South Africa
SARB Majority Rules; Consensus to the Back Burner
August 18, 2009

By Michael Kafe, CFA & Andrea Masia | Johannesburg

Summary

In a surprise move, the Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB) cut its policy interest rate by 50bp to 7% on August 13, despite explicitly acknowledging that the inflation profile remains sticky, and that there are significant upside risks to inflation from cost-push factors such as rising oil prices, downwardly rigid administered prices and high wage settlements - including a shocking 11.2%Y jump in productivity-adjusted unit labor costs over the 12 months to March 2009.  While the significantly overvalued currency and weak credit growth must have contributed to the unexpected outcome, we believe that two over-riding factors dominated the decision.

SARB Does About-Turn on Output Gap Impact... 

First, is the growth outlook: In its statement, the SARB reiterated its concern about the weak domestic growth dynamics, even though it was at pains to highlight that the worst may be over, and that the economic contraction in 2Q09 should be at a slower pace than the -6.4%Q that was posted in 1Q09. We believe that the true motivation here is the MPC's eventual admission that South Africa appears to have lagged the global recession - an implicit suggestion that it expects domestic growth to remain weak for longer than initially anticipated, effectively capping any initial demand-side inflation pressures as the rest of the world recovers. In some respects, this view is at odds with the MPC's penultimate statement's assertion that "While a widening output gap and weak domestic demand pose a downside risk to the inflation outlook, these risks are being increasingly offset by various cost-push and exogenous factors...as well as by deteriorating inflation expectations" - a key motivation for keeping rates on hold at the time.

What is particularly confusing here is the fact that the concluding paragraph of the August MPC statement propounds that "notwithstanding upside cost pressures, the adverse economic conditions appear to tilt the balance of risks to the inflation outlook towards the downside".  Yet the same statement makes it clear that "the CPI forecast of the South African Reserve Bank remained more or less unchanged compared with the previous forecast". Surely, if the SARB was convinced that inflation risks were tilted to the downside enough to warrant further monetary laxity, it would have reflected this in its own central forecast?

Also, while we agree with the SARB that South Africa was slow to respond to the global crisis, we do not share the view that it will necessarily be late in the recovery process. We believe it is important to identify the key sources of linkage with the global economy. As we have pointed out in previous research (see South Africa Chartbook: Global Downturn Aftershocks, February 18, 2009), contrary to its EMEA peers who have massive exposures to Europe and are hence a lot quicker to respond to European growth conditions, South Africa's fortuitous product and geographical diversification (including its disproportionately higher exposure to Asia) meant that it was only when Chinese and broader Asian demand conditions softened earlier this year that South Africa truly felt the heat. But things have changed: It appears that Asia - the last trading bloc to be impacted by the global credit crunch - will be the first to recover. Recent data from Europe also suggest that Europe may precede the US in the global recovery. With Asia and Europe together accounting for more than 60% of exports, we believe that prospects of an early recovery in South Africa cannot be ignored. For the record, we expect South Africa's GDP growth to turn positive by 4Q09.

...Expects PPI Deflation to Place a Lid on CPI

Second, is the historical pass-through from producer inflation to consumer prices: It is important to note that the SARB's core model relies very heavily on producer price inflation as a key input into its inflation forecast. To be clear, if one disregards the lagged dependent variable for a moment, the producer price index is actually the largest truly independent variable in its inflation equation. It is therefore not surprising that the MPC tends to have a relatively positive outlook on inflation whenever producer prices are decelerating/declining.

The August MPC statement was careful to point out that PPI has declined further from -3%Y in May to -4.1%Y in June, suggesting that this should eventually filter through to consumer inflation at some point. However, as we have highlighted previously, the historical relationship between PPI and CPI would have been muted by the fact that the new PPI index is no more than a de facto commodity price index that has limited relevance for consumer inflation.

Finally, the SARB appears to be placing a huge amount of faith in the observed downtrend in producer food prices, with the view that such positive developments would ultimately feed through to consumer food prices too: "After months of relative stickiness, food price inflation at the consumer price level appears to be responding to the favorable trends at the producer level". 

We are less optimistic that any decline in food prices is sustainable in the face of rising oil prices, given that diesel fuel is a significant input in the food production process - ranging from the transportation of seeds, through the running of seed drills and combined harvesters, to the transportation of final produce from farm gate to shop shelf. In fact, our analysis suggests that food inflation will fall to no less than 4%Y by the end of the year, and will average more than 3% in 2010.

Majority Rules, Consensus Walks

On the whole, while we welcome the marginal relief that this surprise 50bp rate cut provides for the ailing economy, we would caution that the SARB may need to adopt a more conservative stance going forward. Although inflation is expected to fall within target in 2Q10, it will likely remain uncomfortably close to the upper end of the target band throughout the remainder of that year, before falling to 5.5% in 2011. This is hardly a trajectory that allows for monetary policy comfort, in our opinion.

Thankfully, one MPC member pointed out in a televised interview that the decision to cut rates was agreed to by a majority of the members of the MPC, and was not unanimous (the SARB prides itself in the fact that its policy decisions are taken by consensus, rather than by majority votes). To the best of our knowledge, this is the first time that this has occurred, and suggests that not all members were convinced that cutting rates in the face of an uncomfortably sticky inflation trajectory was the right thing to do.

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Japan
Policy Uncertainty versus Improved Overseas Economy: Outlook Revision
August 18, 2009

By Takehiro Sato | Japan

Uncertainty Over Economic Policy, but Better Outlook for Overseas Economies Pushes Up Our 2010 Forecast

GDP growth in Apr-Jun was +3.7% annualized, undershooting our estimate (annualized +5.4% dating from June 11). The directional emphasis of economic policy could shift from corporate to the household sector depending on the result of the August 30 general election. However, the current focus of the DPJ's fiscal policy is more on reshaping the current revenue/expenditure structure, and thus some of the spending covered by the supplementary budget for F3/10 could only be reshuffled. We expect overall budget spending in F3/11 to drop heavily from the post-supplementary budget F3/10 level, whether or not political power changes hands.

For the overseas economic outlook, on the other hand, we have made upward revisions chiefly for the US and China from our previous forecast outlined in June. We do not see anything in Japan to significantly alter our cautious outlook domestically, but we have responded to the improving prospects overseas by raising our 2010 forecast marginally. Our 2009 growth outlook has not changed materially.

Recovery Pattern Resembles 1999

The recovery is looking like 1999. The catalysts then were (1) stabilization of the financial system via infusions of public capital, (2) massive fiscal stimulus, and (3) provision of an accommodative monetary environment via the zero interest rate policy (ZIRP) and extension of the credit guarantee system. This time, credit uncertainty has diminished considerably as a result of public capitalization of banks in the US, UK and elsewhere (point 1), and fiscal stimulus across the board, including in Japan (point 2), has helped to avert an economic meltdown. Technically we have not seen zero interest rates, but Japan and the US are close to ZIRP (point 3), and the outlook for the economy at home and abroad has picked up as risk premiums shrink.

The bubble in certain asset classes in Japan and overseas that followed policy stimulus in 1999 may suggest what lies ahead this time. The stock market has reacted positively to Apr-Jun corporate earnings which, despite poor sales, were better than expected due to cost cutting, and stocks have generally performed well even when losses were booked. This is at odds with the state of the real economy, where employment and income conditions are getting worse, and it looks frothy, but means we now need to consider the potential for the upside scenario: a recovery in risk tolerance in the major economies under accommodative monetary conditions could generate a positive feedback loop from asset markets into the real economy, resulting in real economic improvement.

Course of Economic Recovery

Japan and non-Japan Asia (NJA) have seen their economies hit bottom in Jan-Mar, earlier than in the US and Europe, and embark on recovery in Apr-Jun. We also look for a comparatively steep recovery trajectory in Japan's manufacturing industry in the current Jul-Sep quarter too, powered by inventory restocking (estimating that industrial production will follow 8.3%Q growth in Apr-Jun with roughly 7%Q growth in Jul-Sep). The US economy is tracking one quarter behind Japan and NJA, but also appears to have bottomed in Apr-Jun and to be poised after all for a V-shaped rebound in Jul-Sep thanks to restocking pressure (see US Economic and Interest Rate Forecast: It's Bumpy and Slow...but it Will Be a Sustainable Recovery, Richard Berner and David Greenlaw, August 10, 2009). US industrial production for July has already shown the first increase in nine months, boosted by the extension of car-purchasing incentives (our US Economics team's US GDP estimate is +3.5% SAAR in Jul-Sep).

The differences in timing of the bottom for Japan and overseas economies will be more important than generally recognized in tracing the path of Japan's economy over the next 6-12 months. Judging from past recovery patterns, strong performance resulting from inventory restocking in domestic manufacturing would last about two quarters at most, and so we could expect economic recovery momentum to fade in Oct-Dec, two quarters after the onset of recovery in Apr-Jun. But with the inventory replenishment in the US kicking in one quarter later than Japan in Jul-Sep, we think we can actually look for a relatively sharp recovery throughout the rest of the year. What's more, the impact of fiscal stimulus from tax breaks and public investment should start to emerge in earnest from Oct-Dec. China's economy too also responding well to policy-induced demand, and our economist Qing Wang has in one swoop lifted his forecasts for China's growth by two percentage points to 9% in 2009 and 10% in 2010 (see China Economics: Policy-driven Decoupling: Upgrade 2009-10 Outlook, Qing Wang, July 16, 2009). This creates the possibility that economic strength overseas could allow Japan to avoid a sharp retreat in Oct-Dec and Jan-Mar 2010, the period when a normal recovery pattern shows the economy marking time after the effect of inventory restocking has played out. 

That said, there are still a myriad of domestic considerations that could erode recovery momentum. On the fiscal front, we expect the initial budget for F3/11 to be more than ¥10 trillion smaller than the enlarged F3/10 budget regardless of whether there is a change in government. In consequence, we think that a modest second dip in the economy will be inevitable in the first half of F3/11 as the growth rate reacts to the drop in public investment.

Employment and income conditions will also remain adverse, in our view. Cutting the excess capacity created by the downward shift in the global economic outlook that followed the Lehman shock and restructuring Japan's manufacturing industry will be key themes. With capacity utilization stuck at historically low levels, there is little chance that capex will pick up swiftly, and instead a further wave of regular employment cuts is possible as the capacity glut is reduced. In the household sector, income transfers via stimulus programs (including cash handouts, tax cuts/subsidies for the purchase of greener vehicles, and the eco-point award system) will not eliminate the negative impact on consumption of wage constraints. Total cash earnings in July showed the largest decline on record, due to shrinking summer bonuses.

A number of economic indicators are already pointing to deceleration. For example, the Economy Watchers Survey for July showed a notable slowing in current conditions DI improvement. This DI gives a read on grass-roots corporate sentiment and typically leads the direction of the economy by three months, pointing clearly to slowing recovery momentum from Oct-Dec. The Reuters Tankan for August also indicated that improvement in the mindset of large manufacturers has almost dried up, and levels for large non-manufacturers that have continued to drag along a bottom since the start of the year. Overall sentiment among large enterprises and not just SMEs suggests a slowdown in the recovery momentum once restocking, which has now lasted close to half a year, fades.

However, the simultaneous improvement for overseas economies discussed earlier means that we expect the second dip in the first half of F3/11 to be much shallower than the one in Jan-Mar this year.

Risks Lie to the Upside Near Term, Downside Further Out

The risks to the outlook above come in both directions. In the near term, though, we think that the balance of risk is to the upside, given the benefits of domestic and overseas stimulus and a positive feedback loop from buoyant asset markets. Note that we continue to stress the downside risk for 2010, however.

The upside risk is that overseas economies perform well as a result of fiscal stimulus in the US, etc, allowing Japan to avoid an economic lull, and meaning that any dip in F3/11 is scarcely noticeable. The economic impact of the US fiscal stimulus is in fact weighted overwhelmingly towards 2010 rather than 2009, with an eye on the mid-term elections next year. China's economy is also expected to come close to overheating as a result of the stimulus measures. Feedback from the accommodative monetary conditions in Japan and overseas and more buoyant financial markets could give further support in this direction. On the monetary policy front, we do not expect the leading central banks, least of all Japan's, to be looking for an exit strategy at least during 2009.

The downside risk, meanwhile, is that the government changes in Japan and some of the supplementary budget spending for F3/10 gets frozen, as the DPJ has been advocating.

The original F3/10 budget included ¥7.0 trillion for public works, and the government has been front-loading this spending targeting contract signing for some 80% of this total by the end of August. An additional portion (¥1.7 trillion) from the supplementary budget along with the remaining 20% (¥1.4 trillion) from the initial budget is to be disbursed from September, but it is possible that some of this roughly ¥3 trillion would be blocked. The DPJ also says there is a lot of wasteful spending in the public funds established in the supplementary budget (45 funds, total of ¥4.5 trillion allocated), and that it will review spending here, which could lead to some money being withheld.

However, any frozen budget allocations would need to be diverted to other areas to achieve the policy objectives of the DPJ. As such, the important point is that total expenditures would presumably not change much. Any portion withheld (about ¥3-4 trillion) could be used to boost household sector incomes by front-loading child allowances or other programs. In that event the economic stimulus impact might be diluted if households saved some of this diverted income, but suspending the supplementary budget should not lead directly to a slump in the economy.

Outlook for Monetary Policy and Long-Term Interest Rates

We still expect interest rate policy to be eased slightly in Oct-Dec 2009 as the policy rate level is revised to a band of 0-0.10% (0.05% midpoint). At such time, we expect the system of paying interest on reserves deposits to be maintained, with the rate set at 0.05% after the transition to a policy rate band. We acknowledge, however, that the recent stock market rally and stabilization of forex markets has made this less likely right now. If there are catalysts for further monetary easing, look for them at any rate in stock price and exchange rate trends. Note that our currency strategy team is forecasting an end-2009 rate of ¥85/US$.

We are pushing back our forecast for the timing of the policy exit by one quarter to Jan-Mar 2011. This is still earlier than the consensus (F3/12 or beyond), but once the function of financial markets is heading back to normal, we believe that the instincts of the central bank will be to normalize the policy rate earlier than the market is anticipating. The timing of the policy exit by overseas central banks will be an important factor too. Our US Economics team is looking for this in Jul-Sep 2010. Once overseas central banks have moved to raise rates, we cannot imagine the BoJ sticking to its course alone for very long.

However, the BoJ's price outlook (F3/11: -1.0%) is still more cautious than ours (F3/11: -0.4%). There is also the possibility that in the next Outlook Report at the end of October the BoJ will issue a forecast for the economy and prices in F3/12 that calls for deflation even in F3/12, anticipating price feedback from deterioration in the output gap. If such a forecast was taken at face value, normalization of the policy rate within F3/11 would be difficult.

Yet if the BoJ were to revise up such a cautious price outlook, this might simply be a way of sending a certain message to the financial markets. If the BoJ's outlook were still to call for deflation but with prices dropping at a narrower rate, the financial markets would probably price in the possibility of an earlier exit timing.

The possibility remains that the scope of JGB purchasing could be extended as part of non-traditional policy measures. The ‘banknote rule' which sets an upper limit on the BoJ's long-term JGB holdings would be revised at the same time. In practical terms, it would be effective to revise the definition of medium/long-term JGB holdings and deduct those with less than one year left to maturity from the balance held by the BoJ. If that course was taken, the scope for purchasing medium/long-term JGBs would increase by nearly ¥12 trillion from about ¥29 trillion at the end of July.

Long-term yields, however, have been stable at around 1.4% even after the huge bond issuance for the F3/10 supplementary budget; and with the momentum of economic recovery set to slow and supply/demand remaining favorable due to a contractionary F3/11 budget, we expect the 10-year yield to fall to 1.15% at the end of F3/10. In looking for another spike above 1.4% in Apr-Jun 2010, we are factoring for seasonal anomalies, rather than anything of deep significance. Even after the market has discounted for a recovery from the second half of F3/11, we expect the 10-year yield to be stable around the mid-1% level.

Robust Macro Balance Is a Strength of Japan

When it becomes tough to fund government debt internally, long-term interest rates tend to include a fiscal premium because overseas investors demand a risk premium. In Japan's case, however, there is still a buffer of more than ¥200 trillion when comparing net government debt with the private sector investment/savings gap (stock basis). Government debt can thus be entirely funded domestically.

In response to the ballooning fiscal deficit, the government has postponed its target for equilibrium in the primary balance in 2011 by up to ten years. Depending on nominal growth rates and government funding costs, the government debt ratio may continue to rise during this period. However, thanks to the buffer above, the increase in government debt can basically be financed domestically via changes in the asset structure of the public and private sectors. This robust macro balance means that we do not need to worry about a surge of government debt due to soaring long-term interest rates (a debt spiral). Maintaining an accommodative monetary environment should be supportive for the economy and asset markets in general (see Japan Economics: Concerns about Japan's Country Risk Are Overdone, Takehiro Sato, Takeshi Yamaguchi, March 23, 2009).

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Mexico
Fuelling Inflation
August 18, 2009

By Luis Arcentales & Daniel Volberg | New York

When Mexico's central bank meets on Friday, August 21, no Mexico watcher should be surprised to see interest rates staying unchanged at 4.50%.  After all, Banxico announced first in its July 17 policy statement and again, on July 29, in its 2Q inflation report that it was "taking a pause in the current monetary easing cycle" following 375bp of cumulative rate cuts since mid-January.  With surveys suggesting that the central bank will remain firmly on hold through year-end and with only modest tightening expected next year, it seems that there is limited room for surprises on the monetary policy front.  Indeed, expectations for growth in 2009 (-6.93%) are well within Banxico's guidance of -6.5-7.5%; meanwhile, the peso has strengthened modestly of late and inflation expectations for the rest of the year are running near the upper end of the central bank's inflation forecast path.  

But could Mexico's challenging fiscal outlook derail the otherwise benign inflation story?  The authorities have warned recently of a fiscal shortfall to the tune of M$300 billion for 2010, which would have to be filled by a combination of expenditure cuts, a widening of the public sector deficit and/or by boosting revenues.  Even as the noise about a possible tax reform - likely to be submitted to congress with the 2010 budget proposal in early September - is growing louder, we cannot rule out a failure in congress of these changes aimed at increasing non-oil revenues and thus avoiding a more meaningful medium-term deterioration in the fiscal accounts (see "Mexico: The Fiscal Straightjacket", EM Economist, July 17, 2009).  Under such circumstances, one option in the hands of the fiscal authorities is to hike fuel prices at an accelerated pace, as was the case during 2008 when fuel subsidies skyrocketed (see "Mexico: Heavily Subsidized", EM Economist, June 13, 2008).  And though large fuel price adjustments could be politically difficult and economically undesirable, they would not require congressional approval. 

Fiscal Crunch  

The one-two punch of a severe recession and lower oil receipts has dealt a major blow to Mexico's fiscal accounts this year.  The economic slump has taken its toll on non-oil revenues, with VAT and income tax collection down 20.0% and 10.4% in real terms in 1H09.  Meanwhile, despite the timely hedging strategy, disappointing oil output has once again morphed into a major headache for the authorities: in August Pemex cut its 2009 crude production target to 2.65 mbpd, a shortfall of 100,000 barrels relative to the 2009 budget estimate.  Combined with the foregone revenues derived from price relief on selected fuels, the Ministry of Finance estimates a shortfall of a significant M$421 billion (the total estimated shortfall is M$480 billion, but there is an automatic adjustment of M$59 billion caused mainly by a 20% drop in co-participated transfers to the states), on top of the approved deficit of M$228 billion - or a combined 5.5% of GDP.  To plug the gap, the authorities have put in place a forceful strategy whose major initiatives include a cut in expenditure (M$85 billion), the use of the stabilization funds (M$92 billion), a transfer from Banxico related to the sharp depreciation of the peso last year (M$95 billion) and the use of proceeds from the oil hedge (M$100 billion). 

Looking ahead to 2010, despite expected improvement on the economic growth front, the fiscal situation may remain quite challenging, with an officially estimated shortfall of M$300 billion.  The authorities project that, assuming capital expenditures for Pemex at a nominal level in pesos similar to 2009, the overall deficit could widen to as much as 4.2% of GDP.  But rather than using the finance ministry's figures, we have done our own modeling, assuming our base case for real GDP growth (2.4%), inflation (3.5% on average) and the exchange rate (13.6 on average), in addition to WTI at US$60 per barrel, in line with the finance ministry's guidance that the 2010 budget draft is likely to incorporate an assumption for the Mexican oil basket of US$53 per barrel.  And our result does not provide much room for comfort: though somewhat more manageable than the government's estimate, we find that the public sector would still face a shortfall to the tune of M$220 billion, or over 1.7% of GDP, excluding Pemex's capital expenditures. (For the expenditure side of the projection, our model assumes real growth of 4% - reflecting inertial outlays like pensions and some social benefits - relative to the original 2009 budget.  According to changes to the Fiscal Responsibility Law in 2007, the public sector has to run a balanced budget excluding Pemex's capital expenditures.)

Fuelling Inflation?

The projected revenue shortfall in 2010 represents a major challenge to the fiscal authorities and a potential risk to the inflation outlook, in our view.  In order to fill the 1.7% of GDP gap (ex-Pemex) - or 2.4% of GDP as the authorities suggested - there are an array of options that include a combination of finding alternative sources of revenue - which a tax reform would in principle achieve - expenditure cuts and/or relying on additional borrowing. 

The first line of defense, of course, are the three main stabilization funds, which stood at M$174 billion or 1.5% of GDP as of June and of which the authorities have indicated that they expect to use around 60% this year alone.  Thus, we think that the balance left for 2010 should be sufficient to make up for near 0.6% of GDP. 

Additionally, the authorities could turn to measures that are not completely discretionary.  The government could resort to a widening of the deficit by 0.5% of GDP, which, under fiscal rules currently in place, could be permitted under "exceptional" circumstances.  While this step requires congressional approval, we suspect that it may not be difficult to obtain, despite the changed political reality in aftermath of last month's mid-term election.  A further step may be for the authorities to propose and for congress to implement a tax reform that raises non-oil tax revenue; however, this may prove more challenging since the main proposals appear to center on higher taxes on consumption, as well as steps towards liberalizing fuel quotes, which may translate into higher prices.  In the past, tax hikes on these items have proved to be politically difficult.

One alternative - which does not require congressional approval - is to hike fuel prices, thus boosting revenues in order to fill the remaining gap of 0.7% of GDP.  Such a move would be the opposite of the 2009 experience when, as part of actions to stimulate the economy, the administration chose to freeze gasoline quotes, cut by 75% the pace of monthly diesel adjustments and reduce some electricity tariffs (at an estimated cost of M$116 billion).  And recently the authorities have openly pointed out how the current energy pricing structure tends to disproportionately benefit the wealthiest 20% of Mexicans.  While such rhetoric may suggest that changes to the controlled pricing structure may be part of the upcoming reform proposal, it could also signal that the authorities would be willing to hike fuel quotes if necessary. 

However, relying on raising fuel prices to cover next year's fiscal shortfall may have meaningful inflationary implications.  Using WTI of $60 per barrel as a base, we find that to cover the revenue shortfall, prices of gasoline and diesel would have to soar next year by an average 15% from 2009 levels.  This translates into price hikes of just over 2% for every 0.1% of additional revenue. Given that fuel accounts for 3.7% of the consumer price basket (regular gasoline 3.2%, premium 0.5%), the direct impact alone may approach 0.6pp.  Relative to current consensus expectations, this would lift inflation to near 4.5% by end-2010, significantly above the central bank's upper tolerance band of 4%.  And this exercise, of course, ignores the broader impact of higher fuel prices on inflation - after all, fuel is an important input into production and transportation of the vast majority of items in the CPI basket.

Fuel price hikes are not the only ace up the government's sleeve.  To be fair, the authorities could also rely on more expenditure cuts and non-recurring revenues.  For example, even in the midst of the deepest economic slump in recent history, Mexico's authorities signaled their commitment to fiscal responsibility by cutting expenditures in May and July for a total of M$85 billion, of which M$19 came from the public investment purse (see "Mexico: Against the (Fiscal) Wall", EM Economist, July 24, 2009).  And there are potential sources of non-recurrent revenues, such as auctioning optic fiber capacity from the CFE.  However, even in our more constructive 2010 scenario (relative to the finance ministry projections), fuel price hikes cannot be ruled out.

While the inflationary consequences of a fiscal shortfall may pose a risk to our expectation of Banxico keeping policy rates on hold in the months ahead, the risk, paradoxically, diminishes with higher oil prices. We welcome the prudent oil projection that the finance ministry is likely to incorporate in the 2010 budget draft - near US$53 per barrel for the Mexican basket, well below recent average prices of around US$65 - but it is worth highlighting that, if sustained, current oil prices could prevent a more painful fiscal adjustment and reduce the potential need for fuel price hikes.  Indeed, based on current future prices, the fiscal shortfall may narrow significantly by nearly M$100 billion to just M$120 billion.  In turn, this could easily be covered by the stabilization funds and raising additional debt financing to the tune of 0.5% of GDP. 

Bottom Line  

Mexico, still reeling from what should be an inflation-crunching recession, may not see much inflation relief. The looming fiscal deterioration and a difficult political environment that may prevent significant tax reform raise the risk that the government's hand may be forced into hiking fuel prices, thus fueling inflation.  This is a risk, not a base case - there are many moving parts. For one, while we have signaled before that the medium-term fiscal outlook in Mexico may prove challenging irrespective of oil prices, the outlook for 2010 is much more price sensitive (see Mexico: The Fiscal Straightjacket).  However, none of this implies that there is not an immediate need for a reform that addresses the challenging medium-term fiscal outlook.  Absent tax reform, we have found that a major spending adjustment would be required to avoid meaningful medium-term fiscal deterioration.  The time to act is now.

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United States
Review and Preview
August 18, 2009

By Ted Wieseman | New York

Treasuries surged over the past week, reversing the major sell-off of the prior week and extending a very volatile recent trend, as thin summer trading conditions and yields at levels near maximum mortgage convexity have resulted in exaggerated price action.  There wasn't any obvious catalyst for the latest week's surge, but then there wasn't really a strong basis for the prior week's collapse or the enormous curve flattening seen two weeks back.  Economic data were on balance positive, if probably less uniformly so than the recent trend.  Still, we boosted our 3Q GDP forecast slightly to +3.7% from +3.5%, as a better trajectory for net exports and inventories more than offset a lower growth path for consumption after a weaker-than-expected outcome for ex auto retail sales.  More notable, however, was confirmation in the industrial production report of the extraordinarily strong ongoing rebound in auto assemblies that began in a big way in July and is likely to be extended in the coming months as the major automakers ramp up production schedules.  July assemblies were already 200% annualized above 2Q, in line with our forecast that almost all the expected 3.7% gain in 3Q growth will be accounted by this now fairly small industry.  Aside from the data, a pullback in risk markets provided some support.  Equity and credit market losses were nothing too major, but they did end a four-week run of gains to a series of new highs for the year.  The refunding auctions were mostly well received, with only the 10-year auction going poorly and probably only because it took place just ahead of the FOMC announcement.  There was only momentary disappointment with the Fed's decision not to boost Treasury buying but merely to stretch out the remaining US$47 billion in purchases of the US$300 billion announced in March through October from the initially planned end of September completion target.  And the FOMC's, as expected, confirmation that rates would remain near zero for the foreseeable future made investors suddenly notice that the amount of rate hiking that had been priced into futures didn't make any sense, a shift that made the short end appear cheap at mid-week yields. 

For the week, benchmark Treasury yields fell 21-33bp.  This followed a 19-36bp sell-off the prior week and a 35bp flattening in 2s-30s the week before that on big long-end gains and significant short-end losses.  The 5-year led the latest week's surge as mortgages and swaps rebounded strongly from a poor showing during the prior week's sell-off.  The 2-year yield fell 25bp to 1.06%, old 3-year 29bp to 1.56%, 5-year 33bp to 2.50%, 7-year 32bp to 3.16%, old 10-year 29bp to 3.56% and old 30-year 21bp to 4.39%.  There was apparently some money being parked in cash as the stock rally stalled, as the 4-week bill suddenly caught a bid after being stable for a while, with its yield down 6bp to 0.09%, a low since late June.  After the big outperformance the prior week, relative performance by TIPS was terrible, particularly at the shorter end.  The slightly softer-than-expected CPI outcome and a pullback in commodity prices Friday (when September oil fell US$3 a barrel to US$67.51 after having been about unchanged on the week through Thursday) added significantly to the poor showing, but TIPS lagged all week.  The 5-year TIPS yield rose 2bp to 1.33%, 10-year fell 1bp to 1.83% and 20-year fell 9bp to 2.23%.  This left the benchmark 10-year inflation breakeven down 28bp to a one-month low of 1.72%, more than reversing a 19bp rise in the prior week.  Retail gasoline prices have been moving higher in August, and recent moves in futures prices don't point to an imminent reversal, but trading in August CPI suggests that investors may have an exaggerated idea of how large the impact of cash-for-clunkers will be.  It clearly had no impact on the July CPI, with new vehicle prices surging 0.5%, and while we expect that it will have a meaningful impact in August, the effect is unlikely to be large enough to overcome the upside in energy prices and result in the decline in August CPI that derivatives markets have been pricing in. 

Mortgages were able to slightly outpace the big Treasury rally, with yields falling from almost 4.8%, a high since mid-June, back down to near 4.5%.  Mortgage yields have been pretty well anchored around 4.5% since late June, which has kept 30-year mortgage rates near 5.25% since the start of July.  Mortgage spreads appear rich to Treasuries, and while the Fed's plan to continue heavy MBS buying through year-end should keep spreads tight, we believe that it will be hard for mortgages to richen further versus Treasuries.  So the level of Treasury yields will likely continue to be the main determinant of mortgage rates as Fed buying of Treasuries is wound down.  The rebound in mortgages was accompanied by a reversal of a big widening in swap spreads.  The benchmark 10-year spread narrowed 10bp to 22bp after having widened 8bp the prior week, while the benchmark 5-year spread fell 8bp to 38bp after having widened 10bp the prior week from a six-year (and near-record) low reached at the end of July.  MBS volatility has been the primary reason for the swings in spreads recently, but underneath these gyrations, further improvement in interbank funding conditions continues to support narrow spreads.  3-month Libor again hit a record low every day in the latest week, reaching 0.43% Friday, a 3bp decline for the week.  This resulted in a 2bp drop in the spot 3-month Libor/OIS spread to 25bp.  This is the tightest the Libor/fed funds spread has been since the financial turmoil began two years ago, and while it's still somewhat above the 10bp norm seen in the bubble period, it seems unlikely that in the post-crisis world that the spread can move much lower than where it is now.  This was reflected in forward Libor/OIS spreads, which saw larger improvement in the latest week as Fed rate-hiking expectations were scaled way back but continued to price the current Libor/fed funds spread as the cycle low.  A move up to around 35bp is priced in for 2010.  Regarding Fed rate-hiking expectations, the January 2011 fed funds futures contract rallied 40bp and is now pricing an end of 2010 funds target of 1.75% instead of 2% or 2.25%.  The timing of the first hike was also pushed out to March or April from January.  This still seems early to us, but it's a lot more reasonable than the pre-FOMC pricing.  It almost seems, though, as if that earlier pricing made its way into the market in sympathy with a general back-up in rates without much thought being given to what it was actually implying, since we haven't talked to anyone who actually thought rate hikes were likely so soon.

Losses in stocks and investment grade credit were relatively minor in the past week, though the downside did bring an end to a major run-up to new highs for the year seen over the prior month, which provide some support to the oddly strong week for interest rate markets.  On the week, the S&P 500 dipped 0.6%, and the investment grade CDX index widened 12bp to 117bp as of late afternoon trading Friday.  Downside in other markets was more pronounced.  The high yield CDX index was 66bp wider at 803bp at Thursday's close, and the index was down another point late Friday, while the leveraged loan LCDX index was 93bp wider at 704bp midday Friday.  The commercial mortgage CMBX market was crushed, more than reversing a huge rally the prior week.  Still, this only left this increasingly volatile market at its lows since late July and way up since the end of 2Q.  The AAA CMBX index fell 5 points to 78.38, junior AAA 8 points to 41.00 and AA 6 points to 23.80.  There was probably some overexcitement about the impact of TALF and the PPIP in the surge to new highs the prior week, with the latest week's reversal more reflective of still ugly fundamentals in commercial real estate.  And although home sales and construction may be bottoming out, foreclosures continue to ramp up to new highs, putting pressure on the subprime ABX market, with the AAA index down 2.6 points to a one-month low of 26.75 after what's now been a 14% pullback from the high hit August 3. 

On balance, economic data released over the past week remained positive and continued to support expectations for a solid rebound in 3Q growth, but interest rate markets appeared to be cheered by a somewhat more mixed tone to the latest batch of numbers than the broader upside seen in recent prior weeks.  We raised our 3Q GDP forecast to +3.7% from +3.5%, as the wholesale inventories report pointed to a larger drag in 2Q from inventory accumulation, and we now expect 2Q GDP to be revised down to -1.5% from -1.7%, with offsetting upside in 3Q, and a smaller-than-expected increase in the trade deficit provided a better starting point for 3Q net exports, but a surprising drop in ex auto retail sales pointed to a smaller rise in 3Q consumption. 

Retail sales fell 0.1% in July, as auto dealers' receipts (+2.4%) were reported to have risen far less than indicated by the surge in unit sales and ex auto sales declined by a surprisingly large 0.6%.  Some of the weakness in ex auto results reflected an anticipated price-related drop at gas stations (-2.1%), but sales ex autos and gas were also soft at -0.4%, with a number of discretionary categories weaker than we expected based on the chain store results, and the heavily weighted grocery store category was also unusually soft.  The consumption figures use unit sales results instead of the retail sales survey to estimate auto sales, and it is likely that these will result in a much bigger gain in motor vehicle sales in July.  With the downside in ex auto sales, however, we reduced our forecast for 3Q consumption to +2.6% from +3.3%.  A continued improvement in trade, however, should offset this, and in a notable shift from the prior year the trade upside in the current quarter is based on a gain in exports rather than a further collapse in imports.  The trade deficit widened only slightly to US$27.0 billion in June from the ten-year low of US$26.0 billion in May, with both exports (+2.0%) and imports (+2.3%) posting big gains, though mostly entirely because of higher prices.  Still, with real goods exports up 0.6% and imports 0.1%, the inflation-adjusted merchandise trade deficit in June narrowed slightly to US$35.9 billion from US$36.3 billion.  We had been assuming about a US$1 billion widening, and this better starting point (the June real trade gap was US$1.5 billion narrower than the 2Q average) points to stronger net exports in 3Q.  We now see net exports adding 0.2pp to 3Q GDP growth instead of subtracting 0.3pp, offsetting the smaller expected gain in consumption in our GDP forecast. 

Beyond these fairly minor adjustments to incoming monthly figures directly bearing on GDP growth, the key theme in 3Q is the huge ongoing recovery in auto production after an enormous collapse through 1H09 to lows since the early days of the industry had left the level of assemblies far below even the still badly depressed level of sales, rapidly shrinking inventories to more normal levels by the end of June and then unusually low levels at the end of July as sales moved much higher on the cash-for-clunkers incentives.  The magnitude of the upturn was made clear in the July industrial production report, and major automakers have begun to announce substantial further increases in assembly schedules through the rest of the year that should keep the manufacturing upturn going.  Industrial production rose 0.5% in July, the first increase outside of strike and hurricane-related volatility since 2007.  The key manufacturing gauge surged 1.0%, but a 2.4% drop in utility output caused by the unusually cool weather in July was a temporary partial offset.  Upside in manufacturing was concentrated in a 20% surge in motor vehicles and parts output.  Motor vehicle assemblies surged 43% to 5.87 million annualized from a near-record low 4.11 million in June.  A much smaller initial gain in parts production slowed the rise in the broader auto sector, but there should be a catch-up in coming months.  Assemblies are already running 200% annualized above 2Q and are likely to continue rising in coming months, supporting expectations for an extremely large boost to 3Q GDP growth from this shrunken sector.  Motor vehicle output has fallen to less than 2% of the overall economy, but 2% of the economy growing 200% is still worth a four-percentage-point boost to GDP growth. 

After a busy couple weeks, the economic calendar is fairly quiet in the upcoming week.  Data focus will largely be on early indications for the key initial round of August data.  The Empire State manufacturing survey on Monday and Philly Fed on Thursday will help set early expectations for the August ISM, while initial jobless claims on Thursday will cover the survey period for the August employment report.  The sharp rise in the composite ISM index in July and move well into positive territory for the key orders and production gauges suggested that the ISM could move above the 50-breakeven level this month, while even after a somewhat mixed report in the latest week, the recent trend in claims has pointed to further moderation in job losses.  Other data releases due out include PPI and housing starts Tuesday, leading indicators Thursday and existing home sales Friday:

* We look for a 1.0% decline in overall producer price index in July and 0.1% rise in the core.  A sharp pullback in quotes for wholesale gasoline should lead to an outright decline in the headline PPI this month.  Meanwhile, the bizarre elevation in motor vehicle prices seen in the June report appears unlikely to continue.  We're assuming little change in car and truck prices this month.

* We forecast a rise in housing starts to a 600,000 unit annual rate in July.  Home sales and starts finally appear to have bottomed, and the excess inventory is gradually being absorbed.  However, the adjustment process will take some time to play out.  So, we look for only a modest pick-up in homebuilding activity over the near term.  Our July estimate implies about a 3% sequential uptick, with much of the gain concentrated in the volatile multi-family category.

* Based on the components available at this point, the index of leading economic indicators is likely to rise 0.7%, a fourth straight sizeable gain, with significant positive contributions from the yield curve, jobless claims, the manufacturing workweek and supplier deliveries.  Partial negative offsets should come from consumer confidence and the money supply.

* We look for an increase in July existing home sales to 5.00 million units annualized.  The recent improvement in the pending home sales index points to a strengthening recovery in resales.  Our July forecast implies a 2.2% sequential monthly gain.

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