We were in Kuala Lumpur for two days on a fact-finding trip, meeting with political analysts, economists, manufacturers, banks and property corporates/consultants. Apart from the usual cyclical signposts, we were also looking for tell-tale signs of a structural inflexion point. In fact, we think the latter is the more crucial story. As we highlighted before, structural weakness such as the education system, affirmative action policies, declining competitiveness and, as a result, weakening FDI trends and manufactured export share have been some of the key bugbears for Malaysia's asset markets. Longer term, growth also seems to be on a structural decline.
Post-trip, we came away with the sense that a cyclical turnaround is still panning out. In fact, previous cutbacks have now resulted in some resource constraints as new orders came back. Meanwhile, unlike some ASEAN economies where policymakers face the dilemma of needing to lean against a potential asset market bubble amid a tepid macro recovery, the real estate market in Malaysia has in comparison been relatively more subdued. On the structural front, most are of the view that the announced reform measures are well intentioned. Yet, some point to the disparity between policy rhetoric and policy action. In other words, effective implementation remains the key. We are far from turning bullish on Malaysia's structural story, but the change taking place at the margin makes us less bearish than before.
Below Are Our Key Trip Takeaways
Takeaway 1: Cyclical Turnaround and Some Resource Constraints in Manufacturing
The cyclical turnaround is still panning out, thanks to new export orders and restocking. Non-commodity exports have troughed out in January 2009 (which stood at a decline of 35.4% from the peak) and are now standing at 25.3% below the pre-crisis peak levels in May 2008. Indeed in 4Q08, cost measures were taken, e.g., reduction in compensation/overtime, layoffs, shorter work-weeks and plant shutdowns. Now, however, double work-shifts are back and full-hour work-weeks have resumed. Given the previous cutbacks in human resources and rundown of raw materials inventories, industry insiders point out that shortages in these areas have arisen in the past few months. In particular, the manpower shortfall had been aggravated by relatively high turnover as foreign hiring is discouraged but locals prefer to be in the service industry where there is generally no shift-work.
Anecdotally, we hear of how Malaysia has benefited, in some areas, from consolidation elsewhere in the developed world and some parts of Asia. For these corporates where Malaysia has indirectly gained market share and for corporates where it had been previously planned, some capex expansion has been underway. For others, a sense of caution regarding demand sustainability is still prevalent and expansion plans have not come back in a significant way, given the unstretched capacity utilization.
Takeaway 2: Unintended Monetary Tightening?
On the banking sector front, Malaysia did not have a big credit cycle before the turmoil began. Credit growth peaked at 12.8%Y in December 2008. Similarly, the credit deceleration during the downturn had also been relatively mild at 7.5%Y in October 2009. Meanwhile, irrational loan pricing continues to reverse as banks try to stem returns dilution after accounting for credit costs, overhead costs and cost of funding. This is particularly so in household loan products such as hire purchase rates and mortgage loans. Indeed, another round of increase in hire purchase rates (for autos) panned out in late 1Q09/early 2Q09. Indeed, at one point, banks had priced hire purchase rates lower than mortgage rates even though the former tends to be more risky. Recently, mortgage loans were also repriced. In mid-2009, the lowest mortgage rates stood at base lending rates (BLR) less 2.5% and the average stood at BLR less 2.1-2.2%. Mortgage rates have now been repriced upwards by 60-80bp, with the lowest mortgage rate standing at BLR less 1.7-1.8% and the average rate at BLR less 1.5-1.6%.
In our view, Bank Negara Malaysia (BNM) is one of the more dovish central banks in the region. Inflation is still subdued and even when it is reversed, owing to base effects or a possible change in retail fuel pricing as indicated by the policymakers, we suspect that BNM is unlikely to react to the statistical effect or the policy-induced price uptick, preferring to react only to second-round demand-pull inflation. Hence, we think that BNM is likely to start on monetary policy normalization only in 2H10. In this regard, the reversal in irrational loan pricing, to a small extent, has the unintended consequence of an earlier-than-expected de facto monetary policy tightening. However, given that it is the discount to BLR that has been adjusted rather than the BLR rate itself, the higher rates will apply only for new takers of mortgage loans rather than for the existing stock of borrowers.
Takeaway 3: No Signs of Real Estate Asset Reflation Posing Challenges to Policy-Making; KLCC Condominium Supply Remains an Issue
Condominium launches in the KLCC area have slowed down due to concerns about supply. Anecdotally, we understand that high-end condominium prices currently average at about RM1,000/psf compared to RM1,450/psf at the peak. Indeed, BNM, unlike other policymakers in the region, has not had to contend with the dilemma of dealing with rapid asset reflation amid a still tepid macro recovery. With foreigners making up 30-40% of the purchases (as developers' past strategy had been to take it to foreign markets first), the average occupancy rate for high-end condominiums stands at around 30-40% despite previously high take-up rates.
In terms of the rental market, on the supply side, cash-rich foreign and local investors seem less worried about whether they are able to lease out their units, even though developers have concerns that untenanted units may become a security risk. This has provided a cushion to condominium rents even though, on the demand side, the quality of the expatriate base seems less able to support housing rental in the range of RM10,000-15,000/month.
Meanwhile, in office space, oversupply also remains a concern in the Klang Valley. The occupancy rate stands at around 81% currently. According to Jones Lang Lasalle data, around 60 million square feet of incremental supply will come on stream in the next two years, representing an increase of about 71% on the existing stock of 84 million square feet of office space.
Takeaway 4: Looking for the Structural Inflexion Point
In terms of the structural aspect, we sense a general agreement that PM Najib has been undertaking incremental well-intentioned reform efforts. An international public relations firm has been hired to overhaul the image of the policymakers. Divisive issues have been avoided. De-ethnicization of Malaysian politics may now be underway. The affirmative action policies in favor of the bumiputras have now been replaced by the more inclusive Malaysia. Reform measures such as the liberalization of the financial sector, relaxation of the bumiputra equity requirement ratio and the implementation of the National Key Results Areas have been undertaken. Unlike some of his predecessors, PM Najib also appears to have built better international relationships.
Inevitably, the crux of reform measures boils down to the execution and the consistency of policy action with policy rhetoric. Sceptics point out that old guards in the government may impede execution and that some policy actions have diverged from policy rhetoric. On the other hand, optimists believe that reform measures may start as political rhetoric but would gain substance over time. After all, policymakers need to undertake a certain critical mass of reforms ahead of the next elections in 2013, if they want to stay in power.
We are far from turning bullish on Malaysia's structural story. We think that some measures which have been announced (such as the switch in teaching medium for Science and Mathematics to Bahasa from English) have been less ideal than others. However, we became less bearish than we were before during the past 1-2 quarters, as measures were announced. In our view, the combination of the weak election results in March 2008 and the emergence of alternative parties to the incumbent Barisan National Government is more likely than not to force some change at the margin.
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Longer-Term Fiscal Challenges
December 01, 2009
By Marcelo Carvalho | Sao Paolo
While ongoing fiscal expansion could increase near-term policy tensions within the administration, we suspect that underlying longer-term fiscal trends pose challenges too. Despite abundant signs of strong domestic recovery, the fiscal authorities continue to increase the fiscal stimulus. In late November, the authorities extended into next year tax breaks that were initially scheduled to end this year, on top of new tax breaks, including on vehicles, furniture and construction material. This is in addition to the previously announced extension of tax breaks on white-line durable consumer goods. The estimated fiscal cost of the latest measures is not large, at R$2.2 billion, or just about 0.1% of GDP. But the policy signal is clear - fiscal policy is unlikely to tighten anytime soon. Fiscal easing can complicate matters for monetary and foreign exchange policies next year - as we discussed last week (see "Brazil: No Fiscal Exit", EM Economist, November 27, 2009). But this week we want to turn to Brazil's underlying longer-term fiscal challenges.
Three longer-term fiscal challenges stand out, in our view. First, the composition of Brazil's fiscal spending is far from ideal - social security expenses increase steadily over the years, while public sector investment remains desperately low. Second, Brazil's broader fiscal strategy does not look sustainable - relying on a steadily rising tax burden in order to finance ever-rising expenses is not a combination that can be sustained indefinitely. Third, recent changes in fiscal accounting rules are quickly eroding fiscal transparency - the authorities will eventually need to restore fiscal transparency and lay out a clear medium-term fiscal framework.
Challenge #1: Contain Non-Investment Spending
Fiscal numbers are worsening substantially. The primary surplus worsened to just 1.0% of GDP during the 12 months through October, down from a peak of 4.3% of GDP in the 12 months through October 2008. Once the burden of interest payments is added to the bill, the resulting nominal fiscal balance deteriorated to a deficit of 4.6% of GDP, from 1.3% of GDP a year earlier, in October 2008.
According to IMF data, Brazil's headline fiscal stimulus is among the smallest within G-20 economies. So, why worry? One problem is that while fiscal easing elsewhere is countercyclical and temporary, Brazil's increased spending is better described as a permanent increase in items like public sector payroll and social security - as opposed to an increase in public sector investment, for instance.
Brazil's headline fiscal stimulus does not look large by recent international standards, but its nature is different. Indeed, according to a recent IMF study (see "The State of Public Finances Cross-Country Fiscal Monitor", IMF Staff Position Note, November 2009), the composition of fiscal stimulus measures reveals that Brazil lags way behind other G-20 countries in terms of the role of investment in its fiscal expansion.
Brazil's long-term spending patterns look worrisome - especially social security trends. A recovering economy should help to support tax revenues next year, but the recent acceleration in federal spending underscores longer-term concerns. The sharp run-up in federal spending on wages is a relatively recent development, but it comes on top of secular rising trends in items like social security expenses. Indeed, we think that the underlying structure of the social security system is probably the Achilles' heel of Brazil's long-term fiscal prospects. Broad demographic trends turn against pay-as-you-go systems around the globe - in Brazil, the population aged above 65 years old is expected to grow about four times as fast as the overall population over the next decade. In addition, Brazil's social security system has its own idiosyncrasies. In the scheme for private sector retirees, relatively low retirement age requirements and the link to the minimum wage complicate matters. In the system for public sector retirees, generous rules for retirement bloat expenses. In both cases, the long-term viability of the current systems looks questionable.
By contrast, public sector investment remains too low, with federal investment running at about just 1% of GDP. Brazil's infrastructure needs are well known - ranging from roads, railroads, ports and airports, to energy and telecommunications. In order to sustain faster long-term growth, Brazil's public sector ought to be able to redirect its spending towards investment, especially in infrastructure.
Challenge #2: Curb the Tax Burden
Public sector debt dynamics are not an immediate threat. In fact, simple simulations suggest that, under plausible assumptions for real GDP growth and real interest rates, the primary surplus needed to keep the debt/GDP ratio stable falls mainly in the range of 1-2% of GDP.
However, Brazil's current fiscal strategy is not sustainable indefinitely. Maintaining a sufficiently large primary surplus in the context of steadily rising expenses is only possible if the tax burden also increases steadily over time. Brazil has followed this tax-and-spend strategy for many years already, but the tax burden is now already high and cannot simply increase forever (as a share of GDP).
Brazil's tax burden has marched up systematically over the last couple of decades, increasing from about 25% of GDP in the early 1990s to 36% of GDP in 2008. On recent trends, if left unchecked, the tax burden could easily exceed 40% of GDP within the next decade.
Brazil's tax burden is too high by international standards. Once adjusted for its per capita income, Brazil's tax burden should be about 10pp of GDP lower than it is now, if it were to fit a simple cross-country regression. In other words, Brazil seems an outlier - is a Latin country that taxes almost like welfare-state, mature European economies do, but without the provision of public goods seen in the old continent.
Brazil's public sector gross debt looks less encouraging than its headline net debt concept. Brazilian authorities have been successful in focusing observers' attention on Brazil's ‘net debt' as the main benchmark debt indicator. The net debt currently stands at 45% of GDP, as of October. However, according to central bank data, Brazil's public sector gross debt currently stands at 69% of GDP, not too far below the peak of 72% of GDP seen back in the tumultuous days of 2003.
Careful observers should probably watch both measures (gross and net) for a fuller debt picture. Besides the build-up of foreign reserves, the difference between gross and net debt reflects other assets of the public sector. For instance, when the Treasury issues debt in order to help fund development bank (BNDES) subsidized operations, the gross debt goes up but the net debt does not change immediately, although there is an implicit negative carry over time.
Brazil's public sector gross debt stock is not particularly low by international standards, at least among emerging market economies - this fact might work to limit room for much fiscal lassitude over time. According to IMF data, for instance, Brazil's general government gross debt at 69% of GDP is lower than the current average debt level of 99% seen in advanced G-20 economies, but higher than the 39% average for emerging G-20 economies. Similarly, according to computations from S&P, Brazil's gross debt is significantly higher than the median of 36% of GDP seen in investment grade countries with BBB ratings.
Brazil's high tax burden and its complex tax system also represent important microeconomic hurdles for doing business in the country. According to a World Bank annual survey on business environments around the world (Doing Business), Brazil ranks very poorly when it comes to taxes. Out of 183 countries, Brazil ranks poorly at 167, in terms of the amount of taxes and mandatory contributions on labor paid by the business as a percentage of commercial profits - Brazil pays 69% while the median country in the survey pays 41%. But the situation is much worse when it comes to the time it takes to prepare, file and pay (or withhold) corporate income tax, VAT and social security contributions. Here Brazil is hors-concurs, ranked very last (183). It takes companies in Brazil about 2,600 hours per year just to prepare, file and pay taxes, compared to a median of 224 hours in other countries. Here Brazil is a true outlier - it stands the equivalent of about ten standard deviations away from the median.
Challenge #3 - Lay Out Clear Medium-Term Fiscal Framework
Brazil's fiscal accounts are now less transparent than they were a year ago. It seems fiscal transparency has been the first casualty in the fiscal war to spur the economy. The authorities changed the official primary surplus targets, excluded the state-controlled oil giant company from the official numbers, introduced the concept of a ‘sovereign wealth fund' that allows fiscal results to be carried from one year to another, plan to no longer count as fiscal spending certain investments (the so-called Pilot Program for Investment) and then expanded this procedure to expenses in the context of the growth acceleration program (PAC).
In light of so many accounting adjustments, it has become much harder for observers to understand clearly the fiscal numerical outcome the authorities really plan to deliver, despite the official headline primary surplus targets of 2.5% of GDP in 2009 and 3.3% in 2010. It took several years of unwavering commitment and repeated compliance for the authorities to build confidence among market observers on the official fiscal targets. Sadly, the sense now is that the official fiscal targets do not seem to mean much anymore. Looking ahead, incentives for increased fiscal transparency and a clear fiscal exit strategy may prove low ahead of the elections in October 2010. But it would be important that the next administration improves fiscal transparency and lays out a clear medium-term fiscal strategy.
There is room to improve Brazil's institutional fiscal framework too. To cite one example, it would probably be a welcome development if Brazil managed to set up a non-partisan, independent technical body to run medium-run fiscal exercises and monitor near-term fiscal developments. For example, perhaps there are lessons Brazil could learn from the US experience with its Congressional Budget Office (CBO).
Fiscal policy could focus on enhancing potential long-run growth. Beyond simple debt dynamics or near-term fiscal stimulus, fiscal policy could shift its focus to promoting sustained long-term real GDP growth. Brazil's current heavy tax burden and cumbersome tax system, besides meager public investment in infrastructure, are probably a drag on the private sector's ability to grow faster. Also, rebalancing the policy mix with tighter fiscal policies could go a long way in consolidating structurally lower real interest rates over time.
Bottom Line
Whoever wins the October 2010 presidential elections, the new administration will face three main medium-term fiscal challenges when it takes power in January 2011, in our view. First, it will need to contain spending growth and re-think spending priorities. Besides improving efficiency in the public sector (in areas like health and education), the fiscal authorities will need to curb overall spending growth if they want to free resources to invest, especially in infrastructure. That will require addressing budget rigidities and mandatory earmarking, as well as social security reform. In fact, social security is probably the single most important challenge facing Brazil's fiscal accounts over the long run. Second, the new administration will need to curb the tax burden and simplify its arcane tax system, in order to limit the public sector's crowding-out effect and to improve the local business environment. Third, the authorities will need to lay out a clear medium-term fiscal framework.
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Review and Preview
December 01, 2009
By Ted Wieseman | New York
Treasuries posted big gains, led by the intermediate part of the curve over the past week in dead quiet holiday trading activity after another run of very strong auctions and a good flight-to-safety rally Friday, as the Dubai debt turmoil intensified what had already been an emerging trend over the prior week towards an unusually early move to de-risk and deleverage ahead of year-end. To this point, no matter how much supply the Treasury has come with, the demand has more than stepped up to take it down, with robust results in particular at the record-size 5-year and 7-year auctions, which drove this part of the curve to significant outperformance on the week. The 7-year sale Wednesday afternoon was especially impressive. It certainly wouldn't have been surprising in the least to see soft demand at an auction held in the afternoon on the Wednesday before Thanksgiving, but instead a nearly off the charts 72% of the record US$32 billion issue was awarded to final investors, who bid aggressively, as the auction was awarded 2.5bp through expectations. Economic data were actually quite positive on balance through the week but provoked almost no market reaction. Actually not much of anything provoked much market activity, as quiet as trading was. Even the Dubai situation didn't attract a lot of attention initially Wednesday in US trading before the few US investors that actually came into work on Friday were forced to react to some extent, given the much greater focus this situation naturally attracted in overseas markets while domestic market players were eating turkey. The Friday after Thanksgiving is one of the quietest trading days of the year, though, so we'll need to wait until Monday to see a legitimate US reaction to the Dubai World debt restructuring, as hopefully there is more clarity around what at this point still seems to be a pretty confused situation. There was some sense Friday though that because we had been in a bit of de-risking mode for a week already when the Dubai news hit, there might not necessarily be a big additional flight-to-safety bid beyond Friday's gains. The Dubai situation and any spillovers will still likely be the main market focus in coming days, but the economic data flow has been reasonably good recently and we expect will continue to be in the coming week. Particularly notable over the past week was a major improvement in the weekly jobless claims report that accelerated what had already been a three-month long improving trend confirmed the underlying turnaround in the labor market. Combined with what will likely be a significant positive swing in the seasonal factors in the employment report - which appear to have been unusually tough in October and September, masking the underlying improvement suggested by the claims numbers, but now swing around in the positive direction in November - we look for a notably less negative employment report on Friday. The past week also saw surprising strength in both new and existing home sales ahead of the initially scheduled expiration of the homebuyers' tax credit and on net positive results from figures bearing directly on 4Q GDP growth, which we now see running at +3.1% instead of +2.7% as a result of a flattening out in durable goods inventories after a run of big declines.
For the week, benchmark Treasury coupon yields fell 8-22bp, with the intermediate part of the curve outperforming, especially the 7-year. The old 2-year yield fell 8bp to 0.64%, 3-year 10bp to 1.14%, old 5-year 17bp to 2.00%, old 7-year 22bp to 2.67%, 10-year 15bp to 3.21% and 30-year 9bp to 4.20%. TIPS had their first week of meaningful underperformance in a couple of months, as they were unable to keep pace with such big nominal gains with commodity prices coming under pressure late in the week on concerns about the economic impact of the Dubai situation. The 5-year TIPS yield fell 10bp to 0.19%, 10-year 5bp to 1.11% and 20-year 7bp to 1.76%. Mortgages had a terrific week, keeping pace with the big Treasury market gains in the belly of the curve to drop yields towards historical lows. Current coupon MBS yields plunged about 20bp on the week to near 3.9%, back to the lows seen in the spring. Average 30-year conventional mortgage rates already fell to a record low, matching 4.78% the past week according to Freddie Mac's national survey, and if the additional upside seen Friday can be sustained in the coming week, new record lows should be hit in coming days. With such rock-bottom rates, prices holding at extremely low levels even after a continued recovery off the cycle lows that increasingly look to have been set in the spring after a fourth straight gain in the S&P/Case-Shiller home price index in September; and the extension and expansion of the homebuyers' tax credit, housing affordability is as high as it has ever been, so home sales should be well supported moving into 2010. In the near term, however, generally soft daily MBS origination activity recently and severe weakness the past few weeks in mortgage applications suggest that we will probably see a sizeable temporary retrenchment in sales in November and December after a spike in sales in October - +10% for existing home sales and +6% for new home sales - as buyers jumped in before the initially scheduled expiration of the tax credit at end-November.
Risk markets were mixed on the week after some fairly mild weakness Friday compared to more pronounced downside late in the week in overseas markets in response to the Dubai news. Stocks have only more or less stalled out the past week-and-a-half, so there doesn't seem to be any major movement out of equities ahead of year-end at this point, probably just a lack of new money coming in. The S&P 500 was flat on the week. Financials performed poorly, while more defensive areas like healthcare, telecom and utilities did well, and energy and materials were little changed for the week even after a negative response to Friday's commodity price softness. Credit did somewhat worse. After barely moving for several weeks, the investment grade CDX index widened 4bp Friday to 106bp for a 3bp widening for the week. The index opened Friday near 109bp after some notable weakness in European credit over Thanksgiving, but investors in the US appeared to be ready to try to fade the Dubai news to a significant extent, according to the flows our desk saw. High yield similarly saw a small net widening on the week after a Friday sell-off. The HY CDX index was 6bp tighter on the week at 659bp but swung somewhat wider for the week as a whole after the index lost a point Friday. The leveraged loan LCDX index did a bit better, holding on to a 2bp tightening to 563bp through midday Friday. Real estate derivatives markets performed relatively poorly on the week, though this did follow a strong run since early November (which in turn followed some major weakness from mid-October to early November, so things look fairly range-bound now on a couple of months' view). Aside from a small uptick in the junior AAA index, the commercial mortgage CMBX market was weak, with the AAA index down a point to 78.58. The AAA subprime ABX index similarly fell 0.78 point to 30.06.
After the as-expected-downward revision to 3Q GDP growth to +2.8% from +3.5%, it now looks like there will actually be a slight acceleration in 4Q, though this continues to look like an unusually weak recovery and far from the V-shaped rebound typical after such a severe downturn. The trajectory for final sales looks a bit weaker in 4Q after the past week's data, but the inventory contribution is significantly bigger, leading us to boost our GDP forecast to +3.1% from +2.7%. Real consumer spending jumped 0.4% in October, as expected, but the ramp heading into 4Q was a bit weaker, thanks to a slight downward revision to September spending to -0.7% from -0.6% (reflecting the cash-for-clunkers auto sales payback that appears to have been largely reversed in October and November). We now see consumption rising 2.0% in 4Q instead of +2.2% after a downwardly revised 2.9% gain in 2Q - certainly an extremely muted recovery after the worst annual decline in 50 years through 2Q, but this trend of unusually restrained consumption will probably continue for some time as credit remains tight and consumers deleverage and raise savings. The outlook for 4Q business investment also continues to look sluggish after non-defense capital goods ex aircraft shipments fell 0.2% in October following a 0.3% gain in September. We see business investment in equipment and software falling 1% in 4Q after a puny 2% rebound in 3Q. Continued-much-weaker results for structures should lead overall business investment down about 3% in 4Q on top of a 4% drop in 3Q. On the positive side, durable goods inventories were surprisingly flat in October after a run of major declines, averaging 1.3% a month in the first nine months of the year, pointing to another big add to 4Q growth from a slowed pace of inventory liquation (and note we're still likely to see a pretty severe pace of inventory destocking in 4Q, just a lot less so than the peak in 2Q). We see inventories adding about 1.6pp to 4Q GDP growth, up about a half-point from our estimate before the durables surprise, after a 0.9pp add in 3Q.
The economic calendar is busy in the coming week with the initial round of key data for November highlighted by what we expect will be a much less negative employment report. Developments in Dubai will also certainly be a major focus in coming days, as will initial anecdotal reports on the strength of the important Black Friday start to holiday shopping and then monthly sales results from most major companies Thursday. Key data releases due out include ISM, construction spending and motor vehicle sales Tuesday and employment Friday:
* We expect the ISM to dip to 55.0 in November. The results from the initial run of regional surveys was mixed - Empire down, Philly up, Richmond down, KC up - but showed movement toward better convergence in level terms across the various regions. We think this points to a bit of a pullback in ISM relative to the 55.7 reading seen in October. Production is likely to slip after an unusually large jump last month, but the inventory category should continue to move up toward the 50 breakeven threshold. Finally, the price index is expected to retrace the uptick seen in October.
* We look for a 0.3% dip in October construction spending. Construction activity showed an uptick in September following four consecutive monthly declines. However, we look for a renewed downturn in October. The weakness in the housing starts data point to some further moderation in the pace of increase in the residential category. Moreover, we look for continued slippage in commercial activity. Finally, there is little sign of any meaningful stimulus-related activity in the public sector, which remains quite soft.
* We expect motor vehicle sales to increase to a 10.7 million unit annual rate in November, as industry surveys point to a further uptick in sales after a big rebound in October to a 10.4 million unit pace. After the cash-for-clunkers surge over the summer, sales fell to 9.2 million in September, but there seems to have been some significant underlying improvement in recent months beyond the summer volatility.
* We forecast a 75,000 drop in November non-farm payrolls and a decline in the unemployment rate to 10.0% from 10.2%. This view is largely based on an analysis of the likely impact of seasonal adjustment. The seasonal adjustment process attempts to decompose a series into its trend, seasonal and irregular components and adjust for normal and predictable seasonality. The calculations are based on the patterns seen over the course of many years but place the most weight on the most recent observations. Because there was such a sharp drop-off in economic activity around this time last year (along with a more modest drop-off around the same time of the year in 2007), it seems that the seasonal adjustment process has identified some of the ‘real' decline in economic activity experienced in late 2007 and late 2008 as seasonal and is trying to adjust for it. In fact, the pattern of revisions to the seasonal factors for the payroll data over the course of recent months, the huge swing in the seasonal factor in November 2008, and the residual seasonal factor that remains for November and December 2009 point to significant upside influence on payrolls relative to that seen historically. The concurrent seasonal adjustment process that is used is likely to lead to sizable upward revisions to the payroll readings for September and October (totaling 100,000 or so). The seasonal bias impacting the payroll data also appears likely to have an impact on the household survey, and thus we look for a pullback in the jobless rate. Is the improvement that we expect to see in this month's employment data real? Yes and no. We believe there will be some upside bias in the November payroll data but that there was corresponding downside bias in October. So, some of the recent underlying improvement in employment was probably masked by inadequate seasonal adjustment. The revision process will smooth out some of this noise and the true trend in payrolls will be better evident after the November report. The story is not quite as straightforward for the unemployment rate because there are seasonal influences on both the numerator and denominator and because the BLS does not issue monthly revisions to prior data. So, it will take another month or two before we get a clear sense of the true underlying trend in the unemployment rate.
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