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Japan New Wave of Capacity Restructuring Looms: March Tankan United States Perfect Consumer Storm Not Over View GEF Archive

		The Global Economics Team

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The headline number from the March Tankan continued to drop sharply, coming in below the bottom of May 1975, and in each area underlined the severity of the recession. However, a dismal Tankan had been expected, and this should not be a new negative surprise. Instead, at about the same time as the latest Tankan outlines management plans for F3/10, we expect companies to embark on a quest for survival through plant restructuring and, in turn, industry realignment. This could provide a new equity story and represent opportunities in the Japanese market.

Results for the Key DIs

1) Business conditions DIs: The headline (current conditions, large manufacturers) showed the largest drop on record, outstripping the figure in the first oil crisis. In terms of level, it compared with -51 in Japan’s financial crisis (December 1998) and -57 in the first oil crisis (May 1975), marking the historical low. The outlook DI at -51 showed a modest pick-up, however. We expect production to stop declining at long last in April-June, with automobiles and electronic components coming back to some extent after six months of inventory adjustment, as was suggested by the production forecast projected by the METI. The Tankan’s outlook DI also points to a lull in the seemingly bottomless process of production correction. Even so, we anticipate that the headline numbers from the June Tankan onwards will remain mired at historically low levels for the rest of the year. Looking at large manufacturers by industry, processing (-31pp versus last report) fared better than materials (-40pp), with iron & steel industry (-77pp) deterioration standing out. Among processing industries, autos deteriorated most glaringly (-51pp) and, at a level of -92pp, virtually all companies described business conditions as ‘bad’.

2) Supply/demand DIs: The supply/demand and inventory DIs re-emphasized that production cuts are not keeping pace with the retreat in demand. The supply/demand DI continued to fall sharply for both Japan and overseas, while the domestic DI fell by its largest margin since August 1974, in both instances by -25pp QoQ. However, the supply/demand outlook DI is showing improvement similar to its business conditions counterpart. Meanwhile, the inventory DI followed up the December Tankan with another double-digit advance (+14pp), indicating increased pressure to adjust inventory.  Note that November 1980 (+15pp) had been the last double-digit increase in the inventory DI.

3) Price DIs: The output and input price DIs both tumbled. Among large manufacturers, the output price DI (-21pp quarter on quarter) fell by its largest clip since September 1974, and the input price DI posted a record-breaking drop-off (-36pp). The level of the output price DI (-25pp) is also deeply negative for the first time since June 2003 (-26pp).  However, as in the previous December Tankan, the decline in the input price DI this time expanded, which in turn improved the margin DI (output price DI minus input price DI).  Processing industries showed the most pronounced margin DI. However, even with some improvement in margins (terms of trade), future sales volume is seen as generally flat, and we cannot pin much hope on the impact of higher levels of corporate earnings.

4) Employment and production capacity DIs: The employment and production capacity DIs jumped regardless of industry or company scale, and the sense of surplus increased further in both. The employment DI swung by the largest degree since 1975 (+19pp for large enterprises), which is consistent with the rapid deterioration in the labor market nowadays. Likewise, the production capacity DI posted its largest shift in the history of the data (+16pp for large enterprises). This will have an impact on future capex plans. Overall, the issue of triple surpluses in Japan’s economy (employment, capacity and debt) will be a major policy and market theme ahead, in our view.

Overview of Management Plans

1) F3/09 profit plan revisions and F3/10 initial forecasts: In light of the fall in industrial production, manufacturing industry sales in F3/09 are now expected to drop 7.6%Y (from +0.9% in the December Tankan), and the recurring profit outlook has been lowered to -62.7% (-20.6%) (large enterprises overall: sales -2.7%; recurring profit -43.7%). This is not a negative surprise since it matches corporate guidance revisions that reflect October-December results. But the plans for F3/10 released by companies for the first time were much better than our reading, calling for sales to drop 5.1% and recurring profit to drop 11.0% in large enterprises, and they are vulnerable to significant downward revision later, as we doubt that there will be a V-shaped profit recovery of over 70% in the latter half. We think it will take until 2H F3/10 or beyond for the impact of falling energy and raw materials prices on lowering cost of sales (improving terms of trade) to appear, and that negative gearing will remain in effect until then. Note that on the same basis as the Corporate Statistics (parent data), we expect recurring profits for large companies (excluding financials) to fall 60% in F3/10.

Two successive years of plummeting profits would imply the possibility of extensive elimination of capital stock, and thereby progress with industry realignment. The manufacturing industry will see many companies making losses in consecutive terms from F3/09. This is because with capacity utilization rates down to nearly 50%, as discussed later, there is unlikely to be a marked recovery even in the second half of the year as business remains below the breakeven point. However, capital policy constraints mean companies will want to avoid two successive terms of red ink at all costs, which makes it likely that far-reaching restructuring proposals will be released to forestall guidance for losses. We see the potential for this to extend beyond individual capacity restructuring moves to embrace broad restructuring of whole sectors within manufacturing. Areas such as electrical machinery, diversified chemicals and paper & pulp could see such developments as early as 2H of F3/10, in our view.

2) F3/09 capex plan revisions and F3/10 initial forecasts: Capex in F3/09 has been slashed to an unprecedented extent. Large companies have revised down by 3.1% (the revision rate in the 1998 recession was -3.0%) and are now estimating that spending (including land, excluding software) was down 3.3%Y in F3/09. The March Tankan sees downward revisions anyway, regardless of the economic cycle. We are not at all surprised to see major cuts in the current situation of restricted liquidity, given that the unparalleled slump in output has pushed capacity utilization rates in manufacturing industry down to near 50%.

The F3/10 capex projections released by companies for the first time, on the other hand, point to a drop of 6.6% for all companies in all industries (including land, excluding software), while credibility is something of an issue with these plans, given that not all had been set by March. The above is not as dreary as we had forecast; yet, for the full picture, we must wait till the June Tankan (on July 1), when all companies will have disclosed official data.

Looking ahead, both large and mid-scale companies are focusing on the impact of tighter credit standards. A situation reasonably termed a credit crunch, even if small in scale, is not out of the question, one featuring even more stringent controls on credit for large enterprises by banks and liquidity constraints. In addition, conditions for large enterprises to issue CPs have eroded further from last December’s Tankan, from -20pp to -24pp, despite a sharp decline in CP rates triggered by the BoJ’s CP purchase program.

F3/09 Land Purchasing Plan Revisions and F3/10 Initial Forecasts

Land purchasing plans tend to be revised up gradually towards fiscal year-end, but the revision rate of +12.4% for F3/09 was nothing dismal. That said, plans themselves are still below year-earlier levels, at -23.2%. We think companies are refraining from land investment in anticipation of lower prices ahead and due to funding constraints. Plans for land purchasing in F3/10 are naturally cautious too.

Policy Implications

Going forward, we expect progress in the integration of monetary and fiscal policies. The former is running out of traditional means of tackling issues, and looks set to diverge further from the existing policy framework to (1) purchasing risky assets, and (2) supporting the fiscal policy of purchasing more government bonds by the BoJ. Target assets of (1) above are, in order of priority, one-year and longer corporate bonds and other securitized products, and stocks (ETFs). (2) includes boosting the amount of Rimban operations and rolling over maturing JGBs held by the BoJ. We expect monetary policies ahead to replace more of the functions of the existing fiscal policy.

If so, the BoJ’s balance sheet could burgeon, and overseas investors could view this as an incentive to sell Japan. However, there is still the conundrum as to how much the central bank’s balance sheet would swell, and whether a flight of capital would actually occur. The ultimate dilemma for the government/BoJ is that, while a half-hearted fiscal expansion may fail to overcome the downward spiral of the economy, an overblown version risks depressing market confidence in fiscal policy. Nevertheless, because of weakened financial intermediary functions, we see little risk of an imminent inflation, meaning that, surprisingly, the central bank still has ample room for discretion. Although the BoJ has just decided to raise the Rimban value to JPY1.8 trillion/month in the March regular policy meeting, we believe that it has the capacity to expand its purchase of JGBs regardless of the banknote cap on JGB holdings, while maintaining its credibility.

Of course, for the above to be realized, we assume that the complementary deposit facility (allowing interests on excessive reserve deposits) is abolished, and that we enter quantitative easing (QE) with ZIRP again. That said, we do not expect QE ahead to be similar to what we saw in 2001-06 where the target was set well above the reserve amount. We believe that the BoJ will be aiming to follow in the Fed’s footsteps with its version of credit easing, by focusing on the asset side of the balance sheet and extending the target to include a wider range of assets.

Note that we had previously foreseen a return to ZIRP in its full form in January-March 2009, but we have pushed this back by a quarter to April-June in our February 16, 2009 update to our interest rate outlook. Following this revision, we now expect ZIRP to end a quarter later than we initially forecast; our base case assumes October-December 2010. That said, if the BoJ’s price outlook (-0.4% in F3/11) turns out to be accurate, we doubt that ZIRP will be terminated before the end of 2010.

United States
Perfect Consumer Storm Not Over
April 02, 2009

By Richard Berner | New York

The perfect storm for the American consumer is not over, in our view, although incoming retail and consumer spending data signal a temporary break in the clouds.  The good news: Those data likely signal that the acute phase of retrenchment is thankfully in the past.  And there are supportive factors, such as lower energy prices, higher income tax refunds and stepped-up unemployment insurance benefits.  In addition, coming tax cuts and mortgage refis will likely boost discretionary income into next year. 

But the bad news continues: Sinking labor and other income, falling home prices and still-tight credit imply anemic spending growth for now.  More important, the perfect storm of the past 18 months has seared the American consumer psyche, likely launching a sea change in spending behavior.  Beyond the difficult process of deleveraging and simply living within their more limited means, a new era of thrift looms for consumers, and the path probably will be painful.

Potential inflection point in consumer spending.  That path likely won’t be quite as painful as was the retrenchment of 2H08, when real spending contacted at a 4.1% annual rate, the most acute six-month decline since the shock of 1980 triggered by credit controls.  Indeed, incoming data suggest an inflection point that may mark the end of the acute phase of consumer retrenchment.  Real retail sales excluding food and energy jumped by nearly 5% annualized, and overall real consumer spending rose at a 3.2% annual rate in the past two months.  If unrevised, that would mark a stunning turnaround from the fourth quarter, when that real retailing aggregate collapsed at a 16.1% annual clip, and real overall spending contracted by 4.3% annualized.  Encouragingly, surveys suggest that nominal retailing activity at least remained flat over the past month. 

But a closer look at the recent spending data suggest there’s less than meets the eye: First, stepped-up purchases of big-ticket electronics (video, audio and computer equipment), which account for a measly 1.6% of nominal (and perhaps 5% of real) consumer spending, chipped in a whopping 58% of the increase in spending in January-February.  That might appear to signal some pent-up demand; after all, the long housing bust finally promoted retrenchment in spending on furniture and appliances over the course of 2008.  However, the liquidation of a major electronics retailer may be a more plausible explanation, accompanied as it was by once-in-a-recession bargains.  Moreover, another quirk in the data seems to have pushed up spending.  Outlays for prescription drugs, which account for less than 3% of overall consumer spending, added another one-third to the real spending increase.  Apart from those categories, overall spending rose at a 0.3% annual rate over the first two months of 2009.

Still, we cannot overlook the genuinely supportive factors that have helped or will help to lift discretionary spending power.  Some are temporary.  The contribution to discretionary income from the slide in energy quotes amounted to roughly US$230 billion (3.2 percentage points at an annual rate) over the eight months ended in February.  While that support has faded with rebounding energy quotes, the boost from higher tax refunds and extended unemployment insurance benefits will linger.  As of last week, tax refunds are running about 15% ahead of the 2008 year-to-date pace; those refunds have added about US$23 billion to spending wherewithal in the first quarter, on track for a total boost of US$35 billion by June.  (Note: After April 22, comparisons with 2008 tax refunds will turn negative, because the IRS mailed US$51 billion of tax rebate checks between April 22 and May 31, 2008).  The stimulus package enacted in February adds another US$27 billion to spending power through extended unemployment insurance benefits, and the first US$2,400 per capita received in 2009 will not be subject to federal taxes.

Some supportive factors will last longer: A cut in personal withholding tax rates effective April 1 – the first installment of the Making Work Pay Credit – will permanently add about US$25 billion to discretionary spending power, and another US$60 billion will show up in refunds and final settlements in 2010.  And we expect that non-withheld tax payments in April/May will come in US$84 billion (38%) less than a year ago.  Together with a short-term fix for the Alternative Minimum Tax and other credits, individuals will get US$200 billion in cumulative tax relief through the third quarter of 2010.  Moreover, we estimate that the Fed’s efforts to reduce mortgage rates will unleash a refinancing boom that will cut about US$100 billion annualized from the household debt-service burden over the next year or so.  That’s based on 30-year conventional mortgage rates going to 4.5% and our estimate that roughly half of all securitized mortgages could be refinanced in the next year.  These benefits from personal tax cuts and mortgage refis will support spending power over the next year, in our view. 

However, consumers face familiar and still-powerful headwinds: Even allowing for cuts in withheld taxes and modest inflation, contractions in jobs and income mean that real ‘core’ income will likely be flat to down over the course of 2009.  The risk is pointed to the downside: With the unemployment rate likely to hit 10% by year-end, slack in labor markets will likely erode wage gains soon. 

Such terrible income compression should tame spending, and even if income proved somewhat more vibrant, the ongoing slide in household wealth implies that consumers will probably save a larger proportion of current income.  Housing imbalances continue to erode home prices, and earnings risks menace equity markets.  Despite the recent stability in home sales, foreclosures continue to add to housing vacancies.  Single-family vacancy rates stood at a record 2.9% in the fourth quarter, or nearly 100bp above the long-term mean, so it would hardly be surprising if home prices fell by another 10% – representing another US$1.8 trillion decline in household wealth.  And while equity values have bounced by 16% off their March 9 lows, they are still down about 13% this year, lopping another US$1.5 trillion from household wealth.  On top of the nearly US$13 trillion decline in household wealth since mid-2007, those declines will continue to push up the personal saving rate.

As a result, the cyclical part of this adjustment story only represents the first chapter.  Even when recovery comes, it will likely usher in a long period of modest gains in spending.  Balance sheet rebuilding will spread over the next several years, and regulators will seek to limit leverage, thereby reducing credit growth and ROEs for Corporate America, in our view.

We think this crisis has already begun to trigger a sea change in consumer spending behavior, as consumers now embark on a long period of rebuilding thrift.  On the asset side, there is further downside risk to both home and equity prices, and even when they trough, a rapid rebound is unlikely.  On the liability side, it will take time to deleverage and realign debt service with income.  If we’re right that markets recover slowly from these shocks, balance sheet repair will require more saving out of current income and involve real consumer spending growth of no more than 2-2.5% over the next several years, compared with 3.5% over the decade ended in 2007.  The golden age of spending for the American consumer has ended, and a new age of thrift likely has begun.

Lenders also face a slow pace of improvement for both assets and liabilities.  Leveraged lenders must rebuild their balance sheets with new capital, continue to write off and provision for a significant volume of soured loans, and repay the capital on loan from the Treasury through the TARP.  Moreover, regulators will seek to reinforce lender caution and safety by requiring higher minimum capital, thus limiting leverage and reducing credit growth and ROEs.  In all, these forces should promote a much more sober but more sustainable spending backdrop than in the past decade.

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