South Africa
Burgeoning Fiscal Gap, Anemic Consumer Recovery
October 20, 2009

By Michael Kafe, CFA & Andrea Masia | Johannesburg

Summary

We believe that aggressive, front-loaded policy easing should help to place a floor under South Africa's 2009/10 GDP growth rate. In fact, our analysis shows that households in the LSM 7-10 brackets may have already seen an improvement in their balance sheets, thanks to a fall in debt-service costs and above-inflation wage settlements. However, significant headwinds from rising unemployment suggest that a true recovery may be delayed until mid-2010. We look for some moderation in the current account deficit, but this is likely to widen again in 2010 as consumption recovers. Thus, while we have a near-term constructive view on the rand and believe that a re-test of US$7.30 is possible - perhaps even a short peep below 7.00 - we are less optimistic about 2010.

On the fiscal front, we look for a revenue shortfall of about R65 billion and an expenditure over-run of some R15 billion, which should lift the fiscal deficit to 7.3% of GDP and propel the public sector borrowing requirement into double-digit territory. Such a development is also likely to weigh on the rand over the course of 2010, keeping inflation uncomfortably close to the upper end of the inflation target band. We expect the SARB to keep policy rates on hold until 1Q11, where we look for 100bp of hikes.

Anemic Consumer Recovery

Recent sharp falls in disposable income growth - thanks to job losses and weak earnings growth - have forced households to pare back durable and non-durable consumption expenditures; and more recently, outlays on services and semi-durables have contracted sharply too. And while our analysis suggests that some households' discretionary incomes may have swung back to positive territory already (see South Africa Chartbook: Perils of a Leveraged Consumer, October 9, 2009), we do not expect this to translate into a meaningful recovery in aggregate consumer spend before early 2010. It is important to note that although our analysis suggests that some of the 8.7 million South Africans accounting for 80% of total credit extended to households may have seen significant improvements in their balance sheets since the onset of policy easing in December 2008, they make up less than half of the country's 17.5 million labour force, and less than a third of its 31 million adult population. One should therefore be careful to avoid hasty generalizations.

Encouragingly, the rate of contraction in nationwide real disposable incomes appears to have gone past its worst patch, however. For the record, we look for positive disposable income growth by 1Q10 - even though we expect the pace of recovery to be capped at no more than 5% in 2010/11. We concede that such a meagre recovery in income may constrain the marginal responsiveness of consumers to easier money in the forthcoming upswing.  With regards to GDP, we look for an inventory-led 3Q09 rebound of 2.8%Q, complimented by strong government consumption expenditure (mainly wages) in 4Q09, to result in an above-consensus GDP print of -1.7% in 2009, followed by a 2.7% print in 2010 (consensus expects -2% and 2.4%, respectively). So far, high-frequency supply-side data show that manufacturing, mining and electricity production, new vehicle sales, consumer confidence, etc. have all rebounded in 3Q09 - although retail trade has remained uninspiring.

Investment to Remain Weak

Regarding fixed investment, private enterprises have continued to pare back investment spend significantly - in line with tepid business conditions. We also expect public sector capital spend to come under pressure during the remainder of this fiscal year as revenue shortfalls, weak demand growth and a strong focus on cost containment result in public infrastructure budgetary cuts. Already, Transnet has indicated that it will cancel/postpone a number of railroad projects, while Eskom has also made clear its intention to save at least 10% of the costs associated with the construction of its Medupi and Kusile plants via design changes and delayed purchases of spare parts. Quite importantly, double-digit wage awards and employment expansions at provinces/municipalities are also likely to crowd out some capital projects. On the whole, we expect the capital budget to be cut by 5-10% in 2009/10.

Even so, the high import requirements of government-led projects associated with the 2010 FIFA World Cup should keep the pace of public sector capital formation above the growth in local cement sales (i.e., a likely repeat of 2002, where intermediate capital imports associated with the heavy-duty Coega industrial project placed a floor under public sector GDFI growth, despite a discernible fall in cement sales). Unfavorable base effects from a record 80%Q pace in 1Q09, and a further 25%Q in 2Q09 as Eskom invested in the de-mothballing of three coal-fired plants, however, point to a sharp technical decline in the annual pace of public sector capital formation in 2010.

Fiscal Revenues to Undershoot Budgeted Estimates

On the fiscal front, the government has reported that tax revenue generation will come in significantly below its official budgetary estimates, thanks to much weaker-than-expected GDP growth. Officially, the Treasury now expects a shortfall of R60-80 billion this fiscal year. No revised estimates have been provided for 2010, however.

We forecast a revenue undershoot of R65 billion (i.e., at the lower end of the government's range), led mainly by declining VAT and corporate tax revenues. Our analysis shows that cumulative revenues for the fiscal year to August 2009 have slipped behind their comparable three-year averages, with the most noticeable shortfall in international trade and VAT receipts. At 26%, international trade tax revenues are some 10pp below the comparable reading of 36% as imports of white goods and vehicle parts have slowed, and as vehicle producers aggressively offset their tax credits against import costs as provided for under the Motor Industry Development Program (MIDP). VAT receipts (the third-largest tax handle) have also slipped to 29%, versus a three-year comparative of 36.4%.  Personal income taxes show the least undershoot, however, thanks to a combination of bracket creep, efficiency improvements in tax administration (e.g., the introduction of auto-populated returns) and the fact that retrenchments have mostly occurred in the informal employment sector and the bottom rungs of the income tax ladder.

Government Budget Deficit to Breach 7% of GDP

Given the authorities' demonstrated commitment to the pursuit of counter-cyclical fiscal policy, we believe that fiscal expenses will turn out higher than budgeted in 2009/10. In the main, we continue to expect upside pressures from wages and interest to lift the fiscal deficit to 7.3% of GDP this year - from 1% of GDP in 2008/9. 

Recurrent items account for a large portion of fiscal expenditures, particularly government wage and non-wage compensation. Given an average public sector wage increase of 11.5% this year, we believe that the total public sector remuneration expense could even exceed our 15%Y forecast, once provision is made for non-wage compensation, arrears payments and one-off adjustments for Occupational Specific Dispensation (OSD) in doctors' salaries. Transfers to households are also likely to come in above budget, thanks to the rising number of applications for foster care, social relief and child support grants.

Interestingly, our analysis shows that, for the year to August, the cumulative fiscal spend on economic services such as transport; social services such as education and health; and protection services (police service, prisons, etc.) have all come in above their comparable three-year average levels: Transport spend in particular was lifted by final expenses associated with the roll-out of the government's Bus Rapid Transit system ahead of the FIFA World Cup next year. Recent press reports have intimated that passenger interest remains below critical volumes, and that the unanticipated security costs of running the buses have soared. 

Public Sector Borrowing May Soar to Double-Digits

The combination of a revenue shortfall and expenditure overshoot could push the National Treasury to borrow some R80 billion more than initially budgeted. This higher level of borrowing is likely to swell the overall PSBR to 11.5% of GDP in 2009, placing South Africa in the same company as the UK and US.

So far (fiscal year to September 2009), Treasury Bills in issue have soared to R30.9 billion - double the full-year budget estimate of R15.6 billion. For the year as a whole, we expect the government to issue some R55 billion of Treasury Bills (i.e., three times the budgeted estimate). Government bond issuance has also risen sharply, reaching R64 billion in the first half of the fiscal year, and on track to exceed the full-year budgetary estimate of R70.5 billion by some R30-50 billion. Although we admit that rollover risk could become an issue at some point, investor appetite has so far remained exceptionally healthy, with most auctions being reasonably well-subscribed.

Short-Term Fundamentals Underpin ZAR Strength

The rand remains resilient, supported in large measure by buoyant portfolio equity flows, higher-than-expected commodity prices, a steady current of inward foreign direct investment capital, and a weak USD.  In fact, on a year-to-date basis, South Africa has recouped R66.6 billion of the R67.3 billion net portfolio outflows recorded in 2008.

Importantly, our fair value model shows that, at 7.40, the ZAR is some 16% overvalued versus its 4Q09 fair value estimate of 8.65.  However, the model also predicts that USDZAR fair value is likely to appreciate by some 8% between 3Q09 and 1Q10 (i.e., an implied spot-equivalent forecast of 7.20 - from 7.85 in 3Q09), before depreciating over the remainder of 2010 to close that year at 9.00. In the unlikely event that the ZAR remains 16% overvalued, the implied spot-equivalent forecast for end-2010 is 7.90. Thus, although the ZAR should ultimately weaken in the coming quarters, one may need to look beyond macroeconomic fundamentals to trigger a near-term correction.

For the record, we have an official year-end target of 7.60 and expect the rand to close 2010 at 9.00, thanks to a deteriorating fiscal position, narrowing interest rate differentials, a potential capital account shortfall as global risk-love wanes, and a resurgence in the current account gap as consumer imports recover in 2H10.  The rand may also suffer some post-World Cup fatigue.

Inflation Sticky: No Room to Ease

Thanks to downwardly rigid food and administered prices, we expect South Africa's inflation trajectory to remain relatively sticky. Our baseline forecast - which assumes average oil prices of US$62/bbl for 2009, US$76/bbl for 2010 and US$80/bbl for 2011, based on the futures curve as of August 18, 2009; and an average USDZAR of 8.50, 8.30 and 9.20 over those respective years - shows that inflation is likely to remain uncomfortably close to the upper end of the 3-6% target range (i.e., above 5.5%Y) until 2Q11. Given our view of an uncomfortably sticky inflation profile, we expect the SARB to keep rates on hold through 2010, and look for a combined 100bp of policy normalization in two clips of 50bp between January 2011 and March 2011.

At the moment, the market expects GDP to be modestly positive in 2010, while inflation continues to fall. Yet the market is pricing in rate hikes as early as 3Q10. We believe that this may be too early, and look for policy normalization no earlier than 1Q11. A major risk to our call is the rand, however: currency weakness over 2010 could force the SARB to consider raising rates earlier than we anticipate.

Conclusion

Although a number of consumers' balance sheets have improved since 2Q09, we believe that aggregate consumption spend will continue to be constrained by job losses and declining disposable incomes in 2H09. Weak consumption spend should keep overall 2009 GDP in negative territory; however, we do expect a technical recovery in 3Q09 inventories and a jump in 4Q09 government expenditures to help push the quarterly GDP growth rates back into positive territory over the rest of this year. Weak growth prospects will likely hurt tax revenue collection and push the public sector borrowing requirement into double-digits. Thus, although near-term fundamentals remain supportive of the rand, we are less constructive about prospects for 2010, thanks to the deteriorating fiscus, a widening current account as consumption recovers, and a slowdown in capital inflows as global risk-love wanes. With regards to inflation, we continue to forecast a relatively sticky profile, which should help to place a floor under the policy repo rate throughout 2010. 

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Poland
PLN - What's Fair Is Fair
October 20, 2009

By Alina Slyusarchuk & Pasquale Diana | London

Poland's relative macro performance this year has been impressive. Not only did growth never dip below zero, but for example 2Q growth printed a healthy 1.1%Y (Czech Republic: -5.5%Y, Hungary: -7.5%Y, Romania: -8.7%Y), and we think that full-year growth may reach 1.4%. The reasons for the relative outperformance are well known: first, Poland is a more closed economy than most of its neighbors, so the drop in investment in export-oriented sectors affected it comparatively less; second, even in sectors which correlate well with the global cycle (say, industry), the outperformance was notable, likely on the back of better domestic demand dynamics; third, fiscal policy was supportive of growth, with Polish consumers enjoying tax cuts this year, in sharp contrast with fiscal tightening elsewhere (most notably Hungary).

Despite a better growth outlook, the zloty has failed to shine across CEE currencies. Indeed, it sold off comparatively more than its peers in the most intense phase of the post-Lehman crisis, and its recent recovery trend seems to have stalled. We see three main reasons for the zloty's lacklustre relative performance on the currency side. In the initial stages of the sell-off, we believe that there was disappointment with the EMU adoption agenda, and the realization that there would be no ERM II anchor any time soon prompted some investors to lose confidence in the PLN. Earlier this year, the emergence of a fiscal picture which was significantly worse than previously thought (whereas perceptions about, say, Hungary were improving) was another drag on the zloty. Finally, the zloty was (and is) the most liquid currency in the region and is less heavily managed than either the RON or HUF. Therefore, PLN-bearish positions made sense for clients that wanted to express a bearish CEE view.

With risk appetite returning to the market and the wall of central bank-provided liquidity still chasing risky assets, our strategists are positive on EM and EMFX. This is consistent with our structural macro view that sees the zloty as the most attractive currency in the region. In our recent trip to the region, we note that while there is still no clear deficit adjustment path, the assumptions behind the 2010 budget appear reasonable to us. Also, with the cycle turning, most of the bad news on the deficit is most likely already in the open. Overall, therefore, we remain constructive on the PLN.

What Is Fair: PLN Still Undervalued by 5% versus the EUR

In this note, we step back and take a more fundamental look at the zloty. In our attempt at its fair valuation, we use the so-called behavioral equilibrium exchange rate approach. Extending it further, we remove cycle-related components and calculate the permanent equilibrium exchange rate (PEER), which is taken as a measure of the equilibrium rate (see Appendix for full details).

Our results indicate that the zloty overshot in 2008 on the strong side (as we suspect all regional currencies did, relative to their fair values). Since then, fair value for PLN has moved somewhat weaker, in response to a deterioration in the risk variable as well as a deterioration in the relative terms of trade. Even so, the sharp depreciation seen last year and early this year took the zloty sharply into undervalued territory, as one might expect. In our estimate, EUR/PLN current fair value is just around 4.0, so 5% away from current levels. In a risk-loving environment, it is entirely plausible that PLN can appreciate not only to eliminate the gap with equilibrium, but possibly much more (FX undershoots and overshoots).

A Safety Check

Comparing our outcomes to the existing research on the zloty, we find them in line with previously obtained results. We have looked across a number of papers and analyzed the results. Our model seems to be broadly in line with what previous literature has suggested, and therefore looks reasonably robust to us.

Conclusion

We remain constructive on the zloty, which remains our favorite currency across CEE. While we are generally wary of following fair value models religiously, an analysis of macro fundamentals of the PLN also suggests that the PLN is undervalued relative to the EUR. Our current estimate of EUR/PLN fair value is around 4.0, but we see scope for PLN to overshoot on the strong side in the coming months, especially in a constructive risk environment.

Appendix: The Model Explained

In this note, we step back and take a more fundamental look at the zloty. We follow the methodology used by the NBP (2009). In our attempt at fair valuation of the zloty, we use the so-called behavioral equilibrium exchange rate (BEER) approach first introduced by Clark and MacDonald (1998). This approach accounts for behavioral aspects rather than purely normative ones in the sense that it tries to explain exchange rate behavior based on evidence rather than relying exclusively on economic theory. The approach takes uncovered interest parity as the initial condition.

Et (et+1) - et = it - it*

When the parity is presented in real terms and rearranged, it shows that the real exchange rate (q) depends on its expected value and the current real interest rate differential.

qt = Et (qt+1) - RIRt

The expected exchange rate in its term is assumed to be determined by long-term economic fundamentals such as terms of trade, the relative price of traded and non-traded goods (Balassa-Samuelson term) and net foreign assets.

Et (qt+1) = f (TOTt, BSt, NFAt )

We also account for the risk component in the UIP. We add a risk premium proxy represented by government debt relative to industrial output. We use industrial output rather than GDP as we want to run the model monthly. The resulting relationship that we use for the zloty is

                -        -       -      -     +

PLN= f (RIR, TOT, BS, NFA, τ)        (*)

where PLN is a monthly average rate of EUR/PLN deflated by the index of prices in manufacturing in Poland and in the euro area, RIR is a differential of real 10-year government bond yields, TOT is the relative terms of trade between Poland and the euro area, BS is a Balassa-Samuelson term, NFA is a net foreign assets relative to industrial production and τ is the risk premium proxy. The signs above the equation are the expected partial derivatives (negative means zloty appreciation). We focus on the EUR/PLN real exchange rate. The data start in 2000, when the free float of zloty was introduced.

We estimate the BEER equation using a vector error correction  (VEC) mechanism (Johansen (1995)), which assumes that the exchange rate is cointegrated in the long run with fundamentals as described by our model, as in (*) above.

qt = βft

The corresponding error correction specification is:

Δqt = qt - qt-1 = α + λ[qt-1 - βft-1 ] + γΔft + υt

where ft  is a vector of fundamentals, β is their long-run impact, γ reflects the short-run impact of changes in ft, λ is the speed with which the previous period's deviation from fundamentals is corrected in the current period and υt is a stationary disturbance term.

From the specification, it follows that the changes of the variables in the short run in period t are determined by their deviations from the long-term relationship in the period t-1. When the current exchange rate falls below its long-run value implied by fundamentals, an appreciation should occur in the future. This enables convergence to the long-term vector, so that in the long-run equilibrium the term in square brackets goes to zero. Since the equilibrium rate is not an officially observed variable, the estimation process involves two steps. We first estimate the relationship between the real exchange rate, the fundamentals and short-run variables applying the VEC approach. Second, we use parameters of cointegrating vector β to compute the equilibrium exchange rate.

The long-run relationship we estimate is significant. Signs are in line with economic theory and our expectations. All the coefficients are correctly signed and all, apart from the real interest rate differential, are statistically significant. EUR/PLN adjusts significantly to deviations from equilibrium (λ coefficient of -0.36 on first error correction term).

The key determinants of PLN are terms of trade, the debt ratio and net foreign assets. However, the estimated behavioral equilibrium is of limited help as the fundamentals themselves vary greatly and they are often away from their equilibrium value. That's why our next step is to decompose the conditioning variables to permanent and transitory components. Following Clark and MacDonald (2004), we remove the business cycle-related component using a Hodrick-Prescott filter and calculate the permanent equilibrium exchange rate (PEER). We take this as a measure of the equilibrium rate.

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United States
Review and Preview
October 20, 2009

By Ted Wieseman | New York

In very choppy and at times illiquid trading conditions, Treasuries very slightly extended the prior week's big sell-off in the past holiday-shortened week, hurt by a continued run of stronger economic data since the disappointing employment report and a run-up to new highs by stocks into Thursday before a partial pullback Friday.  Investors also seemed a bit nervous about how dovish the Fed remains, as reflected in a speech by Vice Chairman Kohn and the minutes from the September FOMC meeting, with this backdrop of stronger economic releases and equity and credit markets, as the front end was supported by a further near-term dovish repricing of the Fed in futures markets while the longer end sold off further and TIPS inflation breakevens extended what's been a big move higher over the past couple of weeks.  Weakness in current coupon mortgages amid some general disorder along the MBS coupon stack, with the Fed's having apparently bought more of the higher coupons than can be delivered in a reasonable timeframe contributing to enormous performance disparities, also contributed to Treasury market softness and concentrated in the intermediate sector after the prior week's long bond-led bear steepening.  Against these negatives, however, there just seems to be a wall of money out there looking for better returns than the near 0% offered by cash-like investments, generally helping Treasury yields to fairly quickly find support after bouts of weakness while also seemingly driving up stocks, credit markets, commodities et al.  The retail sales report for September was better than expected, as beneath some major cash-for-clunkers-driven volatility in overall sales, ex auto results were surprisingly robust and pointed to a solid back-to-school shopping season.  Based on this upside, we boosted our 3Q consumption forecast to +3.4% from +3.1%.  Combining this with a slower-than-expected rate of liquidation in ex auto retail inventories, we raised our 3Q GDP forecast to +3.9% from +3.7%.  Industrial production also continues to show a surprisingly strong broadening out in the pace of the factory sector recovery beyond autos.  An enormous gain in motor vehicle assemblies has still been the biggest contributor to the best three-month IP run in 12 years, but ex autos manufacturing has also begun to show substantial and broadly based gains.  Looking into early 4Q, the jobless claims report extended what's becoming a major renewed improving trend in the latest week, pointing to renewed moderation in job losses in the October employment report.  The outlook for 4Q GDP was also looking somewhat better based on a stronger starting point provided by the solid end to 3Q.  4Q growth is still likely to moderate from 3Q, largely as a result of cash-for-clunkers payback, but at this early point there appears to be some upside to our +2.0% 4Q GDP forecast, largely as a result of the stronger-than-expected ending point to underlying 3Q consumer spending. 

On the week, benchmark Treasury coupon yields ended up little changed to slightly higher in a mild extension of the prior week's (actually only the last day-and-a-half of the prior week after the 30-year auction) major losses.  The 2-year yield was flat at 0.96%, 3-year unchanged at 1.50%, 5-year up 1bp to 2.36%, 7-year up 2bp to 3.00%, 10-year up 4bp to 3.42%, and 30-year up 2bp to 4.25%.  This mild further net curve steepening on the week had been a lot more notable through Thursday, but there was a decent curve-flattening reversal Friday.  Still, even after a rebound to the end of the week, the 30-year yield has risen 29bp and 2s-30s has steepened 20bp since in just the five-and-a-half trading sessions since just before the 30-year reopening.  During the recent back-up out the curve, the bid at the very short end had remained rock-solid and kept bill yields extremely low.  Over the past week, the 4-week bill yield rose 2bp but to only 0.05%, while the 3-month yield fell 1bp to 0.06%, the 6-month fell 1bp to 0.16%, and 1-year fell 2bp to 0.33%.  Although the market showed some uneasiness with the Fed's dovish public statements, notably in reaction to the FOMC minutes, ultimately investors continued to move to accept this and price the Fed being on hold for a good while longer and hiking slowly when rates start to rise - though the first of these is a much more reasonable conclusion at this point than the second, in our view.  The July 2010 fed funds futures contract gained 4.5bp on the week to 0.64%, moving to price nearly a toss up between the fed funds target being at 0.50% or 0.75% at mid-year, while the Jan 11 contract gained 0.5bp to 1.41%, pricing a year-end 2010 target of 1.50%.  TIPS had another very good week, helped by the weak dollar and associated US$7 a barrel surge in oil prices to US$78.53 a barrel, a high for the front month in over a year, slight upside in CPI in September, with the total and core gaining 0.2% instead of the 0.1% expected, and an ongoing asset reallocation by fixed income investors into the sector that kept relative performance solid recently previously even when the nominal market was rallying and commodity prices were more stable.  The 5-year TIPS yield fell 10bp to 0.73%, 10-year 9bp to 1.44% and 20-year 6bp to 2.02%.  The benchmark 10-year inflation breakeven has now risen 27bp the past two weeks to 1.97%, near the upper end of the range seen over the past five months or so that has extended down to near 1.5% on the low side. 

There have been some big divergences within the MBS market recently, with the Fed's increasingly dominant ownership share apparently contributing to odd-looking distortions.  Nearest to current coupon 4% and 4.5% issues have performed poorly during the back-up in rates over the past week-and-a-half.  There was a bit of a recovery Friday, but current coupon MBS yields still underperformed more stable Treasuries a decent amount on the week, with yields rising from near 4.25% at the end of the prior week to a bit above 4.3% after a run of about a week at 4.1%, a low since May, that ended when rates generally started backing up sharply after the 30-year auction on October 8.  This downside in lower coupons has contrasted with a much better showing by higher coupons that was substantial on net over the past week even after a meaningful move towards normalization Friday.  On the week, Fannie 4%s lost about 12 ticks and 4.5%s 8 ticks, but 5%s were unchanged and 6%s rallied 6 ticks.  The Fed's increasingly overwhelming role in this sector is probably contributing to these divergences.  Our interest rate strategy team estimates that the Fed and Treasury now own more than the entire float of Fannie 5% MBS and that it will take 6-7 months of production at the current pace for the remaining US$33.5 billion that has not been delivered to the Fed to come into existence (see The Interest Rate Tactician: Has the Fed Bought More FN5s than Can Be Delivered? by Janaki Rao, October 16, 2009).  This squeeze is also spreading up to higher coupons as Fed buying moves up the coupon stack. 

Generally upbeat results so far from corporate earnings reports for 3Q helped stocks and, to a lesser extent, credit extend their recent gains.  The S&P 500 gained 1.5% to extend the year-to-date gain to over 20%.  The weakening dollar certainly could be a problem at some point, but for now the positive impact it is having on natural resource stocks is helping to boost the overall market significantly.  The energy sector of the S&P 500 did particularly well the past week with a 5% surge.  Lower-quality credit moved to new highs for the year along with stocks during the week, but higher-quality credit has lagged somewhat recently.  Late Friday, the investment grade CDX index was 4bp tighter on the week at 98bp, somewhat off the recent best level of 91bp reached September 22.  On the other hand, the high yield index was 35bp tighter on the week at 634bp through Thursday and seeing only slight weakness in Friday's trading after reaching the year's best level of 626bp Wednesday, and the leveraged loan LCDX index was also near its best 2009 levels at week-end after a 33bp tightening through midday Friday to 544bp.  With the Fed and some major banks highlighting the poor fundamentals in commercial real estate, the CMBX market performed more poorly.  There was a big rally in the earlier part of the week, but then a sizeable pullback later.  The AAA index still managed a 1.32 point rise for the week as a whole to 81.04 but fell significantly Friday.  The junior AAA also managed a 0.78 point rise to 53.46, but only after a drop from 56.00 on Wednesday, while the lower-rated indices saw bigger reversals that left them down on the week. 

Key economic data released the past week extended the run of better numbers seen since the worse-than-expected employment report a couple of weeks back.  Most notable was an upside surprise in underlying retail sales.  Retail sales plunged 1.5% in September after surging 2.2% in August, as auto dealers' receipts corrected 10.4% following a cash-for-clunkers-driven 7.8% gain.  Beneath this autos volatility, underlying activity showed notable improvement during the key back-to-school shopping season, with ex auto sales up 0.5% in September on top of a 1.0% gain in August.  Also excluding some upside in gas stations, ex auto sales were up 0.4% in September and 0.6% in August after falling 4% annualized over the prior five months.  Building in this better-than-expected outcome for ex autos and gasoline sales, we raised our 3Q consumption forecast to +3.4% from +3.1%.  There wasn't any immediate offsetting impact from retail inventories data, which ex autos fell a bit less than expected in August, and we boosted our 2Q GDP forecast to +3.9% from +3.7% as a result.  Looking to 4Q, the move higher in ex auto retail sales in August and September should help to offset some of the payback in auto sales and moderate the slowing in overall consumption.  We had been looking for consumption to slow to +1.0% in 4Q, but the stronger starting point from this report suggests less of a slowdown to something near +2%, potentially also providing some upside to our 4Q GDP forecast of +2.0%. 

In line with this possible upside into year-end was a ramp-up in production over the course of 3Q, with motor vehicle output in particular (which is what really matters for growth, not motor vehicle sales) on pace to rise a lot further in 4Q on top of a huge rebound in 3Q.  Industrial production surged another 0.7% in September on top of an upwardly revised 1.2% gain in August and a 0.9% rise in July, outside of the post-Katrina recovery the biggest three-month gain since 1997 after the worst annual collapse since 1946 was recorded in the year through June.  The key manufacturing gauge surged 0.9% in September and is now up 13% annualized in the past three months after a 15% collapse in the year through June.  Auto output was way up again, but more notable within manufacturing was how robust ex motor vehicle output was again, as the initially auto-centered rebound continues to spread more broadly.  Manufacturing ex motor vehicle output was up 0.5% in September and 7.5% annualized the past three months, with big gains in sectors including primary metals (by far the strongest area after motor vehicles), machinery, high-tech, electrical equipment and appliances, aircraft, food, chemicals, paper and petroleum products.  Still, the huge recovery in motor vehicles has been the biggest contributor to the turnaround.  Motor vehicle assemblies in all of 3Q were up an enormous 312% annualized over 2Q, and production is scheduled to continue ramping up through year-end, pointing to a big add to 3Q GDP growth and likely a still significantly positive contribution to 4Q.  For 4Q, the ramp-up in 3Q was so steep that the level of motor vehicle assemblies in September was already 59% annualized above the 3Q average. 

After the big rebound in 3Q, the outlook for October manufacturing activity was not clarified much by the initial round of regional manufacturing surveys.  On an ISM-comparable weighted average basis, the Empire State manufacturing survey surged to a two-year high of 56.2 from 49.3, but the Philly Fed fell to 46.2 from 47.0 - by far the biggest-ever divergence between these generally well-correlated reports.  The rest of the regional surveys will be out the last week of the month, hopefully providing a bit more guidance for the next ISM report.  The outlook for the October employment report, on the other hand, is looking unambiguously better at this point after a big recent improvement in jobless claims.  Initial claims and the four-week average of initial claims were both at their lowest levels since January in the week ahead of the survey period for the October employment report and much lower than seen during the September survey week, while continuing claims in the prior week were at their lowest level since March. 

The economic calendar in the coming week is fairly light, with focus largely on some housing numbers, including the homebuilders survey Monday, starts Tuesday, the FHFA house price index Thursday and existing home sales Friday.  A lot of corporate earnings reports will be released, and the impact on stocks will likely continue to be a major focus for rates markets.  With the November 3-4 FOMC meeting approaching, the Beige Book will be released Wednesday, and it will probably report continued signs of a pick-up in the economy after the last edition said that half of the 12 Fed districts saw a pick-up in activity in August and half stabilization.  Another flood of supply is approaching, and the Treasury will announce the 5-year TIPS reopening, 2-year, 5-year and 7-year issues on Thursday that will be auctioned on four straight days the following Monday to Thursday.  We look for yet another record run of US$122 billion of gross issuance, a US$7 billion 5-year TIPS, US$44 billion 2-year, US$41 billion 5-year and US$30 billion 7-year, which would all be US$1 billion bigger than last time.  The budget deficit this year and corresponding funding needs are likely to be somewhat smaller than the records seen in fiscal 2009, but with the Treasury determined to reverse the major shortening in the duration of the outstanding Treasury debt that has occurred over the past year, the amount of duration the market will need to absorb in the coming year will likely be a lot higher than in fiscal 2009 even with somewhat lower overall issuance.  At this point, we see gross coupon issuance surging to US$2.5 trillion in F2010 from US$1.8 trillion (already a record by a very wide margin) in F2009, with an offset from an expected large paydown in bills.  Other data releases due out include PPI Tuesday and leading indicators Thursday:

* We forecast a 0.4% decline in the overall producer price index in September and 0.1% increase in the core.  A partial pullback in gasoline prices - on the heels of a steep run-up last month - should help to drive the headline PPI into negative territory this month.  Meanwhile, a seesaw pattern in the motor vehicle category has been helping to generate considerable volatility in the month-to-month movements in the core PPI.  We're assuming that things settle down this month and thus look for the core to come in close to its underlying trend.

* We look for a further rebound in September housing starts to a 615,000 annual rate.  The inventory of unsold new homes has plummeted and thus has helped to spur a mild recovery in new construction relative to the extremely depressed pace of activity seen earlier this year.  Indeed, the volume of starts seen in August was up about 25% relative to the April lows.  We look for another modest 3% uptick in new housing construction in September, with the upside concentrated in the single-family category.

* We look for a 0.9% surge in the index of leading economic indicators in September, which would represent the sixth consecutive monthly increase.  Over that timeframe, it appears that the index will have posted its sharpest rise since 1983.  In September, the big positive contributors are the yield curve, consumer confidence and jobless claims. It looks like the only meaningful negative will be the workweek.

* We look for a modest 3% rebound in existing home sales in September to a 5.25 million unit annual rate, which would be consistent with the steady climb in new purchase mortgage applications seen over the course of recent months.  Also, while some might point to the very sharp jump in the pending home sales index for August, it's worth noting that we no longer use that gauge as an input to the sales forecast because the statistical relationship between the two series appears to have broken down.

 

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