India
General Elections Verdict - Hope for a New Beginning
May 19, 2009

By Chetan Ahya | Singapore & Tanvee Gupta | India

General Elections Result - A Huge Surprise

The 2009 general elections outcome, announced on May 16, was the best outcome in terms of strength of the leading party's tally since the 1991 elections. Indeed, this is the first time since the 1960s that any prime minister is returning for a second consecutive term in office. We believe that this strong political mandate will allow the new government to accelerate the pace of reforms. Some of the key areas where we expect progress are: a) the government's effort to improve public finances; b) acceleration in infrastructure spending; c) augmentation of government resources through privatization (divestment of stakes in government companies); d) improvement in share of stable capital inflows; and e) implementation of some of the long-pending deregulation measures for the pension funds, banking and retail sector. Building in a potentially stronger policy response from the new government, we are upgrading our GDP growth forecasts to 5.8% from 4.4% for F2010 and 6.8% from 6.2% for F2011.

Upside Risk to Our View Has Materialized

In our recent research reports, we mentioned that upside or downside risk to our growth forecast will depend on the outcome of the 2009 general elections. We argued that, considering the current state of the economy and global growth environment, we believed that the general election results would be important in influencing the medium-term growth outlook. Decisive policy actions would be critical to lift the pace of GDP growth closer to potential. We were of the view then that an outcome of a narrow coalition (single-largest political party getting 170-180 seats) would mean that chances of an acceleration in the pace of reforms would be high. The actual outcome of elections has been even better than our upside case highlighted pre-elections, with the single-largest party winning over 200 seats. This outcome is a huge positive surprise and is likely to allow the new government to initiate some of the long-pending structural reforms, in our view.

Expecting Progress in Addressing Key Macro Issues

We now expect more decisive action from the new government in some of the following areas:

(a) Improvement in management of public finances: Over the last few years, while GDP growth accelerated, the government continued to pursue a pro-cyclical fiscal policy, taking deficit and public debt to higher levels. Indeed, the consolidated fiscal deficit including off-budget items increased to 12.4% of GDP in F2009 from 6.8% in F2008. Moreover, public debt to GDP is at an extremely high level of 83.9% of GDP (including off-budget items) in F2009, as per our estimates. Further deterioration in public finances would likely result in rating agencies downgrading India's rating to below investment grade.

Typically, the cost of a high fiscal deficit would have been higher real interest rates. However, India witnessed an unusually low real interest rate environment right at the time when its fiscal policy had been loose, as reflected in rising public debt to GDP. The key to lower-than-warranted real interest rates was the large capital inflows. However, in the era of global deleveraging and lower capital inflows, the high level of deficit issue will remain in the form of higher real interest rates for the private sector.

Moreover, the current high level of unproductive government expenditure and public debt was weighing on the long-term growth potential. The government's spending on productive areas such as infrastructure, education, health and welfare has been constrained by high levels of non-development expenditure and the high starting point of the debt level. The government's development expenditure has averaged 14.5% of GDP over the last five years, declining from 17% at the commencement of the liberalization process in F1991.

We believe that the new government will ensure that the public finances start correcting over the next 12-18 months, reducing the risk of crowding out private investment. More importantly, we expect improvement in the government spending mix, with a further increase in the share of development expenditure. We believe that the new government will have little incentive to take the risk of a widening fiscal deficit and face a rating downgrade.

(b) Increase in infrastructure spending: For an emerging economy like India with a rising working population and a large unemployed workforce, limitations on potential growth are determined by the pace of reform in the economic environment, which allows resources to operate productively. Although the government had taken some efforts, the actual infrastructure spending was lagging way below the required 9-9.5% of GDP for sustaining 8-9% GDP growth. While private corporate capex had picked up sharply in the last few years, infrastructure spending was lagging. For the tenth five-year plan (F2003-07), the government targeted 41,000MW of capacity addition. However, the actual addition was only 18,400MW. The peak electricity shortage was estimated to be 12% in F2009.

Similarly, the progress on road development has been tardy. There was a distinct slowdown in the awarding of new contracts as well as implementation of contracts already issued. Of the total 33,097km length planned, only 11,037km has been completed as of March 2009. About 50% of tenders for roads projects planned are yet to be awarded. According to the monthly data released by NHAI, not even a single project was awarded between August 2008 and January 2009, even though there was some pick-up in February.

This poor progress in infrastructure development investment resulted in overall ‘effective' capacity growth being weaker than total investment would imply. While theoretically India's potential economic growth can be higher at 10%+, as in China, we think that the slower-than-warranted response from policymakers to create the infrastructure supply was restraining ‘practical' potential growth. As per our estimates, infrastructure spending in India would have been about 6.3% of GDP in F2009. We believe that the new government will increase efforts to accelerate infrastructure spending from the second half of F2010, particularly for sectors such as roads, electricity and railways.

Augmentation of Government Resources

The current high fiscal deficit will likely make it difficult for the government to increase its spending to support economic growth. We believe that in such an environment, the government will need to augment its financial resources through divestment of stakes in government companies. Over the last five years, the government's effort in augmenting resources through divestment has been very poor. One of the key reasons for this trend was opposition by the left parties, which were part of the ruling coalition for a period of four-and-a-half years out of the five-year regime. Although we do not expect aggressive privatization in the form of transfer of management to the private sector, the new government is likely to initiate more divestments.

Increase in Share of Stable Capital Inflows

About 85% of the total US$207 billion capital flows that India received over the four years ending March 2008 were in the form of less stable non-FDI flows. This compares with the ratio of 31% for the other top ten emerging markets. The improved sentiment for the country's macro outlook should help India to increase its overall share of capital flows allocated to emerging markets. Moreover, we believe that the increase in the pace of reforms will enhance the country's ability to attract stable capital inflows, improving the mix.

Some Long-Pending Reforms Could See the Light of Day

We believe that the government is also likely to bring forward some of the reforms which had been held back due to opposition from the left parties. If not all, we believe that some of these reforms will be implemented over the next 12-18 months:

•           Pension reforms: The government may initiate measures to increase penetration of pension products in India, which is currently low, and to attract domestic private sector as well foreign investment in the sector.

•           Insurance sector: The government has been working on increasing the foreign investment cap in the insurance sector to 49% from 26%. A bill to implement this change was initiated a few year years back and is still pending. 

•           Voting rights for foreign investors in banks: The government has for long held back an amendment in the banking regulations, which would allow it to raise voting rights of foreign investors, currently capped at 10% irrespective of their stake in private banks.

•           FDI in retail: A draft cabinet note to allow FDI in specialty retail sectors like electronics, sports goods and stationery has been pending for sometime.

Upgrading Our Growth Forecasts

Our current forecasts had built in a gradual recovery. We were expecting industrial production growth to average 2.7%Y in F2010 and our growth trajectory implied industrial production growth rising to 7%Y by March 2010 from -2.3%Y in March 2009. We are now revising our GDP growth for F2010 to 5.8% from 4.4% estimated earlier. Thus, we are now expecting industrial production growth to average 4.7%Y in F2010 and our growth trajectory implies an industrial production growth of 8%Y by March 2010. On the expenditure side, we are assuming higher private consumption and infrastructure spending and a slightly higher trough for private corporate capex. Similarly, we are increasing our GDP growth forecast for F2011 from 6.2% to 6.8% and industrial production growth from 5.5% to 6.8% (average).

Our new IP forecasts would still be lower than the average IP growth of close to 9% during January 2004 to mid-2008, when the global economy started suffering from the credit turmoil. We see three reasons to prevent growth accelerating to those levels. First, our economics team expects a tepid recovery in G7 economies. It expects G7 growth to be at 1.4%Y in 2010 compared with an average of 2.4% in 1997-2007 (the ten years preceding the recent turmoil). Second, the starting point of a higher level of government revenue deficit and public debt implies that some payback will be inevitable in the form of reduced government consumption spending. Third, the domestic banking system's ability to deliver strong credit growth is likely to be constrained in the near term due to the sharp rise in non-performing loans. Although increased ability of the corporate sector to access capital markets and an improved growth outlook should help to reduce the NPL risks, some part of the damage should remain, in our view.

Upside and Downside Risks to Our Estimates

As highlighted earlier, the two most important factors we see for India's growth outlook include the global risk appetite, which will be reflected in the form of capital inflows into the country, and external demand. In our base case, we expect GDP growth of 5.8% in F2010 and 6.8% in F2011. The upside and downside risks to our GDP growth estimates will depend on the influence of the global growth outlook on these two factors. Based on this framework, we see a bull scenario growth for India at 6.8% in F2010 and 7.8% in F2011 and a bear case at 4.7% in F2010 and 6.0% in F2011. In the bear case, we assume continued risk-aversion in global financial markets and therefore a sustained adverse trend in capital inflows and sharper fall in exports. In the bull case, we assume a recovery in capital inflows and exports growth. We have assumed the political environment to be neutral.

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Mexico
Not Your Same Old Jobs Cycle
May 19, 2009

By Luis Arcentales, CFA & Daniel Volberg | New York

Mexico watchers should brace themselves for a heavy dose of bad news this week when the 1Q GDP report is released on Wednesday, May 20.  Banco de Mexico and the finance ministry have already guided towards a severe decline ranging from -7.0% to -8.0% compared to 1Q08, marking the sharpest annual drop since the Tequila Crisis when GDP contracted by 9.2% in 2Q95 and 8.0% in 3Q95.  And once adjusted for seasonal factors, the sequential contraction in 1Q09 likely approached 20% annualized, nearly double the severe -10.3% pace of 4Q08 and approaching the 21.6% collapse of 2Q95.  Importantly, the meaningful sequential deterioration in 1Q GDP figures in Mexico stands in contrast to data from the US, where the economy posted declines of similar magnitude in the past two quarters at -6.3% and -6.1% annualized.  

Recession Becoming Less Severe

The grim 1Q average activity figures, however, mask an encouraging development: the rate of deterioration in economic indicators slowed in March and April, though the economy has yet to hit bottom.  Most real economy data for March, of course, exaggerated the pace of improvement due to additional workdays from the shift in Semana Santa.  Still, whether we look at seasonally adjusted indicators through March or the few data points already available for April - including formal employment and sales by retail chamber ANTAD - they seem consistent with the view that the pace of deterioration has indeed slowed from the severe rate experienced at the turn of the year.

In fact, at first glance, most economic indicators for March might suggest that Mexico's economy is turning around at a rapid rate.  For example, March industrial exports were off 17% from a year earlier compared to -25.9% in the January-February period, while industrial output - to be released May 18 - will likely show a significant moderation in its pace of decline to around -7.5% from the -12.0% in the first two months of the year.  However, this apparent improvement reflects in great part three additional workdays as Semana Santa trimmed the number of workdays in March 2008.  Actually, the calendar effect may have been even more pronounced because last year Benito Juarez's birthday took place in the same week as Semana Santa, thus producing an even lower comparison base as many workers took off the ‘bridge' days between the two holidays.  April 2009, by contrast, had two extra workdays compared to the same month in 2008.

Though annual comparisons blur the actual underlying trend in the economy, the recession seems to be becoming less severe.  Indeed, this is the case whether we look at several seasonally adjusted indicators through March or the few data points already available for April.  For example, sales reported by retail chamber ANTAD posted annual growth of 2.3% in March-April, which, even considering some boost in buying related to the outbreak of swine flu, were well ahead of 0.7% growth in January-February. 

And seasonally adjusted data confirm this modest improvement.  Even April auto production - one of the hardest hit of all sectors - seems to be turning around from very depressed levels, consistent with rising auto assemblies in the US.  Indeed, incoming data from US manufacturing are exhibiting signs of improvement: April's ISM index rose to 40.1 - the first time above the 40 threshold since September 2008 - and April industrial production was off just 0.5%, a significant moderation from the 17% annualized fall in the prior eight months (see Recovery Closer but Risks Persist, May 11, 2009). 

And even the pace of job losses - which tends to be a lagging indicator - is moderating at the margin. In March and April, the average seasonally adjusted clip of job losses dipped below 400,000 positions annualized, a fraction of the more than one million average job destruction pace between December and February.  The moderation in the pace of job losses during the March-April period was broadly based, particularly in construction (where employment was relatively stable, helped by net hiring of temporary workers).   

In fact, labor markets have adjusted far more rapidly in this cycle than in the past, opening up the prospect of the economy bottoming out sooner than many now expect.  Historically, the full impact of swings in economic growth has hit employment with a lag of three to six months.  Actual data, however, suggest that the current cycle has been atypical by showing a faster and sharper adjustment on the jobs front.  Accordingly, with the recession already turning less severe, we suspect that the deterioration in labor markets going forward may not be as intense as past history would suggest.

Not Your Same Old Jobs Cycle?

The adjustment in employment so far in this cycle has been far more rapid than in the past, according to our modeling work.  Growth recessions tend to hurt labor markets with a lag and in Mexico our work suggests that the full impact of GDP growth fluctuations gets passed through to employment with a lag of one to two quarters.  And if the past is any guide, our work suggests that the current macro environment should have generated a significant contraction in employment towards the middle of this year.  Actual data, however, show that the impact has been significantly faster and that the correction in jobs is already well underway.

Our conclusions are based on our modeling work that helps us assess the relative impact of a few key variables on employment dynamics in Mexico.  We find that GDP growth, inflation, terms of trade, the exchange rate, credit availability and US economic health have a significant bearing on the evolution of Mexican formal employment.  Among all these factors, the strongest impact on jobs seems to come from inflation and GDP growth, both of which tend to be positively associated.  The positive impact of inflation on employment may be due to short-term wage rigidities that allow inflationary shocks to make labor relatively cheaper.  And the impact of growth and inflation on employment is meaningful - our work suggests that, historically, a one percentage point increase in either inflation or GDP growth has a cumulative impact of raising employment growth by 0.64%.  We also find that the full impact of fluctuations in GDP growth is passed through to employment with a one to two-quarter lag, while inflation has an immediate impact.  Therefore, all else equal, the expected 7-8% contraction in GDP in 1Q should generate a 4-5% contraction in formal employment by 3Q.  This contrasts with the 2.3% contraction in formal employment already observed in the first three months of the year.

Confidence may have played a role in driving the faster adjustment in labor markets during the current cycle. In the previous recession, in 2001, the assessment of the current and future business environments by Mexico's captains of industry peaked at essentially the same time as employment, adjusted for seasonality.  In the current cycle, by contrast, both indices peaked about a quarter before employment and, moreover, the subsequent collapse has been on average more severe in terms of magnitude and speed.  These results are consistent with evidence from the hiring intentions index, which preceded the July 2008 peak in employment by an entire year, whereas in 2001 it led by eight months; thus, we suspect that the sharp downturn in confidence, a consequence of global financial stress, has focused firms on the need for cost savings and efficiency in order to prepare for the local impact of the global recession - an environment where jobs were eliminated much faster than in previous business cycles. The end result may be that the necessary labor market adjustment is closer to completion than many now expect; this, in turn, raises the prospect that the early signs of an easing in the pace of deterioration may be sustained.

Forthcoming data releases may show another bout of deterioration inconsistent with a ‘less bad' outlook for the economy, caused by the outbreak of the swine flu - and the brief disruptions it caused in and around Mexico City plus the more long-lasting impact on tourism.  These should have obvious negative implications for economic activity and hiring (see Flu Outbreak: Scenarios and Trade Ideas for Pandemic-Related Tail Risks, May 3, 2009).  Still, while near-term data may be noisy, we would warn against confusing a ‘one-off' shock - which the authorities estimate could trim 0.3-0.5 percentage points off GDP growth this year - and the emerging signs that the worst of the economic slump may be behind us.

Bottom Line

After contracting at the sharpest pace since the 1995 crisis, incoming data suggest that the recession is becoming less severe, though the economy is still not at the point of stability. The improving economic data, combined with evidence suggesting that the adjustment in the labor market - which historically has come with a lag of one to two quarters - has been far more rapid in this cycle than in the past, makes us cautiously optimistic about the prospects for Mexico as the deterioration in labor markets going forward may not be as intense as history would indicate.

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United States
Review and Preview
May 19, 2009

By Ted Wieseman | New York

Even after a small bout of profit-taking Friday, Treasuries had their best week since the mid-March surge that followed the FOMC's announcement that it would be buying Treasuries and sharply boosting its MBS and agency buying.  The temporary shift in supply dynamics - three rounds of Fed Treasury buying during the week and no new coupon supply - was a key positive backdrop for the week's partial recovery from a rough few weeks when the market had to take down an absolute flood of coupon supply.  A general, and obviously not surprising, trend seems to have emerged since the Fed starting buying Treasuries in the past couple of months of the market struggling during the supply weeks and then doing better, holding steadier if not necessarily seeing the sort of upside of the past week in the non-supply weeks, of which there are usually two each during a month. However, the net of this has been one step forward, two steps back, as the losses during supply periods have been bigger than any recoveries in non-supply, Fed buying-only weeks.  On top of this temporarily positive background shift before the next wave of supply after Memorial Day, interest rate markets also benefited from negative turns in both risk markets and the tone of the economic data.  After having surged to recent highs at the end of the prior week, both equity and credit markets saw partial negative reversals - relatively modest reversals certainly compared to the upside of the past couple months, but still about the only meaningful break in the powerful rallies that had been ongoing since early March for stocks and more so early April for credit.  And on the data front, a second-straight weak retail sales report that reinforced expectations for a renewed contraction in consumer spending in 2Q after the small recovery in 1Q along with an ugly jobless claims report that pointed to another painful employment report in May marked a break in what had been a fairly consistent recent trend of economic news that was still bad by any absolute standard but in most cases notably less so than during the 4Q/1Q period when the economy was in near freefall.  To be sure, though, this general underlying trend does still appear to be on track.  A number of data releases directly impacting our 2Q GDP forecast ultimately netted to us slightly reducing our estimate to -2.8% from -2.5%, which would certainly be a lot less bad than the 6% annualized plunge in 4Q and 1Q.  On the other hand, such a contraction would hardly be good news in any absolute sense.  The worst single quarter in the 2001 recession saw GDP fall just 1.4% and the 1990-91 recession 3.0%.  Coming into the past week, though, it had appeared that many investors were thinking that as negative as 2Q could still end up being in an absolute sense, we might have entered a quickly improving path of something like -6% to -3% to +3% or even stronger in short order.  Indeed, we've noticed increasing chatter drawing comparisons to the nearly 8% surge in real GDP in 1983 that followed what was previously the deepest post-war recession in 1981-82, without taking proper account of the much different causes and characteristics of the early 1980s downturn.  The more negative tone of some of the past week's key data appears to have thrown some, in our view certainly appropriate, caution back into the outlook about how soon and how robust the ultimate move back towards actual recovery instead of just slower contraction will be. 

On the week, benchmark Treasury yields plunged 14-20bp and the curve flattened more than reversing the prior few weeks' losses at the short end to take yields to the low end of the ranges seen since the end of January, though only recouping a portion of the recent sell-off in the high yields for the year at the longer end hit at the end of the prior week.  The 2-year yield fell 14bp to 0.85%, 3-year 17bp to 1.29%, 5-year 16bp to 1.98%, 7-year 16bp to 2.63%, 10-year 17bp to 3.13% and 30-year 20bp to 4.08%.  Considering the magnitude of the rally in nominals, weakness in commodity prices, and the major outperformance they were coming off the prior week, TIPS performed very well even if they couldn't quite keep pace with nominals across most of the curve, and the long end even managed to do that.  Big support for TIPS was seen after Friday's slight upside surprise in the headline CPI print.  The 5-year TIPS yield fell 10bp to 0.99%, 10-year 10bp to 1.63% and 20-year 25bp to 2.20%.  The benchmark 10-year inflation breakeven has been holding close to 1.5% for several weeks now after having seen a big move up from the recent low close of 0.84% on March 6 (certainly not coincidentally almost right at the same time stocks bottomed).  The renewed upside in Treasuries helped mortgages get back on track as well after a rough end to the prior week when Treasuries were crushed by the weak 30-year auction that wrapped up the most recent supply deluge.  Yields on 4% MBS rallied from about 4.05% to about 3.95%, right in the middle of what's been a narrow range since the rally that followed the Fed's March 18 upsized buying announcement.  The good news in that clearly is that mortgage rates have been so stable as Treasuries have been under pressure, and spreads have thus come in.  The bad news is that after a quick move to new record lows in late March, average 30-year fixed mortgage rates have also been tightly range-bound, not moving far from 4.80%, and to this point while refi applications and origination activity have definitely picked up notably; at this point, we're really just not seeing a refi wave of nearly the size we had been hoping for a couple of months ago.  Mortgage rates having stalled out has not helped obviously, but the extent to which borrowers are too far underwater on their mortgages to refi even with the relaxed loan-to-value standards adopted by the agencies may also be more severe than was generally thought. 

The rebounds in Treasuries and mortgages in the past week were positive developments, but probably the most notable ongoing trend in the interest rate space was the continued collapse in interbank lending rates and spreads and the knock-on effect this has had on swap spreads the past two weeks.  We have to acknowledge that the magnitude and rapidity of the improvement here indicate that pressures on bank balance sheets may be easing at a more substantial pace, and the credit crunch that has resulted from the bank balance sheet, capital and liquidity strains may thus be easing sooner and more rapidly than we had expected.  3-month Libor has now been lower at every fixing for seven straight weeks, extending last week's initial move to a record low by another 11bp the past week to 0.83%.  The spot 3-month Libor/OIS (a measure of the expected average fed funds rate over the next three months) saw another similar-sized drop on the week to 63bp, a low since right around the time of the Bear Stearns collapse in March 2008.  The improvement in forward spreads remained just as impressive, as the white (Jun 09 to Mar 10) eurodollar futures rallied 8-19bp on the week, with 3-month Libor expected to hit a low (at least on a eurodollar settlement date) of 0.75% on June 15.  As a result of these gains, the forward Libor/OIS spread to June fell about 7bp to near 55bp, September 9bp to 50bp, December 13bp to 53bp and March 12bp to 43bp.  Longer-dated forwards indicate that, in this new financial world, we'll never get to the just 10bp or so spreads seen before mid-2007, and the projected March 2010 spread is not too far from the expected long-run normal level.  It was rather odd that, over the recent months of steady Libor improvement, for some reason it was really only when the new record low was originally hit on May 5 that swap spreads began to respond in kind, but the huge improvement that started then has kept running, with a major further narrowing in the latest week.  The benchmark 2-year swap spread fell another 5bp on the week to 42bp and 5-year 4bp to 46bp, both two-year lows, while the 10-year spread fell 3bp to an all-time low of 9bp.  It clearly won't take much of an additional supply-driven sell-off in 10-year Treasuries for the 10-year swap spread to join the 30-year in negative territory, a phenomenon that has not been so abnormal in many other countries but had never been seen in the US before last fall. 

After hitting their best recent levels following a powerful recent rebound, risk markets gave back some ground in the past week, supporting the bid in Treasuries on top of the improved supply balance and the less positive tone to the data.  The S&P 500 fell 5% after the previous 37% recovery off the March 9 low.  Financials, as usual, remained the high-beta sector, leading on the way down the past week after leading the prior rebound, with the BKX banks stock index down 16% the past week.  To some extent, this appeared to reflect supply pressure and dilution concerns from stepped-up issuance, and so couldn't really be considered a particularly negative sign to the extent that it also indicated the renewed openness of equity markets to bank stock issuance.  A similar phenomenon appeared to be a notable cause of a widening in corporate credit spreads on the week after the recent tights hit Friday, as corporate issuance ran at a robust pace through the week.  In late trading Friday, the investment grade CDX index was 14bp wider at 157bp, still retaining the bulk of the rally from 202bp on April 1 to 143bp at the end of the prior week (the credit rally didn't really get going to the same extent as stocks until a bit later than the early March take-off point for equities).  Similarly, the high yield CDX index was 119bp wider at 1,127bp through Thursday after hitting a recent tight at the end of the prior week and trading down a bit further Friday, while the leveraged loan LCDX index was showing a comparable pullback, widening 112bp through midday Friday to 1,175bp.  In the commercial mortgage CMBX market, the AAA index pulled back 2 points on the week to just above 73, a comparable showing to other risk markets.  The middle-rated indices in this market have been going a bit crazy recently, though.  A huge short squeeze that began in the prior week extended into Monday in the AJ to BBB indices that resulted in eye-popping percentage gains in these indices in a very short time period (including 50% in the AJ in five trading sessions and 84% in the AA).  A portion of these gains were reversed through Thursday, but it looked like a second upside wave might be kicking in Friday, with the AJ in particular posting a big gain.  Netting all this volatility, it ended up being a very good week for the AJ through BBB- indices, but with market positioning and technicals seeming to have taken over market dynamics, the path forward in the near term is obviously subject to a lot of uncertainty.  The subprime ABX market has had a much more stable recent trading pattern - steady upside off the early April lows for the AAA index, little movement at levels not much above zero for the lower-rated indices.  What had been a series of almost daily gains for the AAA index since the April low, however, did seem to be petering out towards the end of the week, with the index falling a quarter point on the week to 26.58, its first down week since the rally off the April 8 low of 23.10 started. 

The past week's active economic data calendar had a number of releases that directly impacted our GDP forecasts.  After swinging around a fair amount in response to the figures, we ultimately slightly reduced our 2Q GDP forecast to -2.8% from the -2.5% we had reset it to on Monday in our regular post-employment report reassessment of our estimates.  The expected composition of the 2Q decline looks more notably different, however.  In particular, a second-straight worse-than-expected retail sales report combined with an updated slightly higher assumption for PCE inflation led us to cut our 2Q consumption estimate to -1.4% from -0.5%.  And a higher-than-expected outcome for retail inventories at the end of 1Q suggested that 1Q growth will be revised up a bit further than we previously estimated, but with an offsetting more negative inventory contribution now expected in 2Q.  On the positive side, though, the trade deficit was substantially narrower than expected in March, providing a much more positive starting point for 2Q net exports, which we now expect to be a neutral influence on 2Q growth instead of a moderate drag.  The trade results also pointed to a somewhat smaller drop in 1Q growth, and combined with the upside in March retail inventories, we now see 1Q GDP being adjusted up to -5.7% from -6.1%.  Also a bit positive for 2Q, moderation in the rate of decline in computer production, part of a broader pattern of slower rates of deterioration across most key industries in the industrial production report, pointed to a slightly-less-severe further decline in 2Q business investment after the record plunge in 1Q. 

Retail sales fell 0.4% in April, a second-straight-renewed decline after a brief bounce early in the year followed the collapse seen in 2H08.  Motor vehicle sales posted a surprising 0.2% gain despite the drop in unit sales, but ex-auto sales dropped 0.5% on top of a downwardly revised 1.2% decline last month.  Softness in non-auto sales in April was broadly based.  The heavily weighted grocery store component (-1.0%) saw unusually large weakness, and there was a price-related pullback at gas stations (-2.3%).  And key discretionary categories including clothing (-0.5%), general merchandise (-0.1%) and electronics and appliances (-2.8%) came in weaker than expected after the somewhat better-than-expected chain store sales results.  The key retail control grouping was down 0.5% in April on top of a downwardly revised 1.2% decline in March, a worse outcome than we expected.  Translating the CPI results into an estimate for the PCE price index also gave us a slightly higher estimate for April than we had been building in, pointing to slightly weaker real spending on top of the downside in nominal outlays implied by the retail control contraction.  As a result, we now see 2Q consumer spending heading down again at a 1.4% annual rate in 2Q after the small (and likely to be revised down a bit) 2.2% rebound in 1Q that followed the near-record 4% collapse in 2H08.  Meanwhile, retail ex-auto inventories dipped 0.2% in March, a significantly smaller drop than BEA assumed in preparing the advance estimate of 1Q growth, pointing to a smaller (but still very large) inventory drag in 1Q, but with an offsetting more negative contribution in 2Q. 

On the positive side, the trade deficit only widened US$1.5 billion in March to US$27.6 billion after having plummeted US$10 billion in February to a ten-year low.  On the face of it, the huge narrowing in the trade deficit since last summer is good news, but the extraordinary collapses in both imports and exports that have driven it are quite disturbing.  In March, imports were down 1.0%, a ninth-straight decline at a record 40% annual rate over this period.  March weakness was led by natural gas, autos and consumer goods.  Meanwhile, exports resumed sinking in March after a small bounce in February, falling 2.4% for an eighth drop in the past nine months, plunging at an unprecedented 31% annual rate over this timeframe.  Downside in March was concentrated in capital goods.  BEA had assumed a larger widening in the March trade gap, and we had built in a bigger widening than BEA, so these results were positive for the 1Q GDP revision and provided a notably positive starting point for 2Q net exports than we had expected.  We now see net exports being about neutral for 2Q GDP instead of subtracting a half point, though we see both exports (-18%) and imports (-15%) falling again.

Although the trend turned a bit more mixed with the past week's retail sales downside and a terrible jobless claims report, the industrial production data extended the general recent trend of continuing negative data flow, but to a lesser extent than when the economy was in freefall in 4Q and 1Q.  IP remained weak in April, but the latest month's 0.5% drop marked a notable deceleration in the pace of decline after a 17% annualized plunge over the prior eight months.  The key manufacturing gauge declined another 0.3%, but this similarly represented a less bad result than the prior trend.  Motor vehicle and parts output rose 1%, a smaller gain than we had expected based on industry data, but there has still been at least some rebound in assemblies after an astounding collapse in January.  It appears likely that the motor vehicles sector will be a small positive for 2Q growth, but clearly this will swing sharply in the other direction over the summer into 3Q as GM implements its plans for extended and widespread plant shutdowns to try to get inventories under control (note also that the dealership closing announcements by GM and Chrysler could have a substantial negative impact on retail employment, probably starting with the June payrolls report).  Manufacturing ex-autos output was down 0.4%, with most key sectors remaining weak, but less so than in prior months.  This included computer production, which declined 2%, a slower pace of decline than seen in nearly a year and a bit less bad than we expected.  Computer investment in GDP is mostly sourced to computer IP, so this slightly boosted our forecast for business investment in equipment in software to a slightly less disastrous -22% from -23% after non-residential investment collapsed at a record rate in 1Q.  Meanwhile, capacity utilization dipped 0.3pp to 69.1%, another record low after a massive collapse from 78.7% in mid-2008.

The economic calendar is very light in the upcoming week, with the data focus likely to be largely on leading indications for the upcoming employment and ISM reports, as initial jobless claims this week will cover the survey period for the May employment report, and the Philly Fed survey on Thursday will help set ISM expectations after the small improvement in the underlying details of the Empire State survey released Friday that lagged the larger gain in the headline sentiment measure.  Unless claims swing back in a notably more positive direction after the terrible results of the past week's report - a big rise in initial claims that reversed much of recent improving trend and a near-record gain in continuing claims to yet another record high - initial expectations for employment will likely be for another grim report.  Supply dynamics should remain positive for another week, with another week of no new coupon supply and three more rounds of Fed buying.  On Thursday, however, the Treasury will announce the terms of the 2-year, 5-year and 7-year notes that will be auctioned after Memorial Day, which will likely start swinging the oscillating week-to-week supply dynamics back in a negative direction.  Note that although SIFMA has partially acquiesced to the Treasury's request to eliminate early closes ahead of holiday weekends (though we'll see to what extent market participants actually follow SIFMA's official recommendations), the early close before Memorial Day remains, so Friday will be a short trading session.  Other than claims and the Philly Fed survey on Thursday, the only data releases of particular note in the coming week are housing starts Tuesday and leading indicators Thursday:

* Outside of a short-lived spurge in February - driven by the volatile multi-family category - starts appear to have settled in near a 500,000 annualized rate over the past several months, and we expect them to remain there in April.  We suspect that this sluggish pace of homebuilding will be sustained for the foreseeable future, which should help to absorb much of the excess inventory of unsold new homes by late 2009.

* Based on currently available components, the index of leading economic indicators is likely to jump 1.1% in April, which would be its first increase in nearly a year and the sharpest gain in four years.  The recent surge in stock prices represents a huge positive contribution, with more modest but still sizeable adds also from the steep yield curve, an improvement in consumer confidence and some slippage in jobless claims.  The only substantial negative offset at this point is from a significant decline in the money supply that is likely related to some tax season volatility.

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