South Africa's 1Q09 current account deficit (CAD) came in at 7% of GDP. This was 1.6pp higher than our forecast of 5.4%. The higher-than-expected outcome is more of a correction from the puzzlingly low reading that was posted in 4Q08 than a renewed deterioration in the trend, in our view.
The country's demand-side GDP aggregates also show that the consumer's condition deteriorated further in 1Q09. And although fixed investment, government consumption and inventories came in slightly better than expected, their positive contribution to GDP growth was fully offset by the decline in consumption spend and a record 55%Q (SAAR) contraction in real exports, taking the overall GDP reading down to -6.4%Q. This is the sharpest contraction since 1984.
Technical Correction in 1Q09 CAD
Details of the external trade data published in the SARB's June 2009 Quarterly Bulletin (the Bulletin) show that, on a seasonally adjusted and annualized basis, South Africa's CAD widened from R137.3 billion (5.8% of GDP) in 4Q08 to R163.7 billion (7% of GDP) in 1Q09. We had forecast a deficit of R123.3 billion or 5.4% of GDP, but highlighted that it could be a lot wider if the statistical quirks in the 4Q08 data were corrected (see EM Economist, June 12, 2009). Interestingly, the 1.6pp deviation of the 1Q09 reading from our forecast matches the deviation of our 4Q08 forecast (7.4% of GDP) from the actual outcome of 5.8% of GDP, and suggests to us that most of the downside surprise in the 1Q09 reading must have been purely technical.
In our analysis of the 4Q08 current account data (see South Africa: Optical Improvement in 4Q08 BoP, March 26, 2009), we highlighted a few data anomalies in the external accounts data, and hinted that these were likely to correct in 1Q09. Specifically, the exceptionally strong performance of manufactured exports (vehicles and transport equipment) reported in 4Q08 simply did not correspond to a quarter where the automobile sector was under severe pressure. Second, we expressed scepticism with regards to the surprisingly buoyant mining export performance that was reported at a time when commodity prices had fallen sharply. Finally, we were at pains to point out the near-halving of dividend payments on non-direct investments. Interestingly, the Bulletin attributes the worse-than-expected 1Q09 deficit to significant overshoots in those three line items (i.e., a grave contraction in the volume of manufactured and mining commodity exports, as well as a 74% jump in gross dividend payments on non-direct investments).
Exports Fall Sharply, Imports Recede by Much Less
Following a decrease of 6.3%Q in 4Q08, the volume of merchandise exports shrank by a substantial 21%Q in 1Q09, as mining and manufacturing exports fell sharply. Given that the volume of gold exports fell by 11.4%Q, non-gold exports must have fallen by more than 20%Q. The Bulletin did not quantify the decline in manufactured exports, but did indicate that "the decrease in the volume of manufactured exports was strongly related to the grave contraction in manufacturing activity of the country's most important trading partners". In rand terms, export revenues fell 18.1%Q to R589.3 billion.
Imports, on the other hand, receded by 13%Q from their 4Q08 level of R739.9 billion to R643 billion, thanks to an 8.4%Q fall in volumes and a 5%Q drop in prices. The volume of oil imports (roughly a fifth of total import spend) rose 39%Q in 1Q09, but was more than offset by a decrease in non-oil imports - mainly consumption goods and intermediate capital inputs.
Net Invisibles Buoyed by Dividend Outflows
With regards to net invisibles, service payments fell from R30.3 billion in 4Q08 to R27.1 billion in 1Q09, thanks mainly to lower trade volumes. Net income payments, on their part, came in at R55.9 billion. And, although the latter was higher than our forecast of R42.0 billion, it nevertheless represents a significant decline from the R64.0 billion posted in 4Q08. This reflects the general slowdown in economic activity and corporate profitability, in our view. A more detailed analysis shows that gross dividend payments on direct investments fell from R58 billion to R51 billion, while interest payments on non-direct investments fell from R35 billion to R28.6 billion.
Bucking the negative trend, however, was a 75% jump in payments on non-direct investments. In our opinion, the jump here is simply a technical correction from the surprise 45% cut in 4Q08 payments, and does not necessarily signal a sustainable recovery in dividend payments to the rest of the world just yet. With commodity prices having fallen from their lofty 2008 levels, company profits having declined sharply, and most companies opting for higher earnings retention ratios in order to shore up their own balance sheets, it is hard to see how dividend payments could rise meaningfully in 2009.
Financial Account Funding Mix Is Still Worrisome
On the financial account, the data continue to show deterioration in the funding mix, with an inordinately high reliance on fickle portfolio flows and ‘unrecorded transactions' to fund the deficit on the current account. Net direct investment inflows fell from R54 billion to R16.1 billion, while portfolio flows swung from -R108.4 billion to R9.1 billion as foreign investors stepped up purchases of South African equities in anticipation of commodity stock outperformance (monthly data published by the SARB show that, on a net basis, foreigners bought R19 billion of South African equities and sold R10 billion of bonds). We would caution readers to interpret the 4Q08 portfolio flow print with caution, as this was distorted by the accounting treatment of the BAT transaction (again see South Africa: Optical Improvement in 4Q08 BoP for details).
At R21 billion, unrecorded transactions also fell to roughly half their 4Q08 level of R39 billion - albeit still in positive territory. Interestingly, the net other investments line - which typically captures proceeds from international bond issues and commercial bank cross-border flows - swung from a massive R55 billion inflow in 4Q08 as commercial banks aggressively liquidated and repatriated their foreign exchange holdings offshore, to a disappointing outflow of R10.8 billion in 1Q09. The outflow here was largely due to a decrease in non-resident deposits with South African banks. SARB data show that commercial banks temporarily refrained from further liquidating their FX deposits with foreign banks in 1Q09, although such liquidations were resumed in April. SARB reserve accumulation fell from R5.8 billion in 4Q08 to just R1.8 billion in 1Q09.
Looking forward, we believe that the current account deficit is likely to remain above the 6% of GDP threshold through 2009/10. This has significant funding implications that will continue to weigh on the currency, rendering the latter vulnerable to the vagaries of global risk appetite. And, while the overall funding mix may well improve in the coming quarters as the foreign direct investment line is boosted by R22.5 billion of capital inflows from the VODACOM transaction, and a R30-40 billion inflow from the possible sale of 49% of MTN to Bharti-Airtel, it is important to note that most of this information is already priced in. Also, with regards to capital inflows, we believe that the strong positive momentum we have witnessed in recent months is likely to slow over the remainder of the year. We therefore maintain our bearish outlook on the rand, and expect USDZAR to close the year at 9.40, before depreciating further to 10.00 at end-2010.
Demand-Side GDP Data Point to Fragile Consumer
Details of the 1Q09 demand-side GDP were also published in the Bulletin. Encouragingly, fixed investment, government consumption and inventories were all better than expected. However, the external sector's contribution to GDP was a lot worse than we had expected, thanks to a record 55% contraction in real exports. At -4.9%Q, the Bulletin also confirmed that the South African consumer's condition deteriorated in 1Q09: Private sector employment fell 2.5%Q and, although public sector employment rose 6.1%Q, overall personal disposable incomes shrank for the third consecutive quarter. Further, bank lending has become increasingly restrictive, effectively capping the household debt/disposable income ratio at 76.7%, despite the significant contraction in household disposable incomes.
The Bulletin further shows that durable goods consumption fell 19.2%Q as credit conditions tightened, while semi-durables contracted 7.9% - the first contraction since 1Q99 - as consumers trimmed their budgetary allocations to clothing, footwear and household goods. Non-durable goods' spend (34% of total consumption expenditure) also fell by 12.2%Q as consumers cut back on even the relatively inelastic goods such as medical and pharmaceutical care, food, beverages and tobacco products. Bucking the trend, however, consumer spend on services (40% of total household consumption) rose 7.5%Q in 1Q09, presumably as a number of households increased expenditure on transportation services, and switched from home ownership to rental.
Moderate Deceleration in Fixed Capital Formation
Gross fixed capital formation moderated only slightly from 3%Q in 4Q08 to 2.6%Q in 1Q09. The details here show that private investment spend decelerated from 2.9%Q to 2.2%Q (thanks to declining investment outlays in finance & real estate), while public corporation and general government reported readings of 6.4%Q and 0.6%Q, respectively. Public sector fixed investment was driven predominantly by Transnet's investment in rail, port and pipeline networks, as well as Eskom's infrastructure build program. In the manufacturing sector, capacity underutilization rose from 17.3% to 21.4%, reflecting the rising slack in economic activity. Such slack may further encourage private sector investors to delay the roll-out of capital infrastructure until demand conditions turn for the better. Unfortunately, such delays are likely to cap the recovery in overall GDP at the turn of the cycle.
Conclusion
On the whole, the Bulletin confirms our view that the current account deficit is likely to remain sticky through 2009/10, with possible negative consequences for the currency and inflation. At the same time, the growth outlook remains grim - although we believe that we may have gone past the worst patch. We expect 2009 GDP to come in at -1.8%Y before recovering to 2.8%Y in 2010. Given the SARB's view that a negative output gap is likely to cap inflation pressures in 2010 (we have our own reservations about this), we believe that it is likely to ease policy rates by a further 50bp at the upcoming MPC meeting. Such a rate cut is unwarranted, in our view, given the upside risks to inflation.
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Looking Past the Bottom
June 23, 2009
By Daniel Volberg | New York
Colombia's economy has not been immune from the global downturn, but we suspect that the worst is over. In fact, when Colombia releases its 1Q GDP results this week, we are expecting the data to show that the country is in a technical recession with output contracting for two consecutive quarters. But while the downturn in Colombia may have been sharper than many had expected, we are turning optimistic that the worst of the slump may be behind us. Indeed, we are looking beyond the worst of the downturn and are turning more upbeat on Colombia's medium-term outlook for four reasons.
Downturn Ebbing
First, recent data in Colombia suggest that the pace of the deterioration in activity is ebbing. While April's annual decline in industrial production - at 14.5% - was the worst such decline since July 1999, we suspect that this has more to do with the calendar - Holy Week fell in April this year and in March 2008 - than with the true pace of growth deterioration. In fact, the average for March-April was down only 7.1%Y, a moderation from the more than -10% pace in the three months through February. And once we seasonally adjust the data, we find that in the three months through April, industry posted an annual decline of 8.4%, an improvement from the 10.4% annual decline in the three months through January.
Meanwhile, manufacturing sales data have been even more constructive. While April's sales did post a deep 12.1%Y decline, the average for March-April was down only 4.0%, an improvement on the 9.7% decline in the three months through February. And the seasonally adjusted data also show that annual growth declines have moderated: to -5.3%Y in the three months through April from -11%Y in the three months through January.
Whereas the data in industry are improving at the margin, the evidence from retail sales has been mixed. The average decline in sales in March-April was 6.9%Y, a worsening from the -3.7% pace between December and February, dragged mainly by falling vehicle sales (ex-auto sales were off 2.3% and 1.1%, respectively). However, once we adjust the series for seasonal factors, the data suggest that, though weak, conditions are not deteriorating further: sales were -3.9% in February-April compared to the same period in 2008 (+0.1% ex-autos), virtually unchanged from the -4.2% in the three months ending January (-1.2% ex-autos).
In sum, incoming data suggest that the pace of the economic downturn is moderating. This gives us confidence that while annual growth in Colombia may not turn positive until 4Q09, we expect that the economy will begin to recuperate in the months ahead.
Labor Correction Is Over
Second, the labor market adjustment appears to have run and may no longer pose a risk to a rebound in activity. We have noted that in many Latin American countries one key surprise was that labor markets adjusted faster than in previous downturns, short-circuiting the negative feedback loop that historically prolonged the pain (see "Speeding Up the Cycle, but Recovery Subdued", EM Economist, June 19, 2009). In Colombia there was no coincident labor market and output adjustment as the downturn began earlier than in much of the region - industry began contracting as early as March 2008. Therefore, labor markets have had ample time to adjust to the downturn in activity - in fact employment had peaked in October 2008. Meanwhile, recent data show that employment growth has resumed. The fact that the turnaround in employment comes well after the start of the downturn in activity makes us constructive that this may be a true turning point and therefore labor market pain may no longer feed into further deterioration in activity.
Countercyclical Policies May Have Helped
Third, in a break with the past the authorities were able to deploy countercyclical monetary easing to help cushion the external shock. In the face of a severe negative global growth shock, since November 2008 the Colombian central bank has cut interest rates by a significant 550bp to 4.5%. The central bank has signaled that the 50bp cut delivered on Friday, June 19 marked the likely end of the aggressive easing cycle as the full effect of the aggressive easing has yet to filter through to the economy. But while monetary stimulus may continue to feed through to the economy in the months to come, we suspect that it may have already begun to work by cushioning the blow to corporate credit. Corporate credit - which accounts for nearly two-thirds of all credit - may have stabilized. Credit growth did fall dramatically - and, in fact, overall credit growth may continue to deteriorate as consumer credit may take longer to rebound, given the inherent risk-aversion of the Colombian financial system. However, after seasonally adjusting the data we find that, on a three-month average basis, corporate credit never contracted in this downturn, a break from the past. Looking ahead, we expect that the availability of corporate credit will support a faster turnaround in economic activity.
External Conditions Have Improved
Finally, Colombia has benefitted from a sharper-than- expected improvement in external conditions. The recent rally in commodities has surprised many, as it comes in the face of a still-challenging outlook for global growth. The main headwind for a substantial growth recovery remains the likely multi-year nature of consumer deleveraging in the US (see The New US Consumer, Gerard Minack and Jason Todd, June 21, 2009). And given that at market exchange rates the US consumer accounts for nearly 40% of all global consumption, we feared that the implied weak global demand would keep commodity prices subdued. Instead, since early March commodity prices have rebounded sharply: oil is up 75%, copper is up nearly 50% and soybeans are up nearly 40%. Colombia's exports are largely commodities and so the rebound has helped to boost the terms of trade, the ratio of export to import prices. We have constructed a terms of trade index for Colombia based on the key factors driving the export and import baskets and find that the rebound in commodity prices has indeed translated into a modest recovery in the terms of trade. In Colombia, as in the rest of the region, a rise in the terms of trade has historically been associated with stronger growth and currency appreciation. Thus, the recent rebound in prices, if sustained, should push growth higher and the currency stronger in the months ahead.
Currency Appreciation
In line with our more constructive outlook, we now expect the Colombian peso to strengthen further in the medium term; accordingly, we are revising our forecasts for this year and next to 2,050 (from 2,300) and 1,950 (from 2,400), respectively. Stronger growth and improved terms of trade have historically been key drivers for currency appreciation throughout the region, and Colombia is no exception. While the markets may prove choppy in the near term, given the sharp snap-back already, we are confident that as the growth recovery gains steam later this year and into 2010, the currency should appreciate.
In addition to the improved outlook, we suspect that the Colombian peso should appreciate as it comes closer to equilibrium after overshooting on the weak side at the turn of the year. We find that in Colombia over the medium term the best predictor of currency fluctuations is the purchasing power parity (PPP). And our estimates suggest that according to this metric the Colombian peso has weakened beyond what is warranted in the medium term. In fact, our calculations suggest that for this year a Colombian peso near 2,050 is more consistent with PPP. Given the better growth prospects, the improved terms of trade and the currency overshooting, we are constructive that the recent gains in the Colombian peso are the beginning of a longer period of (potentially bumpy) currency appreciation.
Bottom Line
We have turned more constructive on the growth outlook for Colombia, and indeed the whole region. While we still expect the recovery to be below trend, we see room for gains on the currency front as better growth, improved terms of trade and a correction of the overshoot at the turn of the year should push the Colombian peso to appreciate in the months ahead.
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Review and Preview
June 23, 2009
By Ted Wieseman | New York
Treasuries ended mixed the past week as a big rally that began after the last round of supply was out of the way late the prior week ended in a big way with a huge sell-off Thursday (followed by only a relatively small rebound Friday) that accompanied the announcement of next week's latest flood of issuance, a record run of US$104 billion in 2s, 5s and 7s. This pattern of rallies during periods of issuance lulls and Fed buying of Treasuries followed by renewed sell-offs, generally ultimately reaching new rounds of high yields for the year recently at the longer end, as soon as the next in the normally bi-weekly floods of supply (which are way too big for offsetting Fed buying to make much immediate offsetting difference) arrives has become an almost invariable pattern in the Treasury market. We've never seen anything like this near-total inability of the market to anticipate issuance, which follows very regular pre-announced patterns and has not been the subject of any recent notable surprises (next week's sizes were larger than expected, but the difference between the US$101 billion in supply expected and the US$104 billion announced was marginal), and smooth out the impact on yields. This would seem to strongly suggest that for all the recent signs of healing, the financial system in aggregate remains badly balance sheet and liquidity-constrained to the point that it is unable or unwilling to exploit what is close to an arbitrage at this point, given how consistent and predictable these supply-driven swings in Treasury yields have become. Adding to the renewed weakness the Treasury market saw Thursday, mortgages came under major renewed pressure after what had been a massive recovery off the high yields since November hit June 10. This has become a new regularity to add to the supply-driven swings, as mortgage spreads apparently remain too tight for the MBS market to withstand Treasury market weakness, so while mortgages were able to rally and outperform for a week as Treasuries recovered, the reversal and underperformance in the other direction was violent when Treasuries plunged, with this intense weakness adding generally to the pressure on interest rate markets, including driving a renewed widening in swap spreads late in the week after a big narrowing in the intermediate part of the curve had tracked the prior mortgage rebound. The more technical market drivers from supply and MBS volatility ultimately again dominated the week's trading even as the data calendar was busy and risk markets - particularly credit - saw some notable weakness. Data were mixed from a market perspective, with inflation in both the CPI and PPI reports surprisingly muted, but the growth-related data pointing to a slightly smaller drop in 2Q GDP - we revised our forecast to -1.3% from -1.5% - as housing starts posted a surprising surge that suggested a slightly smaller decline in residential investment and the more muted consumer inflation numbers pointed to smaller dip in real consumption. And early indications for the upcoming employment and ISM reports for June suggested that the recent pattern of steadily less-bad results is likely to continue.
After moving through wide ranges, for the week the market eventually ended up with decent gains in the short and long ends but small losses in the belly of the curve that were particularly pressured by both the looming supply and the renewed mortgage weakness. The 2-year yield fell 6bp to 1.21% and 3-year 6bp to 1.84%, the 5-year yield rose 2bp to 2.81% and 7-year 2bp to 2.45%, the 10-year yield was steady at 3.79% (after reaching as low as 3.58% mid-week), and the 30-year yield fell 11bp to 4.52%. The very short end came under some recently rare pressure midweek as tens of billions of dollars flowed out of the banking system and into the Treasury's account at the Fed as a big chunk of TARP money was repaid, but this had started to ease a bit by Friday, leaving the four-week bill's yield 4bp higher on the week at 0.10% and the overnight general Treasury collateral repo rate at an average of 0.23% Friday, still elevated compared to recent norms but a bit lower than the midweek highs. With CPI and PPI surprising on the downside and commodity prices weaker, TIPS performed relatively poorly aside from the 10-year, with the 5-year yield surging 19bp to 1.26%, the 10-year unchanged at 1.86% and the 20-year down 5bp to 2.39%.
Mortgages had a good performance for the week as a whole, but yields came well off their recent lows hit Wednesday in a huge sell-off Thursday that only a small part of was recovered in a bit of a rebound Friday. After moving above 5% on June 10 for the first time since before the Fed announced its MBS purchase plan in November, current coupon MBS yields plunged 50bp towards 4.5% over the following week through Wednesday, but yields surged back up towards 4.9% in Thursday's sharp correction before a partial rebound towards 4.75% by Friday's close. Even though this represented a moderate net improvement on the week, the severity of Thursday's plunge still had outsized negative impacts on the intermediate area of the Treasury curve for the week and also put notable renewed upward pressure on swap spreads late in the week. The benchmark 10-year spread hit a recent high of 39bp at the so far worst of the mortgage turmoil on June 10, fell to 19bp June 17 at the recent mortgage peak, and was back up to 26bp Friday (for a small net narrowing for the week as a whole). Spreads at the shorter end, more influenced by Libor/fed funds spreads than mortgage-related flows, were under pressure most of the week, and the benchmark 2-year spread rose 6bp to 48bp. Although 3-month Libor moved to a renewed series of record lows before rising marginally Friday to just above 0.61% and the spot 3-month Libor/OIS spread fell 4bp to 37bp, a low since early 2008, there was increasing pessimism about Libor and Libor/fed funds spreads looking in coming months. The front September eurodollar contract traded particularly poorly on the week, losing 5bp to 0.785%, as investors bet that 3-month Libor would rise 17bp over the next few months. Only a small part of this reflects some minor lingering fears of the possibility of early Fed rate hikes, as the forward 3-month Libor/OIS spread to September rose about 4bp to near 49bp, so this spread is expected to widen 12bp by mid-September from current levels.
Also of note in the normally less risky areas of the bond market, muni bond derivatives came under renewed pressure after having managed a decent rebound recently as the California fiscal situation came back into focus. The 5-year MCDX index was trading about 20bp wider on the week Friday afternoon at around 200bp, a three-month high and up from a recent low close of 166.5bp hit June 5. While the budget situation is dismal to varying degrees in most states, California remains the main worry, and the California MCDX index blew out about 50bp on the week to near 345bp in late Friday trading, well above any other state, as Moody's said it was contemplating cutting the state's credit rating, already the lowest in the country, several more notches. Most states run on a July to June fiscal year, and while California certainly seems to be in the most troubled situation, it is far from the only state having major problems trying to figure out how to balance its budget as the start of the new fiscal year looms.
Riskier markets also came under pressure over the past week, credit more so than equities in an extension of the pattern seen since the employment report release earlier in the month. The S&P 500 fell 2.6%. Financials somewhat underperformed the overall market, but at least for the first part of the week, the more notable trend was underperformance by the most cyclical sectors, apparently reflecting some rising nervousness about the economy. Meanwhile, in Friday afternoon trading, the investment grade CDX index was 20bp wider on the week at 143bp. The high yield CDX index had been holding in somewhat better more in line with stocks for a while but came under some major pressure over the course of the week. Through Thursday, the HY CDX index was 133bp wider on the week at 1,034bp and was managing only a minor rebound in Friday afternoon trading. Leveraged loans also came under notable pressure, with the LCDX index 96bp wider on the week through midday Friday at 995bp. The IG CDX, HY CDX and LCDX index were all on pace to end near their worst levels of the month Friday while stocks managed to end the week on a somewhat more positive note after rebounding later in the week off Wednesday's recent low. The commercial mortgage CMBX market was sharply mixed. Although the initial attempt to extend the TALF to newly issued AAA CMBS failed to attract any interest (next month legacy AAA CMBS will be allowed), some moves by issuers to provide credit enhancements to avoid downgrades of AAA CMBS, which the rating agencies have indicated are likely to be very widespread without such action, helped the AAA CMBX index gain almost 3 points on the week to 72.62, near a three-week high. Lower-rated CMBX indices, on the other hand, were mostly crushed again, with the junior AAA down 2.79 points to 29.02, AA 2.25 points to 17.11, and A 1.82 points to 15.08. A major short squeeze in the indices in the first part of May that lifted them to peaks of 42.79, 27.82, and 25.11, respectively, has now been mostly reversed. The AAA subprime ABX index (the lower-rated indices in this market barely move anymore at levels not far above zero) had also been a significant renewed downtrend after a rebound into mid-May but managed to see a bit of renewed upside Thursday and Friday to end the week. This, at least for now, halted a move back down to the all-time low of 23.10 hit in early April, but the index still lost a point for the week as whole to end Friday at 24.00.
Inflation readings at both the consumer and producer levels were surprisingly low in May, and while headline inflation gauges will likely see some near-term upside as a result of the recent upside in gasoline prices, the enormous and growing slack in the economy should continue to put downward pressure on underlying inflation well into next year. The consumer price index ticked up 0.1% in May, intensifying the annual deflation rate to -1.3%. Although gasoline prices saw greater-than-normal seasonal upside, this was almost fully offset by a plunge in utility costs, leaving overall energy prices flat, and food prices dipped slightly for a fourth straight month. Meanwhile, the core also slowed to +0.1%, lowering the annual rate a tenth to +1.8%. The overall shelter grouping and the key owners' equivalent rent component both rose 0.1%. OER inflation, which accounts for about 30% of the core CPI, has slowed to +2.1% from a peak of +4.3% at the beginning of 2007 and should continue to decelerate going forward as rising vacancy rates, exacerbated by a flood of unsold houses and condos, continue to pressure rents. Meanwhile, the producer price index rose 0.2% in May for a 5.0%Y plunge, the biggest annual drop in 60 years. Energy prices rose 2.9%, as a 14% surge in gasoline was substantially offset by declines in natural gas and electricity, and the headline PPI was further restrained by a 1.6% plunge in food prices. Meanwhile, the core dipped 0.1%, with both core consumer (-0.1%) and capital goods (-0.1%) seeing slight weakness.
Real-side figures released for May were mixed but on net pointed to a slightly smaller drop in 2Q GDP than we previously expected. Housing starts rebounded 17.2% in May to a 532,000 annual rate after having plunged to a record low in April. The volatile multi-family component surged 62% to 121,000 after having plunged 49% to an all-time low last month. More surprising was a 7.5% gain in single-family starts to a 401,000 unit annual rate, a six-month high after three straight increases since a record low was hit in January and February. This recent upturn in single-family construction is not likely to be helpful in trying to restore stability to the housing market, with inventories of unsold homes still at extremely elevated levels. On the negative side, industrial production fell 1.1% in May, with the key manufacturing gauge down 1.0%. Manufacturing output has now fallen in 16 of the last 17 months, leaving the level of output at an 11-year low and the year-on-year rate of decline at -15.3% the worst since the post-war demobilization in 1945-46. Weakness in factory output was broadly based, with major sectors seeing big downside including motor vehicles, machinery, high-tech, fabricated metals and petroleum refining. Small upside in the heavily weighted food and chemical sectors, however, provided a notable positive offset. The overall capacity utilization dropped another 0.7pp to 68.3%, another record low after a massive collapse from 78.7% in mid-2008.
Based on the upside in May housing starts, we built smaller declines in residential construction activity in May and June into our GDP forecast, though this component of GDP is so small now that it doesn't impact the overall growth numbers much anymore. Within the IP report, while computer production remained very weak, the drop in May wasn't quite as large we assumed at -1.5% and the declines in prior months were revised up a bit, pointing to slightly less weak computer investment. And the CPI report indicated a smaller rise in the PCE price index than we previously estimated, pointing to slightly better consumer spending. Taken together, these adjustments boosted our 2Q GDP forecast marginally to -1.3% from -1.5%. We still expect residential investment (-23%), business investment in equipment at software (-24%) and consumption (-0.4%) to decline in 2Q, but at slightly slower rates than we previously estimated.
Looking ahead to the key early round of economic indicators for June due ahead of the July 4 holiday, early indications suggesting some further moderation in the pace of decline. The four-week averages of initial claims and continuing claims, while remaining extremely elevated, both appear on pace to be lower on a May-June survey-week comparison, pointing to a further moderation in the rate of job losses. Our preliminary forecast is for a 250,000 decline in June non-farm payrolls, including the assumption of 50,000 temporary census workers (the hiring of whom boosted the May employment numbers) being fired. Meanwhile, the early regional manufacturing surveys were mixed, and we'll need to see the rest of the surveys that will be released in the coming week to get a clearer picture. In the meantime, though, with an ISM-comparable weighted average of the Empire State survey for June showing a slight dip to 43.0 from 43.3 but the Philly Fed jumping to 44.1 from 38.2, our preliminary forecast for the national ISM is for a further modest rise to 43.5 from 42.8, which would extend the recovery off the December low of 32.9 but at a notably slower pace than in the prior couple of months. A decline in payrolls, excluding the census workers distortion of 200,000, and an ISM of 43.5 for June and a 2Q GDP decline of 1.3% would certainly be lot better than the horrific numbers seen late last year and early this year when the economy was in freefall, but would still only indicate that the economy remains in basically just a more typical recession as of mid-year.
The FOMC meets Tuesday and Wednesday, but we don't expect much to come out of the meeting, which will likely leave the three auctions - US$40 billion in 2s Tuesday, US$37 billion in 5s (up US$2 billion from last month) Wednesday and US$27 billion in 7s (up US$1 billion from last month) Thursday - the main focus in the Treasury market. The causes, consequences and appropriate response, if any, of the recent surge in Treasury and mortgage yields will likely be the main topic of discussion at the FOMC meeting. In our view, which Chairman Bernanke suggested he shared in recent Congressional testimony, although the slowing rate of contraction in the economy and perhaps some normalization of inflation expectations have contributed to the back-up in yields, the main driver has been the financial system's inability to deal smoothly with the enormous Treasury supply, which more recently has been increasingly exacerbated by the big knock-on impacts on the mortgage market. To the extent that this is the main driver of the rise in rates, it represents a shock to a still-fragile economy and probably calls for a stronger Fed response. A number of Fed officials, however, have indicated that they believe rising growth and inflation expectations have been the main causes of the back-up in rates, which, if true, would not call for any Fed response. It seems unlikely that consensus on this issue will be reached at this meeting, so the Fed will probably issue a statement similar to last time, continue with its current quantitative easing measures for now, and see how the economy develops over the summer to try to better gauge whether the surge in rates (as well as the recent increase in energy prices, the causes and consequences of which are also open to debate) is threatening to send the economy into a renewed down-leg or whether the anticipated return to modestly positive growth by year-end remains on track. Outside of supply and the Fed, there's not a lot on the calendar in the coming week that appears likely to be a major market focus. Notable data releases include existing home sales Tuesday, durable goods and new home sales Wednesday, the second GDP revision Thursday, and personal income and spending Friday:
* We expect May existing home sales to rise to 4.78 million units annualized. The recent upturn in the pending home sales index points to another modest gain in resales. We look for about a 2% rise in May that would push the sales pace to its highest reading since last October. A pick-up in new supply tied to rising foreclosures combined with historical lows in mortgage rates appear to be responsible for the improvement in real estate activity over the last few months. However, the recent surge in mortgage rates should dampen affordability somewhat.
* We look for durable goods orders to be flat in May, with modest upside in the volatile aircraft category about offset by slippage in the motor vehicle sector. The key core component - non-defense capital goods excluding aircraft - is expected to post a fractional gain. Such an outcome would be consistent with the results of the latest ISM survey, which showed the orders index moving slightly into positive territory for the first time in a year-and-a-half.
* We forecast a rise in May new home sales to 360,000 units annualized. The NAHB survey has shown considerable improvement in recent months - moving up from the historical lows registered in late 2008 and early 2009. So, we look for about a 2% gain in May sales and a further decline in unsold inventories. Some of the recent improvement is probably attributable to the impact of the first-time homebuyer tax credit. However, there is little doubt that the low mortgage rate environment has also helped to spur the upswing in real estate activity, and it will be interesting to see if the momentum can be sustained in the months ahead now that rates have backed up.
* We expect 1Q GDP growth to be revised to -5.6%, little changed relative to the previously published reading of -5.7%, as the impact of lower inventories should be about offset by higher net exports and public construction. Note that even with the slight upward adjustment to 1Q, the decline in GDP seen over the past two quarters represents the sharpest of such drops since 1958.
* We forecast a flat reading for May personal income and a 0.4% rise in spending. The May labor market report pointed to another dismal performance for income, while the retail sales figures suggest that consumption posted a modest rise. However, we still see real consumer spending posting an outright decline of 0.4% in 2Q since much of the recent gain in nominal spending was tied to higher gasoline prices. Finally, based on our translation of the CPI data, the core PCE price index is expected to be up 0.13% in May, which would push the year-on-year rate down a tick to +1.8%.
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