South Africa
ZAR Resilience Despite Fiscal Deterioration
August 04, 2009

By Michael Kafe & Andrea Masia | Johannesburg

Introduction

Significant revenue shortfalls could combine with sharp rises in the public sector wage bill this year to lift South Africa's fiscal deficit above 6% of GDP, and push its public sector borrowing requirement into double-digit territory. But, while we acknowledge that a deteriorating fiscal position is negative for currencies, we believe that things could be somewhat different for the ZAR: An anticipated crowding out of South Africa's public infrastructure spend should help to contain the import bill and place a lid on the current account deficit. This, together with significant inward direct and portfolio investment, is likely to support ZAR resilience.

Fiscal Revenue Undershoot

Thanks to much lower-than-expected GDP growth this year, we believe that South Africa's fiscal revenues are likely to come under significant pressure. VAT receipts, for example, have posted a cumulative inflow of a mere 8.6% of the Budget for the fiscal year to May-09, compared to 15% in the past three years. Fuel taxes have also slipped below their three-year average levels, thanks to contracting energy demand; meanwhile, international trade tax inflows have ebbed as imports of white goods and vehicle parts slowed. Other tax handles, such as property taxes, excise duties, payroll taxes, etc., are below their three-year averages too. The only tax category that appears to have held up relatively well is personal income taxes. On the whole, we look for a tax revenue shortfall of around R45 billion in fiscal 2009/10.

High Wage Bill to Lift Expenditure, Net Borrowing

The authorities' much-publicized commitment to the pursuit of counter-cyclical fiscal policy leads us to believe that fiscal expenses will turn out higher than budgeted in 2009/10. In the main, we expect upside pressures to show up in wages and interest. While the 2009/10 Budget provides for a 9.9% increase in the wage bill, we believe that the out-turn could be a lot closer to 14% this year, once provision is made for non-wage compensation and Occupation Specific Dispensation (OSD) adjustments. Net transfers to households are also likely to come in above budgeted estimates, thanks to a growing number of applications for foster care, social relief and child support grants. The combination of revenue shortfalls and expenditure over-runs is likely to result in a much higher fiscal deficit than anticipated by the Treasury.

For the record, we believe that the 2009/10 fiscal deficit is likely to breach 6% of GDP - significantly higher than the Treasury's 3.8% forecast. This will no doubt have some implications for the PSBR, which we now expect to overshoot budgeted estimates by some 3.1% of GDP this year, and a further 1.3% of GDP in 2010. In fact, public sector bond issuance rose by some R26 billion in the first quarter of the fiscal year - on schedule to exceed the annual target of R70.5 billion by some R30 billion (for a detailed discussion of South Africa's debt profile and fiscal dynamic, see South Africa Chartbook: ZAR Resilience Despite Fiscal Deterioration, July 29, 2009).

CAD to Benefit from Lower Fixed Investment Spend

While we acknowledge that a deteriorating fiscal position is generally negative for currencies, we believe that things could be somewhat different for the ZAR: This is because the deteriorating fiscal position is likely to force the government to hold fire on selected infrastructure projects for now.  Also, double-digit wage awards to municipality workers raise the risk of relegation of not-so-pressing capital projects to the back-burner. On the whole, we have trimmed our government infrastructure bill by some 5-7%.

The anticipated crowding out of South Africa's public infrastructure spend, as a result of such expenditure pressures, should help to contain the import bill and place a lid on the current account deficit. And, on the back of recent revisions to key commodity forecasts by our commodity team (see Global Metals Playbook - 3Q09: Short-term Caution, Medium-term Optimism, July 1, 2009), we have revised our current account outlook. For example, platinum prices have been bumped up 12% (from US$1,057 to US$1,181) in 2009 and 20% (from US$1,075 to US$1,300) in 2010. Our 2010 coal price forecast is also up 23% to US$80/t. We expect export volumes to decline some 10% in 2009, followed by a 13.5% recovery in 2010 as global demand conditions improve. Regarding imports, we assume that Brent crude prices average some US$60/bbl in 2009 and US$77/bbl in 2010 (in line with the Brent futures curve); and that non-oil import prices fall 10% in 2009 before rising 5% in 2010. We also assume that import volumes fall 8.5% in 2009. Finally, we trim our 2010 import volume growth from 12% to 8.5%, thanks largely to our view on pubic sector capital imports.

With only minor adjustments to our outlook for the net invisibles, we now believe that the current account deficit could fall to 5.7% of GDP in 2009 (6.0% previously) and 6% in 2010 (6.4% previously). This compares with consensus estimates of 6.1% for both years. The potential funding of the current account deficit appears to have improved too, in light of the rebound in portfolio investment inflows over 2Q09 (some US$30 billion worth), and the spate of FDI inflows through the first half of 2009 (the sale of AngloGold Ashanti and Vodacom). With the possibility of further large FDI flows over the remainder of the year (MTN and Bharti-Airtel, Anglo-American and Xstrata), the funding mix of the BoP appears to have improved significantly.

Although the anticipated narrowing of the current account deficit is an encouraging development, a reading in the range of 6% of GDP is not all that positive, relatively speaking. In fact, among a sample of EMEA and Latam emerging markets, we expect South Africa's current account deficit to be second only to Romania. South Africa also ranks poorly on the fiscal gap measure - particularly among the non-oil-based economies. For this reason, we temper our enthusiasm towards USDZAR, and still expect a depreciation from current levels.

Revised USDZAR Forecast

We now expect USDZAR to close the year at 8.50 (9.40 previously), before depreciating to 9.00 at the end of 2010 (10.00 previously). Our analysis suggests that, at the current spot rate of 7.90, USDZAR is some 13% overvalued relative to its fair value estimate of 9.10 (see South Africa: USDZAR Fair Value: A Fresh Look, July 9, 2009). However, our fair value model points to a near-term path of ZAR appreciation as fair value migrates towards 8.40 by 1Q10. This means that, although the rand should ultimately depreciate somewhat, one may need to look beyond movements in economic fundamentals to trigger a near-term correction.

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Brazil
The Credit Channel
August 04, 2009

By Marcelo Carvalho | Sao Paolo

The domestic credit channel can become a key theme for the domestic growth story. Last week we examined the improvement in external conditions facing Brazil (see "Brazil: What Is the China Link?" EM Economist, July 31, 2009). This week we look at domestic factors, focusing on the credit channel. Local conditions are improving across the board - sentiment indicators are rebounding, activity indicators post repeated sequential gains, and labor market conditions find firmer footing. While recent domestic data support a better growth environment in 2009, we suspect that improved credit conditions could prove an important driver for the domestic growth story in 2010. Public sector banks have done the heavy lifting in extending domestic credit so far this year, but there is a growing local perception that private sector lending can continue to gain speed into 2010, as interest rates stay low and local conditions improve. For its part, the national development bank (BNDES) looks set to strengthen further its lending muscle, while local capital markets pick up.

As the credit channel expands, the domestic growth outlook improves. We are upgrading our Brazil real GDP growth forecast to -0.5% in 2009 (from -1.0% before) and to 3.5% in 2010 (from 2.5% before). In turn, stronger growth should help to underpin investor sentiment and thus support capital inflows - we update our currency forecast and now look for the currency to be R$1.9 per US dollar at end-2009 (from 2.1 before), and 1.8 at end-2010 (from 1.9 before). We look for CPI inflation to remain consistent with the official 4.5% target, and continue to expect the central bank to start hiking rates at some point in the second half of 2010.

How Does the Credit Channel Work in Brazil?

The role of credit in Brazil is rising over time. Although still relatively low by international standards, total domestic credit has climbed to a record high of 43.2% of GDP as of June 2009, up from 41.3% at the end of 2008, 34.2% at the end of 2007, or from a share of GDP in the mid-20s earlier in the decade. Credit to individuals has led the expansion over the last several years, and now accounts for about a third of the total. Although still very high by international standards, interest rates charged on domestic loans have fallen over time, at the same time that the average loan maturity has trended higher in recent years. The combined effect of lower rates and longer maturities helps to reduce the size of monthly installments, an important factor in the decision-making process of the average Brazilian consumer. 

Credit conditions ultimately work their way into the economy through their influence on consumption and investment decisions. Improving credit conditions have been an important driver of the overall domestic expansion over the last several years. That can be seen in the correlation between credit growth and retail sales, and seems also reflected in the composition of retail sales - sales of credit-sensitive sectors like durable consumer goods have generally outperformed over the years. Similarly, domestic credit conditions correlate broadly with investment trends over time, although the severe drop in investment at the turn of the year went far lower than credit conditions alone would suggest.

Brazil's idiosyncratic institutional set-up suggests three main credit transmission channels. These are the private sector financial institutions, the public sector banks and the national development banks (BNDES).

The first channel works through credit extended by private sector financial institutions, which account for 61.4% of the domestic credit market as of June - foreign financial institutions represented 19.8%, and national private sector banks were 41.6% of total domestic credit. As the policy rate has now fallen to unprecedented lows, monetary policy enters uncharted territory. Banks can no longer rely on buying short-term government paper to sustain profits, and instead probably will need to turn to lending to the private sector. Domestic private banks have been relatively cautious in their credit decisions so far this year, but look increasingly likely to resume faster lending going into 2010. One area for strong long-run potential credit growth in Brazil is mortgages - housing credit still represents only about 2% of GDP in Brazil. This ratio is very small by international standards, and probably reflects Brazil's previous history of decades of macroeconomic instability, high interest rates and short planning horizons.

A second transmission channel works its way through public sector financial institutions, which accounted for 38.6% of the credit market in Brazil as of June. Public sector banks tend to take account of policy considerations that go beyond narrow market considerations alone. Indeed, in the aftermath of the global crisis late last year, public sector banks in Brazil have been encouraged to take the lead in extending domestic credit, ahead of private sector banks.

A third important credit channel is the national development bank (BNDES). The BNDES is a federal public company - linked to the Ministry of Development, Industry and Foreign Trade. Since its foundation in 1952, the BNDES has often financed large-scale industrial and infrastructure operations. Its goal is to provide long-term financing, and indeed it is seen as the key source for long-term corporate financing in Brazil. It typically offers lending at subsidized rates, which are not directly linked to the policy interest rate. According to central bank data, the BNDES represented 17.3% of the total domestic credit in Brazil as of June. 

In addition, local capital markets can play a relevant role. As rates fall to unprecedented lows, observers wonder about a migration of funds from fixed income to the equity market. In turn, a rising local stock market has supported the resumption of local IPOs - as the recent Visanet transaction illustrates. As the pipeline of IPOs moves along, together with secondary offerings, corporates can find in the local capital markets a source of funding for their investment plans.

What Do Recent Data Say?

Public sector banks have played an increasing role in domestic credit extension lately. Their share in the economy was shrinking from a peak in the mid-1990s until the turn of the decade, but this has been going up rapidly over the last yea.  Latest data are clear: Public sector banks have done most of the heavy lifting (see "June Credit Data Still Difficult", Brazil Financial Institutions, July 28, 2009, by Jorge Kuri and Jorge Chirino).  As of June 2009, credit grew 19.7%Y: credit provided by government-run banks grew 33.8%Y, well ahead of the 6.8%Y pace seen at private sector banks. Put another way, public sector banks contributed with almost 60% of the credit expansion seen in the last 12 months. Within public banks, credit provided by public sector financial institutions grew R$124.6 billion in June from a year earlier - of which R$47.2 billion (or 37.9%) was the increase in BNDES lending, according to central bank data.

Earmarked lending is gaining ground. Earmarked lending refers to BNDES lending and mandatory lending to designated sectors of the economy, including agriculture and housing. Seen from this angle, while total credit grew 19.7%Y in June, non-earmarked lending increased by 17.5%Y, while earmarked lending jumped 25.2%, boosted by BNDES lending - up 27.1%Y - and housing loans - up 41.8%Y. As of June, BNDES accounted for almost 60% of earmarked lending. This upturn in earmarked lending is a clear break from recent years, as most of the credit expansion seen since the start of the decade was led by non-earmarked lending, as earmarked lending had been largely stable as a share of GDP over the years.

BNDES lending has risen rapidly. According to BNDES data, credit consultations and approvals had been rising for years, but jumped high around the turn of the year - corporates seem to have rushed to the BNDES as local corporate credit market conditions tightened after the Lehman Brothers crisis, at the same time that some corporates faced difficulties with exposure to currency derivatives. Actual BNDES disbursements are also on the rise, with a time lag. Once approved, BNDES loans become available to the borrower, who can then choose to withdraw the resources later on, or not at all (if an investment project is cancelled).

Private sector lending will need to speed up in the second half of the year if banks want to meet their guidance for the year. Private sector banks have taken a cautious approach so far. But in an environment of low interest rates and a recovering economy, there is growing local talk that they might eventually start lending more, if they want to recover market share lost to public banks. In all, total domestic credit growth has slowed from 31.1% in 2008 to 19.7%Y in June, but looks set to accelerate again next year, probably with a more balanced mix between public and private sector banks, as the latter return to the market.

One issue to monitor is delinquency rates, which have worsened in lagged response to the economy's previous downturn. The non-performing ratio increased to 4.4% in June, up from 4.3% in May and 3.2% last December. Looking ahead, non-performing loans have yet to peak, perhaps at some point in 2H09. If the growth recovery proves sustained, then asset quality should subsequently improve.

Where is the credit flowing to? Latest data show that credit growth to the housing sector is outperforming so far this year - it had already been picking up steam steadily over recent years, and continues to accelerate so far this year, outpacing credit growth in industry, agriculture and for individuals.

New credit to individuals is recovering sequentially. New credit to individuals fell 5.1% from September to a trough in January (looking at the three-month moving average, seasonally adjusted). As of June 2009, it had rebounded 11.9% from the January lows. Similarly, interest rates on new loans to individuals climbed to a peak of 58.3% in November, but have since declined to 45.6% as of June. By contrast, rates on new loans to corporates have not fallen as much, although their absolute level remains lower than that for individuals.

Policy Implications

On the fiscal front, off-budget and quasi-fiscal decisions can entail fiscal costs. Encouraging public sector banks to lend more aggressively can help to spur the economy in the near term, but might imply eventual fiscal costs if loans eventually turn sour and require future capital injections from the Treasury. For its part, subsidized lending from BNDES is not costless. For instance, when the Treasury issues debt to fund subsidized loans through the national development bank, the Treasury's gross debt goes up, its net debt remains unchanged, but the effective burden of interest payments actually rises, given the negative interest rate differential.

Credit developments have implications for monetary policy too. The latest COPOM minutes send strong signals that the monetary easing cycle is over. Some COPOM members thought that there was support for the idea of staying on hold already at the latest meeting, despite the formal unanimous consensus for a 50bp rate cut. The minutes remove previous references about "margin for residual easing". They also add that "important monetary and fiscal stimulus have been introduced in recent months, which will contribute to growth recovery and to reduction of slack in the economy". Finally, the minutes now add that "a more cautious stance will contribute to mitigate the risk of abrupt reversals in monetary policy in the future". The local market debate will now shift from ‘how far do they cut?' to ‘when do they start hiking?' The local yield curve prices in rate hikes starting already in 1Q10. That sounds too soon - our forecast assumes policy rates on hold at the current 8.75% level well into 2010, with the first hike in 2H10. However, if domestic credit conditions expand fast enough, to the point of questioning the inflation outlook, risks would rise for an earlier rate hike.

Bottom Line

The domestic credit channel can play a key role in the domestic growth outlook. Public sector banks have done the heavy lifting in extending domestic credit so far this year, but there is a growing local perception that private sector lending can gain speed next year, as interest rates stay low and local conditions improve. For its part, the national development bank (BNDES) looks set to strengthen its lending muscle, while local capital markets pick up. As the domestic credit channel expands, the 2010 growth outlook improves. We are upgrading our Brazil real GDP growth forecast to -0.5% in 2009 (from -1.0% before) and to 3.5% in 2010 (from 2.5% before).

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United States
Review and Preview
August 04, 2009

By Ted Wieseman | New York

Moderate losses at the short end and a big rally at the long end led to a huge flattening of the Treasury yield curve over the course of the past week after the curve had moved to near record-steep levels on Monday.  Continued upside in risk markets after a brief pause midweek, a rough couple auctions at the 2-year and especially 5-year sales before a much better end to the latest record run of issuance at a very strong 7-year auction, and incoming data and anecdotal information that continued to indicate that the potentially substantial auto-driven upside to 3Q growth implied by automakers' production schedules is unfolding pressured short end yields somewhat, but investors apparently found longer-end yields attractive after they backed up not too far from the highs for the year hit in June at Monday's close.  Even the short end didn't do badly at all after managing a decent recovery Friday (though the curve continued flattening in Friday's rally) once supply was out of the way, stocks flattened out somewhat, month-end portfolio adjustments brought in some buying, and the GDP report highlighted just how severe this recession has been, even if incoming information continues to suggest that it may have already ended.  The GDP report showed an as expected 1% drop in 2Q GDP, but the recession was revealed to be much more severe than previously thought, with benchmark revisions resulting in a post-war worst 3.9% plunge in GDP in the year through June, an unprecedented four straight quarterly declines in output, and a revised 2.8% annualized drop in GDP from the start of the recession in 4Q07 through 1Q09 that was a full percentage point worse than prior figures.  But as we move further into 3Q, confidence continues to build that this worst recession since the Great Depression is ending and could be ending with a bang, if probably only a temporary one, with a major reversal in the auto sector apparently unfolding that could provide substantial upside to 3Q GDP, lifting growth well above our last official forecast of +1% published early in July.  Weekly industry figures indicate that US car and truck assemblies will likely post a sequential increase in July versus June, which would be extremely unusual since production typically falls by about a third in July on shutdowns in the first half of the month and would result in a huge rise in production after seasonal adjustment.  And the apparently major success of the cash for clunkers program - incredibly, the (initially) only US$1 billion cash for clunkers plan already appears to have had a more positive impact on the economy than the US$787 billion fiscal stimulus plan passed early in the year - indicates that this upside will likely not be a one-off spike but could be meaningfully extended beyond July.  In addition to a major boost to output, this auto sector rebound appears to be having a substantial impact on employment, as jobless claims rose much less than expected for a second straight week, lowering the four-week average to a six-month low and leading us to boost our July payrolls forecast to -200,000 from -300,000.

On the week, small losses at the front end and a major rally at the long end left the curve at its flattest levels since the end of June, a huge reversal from near record-steep levels hit Monday.  The old 2-year yield rose 6bp to 1.08% and 3-year 2bp to 1.60%, while the old 5-year yield fell 4bp to 2.50%, old 7-year 11bp to 3.13%, 10-year 17bp to 3.50%, and 30-year 25bp to 4.31%.  TIPS were about on pace with nominals through Thursday but lagged Friday's strong rally to underperform a fair amount on the week even with commodity prices, after some major volatility, ultimately seeing decent gains on the week (oil was a laggard, but the August gasoline contract jumped to the highest level for the front month contract in a month-and-a-half) as the dollar index fell to its lowest level of the year.  5-year TIPS yield rose 3bp to 1.17%, 10-year fell 14bp to 1.67%, and 20-year fell 15bp to 2.20%.  Mortgages performed quite well on the week to send yields to near their lowest levels since the MBS market breakdown that started in late May, with current coupon yields falling from almost 4.6% to near 4.35%.  MBS yields have been pretty close to 4.5% recently, which kept average 30-year mortgage rates near 5.25% through July, but if the recent improvement can be sustained rates should move down closer to 5%.  Even with the strength in mortgages and continued improvement in interbank funding markets - 3-month LIBOR set another series of record lows to end the week a couple of basis points lower at 0.48%, the spot 3-month LIBOR/OIS spread also fell a couple of basis points to 28bp, another low since January 2008, and forward LIBOR/fed funds spreads saw somewhat larger improvement - swap spreads were somewhat mixed, as the swap rates curve didn't flatten nearly as much as the Treasury curve.

After a mild pause midweek, risk markets resumed moving to new highs for the year Thursday and Friday, though Friday's moves were mostly small with the exception of high yield.  The S&P 500 rose about 1% on the week to extend the year-to-date gain to 9%.  Financials put in a very strong performance after lagging badly during the prior week's market surge, with the BKX banks stock index up 8% on the week.  Credit extended its outperformance versus stocks seen so far this year, with the investment grade CDX index tightening another 7bp to 111bp.  Both high yield and leveraged loans performed well on the week, but there was a notable shift in recent relative Friday.  Through Thursday, the HY CDX index was 59bp tighter at 785bp and the LCDX index 32bp tighter at 708bp.  The LCDX index had previously been outperforming the HY CDX index by a decent amount in the recovery off the recent wides hit June 22, and our desk observed moving out the latter and into the former as a popular trade.  This appeared to swing in the other direction particularly Friday, however, as the HY CDX ripped more than point higher while the LCDX index was a little changed, partly reflecting unwinding of LCDX versus HY CDX trades but with an additional kick from a short squeeze in high yield.  It was also a very good week for the higher-rated parts of the commercial mortgage CMBX and subprime ABX markets.  The AAA CMBX index gained another point to 79.67, not far from the highs seen briefly in May when the Fed initially announced the expansion of TALF to include legacy CMBS, which was subsequently largely foiled by ratings downgrades.  On a relative basis, junior AAA (up 2.21 points to 43.06), AA (up 2.12 points to 26.08) and A (up 1.02 points to 21.17) saw much stronger performance again, suggesting that bad positioning was probably a major contributor to the upside (as also seemed to be the case partially with HY CDX Friday).  Fundamentals probably didn't have too much to do with a further 1.75 surge in the AAA ABX index to 31.18 either. 

Real GDP fell at a 1.0% annual rate in 2Q, an unprecedented fourth straight decline but a major moderation from the 6% annualized collapse over 4Q08 and 1Q.  Final domestic demand fell 1.5%, as consumption (-1.2%) resumed declining after a minor rebound in 1Q, business investment (-8.9%) was down significantly again after a record fall over the prior two quarters, and residential investment (-29.3%) plunged again, but government spending (+5.6%) rebounded after an unusual drop in 1Q.  Meanwhile, inventories were liquidated at a record pace, subtracting 0.8pp from growth in 2Q but potentially setting the stage for a substantial auto-driven reversal in 3Q, but net exports (+1.4pp) were again a big positive as imports remained in freefall.  This GDP release contained a benchmark revision (done every five years or so) and rebasing of the entire history of the data.  Conceptual changes were not material in this revision, but the recasting of the data based on more complete data showed just how severe this recession has been, marking it clearly as the deepest and longest downturn since the Great Depression.  GDP has now fallen for four straight quarters for the first time on record (quarterly figures begin in 1947).  The 3.9% decline real GDP in the year through 2Q09 was the worst contraction since the winding down of war production resulted in an 11% drop in 1946.  Since the recession began in late 2007 through 2Q09, annualized growth is now revealed to have been a horrendous -2.8%, much worse than the already miserable prior figure of -1.8%.  Business investment has fallen at a record pace, the downturn in residential investment remained near peak intensity in 2Q nearly four years into the worst housing collapse ever, consumption over the past year has declined at a rate only exceeded once (way back in 1951) in the post-war period, and inventories have been liquidated at an unprecedented pace.  Trade has been a major positive contributor to growth and provided some offset to this extreme weakness in private domestic activity, but only because imports have collapsed at an even faster pace than the worst downturn in exports in almost 60 years. 

As bad as this recession has been, however, there are increasing signs that it may already be over thanks mostly to a sharp rebound in auto production.  Auto assemblies had collapsed at such an extraordinary rate into the lows seen early in the year that even at the severely depressed sales pace seen through mid-year inventories were seeing very large monthly declines through June.  Indeed, while full details will not be released until the personal income report on Tuesday, we estimate that most of the record US$141 billion drop in real inventories was accounted for by autos, as production was drastically slashed to bring inventories rapidly down to normal levels as the industry was radically restructured in the spring and early summer.  This was achieved in June, and to merely stabilize the level of inventories at these more normal mid-year levels would have required a very large rise in output in July, which weekly industry reports indicate has fully unfolded as the normal substantial downtime the industry takes in the first part of July did not happen this year.  The direct impact of this ramp-up in auto output on industrial production and GDP is potentially very large (and almost incredible for an industry that has shrunk to less than 2% of the economy), and we appear to be seeing a substantial impact as well on employment.  Indeed, with initial unemployment claims rising far less than we expected in the second half of July when there had seemed to a major upward bias to the numbers from seasonal factors looking for lots of temporarily laid off auto workers returning to their jobs, it seems clear that the underlying labor market situation coming out of the recent auto-related volatility in the weekly figures was a lot less bad than we had thought.  As a result, we boosted our July non-farm payrolls forecast to -200,000 from -300,000.  After such apparently unseasonably strong output in July, there may have been some fears that auto assemblies would step back down through the rest of the quarter, but given how successful the cash for clunkers program has been - the initial US$1 billion that was expected to last until November ran out in a week, leading us to boost our forecast for July motor vehicle sales to 12.0 million annualized from 10.2 million, which would represent a nearly 25% surge from June - there is good reason to believe that the July spike in auto production can be significantly extended into the rest of 3Q.  If so, the upside potential to 3Q GDP growth compared to our last official estimate of +1% is potentially quite large. 

On top of the unfolding auto story, there were some other positive signs heading into 3Q in the past week's data.  The cash for clunkers success certainly suggests that consumption is off to a positive start overall in this quarter, even if at this point it appears to be highly concentrated in this one area.  We'll see in Thursday's chain store sales release whether there have been any signs of life in non-auto retailing.  Core capital goods orders showed a sizable rebound in May and June from the prior collapse, rising a cumulative 6% after a 26% plunge over the prior year, and core capital goods shipments also surprisingly posted a marginal gain in June, suggesting that investment may be stabilizing after the unprecedented contraction seen through mid-year.  New home sales showed a good increase in June, adding to other recent positive indications for the housing market, though the back-up in mortgage rates that began in late May probably has not fully been reflected in official housing market data yet, and a drop off in mortgage origination activity recently suggests it could be leading to renewed weakness.  Still, some upside in consumption, at least some likely moderation in the rate of decline of business and residential investment, and what could be a major auto-led boost from inventories appear to be coming together to drive some substantial upside in 3Q.  We still think that continued deleveraging, increased saving and credit restraint will lead this recovery to be unusually muted over the next year-and-a-half, but it could temporarily at least continue to feel like the V-shaped recovery (which risk markets seem to be latching onto much more enthusiastically than still comparatively cautious interest rate markets) is taking hold. 

There is a very busy calendar in the upcoming week, with the key early round of July data out - with the turnaround in the auto sector likely to be reflected in improvement in motor vehicle sales, ISM, and employment - and supply remaining in focus with the Treasury's quarterly refunding announcement Wednesday.  Like most analysts, we were surprised by the Treasury's decision to raise the 2-year, 5-year and 7-year sizes at the past week's auctions, which was combined with a slight trimming of bill sizes.  Based on this move, it appears that Treasury continues to be moving fairly aggressively to extend the average duration of the public debt back out after the prior spike in bill supply caused it to shorten dramatically when the deficit first starting blowing out.  So we expect that all of the issue sizes at the refunding will also be bumped up.  We look for a US$36 billion 3-year, US$23 billion 10-year and US$15 billion 30-year to be announced Wednesday for auction the week of August 10, all of which would be US$1 billion increases to another round of record highs.  Data focus in the coming week will of course be on Friday's employment report, but there are a lot of important reports throughout the week, including ISM, construction spending and motor vehicle sales Monday, personal income and spending Tuesday (which will be accompanied by the details of the 2Q GDP revision, which will allow us to start to firm up our upwardly revised 3Q GDP outlook), non-manufacturing ISM and factory orders Wednesday, and chain store sales Thursday:

* Based on the regional data, we expect to see signs of some further moderation in the pace of decline in manufacturing activity in the July ISM report, with about a one-point rise in the headline diffusion index to 45.5.  Based on past performance, we doubt that the very sharp jump in motor vehicle output that occurred in July will have a significant impact on the ISM.  The only experience we have with a sequential jump in seasonally adjusted vehicle output that is anywhere to close to what is expected in July occurred in the aftermath of a UAW strike during the summer of 1998.  In that instance, there was no noticeable impact on ISM when the plants reopened.

* We look for a 1.6% drop in June construction spending.  The recent rebound in housing starts points to an eventual bottoming in residential construction.  However, the number of homes under construction is still drifting lower, so we look for a further decline in the residential component of construction spending in June.  Moreover, we continue to look for a reversal of the bizarre rise in non-residential activity that has been evident in recent months.  And we continue to believe that it is a bit too early to see any noticeable upside from stimulus-related infrastructure spending in the public sector.

* We expect July motor vehicle sales to rise to a 12 million unit annual rate.  The cash for clunkers program appears to have triggered a spike in sales as the month came to a close.  Moreover, by all accounts, the overall level of activity at dealerships soared.  So this was not just a case of those who were inclined to buy anyway merely taking advantage of a government-sponsored discount.  Industry sources and some government officials indicate that the initial US$1 billion of funding cash for clunkers was exhausted during the first week of the program.  Since the average cost associated with each transaction is US$4,000, this implies that about 250,000 vehicles were sold under the program - or about 3 million units at an annual rate.  Moreover, there has been some industry chatter pointing to an uptick in fleet sales.  Taking all this into account, we view our estimate as fairly conservative.  Finally, note that revised seasonal adjustment factors for July had not yet been issued as of Friday afternoon, and this presents a small degree of uncertainty.

* We forecast a 1.3% decline in June personal income and a 0.2% rise in spending.  A special one-time government stimulus payment to Social Security beneficiaries accounted for almost all of the sharp 1.4% rise in personal income seen in May.  This effect should be entirely unwound in June, with a corresponding pullback in the personal savings rate.  Moreover, the employment report pointed to further weakness in underlying wage income.  So, we look for a flat outcome for personal income excluding the special factor.  On the spending side, another sharp jump in gasoline prices helped to boost June retail sales.  But the headline PCE price deflator should be up about 0.5%, so consumption appears to have posted an outright decline in real terms.  Meanwhile, the CPI data point to a 0.22% rise in the core PCE price index, with the year-on-year rate holding at +1.8%.

* We forecast a 1.0% decline in June factory orders.  A decline in bookings for aircraft helped to restrain the durables component.  Higher energy prices should give a lift to the non-durables category, but we still look for a decline in overall factory orders.  Shipments should be about unchanged, and we look for inventories to slip 0.6%, leading to some moderation in the still very elevated I/S ratio.

* We look for 200,00 decline in July non-farm payrolls, which would be the smallest drop since the economy fell off a cliff almost a year ago  The main driver of the relative improvement is an expected gain in auto industry jobs.  Indeed, we look for nearly a 100,000 rise in the motor vehicle component of manufacturing - versus an average monthly decline of 40,000 during 1H09.  About half of the anticipated rise in auto industry jobs reflects the recent reopening of plants that were shuttered earlier in the year. The other half reflects the likely impact of seasonal adjustment - the same factor which has helped to depress readings for initial and continuing jobless claims in recent weeks.  A portion of the anticipated advance in auto-related employment is expected to be offset by reduced summer hiring in sectors such as leisure and S&L government. But the recent jobless claims data are also consistent with the notion that the worst is behind us.  Sorting through the statistical noise in the initial claims figures, it appears that the underlying level of filings has dipped from 615,000 to 620,000 in June to about 560,000 at present.  More importantly, it appears that continuing claims have begun to move lower - even after accounting for benefit expirations.  Finally, the jobless rate is expected to edge up by another 0.2 percentage points in July to another post-1983 high of 9.7%.

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