Looking Beyond the Recovery Call
May 14, 2009
By Takehiro Sato | Tokyo
Case for Mounting Optimism Fed by a Production Trough
Production and exports are expected to do well in the near term Industrial production bottomed tentatively in February, though micro data in the electronic components and auto industries had made this foreseeable to a large extent. But market optimism is mounting as preliminary industrial production data for March and the survey of production forecasts for April-May provide hard evidence of a post-March pick-up. As the April-May survey of production forecasts showed, production and exports ahead are seen as fairly brisk due to restocking. The six months following the Lehman shock in September saw an unprecedented production correction, especially in the auto industry, as sales financing came under pressure and trade financing dried up. Now, however, as financing constraints ease with policy support, sales inventories overseas are starting to look too thin, and manufacturers are switching to a mode of inventory building. This restocking is symptomatic of the early phase of a recovery, and as inventories revert to appropriate levels, production and exports tend to perform quite well. For example, in the recovery from January 2002 that followed the collapse of the IT bubble, pressure to replenish inventories of high-tech components that were used in large quantities in the military action in Afghanistan caused production and exports of electronic components and devices to thrive, which became a driving force behind a genuine recovery. Yet, early in 2002 very little attention was paid to this brisk production trend, partly due to problems in the domestic financial system. Slowing inventory adjustment is also positive for GDP The unintended build-up of inventories due to plunging sales meant that the inventory contribution to October-December 2008 GDP was +2.0pt annualized, boosting GDP superficially. But we expect this to slip to a -1.4pt contribution in January-March due to inventory correction, dampening GDP. As this inventory adjustment progresses, GDP could be lifted in a period of correction from as early as April-June, as the BoJ also indicated in its April Outlook Report. Since inventories in GDP data are captured by flow (increase/decrease) rather than level, this contribution factor is indicative of the degree of acceleration. Even in a phase when inventory levels are decreasing due to adjustments, there should be a positive contribution to GDP if the speed of inventory drainage relents. In our upwardly revised economic forecast (April 15) made in light of the announcement in April of the economic stimulus package, we include a modest positive contribution from inventories for the April-June quarter onwards (see Upgrading Outlook for Fiscal Stimulus Effects, Yet to See Full-Blown Recovery, April 15, 2009). So we highlight that, despite low headline growth in the real economy, positive elements such as brisk production/exports, inventory contribution to GDP turning positive and a boost to real incomes from lower prices could trigger unforeseen upside in the growth rate. Corporate fixed-cost cutting pressure is a hindrance Factors that dampen growth are also apparent, though. Although production activity in manufacturing is recovering, utilization rates are not ready to pick up to the average level prior to this recession of more than 80%. To avoid losses from falling utilization rates, companies therefore need to axe their fixed costs. We estimate that even if capacity utilization recovers to 66% from the trough in the January-March quarter, major manufacturers would need to cut fixed costs by over 5% to generate positive operating profits. This would be achieved mainly by eliminating idle capital stock and cutting labor costs (see Still Deep in the Woods: Earnings Levels Implied by Rebound in Operating Rates, April 24, 2009). Private-sector demand in Japan is inevitably facing pressure. Economic Recovery Implied by the Coincident CI Assessment based on the coincident CI could show the economy no longer declining in summer, and improving in early autumn from a technical perspective Since seven of the 11 indicators forming the coincident index of business conditions are linked to industrial production, the coincident CI (composite index) can reasonably be understood to take a very similar path to production. Let us briefly explain the Cabinet Office’s basis for assessing the economy using the coincident CI. Since the CI for any single month is liable to be destabilized by temporary factors, the government uses an objective standard focusing on the gap versus the previous month for the three- or seven-month backward moving average (BMA(3), BMA(7)). The indication of an ‘arrested decline’ is when the BMA(3) turns positive month on month, and an ‘improvement’ is signaled by three consecutive increases in the BMA(3). Reflecting the transition to a mode of production increase in manufacturing from March, as outlined above, we can expect the BMA(3) to turn positive as early as the May data. (According to the preliminary figures in the March BCI (Business Conditions Index) on May 12, the coincident CI fell 0.3pt versus February, albeit by a smaller negative margin. We simulated the coincident CI based on the METI’s production forecast, and concluded that there is a decent chance for the May coincident CI to turn positive on a three-month backward-moving average basis.) In that case, though partly dependent on the momentum of the CI increase, the Cabinet Office could decide in early July when the CI for May is released that ‘the economy’s decline has halted’. We would have a technical ‘recovery’ if the BMA(3) climbs for three consecutive months. The earliest we could confirm that to be the case would be in the July CI, and therefore the earliest the Cabinet Office might officially assess ‘improvement’ would be early September when this July figure is released. (Such recovery call would be from the ESRI (Economic and Social Research Institute) of the Cabinet Office, instead of the government itself, thus the assessment could be different from the government’s. The government’s official confirmation of a recovery typically trails the actual trough for the economy by over one year.) There are risks as well This scenario for a halt in decline in July and an improvement in September represents the earliest possible timeframe, and for this assessment to be made, production would have to attain a certain momentum, rather than simply stay in a mode of increase. Specifically, to call a halt to the decline from the May data would require a positive move of more than one standard deviation (generally +0.55pt month on month), rather than just a positive turn in the 3MMA CI for May. This is a comparatively high hurdle, but as understocked inventories return to appropriate levels, production and exports tend to perform quite strongly, as discussed, and since the pace of inventory adjustment until February was extremely rapid, the rebound might be similarly fast. This is not necessarily expecting too much. There are risks, however. If production and exports fail to rebound vigorously, it would be ambitious to assume that production will increase sustainably for the coming six months. Signs of a slowdown in April exports out of Korea and Taiwan, which are a leading indicator of Japanese exports, raise concern here. Pre-Election Declaration of Recovery Could Help the Ruling Coalition Best case politically is the economy is deemed to have stopped sliding in summer The best case for the government would be for the coincident CI to support an objective assessment that the economy is no longer in decline or is recovering in the July-September quarter, prior to the general election, which would provide the ruling parties with a chance to argue that the economic stimulus is working. Cabinet support ratings show close empirical links with the state of the economy and share prices, and the recent pick-up in the current cabinet’s support rating attests to this. However, the recovery is going to be export-driven, with the critical element of domestic private-sector demand remaining sickly. The market implication, from a contrarian stance, is that the peak of market optimism marked by a government declaration of recovery would probably be the time when the market begins to change course. Additional stimulus central to path of economy in F3/11 Whether we will see additional stimulus will depend on the makeup of the post-election administration, and thus is opaque currently. Generally, if the economy is on a recovery track at the end of the year, even if this is export-led, incentives to produce major additional stimulus measures diminish. In this event, there would be a risk that domestic demand, having held up only thanks to public-sector demand, would suffer a double-dip as the stimulus impact fades. Our economic forecast from April 15 is based on this assumption. The upside risk, on the other hand, is that a massive new fiscal stimulus is provided with an eye on the coming general election. This would allow public demand to continue to prop up domestic demand, and open the door to a return to measured growth in F3/11. Past cases of large supplementary budgets, in fact, show that rarely is the stimulus delivered in a single round, and in 1993, 1995 and 1998, which saw particularly extensive spending, there were 2-3 dollops of stimulus. BoJ’s corporate funding assistance has been unexpectedly powerful Corporate financing assistance arranged by the government and BoJ to ward off a funding crisis for large firms and SMEs has proved to be unexpectedly effective. CP purchasing by the BoJ has sharply lowered interest rates in CP issues, and its corporate bond buying operations are similarly triggering a mini-bubble in the primary and secondary markets. The corporate financing assistance operations have also had a major impact ahead of the end of the fiscal year, by providing banks with backed financing to lend to corporations within the range of eligible collateral at a fixed rate set at the policy interest rate (0.1%). It was decided at the February MPM to continue these measures until September, but we see a possibility of an extension of six months looking ahead to the end of F3/10. In 1999, enhancement of the credit guarantee system for SMEs (providing special guarantees) led to formation of excess liquidity. In this context, it is worth monitoring whether such measures feed unexpected upside for asset markets.
Important Disclosure Information at the end of this Forum
Growth Cycle – Taking Stock
May 14, 2009
By Chetan Ahya | Singapore & Tanvee Gupta | India
Overall Growth Trend Still Close to a 16-Year Low We believe that, in the context of assessing the overall growth trend, particularly for the corporate sector, industrial production (IP) has been the most relevant indicator. Corporate revenue growth has closely followed IP growth. IP growth touched a 16-year low of -2.3%Y in March 2009, from the peak of 13.6%Y during the quarter ended January 2007. We believe that both domestic and external demand have been extremely weak. Private Consumption Trend to Bottom First Discretionary spending has started showing signs of improvement. After a decline of 1.8%Y during the quarter ended December 2008, consumer durables production growth accelerated to 5.4%Y during the quarter ended March 2009. As per press reports, sales of refrigerators and air conditioners have picked up. Similarly, two-wheeler sales increases accelerated to an average of 8.2%Y over February-April 2009 numbers, compared with a decline of 9.9% in October-December 2008. Passenger car sales gains also accelerated to 13.3%Y over the three months ended April 2009 compared with a 1.2% increase registered in the previous three months. However, the consumer non-durables segment, which tends to lag the consumer durables, has now started to weaken significantly, declining by 4%Y in February-March 2009. This pushed overall consumer goods production growth to a low of -1.5%Y during February-March. We believe that consumer non-durables and overall consumer goods production will start recovering over the next 3-4 months. Policy Traction Supporting Gradual Recovery in Discretionary Consumption Many market commentators have given credit to an acceleration in rural demand for the slight improvement in private consumption segments like durable goods and auto sales. We believe that, while rural consumption likely remained steady at healthy levels, the main reason is a function of the government’s policy response. Government spending has increased sharply since October 2008, from an average of 25.2%Y growth during April-September 2008 to 67.1% during October-December 2008, and 51.7% during the two months ended January-February 2009. We estimate that the consolidated fiscal deficit (including off-budget expenditure) will be 12.4% of GDP in F2009 (12-months ended March 2009) compared with 6.8% of GDP in F2008. A large part of the expansion in the deficit came through in the last six months of the financial year. The aggressive monetary policy measures of the Reserve Bank of India (RBI) are also beginning to gain traction. Although initially banks were reluctant, over the last two months they have been cutting lending rates across the board. The improving liquidity environment is also reflected in narrowing spreads. The spread of 3-month CP rates over 91-day T-bill yields has compressed to 191bp currently from the peak of 763bp at end-October 2008. External Demand – Worst Is Likely Behind Us… Exports are estimated to have declined again in April by 23.6%Y (provisional, according to Live Mint newspaper), albeit at a slower pace than the 33.3%Y decline witnessed in March 2009. While we maintain our view that exports will remain weak over the next 3-4 months due to the global slowdown, we expect the year-on-year decline to narrow from here (i.e., exports will still decline, but to a smaller extent). The second-order derivative for the US ISM New Orders Index (3-month moving average), which leads export growth by about four months, has improved for the fourth consecutive month (40.5 in April versus 35.8 in March and 29.8 in February). …but Capex Growth Should Decelerate for Longer Capex growth has been decelerating sharply but has held up better than private consumption so far. We expect capex growth to weaken further. Private corporate capex, which was one of the main drivers of overall investment growth, will likely take the biggest hit. The excess capacity burden remains high. The corporate sector is suffering from large operating leverage. The gap between corporate capacity for growth and realized growth is expected to be much wider in the current cycle than in the mid-1990s; that is, the capex binge has been much larger in the current cycle. Private corporate capex to GDP increased to 15.9% as of F2008 from 6.8% in F2004. However, IP, which is a proxy for utilization of capacity created, contracted by 2.3%Y in March 2009 from the peak of 13.6%Y during the quarter ended January 2007. Even with the recovery in IP, we believe that capacity utilization for the corporate sector will remain relatively low, dissuading companies from initiating any major new capex plans. IP Growth Recovery to Begin in June-July, but at a Gradual Pace While consumption should start improving over the next three months, private corporate capex will be a drag, in our view. We expect IP growth to start recovering only gradually, to reach 6-7% by March 2010. This would still be lower than the average of close to 9% during January 2004 to mid-2008, when the global economy started suffering from a credit crisis. Apart from a tepid recovery in G7 economies, we believe that India’s growth trend will be constrained by the effect of the loose monetary and fiscal policies pursued during the last four years. These effects are now showing up in rising non-performing loans in the banking system and a high fiscal deficit burden in addition to public debt. Upside Risks to Our View The first upside risk to our estimates is a potentially faster recovery in global growth than currently implied in our team’s forecasts. Our economics team currently estimates global growth of -1.6% in 2009 and +2.7% in 2010. Stronger global growth would help India by way of an increased financial risk appetite, implying greater capital inflows and stronger export growth. This, in turn, would mean lower real interest rates, a quicker improvement in capacity utilization and greater corporate confidence for investments. The second upside risk is a surprise in the outcome of the general election on May 16. If either the Congress or the BJP were to win about 170-180 seats out of a total of 543 seats in the parliament, the winning party would be allowed to form a coalition that would be narrow compared with the current ruling coalition, and this would likely increase the pace of reforms, boosting business confidence, in our view.
Important Disclosure Information at the end of this Forum
Policy/Politics Impact of Ozawa Resignation: Stagnation Now, Better Metabolism Later
May 14, 2009
By Robert Alan Feldman, Ph.D. | Tokyo
Top candidates include Katsuya Okada (55), Yoshihiko Noda (52), Naoto Kan (62) and Kazuhiro Haraguchi (49). Okada is a former METI official, with a record of pro-reform positions. Noda is a center-left, pro-reform candidate from Chiba. He has significant faction support in the party, and has the advantage of never having been party chairman. However, his support base is not wide. Kan was DPJ chairman until a scandal forced him to resign. He is popular with the left wing of the party, but has little broad popular appeal. Haraguchi is center-left and somewhat populist in his stances. Oft-mentioned is Seiji Maehara (47), but he (also a former party chairman) has said clearly that he does not intend to stand. Note that the left wing of the party does not have any prominent candidates, other than Kan. A lively contest – which pits the different factions in the party against each other in an open process – would be positive for the momentum of the DPJ, and would enliven the debate on economic policy. Indeed, a weak, divided opposition party has been one of the key elements benefiting the ruling party recently. Pocketbook issues will remain central to the battle for DPJ leadership. Moreover, the DPJ will likely choose a candidate who contrasts with PM Aso on as many fronts as possible, but still has popular support. Given developments in the geopolitics and the global economy, the new leader must have credentials in economic management, international relations (especially strong ties with the US – given the recent missile launch by North Korea), and in social policy, in order to have credibility with swing voters. Moreover, in order to contrast with the air of ‘old politics’ that surrounded Ozawa, the new DPJ leader will need to be a new face, as well. According to these criteria, Noda and Haraguchi seem more likely. That said, Okada remains the frontrunner, because of his name recognition, his serious and highly developed policy stances and his lack of membership of any particular DPJ faction. Okada’s weak points are that he is not considered to be an inspiring speaker, and that he was party leader when the DPJ lost badly to PM Koizumi in the September 2005 election. On Policy and Election Timing We do not expect major delays in the supplementary budget; the laws will pass the Lower House on May 13, and take effect automatically 30 days later, regardless of action by the Upper House. There are some other pieces of legislation needed to implement the budget, but some sources say that 90% of the budget is not dependent on such implementing legislation. However, the LDP cannot easily dissolve the Diet without passing these laws, even though it will face much delay while the DPJ regroups. In addition, there are other important laws (e.g., the bill to allow Japan to aid with global anti-piracy efforts and the bill to establish a Consumer Affairs Agency) that must be passed, and so the early dissolution scenario would not likely gain approval in the LDP. The key point for the DPJ is to project a clear, appealing philosophy. An invigorated DPJ will probably improve the quality of debate in the Diet on the supplementary budget, removing pork-barrel projects and constraining bureaucratic privilege. Sharp attacks by the DPJ on excess or wasteful spending would hurt the LDP’s prospects. On election timing, the two most likely dates remain August 23 and October 18. The earlier date presumes poor support for the DPJ in the wake of the leadership change, and the LDP would take advantage of this with an early election, just after the summer holidays. The latter presumes that the DPJ does better, making the LDP reluctant to call the election early. Market Reaction In the short term, market reaction to Ozawa’s resignation will likely remain subdued. Investors are far more concerned with earnings, and have little time to ponder the uncertainties of politics now. At least a week of uncertainty remains before the DPJ leadership issue is settled, and even then the impact of the new leadership on policy will likely take time to emerge. Markets remain extremely skeptical of the potential for real political change. Hence, not only the top leadership in the DPJ but also the new senior party positions will have to be filled by credible reformers, in order for the change to have an immediate impact. Recall that the market declined for a full year after PM Koizumi took office, until his decisiveness in the financial turmoil convinced investors that he would take serious action. That said, an improvement in political metabolism is good for policy and for economic recovery prospects. None of the policy contradictions or factional disputes inside either major party has been resolved. Thus, a faster metabolism in the wake of Ozawa’s resignation will likely hasten the reorganization of political parties. We continue to believe that such a reorganization will occur. Note also that former PM Koizumi remains by far the highest in public opinion polls of who people want for PM. (A recent Yomiuri poll put Koizumi at 15%, with Aso next at 7%.) The demand for a reform agenda among the population remains strong.
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.
Global Research
Conflict Management Policy
Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.
Important Disclosures
Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.
Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.
As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.
|
![](/img/clear.gif"){kind=spacer}