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Japan Expectation and Reality Diverge: June Tankan Global Global QE, Global Inflation View GEF Archive

		The Global Economics Team

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Major improvement in the headline Tankan number bears out the recovery underway since March, but doubts remain about companies' profit targets, which are less conservative than our top-down forecasts. Earnings for the April-June quarter to be reported from late July could support a relatively optimistic outlook from companies, but we expect profits plans to be revised down further from 2H, given the sluggish momentum of sales recovery.

Results for the Key DIs

1) Business conditions DIs: The headline (current business conditions, large manufacturers) improved from -58 in March to -48, as normalized trade financing and restocking of sales inventories overseas put a brake on the slide in production and exports. The outlook DI at -30 also indicates sustained improvement, and that companies are increasingly confident of further improvement ahead. The pattern for large non-manufacturing firms was similar, albeit somewhat slower. The headline improvement for larger firms provides tentative confirmation via the Tankan that the recession from November 2007 ended in February 2009.

Meanwhile, despite the pick-up in grass roots sentiment evident in the Economy Watchers Survey and Shoko Chukin Bank's Business Survey Index for Small and Medium-sized Enterprises the DI for SMEs suggests, SMEs have missed the recovery overall. The non-manufacturing DI, in particular, worsened from the March survey. The aggregate across all company sizes and industries shows a headline improvement of just 1ppt, and thus a polarized recovery.

2) Supply/demand DIs: As with the headline number, large companies showed comparatively strong improvement both in domestic and overseas demand assessment. The uptrend was more pronounced in the materials industries. The outlook DI is also improving rapidly, at a similar pace to that through June.

The inventory and distributor inventory DIs showed that the glut is receding in tandem for both materials and processing industries, indicating progress in inventory adjustments.

3) Price DIs: The input and output price DIs point generally to margin deterioration, reacting to the recent run-up in commodity/energy prices and intensifying downward pressure on final goods prices as domestic demand falters. In other words, the increase for the output price DI was smaller than for the input price DI. Margin deterioration was marked in the materials industries, but there is no sign of major change in the processing industries at this stage. The output price DI fell further for SMEs. This renewed margin pressure constitutes a fresh headwind for corporate earnings.

4) Employment and production capacity DIs: These output gap-related DIs strongly suggest persistently high idle manufacturing resources, in contrast to the improvement in the business conditions DIs, which springs from inventory adjustment and an export pick-up. The need to reduce the surplus by cutting capex, employment and wages implies that domestic demand will remain weak. The degree of change for the surplus has narrowed appreciably from the previous period (December 2008 through March 2009), however, indicating that the upturn in sense of redundancy on this front is close to peaking.

Overview of Management Plan Revisions for F3/10

1) F3/10 sales and profit plan revisions: Large companies across all industries were projecting a surprisingly moderate decline in recurring profit for F3/11 (-11.0%Y) in the March Tankan. However, the reliability of that data was questionable since only a few companies had firmed up plans for F3/10 by the deadline for responding to the last survey (March 10). The data this time are considerably more reliable, being founded on official guidance released alongside F3/09 results.

In the end, we saw large firms in all industries revise down recurring profit outlooks to -19.8%Y (revision rate a hefty -12.6%), in line with the market's bottom-up outlook. But companies are still optimistic relative to our cautious top-down forecast (we tentatively revised to -30%Y in light of F3/09 results). The significance of this may be that the inclusion of figures from companies which refrained from providing guidance in the last Tankan resulted in an upward bias of the Tankan management plan. However, the other companies (which submitted management plans at that time) have little incentive to change their earlier guidance, and probably just kept their forecasts for the latest survey.

We think that April-June results reported from late July will give support to a constructive outlook from the companies, since inventory restocking from threadbare January-March levels should provide a boost on the sales cost side, especially a lower prime cost effect in manufacturing industry. It would not be strange to see large manufacturers get back to breakeven point for recurring profit as their prime cost ratios fall simply as a consequence of restocking.

However, since companies have tight plans for 2H originally, they will probably not reassess full-year forecasts even if April-June outpaces their targets. We believe that corporate guidance may be based on overestimates for capacity utilization rates and sales, and that they will have to face reality and start revising down after 1H results, from October-November.

In fact, sales and profit targets for 2H in the June Tankan show the apparent contradiction of comparatively steep downward revisions at the top line, mainly for exports, but upward revisions for recurring profit. This could indicate that companies are overly optimistic regarding margin recovery in 2H, or that they plan sweeping fixed-cost cuts.

Meanwhile, in assessing whether profit guidance is reachable, we must look at fixed-cost cutting initiatives. Our impression from the initial plans that companies are being surprisingly aggressive in reducing fixed costs still stands.

However, these efforts to cut fixed costs may herald the elimination of a huge amount of capital stock and thus the potential for industry realignment. Capital policy constraints mean companies want to avoid two successive terms of operating losses, and they have been releasing far-reaching fixed-cost cutting plans with the announcement of their profit guidance.

The above could lead not only to the restructuring of facilities, but also full-blown reorganization of manufacturing industries. We foresee the initiation of such moves in areas including electronics, diversified chemicals and paper/pulp, from the second half of F3/10. The government is also trying to promote such moves with financing/capitalizing schemes through the Development Bank of Japan.

2) F3/10 capex plan revisions: At the time of the March Tankan release, capex plans were not very reliable as a complete list of corporate plans was unavailable. June Tankan capex plans are comparatively reliable in sales and profit plans, as the figures are based on F3/10 company guidance.

Large companies have revised down their capex plans for the first time in a June Tankan since F3/03, expecting a 9.4%Y cut (revision rate from March of -6.3%; a 10.8%Y decline adjusted for leasing accounting puts the revision rate at -7.3%, including software but excluding land), as capacity utilization rates are recovering only slowly even now, and companies are expected to continue to close or scrap unused facilities.

Incidentally, the Nikkei capex survey (released on June 8) indicates that large companies plan to reduce capex by a hefty 15.9%Y (manufacturers -24.3%, non-manufacturers -4.5%).This survey tracks domestic and offshore investment on a consolidated basis, so cannot be directly compared with the June Tankan (which covers parent-level, domestic capex), but both point to a grim outlook for capital expenditure.

The sluggishness of the current rebound in utilization rates underlies the capex cuts. Industrial production data for May virtually locked in a sharp output recovery for April-June, but the utilization rate for the same quarter will be around 56% at best and only about 60% in July, which is still far below the point of profitability.

The only ways for the utilization rate to rise are for output (the numerator) to recover beyond expectations as demand rebounds, for production capacity (the denominator) to be reduced meaningfully, or for the two to occur simultaneously. Yet there is little prospect of global economic growth - which correlates closely with Japan's IP - reverting to the pre-recession level of about 5%, making it hard to envision robust production growth continuing. In that case, plant restructuring matching the pace of the recession that followed the 2001 IT bubble would be needed to lower the production capacity denominator. As such, we foresee that capex will remain in the doldrums, except for some infrastructure upgrading investment in non-manufacturing areas (electric power, telecommunications, etc.).

We expect financial conditions overall to become a bit more relaxed throughout the fiscal year, due to policy effects. Financial institutions have relaxed their credit stance compared to the immediate aftermath of the Lehman shock last September, and thanks to the BoJ's CP and corporate bond purchasing operations and special corporate financing assistance (so-called ‘monster' operations), corporate financing if anything now appears to be accommodative.

Banks' lending stance as seen by companies in the Tankan shows a comparatively strong improvement of +8ppt (to -9 in June from -17 in March) for large companies. Large companies' financial position DI turned positive, standing at +1 in June compared with March's -4. In addition, the sharp decline in CP rates triggered by the BoJ's CP purchase program led to a marked improvement in CP issuance conditions for large companies, from -24pt in the March survey to -14.

F3/10 Land Purchasing Plan Revisions

Land purchasing plans tend to be revised up gradually towards fiscal year-end. However, large companies' F3/10 plans were revised down by 20.9%, with actual plans also down a steep 47.6%Y. It is natural for companies to refrain from land purchasing in anticipation of lower prices ahead and funding constraints.

Monetary Policy Outlook

The economy pulled out of its tailspin in January-March, but with the dollar somewhat weakening, overseas long-term interest rates spiking last month, and increased JGB issuance coming from July domestically, monetary policy is likely to come under renewed stress. The imminent risk of inflation is low due to the weakened financial intermediation function, and in Japan's case especially, the central bank has significant room for discretion. The BoJ decided to increase JGB buying (Rimban) operations only recently in March, but we think it has room to expand buying operations, exceeding the so-called banknote ceiling, while maintaining credibility in the yen. Going forward, we expect to see fiscal and monetary policies becoming increasingly integrated in the form of increased JGB buying by the BoJ and reexamination of the cap on JGB holdings (banknote ceiling).

As a preliminary step, we could see the special operations to assist corporate funding (part of the extraordinary measures introduced in turbulent times last year) extended beyond the end of September. The CP and corporate bond purchasing operations are likely to lapse at that point. The special corporate funding measures can substitute for these operations, and CP issuance rates have come down sharply, reducing the demand from investors. There have been cases in which no bids have been entered to buy CP, so even if this program is extended, it should not be damaging. That said, moves to end CP purchasing should not be tied to exit plans either.

We still see a possibility of a further rate cut within this year in October-December depending on currency, stock market and political trends. The timing of a rate hike, on the other hand, we expect to be October-December 2010, for a slightly earlier exit than the consensus view. However, if the BoJ's extremely cautious price forecast materializes (F3/11: -1.0%), we think it would, in practice, be difficult to exit within F3/11.

Global
Global QE, Global Inflation
July 03, 2009

By Joachim Fels & Manoj Pradhan | London

Inflation complacency: With headline inflation gauges in negative territory in many countries and the global economy only just emerging from the ‘Great Recession', it may seem absurd or at least premature to worry about inflation risks.  Indeed, most investors appear to be undaunted by inflation, a view that is also reflected in market-implied 10-year inflation expectations for the US and the euro area of less than 2%, which would be lower than actual inflation over the past decade.  In our view, however, markets are too sanguine about longer-term inflation risks.  It appears more likely to us that in the coming decade inflation will significantly exceed the levels seen over the past decade. 

Three reasons to expect higher inflation: Our inflation view is based on three pillars, which we discuss in turn: 

•           We think that most observers vastly overestimate both the size of the ‘output gap' and the importance of this gap for determining inflation. Our earlier research has shown that global factors, rather than national output gaps, are the main determinant of inflation these days.

•           The ‘secular' global forces that helped to push inflation lower or keep it low over the past couple of decades - productivity, deregulation and globalisation - will likely be less prevalent in the years ahead.

•           Quantitative easing (QE) is in full swing globally, and we think that central banks will be slow to exit from it collectively, especially if economic growth remains subdued.  The longer super-easy global monetary conditions remain in place, the more likely it becomes that inflation expectations and actual inflation will start to rise significantly.

Output gap approach problematic: The most frequently voiced argument for low inflation in the foreseeable future is that the Great Recession has created a huge gap between actual and potential output and thus much spare capacity that will take years to be absorbed. However, we are inclined to discount the output gap argument for two reasons:

•           First, any real-time estimates of the output gap are highly uncertain due to data revisions and because estimates of potential output evolve as more data become available.  For example, as work conducted by Athanasios Orphanides during his time at the Fed has shown, monetary policymakers' misperceptions about the size of the output gap were a major factor in the inflationary surge in the 1970s. For a long time during and after the mid-1970s recession, the Fed believed the output gap to be larger than it actually was.  The reason for this was that it overestimated potential output, which later turned out to be much lower than initially thought.  In fact, there is reason to believe that the credit and economic crises of the past year have led to a downshift not only in actual output but also in potential output. With the end of the consumer and housing boom in the US, the UK and other countries, resources and excess labour need to be shifted into other sectors, which will take time and could keep structural unemployment high.  Also, the cost of capital is likely to stay higher than in the bubble years, and the plunge in capex will contribute to lower potential growth, too, in our view.

Our more sceptical view on potential output and thus the size of the output gap is supported by our natural interest rate model, which also generates an estimate of potential output. Tellingly, our model produces an output gap for the US that is much smaller than the ‘official' one generated by the Congressional Budget Office (CBO).  Similar results have been reported in a recent study by San Francisco Fed economists Justin Weidner and John Williams ("How Big Is the Output Gap?" FRBSF Economic Letter, June 12, 2009).

 •          The second reason why we are inclined to discount the ‘output gap' argument is that in our previous research we found that output gaps only have a weak influence on inflation.  Rather, global inflation has become the dominant driving force for domestic inflation rates. If our estimates are anything to go by, an output gap of 1% pushes inflation down by barely 15bp in the US (see Inflation Goes Global, July 16, 2007).

Global factors less disinflationary: So how about the global factors determining inflation?  In the last one or two decades, central banks were helped in keeping inflation low by a confluence of three factors: globalisation, deregulation and faster technological progress.  However, the tailwinds for central banks from each of these factors have turned into headwinds:

•           Globalisation is likely to proceed less rapidly in the next several years due to the creeping protectionism that has been reinforced by governments' reactions to the Great Recession. Increased support for national industries is likely to slow restructuring and reduce import competition. 

•           Deregulation has been largely achieved in most sectors.  Now, consolidation in deregulated sectors and government-induced re-regulation in some areas are reducing competition, and thus potentially adding to inflation pressures.

•           The big boost to productivity from the IT boom of the 1990s is behind us, and trend productivity growth in the technology leader, the US, has probably slowed significantly.  Lower productivity growth that is not accompanied by slower wage increases implies rising unit labour cost pressures.

But monetary policy matters most: The most important factor for the global inflation outlook, however, is the current and future stance of monetary policy.  Central banks have responded to the crisis with an unprecedented amount of monetary stimulus, and we fear that the accommodation will be kept in place for too long.

QE is alive and kicking... The sharp increase in US 10-year yields and mortgage rates, with 10-year yields reaching 4% in mid-June, led many investors to question the effectiveness of the QE programme. While a continued increase in yields would certainly create headwinds for economic recovery, it is important to keep in mind that keeping yields low was only one aspect of the programme. As important, if not more so, is the increase in money supply and excess liquidity. On this measure, the Fed has continued to run a successful campaign, as have a host of other countries that have implicitly or explicitly turned to QE.

...globally: On our count, the Fed, the ECB, the BoE, the BoJ, the Swiss National Bank, the Swedish Riksbank, the Norges Bank and the Bank of Israel all adopted some form of QE around September 2008 (see "QE2", The Global Monetary Analyst, March 4, 2009). M1, the measure of narrow money supply, has been growing strongly in most of these countries since then. M1 growth in the G4 is ticking along at 12%, driven by M1 growth of nearly 20% in the US, around 8% in the euro area, and a move into positive territory for M1 growth in Japan. Outside the G4, money supply is moving up strongly in Switzerland and Israel, with the latest M1 growth numbers showing 42%Y and 54%Y growth, respectively. The Norges Bank's QE programme has kept the monetary base at highly elevated levels and M1 growth has begun to shrug off the effects of previous tightening and is now in positive territory. Finally, the increase in the monetary base allowed by the Riksbank has pushed up M1 growth to over 6%.

While there has been no QE announcement from the Chinese monetary authorities, the efforts made to increase money supply and credit in China over the past few months have been highly successful.  M1 growth has clocked in at 18.5%Y while loans are growing at 28%Y. India briefly flirted with QE-type policies (see India: Flirting with QE, April 7, 2009) by buying a sizeable chunk of government bonds since April. However, efforts to push up money supply don't seem to have been pursued vigorously since then. Both economies are expected to outperform the global economy. If anything, our economics team sees the dramatic rally in equities and property as a development that central banks will have to monitor closely (see Rise in Asset Prices: New Challenge for Asian Central Banks, June 30, 2009).

More to come: In the major economies, there is plenty more to come. The Fed is about halfway through its US$1.75 trillion purchase programme, while the Bank of England has about 18% (£23 billion) of its programme yet to go. Meanwhile, the ECB will start purchasing €60 billion of covered bonds this month. In short, there is plenty of firepower waiting to come out of the central banks' QE muzzles. If the impact on money supply so far is anything to go by, we can expect excess liquidity to continue to grow (see "The Global Liquidity Cycle Revisited", The Global Monetary Analyst, May 27, 2009) and support economic recovery and asset markets.

...but the way out is tricky: While talk about ‘QExit' has started, we believe that central banks will most probably not be able to withdraw monetary stimulus rapidly without putting at risk the tenuous recovery that our global team expects. On our latest forecasts, the G10 economy will shrink by 3.5% this year and grow by only 1.3% in 2010. In such a scenario, central banks are likely to unwind QE and normalise policy rates fairly simultaneously and very slowly (see "QExit", The Global Monetary Analyst, May 20, 2009), raising the risk of inflation. Importantly, given the importance of global factors that we pointed out earlier, keeping the inflation genie bottled up will mean that it probably won't be sufficient if one or two central banks get the timing of exit right - this is a feat that a majority of central banks will have to achieve in order to keep global inflation subdued, in our view.

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