Output, Prices and Profits − The Vortex
February 05, 2009
By Richard Berner | New York
Hopes are strong that a combination of timely fiscal stimulus and a fix for the financial system will end the US and global recession and promote recovery. Eventually, we think they will, but there are three major hurdles.
First, only 20% of the $819 billion fiscal stimulus package moving through the Congress will occur in FY2009, much of the spending and tax cut thrust will be deferred into 2010 and 2011, and it would be difficult to accelerate the spending. Second, any plan to clean up lenders’ balance sheets, mitigate mortgage foreclosures and recapitalize lenders will also take time. Encouragingly, the Fed’s January Survey of Bank Lending Practices suggests that banks stopped tightening their lending standards last month. But credit is still tight. For example, “only” 47.5% of respondents (on a weighted-average basis) reported tightening their mortgage lending standards last month versus 79% in July, and an index of willingness to lend to consumers bounced to -16% from -47.2% in October. But both readings still indicate a bigger credit crunch than any in the survey’s history, and the cumulative impact of past tightening is still working its way through the economy with a lag. Finally, and reflecting that lag, declining output, prices, and profits are connected in a vicious circle that is unlikely to abate soon. Pricing power is dwindling and margins are shrinking, in turn weakening corporate credit quality, access to credit, and capital spending. Although GDP declined by a less-than-expected 3.8% in the fourth quarter of 2008, the upshot is that we expect the economy to weaken further through the first half of 2009. Details follow. Fourth quarter GDP data reveal that inventories are top-heavy in relation to sales, implying near-term downside risks to production and thus employment. Demand fell much faster than output in the final quarter of 2008, strongly suggesting an unwanted buildup of inventories that companies will have to work off in the first half of 2009. Real final sales in the fourth quarter tumbled at a 5.1% annual rate, while inventory accumulation contributed 1.3 percentage points to growth. Consumption, business fixed investment, and residential construction all posted huge declines. The ratio of inventories to sales for nonfarm business also signals inventory excess: The ratio rose to 3.63 in the fourth quarter, a three-year high. That jump corroborates our estimates of a sharp rise in inventory-sales ratios from monthly manufacturing and trade data. With pressure still on demand, the required liquidation of those unwanted inventories will likely shave an extra percentage point from the change in first quarter real output, and a half a point from GDP in the second quarter. Tentatively, we estimate the change in Q1 and Q2 GDP at -5.5% and -2%, respectively, compared with -4.5% and -1.5% previously. Some believe that just-in-time inventory management has kept stocks so lean that they will melt quickly with only a modest sales turnaround, thus promoting a production snapback. We agree that JIT has promoted a secular decline in I-S ratios over the past twenty years and limited inventory excesses, moderating business cycles compared with the past. The problem this time around, however, is that the credit crunch is still hurting sales globally. And even if sales stabilize, credit constraints and falling prices have made the real cost of carrying inventories prohibitive. The message: JIT has not eliminated inventory or business cycles; they still call the tune for recession and recovery. So liquidation seems likely to persist for at least the next few quarters and will likely linger even after demand stabilizes. Fourth-quarter data also suggest rapidly dwindling pricing power. The sharp plunge in energy and material prices has brought headline inflation down around the world, and that’s true for US GDP prices as well: US output prices were flat in the fourth quarter, and the price index for gross domestic purchases (gross demand excluding net exports) plunged at a record 4.7% annual rate in Q4. In addition to energy and materials, the collapse in global demand is grinding down pricing on a broader front, reinforcing our view that deflation, not inflation, is the bigger risk for now. In fact, despite admirable capital discipline by firms that limited growth in capacity over the recent expansion, pricing power is now deteriorating as operating rates are sinking and output gaps are widening − just the reverse of our call earlier this decade for a rebirth of pricing power. We based that call on the idea that ‘capital exit’ would eventually promote a better balance between supply and demand. That will happen again, but it will take time. Meanwhile, US manufacturing operating rates have plunged to just over 70%, or quarter-century lows. We expect that the output gap − the difference between actual and potential output, now at 3.7% of GDP − will move to 7% over the course of 2009. That economic slack will further pressure the price of US output, which matters for earnings. By category of demand, the price deceleration excluding food and energy extends to consumer spending, housing, and exports. Ironically, plunging prices have boosted estimates of output but hurt profits. That’s because sharp declines in energy and materials quotes hid unwanted stockbuilding (which added to real output) as sales plummeted. Specifically, those price declines depressed the book value of inventories, which encompasses the volumes and value of stocks held at a point in time. In effect, capital losses on inventories, which reduced their book value and which show up in the inventory valuation adjustment (IVA), masked a swing from liquidation in the year ended in Q3 2009 to unwanted accumulation in Q4. Specifically, the book value of nonfarm inventories tumbled by $266.2 billion in Q4, while nominal nonfarm inventories − purged of the IVA − rose by $41.7 billion. The swing in the IVA also hurt profits: Weaker pricing depressed nominal top-line sales, squeezing margins and promoting losses on inventories acquired at the peak of the global boom. The real story is one about margins: In our view, the combination of recession and high operating and financial leverage in Corporate America is toxic for margins and earnings. Operating leverage is working in reverse, with decreases in revenue going right to the bottom line. In addition, slower growth has crushed operating rates and reduced pricing power, which drops straight to the bottom line. For some companies, costs for energy, materials, commodities, and imported goods are falling, offering some margin relief. But the plunge in inventory profits − already dramatically underway in Q4 − may subtract 500-700bp from earnings in the year ended Q2 2009. Financing the boom with debt and buying back stock increased financial leverage and, of course, raised ROEs and earnings per share. Our strategy team estimates that corporate buybacks may have added 250bp to S&P earnings gains in 2006, a whopping 300bp in 2007, and 87bp in 2008. Now, losses on credit extensions at both financial and nonfinancial companies is squeezing margins further, and the deleveraging of Corporate America is reducing ROEs and EPS. A global recession is weakening US top-line sales by undermining exports and is eroding the bottom line at US affiliates abroad. Measured in the NIPAs, earnings of US affiliates abroad have already slowed to 5.1% over the year ended in Q3 2008 and could decline by a similar amount by the middle of next year. Such earnings amounted to a record 37% of overall earnings in the third quarter of 2008; S&P measures show a similar share. That’s double the share of twenty years ago, so the impact of a global recession on US earnings today has similarly doubled. Likewise, the stronger dollar, if sustained, could depress US earnings through two channels. First, foreign earnings will soon be translated into fewer dollars. On a broad, trade-weighted basis, the dollar has jumped by 12.7% from a year ago, and our empirical work suggests that such a rise would reduce US earnings from abroad by at least 3% and as much as 6%, the latter cutting overall earnings by 150bp. In addition, both global recession and a stronger dollar will hurt US companies trying to recapture market share. A sharp deterioration in corporate profitability, in turn, is eroding credit quality, access to credit, and capital spending. Key credit quality metrics − such as interest coverage − are coming under pressure as earnings fade and investors question borrowers’ ability to stay current. Together with rising defaults and the fear of limited recoveries in the event of default, slipping earnings have made lenders and investors wary. And of course, sliding cash flow and the factors promoting the declines are squeezing capital spending, as companies struggle to cut costs and conserve resources. One more macro risk keeps us awake at night: Recessions always raise the threat of protectionism, and the threat of barriers to trade and capital flows this time may be especially high. Globalization has knit economies closer in the past two decades, bringing benefits for consumers but pressure on companies and workers in developed markets. Efforts to protect old jobs rather than create new ones would prolong the global recession, hobble productivity and raise the specter of stagflation. Signs of incipient protectionism and trade tensions are rising: Some EM countries have raised employment barriers. Officials in various countries have discussed directing credit from institutions that receive government assistance to domestic borrowers only. The US stimulus package contains Buy American clauses. And US officials are revisiting the question of whether China is manipulating its currency. None of these creates a favorable backdrop for financial markets.
Important Disclosure Information at the end of this Forum
Good Deflation Isn’t a Cause for Concern
February 05, 2009
By Elga Bartsch | London
Lower Inflation Estimates, Not Concerned About Deflation Three factors cause us to lower our inflation forecasts by more than a full percentage point over our forecast horizon of 2009 and 2010. A combination of a new oil price assumption (see Global Oil Outlook, The Global Engine, Stalled and Flooded, February 2, 2009), a forecast for a stronger EUR (see FX Pulse O-Nine, Rise ‘n Shine, January 8, 2009) and a downside surprise in the January HICP flash estimate cause us to expect HICP inflation to average 0.5% this year, instead of 1.1% before. Based on these external assumptions, HICP inflation will likely turn negative between June and August of this year. If confirmed by official data, this would mark the first time ever that the euro area as a whole posts a negative year-over-year print for inflation (both on the official area-wide time series starting in the early 1990s and on aggregated country data going back to 1970). Negative inflation rates will likely reinforce near-term deflation concerns among investors – even though break-even inflation rates have bounced off their lows recently, on the back of quantitative easing giving rise to inflationary concerns over the longer run. Next year, we see inflation moving back up towards the ECB price stability norm and project an average inflation rate of 1.6%. Sharp Fall in Inflation Is Positive for the Euro Area In our view, the sharp fall in inflation is positive because what the euro area is likely to experience is ‘good’ deflation rather than ‘bad’ deflation. It is mainly due to external factors, most notably a sharp fall in commodity prices. It is the economic drivers behind the fall in the overall price index that matter in gauging the deflation risks, not the time-frame over which inflation might be negative or the extent to which inflation might dip into negative territory. On our estimates, the main factor dampening inflation this year is the price of (imported) oil and oil products. Our commodities team expects crude oil prices to fall by an average 60% or so this year once they are translated into euros. According to their forecast profile, the price of Brent oil will likely reverse from a peak of 85 EUR pb recorded last summer to just 20 EUR pb by early summer. As a result, the euro area’s import bill will shrink considerably and a much smaller amount of euro area income will be transferred to oil exporting countries. To the extent that the fall in oil prices gets passed on to end-users, falling energy prices will cut the energy bills of both consumers and corporates, thus providing a very welcome relief in tough times. Hence, for now, deflation is likely to lend support to domestic demand in the euro area. Lower Oil Import Bill Helps to Support Euro Area Income Based on our new oil price forecasts, the sharp fall in oil prices will likely cause the transfer of income from the euro area to oil exporting countries to fall by more than 0.8% of Euroland GDP (or EUR 73 billion). Not all of the fall in crude oil prices will benefit end-users, notably consumers, though. Some of it will benefit energy companies all along the supply chain – many of which still are subject to some regulation as far as retail energy prices, notably utility bills, are concerned. On our estimates, at the end-use level, lower energy prices will shave a little more than one percentage point off overall inflation, thus causing a big swing in headline HICP inflation from an average 3.3% last year (when higher energy prices added a similar amount), to merely 0.5% this year. The sharp fall in energy prices at the consumer level alone provides a sizeable cushion of around 1.1% to real disposable income this year – a cushion that will come in handy to soften the blow of protracted job losses, lower wage inflation and tighter financing conditions. Consumers and Corporates Benefit From Lower Prices Consumers are not the only ones to benefit from lower energy bills though. Companies will likely benefit too. Beyond the near-term cost savings in the corporate sector, the division of the long-run benefits of lower oil prices between consumers and corporates crucially depends on the adjustment in wages. Here, institutional factors such as the degree of wage indexation, the generosity of unemployment benefits and other factors determining the wage-setting mechanism play an important role. Note that these factors might vary considerably between different euro area countries. In the extreme case, where lower consumer price inflation would eventually translate fully into lower nominal wage increases, consumers would only temporarily benefit from falling oil prices (i.e., until their wages adjust, which typically happens over a 12-month cycle). In the long run, real wages will be completely stable and corporates would see their profits boosted considerably, causing investment spending and employment levels to rise. The short-term rigidity in nominal wages, which typically only adjust when annual wage contracts get renewed, implies that in the near-term corporates won’t be benefitting as much. We estimate that of the EUR 73 billion windfall from lower oil prices for the euro area, eventually about EUR 48 billion (around 60%) will accrue to consumers, while the remaining EUR 24 billion (40% of the total) will fall to corporates. Lower Oil Prices Are Good for 2009 GDP Growth Hence, at the margin, the new oil price assumptions would introduce some upside risks to our 2009 GDP growth estimates. As a rough rule of thumb, the impact on GDP growth is about half the size of the impact on inflation. Hence, these upside risks could potentially add up to half a percentage point between now and the end of 2010. But for now we intend to keep our powder dry. For one because we believe that these potential upside risks could be offset by what might turn out to be a more marked contraction in activity this winter. With the release of the 4Q GDP reports just a week away, we rather wait for these key reports before fine-tuning our full-year GDP estimates. Hence, we leave our Euroland growth forecasts unchanged at -1.6% for this year and at 1.1% for next year. The lower oil price assumption and the resulting downward revision to our inflation forecasts also reinforces our forecast of consumer spending in the euro area holding broadly steady his year. Such robustness in consumer spending would set the euro area apart from many Anglo-Saxon countries. Deflation Is Unlikely to Be a Problem Over the Medium Term Externally caused deflation could become a concern if the fall in the overall price level starts to spill into lower wages, profits and incomes. The likelihood of this happening is much more a function of the length and depth of the current recession than of the near-term fall in consumer prices. In other words, it is the shape of the recession that determines how much of a hit the labour market is going to take over the forecast horizon. Typically, in the euro area there is a rather long time-lag of around two years between a rise in the unemployment rate and a decline in wage inflation. Many elevated pay packages agreed on in the second half of 2008 will be relevant for wage inflation in 2009. Together with a sharp cyclical slowdown in labour productivity growth, these pay increases will likely send unit labour costs much higher (see detailed forecast table at the end of the full report). In our view, this will limit the decline in core inflation this year. Furthermore, the capacity utilisation rate in the euro-area industrial sector has only just started to fall below its long-term average. Similarly, the euro area output gap – a broad measure of the resource utilisation in the economy defined as the ratio between actual output and potential output – has only started to dip into negative territory around year-end, we think. An unemployment rate that remained below the natural unemployment rate until now also suggests that the downward pressure on underlying inflation is only just beginning. This downward pressure is typically very moderate in the euro area. On our estimates, any 1% shortfall in GDP eventually shaves 0.15% off the HICP (see Euroland Economics: The Long Shadow of the Energy/Food Spike, May 19, 2008). ECB Unlikely to Be Concerned by Negative Inflation Thus, we don’t believe that the ECB will be overly concerned about a couple of negative inflation prints over the summer, and leave our target for a trough in the refi rate unchanged at 1%. But, we now expect this trough only to be reached in the course of the second quarter, given that the Bank is likely to stand pat on interest rates this week. Note that further refi rate cuts below 1% will not make much of a difference as far as the EONIA overnight rate is concerned (see EuroTower Insights: ECB to Enter ZIRP, January 7, 2009). What could potentially make much more of a difference is a commitment by the Bank that it intends to leave interest rates at rock-bottom levels for an extended period of time. However, such a commitment is unlikely to be the consensus view of the Council at this stage. Instead of coincident headline HICP inflation, the ECB will likely focus on a broad range of indicators in gauging whether deflation is a serious risk in the euro area – most notably the inflation outlook over the policy relevant horizon of 12 to 18 months. The ECB’s own inflation forecasts, which are based on forward contracts, will likely show a somewhat higher profile than ours. Rather than the very volatile inflation profile over the course of this year, we believe that the Bank’s interest rate decisions will likely depend crucially on any signs of a credit crunch in the euro area materialising. Here, alternative policy options in the context of fiscal policy stimulus and financial rescue packages are key in fending off a potential credit crunch and in stabilising economic activity in the months ahead. Downward Pressure More Protracted in Some Countries While disinflation, or even short-lived deflation, would be welcome at the euro area level, the situation might be more nuanced for individual countries. Some countries piled debt much higher than others over the last ten years, making them potentially more susceptible to the danger of debt deflation. In addition, some countries also are likely to weather the present downturn worse than others. Last but not least, we have seen divergent price developments at the country level over the last ten years. In fact, it seems that a number of countries, which saw strong domestic demand growth over the last decade (often fuelled further by asset price appreciation and rising private-sector debt), are also the ones that outpaced the euro area as a whole in terms of the rise in core consumer prices. Clearly, within the monetary union it is not possibly for individual countries to inflate their way out of the debt burden (see Euroland Economics: How Much Traction the Policy Action, January 21, 2009). Many of the high debt nations actually need to do the opposite, i.e., to regain price-competitiveness by sporting a below-average inflation rate for a number of years. Such periods of relative disinflation have already been experienced in countries such as Germany, the Netherlands and Finland in the past. And they now seem to be starting in Portugal and Ireland. Again, we would aim for ‘good deflation’ due to structural reforms improving the supply-side, rather than ‘bad deflation’ through denting domestic demand.
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.
Global Research
Conflict Management Policy
Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.
Important Disclosures
Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.
Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.
As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.
|
![](/img/clear.gif"){kind=spacer}