62-year history of the data (exceeded only by a 7.8% fall in 2Q80 and a 10.4% drop in 1Q58).  The mix of expected growth changed substantially based on the past week’s data, with a much more negative consumption outlook and worse picture for investment pointing to significantly weaker domestic conditions, but a surprisingly large improvement in the trade balance suggesting that net exports will not be the drag on growth in 4Q that we had previously expected.  With the global economy seemingly in freefall, however, it seems likely to be only a matter of time before net exports turn from the huge add to US GDP growth they were for the two years through 3Q – accounting for most of overall growth over that period – to a significant drag.  We expect that this negative swing will start in early 2009 and be a meaningful contributor to a further 4.5% plunge in 1Q GDP.

 

Retail sales dropped 2.7% overall in December and a record 3.1% excluding autos, on top of big downward revisions to November and October.  While much of the downside reflected a 15.9% mostly price-driven drop at gas stations, even excluding gasoline ex-auto sales it fell 1.5% for an 11% annualized drop over the past three months, the worst holiday shopping season on record.  Weakness in December was broadly based across key discretionary categories, including general merchandise, clothing, electronics and appliances, restaurants and furniture.  Even sales at grocery stores posted one of the biggest declines on record.  The key retail control component dropped 3.0% in December, much more than we expected, on top of big downward revisions to November (-2.4% versus -1.5%) and October (-2.9% versus -2.5%).  Incorporating these results, along with a smaller expected decline in the PCE price index after incorporating the CPI and PPI results, we slashed our estimate of 4Q real consumption to -3.7% from -1.7%.  Meanwhile, retail ex-auto inventories dropped a much-larger-than-expected 1.0% in November, pointing to a bigger inventory drag in 4Q.  New data on truck inventories also pointed to a smaller boost from retail auto inventories.  We see inventory destocking subtracting 1.7pp from 4Q GDP growth.  And with the overall business inventory sales ratio having surged from 1.23 in June, a record low, to 1.41 in November, high since the 2001 recession, inventories are a worsening problem heading into 2009 even with the expected further attempts at bringing them back in line in 4Q, which will likely continue to weigh on output into 2009. 

 

In addition to greater weakness in consumption and inventories, a terrible industrial production report pointed to worse business investment.  IP fell 2.0% in December, with the key manufacturing gauge down an extraordinarily broadly based 2.3% (the only sector not down was aircraft, which is still rebounding after the end of the Boeing strike).  Manufacturing output has now collapsed at a 19% annual rate in the past five months, one of the worst such runs in the 88-year history of the data.  Of particular note, high-tech output fell 4.1% in December on top of big downward revisions to November (-5.8%) and October (-2.3%).  Indeed, that terrible three-month run was actually much worse than over any comparable during the 2001 tech bust.  Computer investment in GDP is mostly based on computer IP figures – and the picture now looks much worse after this release.  We now see business investment in equipment and software plunging at a 24% annual rate in 4Q and overall business investment 15%.  Motor vehicle output also remained in freefall, falling another 7.2% in December.  Motor vehicle assemblies tumbled 13% to just 6.6 million units annualized, a 25-year low.  A nearly 50% annualized plunge in assemblies for all of 4Q points to a major GDP drag from this sector.  The manufacturing capacity utilization rate tumbled 1.7pp to 70.2%.  Lower readings than this have only been recorded in the 60-year history of the data for a few months during the 1981-82 recession.  There is huge slack building up in the industrial sector that will badly constrain pricing power going forward.

 

Partly offsetting the much more negative outlook for 4Q consumption, the larger likely drag from inventories, and much weaker outlook for computer investment, however, was a much-better-than-expected trade report.  The trade balance plunged to a five-year low of US$40.4 billion in November from US$56.7 billion in October, with imports collapsing 12.0% and exports plummeting 5.8%.  The majority of the import drop was accounted for by a 37% decline in petroleum products, which was mostly, but not entirely, price-related, but weakness was very broadly based, with sizable declines also in food, non-oil industrial materials, capital goods, autos and consumer goods.  The drop in exports was also across the board, with big drops in all major categories – food, industrial materials, capital goods, autos and consumer goods.  Though much of the drop in both imports and exports was price-related, real imports still plunged 6.8% and exports 3.2%.  This resulted in the real goods trade balance narrowing US$6 billion in November, a much better outcome than we expected.  As a result, we now see net exports being neutral for 4Q growth instead of subtracting 1.4pp, with real exports expected to be down 22% and imports 18%. 

 

Meanwhile, inflation measures remained in freefall, with the PPI moving into outright deflation on an annual basis and the CPI likely to get there next month.  The consumer price index fell another 0.7% in December, as a further 17% collapse in gasoline prices caused the energy component to fall 8.3%.  On a year-on-year basis, overall CPI remained barely positive at +0.1%, but should fall into deflationary territory in the coming months for the first time since 1955.  The core CPI was unchanged, lowering the year-on-year pace to +1.8% from +2.0%.  Over the past three months, the core has actually fallen at a 0.3% annualized rate as nominal demand has fallen at a pace not seen since the Great Depression in 4Q.  Meanwhile, the producer price index tumbled 1.9% in December for a 0.9%Y drop, on downside in food (-1.5%) and especially energy (-9.3%) on another plunge in gasoline prices (-26%).  The overall PPI has now fallen at a record 24% annual rate over the past three months.  The core showed some elevation, rising 0.2%, but all of the upside was attributable to the unreliable motor vehicle price figures, which gained about 1%.  Ex-autos, the core was about flat, as expected.  Clearly, it is very unlikely that actual motor vehicle prices saw such significant upside in December.  Early stage results pointed to a further collapse in pipeline cost pressures, with major declines across headline and core intermediate goods and crude materials gauges. 

 

The economic calendar is very quiet in the upcoming holiday-shortened week.  After the very heavy run of issuance from a variety of sources – Treasury, corporate, agency, TLG – to start the year, another big slug of new Treasury debt is coming with a 20-year TIPS, 2-year note and 5-year note scheduled to be announced Thursday for auction in the last week of the month.  Initial jobless claims this week will cover the survey period for the January employment report, so economists will start putting together non-farm payroll estimates.  Otherwise, the only data release of note is housing starts.  The inventory of unsold new homes remains quite elevated, and the labor market data showed ongoing weakness in the construction sector during December.  So, we look for a further 4% decline in starts in December to a 600,000 unit annual rate.  From a historical perspective, the pace of homebuilding is now so low that starts are probably very close to a bottom.  However, we don’t expect to see much of a recovery in this sector until 2010.

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