Industry - No Longer a Bottomless Pit
June 24, 2009
By Pasquale Diana | London
The collapse in industrial dynamics across the region in the last six months has been extraordinary. IP growth in the region peaked in 2007, when it reached double-digit growth rates in most countries. It started slowing in 2008, but output was still expanding at a healthy 5% pace in 1H08. Since last summer, however, momentum collapsed, and output contractions in the first few months of the year ranged from around 10%Y in Poland and Romania to 20%Y in the Czech Republic and Hungary. The level of industrial output has erased several years of gains, and in some cases (again, the Czech Republic and Hungary) now stands at the levels seen at the beginning of 2005.
Surveys suggest that the phase of deepest contraction in industrial activity is behind us. There are some rays of hope. The May PMI surveys across the region continue to show steady improvement. While the level of the surveys is still consistent with industrial output declining (i.e., below the 50 mark), the change suggests that the most intense period of contraction is behind us. This is in line with our view that probably the worst of the recession took place in 4Q08 and 1Q09, and a return to growth is likely in 2H09. In this note, we look in particular at the role played by inventories, and the outlook for productivity and unit labor cost growth across the region once industrial output stabilizes.
Inventory adjustment was severe, but seems to have moderated in recent months. Data on industrial sales and output (available in the Czech Republic and Hungary) show that over recent months output contracted more severely than final demand, though the gap appears to be closing.
In other words, firms were meeting whatever little demand they had by running down existing stocks rather than producing. We found similar evidence in the GDP release in Poland (massive negative inventory contribution in 1Q09) and in the Czech Republic. There is no easy way to track inventory levels in real time, but the best gauge we found is in the EC survey, in the component which measures stocks of finished products (‘unwanted inventories', so we invert the axis). The data for April and May show that firms still think that they have excessive inventories, but at least their perceptions are not deteriorating any further. This suggests that the point of maximum drag from stocks drawdown on GDP growth is probably behind us.
This view also fits in with what our euro area economics team thinks is happening in Central Europe's main trading partners. Elga Bartsch highlights that euro area corporates now view inventories as "less excessive than before", and expects them to be a much smaller drag on GDP in 2Q than in 1Q. In previous research, she observed that companies likely moved to a more widespread use of just-in-time management (see Euroland Economics: Inside the Inventory Cycle, February 23, 2009). Essentially, given closer integration among companies, information flows faster and companies adjust their inventory levels more frequently. Therefore, in a recession, they will adjust these levels to a minimum, and slash production aggressively. Given the high (and rising) correlation in the industrial business cycle in Germany and CE, it looks highly likely to us that the above also applies to Central European plants, which are newer, on average more efficient and operate with flexible labor arrangements. Note also that Central European countries are on average more reliant on industry than the EMU average (the Czech Republic stands out in particular). Therefore, while they suffered more from the industrial contraction over the last six months, the rebound should also benefit them in greater measure.
A Look at Labor Markets, Wages and Unit Labor Costs
The above suggests that, thanks to stabilizing global demand and a smaller inventory drag, the trough in industrial output growth is not far away. What this means for wages, productivity and unit labor costs is key for the inflation outlook. Over recent months, industrial output growth has slowed far more rapidly than either employment or wages. In other words, unit labor cost (ULC) growth has accelerated.
In a way, however, this was unavoidable. Firms adjust output much more quickly than they can adjust either employment or wages, due to contracts and initial labor-hoarding. Firms who had significant profit margins to fall on will have been inclined to absorb the rise in ULC growth rather than to pass it on to consumers, given the state of the economy. With profit margins having evaporated and turned into losses, however, it is clear that firms would not be able to sustain ULC growth of this magnitude indefinitely, and would have to correct wages, employment or prices.
While we are not as confident as others are in the power of the output gap to bring inflation to very low levels, we do think it is unlikely that firms pass these increases on to prices. In addition, stabilization in industrial activity and continued labor market correction will change the ULC picture radically in the coming quarters, in our view. If we plug in realistic assumptions for wage and employment growth between now and 2010, and assume that IP begins to stabilize and then expand at a moderate pace, ULC growth looks set to approach zero, and even turn negative in some cases (Poland).
Bottom Line
As we argued in the past, car incentives in Germany and their positive spillovers to Central European industry probably account for some portion of the recent improvement in manufacturing sentiment across the region, as recorded by the PMI. However, we find encouraging evidence in the surveys that the most intense phase of inventory adjustment is behind us (not just in the auto sector), and this could even mean some modest restocking in the quarters ahead. However, even with industrial output stabilizing, unemployment should continue to rise as firms adjust to the weaker environment with a lag, and wage growth will likely go towards zero or perhaps even negative in some cases. ULC growth has shot up in the last few months, but we do not think this is a lasting phenomenon, and it should not have a meaningful impact on final prices.
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Temporary Upside Risks, but Still a Slow Recovery
June 24, 2009
By Richard Berner | New York
Investors have taken cheer from less-bad US economic news over the past few months, but the recent stalling in both equity and credit markets suggests that more positive data are needed to extend the rallies that began in March. In the immediate short run, market participants may get their wish: Relative to expectations, we think there are some near-term upside risks to US economic growth. They are concentrated in severely depressed industries such as housing and motor vehicles, as financial conditions have become less restrictive and as inventory liquidation and job loss become less intense.
Even if those improvements materialize, they likely will be fleeting and don't change the overriding dynamic of a slow recovery. Headwinds include consumer deleveraging, still-restrictive financial conditions, budget woes at state and local governments, and cyclical weakness in capital spending and US exports. In addition, if the back-up in mortgage rates and in energy quotes persists, it will reinforce the slow growth dynamic.
If these upside risks are likely to be temporary, why not consider them just noise? First, market participants may be encouraged by any positive data and extrapolate them into a more bullish story. Instead, we would view them as part of the inherently bumpy process of bottoming in the economy, and would note that our call for the end of recession is quite different from calling for even a moderately robust recovery. Second, we expect that Fed officials will look through them and continue their focus on a tepid medium-term economic picture that does not indicate a need for restraint any time soon.
Near-Term Upside Risks...
Though they are likely to remain depressed, housing and motor vehicles are showing a faint pulse. Housing is getting support from the first-time homebuyer tax credit, the lagged effects of lower mortgage rates and home price declines. First enacted in 2008, the tax credit was expanded for homes purchased in 2009 to the lesser of 10% of the purchase price or US$8,000 for first-time buyers of a principal residence with income up to US$150,000 (married, filing jointly). The credit is fully refundable; someone with no taxable income who qualifies as a first-time homebuyer may file for the sole purpose of claiming the credit for a refund, according to the IRS. Although they are still below where they stood in November, mortgage rates have backed up more than 80bp from historical lows since the beginning of June. Still, the lagged effects of the declines in mortgage rates earlier this year have yet to show up fully in housing demand data. Finally, the decline in home prices will continue to improve affordability for many. The result: Despite lingering imbalances between supply and demand in housing, further small gains in sales and starts seem likely in the next few months.
Likewise, less restrictive financial conditions, benefits from ‘cash for clunkers', and restocking should help vehicle sales and possibly output. The captive finance companies have raised loan-to-value ratios to 89% from 85%, improving vehicle affordability; that may reflect the finance arms' ability to securitize TALF-eligible loans. Passage of the cash for clunkers bill - which will offer incentives of US$3,500-4,500 for purchasing fuel-efficient vehicles - will also help. Both the window and the budgeted amount in the current bill are limited: To qualify, buyers must purchase between July 1 and November 1, and only US$1 billion has so far been set aside (good for about 250,000 unit sales). But that ‘use it or lose it' timeframe could create a temporary sales surge - one that borrows from the future (see Cash for Clunkers: Not Much Bang for the Buck, April 24, 2009).
The outlook for vehicle output, which is what matters for GDP, is more uncertain. With two major OEMs in bankruptcy, it is difficult to forecast with any degree of confidence. While GM may put 14 plants on extended vacation this summer, Chrysler is restarting shuttered plants, and Toyota and other nameplates are reportedly poised to step up production. Reflecting these cross-currents, our autos team is expecting a 40% increase in 2H09 production to 2.6 million units; unless sales improve a lot, anything close to that step-up will simply build unwanted inventories. The upshot is that changes in vehicle output are a wildcard for the near-term outlook.
Turning back to demand, consumer spending could show slightly more growth in the coming months. The near-term forces are mixed: On the plus side, more than 50 million Social Security and Supplemental Security Income (SSI) beneficiaries received one-time checks of US$250 in May and June, giving a boost to discretionary income. But each penny increase in gasoline prices boosts fuel costs by US$1.3 billion. Thus, after seasonal adjustment, rising energy costs through June are acting like a US$50 billion tax hike, offsetting the Making Work Pay tax credit that reduced withheld taxes effective April 1. And the back-up in mortgage rates has closed the window on and limited the cash flow benefits to consumers from mortgage refinancing; that benefit seems likely to be only one-quarter of the estimated US$100 billion windfall that would have occurred if conventional mortgage rates had fallen to and stayed near 4.5%.
Finally, recent data suggest a near-term improvement in output, employment and business conditions. Improved financial conditions and rising commodity prices have dramatically reduced the cost of carrying materials inventories, hinting that restocking in those products could lift domestic output or at least temper the declines, as has been the case in Asia. Initial and continuing claims for unemployment insurance have peaked, at least for now, and thus job losses in June (excluding the loss of 50,000 census workers) probably declined to the slowest pace since August 2008. And the evidence from business surveys, such as the ISM and our own MSBCI, points to improving business conditions. The MSBCI moved above 50% in May and improved further in early June for the strongest performance in three years.
...but Slow Recovery Dynamic Persists
Despite these positive signs, the economy is unlikely to get beyond a slow recovery for several reasons. First, housing imbalances are still evident, fueling further declines in home prices, corresponding reluctance by lenders to reduce required down-payments, and further increases in mortgage foreclosures. Homeowner vacancies dipped nationwide in 1Q to an 18-month low of 2.7%, but remain a full percentage point above past norms. Home prices may be bottoming in what had been bubble metro areas, as foreclosure sales are turning up bargains, but they have only begun to decline in previously immune areas. Falling home prices and uncertainty about employment are still persuading consumers to save more out of those stimulus checks and current income and to keep deleveraging their balance sheets (see Deleveraging the American Consumer, May 27, 2009).
In addition, credit terms and conditions are still relatively restrictive, and the combination of tighter risk controls and new regulations will probably keep credit availability below historical norms. The Credit Cardholders' Bill of Rights Act of 2009 passed in May should reduce the inappropriate lending of the past few years, but its restrictions also seem likely to restrict access to credit and make it more costly for the typical consumer. Likewise, if enacted, the Administration's just-proposed plans for financial regulatory reform would not derail the progress made in restarting securitization markets but will likely limit the recovery in more leveraged forms of credit extensions, such as leveraged loans and CMBS, that contributed to the boom.
Third, domestic and global cyclical forces are depressing capital spending and US exports. In the business sector, record-low operating rates and margin pressure are prompting firms to cut capital spending and continue liquidating top-heavy inventories (see Capex Bust and Capital Exit, April 20, 2009). A slow-growth global recovery is likely to persist into 2010 (see Global Forecast Snapshots, June 18, 2009). Fourth, state and municipal governments are cutting spending and raising taxes despite federal assistance. According to a survey by the National Association of State Budget Officers, governors are responding to revenue shortfalls by proposing some US$24 billion in tax hikes in the fiscal year beginning July 1 for all but four states. And the same canvass indicated that state general fund spending may decline by 2.2%, or about US$35 billion, in the coming fiscal year. Finally, if they persist, the back-up in mortgage rates and in energy quotes will reinforce that dynamic.
For their part, Fed officials are likely to look through any near-term improvements in the economy. They are well aware that the actual path of bottoming and economic recovery will likely be far bumpier than the smooth pattern in their forecasts and ours. As a result, they will likely focus on the medium-term forces that will keep the recovery subdued and limit inflation risks, pushing any policy tightening into 2010 (see The Two Sides of the Inflation Debate, June 15, 2009). Their key challenge lies in communicating the balance between retaining their accommodative stance for an extended period and the need to clarify how and under what circumstances they will exit from quantitative easing and zero interest rates.
To be sure, the Fed's forecast revisions will probably be positive, reflecting the tone of incoming data, and that may limit their willingness to do more to counteract downside risks for output and inflation. But it will take far more positive evidence and a change in underlying forces to improve their fundamental outlook and alter their perception of the appropriate policy response. Indeed, with core inflation beginning to moderate again, and legitimate threats to recovery still in evidence, officials have scant reason to turn hawkish. And if and when officials do turn distinctly more positive, those factors afford them ample time - measured in months - to begin considering any shift in policy.
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