Globally Challenged
March 31, 2009
By Daniel Volberg & Luis Arcentales, CFA | New York
In recent weeks we have witnessed a remarkable return of risk appetite. Could this mark the beginning of a sustained recovery? Indeed, the rally in Latin American equities, currencies and credit has given renewed hope to optimists expecting a rebound in economic activity later this year. After all, while the incoming data have been bleak, in many cases the sequential declines have been less severe than in late 2008. Further, incoming data are a lagging indicator – investors are instead focused on the direction in 2009. While we have a great deal of sympathy for much of what the optimists argue, we are concerned that Latin America may be facing a prolonged period of economic weakness that could begin to undermine the progress made in recent years of global abundance.
The Case for Optimism The optimists’ argument for a recovery later this year is based on three key factors: it centers on the impact of policy stimulus, the resilience of domestic demand and Latin America’s starting point. First, the optimists point out that policy stimulus has been significant and that more is in store both within the region and particularly on a global basis. One of the advantages of the fact that the epicenter of the global downturn is in the developed world is that the policy response has been massive and swift. And globally, the newly rolled out IMF facility coupled with an increase in resources – Japan has committed US$100 billion and the EU has pledged €75 billion, near doubling the IMF’s current US$250 billion in resources –could be an important development in helping prevent financial accidents among some of the more vulnerable emerging economies. Meanwhile, in Latin America, we have seen the region join the global wave of aggressive monetary policy easing, tax cuts and boosts to infrastructure investment plans. Second, the optimists argue that internal demand will buffer the negative external shock hitting Latin America’s economies. They point out that Brazil is a relatively closed economy – with exports accounting for only 14% of GDP last year. Further, they focus on the relative resilience in consumer spending: Brazil’s January retail sales were still up near 6%Y while industry – which is much more export-oriented – contracted near 17%. The difference, they argue, is a reflection of consumer resilience that could cushion the downturn once inventories adjust and production is restarted to satisfy domestic consumer demand. Finally, starting points matter and Latin America is much better prepared to deal with the current downturn than it has been in decades. The abundance of the last five years has not produced the kind of macro vulnerabilities that often accompanied past upturns in the region. Latin America used the abundance years to reduce its reliance on external and short-term debt, and built up formidable international reserve stockpiles while avoiding ballooning fiscal and current account deficits fuelled by excessive consumer spending. The Case for Caution We sympathize with much of what the optimists argue, but we are not ready to throw away our cautious mantra just yet. We are concerned that, given the magnitude and duration of the global downturn, and given the importance of external conditions for local growth dynamics, the ability of policy stimulus and domestic demand to cushion the downturn in Latin America may be limited. No Financial Accidents We agree that starting points matter, and this is why we expect no financial accidents among the region’s largest economies. Despite one of the most severe downturns in the global economy – our global team expects a contraction of 1.2%, the deepest in six decades – we do not expect financial accidents among any of the largest economies in Latin America over the next 12-18 months. This is a clear improvement for the region from ten or even five years ago. But, while it does help to avert a financial accident, the improved starting point does not make Latin economies immune to the business cycle. Latin America’s sharp economic contraction in 4Q should have dispelled any lingering doubts on that front. Magnitude of the Downturn Having reviewed the growth record of the region, we continue to come to the same conclusion: most of the improvement in growth appears to have been the product of external factors. When we decompose the growth record over the past five years of some of the region’s largest economies, we find that external factors explain virtually all of the growth upturn in the region (see “Latin America: Growing Risk, Growing Disconnect”, EM Economist, March 7, 2008). In fact, we estimate that were it not for the unusually favorable global conditions, growth in Brazil over the past five years would have been on average 2.7% rather than the actual 4.2%. The deterioration in three out of the four external factors that were key to Latin America’s growth upturn during the abundance era – commodity prices, risk premiums and global growth – has been severe. According to the Commodity Research Bureau, commodity prices are down sharply from last year’s average: soft commodities are down near 30%, metals are down near 40% and oil is down near 60%. Meanwhile, risk premiums in Latin America have shot up as investor risk appetite has diminished. Risk premiums have risen. Brazilian five-year credit default swaps implied a risk premium of 400bp earlier this month, up from 184bp on average in the first three quarters of last year. Mexico fares little better – risk premiums have widened from 120bp in the first three quarters of last year to close to 370bp now. Global growth is expected to contract. Our global economics team expects world GDP to contract by 1.2% this year, the deepest contraction in six decades. Given the sharp deterioration in external conditions, we suspect that the contraction in Latin America is far from over. We expect Latin American economies to sequentially contract in 1H09, but at a more modest pace than in 4Q08. This is in line with our global team’s forecast for further contraction among the developed economies in 1H09. In addition, we suspect that the effect of the deterioration in external conditions has not yet been fully transmitted to the region. We estimate that the full impact on the region may be delayed by 3-5 months (see “The Asian Aftershocks”, EM Economist, February 13, 2009). In fact, last week’s Mexico January GDP release – a contraction of 9.5%Y – confirms that the 4Q pain in Latin America has persisted into early 2009. Duration of the Downturn After the sharp contraction late last year and early this year, we suspect that growth in the region may not rebound as the global backdrop may remain challenging for longer than many are prepared for. Our US economics team expects a multi-year adjustment in balance sheets of the US consumer. It is forecasting a rise in the personal saving rate from an average of 1.3% of disposable income over the 2003-08 period to an average of 5.4% over this year and next. In our view, this is a key structural change in the global economy since the US consumer was the demand-side engine of global growth in the past five years of global abundance. With that engine sputtering and in for a long adjustment, we suspect that emerging economies – that were the suppliers of consumer goods for America – are now dealing with an external shock of dramatic proportions. In Latin America, where external factors had been so critical in driving the growth upturn, the structural downshift in US consumer demand may delay the recovery that many are hoping for later this year. The increase in personal saving in the US will be offset by massive fiscal stimulus, but the dramatic public dissaving may not help to boost world demand. Indeed, we suspect that the fiscal stimulus – with its ‘Buy American’ provisions – may be more inwardly focused and a bigger boost for domestic, rather than global, production. Domestic Demand Buffer The optimists may not subscribe to the view that the US consumer was the demand-side driver of global growth and expect demand in emerging economies to pull them out, even while the US slumps. They continue to point to the fact that much of the global growth over the last few years had been driven by emerging economies. We believe that their analysis may be missing at least two important elements. First, the optimists may be underestimating the scale of the adjustment. Global growth is calculated using GDP aggregated with exchange rates adjusted for the price differences of non-traded goods across countries – the so-called PPP-adjusted exchange rates. But in a global rebalancing that is currently taking place, the adjustment should come through international trade and financial flows, where market exchange rates are the most appropriate measure. At market exchange rates, consumption in the US was near 40% of all world private consumption last year. In contrast, China’s private consumption was less than 5% of the world total in 2007 (the latest data available). In fact, we calculate that once we add in the Euro-zone, Japan and the rest of the developed economies, they account for nearly three-quarters of all private consumption over the past few years. The numbers, in our view, suggest that a multi-year reduction in US consumption growth may pose a formidable challenge for economic growth in emerging economies. Second, we suspect that, in the near term, domestic demand in Latin America is likely to suffer as labor markets soften. After a multi-year period of positive employment and wage growth, that trend has been broken. Late last year and in the first months of this year, we have seen employment decelerating or even contracting in Brazil, Colombia, Chile, Mexico and Peru. In Mexico, for example, formal employment sequentially contracted at a pace of over 6% annualized in the three months ending February, already eclipsing the worst pace seen during the 2001 recession of near -3.5%. Meanwhile in Brazil, formal employment sequentially contracted at an annualized pace of 1.6% in the November-January period. We are concerned that the ongoing labor market softening may undercut income and thus restrain consumption, prolonging and even amplifying the downturn. After all, employment growth, and the associated internal demand, lagged the growth upturn that was driven by external factors. Relying on domestic demand to now cushion the downturn may be a risky bet. Policy Slippage Given our expectation that Latin American economies shrink and then bump around the bottom, we are trying to work through the potential and the timing of policy slippage in the region. We are concerned with ‘translation risks’, as the policy remedies being deployed in the developing world are adopted (and adapted) in Latin America and emerging markets. It is only a few months into the downturn, and we have already seen several examples – either considered or adopted by the authorities – of the kind of measures that could affect the potential for a strong recovery down the road. Argentina has been leading the way on this front – with the nationalization of the pension funds in October, rising protectionism and most recently the decision by the authorities to exercise their new-found power to name directors to corporate boards of major domestic firms, a result of the takeover of the equity stakes formerly held by the local pension fund industry. But Argentina is not the only country where policy slippage is taking place. In Mexico, for example, local pension funds pledged to buy only local assets for a period of 12 months. Yes, that move was voluntary, but the risk of legislative action may have played a role in the pension fund’s decision. And just last week, congressional committees approved new financial sector regulations, giving the authorities enhanced powers to cap interest rates and bank fees. In Brazil, last month the authorities considered a measure that would have replaced automatic import licenses with a discretionary pre-approval mechanism. While the proposal was quickly scrapped, a prolonged downturn may temper opposition to such policy reversals. And in Peru, last week the authorities implemented a 30% tax on derivatives that may have an important impact on the non-deliverable forward currency market. Just as a prolonged downturn increases the risk of policy slippage, the election calendar could be an important factor in the timing of such actions. The translation into policy reversals may be linked to the need to adopt populist measures in order to secure victory on election day. In fact, Argentina’s congressional elections – recently moved to June this year – may have been a key consideration in the policy reversals seen in that country. Mexicans are next in line with mid-term elections in July. Brazilians and Colombians are set for a general election next year. Peru’s elections are not until 2011. Bottom Line We would like to turn optimistic – in fact, we are carefully looking for signs of a turnaround – but at this juncture, we expect Latin American economies to contract further and then bump around the bottom for an extended period. The ability of the region’s economies to absorb the severe global shock without any financial accidents is testament to the dramatic improvement in the region’s starting point. But given the likelihood of a prolonged adjustment in the developed world, we suspect that Latin America may not see a meaningful recovery for some time.
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Review and Preview
March 31, 2009
By Ted Wieseman | New York
With all the big announcements about the Treasury’s legacy asset and loan purchase plans and strong rallies seen in most risk markets in response, as well as some better-than-expected economic data, Treasury and other interest rate markets had a surprisingly quiet week that was mostly focused on supply and left Treasury yields mixed. In addition to largely ignoring the surge in stocks and rallies to varying extents in other key markets in response to the Treasury plan – with a very strong rally by the commercial mortgage CMBX market versus a comparatively soft response by the subprime ABX market particularly interesting – Treasuries also paid almost no attention to a round of overall better-than-expected data, probably partly because investors were looking ahead to what’s expected to be a rough run of more important early figures for March in the coming week’s employment, ISM and motor vehicle sales results. The data were also a good bit better on a headline basis in a number of cases than in some of the important underlying details. New and existing home sales both posted rebounds off their lows in February but showed little progress in working down the severely bloated inventory situation heading into the key spring selling season. Both overall and core durable goods orders posted good gains in February but only after extremely large downwardly revised declines in January. Even with a slight recovery in February, capital goods shipments were so weak in the revised January numbers that the outlook for 1Q investment continued to worsen. Fourth quarter GDP growth was revised down less than expected to -6.3% from -6.2% but partly because of a smaller downward adjustment to inventories that pointed to a partly offsetting larger inventory drag in 1Q. Even with a stronger path for 1Q consumption implied by the personal income report, we cut our 1Q GDP estimate to -5.1% from -4.9%. Instead of trading on the Treasury plans, other markets’ reactions to the plans or the economic news, supply was the overriding market focus in what activity there was during the week’s sluggish trading, and this cuts two ways. The Fed’s surprise announcement that it would be including long bonds in its initial round of Treasury purchases after previously saying buying would be focused in the 2-year to 10-year range helped the long end outperform on the week. And the very rapid start to the buying program provided additional support. As heavy as the Fed’s US$15 billion in purchases was, it was only a fraction of the record US$98 billion of new coupon supply in 2s, 5s and 7s during the week. After a solid start to the three auctions with Tuesday’s 2-year, the week’s Treasury market lows were hit after a poor 5-year sale Wednesday that added to supply jitters from the failed UK gilt auction. Once the much better 7-year auction wrapped up the supply on Thursday, however, and the market was able to look ahead to a busy schedule of Fed buying combined with a week-and-a-half break in new issuance, the market was able to rebound to close the week Thursday and Friday. For the week, benchmark Treasury yield moves ranged from modest gains driven by the Fed’s surprise announcement to decent losses in the intermediate part of the curve led by the 7-year, which reversed much of its strong outperformance in initial response to the FOMC’s Treasury buying announcement. The old 2-year yield was flat at 0.86%, 3-year up 4bp to 1.26%, old 5-year up 12bp to 1.76%, old 7-year up 15bp to 2.31%, 10-year up 13bp to 2.76% and 30-year down 6bp to 3.62% (for the new issues, there was about a 4bp yield pick-up for the 2-year and 5-year and 6bp for the 7-year). Even with risk markets surging, demand for cash reached new extremes, though this may have mostly just reflected quarter-end book-squaring. Very short-dated bills closed negative Thursday before reversing course slightly on Friday to leave the 4-week bill’s yield down 7bp to 0.01%. For the week, commodity prices weren’t much changed, with only small further upside in oil prices in particular, but TIPS performed extremely well even after a partial pullback to extend what’s now been a three-week run of major outperformance. The 5-year TIPS yield fell 13bp to 0.82%, 10-year 4bp to 1.34% and 20-year 14bp to 1.92%. Current coupon 4% mortgages ended the week about unchanged (and with little day-to-day volatility) to outperform the sell-off in the intermediate part of the Treasury curve (though performance was notably worse on an option-adjusted spread basis as interest rate volatility declined). This left yields on 4% MBS a bit above 3.9%, down from near 4.15% two weeks ago and the year’s highs above 4.3% at the end of February. Mortgage rates being offered to consumers have tracked the rally in the MBS market, falling to record lows in the latest week. Fed Treasury buying got off to a fast start, with two US$7.5 billion purchases, the first in the 7-year to 10-year range and the second 2-year to 3-year. Interestingly, by far the biggest purchase in the former was of the on-the-run 7-year issue and almost all of the buying in the latter was in the current 3-year. The Fed always stayed away from buying benchmark issues in the past as it expanded its Treasury portfolio gradually over the years (until reversing course after mid-2007 when it began selling down a large portion of its Treasury holdings as it was initially sterilizing its other liquidity facilities). But the goal now is clearly to lower broader borrowing costs as effectively as possible, not to gradually expand the Fed’s balance sheet in a non-market disruptive way in the manner of previous historical coupon passes, and these first two operations certainly suggest that the Fed quite reasonably thinks that largely focusing on supporting yields on the benchmark issues is the best way to do this. There will be three more rounds of Fed buying in the coming week – August 2026 to February 2039 maturities Monday; May 2012 to August 2013 Wednesday; and September 2013 to February 2016 Thursday. This additional buying will come during an off week for new Treasury coupon supply before 10-year TIPS, 3-year and 10-year auctions the week of April 6. On top of the fast start to the Treasury buying, the Fed’s net purchases of MBS of US$33 billion in the most recent week were also a new high, though the past week’s agency purchase (agency purchases are expected to take place generally once a week going forward under updated guidelines released by the New York Fed) of US$2.7 billion was around the average size seen up to this point. A continued pick-up in the pace of mortgage purchases may be needed in the weeks ahead as refinancings are likely to ramp up very sharply and put substantial supply pressures on the mortgage market. The announcement of the Treasury’s legacy asset and loan purchase plans helped risk markets generally extend or resume significant rebounds that in most cases started off lows hit March 9. The S&P 500 gained another 6% on the week for a 21% rebound from the March 9 low. Financials continued to lead the bounce, with the BKX banks stock index up 12% on the week, but their leadership position faded late in the week after a stronger initial outperformance in response to the Treasury’s announcement. In corporate credit, the new series 12 investment grade CDX index tightened 15bp to 184bp in its first full week of trading, while the prior series 11 closed the week near 225bp after hitting a recent wide of 262bp on March 9. The high yield index was 132bp tighter on the week at 1,619bp through Thursday, down from 1,894bp on March 9, but the index was trading off about 3/4 of a point Friday. The leveraged loan LCDX index, which could benefit from the legacy loan portion of the bad bank plan, had a very good week but remained pretty far in the red for the year. Through midday Friday, the index was 379bp tighter on the week at 1,893bp, near its best level since the first half of February but still quite a bit wider than the 1,303bp close at the end of 4Q. The relatively strongest response to the Treasury plan was in the highest-rated parts of the commercial real estate market. The AAA CMBX index tightened nearly 200bp on the week to 559bp, wiping out almost all of the prior year-to-date losses. While the Treasury’s plan was clearly taken as good news for owners of high-quality commercial mortgage-backed securities (though AAA cash CMBS still trades quite a bit wider than the AAA CMBX index at this point, and lower-rated CMBX indices did not perform nearly as well), our desk notes that current spreads are still astronomically higher than where they traded a couple years ago before the financial crisis began – currently about 900bp for AAA CMBS versus only about 25bp pre-crisis. As a result, commercial real estate funding is punishingly expensive even after the recent market rebound, continuing to put intense pressure on commercial property valuations. Meanwhile, a comparatively much weaker performance by the subprime ABX market sharply contrasted with the CMBX strength. The AAA ABX index only gained 2 points from the record lows hit last week and at 26.17 is still down 33% so far this year. Lower-rated ABX indices saw almost no upside from recent record lows, with the AA index only up 0.02 point to 4.04 (incredibly, this index once traded as high as 97.00). Although the muted performance of the subprime market to some extent probably reflected uncertainties about how effective the Treasury’s plan would be, there appeared to be at base a simpler explanation. In contrast to the apparent assumption of the Treasury and many investors, our desk does not believe that current levels in the ABX market, even as far as they have crashed, have been trading at substantially depressed fire-sale prices relative to horrendous underlying fundamentals, so bids well above current market prices for these assets by the PPIFs or through the TALF seem unlikely. The past week saw a somewhat more positive tone to the economic data after what’s been mostly a steady run of gloomy results for some time, though underlying details of the figures in many cases weren’t as good as the headline results. For example, home sales rebounded, but there was little improvement in the horrendous inventory situation as we move into the key spring selling season. New home sales rose 4.7% in February to a 337,000 unit annual rate, rebounding from the all-time low hit in January to the second worst reading ever. Even with the number of homes available for sale down for a 22nd consecutive month to a seven-year low, the months’ supply of unsold new homes only moderated to 12.2 months from the record high 12.9 months hit in January. Around 5-6 months of supply would be consistent with a balanced market, so inventories are still completely out of hand heading into the crucial spring selling season. Meanwhile, existing home sales gained 5.1% in February to 4.72 million after hitting a 12-year low, but inventories were unchanged, remaining badly elevated at 9.7 months. Similarly, durable goods orders at first glance looked much better than expected, but underlying details, in particular the extent of the revisions to prior months, ended up being much more negative. Overall durable goods orders jumped 3.4% in February, but this followed a downwardly revised 7.3% plunge in January and still left orders down at a near record 35% annual rate over the past six months. Non-defense capital goods ex-aircraft bookings, the key core gauge, jumped 6.6% in January, but this similarly followed a downwardly revised 11.3% collapse in January, a record decline, and left the recent trend extraordinarily weak. Non-defense capital goods shipments ticked up 0.6% in February but only after a record downwardly revised 8.9% drop in January, pointing to severe weakness in business investment in the first quarter. We cut our forecast for 1Q equipment and software investment to -29% from -24.5% and overall investment to -27% from -24%. A 27% drop in current quarter investment following the 22% fall in 4Q would mark the worst six-month decline since the Great Depression. The inventory drag in 1Q also appears likely to be worse, as durable goods inventories fell a larger-than-expected 0.9% in February on top of a downwardly revised 1.1% drop in January. Note that the drop in sales has been so severe, however, that even with this sharp recent pullback, the I/S ratio in this sector remains very close to a 17-year high. On top of the weakness in durable goods inventories early in 2009, the smaller-than-expected downward revision to 4Q growth to -6.3% from -6.2% (and the way too high -3.8% advance estimate) was partly a result of a smaller-than-expected downward revision to inventories, pointing to a likely greater drag from inventories in 1Q. We now see inventory destocking knocking 2.1pp off 1Q growth instead of 1.5pp. Against the expected bigger negatives from investment and inventories, the consumption picture at least looks a bit better. Real consumer spending fell 0.2% in February, as expected, but January was revised up to +0.7% from +0.4%. As a result, we now see 1Q consumption rising 1.3% instead of +0.9%. While the swing into positive territory would be a positive development, the upside we’re forecasting would mark a meager rebound after a near-record 4.1% annualized collapse in 2H08. Combining the expected downside in investment and inventories against the upside in consumption and also incorporating our February trade forecast and other underlying details of the 4Q GDP revision, we marginally reduced our 1Q GDP forecast to -5.1% from -4.9%. With 4Q GDP only being revised down to -6.3% instead of the -6.8% we were expecting, the net decline in the economy over the 4Q/1Q period still looks to be extremely severe, but slightly less so than we were forecasting coming into the week. After some recently rare improvement in some of the economic data seen over the past week, we expect the key early round of March data to have a much more negative tone. We look for the worst employment report yet in this downturn, some renewed weakness in the ISM (though less so than we anticipated coming into the week after better results from the second round of regional reports), and another disastrous month for motor vehicle sales. Key data releases due out in the coming week include consumer confidence Tuesday, ISM, construction spending and motor vehicle sales Wednesday, factory orders Thursday, and employment Friday: * We look for the Conference Board’s consumer confidence index to rise to 26.0 in March. Both the Michigan and ABC gauges suggest that sentiment was little changed during early March, so we look for the Conference Board measure to hold near the record low of 25.0 posted in February. * We expect the ISM to decline a point to 35.0 in March. The regional surveys released to this point have been mixed. On an ISM-weighted basis, Empire and Philly posted declines, while Richmond and KC registered gains. So, we look for another relatively steady result on the ISM. The key orders gauge is expected to show an uptick, but employment and inventories should move lower. Finally, the price index is likely to register a pullback this month. * We forecast a 0.5% decline in February construction spending. The housing starts data suggest that construction activity may have received some temporary support from unseasonably mild weather conditions across parts of the country. So, we look for a much smaller decline in spending than seen in recent months. Renewed weakness in homebuilding and a more rapid pace of decline in non-residential activity should be evident in the coming months. Finally, we don’t expect to see any noticeable support for public infrastructure spending tied to the recently enacted fiscal stimulus legislation until the second half of the year. * Motor vehicle sales hit a 28-year low of 9.1 million units in February. Anecdotal reports suggest that the sales environment remained miserable in March, and we look for a little changed 9.0 million unit sales rate. * As foreshadowed by the durable goods data, we look for a sharp 1.9% rise in February factory orders combined with a significant downward revision to January. Meanwhile, shipments are likely to show little change. Inventories are expected to slip 0.7%, with the I/S ratio ticking down a tenth to 1.45 after a major prior run-up. * We look for a 700,000 drop in March non-farm payrolls. The readings on both initial and continuing unemployment claims are still pointing to a steady deterioration in labor market conditions. However, we actually expect to see an even steeper drop in jobs this month relative to the 650,000 or so declines that were posted in each of the first two months of the year. In particular, we look for some restraint tied to weather-related influences. Although conditions appear to have been near normal during the March survey period, this follows on the heels of much milder than usual weather in February. So, we suspect that favorable weather may have helped to prop up employment in February and this effect could be unwound in March. But any swing to the downside is likely to be tempered by the impact of concurrent seasonal adjustment (a statistical technique that has been used for the past five years or so). Interestingly, all of the large net downward adjustment to the December and January payroll figures in last month’s report was attributable to revised seasonals. The unadjusted figures were actually pushed up a bit. Thus, concurrent seasonal adjustment helped to push up the February reading and offset this by lowering the results for the prior two months. The smoothing process that results from concurrent seasonal adjustment is one reason why the declines in payroll employment seen to this point have not been even larger. Finally, the unemployment rate should continue to move substantially higher to 8.5% from 8.1% (note: we still look for a 9.9% peak by year-end).
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The Optimum Election Outcome
March 31, 2009
By Tevfik Aksoy | Istanbul
Impact on our views: The local elections held over the weekend yielded results that made even the most AKP-skeptic opinion polls look overly optimistic. In comparison to the overwhelming victory in the general elections of 2007, AKP faced a noticeable erosion in popularity (down to 39%), while the main opposition CHP (up to 23%) and MHP (up to 16%) improved their status. Meanwhile, the ethnic identity of the south-eastern region was manifested in the results, as DTP not only received a strong portion of the votes in the region, but also claimed victory in eight provinces where AKP had been hopeful. That said, AKP maintained its overall strength and remains the most popular party in the country. In that sense, we do not expect any significant changes in the political climate and this is a positive result, in our view. To us, the election results will serve as good feedback to the ruling AKP government and will give PM Tayyip Erdogan the opportunity to steer party politics back in the right direction. In our view, he might need to assume a more conciliatory stance and, most importantly, acknowledge the fact that the poor economic performance since the general election of 2007 has been a key factor in the loss of popularity. Facing the facts: Following the weaker-than-expected election results, PM Erdogan openly acknowledged the disappointing outcome for AKP and, in a downbeat press conference, he mentioned that a revision in the cabinet might be a possibility. He added that the rising economic challenges and the ongoing weakness in the markets must have had a significant impact on the results. Moreover, referring to the rising popularity of DTP (a party that represents Kurdish ethnic votes mostly from the south-eastern part of Turkey), PM Erdogan stated that ethnic identities had played a role in the voting preferences. PM Erdogan stressed that AKP would analyze the election results thoroughly and draw lessons from the overall outcome, which he considered as “unsatisfactory”. In our view, all of these statements are assuring and a sign that PM Erdogan will use his pragmatic approach to improve the party’s overall standing in the coming months. Calling for improved economic policy-making: We believe that the AKP government should first address the weakening macro fundamentals. We believe that a first step would be to revise official macro forecasts and sign a new Stand-By Arrangement with the IMF. This would not only allay concerns regarding the expected external financing gap but also provide a means to restore domestic confidence, in our view. As opposed to the general view that a loss of popularity would trigger further populism and risk the fiscal picture, we believe that AKP will resort to a logical approach. We saw a good example of this during 2002-07, when a tight fiscal policy supported by structural reforms led to economic expansion. Clearly, the global backdrop is completely different now, and this is why we believe that rather than trying to go its own way, AKP may decide to team up with the IMF. A well-designed and comprehensive IMF Stand-By Arrangement would address fiscal issues (debt dynamics) and structural reforms, and could lead to an improvement starting in 2010 rather than 2009. The government needs to act fast: Due to the lagged nature of macroeconomic data flow, we expect the next 3-6 months to witness a series of weak indicators for GDP growth, the central budget, industrial production, capacity utilisation and (non-financial sector) company earnings, not to mention record levels of unemployment. Unless the government signs a deal with the IMF soon, a late agreement might only give the impression of a desperate move and hence could prove ineffective. A good outcome: Overall, we consider the outcome of local elections as positive for all parties: 1) AKP is likely to draw useful lessons regarding the outcome of its implementation (and political approach) in the past 20 months. 2) Opposition parties will likely be encouraged to see a possibility of future success if they come up with something to offer to their constituency (which seemed to have been a remote possibility following the overwhelming victory of AKP in July 2007). 3) Voters once again realize that they are in charge and democracy works best when politicians are given feedback.
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