Mexico
Reassessing the Balance of Risks
April 21, 2009

By Luis Arcentales & Daniel Volberg | New York

Banco de Mexico’s decision to cut rates by 75bp to 6.0% on April 17 represented an important turning point for monetary policy, in our view. Though the magnitude of the rate cut was not in itself a major surprise – the market consensus was pricing in a cut of 50-75bp – the dovish tone of the statement seemed to signal a major turning point in the central bank’s approach to setting monetary policy in the months ahead. We suspect that the balance of risks that the central bank considers when setting monetary policy has shifted; consequently, the central bank may now be able to focus away from the recent mixed inflation releases, and instead become more forward-looking in setting monetary policy. This change in tone and shift in focus is particularly relevant, given our view that Banco de Mexico will have to revise its near-term inflation forecast range higher in its forthcoming Inflation Report due April 29. Over the past few months, the swings in the pace of monetary easing – from 50bp in January to half that amount in February and to 75bp in March – had raised questions that policy decisions had become exceptionally currency-driven (see “Mexico: The Policy Dilemma”, EM Economist, February 27, 2009). No longer hostage to exchange rate weakness – or “financial turbulence” in Banco de Mexico’s own words – the peso’s return to near 13 per US$ allowed the authorities to finally, rightly in our view, overlook the mixed inflation data of late and instead focus on the already severe recession and, as a result, the benign outlook for inflation.

Given Banco de Mexico’s new-found maneuvering room, we are revising our interest rate forecast for this year to 4.0% from our previous forecast of 5.25%. Several factors underpin our call for more aggressive monetary easing. The move in the peso to around 13 per US$ has significantly altered the risks of pass-through from the weaker currency into prices, in our view. Recent policy actions like the agreement with the IMF have been instrumental in shifting sentiment towards the peso, allowing a greater role for the strong fundamentals in driving the currency and reducing the potential for another bout of sharp weakness. Combined with the ample slack created by the severe domestic recession – which has helped to cap wage pressures and keep inflation expectations anchored – we suspect that Banco de Mexico feels more comfortable with the ongoing disinflationary dynamic, thus opening the door for a more aggressive easing cycle than many Mexico watchers are ready for.

Mexican Peso: No More Peso-mism?

The peso’s near-uninterrupted weakening into March had rightly raised concerns about currency weakness, putting significant upward pressure on prices that could offset any downward price benefit from lower commodity prices and domestic slack. Faced with this risk, Banco de Mexico warned in its February 20 communiqué that although the downside risks to growth seemed greater than the upside inflation risks and it believed that inflation had peaked in December, it was concerned that peso weakness could jeopardize the expected continued improvement in inflation. And the authorities’ concerns were not without merit: the clear disinflationary trend in domestic-focused services – likely a reflection of the severe economic slump – had been fully offset by the upturn in prices of goods ex-food, a move likely prompted by the sell-off in the currency. As a consequence of this dynamic, the improvement in annual inflation to date – which Banco de Mexico had rightly predicted would peak in December at 6.53% – has been quite modest: as of March, inflation was running at a still-elevated 6.04% pace.

The recent shift in sentiment towards the peso – and the associated reversal of its depreciating trend – has provided Banco de Mexico with additional degrees of freedom by allowing fundamentals to drive the currency, in our view. With the peso reaching its weakest level ever in early March, Mexico watchers were increasingly questioning whether something was fundamentally wrong with Mexico, beyond its greater vulnerability to the US business cycle.  Concerns seemed to be focused mainly on the impact of lower crude prices on the fiscal accounts and the sustainability of Mexico’s balance of payments. Our work suggests that both of these concerns may have been overblown (see “Mexico: Stress-Testing the Balance of Payments”, FX Pulse, March 12, 2009 and “Mexico: No Oil, No Problem?” EM Economist, February 27, 2009). Since then, the benign fundamentals appear to have reasserted themselves in driving the currency, in part helped by policy actions – above all Mexico’s US$47 billion Flexible Credit Line agreement with the IMF unveiled at the beginning of April (see “Mexico: Calling on the Fund”, EM Economist, April 3, 2009).

The stronger currency has significantly altered the balance of risks for Banco de Mexico by diminishing the risk of pass-though. This is a point we cannot stress enough: the degree of pass-through may be non-linear, with a sharp real depreciation in the currency potentially having significant inflationary consequences. By contrast, modest currency shifts – possibly below the 20% mark – may have a relatively more limited impact on prices as they could be partly absorbed by diminished margins and expectations of general price stability. The recent return of the exchange rate to the 13 range, therefore, has more significant implications for Banco de Mexico’s ability to ease rates than is often appreciated. Had the peso remained during all of 2009 at its weakest point of 15.6 reached in early March, the real depreciation would have approached 25%. A move of such magnitude could have possibly had a disproportionately negative impact on inflation. Instead, if the peso were to remain at current levels, the real depreciation this year compared to the average of 2008 would be around 10-12%, a level that is unlikely to keep the authorities unduly concerned regarding exchange rate-driven inflation. Indeed, the diminished concerns about currency pass-through may allow the central bank to shift its focus more towards the bleak outlook for economic growth.

The Economy: From Bad to Worse

In its April policy statement, Banco de Mexico provided a grim assessment of the economy which, in our view, was fully justified, given recent data and the outlook for US manufacturing (see, for example, Richard Berner’s US Economics: Depth and Breadth Matter, April 6, 2009). First, the statement acknowledged that the turmoil was having a “very severe” impact on the Mexican economy. Second, economic indicators point to a “strong contraction in the economy and employment in the past two quarters” which will lead to a “substantially superior” fall in GDP growth in 2009 than currently expected by the central bank (-0.8% to -1.8%).  

The most recent string of economic data suggests that conditions in 1Q deteriorated further compared to 4Q08. Mexico’s GDP-proxy, IGAE, posted a 9.5% contraction from a year earlier in January – the worst decline since the Tequila Crisis. The economy shed formal jobs at a rate of -6.8% annualized in 1Q – already twice as bad as the worst pace during the 2001 recession. Industrial production plunged on average by 12%Y in January and February, consistent with a sequential seasonally adjusted drop of 20% annualized on average in the December-February period. Meanwhile, US manufacturing – where the link to Mexico is the strongest – posted a decline of 15% in March, the deepest annual drop since the winding down of war production in 1945-46, according to our US team. And though April regional surveys suggested that the pace of the slump in US industry was somewhat slower than in previous months, activity was still declining. Indeed, even if Mexico experiences a meaningful sequential growth improvement – which is unlikely, given the data available so far – 1Q’s slump is very likely to eclipse the sharp 10.3% sequential annualized contraction of 4Q08. 

The severity of the ongoing slump in the Mexican economy has important disinflationary implications, in our view. First, the contraction in production – manufacturing is in the midst of one of its deepest downturns ever recorded – has translated into meaningful slack, which is likely to constrain pricing power going forward. Though capacity utilization series from the central bank only date back to 1998 (GDP data are available starting 1980), the most recent February point approached 68% once seasonally adjusted, already below the trough level in the 2001 recession. In addition, weakness in labor markets has translated into muted wage pressures. In the first three months of the year, nominal contractual wages rose 4.41% on average, just 0.05% higher compared to the same period in 2008, trailing by a wide margin the jump in inflation in the same period (an extra 2.28%). Indeed, a growing number of employers are reporting fewer difficulties in hiring personnel, even the historically more scarce ‘qualified’ workers. 

Inflation Implications  

The downturn in inflation, which has been modest so far in 2009, is set to intensify ahead, in our view. The ongoing recession is leading to a meaningful slack build-up; moreover, softening labor markets should keep a lid on wage pressures and inflation expectations – both of which have traditionally been key concerns for Banco de Mexico. Further, with the exchange rate regaining ground, the risk of meaningful pass-through has been greatly diminished – a particularly important development for the inflation balance of risks, given the uncertainty about the possible non-linear nature of pass-through.  

Our modeling work suggests that the sharp recession – we expect a 5.0% real GDP contraction in 2009 – could knock off around two percentage points from inflation this year, with a further impact of around one percentage point in 2010. The impact of the weak economy on inflation will be partly offset by currency-related pressures, but our work points to an effect from the economic slack this year dominating by a factor of around two, assuming that the exchange rate remains around 13 for the rest of the year. Finally, inflation expectations have come off significantly from their late 2008 peaks. Though March expectations remained above target for 2009 at 4.25%, according to the central bank’s monthly survey, our model suggests that they should trend lower as the effect of the growth slump works its way through. Well-anchored expectations are a key factor in our assessment that inflation should ease significantly over 2009 and into 2010 as well. 

Given the balance of risks, Banco de Mexico is likely to be more comfortable with the disinflationary dynamic, and thus we see ample room for further rate cuts to 4.0%. Indeed, we agree with the assessment from the April 17 statement – which will be further detailed in the Inflation Report from April 29 – in which the authorities, who seemed willing to look past recent mixed inflation data, guided towards a “more pronounced fall” in inflation starting in May, driven by the deep economic slump and “greater financial stability” of late. The pace of easing – whether Banco de Mexico keeps the recent 75bp clip or takes a more conservative approach – is likely to be data-driven. Inflation in April, for example, is likely to remain stuck near 6%. But whether May’s inflation decline turns out to be “more pronounced” or not, the intensifying disinflationary trend in the months ahead should provide enough room for the authorities to deliver another 200bp in rate cuts, in our view. 

Bottom Line

We suspect that the balance of risks in Mexico has shifted and may allow Banco de Mexico to deliver more aggressive monetary stimulus in the months ahead. The return of the Mexican peso to levels more consistent with the macro fundamentals has shifted the central bank’s focus from worrying about evidence of currency pass-through in recent inflation releases to the intensifying severity of the recession that Mexico is facing and that we expect will crunch Mexico’s elevated inflation in the months ahead. And the central bank’s shift of focus from backward-looking to forward-looking may allow significantly more aggressive monetary policy easing in the months ahead – we are expecting the target rate to be cut this year by a further 200bp to 4.0%.

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United States
Capex Bust and Capital Exit
April 21, 2009

By Richard Berner | New York

Amid the euphoria of improving economic prospects, investors seem too willing to overlook the downside risks to the outlook.  A case in point is the classic and relentless bust in capital spending that is likely to weigh on the US economy for at least the next year.  Indeed, we think that this collapse in spending, just like many other facets of this recession, will set or come close to setting post-war records for depth and duration. 

For example, we expect a 28.9% peak-to-trough decline in overall real equipment and software outlays, which would shatter the previous record for depth in 2001-2 (11.7%) and equal it for duration (eight quarters).  Such real outlays have already tumbled by 11% in the four quarters ended in 4Q08.  Incoming data suggest further profound weakness: Shipments for non-defense capital goods excluding aircraft tumbled at a 30.7% annual rate in the three months ended in February, while orders sank at an even sharper 38.9% rate.  Likewise, we expect a 20.4% peak-to-trough decline in structures (commercial and plant) outlays (from the peak in 3Q08), which would be the second-largest decline on record.  With non-residential construction outlays down at a 20.6% annual rate in the three months ended in February, the foundations for commercial construction look increasingly shaky.

The good news is that this bust is promoting ‘capital exit’ – a much-needed housecleaning for Corporate America.  Despite aggregate capital discipline in this expansion, there are clear pockets of excess.  For example, non-residential construction outlays advanced at a 10.4% annual rate in the past two years, well beyond the 3% rate needed to maintain the ratio of structures to output.  And at the micro level, changes in relative energy prices have made certain kinds of capital obsolete.  Some may think that the downturn will leave companies bereft of capital, uncompetitive and ill-equipped to meet the needs of recovery.  We disagree.  We think that this process will begin to eliminate excess and obsolete capacity, ultimately setting the stage for improved pricing, better returns on invested capital, and higher profit margins.  This should be good news for equity and fixed income investors alike.

Three factors are driving the investment bust: First, a slumping economy has turned the time-honored capital-spending ‘accelerator’ into a brake.  The flexible accelerator model of investment implies that business investment will respond with a lag to changes in the desired stock of capital in relation to output.  Managers will tend to extrapolate a slowdown in business activity into dimmer expectations of future growth, lower perceived returns from investing, and a reduced need to invest.  As a result, even a slowing in economic growth will depress growth in investment, and a recession will crush it.  And those lags are critical because the past deceleration of the economy – a negative ‘second derivative’ – will continue to depress capital spending until next year, even when current growth rates trough.  For example, on a year-over-year basis, the deceleration (second derivative) of the economy will only bottom in the current quarter at -8.1%.  That’s especially ironic today, because investors are currently entranced by an emerging positive ‘second derivative’ in other economic data.

Second, the credit crunch has raised the cost and reduced the availability of funding for new investment projects.  Although they have eased in the past few months, there is no mistaking the fact that financial conditions are restrictive.  Despite the recent rally in high yield debt, rates for lower-rated borrowers are still well in double or at least high single digits, while those for investment grade borrowers are still elevated in relation to inflation.  And while for the second quarter in a row, fewer banks likely tightened lending standards in the past three months and securitization markets are improving, the cumulative impact of past restraint is still strong, and securities markets are far from fully functional.

However, the recent decline in corporate borrowing costs is unlikely to promote a quick turnaround in capital spending.  Empirical evidence suggests that investment outlays aren’t as credit-sensitive as housing or big-ticket consumer durables, and the lags between changes in financial conditions and changes in capital spending may be longer than for those two components of demand.  For example, standard models of investment spending suggest that a 100bp decline in corporate bond yields might promote a 2pp increase in business capital spending over two years (note that the real capital stock is six times the level of spending, so the elasticity of financing costs with respect to the capital stock would be one-sixth as large; see Ricardo J. Caballero, “Aggregate Investment”, Handbook of Macroeconomics: Volume 1B, edited by John B. Taylor and Michael Woodford; Amsterdam: Elsevier, 1999; and Simon Gilchrist and John C. Williams, “Investment, Capacity, and Output: A Putty-Clay Approach”, Finance and Economics Discussion Series No. 1998-44).  Moreover, those estimates likely overstate the impact in today’s circumstances because both diminished credit availability and rising credit costs have contributed to the tightening, and gauging the interplay of these effects is difficult (Fed Chairman Bernanke and his co-authors refer to such an interplay as the ‘financial accelerator’). 

Capacity glut will likely persist.  Finally, a plunge in operating rates and rise in office and other commercial real estate vacancy rates has unmasked a glut of capacity that will persist even as the economy recovers.  Independently from the accelerator, increases in idle capacity depress capital spending.  They signal that managers should scale back expansion plans as falling operating rates indicate that there is plenty of capacity to accommodate future expansion.  Put in the vernacular of standard investment models, falling operating rates postpone the adjustment of today’s capital-output ratio to the desired stock in relation to output.  The plunge in factory operating rates in this downturn has been breathtaking: Just over the past year, capacity utilization in manufacturing has fallen by 12 points (a one-year slide only eclipsed in the 1974-75 recession) to a record low of 65.8%.  That is fully 15 percentage points below the average of the past 60 years.  The output gap – the difference between actual and potential GDP – tells a similar story for the broader economy; it appears headed to a record 8.5% of GDP by the end of this year.  And office vacancy rates play a parallel role for commercial construction.  At 15.2% in the first quarter, according to REIS, such vacancy rates appear headed close to their record peaks in the mid-1980s (20%) when a construction boom created a glut that lasted several years. 

Those same three factors are creating collateral damage for the economy that reinforces the downdraft in investment spending: Slumping activity and wider margins of unused capacity are sapping pricing power and reducing operating leverage and thus profit margins.  Measured by the ratio of after-tax ‘economic’ profits to corporate GDP, we expect margins to fall all the way back to 1986 levels, or 770bp below their 2006 peak.  And we project an average 19.4% annualized decline in corporate cash flow (undistributed profits plus depreciation) in each of 2008 and 2009, which is sapping companies’ ability to use internally generated funds to finance capital spending.  Indeed, many are slashing dividends, 401k matching contributions and other ‘fixed’ expenses to stay cash-flow positive.  Rising commercial real estate vacancies pressure rents and cash flow, just as plunging operating rates squeeze pricing and margins.  Finally, we don’t expect deflation, but deflation scares are likely, and both factors should compress margins and pressure the bottom line (see Deflation Still Unlikely, but Mind the Risks, February 25, 2009).

The silver lining in this capital spending bust is that it will help to purge investment excesses; indeed, it is essential to do so.  Most of the excesses in this cycle have been concentrated in housing, where foreclosures continue to fuel vacancy rates and supply-demand imbalances.  But as noted above, easy credit did fuel exuberance in commercial construction, and the downturn has unmasked acres of obsolete plant and equipment.  The cure for excessive investment is the exit of capital from what my former colleague Steve Galbraith calls the ‘capital pigs’ – overcapitalized industries – and the redeployment of that capital into new products and new industries that can use it productively. 

That process will take time.  But there is some more good news: Judging by the growth in industrial capacity, we believe it is already underway.  Capacity in manufacturing excluding high-tech and motor vehicles and parts industries has expanded by a meager 0.3% over the past year.  And capacity in another industrial subaggregate – including primary metals, electrical equipment and appliances, paper, textiles, leather, printing, rubber and plastics, and beverages and tobacco – has contracted by 0.9% over the past year.  As a result, the bust now in high- and low-tech equipment outlays will eventually lay the groundwork for renewed growth.  And investors will likely reward those companies who rediscover the discipline of producing high returns on invested capital.

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UK
Budget Preview: Less Growth, More Borrowing
April 21, 2009

By Melanie Baker, CFA, Laurence Mutkin & Owen Roberts | London

Budget Preview

This year’s Budget is unlikely to include another major fiscal stimulus package.  But it is likely to include further downgrades to the Treasury’s economic and public finance projections.  In this respect, an announcement of further fiscal consolidation (higher taxes and/or lower spending) in the years ahead seems very plausible.

Major Revisions to the Deficit

Major revisions are likely to the Treasury’s projection for Public Sector Net Borrowing (PSNB, effectively the UK’s measure of its fiscal deficit).  This follows the continued sharp deterioration in the economy.  We think that the Treasury could raise its PSNB projection for 2009/10 by around £30 billion to about 11% of GDP, with another 11% of GDP in 2010/11 too.  This would imply significant additional Gilt issuance than seemed likely at the end of last year.

Further Cuts to HMT Growth Forecast Likely

In the Budget there is likely to be a further downward adjustment to projected near-term growth.  The April 6, 2009 Times newspaper suggested that the Treasury is preparing a forecast where the economy contracts by 2.5-3% this year.  Consensus, as of mid-April, was for GDP growth of -3.4% in 2009 and 0.3% in 2010. 

In our best guess of what the Treasury might predict, we have assumed a close to consensus GDP forecast of -3.5% in 2009 and 0.5% in 2010 (where the Treasury tends to use the bottom of its forecast range to project the public finances).  Our own forecast for GDP growth (despite our recent downward revision) remains on the optimistic side of consensus at -2.5%.  Hence, we think that the Treasury’s revised GDP and public sector finances forecasts may eventually end up being too gloomy and need to be revised upward at the time of the pre-Budget or, more likely, at next spring’s Budget. 

New Policy Announcements Likely

Some form of additional fiscal stimulus will be announced in the pre-Budget, although we expect the measures to be very targeted and the overall scale to be small.  Measures targeted at re-training, a scrappage scheme to encourage the trade-in of old cars and measures to boost investment in alternative energy all seem plausible.  Other measures might include plans to allow a big expansion in the new building of social housing plus the launch of the previously announced plans to help those people who are struggling to pay their mortgage.

Our own central economic forecasts suggest that the UK can recover without further major fiscal stimulus, given the amount of policy stimulus (fiscal and monetary) and banking sector reform in the pipeline already.  However, smaller, more targeted measures aimed at helping people to get off unemployment benefits or further help for households facing mortgage payment difficulties, for example, would be welcome.  A further major fiscal stimulus would be a risky move (in terms of the potential effect on bond yields), particularly as the Bank of England starts to get to the end of its current £75 billion asset purchase programme (it is more than a third of the way through).

However, with the deficit likely to reach above 10% in the next year or two, measures to shore up the public finances further down the line are becoming more pressing.  Some further fiscal consolidation for the years ahead (though not in the year ahead) seems plausible (including, for example, a further crackdown on tax avoidance).  In November’s pre-Budget the Treasury announced, for example, cuts in personal tax allowances for the highly paid (from 2010-11) and increases in National Insurance Contribution rates (from 2011-12).  However, large tax increases or spending cuts would risk potentially prolonging the recession by increasing households’ desire to save.  But not announcing a credible plan to get the deficit lower in the future would also be very risky.

Issuance Likely to Remain High in 2009/10 and 2010/11

Our best guess for the kind of economic forecast the Treasury might announce (a close to consensus -3.5% GDP growth in 2009 and 0.5% for 2010) would imply (very roughly) public sector net borrowing of around £149 billion in 2009/10 and £158 billion in 2010/11, in our view.  This leads to an estimate of gross Gilt issuance of £167 billion in 2009-10 (higher than in 2008-09) and £197 billion in 2010-11 (when significantly higher redemptions kick in). 

Our own economic forecast (-2.5% GDP growth in 2009 and 1.7% for 2010) leads to a public sector net borrowing forecast of around £140 billion in 2009/10 and £148 billion in 2010/11.  This is a little worse than the Morgan Stanley ‘pessimistic’ case estimates published in the Green Budget (from the IFS in collaboration with Morgan Stanley).  This would imply an estimate of gross Gilt issuance of £159 billion in 2009 and £187 billion in 2010-11. 

Either way, 1) this is a lot of issuance, but 2) it may be less than some investors expect.

There are some significant upside and downside risks to the issuance forecasts (not least from the path of the economy), including what happens to National Savings and Investments (inflows from this could stay relatively strong), a potential desire to rollover some of the existing T-bills issued into Gilt issuance (we estimate that this could add about £10 billion to the total) and future inflows and outflows from the government’s intervention in the financial sector (which are very uncertain in either direction). Further, the DMO has suggested that it may syndicate some Gilt issuance during 2009-10, which could total up to £10 billion.

Taking all this into account, we think there is more downside than upside risk to our 2009-10 gross Gilt issuance estimate.

The Distribution of Gilt Issuance

The DMO’s recent bias towards skewing issuance to long conventional and index-linked Gilts could well be reduced in 2008-09, due to the steepening of the yield curve.

The DMO has in recent years skewed issuance to long conventional and index-linked Gilts, because it sees strong demand for these sectors from the pension fund and life insurance industries. It has justified this view partly by reference to the shape of the yield curve and partly by reference to its consultations with GEMMs and end-investors (see, for example, the Debt and Reserves Management Report 2008-09).

Thus, in fiscal years 2006/07 and 2007/08 combined long conventional and index-linked issuance amounted to 66-68% of all Gilt issuance; and the original plan for 2008-09 was for 53% of issuance to be in long conventionals and index-linked combined.

But the out-turn during 2008-09 was very different from the initial remit, thanks to the composition of the sharply increased Gilt issuance during the second half of the year. As it turned out, only 35% of total 2008-09 issuance has been in long conventionals and index-linked.

Further, the steepening of the yield curve seen during the past year has diminished the strength of the argument for issuing such a large proportion of long conventionals. Not only has the whole curve steepened, but 10s/30s have steepened by more than the steepening in 2s/10s would suggest. We therefore expect that the distribution of issuance in 2009/10 will be much more like the 2008/09 out-turn than like previous years.

We calculate that the steepening of 10s/30s implies that longs should be just 10% of conventional issuance in the coming year, ignoring the effect on the curve of the BoE’s QE Gilt purchase programme. Adjusting for the purchase programme, we reckon that 20% of conventional issuance should be in longs in the coming year – well down from the 24% in 2008/09 and from the 50%+ seen in the two prior years.  Indeed, in cash terms long conventional Gilt issuance could be slightly lower in 2009-10 than it was last year.

On our assumptions, index-linked issuance will also remain close to 2008-09 levels, while issuance of mediums will rise to £43 billion (+£10 billion from last year) and shorts to £72 billion (+£9 billion).

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