China
Green Shoots in Profits
June 30, 2009

By Qing Wang & Steven Zhang | Hong Kong

Identifying the Inflection Point for Profits

Latest data releases suggest that green shoots in the economy have taken root (see China Chartbook: Green Shoots Take Root, June 19, 2009). We expect headline year-on-year GDP growth to accelerate in the remainder of the year. Looking ahead, the focus of market observers will likely shift to another key question: when to expect green shoots in profits?

Industrial profit is the widely watched indicator of overall corporate earnings in China. Latest data (through May) indicate that the decline in industrial profit growth narrowed substantially from about -30%Y in January-February to -16%Y in March-May. The improvement is particularly strong for downstream manufacturing sectors (from -40%Y to -3.5%Y).

Export growth appears to be able to help identify the inflection point for profit growth, as industrial profit growth tracks export growth closely. We see at least two reasons for this pattern. First, export growth serves as a proxy indicator of the negative shocks that the Chinese economy suffers. When the economic system is subject to large negative shocks - all of which happen to have stemmed from the collapse in external demand in China in the past decade or so - profits tend to plunge accordingly. China's industrial profits have had three major slumps since 1997, with each taking place against the backdrop of a major global downturn: Asian Financial Crisis in 1997-98, burst of global IT bubble in 2001-02 and the ongoing global financial/economic turmoil.

Second, and of particular relevance to the export-oriented industries, when external demand weakens, those Chinese enterprises who produce for the export markets will have to turn inward, seeking compensation from domestic demand. This exacerbates oversupply in the domestic market, undermining the pricing power and thus profitability of the export-oriented sectors in particular.

In this regard, indicators of overall economic activity - such as industrial production and sales - are less useful gauges of inflection points of profit growth, especially amid economic downturns. These headline figures tend to reflect a mix of underlying organic strength of the economy and the effect of pro-growth policy stimulus. Industrial profits are a function of genuine strength of the economy instead of policy stimulus, as the latter may help to produce decent top-line figures but tends not be able to deliver bottom-line earnings performance, in our view.

Recovery in Exports Points to Recovery in Profits

Morgan Stanley's global economics team forecasts that the G3 economies will bottom out between 2Q09 and 3Q09 and embark on a tepid recovery through 2010 (see Global Forecast Snapshots, June 18, 2009). We believe that this economic outlook for the G3 economies, together with a substantial reduction of systematic risk in the financial sector, indicates that the impact of the negative shock on the Chinese economy has subsided considerably. Against this backdrop, the New Export Orders component of China's PMI has improved substantially since March this year, suggesting that export growth is bottoming out. We forecast that the negative export growth in China would narrow substantially in the coming months, and the growth rate may turn slightly positive towards year-end.

The improvement in the global environment in general and external demand in particular should help to boost confidence and sentiment as well as demand for exports from China. In view of the predicting power of exports for industrial profits, we expect that industrial profit growth would be bottoming out, with the decline in the year-over-year growth rate of industrial profits poised to narrow significantly in 2H09. And we estimate that, on a sequential basis, the improvement in profit growth in 2H09 compared to 1H09 will likely be positive, with the annualized rate potentially reaching as a high as 15%.

Benefiting from Lower Cost Pressures

In addition to better overall economic conditions, the low cost pressures stemming from the still relatively low raw material prices will likely contribute to improved profits. In the immediate aftermath of the financial turmoil, both the PPI (i.e., factory-gate prices) and the raw material price index (RMPI) dropped sharply. However, the latter declined much more than the former. As a result, the cost pressures on Chinese downstream manufacturing sectors - which usually account for 60-80% of total industrial profits - have eased substantially, as measured by the widened price gap between PPI and raw materials, or the terms of trade for the downstream manufacturing sectors.

While the low cost pressures have not yet been fully reflected in improved profit growth, we expect that the attendant benefit will begin to show in the coming months. Here is why:

First, despite the sharp improvement in their terms of trade in late 2008 and early 2009, producers were unable to realize the potential gains back then, because activity like production and sales dropped to very low levels at the height of the financial turmoil.

Second, as activity starts to pick up, the low cost benefits should show accordingly, especially for the producers who have seized the opportunity of very low international commodity prices to build up their inventory of raw materials.

Third, despite the recent rebound of international commodity prices, Morgan Stanley's commodity research team remains cautious that the rally could be sustainable. In particular, it does not think that the rise in demand due to an early economic recovery in China alone will be able to substantially drive up international commodity prices.

Fourth, the recent developments in international commodity price markets have largely reflected normalization of the relative prices between commodities and manufactured goods - the structure of which had been compressed to unsustainable levels at the height of the financial turmoil - instead of inflationary pressures due to a broad-based recovery in global demand. Commodity price increases due to relative price normalization is consistent with the competitiveness of China's manufacturing sector and is thus unlikely to have much negative implications to corporate profitability, in our view.

Modest Improvement in Capacity Utilization

Besides lower cost pressures stemming from relatively low commodity prices, the modest improvement in industrial production capacity utilization appears to have also helped profit margins. Industrial production capacity utilization - as measured by the diffusion index for capacity utilization based on a survey of 5,000 industrial enterprises - registered modest improvement in 2Q09 after sharp declines for three consecutive quarters since 3Q08. Meanwhile, the industrial gross profit margin has shown a similar trend.

The improvement in capacity utilization has reflected the Chinese authorities' supply-side adjustment policy as well as the incipient recovery in overall economic activity, in our view. At the start of the year, the Chinese authorities announced plans to ‘rejuvenate' ten key industrial sectors as part of an overall anti-crisis policy package. We believe that this is a supply-side adjustment policy, the primary purpose of which is to effect a government-guided, orderly production capacity retrenchment (see China Economics: The Supply-Side Adjustment, March 12, 2009).

Since our global economics team expects the global economy to enter into a relatively low-growth phase in the coming years, it seems unlikely that production capacity utilization and profit margins can recover back to the peak levels anytime soon unless the supply-side adjustment policy is carried out aggressively. We therefore suggest that market observers follow the progress on this front closely.

Implications

The recovery in industrial profits should help to underpin private investment in the industrial sectors in 2010, when the effect of policy stimulus is envisaged to be phased out. Given the outlook for a tepid recovery in the global economy in 2010 and beyond, private investment in industrial sectors is the key source of vulnerability to China's growth outlook in 2010 and beyond, in our view.

If the green shoots in profits can lead to a broad-based recovery in profits going forward, the risk of a substantially weak industrial investment should diminish materially. This, together with, the strong recovery in China's property sector, would imply that organic domestic demand will likely be able to prevent a potential double-dip in the growth rate when the effects of the policy stimulus are phased out in 2010 and beyond (see China Economics: Property Sector Recovery Is for Real, May 15, 2009).

While the listed companies (‘listcos') in the industrial sectors are a small sample relative to the industrial sectors, the growth of EPS of listcos tends to follow a similar trend to that of industrial profits. This is especially the case prior to 2005 when the listcos' space was dominated by industrial companies. The recovery in industrial profits that we expect to materialize in 2H09 is broadly consistent with and thus lends support to the recent upgrade of the consensus earnings outlook for the listcos.

Risks

The risk of green shoots in profits turning brown later this year is higher than that of the green shoots in the economy in general, in our view. In view of the strong policy response, we have become increasingly convinced that the green shoots in the economy have taken root and that a strong recovery will be underway in the remainder of the year. However, the outlook for profits is definitely murkier because it hinges on several factors, including a meaningful recovery - albeit a tepid one - in the global economy, the genuine strength of the underlying economy, relatively low commodity prices and the follow-through of supply-side adjustment policies. While these factors appear to be working in the same direction at the current juncture, we caution that the risk of slippages on any one of these fronts is not low.

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Russia
Harder Choices for 2010
June 30, 2009

By Oliver Weeks | London

While signs of green shoots are multiplying globally and easing cycles appear close to an end, the contraction in Russia has yet to turn, and monetary easing is not yet halfway through, we think.  Delayed fiscal stimulus and progress on arranging bank recapitalization make us more positive than we were on the prospects for growth in 3Q and 4Q.  Still, risks to our 8% real GDP contraction forecast for 2009 already look slightly to the downside.  A systemic banking crisis looks increasingly avoidable, though a recovery in credit and investment still looks remote.  The Oil Fund reserves have allowed the government to avoid most hard choices so far in the crisis, but unless oil prices keep rising, fiscal tightening in 2010 risks cutting off a fragile recovery as the budget becomes reliant on external borrowing.  We still expect CPI growth to slow sharply over the next nine months but expect a rebound later in 2010.  Risks of a new crisis in 2H seem low (unlike in Latvia, Lithuania, Ukraine and Belarus), but we remain quite gloomy on longer-term growth prospects. 

Oil dominant, balance of payments secure ... Rising oil prices can mask a multitude of weaknesses. Crude prices in 2Q have been well above our expectations, and we expect global liquidity to remain abundant and the USD to weaken further.  For our oil assumptions we are using the futures curve. Given Urals at US$70 for the rest of the year, we would expect a current account surplus of around 3.0% of GDP in 2009. We estimate that US$10 on oil prices is worth about 3.5% of GDP on export revenue, and 8-10% on the fair value of the RUB, dominating most other factors (see Russia: All About Oil, February 5). Still, in most plausible oil price scenarios, risks of a break of the 41 RUB basket floor still look remote to us.  The government's withdrawal from its earlier blanket bailout promise and progress on corporate FX debt restructuring leave the sovereign (and quasi-sovereign) balance sheet secure.  A broadly weaker USD not only boosts oil prices (as measured in USD) but, since the population primarily watches RUBUSD, also raises popular confidence in the RUB without excessive real effective appreciation.  Deposits and cash holdings are returning to RUB and foreign debt markets are reopening for the strongest corporates.  Barring a return to US$40 oil, the worst looks clearly behind, though we are less convinced that the RUB should appreciate much further, or that higher oil prices will drive a durable recovery in real GDP growth. 

... yet case for further RUB appreciation is weak: While the RUB has strengthened more than we expected in 2Q, we are not convinced that the current strength of the balance of payments implies significant further RUB appreciation.  Both the CBR's recorded FX purchases, US$32.6 billion in February to May, and the rise in FX reserves, US$21 billion over the same period, overestimate the strength of underlying capital inflows.  FX purchases are boosted by declines in commercial bank FX holdings at the CBR, and reserves by the weakness of the USD.  Net private sector capital outflows have slowed sharply from the US$38.8 billion in 1Q (most of that in January), but we estimate that April to mid-June has still seen an outflow, albeit only around US$5 billion.  In the next few months we think it is probable that, without continuing increases in oil prices, the recent strength of inflows can fade further.  On the current account side, the recent import decline, a spectacular 45%Y in April, seems unlikely to be sustained as policy stimulus picks up and trade finance reappears.  On the capital account side, effective inflows from a return to RUB savings are significant but finite.  A return of household deposits to the 14% FX share seen before the crisis would imply a US$30 billion effective inflow, but this seems on the optimistic side to us.  Given FX debt repayment needs, we think it unlikely that corporate deposits return to anywhere near the 33% FX share before devaluation.  CBR data still imply US$75 billion in FX debt amortization in 2H, before rescheduling, and US$91 billion in 2010.  Selected companies are now able to refinance but some also seem to have negotiated short-term moratoria on debt servicing that may shortly expire.  With some of the inflows in 2Q also speculative and short term, the case for a balance of payments surplus in 2H does not seem strong to us. 

To float or not to float? Equally importantly, we think that the limits of government and exporter tolerance of RUB strength are not far away.  The CBR continues to push for a free float, which would allow it to move towards a conventional monetary policy.  A more flexible exchange rate would be a welcome consequence of the crisis.  Sharply negative real interest rates over the past few years, driven by inflows and intervention, were partly responsible for the current weakness of the domestic financial system.  However, comments by PM Putin and presidential adviser Dvorkovich underline that politicians' willingness to devolve this much power still has its limits.  Given the volatility of oil prices, continued intervention looks inevitable to us.  While CBR officials also insist that policy focuses only on the basket, the 30 level on RUBUSD appears to be a significant barrier for the PM, finance minister and many influential exporters.  With a recovery in oil prices, a return to basket levels close to 36.0 would be unlikely to be strongly resisted.  However, even with rising oil, the fragility of many exporters and the weakness of the fiscal position argue for caution on appreciation.  As the basket approached 36, the CBR was altering its intervention rules in favor of greater intervention, roughly we understand to buy US$0.7 billion for every 5 kopecks of appreciation.  With the CBR's intervention level on the weak side more distant, risks do not seem to us to favor long RUB positions.  We expect further controlled depreciation in 2H, the basket reaching 38.8 and USDRUB 32.3 at year-end.  Lower interest rates appear to be a higher priority for the government than a strong RUB. 

Still room for rate cuts, even with weaker RUB: Indeed, even with a weaker RUB we remain positive on the outlook for interest rate cuts.  Russia's easing cycle began late and in our view still has much further to go.  Nominal rates remain high - the CBR's recent first one year non-collateralized auction came in at 15.0% - with loans for corporate borrowers significantly more expensive when available.  Although post-crisis policy will be constrained by a commitment to positive real rates, we continue to think that inflation is on track to fall sharply over the next nine months.  Consumer demand continues to weaken and wage growth to slow.  Weekly data suggest that June CPI can fall to 11.8%Y.  On the supply side, most wholesale grain and oil prices are still down 35-60% on a year ago.  RUB money supply growth has begun to recover, and will rise sharply as oil funds are spent, but for now monetary policy remains relatively tight and the lag between money supply growth and inflation appears still long, in the order of a year. The most recent anti-crisis program confirms that regulated price hikes in 2010 will be lower than previously agreed, likely driving a further year-on-year fall in 1Q.  Retailers report consumers also switching to cheaper items, an effect that will mainly show in CPI when the basket is reweighted in January.

We think that headline CPI may fall as low as 7.5% by March.  We also think that this will be the trough and inflation is likely to reaccelerate later in 2010 as the impact of policy loosening feeds through.  Structural inflationary factors, notably the lack of support for competition and difficulty of setting up small businesses, are not improving.  The longer-term outlook would justify caution on interest rate cuts, but we think that political pressure to cut rates as inflation falls is likely to be hard to resist.  With moderate RUB weakness welcomed by the government, we think that the official refinancing rate, currently at 11.5%, can be cut as low as 9% by 1Q10, though it will have to be raised in 2H. 

Systemic second-wave bank crisis avoidable ... However, rate cuts look unlikely to do much to improve access to credit, given the ongoing weakness of the financial system.  We think that recapitalization of the major banks is likely to prove affordable, and that a systemic crisis can be avoided.  The dominance of the state banks meant that the system was weak but still relatively small when the crisis hit.  The current capital of the banking system stands at 8.5% of GDP, private sector credit at just 45% of GDP.  Thus, current measures of the extent of bad debt look clearly inadequate to us.  Overdue corporate loans officially stood at 4.4% of the loan book at the end of May, and retail loans at 5.5%, but these count only the overdue tranche of a loan and none of the high proportion of debt that has been restructured. With the average corporate loan maturity around two years and the crisis still only three quarters old, sharp rises look inevitable to us.  However, even on our assumption of NPLs peaking at 20% and a recovery rate of 30%, capital losses would be in the order of 6% of GDP spread over two to three years, not all of which the government would have to cover.  (S&P's 38% estimate includes all restructured loans and implies correspondingly higher recovery rates.) The capital adequacy ratio across the banking system stood at a comfortable 18.1% at the end of April - certainly helped by softer definitions - but we expect regulatory forbearance to continue.  The most recent anti-crisis program allocation of RUB 495 billion for recapitalization of the banking system (ex-Sberbank) looks low, based on NPLs rising to 12%.  The bailout of the small Kit Finance alone appears to have cost the state RUB 135 billion so far.  Much remains unclear about the timing, scope and size of the government's program to recapitalize private banks by buying preference shares for OFZ bonds.  Official comments on whether the plan will be limited to the top 60 or 150 banks have been contradictory.  Yet, with the top 50 accounting for 82% of banking assets, and recapitalization of the top five (48% of assets and all state-owned) relatively straightforward, a further crisis looks quite avoidable, we think.

... but credit resumption remote: Whether this results in any credit growth over the next year looks more doubtful.  Private sector credit shrank 2.5% between February and April.  Even Sberbank, with its CBR ownership and impressive pricing power, is making no commitment to lending growth.  With the Duma due to be on holiday from July 13 to August 23, delays to the private sector recapitalisation program still look possible.  Debt restructuring and disputes over assets will inevitably prove protracted and highlight the weakness of the legal system.  The head of the Supreme Arbitrage Court has promised to make the courts more creditor-friendly, but regular interventions on the side of debtors by the president and PM will do little to encourage repayment, and thus new lending.  While CBR representatives have discussed aggregate stress tests, there is little sign so far of rigorous individual analysis of banks' positions, or of the pressure to clean up balance sheets that would allow new lending.  The non-market nature of much collateral may make such analysis harder.  Government interest rate ceilings and lending requirements risk making it even harder for banks to earn their way out of crisis.  Meanwhile, in the Eurobond and syndicated loan markets, further widespread triggering of leverage and change of control covenants look inevitable as earnings weaken and state holdings rise.  Closed debt markets also tend to reduce incentives for good corporate governance and transparency. 

GDP likely stronger in 4Q but recovery to be weak: While higher oil prices have an immediate impact on the balance of payments and narrow money supply, without a recovery in credit they will have much less impact on real growth.  The spectacular collapse of 1Q is highly unlikely to be repeated, but unlike in Asia recovery has yet to begin.  May's data were remarkably weak, with construction and fixed investment plunging 7.9% and 9.5%, respectively on a seasonally adjusted monthly basis on our calculations.  Retail sales and wage data are more encouraging, but a dip in headline unemployment looks to be a largely seasonal phenomenon, and job fears will continue to constrain demand.  We think that the 9.5%Y GDP contraction reported for 1Q may eventually be revised up.  Monthly output and trade data point to a less drastic fall, at least implying a massive temporary inventory adjustment.  The 1Q fall also reflects a very sharp fall in gas export volumes, driven by the fact that oil-linked export prices will be far lower in 2H.  Gas production volumes are already turning up, and while neutral for the balance of payments, the impact on real output numbers will likely be significant.  We still expect positive growth in 2H, helped also by inventory rebuild and late delivery of fiscal stimulus.  However, longer-term investment plans, including Gazprom's, continue to be revised down.  Risks to our 2009 forecast for a real GDP contraction of 8% appear already slightly on the downside.  We have raised our 2010 forecast marginally from 2.0% to 2.5%, but forced fiscal tightening in 2010 risks seeing growth slowing again in 2H10.  We see Russia lagging our global forecast for 2010 (2.9%) and all the BRICs bar Brazil, also at 2.5%. 

Fiscal stimulus large but late ... Such a large 2009 GDP contraction, and higher bank bailout costs, will eventually also limit fiscal room for manoeuvre.  With government debt at 7% of GDP, the oil reserve funds at 12.5% of GDP, and oil currently almost US$30 higher than assumed in the revised 2009 budget, near-term fiscal constraints are minimal.  Indeed, the main problem currently appears to be delivering the planned stimulus, one reason why 1H has proved so weak.  The consolidated government budget in January to April showed only a 0.4% of GDP deficit.  In May, federal spending contracted by 29%.  We still expect the fiscal stimulus to come through strongly in 4Q.  Urals averaging US$60 rather than US$41 adds around 3.5% of GDP to 2009 fiscal revenues over the year, we estimate.  However, we also think that a real GDP contraction of 8% rather than the planned 2.2% cuts non-oil revenue by around 1.7% of GDP.  USDRUB averaging 32 rather than the 35.1 in the budget cuts revenue on our estimates by 0.6% of GDP.  Given that we think the RUB 900 billion in planned spending cuts this year may prove hard to deliver, that bank bailout costs will be higher than budgeted, and that local governments may require further subsidy to avoid Pikalyovo-style unrest, we expect the 2009 federal deficit still to be close to the 7.4% of GDP in the budget law - a large stimulus after a 4.1% surplus in 2008.  However, for 2010 constraints become much tighter. 

... and to be withdrawn in 2010 as issuance constrains: Assuming no external borrowing in 2009, this would imply the Oil Reserve Fund falling almost two-thirds over the year to around US$50 billion.  (Note that this has no direct impact on FX reserves until the RUB spent by the government are converted by recipients to FX.)  For 2010, the Finance Ministry has indicated that it will cut the deficit to 5% of GDP.  If oil prices do not rise, and nominal revenues are up around 10%, nominal spending would have to fall 2%, politically challenging after a 28% rise in 2009 and an average annual rise of 29% over the past decade.  The Ministry of Finance so far has an even more conservative base scenario with Urals at US$50 in 2010 and real GDP up only 0.5%.  At the same time, the PM has promised further rises in social spending, medical spending and unemployment support, and a 45% rise in the basic state pension, while delaying the corresponding ESN tax hike, at a cost of around 3.5% of GDP.  President Medvedev did not gloss over the challenges in his budget address to the Duma, but the list of untouchable spending areas remains long.  Although government debt is very low, the weakness of the domestic financial market and the risk of crowding out domestic lending constrain the government's ability to fund itself.  The Finance Ministry is promising to limit external borrowing to US$10 billion in 2010.  Risks to this look well to the upside, at a time when G7 sovereign issuance and Russian quasi-sovereign issuance will also be testing investors' appetite.  Pressure for tax hikes, including on the gas sector, is also likely to grow. 

Longer-term challenges multiplying: Further drastic cuts to federal and local investment spending look likely, further constraining longer-term growth in an environment where infrastructure is inadequate and even pre-crisis investment low.  Although we are optimistic on short-term inflation, we are not convinced that a monetary framework is yet in place to prevent a longer-term inflation rebound.  The rapid spending of the oil funds represents a massive injection in liquidity, equivalent to around 70% of base money in 2009.  It is not clear that the CBR will manage to sterilize this adequately by withdrawing loans at a time when banks will be under pressure from rising bad debt.  The structural problem of inadequate competition is only growing as state banks and Rostechnologii expand their spheres of activity.  Without bringing down long-term inflation expectations it will remain hard to access long-term RUB funding, at a time when external funding should remain much harder to obtain.  The domestic banking system remains weak at mobilizing and allocating domestic savings, particularly as the state part of it continues to grow.  Ikea's decision for now to abandon its struggles with local bureaucracies over new stores underlines the cost of such obstacles at a time when competition for foreign investment is growing.  More importantly, the decision to suspend WTO negotiations suggests another policy shift towards uncompetitive producer interests.  If the long-term commodity supercycle has only paused, Russia will benefit from the rebound.  However, with the workforce also beginning a long decline, long-term real potential output growth seems likely to be relatively low to us, in the region of 3% a year.

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Brazil
Are Lower Real Rates Here to Stay?
June 30, 2009

By Marcelo Carvalho | Sao Paolo

Brazil's nominal policy interest rate has now fallen to single-digits for the first time in memory, and real rates have dropped to record lows. Are they here to stay? Macroeconomic improvement over the last several years indeed suggests that the equilibrium, or ‘neutral' real rate should now be lower than in the past. But part of the recent aggressive monetary easing is an emergency cyclical response to a sharp growth downturn - a response which (correctly) brought real rates temporarily below their ‘neutral' level. As conditions normalize down the road, interest rates will eventually need to rise again, perhaps some time late next year as the central bank then focuses on the 2011 inflation outlook.

There are two main camps in the debate: The first camp argues that the global crisis has created a window of opportunity for Brazil to bring real rates down - and to keep them there, at a permanently lower level. Analysts in this camp often have a ‘multiple equilibrium' framework in mind - real rates have historically been high in Brazil in part because of inertia, or habit. Once rates come down, it is easier to keep them there. A second camp argues that structural factors drive the equilibrium real interest rates over time - while cyclical considerations can temporarily bring real rates below their long-term equilibrium, the central bank would still have to eventually hike rates as the output gap closes, down the road.

But we sympathize with the second camp: in our view, equilibrium or ‘neutral' real rates in Brazil are now lower than in the past, but are also higher than actual current real rates. In our opinion, structural convergence to sustainable lower real interest rates will likely prove a gradual process over time, still dependent on further structural progress.

Camp #1: Window of Opportunity for a New Equilibrium

Observers in the first camp enlist several arguments in favor of the notion of sustainably lower real interest rates: They argue four main points:

First, macroeconomic fundamentals have improved: Indeed, Brazil is now investment grade - and deservedly so, in our view. In fact, our own work on macro radars indicates that Brazil is comfortably comparable to emerging market peers with investment grade status, across a range of solvency ratios that rating agencies typically look at. That was not the case, say, five years ago. So, there is clear improvement across a range of macroeconomic indicators over the last several years.

Second, policy credibility has strengthened: Monetary policy has gained credibility in Brazil over the years, since the introduction of the inflation-targeting framework and a floating exchange rate regime in 1999. The central bank is perceived as operationally autonomous in its decision-making, and inflation targets have gained an increasing role as an anchor for inflation expectations. On the fiscal front, a much better debt structure, improved debt dynamics and Brazil's commitment to primary surpluses have gone a long way in soothing investors' previous concerns about fiscal policy. More broadly, policy pragmatism has supported confidence. In all, as macroeconomic indicators improve and policy credibility strengthens, then risk perceptions improve, paving the way for lower rates.

Third, the days of a strong disinflationary effort now seem largely over: Brazil faced double-digit inflation readings at the start of its inflation-targeting regime, so for years monetary policy in Brazil had a hawkish bias, with interest rates higher than otherwise, as the central bank was working hard to drive inflation lower over the years. Now that inflation is broadly consistent with the targets, monetary policy is more about keeping inflation under control over the cycle than about pulling inflation steadily down over the years.

Last, but not least, observers in the first camp often seem to have a ‘multiple equilibrium' mind-set: Brazil has been stuck in a ‘bad equilibrium' of high real rates, but the global crisis creates a unique opportunity for Brazil to quickly move to a new ‘good equilibrium', and stay there - the argument goes. In this view, habit (or hysteresis, to use the academic jargon) helps to explain why rates in Brazil have been high for so long.

Camp #2: Remaining Structural Constraints

An alternative view - that real rates will not stay permanently low - comes from the second camp: The argument centers on three points:

First, domestic institutional credit distortions may help to explain high headline policy rates in Brazil - observers in the second camp would argue. According to this view, the relevant average interest rate in the economy is actually lower than the headline policy interest rate would suggest, in light of subsidized lending. Indeed, directed mandatory bank lending to agriculture and housing can distort the domestic credit market. Also, corporates with access to subsidized lending from the national development bank (BNDES) face lower funding costs.

Second, fiscal concerns remain, despite progress in recent years. Most observers focus on a declining public sector net debt/GDP ratio in recent years: down to 36% of GDP at the end of 2008, from a peak above 55% in late 2002. But progress on the gross debt has been less pronounced, ending 2008 at 64% of GDP, from a peak of 74% in late 2002. Fiscal challenges remain - Brazil's tax burden is too high by international standards (crowding out the private sector), social security trends do not look sustainable, and budget rigidities persist. Importantly, ongoing expansion in permanent spending can become a problem over the years, at the same time that public sector investment remains low.

Third, productivity gains and faster potential real GDP growth are key to supporting structurally lower real interest rates over time: Structural real interest rates can be thought of as a function of productivity. To sustain lower real interest rates, a country needs to increase its productivity. As conditions for faster growth are put in place, lower structural rates will follow. Despite macroeconomic progress, which has allowed Brazil to achieve investment grade status, microeconomic challenges also remain. According to an annual survey conducted by the World Bank (Doing Business), Brazil ranks very poorly when it comes to its business environment. A Byzantine and complex tax system, a heavy tax burden and rigid labor laws are some of the factors that conspire against a more business-friendly environment in Brazil. Similarly, despite progress, a lot remains to be done on the education front, in order to boost human capital in Brazil.

Our View: Structural Change Drives Real Rates

In our view, structural change is what drives equilibrium real interest rates over time: We sympathize with several of the arguments put forward by observers in the first camp, but remain skeptical of the ‘multiple-equilibrium' approach. In our opinion, macroeconomic improvement and stronger policy credibility mean that rates indeed should be lower than before. But there is more to do on the structural front if Brazil wants to enjoy structurally lower rates on a sustainable basis. In our view, emergency rate cuts have brought current real interest rates below the ‘neutral' level - and correctly so. But as cyclical conditions normalize later on, rates in Brazil will eventually need to rise again.

In other words, the equilibrium ‘neutral' rate in Brazil is now probably lower than before - but probably higher than current actual real rates: No one knows for sure where the precise ‘neutral' real rate stands today, not even the central bank. Actual real interest rates have been around 10% on average since 2000, and currently stand at about 4-5%. We suspect that the neutral rate might be somewhere in between, somewhere in high single-digits, although exact numerical estimates of the neutral rate in real time can only be offered with much trepidation .

We assume that policy rates remain low for a prolonged period, but start going up sometime next year: As the current monetary easing draws closer to an end, the central bank may cut once or twice from here, perhaps by 25bp or 50bp per meeting, and then stay on hold well into 2010. In all, our forecast assumes a final 25bp rate cut on July 22, so that the policy rate ends 2009 at 9.0%. We pencil in rate hikes in late 2010, so that rates climb to 10% by the end of next year.

Where to from Here?

Brazil's interest rates remain high by international standards: Brazil is currently no longer the world champion on nominal interest rates - but it still ranks high, judging from a sample of countries we cover. Real rates in Brazil are relatively high as well, although outright headline deflation in some places makes real rates actually higher than nominal rates in a few countries.

Brazil's interest rates have fallen over time: The policy nominal interest rate has now fallen to 9.25%, dropping into single-digits for the first time in memory. With inflation falling in the 4-5% range, real rates are about 4-5% too. This is low by Brazilian standards - the average real rate since 2000 has been about 10%, and spikes in real rates to 20% or 30% were not rare in the days before the floating of the currency in 1999. 

Are there relevant parallels between Brazil today and the past experience of Mexico and Chile? Some observers often point to the previous experiences in these two countries to illustrate how rates can move to a permanently lower range. However, these experiences must be understood in their appropriate context. Real interest rates in Chile did shift lower, from near 5.5% in the late 1990s to near 2-2.5% since 2002. According to our colleague, Daniel Volberg, Chile has been engaged in economic reforms since the 1970s, but perhaps the most important recent development driving the compression in real rates was the adoption of the structural fiscal rule of 1% of GDP in 2001 and elimination of all capital controls that same year. As for Mexico, real interest rates did not fall much, but nominal rates did as Mexico conquered inflation - average real interest rates in Mexico have been relatively steady at around 4% during most of the current decade.  Brazil's recent rate cuts have been largely an emergency response to the global shock: The central bank has cut policy rates by 450bp so far in the cycle, since the first cut in January. Judging by the historical empirical relationship between real policy interest rates and real GDP growth in Brazil, it seems that the global shock had an impact equivalent to a sudden hike of several percentage points in real rates. As conditions eventually begin to normalize, emergency monetary stimulus may well start to be unwound too.

Risks to the Rate Outlook

The global environment, the domestic policy environment and the inflation outlook as a function of the output gap seem to be the key drivers for monetary policy outlook in Brazil in 2010. Developments in these areas thus represent important factors that could either speed up Brazil's eventual monetary hiking cycle next year, or else push it back to 2011.

Which factors could keep rates lower for longer? Our global economics team thinks that central banks will not want to ‘rock the boat' - we expect most major central banks to keep rates at current exceptionally low levels until well into 2010. Also, quantitative easing will likely be unwound only very gradually (see Global Forecast Snapshots, June 18, 2009). Here, a global growth relapse represents a risk, if that means monetary easing continues for even longer. If excess global liquidity keeps expanding, and capital flows into Brazil prove buoyant (including from Asia), then a strong external supply of capital might help to pull rates down - if one thinks about interest rates as the result of demand and supply of capital. As for the domestic policy environment, there is little hope for much structural reform before general elections in October 2010, but formal central bank independence and lower future inflation targets would help to consolidate policy credibility. As for elections themselves, we assume that they don't directly affect monetary policy, which we assume will be driven by technical considerations. Finally, if the domestic growth recovery proves no more than anemic, and inflation prospects fall further below targets, then the central bank would have incentives to keep rates lower for longer.

Which factors could force earlier tightening? The global environment matters - in one alternative scenario, the global market's focus quickly migrates from quantitative easing to exit strategies, and inflation fears rekindle. As for domestic policy, one risk is that fiscal policy turns overly expansionary, which could complicate monetary policy decisions. More broadly, policy slippage remains a potential risk. As for inflation prospects, sticky services price inflation and potential upward pressures from commodity prices (especially food prices, which are highly visible) seem to be areas that the central bank would be watching closely. Finally, monetary tightening might start sooner rather than later if the output gap were to close faster than anticipated. Here it is worth keeping in mind that private sector consumption has recovered surprisingly soon, but investment remains depressed, which could hurt the supply side of the equation.

Market implications - real yields seem to reflect more caution than before in bets on the convergence story: Longer-dated real yields had already fallen to the 6-7% range around mid-2007, as investors back then had felt confident about the ‘convergence play', according to which real interest rates in Brazil would steadily fall towards international standards. But then a booming domestic economy, inflation concerns and eventual monetary tightening pushed real yields up until late 2008, when recession worries brought real rates sharply down.  Interestingly, the shorter-dated contracts, such as the yield for mid-2010, price in lower real rates, but yields now rise for longer-dated contracts. In other words, the real yield curve appears to reveal some skepticism that lower real rates are here to stay. As for the local nominal yield curve, abstracting from any risk premium, it foresees rate hikes already by early 2010 - which sounds too early, in our view. For their part, breakeven inflation data show a steady increase during 2008 in expected future inflation, reflecting rising actual inflation. The temporary spike in breakeven inflation in late 2008 seems to reflect currency depreciation, which in the end did not feed into inflation. Recession brought breakeven inflation down in early 2009, but the last few months would seem to reflect signs of growth recovery.

Bottom Line

Brazil's nominal policy interest rate has now fallen to single-digits for the first time in memory, and real rates have dropped to record lows. Are they here to stay? In our view, equilibrium or ‘neutral' real rates in Brazil are now lower than in the past, but are also higher than actual current real rates. In our opinion, structural convergence to sustainable lower real interest rates will likely prove to be a gradual process over time, still dependent on further structural progress.

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United States
Review and Preview
June 30, 2009

By Ted Wieseman | New York

Treasuries posted big gains over the past week as the market was able to smoothly take down a record run of supply after having initially plunged the prior Thursday when the new issues were first announced.  While a tightening of regulations provided a somewhat artificial boost to participation by final investors as it turns out that prior shares had been understated, at all three auctions very high overall bid/covers, awards stronger than pre-auction when-issued levels, and surges in the shares of the sales going to final investors versus dealers that were likely far too large to be only explained by more accurate reporting by dealers made for a run of three very strong auctions that totaled a huge US$104 billion in total gross 2s, 5s and 7s supply.  A sizable rally by mortgages that kept pace with the Treasury gains lowered their yields back towards 4.5% from 4.9% after the rout that followed the prior week's Treasury supply announcement and added a mortgage duration-related buying and receiving kick to the overall interest rate market upside.  Overall neutral economic data and a flattish week for risk markets didn't have much market impact, though there did seem early in the week to be notably pessimistic shift in sentiment about the economic outlook that helped get the bond market rally going and pressured risk markets Monday before they largely recovered over the rest of the week.  And even though there was some initial disappointment that the Fed didn't decide to raise its purchases of Treasuries or reallocate its buying plans from mortgage to Treasuries - a move we think is still a reasonable possibility at some point if mortgage rates remain elevated - ultimately the Fed's cautious take on the economic outlook supported the market's less optimistic near-term view after what's been a steady trend of progressively less bad economic data that we expect to continue in the upcoming week's run of key initial data for June.  For all of 2Q, we continue to see the recession moderating to a more typical 1.3% decline in GDP after the 6% collapse over 4Q and 1Q, as some upside in capital goods shipments in the durables report was offset by a slightly weaker-than-expected outcome for consumption in the personal income report and a more negative-than-expected inventory/final sales mix in the slight further upward adjustment to 1Q GDP to -5.5% from -5.7%.  Meanwhile, home sales held about unchanged in May, extending the general stability seen through the first part of this year, though with mortgage rates not having started their recent jump higher until the last few days of May, this stability will likely be challenged in coming months. 

On the week, benchmark Treasury yields plunged 16-30bp, with the intermediate part of the curve leading after substantially lagging over the prior week.  The old 2-year yield fell 16bp to 1.05%, 3-year 22bp to 1.62%, old 5-year 30bp to 2.51%, old 7-year 29bp to 3.16%, 10-year 28bp to 3.51%, and 30-year 22bp to 4.30%.  Aside from the long end, which held in pretty well, TIPS relative performance on the week was terrible in the face of the plunge in nominal yields and some slight softening in commodity prices.  The 5-year TIPS yield rose 3bp to 1.29%, 10-year fell 5bp to 1.81% and 20-year fell 20bp to 2.19%.  That left the benchmark 10-year inflation breakeven at 1.70%, a five-week low after a 40bp decline from the peak hit a couple of weeks ago.  For about a week after the widespread TARP repayments that drained tens of billions of dollar from the banking system (since the Treasury is keeping almost all its cash at the Fed instead of at banks these days), there was notable tightness at the very short end, but things were back to recent norms by Friday, with the 4-week bill yield down 4bp on the week to 0.04%, effective fed funds moving back closer to the middle of the Fed's 0-0.25% target range after a number of days of trading at the top of the range, and the average Treasury overnight general collateral repo rate similarly settling back down to 0.11% Friday after having been up near 0.25% for a time.  Mortgages had a very strong week that tracked the surge in Treasuries, with current coupon yields falling to near 4.5% from 4.8% at the end of the prior week as 4.5% MBS rallied about one-and-a-third points to just below par, which if it can be sustained would likely lower 30-year rates down towards 5.25%, which would still be up substantially from record lows near 4.75% that were seen consistently for a couple months until late May but would at least mark some improvement from recent averages closer to 5.5%.  This big mortgage rally helped the intermediate part of the Treasury curve and also drove a notable tightening in swap spreads.  The benchmark 10-year swap spread fell 6bp on the week to 20bp.  A notable improvement in expected interbank funding conditions going forward also supported swap spreads narrowing.  3-month Libor continued gradually moving to new record lows, dipping about 1bp on the week to just below 0.60%.  More notable was a major scaling back in the expected rise going forward.  While there was a slight further scaling back of Fed rate-hiking expectations after the FOMC continued to predict that rates would stay at current rock bottom levels for an "extended period", most of the rally in shorter-dated eurodollars instead reflected a forecast for tighter Libor/fed funds spreads.  The forward Libor/OIS spread to September fell about 9bp to near 40bp, December 12bp to 50bp, March 7bp to 44bp, and next June 7bp to 43bp, still reflecting some slight upside from current spot levels near 38bp but back down near prior lows after some temporary upside seen recently. 

Equity and credit markets were generally not much changed after recovering over the course of the week from big losses Monday.  Monday saw substantial weakness in risky markets and commodities, a rally in interest rate markets, and a safe-haven boost to the dollar as pessimism about the global growth outlook rose, but the strong auctions helped Treasuries to continue gaining through the week even as stocks and credit markets recovered.  Stocks ended the week down 0.3%, and investment grade credit was similarly flat, with the IG CDX index unchanged on the week at 141bp in Friday afternoon trading.  High yield and leveraged loans did better, with the HY CDX index 53bp tighter on the week through Thursday at 993 and seeing only a small sell-off Friday afternoon, while the LCDX index was 39bp tighter on the week at 975bp as of midday Friday.  Meanwhile, the commercial mortgage CMBX market was mixed but fairly stable after some significant recent volatility.  The AAA index fell nearly a half-point to 72.23 after having jumped almost three points the prior week, while the lower-rated indices mostly saw some upside after taking big losses the prior week.  The AAA ABX index also reversed course notably after dropping to only about a half-point above the April all-time low of 23.10 on Monday, eventually gaining 0.68 point on the week to 24.68. 

Overall durable goods orders rose 1.8% in May even with an 8.1% further collapse in motor vehicle and parts bookings and big drop in fabricated metals (-2.5%) that likely partly reflected the autos plunge.  Underlying orders were much stronger, with non-defense capital goods ex-aircraft orders, the key core gauge, surging 4.8%.  Upside in core orders was largely driven by a 7.7% rebound in recently weak machinery bookings along with a 2.2% gain in high-tech orders led by computers.  Core capital goods shipments were up a slight 0.3%, but this was a much better result after big declines in the prior two months.  Those prior declines still pointed to another big drop in equipment investment in 2Q, but the rate of decline is clearly slowing after the record plunge in 1Q.  We see business investment in equipment and software on pace for a 21% drop in 2Q and overall business investment running at -12%, somewhat better than our prior forecast as a result of the surprising uptick in May capital goods shipments.  On the negative side, real consumer spending rose a less-than-expected 0.2% in May after declines in April (-0.1%) and March (-0.2%), confirming expectations for a small renewed contraction in consumption in 2Q after the meager 1.4% bounce in 1Q that followed a near-record 4.1% annualized collapse in 2H08.  We see consumption on pace for a 0.5% drop in 2Q, slightly weaker than our prior forecast.  In addition, the upward revision to 1Q GDP growth to a slightly less disastrous -5.5% from -5.7% had a more-negative-than-expected mix, with the inventory subtraction unexpectedly adjusted down and final sales revised up less than expected.  This pointed to a larger inventory drag in 2Q, and we now see inventories subtracting another 0.6pp from 2Q GDP growth on top of the 2.2pp subtraction in 1Q.  Netting the upward adjustment to our investment forecast and the slightly more negative trajectory for consumption and inventories, we continue to see 2Q GDP growth tracking at -1.3%. 

Home sales extended their recent roughly stable trend into May, but the big back-up in mortgage rates that began late in May will present a significant challenge to this stability in the months ahead.  Existing home sales gained 2.4% in May to a 4.77 million unit annual rate.  This was a seven-month high, but sales have been pretty stable near 12-year lows since the end of last year.  The number of homes available for sale fell 3.5% for a 15% drop from the highs hit last year, though the level of homes for sale remained unusually high from a longer-term perspective.  Combined with the uptick in the sales rate, the months' supply of unsold homes fell to 9.6 months from 10.1 months, down somewhat from the high since the mid-1980s of 11 months in November, but still very elevated relative to more balanced levels around 5-6 months.  Meanwhile, new home sales dipped 0.6% in May to a 342,000 annual rate after downwardly revised readings over the prior few months.  Overall, though, new home sales have also been very steady so far this year, albeit at close to record lows.  With starts having plummeted as well, the number of unsold homes fell 2.3% in May to 292,000 units, which allowed the months' supply of unsold homes to dip to 10.2 months from 10.4 months.  While this is at least a decent improvement from the record high of 12.4 months hit in January, it is still extremely elevated relative to more balanced levels. 

The upcoming holiday-shortened week will end with an unusual employment Thursday, when based on the improvement in claims in June, we look for some further moderation in the pace of job losses.  Other data releases due out include consumer confidence Tuesday, ISM, construction spending and motor vehicle sales Wednesday, and factory orders Friday:

* We look for the Conference Board's measure of consumer confidence to rise marginally in June to 55.0.  Based on the latest readings for the ABC and University of Michigan sentiment gauges, we look for little change in the Conference Board measure for June following the sizable gains registered over the prior two months.

* We forecast a small further increase in the June ISM to 43.5.  The regional surveys that have been released to this point indicate that factory activity declined at a slower pace in June.  So, we look for a rise in the ISM index for the sixth consecutive month (versus the 42.8 reading seen in May).  The prices paid gauge is also expected to register an uptick (+4 points to 47.5).  We will update our ISM estimate if there are any meaningful surprises in the regional reports still to be released.

* Despite the uptick in May housing starts, we look for a sharp 1.9% decline in overall construction spending in May.  Indeed, the number of homes under construction continues to plummet, so we should see some further deterioration in the residential category.  Also, we don't believe that the recent string of upside surprises in the non-residential sector is sustainable and look for a sharp pullback in May.  Finally, we do not yet detect any signs of a meaningful rise in government infrastructure spending but should see some pick-up starting later this year.

* We look for some further modest improvement in motor vehicle sales in June to a 10.5 million unit annual rate from 9.9 million in May.  Indeed, anecdotal reports suggest that bargain hunters have surfaced at GM and Chrysler dealerships in the wake of recent bankruptcy filings by those companies.  Moreover, some Chrysler dealers who are on the verge of shutting down are being incentivized to unload their inventory as quickly as possible.

* We forecast a 250,000 decline in June non-farm payrolls.  The jobless claims data - both initial and continuing - appear to point to a slower pace of decline in employment over the course of recent weeks. So, we look for a more modest drop in payrolls even after accounting for the expected impact of departing census workers.  To recap, about 85,000 such workers were hired on a temporary basis over the course of recent months and, according to the BLS, 56,000 remained at the time of the May payroll survey.  This means that our ex-census payroll estimate for June is about -200,000. For some reason, the markets seem to have become fixated on claims that the so-called birth/death adjustment is leading to distortions in the payroll data.  Our own checks don't point to any notable bias one way or the other but, admittedly, there is no way to be certain that the birth/death adjustment is entirely accurate.  Still, it is worth noting that the same type of claims of bias in the data were prevalent last year, and the subsequent benchmark revision revealed that there was absolutely no hint of any problem with the birth/death adjustment. Indeed, the revision that was needed to account for inaccuracies in the birth/death estimates was statistically insignificant (less than 0.1%).  Finally, the recent rise in the labor force participation rate seems quite odd. A partial pullback is expected to help restrain the rise in the unemployment rate for June.

* Some price-boosted upside in non-durable goods orders combined with the previously reported jump in the durables component should result in a 1.4% jump in overall factory orders in May, the largest rise in nearly a year.

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