We are marking to market our 2009 GDP forecast to -2.5%Y from -3.5%Y, taking into account the strong momentum observed in the manufacturing segment in 3Q09. Indeed, manufacturing staged a strong turnaround, bolstered by the robust performance in the biomed segment, which provided a lift to headline macro numbers. As a result, the recently announced 3Q09 GDP growth of +0.6%Y (while lower than the advance estimate of +0.8%Y) had been significantly higher than the negative momentum embedded within the quarterly profile in our model. On the demand side, the bulk of the GDP revision is on the back of net external balance, which we now expect to shave a lesser 1.8pp off GDP headline, compared with -2.7pp previously. Today's revision will take us to the lower end of MTI's 2009 growth forecast range of -2.5% to -2.0%.
...but Still Keeping a Conservative View on 2010
Beyond the 2009 GDP revision, we reiterate our conservative outlook on 2010 and keep our 2010 and 2011 forecasts unchanged at 4.0% and 4.5%, respectively. In our view, the single-most important factor for the Singapore economy is the global macro outlook. As per the Morgan Stanley global economics team, the world is unlikely to return to the leverage-driven growth of 4.8% of 2004-07. A square-root shaped type trajectory with a dull global expansion of 3.7% for 2010 and 2011 is our base case assumption. Against this backdrop, external-oriented economies such as Singapore are unlikely to outperform domestic demand economies with favourable local dynamics.
Indeed, the recovery in Singapore will have to be export-led before spilling over to the domestic economy. To be sure, the export turnaround is panning out. Yet, the sustainability and strength of the turnaround remains in question. The biomedical segment, which has been underpinning the recent strength in manufacturing and export, is known to be very volatile. As it is, the latest October industrial production numbers show momentum slowing to +3.6%Y (versus an average of +15.8%Y in Jul-Aug 09) as biomed momentum tapered off sharply.
Export-Led Macro Recovery Likely to Be Uneven
Moreover, we believe that the export-led recovery is also likely to be uneven as capex recessions could persist for longer. Indeed, corporates have been making capex expansion plans right up to the Lehman event, predicated on trailing growth expectations, and Singapore saw the biggest property boom within ASEAN before the turmoil started. In this regard, macro activity will need to resume to levels closer to, if not more than, where they were prior to the sub-prime crisis before capex expansion will resume, in our view. Indeed, as a benchmark, in the 1995, 1998 and 2001 cycles, GDP saw 3-4 quarters of declines but fixed capex saw between 5-12 quarters of year-on-year percentage declines.
Separately, we suspect job creation could remain weak for a while amid the macro recovery. The recent downturn has been a ‘job-rich' one, as aggressive capacity expansion plans commissioned during the bull years were still being completed during the depths of the downturn and hirings had to take place in areas (such as pharmaceutical, chemicals, retail and hotel segments, etc.) where previously committed capex plans have come on-stream. Additionally, the government also operated as an employer of last resort and the Job-Credit Scheme also helped provide a cushion. However, this will have implications for the labour market going forward. A more resilient job market did not prevent adjustments from being borne out on the wage front as well as in terms of retail spending momentum. Going forward, to the extent to which corporates did not shed excess capacity, the incremental need to take on extra manpower during the upturn is also correspondingly lesser. Indeed, in our view, if hiring is ultimately tied to final external demand and with that capex expansion, the excess slack in the system and the time needed for capacity utilisation to normalise, we think that even when job declines eventually reverse, job creation could likely stay weak. With new labor market entrants every year, job creation has to reach a certain level below which the unemployment rate will still continue to rise.
Macro-Rebalancing Needed in a New World Order
From a structural perspective, the unwinding of the debt supercycle and the US consumer de-leveraging will spell a different era for export-driven economies like Singapore. To a certain extent, macro-rebalancing will be needed. Given the small domestic demand base, an export model is still likely to be pursued. However, policymakers are likely to move away from plain vanilla manufacturing export outsourcing to a model where policymakers play the role of a broker, bringing together relevant parties to develop next-generation products catering to the three secular trends of urbanization, ageing and growth affluence, thereby creating new demand for the existing industries in Singapore once these products are developed. Continued efforts at policy renewal should yield better growth prospects than not, but policy diversification will take time and we think growth adjustments during the global re-balancing interim is still inevitable in the short term.
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Recovery Losing Steam: December Tankan Preview
December 04, 2009
By Takehiro Sato
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.
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Later 2010 Rate Rises
December 04, 2009
By Melanie Baker & Cath Sleeman
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.
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