The Democratic Party of Japan (DPJ) victory was largely as expected, taking 308 seats in the 480-seat Diet. However, the DPJ does not have two-thirds majority (320), and thus will need coalition partners in order to ensure smooth passage of laws through the still-divided Upper House. DPJ must pass legislation there quickly, in order to have a track record ready by the July 2010 Upper House election - its first chance to gain majorities in both houses. Indeed, the bargaining power of the small coalition members in the Upper House was enhanced by the election outcome, even though one of those parties, the People's New Party, lost four of its seven seats in the Lower House.
There are two coalition choices for the DPJ: a) continued coalition with the PNP, the Japan New Party, and the Socialists (it needs all), or b) switch to a coalition with the Komeito. In a late-night press conference, Mr. Hatoyama was distinctly non-committal when asked about potential coalition partners. This answer implied that the DPJ may be open to either choice. That said, reports indicate that the DPJ will try the PNP/Socialist/JNP combination first. The final choice will be made by the senior governing board of the party, and thus will be heavily influenced by former DPJ president Ozawa.
DPJ Economics
The direction of DPJ economic policy will remain unclear for several weeks at least, until political factors settle. The DPJ will have to choose coalition partners, appoint personnel, determine policies, and then propose and pass legislation. Investors are likely to remain skeptical even after announcements are made, in view of the history of budget legislation here. The skepticism may remain until legislation is passed and implemented.
The DPJ economic philosophy remains unclear. For example, at the post-election late-night press conference, Mr. Hatoyama said that not all market outcomes are bad and that deregulation should be pursued in some areas but pared in others (e.g., taxis). He gave no clear guidelines for how such decisions would be determined. (The DPJ manifesto does not mention the word ‘deregulation', and the DPJ Policy Index does so only in a negative connotation.) On growth strategy, he pointedly prioritized getting money into household pockets first, and then pointed to science and technology areas (IT, bio, etc.) as sources of growth.
The selection of the Cabinet will be important, and Mr. Hatoyama said that it had to be done quickly. However, there is no reliable information on who will get which posts. Investors should watch for the balance between pro- and anti-market-oriented ministers, along with the interest groups that support the ministers most strongly. In addition, the DPJ's ambitious policy of sending many Diet members into the bureaucracy will likely lead to delays in establishing policy direction. The personnel decisions will likely seek balance within the DPJ and coalition partners. Cabinet posts for coalition partners will be particularly important signals of direction.
In addition, Mr. Hatoyama's press conference emphasized the creation of the new National Strategy Council, which would have much broader powers than the Council on Economic and Fiscal Policy, and would be able to enforce decisions on reluctant ministries. The personnel decisions for this new council could be among the most important of the new administration.
The first major economic test for the DPJ will be formation of the F2010 budget, which is already behind schedule due to election timing. The decisions made during the budget formation will give investors the first concrete idea of where the trade-offs lie in DPJ policies (e.g., CO2 reduction versus lowering highway tolls). Moreover, it is important to remember that initial budget numbers are seldom final. The disparate and competing interest groups inside the DPJ will need to make many compromises in order to fulfill Mr. Hatoyama's pledge not to increase deficit bond issuance.
Political Dynamics Will Impact the Economic Debate
Because of the uncertainty surrounding the new government, political dynamics between other the DPJ and other parties - and within other parties - will likely impact the economic debate.
Within the LDP, the disagreements between pro-reformers and anti-reformers remain unresolved, and there is no clear pattern - either pro- or anti-reform - to the LDP members of the new Diet. Hence, the redefinition of the philosophy of the party will take time, and will reduce the ability of the party to play an active role in the policy debate. The first tests will come soon: because PM Aso has resigned as party chairman, the LDP will have to choose a new leader, probably at the end of September. This leadership battle, however, may only start the process of redefining the party. The longer the process of identity redefinition for the LDP takes, the longer the new DPJ government will have to pursue its policies without strong opposition.
The major loss of seats by the Komeito (from 31 to 21), including that of their party chairman, indicates that their voters have rejected the Komeito coalition with the LDP. The Komeito, under new leadership, could well seek a coalition with the DPJ. There is a difficult political history between the DPJ and the Komeito, but the numbers are there. The Komeito still has 21 seats in the Upper House, enough to create a comfortable majority with the DPJ's 112.
Small party developments will likely impact the economic debate positively. The People's New Party (formed by LDP rebels who opposed the Post Office privatization) did badly, falling from seven seats to three and losing the party chairman, Minpo Watanuki. The Socialist Party and the Communist party both retained their previous seat levels, seven and nine, respectively. The pro-reform Minna no To (Your Party) garnered five seats, enough to ensure exposure in national media.
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Review and Preview
September 01, 2009
By Ted Wieseman | New York
Treasuries posted solid further gains across the curve over the past week, sending yields to their lows since mid-July, a very good showing against continued upside in the economic data, a flood of supply, and not much in the way of offsetting support from stable risk markets. The week's economic data flow was uniformly positive, with upside in figures related to housing, business capital spending, employment and consumer spending sentiment. The housing market seems increasingly to have put in a bottom, with a surge in new home sales and sequential improvement in home prices adding to prior reports showing a jump in existing home sales and a gain in single-family housing starts. A gradual turnaround in business investment is also becoming more established after another gain in capital goods shipments that follows a substantial rebound in capital goods orders in recent months. Real consumer spending in July was a bit softer than expected, but this was more than offset by upward revisions to prior months, pointing to a better rebound in consumption in 3Q than we previously expected. The jobless claims data suggested that the labor market may have resumed improving after a few weeks of stabilization in these figures that followed a huge improvement in July. Consumer confidence saw a big gain in the Conference Board survey, which focuses on labor market conditions, and a surprising drop in the early August Michigan survey was revised away in the full-month results. Taken together, upside in the data on residential investment, business investment and consumption led us to boost our 3Q GDP forecast to +4.8% from +3.9% coming into the week and +3.5% early in the month. We haven't changed our estimate of motor vehicle output since we were estimating a +3.5% GDP gain and continue to see autos contributing about 3pp to 3Q growth. Instead, the recent upside has reflected growing evidence that the broader economy is gradually turning the corner. Indeed, we now see all three components of private domestic demand - consumption (+2.9%), business investment (+2.4%) and residential investment (+5.4%) - growing in 3Q after a disastrous run into 2Q that saw the worst year-on-year drop in consumption in almost 60 years, the worst annual drop in business investment on record, and an incredible 14 straight quarters of declining residential investment. While there's little doubt that there will be payback in coming months in auto sales after an expected further sharp spike in August or that auto production will flatten out early next year after the big ongoing recovery extends into 4Q as inventories are boosted back to more normal levels, the key lasting contribution from cash for clunkers and the broader auto sector rebound will probably be that it will provide substantial overall support to growth while the broader economy is gradually moving into a more sustainable, if probably modest, upturn. Note also that the surge in auto output in 3Q wasn't really a result of cash for clunkers, which should instead end up being more of a 4Q boost to the economy than 3Q. Even before the cash-for-clunkers surge in sales, automakers were planning to sharply boost severely depressed 1H assembly levels to stabilize plummeting inventories. Cash for clunkers has meant that this jump in assemblies in 3Q will not in fact boost depleted inventories much, so there will need to be a further ramp up in output in 4Q that will probably add another half-point or so to 4Q GDP growth after the expected 3pp 3Q add.
On the week, benchmark Treasury yields fell 10-15bp, with the old 2-year yield down 11bp to 0.97%, 3-year 10bp to 1.54%, old 5-year 11bp to 2.44%, old 7-year 13bp to 3.07%, 10-year 10bp to 3.45% and 30-year 15bp to 4.21%. The 2-year, 5-year and 7-year auctions all went well, with strong distribution to final investors at the auctions. TIPS badly underperformed to reverse the prior week's significant outperformance. Commodity prices were mixed but overall a bit lower on the week, with October oil down US$1.15 a barrel to US$72.74, and the dollar strengthened a bit after bouncing back from a sharp drop Thursday afternoon, but TIPS weakness seemed to be only influenced to a limited extent by these drivers, as selling seemed to persist through most of the week. The 5-year TIPS yield rose 8bp to 1.23%, 10-year 8bp to 1.74% and 20-year 2bp to 2.16%. This left the benchmark 10-year inflation breakeven down 18bp at a seven-week low of 1.71%. Mortgage market performance was comparatively lackluster, as current coupon 4.5% MBS only managed a minor rally on the week, slightly lagging Treasuries each day. This left current coupon yields a bit below 4.5%, which is right about where they've been, with only a few brief notable swings in either direction, since mid-June. Against this stability, however, there does seem to have been some recent compression in consumer rates versus MBS yields. The main national survey has shown 30-year mortgage rates close to 5.125% the past two weeks, down from previous levels near 5.25% back to early July. Current rates are about 40bp above the record lows, consistently very close to the 4.75% seen from late March to late May, but clearly this level of rates is not proving to be an impediment to a big recent recovery in home sales. Swaps outperformed both mortgage and Treasuries on the week, with the benchmark 10-year spread falling 4-23bp after small declines each day through the week.
Interbank funding conditions continued to be supportive of swap spread narrowing. The nearly four-month-long run of almost uninterrupted record lows in 3-month Libor actually accelerated the past week, with a 5bp plunge to only 0.3475%, dropping the spot Libor/OIS spread to only 17bp, only about 4bp above levels seen in August 2007 just before turmoil that began in European money markets after BNP Paribas froze redemptions in several funds with heavy subprime exposure, which effectively marked the start of the financial market turmoil. At this point, there's no reason to believe that we're not going all the way back to those pre-crisis spreads imminently. Forward Libor/fed funds spreads have grudgingly been moving lower as the spot spread has hit new post-crisis lows, but pricing continues to indicate that investors do not believe that current spreads are sustainable. A small further improvement to 15bp is priced in for mid-September but then a move back towards around 25bp by year-end and into 2010 and 2011, though our interest rate strategy team believes that this may actually be the average of a more binary outlook instead of an estimated normal level - if market turmoil returns at some point, Libor/fed funds spreads will move much wider, but if it doesn't, pre-crisis spreads closer to 10bp should prove sustainable, in their view (see Laurence Mutkin's report, Back to (Nearly) Normal - Money Market Update, August 27, 2009).
Risk markets, for the most part, barely moved all week, though for some reason minor day-to-day and intraday gyrations at times had seemingly outsized impacts on rate markets. After closing in an extremely tight range of less than 5 points from August 21-28, the S&P 500 squeaked out a marginal 0.3% gain on the week. Moves by sector were also minor, with small upside in financials being partly offset by a bit of weakness in energy. Credit also hardly moved. In late trading Friday, the investment grade CDX index was 2bp wider at 116bp after having closed at 115bp Monday through Thursday. It was a similar story in high yield, with the HY CDX index 10bp wider at 811bp at Thursday's close and then seeing small further losses Friday, which left its move for the week in line with a 22bp widening in the leveraged loan LCDX to 722bp as of midday Friday. Real estate derivatives markets were also largely little changed. The AAA subprime ABX index rose 0.13 points to 26.98, having not traded far from 27 for two-and-a-half weeks now. The AAA commercial mortgage CMBX index fell 0.02 points to 76.75 and also hasn't moved much recently. Lower-rated CMBX indices, however, were an exception to otherwise sleepy week for risk markets, ripping higher on the week, though even here all the action was early in the week and there was little movement after Wednesday. Still for the week, the junior AAA surged 3.34 points (+8%) to 45.40 and AA 1.88 points (+8%) to 25.96. It seems to have largely been forgotten by most investors, but this area still seems to be showing optimism about the Treasury's Public-Private Investment Program, which is expected to launch in September.
Economic data released the past week were better-than-expected across the board, with upside in reports on housing, capital goods demand and consumer spending leading us to boost our 3Q GDP forecast to +4.8% from +3.9%. A big but falling portion of this growth is expected to come from a significantly less intense pace of inventory liquidation. 2Q growth was unexpectedly held steady at -1.0%, but the half-point further drag from inventories to -1.4pp was as expected and caused no revisions to our forecast that inventories will add about 1.8pp to 3Q growth. Instead, it's becoming more likely that we will see an earlier-than-expected return to growth in both residential and business investment, while the outlook for consumption is looking somewhat more robust.
Real consumer spending rose a slightly-less-than-expected 0.2% in July, but this was more than offset by upward revisions to June (+0.1% versus -0.1%) and May (+0.1% versus 0.0%). This stronger starting point led us to boost our 3Q consumption forecast to +2.9% from +2.6%. A large portion of this gain is expected to come from motor vehicles, but spending on services has also picked up a bit recently, with real services spending up 1.2% annualized in the past couple of months after falling 0.3% over the prior year. This upturn should receive a notable boost in August from more normal summer weather's impact on utility spending, which plunged through July on the unseasonably cool weather. Non-auto goods consumption has remained weak, and we'll see in Thursday's chain store sales whether there are any signs of life there.
Durable goods orders surged 4.9% in July. The majority of the gain came from a 107% spike in civilian aircraft, but there was still a robust 1.9% gain excluding this volatile category. The sharp rebound in motor vehicle production was a key driver of the ex aircraft upside. Motor vehicle shipments - the census only counts finished motor vehicle orders at the time of shipment, so there will probably be a much bigger rise in August - gained 0.9% and there appeared to be notable spillover into other areas, including primary metals (+2.6%) and fabricated metals (+2.8%). Non-defense capital goods ex aircraft orders dipped 0.3%, but this followed a huge rebound over the prior couple of months that resulted in a 35% annualized surge in the three months through July. And this started to come through in shipments as well. Non-defense capital goods ex aircraft shipments rose a better-than-expected 0.5% in July on top of an upwardly revised 1.3% gain in June. We now see overall business investment rising 2.4% in 3Q instead of falling 1.5% and the equipment and software component gaining 2.3% instead of falling another 3% after the record plunge in the year through 2Q.
Housing market data continued to surprise in a big way on the upside. New home sales surged 9.6% in July to a 433,000 unit annual rate, a high since September, and there were significant upward revisions to prior months. Sales have now rebounded 32% over the past six months from the record low hit in January. The sharp pick-up in sales, together with the ongoing plunge in housing completions - which have caught up with the prior collapse in starts and are now running down 41% from a year ago - is finally making a significant dent in the inventory of unsold homes. The months' supply of unsold homes has plunged from a record high of 12.4 months in January to 7.5 months - not far from a more balanced level near 5.5-6 months. If the current pace of sale can be sustained, inventories should be at more normal levels by year-end. This upside in new home sales, which followed a nearly as big gain reported the prior week in existing home sales, should help to drive a modest gain in overall residential investment in 3Q. The brokers' commissions component that is directly tied to home sales is a fairly small share of overall residential investment (though its weight has risen a good bit in recent years as homebuilding activity has cratered), but the recovery in home sales has been so robust that we see this category surging enough (by close to 90% annualized) to move overall residential investment into growth territory in 3Q. Moreover, there were big changes in the price deflator for new homebuilding in the 2Q GDP revision that is carrying into 3Q and providing notable upside. The price index for new homebuilding plunged nearly 10% annualized in 2Q, and the trend in the revised underlying monthly figures in July now points to another similar-sized plunge in 3Q. This probably won't be enough to move real spending into positive territory, but incorporating these new figures, we now see real homebuilding activity only declining another 9% in 3Q, which would be by far the smallest drop since 1Q06. With this relatively moderate drop in homebuilding, an expected similar-sized decline in improvements and the likely huge gain in brokers' commissions, we now see overall 3Q residential investment rising 5.4%, up from our near +1% forecast coming into the week and -4.7% earlier in the month. This would mark the first rise in residential investment since 4Q05. Even home prices may have bottomed a lot sooner than previously expected, as the S&P/Case Shiller home price index saw its first sequential increase in seasonally adjusted terms in June in three years.
The economic calendar is very busy in the coming week, though it seems likely that light summer trading conditions will continue until after the late Labor Day. Focus will be on the key early run of August data - employment Friday, manufacturing ISM Tuesday, non-manufacturing ISM Thursday and indicators for consumer spending in motor vehicle sales reports Tuesday and chain store sales reports Thursday. Other reports due out include construction spending Tuesday and revised productivity and factory orders Wednesday:
* We expect the manufacturing ISM to rise to 51.0 in August. The regional surveys overall have shown notable improvement, so we look for the national ISM, which stood at 48.9 in July, to move above the 50 breakeven threshold for the first time since January 2008. Also, the price index is expected to register another uptick to 58.0.
* We look for a 0.5% decline in July construction spending. Housing starts have moved off their lows, but the number of homes under construction is still declining - and should continue to do so for several more months. So, we look for a further decline in the residential category. Meanwhile, despite widespread anecdotal reports of a collapse in commercial activity in response to rising vacancy rates and tight credit conditions, the private non-residential component of construction spending has remained remarkably resilient in recent months. We continue to expect the data to catch up with reality relatively soon and thus look for a decline this month. Finally, state and local government budget pressures are offsetting some of the trickle of Federal stimulus money. So, we look for only a modest uptick in the public category.
* We forecast a surge in August motor vehicle sales to 16.0 million units annualized. It appears that the US$3 billion of funding authorized for the cash-for-clunkers (C4C) program will be largely exhausted by the end of August. Moreover, it seems that July sales under cash for clunkers were a good deal less than suggested by early reports due to some processing delays. So, we are assuming about 600,000 of C4C sales for the month of August (150,000 carried over from the initial US$1 billion of funding and another 450,000 or so tied to the extra US$2 billion). This translates to about 6-7 million units of C4C-related sales in August on a seasonally adjusted annual rate basis. This should help to boost the overall monthly sales tally to its best reading since late 2007. With the expiration of the C4C program, sales are expected to return to about a 10 million unit pace for the next few months before gradually rising in line with the anticipated underlying improvement in the overall economy. At the end of the day, the C4C program is likely to go down as one of the most effective stimulus efforts in terms of bang for the buck in the history of US policymaking.
* We expect 2Q productivity to be revised up to +6.6%. A small upward revision to the measure of output relevant for this report should lead to a slightly larger surge in productivity compared to the initially reported +6.4%. Unit labor costs should see a slightly larger downward adjustment in 2Q to -6.1% from -5.8% on marginally weaker income growth on top of the productivity revision, and there is also likely to be a downward revision to 1Q costs as a result of a downward adjustment to wages and salaries contained in the GDP revision.
* We look for a 2.0% gain in July factory orders. The huge gain in durable goods, which was led by the volatile aircraft component but also reflected meaningful upside related to the surge in auto output, should be partially offset by a bit of price-related softness in non-durables after a sharp gain last month.
* We forecast a 250,000 decline in August non-farm payrolls, very similar to the 247,000 decline that was registered in July, with some modest underlying improvement in labor market conditions being about offset by partial payback of a seasonal quirk that provided a modest boost in July. Specifically, many of the auto plants that are typically shuttered for retooling during the July survey period were actually up and running this year. The seasonal-adjustment factors anticipate that the auto employees who are usually out of work in the July survey return in August. But since many of these people remained on the job in July, there won't be as much of an incremental rise in the raw number of workers this year. We believe that there was an artificial boost of 30,000 or so to July payrolls from seasonal factors trying to account for temporarily laid off workers who weren't in fact laid off this year, and this should be unwound in August. Meanwhile, the downtick in the unemployment rate seen in July was largely attributable to a sharp drop in the labor force participation rate, which can be quite volatile on a month-to-month basis. We look for a partial correction this month, which should lead to a resumed climb in the unemployment rate. Otherwise, average hourly earnings are likely to post a slightly above-trend increase, reflecting the impact of the final phase-in of the hike in the federally mandated minimum wage that was enacted a few years ago. Finally, the manufacturing workweek is expected to edge higher, but we suspect that this might not be quite enough to push the overall workweek up for a second straight month.
* We look for the trade deficit to widen US$1.5 billion in July to US28.5 billion, with exports up 1.0% and imports 1.8%. Exports should be boosted by good upside in capital goods, led by high-tech products but with a partial offset from aircraft. On the import side, port data point to upside in non-energy goods after a sustained period of major weakness, and Energy Department figures suggest that a further recovery in volumes should offset a drop in prices and lead to a further rebound in petroleum products.
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