United States
Review and Preview
March 03, 2009

By Ted Wieseman | New York

Treasuries were pounded by an unprecedented flood of $94 billion in coupon supply over the past week, with the belly of the curve taking heavy losses, even as economic data remained uniformly abysmal, the stock market fell to new lows, and other risk markets mostly also deteriorated to varying extents, with a severe correction in commercial real estate particularly disturbing.  Investors in risk markets appear to have largely lost faith in the government’s ability to revive the economy or financial system, while investors in Treasuries expect the government will continue to spend ever increasing amounts of money trying to do so to little effect, keeping issuance at its record, shattering recent rates.  Certainly nothing happened over the past week to raise investors’ confidence in government policy.  We’ve still heard nothing more about the bad bank plan, massive tax increases including on dividends and capital gains were announced in the middle of an equity market severe correction and what will likely end up being the worst recession since the 1930s, the new ‘Capital Assistance Program’ to buy convertible preferred stock in banks had punitive terms that made it unlikely any company would want to participate that wasn’t forced to as a result of failing its stress test, the latest effort to support Citigroup was terribly received by the market, and there’s still no TALF, so the February timeline for implementing this program announced months ago has now been missed. 

As bad as the economic data were − a revision in GDP to one of the worst quarters on record in 4Q, collapsing capital goods orders and shipments and home sales continuing to point to about as bad an outcome for 1Q, consumer confidence plunging to a record low, jobless claims hitting more new highs ahead of the employment report, and regional manufacturing surveys showing uniform weakness ahead of the ISM report − they were almost completely ignored by the market. Investors already fully recognize the severe ongoing economic downturn and see no end in sight, so economic data that confirm that view − as pretty much everything we saw the past week did − are as expected.  It was somewhat more surprising that the Treasury market was unable to find any meaningful support during such a disastrous week for the stock market, but the overwhelming supply appears to be providing too much offsetting pressure at this point.  The seemingly clear solution to this disconnect is for the Fed to start buying Treasuries in large amounts, but there have been no indications that such a shift in policy is imminent even as the weakness in Treasuries continues to completely frustrate the Fed’s efforts to bring down mortgage rates through heavy MBS purchase, as MBS yields hit their highest levels since early December after a terrible week.  The bill sector, on the other hand, did see strong gains on the week (and the short end of the coupon market outperformed) to send very short-end yields to their lowest levels in some time, so money fleeing risk assets for cash did at least boost this part of the market.  There’s no let up in the supply flood, as Treasury prepares to announce on Thursday another heavy round of issuance of 3s, 10s and 30s for sale during the week of March 9.  The key round of early economic releases for February are also scheduled to be released in the coming week − employment, the ISM surveys, motor vehicle sales and chain store sales − and they are likely to continue to be terrible across the board, so the market will likely again face a week in which it has to balance supply pressures against grim fundamental news, a battle that supply pressures easily won over the past week.

On the week, benchmark Treasury coupon yields rose 4-27bp, with the belly of the curve leading the losses as the market priced a big concession for the arrival of the revived 7-year note, while the short end received relative support from the stock market plunge and the long end received some support from month-end index duration extension-related buying.  The old 2-year yield rose 4bp to 0.98%, 3-year 10bp to 1.40%, old 5-year 19bp to 1.98%, 10-year 27bp to 3.035% and 30-year 16bp to 3.72%.  The flight to safety and out of risk assets that helped the 2-year outperform was more pronounced at the very short end, with the 4-week bill yield falling 3bp to 0.15% and 3-month 2bp to 0.26%, lows in about a month.  TIPS were mixed.  The shorter end did relatively well as oil and other commodity prices rebounded somewhat, but the longer end performed terribly.  The 5-year TIPS rose 18bp to 1.28%, 10-year 41bp to 2.03% and 20-year 32bp to 2.54%.  Long-end TIPS yields have moved up to levels that have until recently proven attractive to investors, so we’ll see if the recent cheapening renews interest in coming days after steady selling over the past week.  Mortgages had a terrible week, sending yields on current coupons through their prior highs of a few weeks back to new peaks since early December.  4.5% MBS are now trading only about a quarter point above par, so yields are approaching 4.5% after having traded below 4% in early January when the Fed began its MBS purchases.  4% MBS have plummeted 3 points from those early January peaks to move from a price above 101 to only just above 98 now.  The largely supply-driven pressure on Treasury yields has thus completely foiled the Fed’s efforts to bring down mortgage rates despite very heavy buying of MBS that has run at around a $5-billion-a- day pace for nearly two months now.  Sentiment towards agencies, at least, has taken a notable turn for the better recently.  The White House has indicated that it is considering fully incorporating the results of Fannie Mae and Freddie Mac within the federal budget, which would obviously create a quite explicit link between them and the Treasury after some previous concerns about how firm the Treasury backing of agency debt was.  Renewed confidence in Treasury’s backing of agency debt contributed to very strong demand for a record new issue for a second straight week, a $15 billion 2-year the past week after the $10 billion 3-year the prior week.  Weakness in mortgages and worsening conditions in interbank markets contributed to significant widening in swap spread.  The net move on the week was minor, but 3-month Libor continued gradually drifting higher, setting Friday at 1.26%, high since early January.  The spot 3-month Libor/OIS spread ended the week near 100bp, and significant widening in forward spreads pointed to no improvement over the course of this year, with the forward spreads to March, June, September and December all ending the week close to the current 100bp spot level. 

The past week’s Treasury sell-off came not only in the face of terrible economic data but also as the stock market fell to new lows and other risk markets mostly suffered to varying extents.  For the week, the S&P 500 plunged 4.5% to its lowest close since 1996, bringing the year-to-date decline to 19%.  Although there were some obvious glaring exceptions, financials actually performed relatively well for the week amid very high day-to-day volatility, with the BKX banks stock index gaining 11%.  Although market reaction to the President’s budget was quite negative, with healthcare stocks in particularly taking a beating in response, financials were helped by the suggestion that the White House might request a doubling of the initially allocated $750 billion in TARP funds.  Instead of the usual financial-led weakness, it was more cyclical sectors, especially industrials that led the latest week’s stock market sell-off in addition to the plunge in the healthcare sector.  Credit also had a rough week.  In late trading Friday, the investment grade CDX index was 13bp wider on the week at 225bp.  This would be a new-wide close since mid-December, but would still leave the index a good bit better than the 280bp all-time wide hit November 20 even as stocks have broken to multi-year lows.  High yield, on the other hand, has performed more in line with the equity correction.  The HY CDX index was 3bp tighter on the week through Thursday at 1522bp, but a sell-off of nearly a point on Friday was putting on pace to move through the prior all-time wide of 1546bp hit November 21.  Two areas that had been getting pounded up through the end of the prior week moved in opposite directions in the latest week.  The leveraged loan LCDX index rebounded, tightening 201bp to 2014bp through midday Friday to obviously far outperform HY CDX.  The year-to-date performance of this index remains terrible − it closed 2008 at 1303bp − but at least the recent severe correction has at least temporarily stopped.  Not so for much of the similarly struggling commercial mortgage CMBX market.  The highest rated CMBX indices did manage to stabilize − the AAA widened 3bp to 703bp and the junior AAA tightened 6bp to 2038bp − but the lower rated indices remained in freefall, with widening for the week ranging from 257bp by the AA to 591bp by the BB-.  Like the LCDX index, all the CMBX indices remain deeply under water for the year, so if things don’t turn around in March, we think there could be another round of ugly mark-to-market losses by banks on commercial real estate and leveraged loan portfolios. 

Economic data released the past week were uniformly terrible, with the economy on pace to show its second worst two-quarter contraction since the Great Depression in 4Q and 1Q and with no signs emerging of any looming improvement.  Fourth quarter GDP growth was revised down to -6.2% from -3.8%, the fourth-worst quarter since the Great Depression, with bigger drops only recorded in 1982, 1980 and 1957.  Final sales were revised down to -6.4% from -5.1%, and final domestic demand to -5.7% from -4.9%, larger-than-expected adjustments.  The surprise was a bigger-than-anticipated downward revision to consumption to a disastrous -4.3% from -3.5%.  Coming on top of a 3.8% fall in 3Q, this marked the second worst two-quarter performance in the post-war period, and the only worse two-quarter showing, in 1980, was almost entirely concentrated in one of the two quarters.  We've never before seen two straight quarters in which consumption declined near 4% annualized.  Inventories were also adjusted down substantially from the bizarre surge initially reported, now adding 0.2pp to growth instead of 1.3pp.  This was a somewhat bigger downward revision than we expected, which suggests a slightly smaller inventory drag in 1Q.  However, inventories entered 2009 badly bloated across the economy, so inventories are likely still to be a big negative for growth in the first part of this year.

The GDP revision showed that business investment plunged 21% in 4Q and the equipment and software component 29%, and a terrible durable goods report pointed to a similar rate of contraction in 1Q.  Durable goods orders plunged another 5.2% in January, with nondefense capital goods ex aircraft orders, the key core gauge, plummeting 5.4% on top of a downwardly revised 5.8% drop in December.  Core capital goods orders have now fallen at an unprecedented 37% annual rate over the past six months, with a particularly severe collapse in machinery bookings over this period.  Core capital goods shipments plunged 6.6% in January after a downwardly revised flat reading in December, pointing to another severe decline in equipment investment again in 1Q after the plunge in 4Q even with a likely sharp post-strike 1Q rebound in aircraft investment.  We see equipment and software investment falling 26% in 1Q and overall business investment 22.0%.  These results would be substantially worse than we previously expected.  With a marginal positive offset from the slightly bigger-than-expected downward revision to 4Q inventories (though we still see inventories subtracting 1.5pp), we now see 1Q GDP growth running at -5.9%, down from our prior -5.0% forecast.  Coming on top of the 6.2% plunge in 4Q, this would represent the second worst two-quarter contraction in the economy since the 1930s, exceed only modestly by a severe six-month downturn in 1957-58 that was badly exacerbated by an auto strike. 

Meanwhile, the housing market remains a complete disaster.  At least the plunge in new homebuilding has been so severe that residential investment is a nearly negligible component of GDP at this point, so the likely further severe weakness in housing starts won’t have much additional direct impact on GDP growth.  New home sales plunged 10.2% in January to a record-low 309,000 units annualized.  Even with the number of homes available for sale down another 3.1%, a twenty-first consecutive decline to a six-year low, the far bigger drop in the sales pace caused months’ supply on unsold new homes to spurge to another record high of 13.3 from 12.2, severely above a more normal level near 5 to 6 months.  It’s hard to see any prospect of a floor on already record-low housing starts with inventories so out of control.  Meanwhile, existing home sales fell 5.3% in January to 4.49 million units, low since 1997.  Inventories of unsold existing homes rose to 9.6 months from 9.4 months as foreclosed properties continue to flood the market, making up nearly half of January’s sales.

There’s a very busy economic calendar in the coming week as well as more heavy supply news.  Treasury on Thursday will announce a new 3-year and reopenings of the 10-year and 30-year issue for auction the following Tuesday through Thursday.  We’re looking at a $2 billion increase in the 3-year to $34 billion, $2 billion increase in the 10-year reopening to $18 billion, and a $10 billion first reopening of the long bond for total gross issuance of $62 billion.  This would bring gross coupon issuance in just the one-month period starting with the February refunding auctions to an astounding $223 billion.  That amount of issuance in just one month would amount to nearly a third of total issuance in all of F2008, which was itself already nearly a record year.  Key data releases due out include personal income, manufacturing ISM and construction spending Monday, motor vehicle sales Tuesday, nonmanufacturing ISM Wednesday, chain store sales, revised productivity, and factory orders Thursday, and the employment report Friday:

 

* We forecast a 0.3% decline in January personal income and a 0.4% rise in spending.  The employment report pointed to another dip in personal income.  Meanwhile, a bizarre rise in retail control – that seems totally at odds with company reports – points to the best gain in consumer spending since 1H08.  Finally, our translation of the CPI data points to a 0.1% outcome for the core PCE in January (+1.6%Y versus +1.7% in December), with the headline PCE expected to come in at +0.2%.

* We expect the ISM to fall to 34.0 in February.  The regional results showed deterioration in factory activity during February across the country.  Thus, we look for a partial reversal of the rebound to 35.6 that was seen in January.  The key orders and production components are expected to show noticeable slippage.  Indeed, we would anticipate an even sharper drop in the headline diffusion index were it not for a likely rise in the inventory category.  Finally, the recent uptick in energy prices points to some further recovery in the price gauge – even though it is likely to remain at a very depressed level from a longer-run standpoint.

* We look for a 1.6% decline in January construction spending.  The latest plunge in housing starts points to another significant drop in residential activity.  Meanwhile, the nonres and public categories are also expected to register declines as colder-than-usual temperatures across much of the nation during the month should reinforce the downside associated with deteriorating economic fundamentals.  Note that it will probably take several months before we see any noticeable support for state and local government construction activity tied to the recently enacted fiscal stimulus legislation.

* We expect motor vehicle sales to fall to just 9.0 million units annualized in February, as industry reports suggest that sales slowed further in February relative to the 9.5 million unit pace seen in January.  Cleary, very weak consumer confidence and tight credit conditions represent significant headwinds for the motor vehicle industry at this point.  Indeed, it looks like January and February will show the first back-to-back sub-10 million unit sales paces since 1982. 

* We look for 4Q productivity to be revised down to -0.5% and unit labor costs up to +5.8%.  The revised GDP data point to a significant downward revision to 4Q productivity and a corresponding upward adjustment to unit labor costs.  Indeed, the measure of output that is relevant for the calculation of productivity and costs was cut to -8.7% (from -5.5% in the initial report).  This would put the year-on-year growth rate at +1.8% − almost a full percentage point below that previously reported.  Meanwhile, unit labor costs appear to be running at +1.8%Y.

* We forecast a 2.0% decline in January factory orders.  A modest gain in nondurables after an unprecedented collapse over the prior five months as a result of a bounce in energy prices should provide some offset to the plunge in durable goods orders but still leave overall factory orders down substantially for a sixth straight month.

* We look for February nonfarm payrolls to plunge 625,000, a slightly larger decline than in recent months.  In particular, the retail trade sector, which was supported by friendly seasonal adjustment in January, is expected to post a much larger fall-off this month.  Also, continued significant declines are likely in sectors such as manufacturing, construction and temp help.  In percentage terms, our estimated February payroll decline would be the largest since May 1980.  Meanwhile, the jobless rate is expected to jump to 8.0% (versus 7.6% in January), as the employment decline should continue to more than outweigh another significant drop in the participation rate.  Finally, a shift in the composition of workers – as opposed to wage inflation – is expected to lead to another moderate rise in average hourly earnings.

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Brazil
Fiscal Slide
March 03, 2009

By Marcelo Carvalho | Sao Paulo

Brazil’s recent fiscal deterioration can prove a harbinger of things to come. True, Brazil’s public sector net debt is lower than in the past, and debt dynamics today are much less vulnerable to currency devaluation. However, fiscal accounts remain sensitive to growth. As recent numbers are beginning to illustrate, the growth downturn can seriously dent tax revenues at a time when public sector spending seems unlikely to be cut back sharply. 

The end result: fiscal accounts can worsen well beyond official targets in 2009. The so-called primary surplus could slide towards zero. True, aggressive monetary easing can alleviate the burden of fiscal interest payments. Still, Brazil’s overall budget deficit looks set to worsen more than observers seem ready for. Debt sustainability is far from any immediate threat. But fiscal deterioration can eventually unearth concerns on remaining long-term, structural fiscal challenges.

Growth Matters

Recent tax revenues take a sharp downturn with the economy. Federal tax revenues had grown at an average nominal pace of 16.3%Y during January-October last year.  However, on the heels of a weakening economy, the federal tax expansion slowed to 4.4% in November, then to 0.9% in December, and to -1.8% in January – the first outright negative nominal year-on-year tax reading since August 2001.  In real terms (adjusted for inflation), the tax decline in January deepens to -7.3%Y. 

Likewise, the public sector’s fiscal budget is worsening. Brazil’s headline fiscal concept is the so-called public sector ‘primary’ fiscal balance, which excludes the burden of interest payments. Brazilians call the ‘nominal’ fiscal balance what elsewhere is known as the budget balance. Brazil’s primary surplus ended 2008 at 4.1% of GDP. That was already down from a 4.6%-of-GDP peak in the 12 months through September. The 12-month trailing sum then weakened further, to 3.6% of GDP in January, sliding already below the official 3.8% target for the full calendar year. Although late approval of the 2008 budget may have distorted the 12-month cumulative readings, there is little doubt about the likely underlying direction of fiscal accounts for coming months, in our view.

Brazil’s fiscal revenues seem more sensitive to growth than is often realized. Growth abundance went a long way to boost fiscal revenues in recent years. Abundance came in many forms, including booming international trade flows, expanding domestic formal labor markets, rising corporate profits, IPO-linked gains, and oil-related royalties. Unhappily though, virtually all revenue tailwinds blowing in favor of Brazil’s fiscal revenues during recent years now seem to morph into headwinds. 

If anything, the risks would appear biased to the downside. If recent history is any guide, our below-consensus forecast for zero real GDP growth in 2009 would suggest that growth in real federal tax revenues could slump into high-single-digit declines, in the year-on-year comparisons. And we fear that our zero real GDP growth forecast could soon start looking optimistic (see “Brazil: Growth Black Swan”, EM Economist, February 20, 2009). As a very rough rule of thumb, each one percentage point reduction in real GDP growth might sap fiscal revenues to the tune of almost one percentage point of GDP, all else constant.

In addition to the growth downturn, discretionary tax breaks can hurt fiscal performance too. Indeed, the authorities have already announced a variety of tax breaks in order to support the economy, including an IPI tax break on car manufacturing, lower IOF taxes on financial transactions and reduced effective income tax rates. The measures announced so far add up to R$18.3 billion in tax exemptions, or 0.6% of GDP. Looking ahead, growth recession suggests that pressures for further tax breaks are more likely to increase than to subside.

In turn, sharp spending cuts seem unlikely. In previous crises, under intense market pressures, the authorities typically would tighten the fiscal belt by curbing spending, in order to preserve the fiscal targets despite falling tax revenues. However, market pressures for fiscal restraint now seem much less than in the past, for at least two reasons. First, Brazil’s debt dynamics are in much better shape than ever before. Second, fiscal spending has become much more fashionable everywhere else in the globe these days. 

We assume fiscal spending simply continues to expand at the average pace seen in recent years. There is no need to assume any dramatic spending spree – given the likely significant downturn in revenues, simple extrapolation of spending trends from recent years is enough to substantially erode the fiscal bottom line. On the other hand, recent policy decisions such as a generous minimum wage hike (which boosts social security expenses) do not support the notion that a major cutback in fiscal spending is under way. While the authorities may temporarily ‘freeze’ some budget spending items, a permanent downshift in expenditures should not be taken for granted. International evidence indicates that dynamics ahead of elections rarely strengthen incentives for fiscal rectitude – and Brazil faces presidential elections in October 2010.

In the end, the primary surplus may fall well below the 3.8%-of-GDP official target in 2009, for the first time in many years. Under some assumptions, the underlying primary surplus can actually vanish this year. True, new accounting mechanisms could ‘enhance’ the headline fiscal numbers. For instance, resources directed to a sovereign wealth fund were already counted as spending last year, but could effectively be spent this year. That can amount to about 0.5% of GDP. Another 0.5%-of-GDP help can come from the ‘pilot investment program’ – an arrangement agreed with the IMF many years back. In this scheme, some public expenses classified as investment would not officially count as primary spending. In all, accounting arrangements may make the headline fiscal numbers look better, but do not change economic reality.

Monetary Easing Does Not Save the Fiscal Day

Falling interest rates help partially mitigate – but do not prevent – overall fiscal deterioration. Our forecast does assume aggressive monetary easing. We expect the policy interest rate to fall by a total cycle of 400bp from peak to trough, to 9.75% by mid-2009. Falling rates help the fiscal accounts. The fiscal burden of interest payments stood at 5.6% of GDP in 2008. This burden could fall to about 4% of GDP in 2009, in our computations. But if the primary surplus worsens from 4.1% of GDP in 2008 to zero in 2009, the resulting overall nominal balance still deteriorates, from a deficit of 1.5% of GDP in 2008 to a deficit of 4.0% of GDP in 2009. In other words: aggressive rate cuts only partially mitigate fiscal worsening coming from a shrinking primary surplus. The upshot: the nominal budget deficit will worsen. 

Off-budget decisions can also entail fiscal costs, if not always explicit or transparent. Many Brazil observers often miss this point. The public sector headline net debt has trended steadily lower in recent years, to 36% of GDP at the end of 2008, but the gross debt remains much higher, at 64% of GDP last year. The difference between gross and net has to do with public sector assets, such as international reserves or claims against the private sector. The difference between the gross and the net debt has fiscal implications – the interest cost the government pays on its liabilities is typically higher than interest earnings the government obtains from its assets. For instance, suppose the Treasury issues debt in order to fund subsidized loans, say through the national development bank. The Treasury’s gross debt goes up, the net debt remains unchanged, but the effective burden of interest payments actually rises. In sum, often overlooked, subsidies may be fiscally opaque, but are not costless. 

Brazil is not alone on fiscal deterioration. We foresee an overall (nominal) budget deterioration in the range of 2% to 3% of GDP in Brazil this year. That is a marked reversal from recent trend, but it does not look particularly worrisome by the latest global standards nowadays. For instance, the IMF forecasts that the global fiscal deficit will worsen by more than three percentage points of global GDP in 2009, from a deficit of less than 2% of GDP in 2008 to a deficit of more than 5% of GDP in 2009, before some partial improvement in 2010. Global fiscal deterioration in 2009 is unlikely to spare emerging economies, but promises to prove most dramatic in advanced economies.

But beware of potential crowding-out effects. Brazil’s likely fiscal worsening in 2009 pales in comparison to huge fiscal deterioration foreseen in some other countries this year, particularly in the developed world. Still, fiscal expansion is normally the flip-side of debt issuance. For emerging countries like Brazil, funding a larger fiscal deficit may not become much easier when many other countries are quickly stepping up their own funding plans at the same time. 

The Good News: Better Debt Dynamics Now

Brazil’s public sector debt dynamics are in much better shape today than at any point in its recent history. Above all, Brazil’s public sector’s vulnerability to currency devaluation is much less than in the past. In fact, Brazil’s public sector has become a net creditor in dollar terms – thanks to large accumulation of international reserves, lower public external debt and elimination of domestic dollar-linked bills. Today, as a rough rule of thumb, a 10% currency devaluation can help the net debt-to-GDP ratio to the tune of almost 1.5 percentage points. 

That is a major break from a not-too-distant past. Years ago, Brazil used to face a pernicious vicious cycle situation.  Back then, worsening investor sentiment would weaken the currency, immediately hurting Brazil’s fiscal accounts. This would normally trigger fiscal and monetary tightening as a policy response, which would darken the economy’s outlook, which in turn could actually further undermine sentiment. Those days are now gone, as currency depreciation today no longer entails fiscal worsening. 

Also, starting points matter. Brazil’s debt-to-GDP ratio is significantly lower now than five years ago, for example. In principle, today’s lower debt starting point should give Brazil more leeway for fiscal deterioration in the eyes of the market than in the past. Unlike previous episodes, debt sustainability today is not an emergency issue threatening to spiral out of control. 

Still, left unchecked for too long, steady fiscal deterioration may start to question investors’ confidence over time. The years of repeated declines in Brazil’s debt ratios seem over for now. The net debt-to-GDP ratio may well start to drift up going ahead. It could rise from 36% of GDP last year perhaps towards the 40% mark over the course of coming quarters. While currency devaluation now actually helps, the cumulative effect of nominal deficits amid weak growth can hurt over time. 

Fiscal deterioration can also eventually unearth worries on structural, long-term fiscal challenges. Amid strong growth and soaring tax revenues, the fiscal bonanza of recent years helped push longer-term concerns to the back burner. However, the prospective ebbing tide could eventually uncover remaining structural challenges facing Brazil. These range from social security secular trends and the straightjacket of budget earmarks, to an excessively large tax burden and a complex, byzantine tax code. In turn, while Brazil’s recently obtained investment grade status seems unlikely to be lost overnight, in our view, further sovereign debt upgrades do not appear in the pipeline anytime soon. 

Bottom Line

Brazil’s debt dynamics are in much better shape now, with less vulnerability to currency devaluation, and lower debt ratios to begin with. Still, Brazil’s fiscal accounts remain sensitive to growth. The fiscal balance looks set to worsen more than most observers seem ready for. Debt sustainability is not any immediate threat, but fiscal deterioration can eventually unearth longer-term remaining challenges. 

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Malaysia
GDP Downgrade: Facing a Triple Whammy
March 03, 2009

By Deyi Tan, Chetan Ahya | Singapore & Shweta Singh | Mumbai

What’s New?

Last Friday, Malaysia was the last country within AXJ to announce its 4Q08 GDP. Our comments are as follows:

1) Heading into a technical recession: Similar to other AXJ countries where a slew of extremely weak results were seen, the economy registered very poor momentum (+0.1%Y versus +4.7%Y in 3Q08). External demand (-13.4%Y versus +5.1%Y in 3Q08) drove the bulk of the slowdown, shaving 5.5pp off the GDP headline (-2.6pp in 3Q08). Domestic demand also slowed down, and the biggest pullback was seen in fixed capex (-10.2%Y versus +3.1%Y in 3Q08) which knocked 2.3pp off the GDP headline (+0.7pp in 3Q08). The 2008 GDP stood at 4.6%Y.

2) Our already below-consensus forecast now looks tame: Our -1.0%Y GDP forecast for 2009 is below consensus levels of +1.0%Y. However, with the entry point into 2009 now standing at close to zero and the slowdown certain to broaden out even further to the domestic part of the economy, even our conservative forecast is now looking too high.

Facing a Triple Whammy

Indeed, not only has backward-looking data come in worse than expected, global macro outlook has also deteriorated further since we last reviewed our GDP numbers. A two-year global recession is now in the offing. Our global GDP forecasts stand at -0.3%Y for 2009 and +3.0%Y for 2010 (versus +0.5%Y and +3.3%Y, respectively, during the last downgrade). As such, we are downgrading our GDP growth forecasts for 2009 to -3.5%Y from -1.0%Y and 2010 to +3.8%Y from +4.0%Y. Below, we update and highlight the key macro factors which will continue to cloud the outlook:

1) Manufacturing recession started in mid-2008 and will continue to unravel: Within the ASEAN basket we cover, Malaysia has the second-highest trade linkages (after Singapore), which makes it one of the most vulnerable economies to the severity of the global recession. To be sure, Malaysia’s exporters face a combination of cyclical and structural headwinds. Since 2001 when China started to exert its dominance as the manufacturing hub within Asia, Malaysia has been losing market share in the non-fuel export segment from 1.5% to 1.3% in 2007 while its global share of office and telecommunication exports have declined from 5.3% to 4.5%. Indeed, manufacturing employment had started to decline as early as May 2008 even before the manufacturing production declines began in September 2008. As at December 2008, manufacturing employment declined -4.8%Y (3MMA), while manufacturing production and exports of machinery and transport equipment contracted -10.2%Y (3MMA) and -16.7%Y (3MMA), respectively. Cyclical headwinds will further compound pressures in this segment. Near-term visibility for demand is very low and inventory levels stay high. Factories have shifted to a four-day work week. Cost consolidation is underway and will be more emphasized as the downtrend unfolds.

2) Commodity price declines to worsen terms of trade: Within ASEAN, Malaysia is the biggest net commodity producer. The run-up in commodity prices has benefited macro conditions by providing a strong liquidity boost and a positive income effect, particularly to the rural sector as the upstream crude palm oil industry is fairly fragmented with landholdings by small plantation owners. However, with the decline in commodity prices, terms of trade has now become less favorable and the positive income impact on the rural sector, reversed. Indeed, as at December 2008, the petroleum and edible oils trade balance has dropped from a peak of 15.2% of GDP (monthly, annualized) in July 2008 to 8.9% of GDP. The bursting of the commodity bubble, together with the weakness in the electronics export segment, mean that significant current account surplus compression is underway.

3)  Limited stimulus from the public sector economy: With a government generally more pre-disposed to fiscal pump-priming, Malaysia has a more sizable public sector economy as compared to other economies within AXJ. Concerted fiscal policy response would have been a silver lining for the economy except that we see two headwinds to this leg of the economy. First, commodity revenue constitutes a significant part of total government revenue (~40% of Federal government revenue and ~9% of GDP in 2007). While the huge increase in commodity-related revenue (versus 18.2% of government revenue and 4% of GDP in 2003) has kept the fiscal pump-priming machine well-oiled previously, the reversal will now put downward pressures on government coffers at the margin. Second, for the first time since independence in 1957, the opposition alliance is at its strongest, transitioning the country from primarily a one-party government to a two-party one. In this regard, the ongoing attempts at power consolidation on both sides could pose risks to the implementation and coordination of fiscal pump-priming efforts, in our view.

Temporary Deflation in the Pipeline

On CPI, we believe that Malaysia will also face temporary deflation, similar to other ASEAN economies such as Singapore and Thailand. Fuel and utilities have a weight of 10.8% in the CPI basket, and this is the highest within ASEAN4. The government-administered retail fuel price reductions since August 2008 have brought fuel prices back to around pre-price hike levels. Additionally, an average electricity tariff reduction of 2.5% for households is effective from March 2009. Hence, we expect deflation to set in towards mid-2009 when the base effect from commodity prices is the highest due to the fuel price hike implemented in June 2008. This, together with the greater extent of demand destruction, mean that we are also revising our inflation forecast for 2009 to +0.2%Y from +1.3%Y and 2010 to +1.5%Y from +2.7%Y.  

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Peru
From Boom-Town to Bust-Town?
March 03, 2009

By Boris Segura | New York

Decelerating GDP growth this year could give Peru’s central bank more room for monetary easing. However, we would not bank on aggressive rate cuts. 

Even after we reduced our 2009 GDP growth forecast for Peru to a below-consensus 4% last year (see “Latin America: The End of Abundance”, EM Economist, October 10, 2008), we got some pushback despite the fact that consensus has only recently begun catching up to our initial forecast.

However, economic activity in Peru is suffering even more than we initially expected from the global fallout. In particular, the collapse of commodity prices (after all, commodities represent 80% of Peruvian exports) and lower capital inflows are beginning to spill over into lower consumer and business confidence. While fiscal stimulus is likely to cushion those headwinds somewhat, we still expect a major deceleration of Peru’s economy going forward.

We are trimming our 2009 GDP growth forecast to 3%, from 4% earlier. This figure is still well below consensus and lower than the Peruvian authorities’ 5% target. We still expect Peru to show the fastest economic growth of the major Latin economies that we track. Economic activity is likely to rebound to 4% in 2010, from 5% previously, on our estimates.

Deceleration in Economic Activity Setting In

While Peru enjoyed the fastest GDP growth rate in Latin America last year (9.8%), deceleration in economic activity was still noticeable. The slowdown is more visible now that statistics agency, INEI, has recently released a revised monthly GDP series. Up to last September, Peru’s economy was growing at over 10%; however, growth in the last quarter of 2008 was underwhelming (compared to recent history), coming in at 6.6%.

We expect further deceleration in economic activity to around 4% in 1Q09. We look for a recovery in public consumption, from a depressed reading in 4Q08 (recall the ‘modulation strategy’ pursued by the previous Minister of Finance), as well as a further drop in exports. This reading would be consistent with our full-year 3% GDP growth forecast.

The downdraft in GDP growth for 2009 is likely to be led by a sharp fall in consumer and business confidence, which is likely to result in slower private consumption growth and an outright contraction in private investment. Again, surging public sector consumption and investment can be expected to soften the blow, in a typical countercyclical fashion. We elaborate on these issues below.

Confidence: Heading South

Employment angst is replacing inflation fears as the main driver of consumer confidence. As such, we find the recent rebound in headline consumer confidence from a September low to be somewhat questionable, reflecting relief from high inflation prints in 2008. The jobs component of consumer confidence has paused in its decline, but we suspect it will resume its downdraft in coming months.

We are already witnessing a marked deceleration in job creation. In particular, generation of jobs in the formal sector peaked in mid-2008 and is decelerating fast. And we fear more weakness ahead: local polls suggest that firms are likely to show more restraint in hiring going forward.

Reluctance to hire is the mirror image of reluctance to invest, as local firms are progressively cutting back or delaying their investment plans, given the more unsettled economic outlook. As such, we expect an outright decline in private investment this year.

The Policy Reaction

While initially policymakers minimized the impact of the international turmoil on Peru, they have put forth an aggressive fiscal stimulus plan. Our view has been that Peru was well positioned to undertake countercyclical fiscal policy (see “Colombia and Peru: The Debt Debate”, EM Economist, November 28, 2008). Public sector debt is low and fiscal authorities put away part of the ‘abundance dividend’. After the initial hesitation, policymakers have responded in kind: following a change at the helm of the Ministry of Finance, fiscal authorities enacted an Economic Stimulus Plan which amounts to S./ 10 billion (2.3% of GDP), intended to put a floor of 5% to GDP growth this year.

The Economic Stimulus Plan puts emphasis on infrastructure and low-income housing. Other areas that get an increased budget allocation are social programs and subsidies to exporters and other businesses. But perhaps more importantly, the government is pushing for more expedited spending execution guidelines, which bodes well for the pace – but not necessarily the quality – of public expenditure.

We expect major fiscal deterioration in 2009; after all, that is the logical result of fiscal stimulus. From a surplus of 2.1% of GDP in 2008, the non-financial public sector is likely to post a deficit of 1.7% of GDP this year. But given low amortization needs, the increased public sector borrowing requirement is easily financed out of proceeds in the Fiscal Stabilization Fund and government deposits at the central bank. 

Inflation Targeting on Hold

Monetary authorities have also responded to the ongoing economic slowdown. In a nutshell, the central bank has undone most of the hikes in reserve requirements on bank deposits undertaken throughout 2008, in order to inject liquidity into the system. Partly as a result, growth of domestic credit has actually accelerated since last September. The closure of local markets to corporate debt issuance and cutbacks in external financing to Peruvian corporates have also influenced this surge of domestic credit, as the local banking system has filled the gap.

Even while there are remaining risks to the inflation outlook, we expect the monetary authorities to continue cutting the reference rate. Inflation has taken a back-seat to economic growth in Peru as the main consideration driving monetary policy. In fact, the central bank has been signaling an easier monetary policy since last November, but a challenging inflation outlook has only allowed it to start cutting its reference rate last month.          

We do expect headline inflation to finally come down this year. From a decade-high of 6.7% last year, we now forecast inflation at 3.6% by the end of 2009, versus 4.7% earlier, although still above the central bank’s 2% target.

We think BCRP is likely to continue cutting its reference rate to 5.0% by year-end, versus 6% earlier. We expect the cuts to be front-loaded. But the current stance of monetary policy is not tight at all: given inflation stickiness and the low level of the (nominal) policy rate, monetary policy does not come across as particularly restrictive.

But relaxing monetary policy poses a dilemma to authorities: if they cut rates aggressively, the cost of long USD positions diminishes. Given high dollarization in Peru, authorities are not only worried about currency depreciation pass-through to inflation but, more importantly, about adverse effects on balance sheets of firms and consumers provoked by real currency depreciation.

In the context of deteriorating external accounts, this policy of ‘reducing exchange rate volatility’ could become problematic. We expect a widening of the current account deficit to 6.3% of GDP this year, from 3.2% of GDP in 2008.  Based on our expectation for the financial account of the balance of payments, we look for a loss of net international reserves of US$4.5 billion; however, our measure of ‘net’ net international reserves (i.e., deducting the stock of dollar-linked paper sold by the central bank to defend the currency) has already dropped US$3.7 billion in the first two months of 2009 (US$8.6 billion since September 2008). If this trend continues, it would pose further downside risk to our already bearish 3.45 year-end forecast for the Peruvian sol.

Therefore, don’t expect aggressive rate cuts as in other Latin American economies. We doubt that the positive output gap in Peru has dissipated – even when this factor is taking a back-seat in the formulation of monetary policy. The policy rate in real terms is not high, and authorities are showing unease in allowing the currency to float. Thus, we see limited room for aggressive rate cuts by the central bank.

Bottom Line

We expect Peru’s economy to decelerate further this year, with GDP growth slowing to 3%, from a red-hot 9.8% in 2008. This should give the central bank more room to extend its monetary easing campaign, as inflation has taken a back-seat to economic growth as the main consideration driving monetary policy.

However, don’t bank on aggressive rate cuts. The current monetary policy stance is not tight, and the authorities’ unease in allowing the currency to freely float would certainly limit the extent to which they are willing to reduce the cost of long USD positions.

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