Japan
Recovery Losing Steam: December Tankan Preview
December 04, 2009

By Takehiro Sato | Tokyo

Recovery Slowing Even at Large Manufacturers, While Firms Tied to Domestic Demand Are Still Being Left Behind

We expect the December Tankan survey to show a stalling pace of improvement in export sector sentiment, and continued weakness in the domestic demand sector. A modest improvement in the headline number (DI for large manufacturing firms) has already been discounted by the markets, making a positive surprise unlikely. We think business plans for F3/10 will basically be left unchanged despite another overshoot relative to guidance for earnings in the July-September quarter, given concerns about the strong yen and an outlook for deceleration in overseas economies. Ultimately, worries about the sustainability of sales recovery and cost cutting in 2H persist, and will be reflected in corporate sentiment.

Business Conditions DIs: Headline Improvement to Slow

We expect the Tankan headline (business conditions DI for large manufacturers) to pick up from -33 in the September survey to -28, but this would represent a slowing rate of improvement. This is a reaction to the waning in October-December of production and export recovery momentum brought by restocking of sales inventories overseas. Meanwhile, we expect the outlook DI improvement trend to stall to a reading of -25 amid concerns about the sustainability of external demand and the strength of the yen. For large firms in non-manufacturing, we look for the current DI to remain close to the past trough, moving from -24 to -25, reacting to feeble domestic demand in the private sector.   We also expect the SME (small and medium-sized enterprise) DI overall to tread water or worsen marginally, in light of the cautious grass roots sentiment in the Economy Watchers Survey and Shoko Chukin Bank's Business Survey Index for SMEs.

Despite the recent move up in commodity and energy prices, we expect the input and output prices DIs to imply overall margin deterioration due to intensifying downward pressure on prices for end products brought by the retreat in domestic demand.

Measures related to the output gap such as the production capacity and employment DIs are likely to clearly highlight that the capacity surplus is peaking out. Already capex decline has tailed off in July-September, and employment-related indicators have picked up for three consecutive months. However, it is premature to say that labor market conditions have improved meaningfully, and we expect the Tankan to confirm that companies are taking a cautious approach to employment.

Our Forecast for F3/10 Management Plan Revisions

1) Sales/profit plans to be largely unchanged: Results for July-September again surpassed guidance, but given changes in the external environment such as the stronger yen, we expect companies to be increasingly conservative. Consequently, profit plans (large companies, all industries) which were unexpectedly lowered in the September Tankan to -22.0%Y (revision rate from the June survey: -2.8%) will probably not be revised up this time.

The likelihood is that recovery momentum in Japan will ease from October-December as policy stimulus fades, and there are fears too that international financial markets will receive another jolt as credit concerns escalate for certain emerging markets. In this context, it is rational for companies to worry about demand sustainability. The strength of the yen is also hurting export profitability. In our simulation, the export profitability rate for manufacturing overall is about ¥94 during the October-December quarter and the improvement in this rate is slow. The reason is that the rebound in operating rate is sluggish, and elevated fixed-cost ratios are pushing up companies' break-even points.

Also note that while the profit plans of large companies look rosy in comparison with our cautious top-down forecast (parent-based recurring profit to drop 25%Y), a vexing gap between consolidated and parent data prevents a straightforward comparison.

2) Capex plans of large firms likely to continue to be trimmed: Large firms across all industries called for a 10.8%Y drop in capex in the September Tankan (revision rate from the June survey: -1.5%), as plans were lowered further. The pattern of past revisions indicates that when plans are reduced in September, there is little chance of an upward revision in the December survey which reflects 1H results. GDP data for July-September confirmed that the capex decline is being arrested, but we think that further cuts to full-year plans are likely ahead.

The sluggishness of the current rebound in operating rate explains why capex plans have been cut. October data for industrial production suggest that the pace of output increase in October-December might slow sharply. The operating rate will be about 66% for the quarter at best, slowing in similar fashion to the production recovery. With the recent yen strength and weaker recovery momentum in leading international economies as the pace of restocking moderates presenting new risks, the hurdles to higher levels of capacity utilization are rising. We expect capex demand other than upgrade investment in non-manufacturing sectors (electric power, telecom) to remain sparse for the time being.

Overall, we are expecting the capex plans of large companies (all industries) to call for a year-on-year drop of 11.4% (revision rate: -0.8%), comprising -27.4% for manufacturing (revision rate: -2.3%) and -2.2% for non-manufacturing (revision rate: -0.1%).

Policy Implications: Possibility of Additional Easing Continues to Be Aired

At the special MPM on December 1, the BoJ announced an effective revival and expansion of the special lending facility for corporate financing that it agreed at the October MPM to end by the end of F3/10. The BoJ will provide three-month term money at a fixed rate of 0.1% and up to ¥10.0 trillion, thereby eventually forcing down term rates. Increased JGB buying and a rate cut, which market participants were hoping for, were passed over.

Based on the series of events, however, the BoJ indicated that it could opt for further measures depending on government pressure. In this sense, we doubt that the December 1 special MPM marked the end of the easing. We should highlight also potential for the economy to further slow in the January-March quarter, and for recovery in prices to stall.  With the economy at a standstill, we expect delayed improvement of the output gap to keep baseline prices (core-of-core) in deep negative territory. We believe that the DPJ government will see this as an intensifying issue ahead of the Upper House elections in July 2010, where it feels its top priority is to win a majority. Given the above, we outline four options on the menu for more accommodative policy ahead, in order of likelihood.

1)         Enhanced provision of ample funds ahead of year-end and fiscal year-end: This is the most realistic and likely step, in our view.

2)         Repeated rollover of JGBs held by the BoJ: This would have the same economic effect as an increase in short-dated JGB purchasing to reduce the amount that needs to be absorbed in the market. We could also see stepped-up Rinban operations (JGB purchasing), but long-term yields are coming back down and from the perspective of JGB market stability, we think this is unlikely at the moment. That said, increased Rinban operations could be seen as a substitute for short-term market operations from the perspective of supplying liquidity.

3)         Unsterilized FX intervention: This would require a change in the currency policy of the Ministry of Finance and intervention in forex markets, because there would be an essential contradiction in the government pursuing a strong home currency despite having declared that Japan is in deflation.

4)         Stronger commitment to policy duration and rate cut: The probability of a rate cut has diminished, but this remains possible depending on equity and forex markets.

We think the first two measures above are likely, and that the first half of 2010 is the probable timing. However, the market may well regard this as insufficient, if the government is serious about tackling deflation.

Ultimately, if the government is serious about beating deflation, it could adopt an inflation target. To date, the BoJ has consistently played down this option, maintaining that under deflation there is no means of achieving an inflation target. However, Japan could follow the example of the UK, where the government has set an inflation target but handed the central bank a mandate to achieve it. As market expectations for inflation would kick in under these circumstances, the BoJ would likely respond by buying more JGBs. The government/MoF could then revise their strong yen policy, in line with the easing options listed above. A policy of support for the home currency during deflation represents a contradiction. The macro policy consistent with escaping deflation is a combination of further monetary easing with a weaker home currency. We are expecting Japan's macro policy to turn in this direction in 2010.

Important Disclosure Information at the end of this Forum

UK
Later 2010 Rate Rises
December 04, 2009

By Melanie Baker & Cath Sleeman | London

Changes to Our Forecasts

We continue to think that the MPC will not extend QE in February, but this is contingent on seeing relatively strong 4Q GDP growth.  We have pushed back the timing of a first rate increase by the MPC from May to 4Q10, after a period of ‘monetary policy calm'.  Thereafter we have assumed a less front-loaded pace of rate increases.  However, the path for monetary tightening will be particularly dependent on fiscal policy decisions. Our new outlook has the first rate increase about the same time as consensus expects, but a somewhat slower pace of rate increases thereafter.

A Different Take on the MPC Reaction Function

There are three reasons why we have pushed back our ‘first rate increase'. First, and most importantly, we have changed our view as to how the MPC reacts to its inflation outlook.   Rather than just do enough to get inflation back to target in the medium term, the MPC appears to be more concerned than we'd expected about the amount of time that inflation spends below target on its forecasts.  Second, it is now clear that fiscal policy will be close to front and centre of parties' election campaigns.  If we assume a May election, it will take several months for the dust to settle, during which the MPC would not wish to make its first hike. Third, we think that GDP growth will disappoint the MPC over 2010 as it looks ahead into 2011.

1) Doing More than Enough to Get Inflation Back to Target

The MPC has been willing to purchase very large amounts of assets to be ‘more sure' of meeting the inflation target.  Its discomfort at the length of time inflation spends below target has been greater than we'd expected.  Broadly, the MPC appears to be have been less worried than we'd have expected about the upside inflation risks from its extraordinary actions.  A later first rate rise and a more gradual profile for interest rates now seems more likely to us:

•           Inflation above target in two years' time... The MPC's central forecast for inflation is above target (2.35%) and rising sharply at the two-year horizon in the case where monetary policy is unchanged over the next couple of years (i.e., interest rates stay at 0.5% and QE at £200 billion).  That might still have been the case we think even had the MPC not extended QE in November. 

•           ...but discomfort at the time inflation spends below target: It appears that discomfort at the amount of time inflation spends below target on the MPC's forecasts was a factor behind extending QE in November.  This, and the related balance of risks, appear to have been more important considerations than ‘most likely' meeting the inflation target in the medium term. 

•           We think that inflation will spend a long time below target: On our existing forecasts, inflation spends a long time below target (the last few months of 2010 and almost all of 2011) and only just meets the target at the start of 2012.  That now sounds like a profile the MPC would be rather unhappy with, suggesting that later rate rises now look more likely than on our existing forecast.  See CPI Inflation Starts a Steep (Brief) Ascent, November 17, 2009, for our own inflation forecasts.

2) A Period of (Monetary Policy) Calm Waiting for the Political Dust to Settle

We face several months of calm on the monetary policy front.  Barring a further sharp deterioration in the UK economy, we think it would be rather unwise to extend QE still further (see QE: Necessary, Successful and Ready to Withdraw, November 23, 2009).  But a policy tightening looks some way off.

The Bank of England's MPC normally makes major decisions on monetary policy when it releases its quarterly Inflation Report, following a round of in-depth forecasting. We think that the decision to tighten monetary policy will be made at one of these meetings.  The outlook in February 2010, the date of the next Inflation Report, is likely be clouded by the rise in VAT to 17.5% (from 15%) in January and the distortive effects that this will have on data in 4Q and 1Q10.  The subsequent Inflation Report, in May, could well coincide with the General Election (although the timing of this is very uncertain).  The Bank of England would probably baulk at taking such an important monetary policy step then, particularly given the significance of fiscal policy for the economic outlook. 

Current polls suggest that the most likely possibilities are a majority Conservative government or a Conservative-led coalition/minority government.  A lot could change between now and then, but either of these two outcomes would likely make August 2010 the first date when a monetary policy tightening is seriously considered.  The leader of the opposition Conservatives, David Cameron, has said that he would hold an emergency budget within 50 days of the election.  On top of this, any coalition government would presumably take some time to form a detailed fiscal programme.  Assuming a credible, but not heavily front-loaded tightening, a May election and benign market response (a lot of ifs), we ‘pencil in' a first rate rise for 4Q10 (i.e., after we have more clarity on the economic outlook and fiscal policy specifics).

3) Real Economy Conducive to ‘Lower for Longer'

Given how deep policy is into ‘unconventional territory', we think that the MPC will want to get back to a more normal policy setting sooner rather than later once there is evidence that the economy is on a firm, sustainable path to recovery.  However, this could be ‘later rather than sooner':

•           We expect a sub-par recovery: Unless we get a very sharp pick-up in net exports, growth seems likely to be weak.  Incentives for firms to invest are limited by significant amounts of spare capacity, and in the case of smaller companies they are limited by difficult credit conditions.  Further, we think as a global team that double-dip fears will persist throughout 2010 as different economies roll off various stimulus programmes.  Such economic uncertainty will further limit incentives to invest.  Incentives for households to spend are likely to be limited by concerns on fiscal tightening (public sector job losses and possible further tax increases), increased incentives to save (greater economic uncertainty compared to pre-crisis levels, high levels of indebtedness relative to income, significant amounts of negative equity in homes and continued tight credit conditions for unsecured borrowing in particular).  Public spending and investment are likely to directly detract from, rather than add to, GDP growth over the next few years.

•           Near-term growth risks could prompt even more QE: For the MPC to raise rates in 2010, the UK needs to emerge convincingly from recession.  The weak 3Q GDP number, it appears, was a factor behind the MPC's decision to extend QE in November. If GDP in 4Q significantly undershoots the MPC's central forecast (-2.7%Y mode, -2.8%Y median - the latter would imply +0.6%Q for 4Q GDP), then it might do more QE.  While we think that GDP growth will be positive and not far from the Bank of England's central forecast in 4Q, the UK economy is not in a healthy state and has the capacity to disappoint again.

•           Growth could continue to disappoint the MPC: GDP growth may continue to disappoint the Bank of England's forecasts.  We think it probably will, though more in 2011 than in 2010. For one, the BoE's projections do not incorporate any more fiscal tightening than what has already been announced.

•           Political consensus for significant fiscal tightening: The likely tightening in fiscal policy will contribute towards a relatively weak, sub-par recovery over the next couple of years, in our view.  All parties seem to agree that there needs to be significant fiscal tightening; the biggest disagreement (at least on the surface) relates to timing, with the Conservatives appearing to favour earlier, more front-loaded action.  Heavily front-loaded fiscal tightening (by which we mean additional tightening that takes effect in 2010, for example a possible further rise in the VAT rate, and with the brunt falling in 2011) would push back the first interest rate rise, potentially into 2012, we think.  Such a front-loaded fiscal tightening would risk a second dip, creating a W-shaped recession, and interest rates would then stay flat, at least until the economy's reaction to the fiscal measures become clear.  Successful programmes of strong fiscal tightening (e.g., Canada in 1990s) have been accompanied by loose monetary policy. 

But There Is Still a Risk the MPC Tightens Sooner

An early election combined with a relatively gradual planned fiscal policy tightening could bring forward the timing of the first rate increase.  Should more channels of the monetary transmission mechanism show signs of stirring (particularly faster lending growth), that could also push the MPC into early action.  Any signs of medium-term inflation expectations rising (especially on the part of households and businesses) would prompt swift action from the MPC, in our view.  As would a sharp further decline in sterling and/or a sharp re-pricing of government debt that reflected inflation concerns (for example as a result of market disappointment at a lack of fiscal tightening). 

Ifs and Buts - the Role of Fiscal Policy

Any forecast for monetary policy tightening (and for the economy) over the next couple of years relies on taking a view on the timing and outcome of an election in a way that it has not done for several years.  Fiscal policy issues so far look likely to be front and centre of the major parties' election campaigns.  However, the detailed fiscal policy decisions on tax and spending may not become clear until after the election, no matter which party wins. 

Don't Rule Out Lower Reserves Remuneration

The November MPC minutes implied that members thought lowering reserves remuneration was a potential policy tool but one that they did not want to use "at the present time".  We continue to think that lower reserves remuneration, particularly if it involves readopting the old ‘Red Book' framework, makes more sense when QE is not being conducted (see Reserves Remuneration, October 2, 2009).  The MPC also noted that asset purchases "were currently a more effective instrument for affecting monetary conditions" and that "such an action would be unlikely to have a significant impact on the outlook, given the already low levels of short-term market rates" [our italics].  At the risk of reading too much into this, it suggests to us that, if short-term market rates start to rise before the MPC is ready to tighten policy, then lowering remuneration on a portion of reserves is much more likely to happen.  This could help to put a cap on short-term market rates.

Exit Strategy - Beyond Interest Rates 

We have a (very contingent) forecast for a first rate increase in 4Q10 and assume that asset sales will start at the same time.  However, any such sales are likely to be rather gradual to avoid significant disturbances in the gilt market, given the likely environment for issuance next year. Our interest rate strategists point out that net gilt issuance less Bank of England asset purchases in 2009/10 will be almost zero. In 2010/11, that looks set to jump to nearly £180 billion (assuming that the BoE does not extend QE in February).  Hence, we expect interest rates to be the main instrument for monetary policy tightening.  However, interest rates don't have to rise on the same timetable as assets are sold.

Asset purchases may start to unwind slightly earlier: UK banks need to build up their holdings of liquid assets.  It is plausible that in 2010 we could see some swap of commercial banks' holdings of reserves at the central bank for (central bank) holdings of gilts.  That would be a rather neat way for asset purchases to unwind without causing a major disturbance in the gilt market.  This would be more likely to occur if the prices of risky assets continued to rise well into 2010, persuading the MPC that it ought to reduce the amount of generalised liquidity in the system.

Governor King on reversing QE: In testimony before the Treasury Committee, Governor King suggested that he thought there was not an enormous difference between raising the policy rate and reversing QE, that the transmission mechanisms are similar.  However, we'd point out that raising the policy rate will have a direct (and quick) effect on the cost of many existing household mortgages in a way that asset sales are unlikely to.  If the BoE decides to tighten monetary policy at some point over the next 12 months, it may prefer to start reversing QE ahead of raising rates, particularly if any new fiscal policies are likely to hit household finances directly (e.g., a significant reduction in family tax credits, or rise in VAT).

Other support measures have end-dates or will wind down naturally: Other financial sector support measures, such as the SLS, have planned end dates (January 2012 in the case of the SLS) or demand should reduce naturally as the financial sector recovers (e.g., extended collateral long-term repos).  In the case of the latter, the BoE sets a minimum yield for bids involving wider collateral. It sets this at a level such that in non-stressed conditions it thinks it should encourage banks to finance collateral in the private repo markets.

Our New Central Forecast for Interest Rates

Assuming we get no significant disappointment in 4Q GDP, a further extension to QE seems unlikely to us. We have, however, pushed back the first rate rise until 4Q10, and that's due to three factors: the MPC's apparent discomfort with the time inflation is likely to below target, a number of timing issues related to fiscal policy and our expectation that the recovery will be weaker than the MPC is expecting.  On our new forecasts, rates end 2011 at 2.25%, though the rate profile is contingent on not seeing a heavily front-loaded fiscal tightening.  Our revised outlook means that the UK's monetary policy tightening will lag the tightening in the euro area and in the US. This supports our strategists' view that sterling will weaken further before recovering and complements our fixed income strategists' view that gilts will outperform Bunds. 

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. Incorporated, and/or Morgan Stanley C.T.V.M. S.A. and their affiliates (collectively, "Morgan Stanley").

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosure for Morgan Stanley Smith Barney LLC Customers The subject matter in this Morgan Stanley report may also be covered in a similar report from Citigroup Global Markets Inc. Ask your Financial Advisor or use Research Center to view any reports in addition to this report.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.