Latin America
Latin America: Abundance Forgives All
December 18, 2009

By Gray Newman & team | New York

Abundance is back: that should help Latin America surprise to the upside on growth and keep the region's currencies strong in 2010. The upswing in economic activity next year may be exaggerated as the region bounces off a weak base; we estimate that Latin America's largest economies contracted by 2.6% in 2009. Accordingly, we would caution against extrapolating from the 2010 growth record to construct a view that the region's long-term growth potential has improved sharply.  But starting points matter, and Latin America's starting point for 2010 means that it should enjoy a much stronger recovery than most developed economies.  After all, unlike many developed economies, Latin America is not saddled with significant fiscal costs to deal with a debilitated banking system, nor with the knock-on effects of a housing bubble that burst.

The Birth of an Asset Class

Latin America is also likely to benefit in 2010 for another reason: the birth of emerging markets as an asset class. It may seem odd to speak of emerging markets being born in 2009; after all, for nearly two decades now there has been a group of market strategists and economists who have identified themselves as emerging markets specialists.  But we would argue that for both good reasons as well as bad, a much wider group of investors are likely to treat emerging markets as an asset class in a way that had not taken place until today.  Indeed, we suspect that the single greatest beneficiaries of the Great Recession are emerging economies, which are likely to see increased investor interest translate into inflows.

There is good reason for this long-overdue recognition by a wider investor base of emerging markets.  Despite some setbacks and calls for greater protectionist measures, particularly in the past two years, the economic fact of global labor markets - linking primarily China, but also India and Central Europe and Russia to the developed world - remains largely intact.  And that, in turn, leaves most of Latin America as a beneficiary. 

However, we believe that there is some sloppiness in the evidence marshaled in favor of Latin America in particular and more broadly of emerging markets. The gap between growth rates in emerging and developed economies is likely to be exaggerated at this point in the cycle as Asia roars back, while the US and Europe are saddled with the clean-up costs of a credit bust.  Further, because the Great Recession was short-lived, it never tested our concerns that a prolonged global downturn could lead to severe deterioration within Latin America and many emerging economies. 

Our argument last year as we looked towards 2009 was that, given the trio of massive reserve accumulation, current account improvement and better fiscal results, Latin America had its house in better order than in decades and hence the shorter the global downturn, the better the region would emerge (see "Latin America: Sliding in 2009", EM Economist, December 12, 2008).  If the downturn was prolonged, however, we argued that Latin America would suffer disproportionately, given much more limited space for counter-cyclical fiscal policy and the limited traction of monetary policy in the region.  There would be less room for counter-cyclical fiscal policy, we argued, as risk-aversion would limit Latin America's access to greater debt financing just when it was needed the most.  And limited financial intermediation would likely play a role in weakening the traction of any attempts at accommodative monetary policy. 

As it turned out, the synchronized global downturn was short-lived, and it was China that began to lead other emerging economies out of the Great Recession.  Nonetheless, we still believe that the principal drivers of the better growth that Latin America enjoyed during the second half of the past decade were a series of external factors reflected in a period of favorable financial and credit conditions, strong global demand and a remarkable surge in the terms of trade.  Had the global downturn of late 2008 and early 2009 intensified and lengthened, we are not sure that the popular distinction between weak DM (developed markets) and robust EM (emerging markets) that is in vogue today would exist. 

The global environment, as outlined by our global team of economists at Morgan Stanley, should prove to be very favorable for Latin America in 2010.  Our global team expects the pace of the exit strategies in the developed world to be a "crawl" as central banks approach the exit in a "cautious, gradual and transparent manner" (see "2010 Outlook: From Exit to Exit", Global Forecast Snapshots, December 9, 2009).  With "fragility" remaining in the financial sector, our global team expects monetary policy to move only from "super-expansionary" to "still-pretty-expansionary".  This, in turn, should bode well for risk appetite, which along with the good growth recovery we expect for Latin America, should bolster investor interest in the region.

Risk to Abundance, the Risk of Abundance

We see two major risks to our forecast of good growth in Latin America in 2010 and strong currencies: one is external, the other internal. Because Latin America remains vulnerable to external conditions, if the global economy were entering into a period marked by excess savings, then this ‘paradox of thrift' could unleash a prolonged period of lower-than-trend economic activity.  Latin America's growth profile would also suffer.  Despite the recovery we are expecting in the region in 2010, we continue to monitor external conditions carefully.

The internal risk, however, is more dangerous precisely because it is less likely to be understood than the external risk around which a lively debate has already formed.  The internal risk could be called ‘the risk of abundance'.  Abundance forgives all.  This, in turn, can lead to a dangerous situation in which policymakers make poor decisions which investors initially overlook. There is already a debate among investors about the wisdom of some of the measures that Brazil has taken to reduce its exposure to inflows.  If, as we suspect, growth continues to surprise to the upside in Latin America, policy mistakes are likely to be forgiven - in the near term.  Unfortunately, this can set the region up for even greater policy mistakes. 

In the end, the greatest risk, in our view, is that the region's policymakers confuse the heady recovery likely to be experienced in 2010 with a path of sustainable, stronger growth, and this confusion leads to a failure to tackle the region's pressing structural reform agenda.  Much more needs to be done to raise human capital, boost public and private investment in infrastructure and strengthen further the framework for a greater competitive environment in Latin America. The ‘risk of abundance' is not only that progress on the reform agenda stalls, but also that counter-productive measures are taken that ultimately increase uncertainty in the region.  This is not our base case, but remains the risk that we think should be monitored most closely, especially in 2010 as growth rebounds.

Country Specifics

We expect Latin America to grow by at least 4.1% in 2010 and suspect that there is further upside risk to our forecast.  In every major economy in the region save one, we expect growth to surpass the latest consensus.  The only country where our forecast is not clearly above consensus is Brazil, where Marcelo Carvalho expects 4.8% growth in real GDP in 2010.  Consensus may have moved too fast in Brazil and may suffer a setback following the release of a not as strong-as-expected 3Q GDP report in mid-December.   

Indeed, in Brazil, Marcelo expects three main themes to capture observers' attention in 2010.  Marcelo is focused on the risk of greater policy interventionism, the need for the central bank to begin to use monetary policy to avoid an overheating economy and market volatility surrounding the October 2010 general elections.  All these concerns are already much talked about by investors in Brazil, but much less so among investors abroad, and are particularly absent as concerns among the larger new ‘non-dedicated' entrants to Brazil's markets.  We think that all three themes are worth watching carefully, but suspect that good growth in Brazil combined with a healthy appetite abroad for risk means that these concerns are not likely to substantially dent an increasingly upbeat attitude towards all things Brazilian.

In Mexico, Luis Arcentales is very constructive and highlights three reasons. First, recent manufacturing data and leading indicators in both the US and Mexico point to sustained momentum into next year; given the strong links between the industrial sectors in both countries, Mexico is poised to benefit from the rebound in US manufacturing output and sales of North American produced cars.  The improvement in export-linked areas of the economy should boost trade-related services and, over the course of next year, start to broaden into an improvement in domestic-focused sectors, for which Luis expects only a very moderate recovery at about half the pace of the past five years.  Second, Luis expects to see others revise upward their growth outlook for 2010 towards his 3.8% estimate, which, in turn, should translate into a strengthening of the exchange rate towards 12.5 to the US dollar.  Stronger growth should provide the authorities with additional fiscal maneuvering room.  Third, contrary to market expectations and despite the inflationary shock caused by the tax reform, Luis expects that Banco de Mexico will keep its policy rate unchanged at 4.5% next year because of the temporary nature of the shock, the ample slack in the economy and downward risk to fuel price adjustments next year, which represent the most important source of potential inflationary pressure. 

Chile's economy, after weathering the 2009 storm quite well, also seems poised to rebound briskly in 2010, according to Luis.  A great part of the recovery - we see real GDP rising 5.0% next year (from 3.8% previously) - will likely be driven by a powerful inventory cycle following the unprecedented destocking that began in 4Q08 and that knocked off over 5 percentage points from annual GDP growth in the past year.  Surveys of industry and retail indicate that inventories are no longer bloated.  Meanwhile, consumer confidence is back in positive territory, reflecting strong real wage gains, looser credit conditions and a mild turnaround in labor markets; this improved backdrop, in turn, should sustain modest gains in consumption.  Monetary policy is likely to remain accommodative throughout 2010 as the central bank is unlikely to begin tightening rates before 3Q amid signs of very subdued inflationary pressures and a strong currency, which is likely to reach 530 by the end of next year (from 590 previously).  In the political arena, the presidential succession process is unlikely to lead to any major shifts in the prudent set of policies that has served Chile well in withstanding the recent financial and economic crises.

Argentina should experience a modest rebound in 2010 on the back of improvement in external conditions, particularly commodity prices and a strong Brazilian economic recovery, according to Daniel Volberg.  Daniel now expects Argentina to grow by at least 3.3% in 2010, versus his previous estimate of 1.0%. Despite the modest rebound, Daniel warns that tax revenue growth should remain below expenditure growth through most of next year, contributing to further fiscal deterioration. Indeed, he warns that a fiscal shortfall is likely to be Argentina's main challenge next year, with provincial and federal fiscal positions rapidly deteriorating. This, in turn, should prompt the authorities to redouble efforts to regain access to debt markets, in part by restructuring the leftover defaulted debt, most likely in January. Although we estimate that Argentina will have enough internal resources to cover its debt obligations, the recent intensification of policy heterodoxy, our expectation of anemic recovery and a rising fiscal challenge may keep the balance of risks skewed to the downside in the next 12-18 months.

We expect a strong rebound in both Peru (4.9%) and Colombia (4.1%) next year on the back of a recovery in domestic demand. Daniel and Luis expect investment to be a key driver of growth in 2010 in both countries. However, with growth on the mend in Peru, Daniel warns that inflationary pressure is likely to begin to build in 2H10, and thus he expects the central bank to begin normalizing rates, hiking the target rate by 350bp to 4.75%. Meanwhile, in Colombia, Daniel warns that there has been disproportionate attention given to the restrictions on trade imposed by Venezuela.  But we suspect that the domestic recovery as well as continued healing in global markets should be relatively more important factors.  Given the more upbeat forecast for growth, we expect the central bank of Colombia to hike interest rates by 200bp to 5.5%, well in excess of most local forecasters, who are looking for marginal rate hikes of just under 50bp. 

In Venezuela, we believe that concerns in 2010 may remain focused on debt servicing as well as the possibility of a devaluation of the official exchange rate. Despite mounting imbalances in the economy, Guiliana Pardelli and Daniel Volberg consider that Venezuela should be able to avoid a severe debt problem or a sharp devaluation next year. With the markets - particularly crude prices - and the global economy healing, the authorities are likely to have enough maneuvering room to maintain their commitment to a fixed exchange rate at Bs$2.15 and thus prevent a more serious spike in already-elevated inflation. In turn, the extra revenues derived from higher crude are likely to allow the authorities to keep spending, maintain debt servicing and boost dollar sales, in order to diminish the gap between the official and the parallel market exchange rate.  While economic activity should improve, as private consumption recovers and government spending continues to rise, elevated inflation will likely continue to be a concern, amid loose monetary policy.

Bottom Line

Abundance appears to be back in Latin America.  Part of the recovery is simply a bounce after the decline in early 2009, but part of the strength in the region is also the consequence of its increasing ties to China as well as the relatively healthy state of the region's small but growing banking system.  While we believe that Latin America is still vulnerable to external conditions and we think it is far from settled how strong the global economy can be expected to be in 2011 and beyond, given the damage inflicted in the developed world from the Great Recession, it may simply be too early to expect those issues to come home to roost in 2010.  If the liquidity cycle remains intact - with the move to an exit more like a "crawl" in the forecasts of our global colleagues - then Latin America is likely to enjoy a heady recovery sooner and stronger than many expect.

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ASEAN
Prefer Domestic Demand Plays in a Slow and Steady World
December 18, 2009

By Chetan Ahya, Deyi Tan & Shweta Singh | Singapore

We Prefer Domestic Demand Secular Stories to External Demand Cyclical Stories

With global growth likely to stay modest as rebalancing adjustment gets underway, we favor domestic demand secular stories over external demand cyclical stories. Within ASEAN, Indonesia is the least export-oriented economy, with its export share standing at 27% of GDP, followed by Thailand (64%), Malaysia (90%) and Singapore (185%). The low export share in Indonesia should serve as a buffer against lower global growth trends in 2010-11 compared with 2004-07. In addition, on the domestic front, a confluence of growth-conducive factors such as demographic dividend/natural resources, a structural decline in the cost of capital and a strengthened political mandate should also help to push Indonesia towards its potential growth of 6-7% from 2011.

At the other extreme, Singapore remains the most exposed to the global cycle with its high export orientation. This exposure is further aggravated by policymakers seeming to have added more beta into the macro portfolio with the inclusion of highly cyclical industries such as financials and tourism. Moreover, the growth strategy of catering to global demand means that domestic demand has become less domestic in nature and is inevitably a function of the former.

We Prefer Net Commodity Exporters to Net Commodity Importers

In our view, near-term inflation could remain subdued. However, unlike in the last cycle, inflation pressures could come back sooner over the medium term as the one-off structural factors underpinning the ‘Goldilocks' nature of 2004-07, such as the entrance of huge excess capacity into the trading system (e.g., China), are no longer present. On near-term inflation, while core inflation is likely to remain relatively low, given the buffer from excess slack, headline inflation could see a step-up from a reversal in base effects from commodity prices amid the tight supply-side dynamics.

Based on the latest oil futures, oil prices could be expected to average US$84/bbl and US$87/bbl in 2010 and 2011, up from US$64/bbl in 2009. In this regard, we would prefer net commodity exporters over net commodity importers as a ‘hedge'. Malaysia and Indonesia are the top two net commodity exporters within Asia. Singapore and to a lesser extent Thailand are net commodity importers. Coincidently, net commodity exporters in ASEAN also tend to have a retail fuel subsidy system. Ceteris paribus, not only will there be a net transfer of commodity dollars from elsewhere to these economies, but the internal transfer of income from consumers to producers will also be mitigated, allowing the positive spillover from the commodity prices to be more widespread.

We Prefer Economies Where Policymakers Implement Aggressive Policies Could Offer More Domestic Demand Alpha

In ASEAN, we think 2010-11 will entail a phasing out of policy stimulus at a gradual pace. However, in the case of Thailand, the flow of events and the implementation timing of the second stimulus package mean that fiscal policy (including extra budgetary spending) is likely to get more expansionary in 2010 (versus 2009) while others are winding down their fiscal policies. Thailand is running an aggressive policy response because macro conditions have been dampened by the political climate. However, we think that the size of the stimulus package, the improvement in government execution, and the potential crowding-in from the private sector as improved execution is perceived as a pick-up in political conditions will mean that the policy response could offer the most alpha to domestic demand for Thailand. Separately, we prefer Malaysia and Singapore over Indonesia in this aspect. Malaysia is typically more fiscally accommodative, while Singapore has the strongest government balance sheet in ASEAN.

What's the Pecking Order?

Taking the above into consideration, we like Indonesia the most. Our rankings for Thailand, Malaysia and Singapore fall within a tight range. We see Thailand and Malaysia as offering similar growth prospects. However, we rank Thailand ahead of Malaysia because of the positive expectation gap (relative to the market's perception) that we expect on fiscal implementation. Lastly, we think that Singapore would find it hardest to extract growth in the global environment that we envisage.

What Are the Key Risks?

The risks around our global growth forecasts are evenly balanced. Similarly, the risks are also somewhat evenly balanced around our base case of 0%Y for 2009, +4.8%Y for 2010 and +5.4%Y for 2011 for ASEAN4 GDP. We remain comfortable with Indonesia being our top preference in our bull, base and bear case scenarios. On the other hand, while we are comfortable with our baseline, Singapore is where we run the highest possibility of being wrong, in terms of both growth revisions and ranking preference, due to its high-beta nature.

We think that the global rebalancing process needs time to bear fruit, which will have implications on the sustainability of a V-shaped trajectory beyond inventory adjustments. However, if we are wrong and upside risks do pan out, Singapore will benefit most, given its high-beta nature. Our preference rankings in this scenario would be Indonesia, Singapore, Malaysia then Thailand. Having said that, our global colleagues also note that even this blow-out scenario could be a short-lived growth spurt. Surging global growth could push up inflation and cause aggressive policy tightening in 2011. This could well push the global economy back into a more conventional, policy-induced recession in about two years' time. On the other hand, with the recent global recession having purged much of the imbalances, our global colleagues highlight that the main downside risk is now a premature policy reversal with macro fundamentals failing to grab the growth baton when that happens. In this scenario, our preference rankings would stay the same as in our base case.

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India
Growth Recovery Gathering Pace
December 18, 2009

By Chetan Ahya | Singapore & Tanvee Gupta | India

The aggressive global policy response to the 2008-09 economic recession has triggered a meaningful recovery almost synchronously around the world. India is no exception. Various economic indicators have been surprising on the upside, confirming that the economy is on a solid recovery path. Indeed, industrial production (IP) growth accelerated to 10.3%Y during the three months ended October 2009 compared with the trough of 0.3%Y in the three months ended February 2009. The key stimulus for this rebound is the lagged impact of an expansionary fiscal policy and loose monetary policy. However, over the next 12 months, we expect export growth to recover with the private sector assuming the lead, enhancing the growth quality mix. We expect a pick-up in GDP growth to 8% in 2010 from 6% in 2009, to be underpinned by faster private consumption and infrastructure spending growth. A favorable base effect for agriculture will also help. Business investment is likely to remain slow in 1H10 with a modest recovery in 2H10. In 2011, we expect strong GDP growth of 7.6% to be driven primarily by domestic demand but also by a revival in business investment.

V-Shaped Recovery in Industrial Production

Industrial production growth has turned around, accelerating 10.3%Y in October 2009 after touching the bottom of -0.2%Y in December 2008. The seasonally adjusted industrial production index in September increased by 7.4% over May 2009. Unless there is a meaningful decline month-on-month - we think this is unlikely - IP growth should remain strong for the rest of the financial year. Various other economic indicators are also rebounding sharply from lows touched in the quarter-ended December 2008. Growth in passenger car sales picked up during the three months ended November 2009 to average 32.4%Y compared with the bottom of 1.2%Y during the three months ended January 2009. Two-wheeler sales growth also recovered, to an average 38.4%Y during the three months ended November 2009, after easing to a low of 9.9%Y in the quarter ended December 2008. Growth in cement dispatches revived to 10.2%Y in the three months ended October 2009 from the bottom of 5.8%Y in the three months ended October 2008.

2009 - Better Policy Traction and Revival in Risk Appetite

We believe that much of the rebound in IP growth is due to stronger domestic demand while exports remain weak. Faster growth is being driven mainly by the lagged effect of an expansionary fiscal policy and relaxed monetary policy. The traction from the government's policy measures has been better than expected. Moreover, a swift return of the global appetite for risk has allowed India's corporate sector to access risk capital from international capital markets more easily than expected. This has helped corporates repair their balance sheets faster and reduced the risk of a vicious circle of large non-performing loans in the banking system that could have led to increased risk-aversion and slower growth. We estimate that capital inflows into India increased to about US$10 billion (annualized rate of US$40 billion) during the quarter ended September 2009 (QE-Sept 09) compared with an inflow of US$6.7 billion in the QE-Jun 09 and outflow of US$5.3 billion in the QE-Mar 09.

2010 - Shift in Driver from Policy to Private Initiatives

We expect the recovery in GDP growth to be sustained, accelerating to 8% in 2010 from 6% in 2009, even as policymakers gradually start withdrawing monetary and fiscal policy support. Global growth is vital for the recovery. India's growth trend remains highly influenced by capital inflows, and improving global growth should mean more such capital for India, as well as bolstering external demand. We believe that the moderation in government consumption spending will be offset by a significant recovery in external demand and modest pick-up in the investment cycle.

2011 - Growth of 7%-Plus Looks Sustainable

While we estimate that India's headline GDP growth will slip slightly to 7.6% in 2011 because of the normalization of agriculture growth, we expect non-agriculture GDP growth to remain strong at 8.5% compared with 8.8% in 2010. Domestic demand is likely to remain the primary growth driver, but capex, together with private consumption and infrastructure spending, should also underpin growth. We estimate that real gross fixed investment growth will rebound to 8.6%Y in 2011 from 6.4%Y for 2009. While we expect a sharp reversal in monetary policy support in 2010, the fiscal consolidation trend should be maintained through to 2011.

Normalization of Interest Rates Underway

The Reserve Bank of India initiated the first step toward the ‘exit' in its quarterly monetary policy review on October 27, 2009, by discontinuing several unconventional liquidity support measures that were taken in response to the unfolding of the credit crisis last year. In addition, it has tightened prudential norms for loans to the commercial real estate sector and stipulated that banks should maintain a loan loss coverage ratio of 70% by September 2010. This is a clear indication from the RBI that monetary policy is beginning to be reversed. We maintain our view that the RBI will lift policy rates by 25bp in January 2010. By that time, the RBI should have adequate confirmation of the pace of recovery. Indeed, we expect a cumulative increase of 150bp in the repo rate in 2010. However, this potential policy rate hike is unlikely to derail the recovery as it represents a move toward normalization rather than a restrictive policy.

Return to 9% GDP Growth Will Remain a Challenge

We think it will be difficult for India to achieve GDP growth of close to 9%, the rate witnessed prior to the global credit crisis (2004-2007). We see three constraints on growth: First, we believe that the global growth environment will be weaker than during 2004-07. Our economics team expects global growth of 4.0% in 2010 and 3.9% in 2011, compared with average growth of 4.8% in 2004-07. Second, the starting point of elevated levels for the government's revenue deficit and public debt implies that some payback will be inevitable in the form of reduced government consumption spending. Third, while we expect infrastructure spending to increase, we believe that it will be lower than the required 9% of GDP.

Upside and Downside Risks to Our Estimates

We believe that India's growth outlook in 2010 and 2011 will be influenced by two key factors. The more important will be the global growth trend, which will be reflected in the global risk appetite and capital inflows, as well as external demand. The other factor is the pace of structural reforms initiated by the government. The influence of these two factors will form the upside and downside risks to our GDP growth estimates for 2010 and 2011 of 8% and 7.6%, respectively. Based on this framework, we see growth for India in our bull case scenario of 9.5% in 2010 and 9% in 2011; in our bear case, we see 6.5% in 2010 and 6% in 2011.

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Asia Pacific
Domestic Demand - Cyclical Story Intact
December 18, 2009

By Chetan Ahya | Singapore & Sumeet Kariwala | India

Asia maintains its lead in global recovery cycle: Unlike the previous two cycles, Asia has had a distinct lead in the current global recovery. AxJ industrial production grew 9.5%Y as of September 2009, compared with declines of 12.4% in the EU and 6.1% in the US. Indeed, production levels in AxJ are already well above the peak levels seen in February 2008, whereas EU and US production levels are 16% and 12% below peak, respectively, as of September 2009. Moreover, unlike in previous cycles, the key factor driving recovery is domestic demand - particularly household consumption spending on discretionary items and residential property, and government spending on infrastructure and handouts.

However, we believe the heavy lifting remains to be done, and efforts toward more sustainable long-term domestic demand reflation are far from desirable levels. While we can argue that regional policymakers should respond to the challenge of rebalancing by initiating structural reforms to boost domestic demand on a sustainable basis, doing the right thing is not easy. As the external demand shock crushed growth, policymakers are undoubtedly taking small steps in the right direction. Yet, in our view, the approach toward domestic demand reflation remains piecemeal and, in reality, comprises more short-term stop-gap measures to fill the vacuum created by the collapse in exports rather than being structural.

Loose monetary and fiscal policy have been at the heart of this cyclical boost to domestic demand: AxJ central banks have cut policy rates to unusually low levels. As a result, short-term interest rates have been brought down to just 2.5% from 5.5% in July 2008. We expect the fiscal deficit in the region to expand to 4.0% and 3.5% of GDP in 2009 and 2010, respectively, from a surplus of 0.1% of GDP in 2007. This sharp cut in policy rates and major expansion in the fiscal deficit have played a key role in the revival of the growth trend. Unlike in the previous cycle, the banking system was in a much stronger position this time to ensure quick transmission in the form of improved credit conditions. Government spending also produced more bang for the buck. In previous cycles, the government deficit was also used to bail out the financial sector.

While external demand is improving, recovery to peak levels is some time away: Even after the sharp improvement in the past two months, October exports (adjusted for seasonal factors) are still 19% lower than peak in value terms. In volume terms, the export trend is better, but still 5% lower YoY for AxJ (excluding India and Indonesia) as of September 2009. This gap between value and volume reflects lower commodity prices and inflation. Exports from most countries in the region are 9-15% lower than the peak in volume terms (the exception is Korea, which has outperformed the region, recovering to peak levels). Considering that the region's exporters would have been geared up for about 10-15% growth pre-crisis, capacity utilization in export businesses is still likely to be low. We believe that policymakers will look for revival in external demand and/or sustainability of domestic demand before initiating steps toward meaningful tightening.

Time to reverse extremely accommodative policy? We believe that concerns about inflation remain low. AxJ headline inflation increased to 2.5% in October 2009 from 1.5% in July 2009, mainly driven by food and energy prices. Indeed, the core inflation index in AxJ (excluding India) remains low at 1.3%Y as of October 2009. However, many central banks in the region, including in Korea, India and China, have reflected their concerns of the risk of excess liquidity fueling asset prices. Moreover, the sharp recovery in industrial production may indicate that the time has come to start withdrawing the extraordinary policy support. However, we believe that policymakers will make a distinction between this policy-driven recovery and an autonomous recovery. In other words, they are likely to move gradually in withdrawing policy support until there are strong signs of an autonomous private sector recovery.

Rate hike cycle to begin from 1Q10: We expect India and Korea to go first. Central banks there are likely to increase policy rates by 25bp each in January 2010. Indeed, we can argue that technically India has already moved ahead of Korea, as the RBI initiated the first step toward ‘exit' by discontinuing in the October monetary policy review several unconventional liquidity support measures that were taken immediately after the unfolding of the credit crisis last year. Both the Indian and Korean central banks have been relatively hawkish in the past, and both countries have witnessed a surprise in growth data recently. India has surprised on domestic demand, with almost a vertical rise in IP in the last four months, while Korea's exports in volume terms have grown 8%Y.  The rest of the region, meanwhile, saw a decline of 5%Y as of September 2009.

How do we read these potential rate hikes? We see them as a trend towards normalization. The short-term real interest rate on core inflation is very low at an average of 1.2% even as industrial production has accelerated to 9.5%Y as of September 2009. We expect the weighted average policy rate in the region to rise to 5.8% by end-December 2011, compared with 4.6% as of end-December 2009, as core inflation is still very low, with capacity utilization not at levels that are likely to exert pressure. Moreover, as the recovery has been largely driven by a strong policy response, central banks will be conscious of this fact in their pace and timing of tightening.

Risks to our base case: The two key factors to watch in the context of growth and interest rate outlook are the trends in exports and commodity prices. A rise in exports would give comfort that autonomous demand is recovering and encourage policymakers to quicken the pace of tightening. In this context, we tend to watch closely the US ISM New Orders Index (a leading indicator). Similarly, we would also watch commodity prices. AxJ remains a big importer of commodities. Oil prices also tend to influence food prices, and food is a big part of the consumption basket, weighing on inflation expectations.

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China
A Goldilocks Scenario in 2010
December 18, 2009

By Qing Wang, Denise Yam, CFA | Singapore & Steven Zhang | Shanghai

A Goldilocks Scenario in 2010: Stronger Growth

We expect the Chinese economy to deliver stronger, more balanced growth with muted inflationary pressures in 2010, featuring 10% GDP growth and 2.5% CPI inflation. This baseline forecasts hinge on two key assumptions: i) the strong domestic demand in 2009 is largely sustained; and ii) the recovery in G3 economies remains tepid (see Global Forecast Snapshots: ‘Up' without ‘Swing', September 10, 2009).

The tight supply of raw materials and energy inputs has been a significant headwind to rapid expansion of the Chinese economy in recent years. When economies in the rest of the world are also in an expansionary phase of the cycle, any incremental demand from China tends to drive up the global prices of commodities, generating inflationary pressures and making it a challenge to deliver a Goldilocks scenario - a mix of high growth and low inflation.

If, however, the recovery of the rest of the global economy were to remain tepid in 2010, it would help China to benefit from relatively low commodities prices for a reasonably long period of time until the economies of its competitors for the same limited amount of supply of commodities recover. This potentially creates a ‘window of opportunity' for China to deliver a Goldilocks scenario.

We forecast China's GDP growth at 10% for 2010 and think that the growth drivers are likely to become more balanced. The aggressive policy responses so far this year will likely continue to fuel rapid investment growth in the rest of 2009. Also, we expect property investment to accelerate in 2010, partly offsetting the slowdown in infrastructure investment expected to materialize because of the high base in 2009. Private consumption is likely to improve steadily through 2010 as consumer confidence and employment improve. We expect export expansion to resume in 2010 following a sharp contraction in 2009, which, together with a recovery in profits, should help underpin non-real estate private investment.

In terms of trajectory, while the 2Q09 rebound represents a sharp bounce from the cyclical trough, we expect the sequential growth rate to return to a more sustainable 2.0-2.5% in the quarters ahead. Nevertheless, we project that the year-on-year growth rate is set to accelerate further in the next few quarters, surging to double-digit rates by 4Q09 and peaking in 1Q10, before tapering off - on the base effect - toward a more sustainable high-single-digit level. The moderation in growth rate over the course of 2010 would reflect acceleration in private consumption and investment (e.g., property investment) and recovery in exports, partly offset by a smaller dose of policy stimulus.

A Goldilocks Scenario in 2010: Muted Inflationary Pressures

Despite strong headline GDP growth, concern about possible high inflation in China in 2010 is unwarranted, in our view. We forecast average CPI inflation at about 2.5% in 2010. Of note, we caution that predicting high inflation in 2010, based on the strong growth of monetary aggregates so far this year, could err on the side of being too simplistic and mechanical.

•           First, the strong headline M2 growth in 2009 substantially overstates the true underlying monetary expansion, as it fails to account for the change in M2 caused by the shift in asset allocation by households between cash and stocks. We estimate that the growth rate of adjusted M2 - the rate that truly reflects the underlying economic transactions - is much lower than suggested by the high growth of headline M2 (see China Economics: Worried About Inflation? Get Money Right First, October 19, 2009).

•           Second, generally weak export growth, which we think could be a proxy for the output gap in China, will remain a strong headwind containing inflationary pressures. These two demand-side factors combined would suggest that the 2000-01 situation - featuring relatively high money growth but relatively low inflation - is likely to be repeated in 2010.

•           Third, from the supply side, while our commodities research team expects commodities prices to rise steadily in 2010, they do not foresee a significant surge in prices. They project crude oil at about US$85 per barrel in 2010 (see Crude Oil: Balances to Tighten Again by 2012, September 13, 2009). Assuming the cost pressures stemming from these supply-side shocks are able to pass through the supply chain to be reflected in the corresponding price increase of downstream products without much constraint from the demand side, we forecast a similar trajectory of CPI inflation for 2010 to the one derived from demand-side analysis (see China Economics: Inflation Outlook in 2010: A Supply-Side Perspective, November 1, 2009).

A Goldilocks Scenario in 2010: Policy Normalization

The super-loose policy stance is to normalize but remain generally supportive in 2010. In view of the inflation outlook, we expect the current policy stance to turn neutral at the start of 2010 as the pace of new bank lending creation normalizes from about Rmb10 trillion in 2009 to Rmb7-8 trillion in 2010. The M2 growth target will likely be set at 17-18%, in our view.

Policy tightening in the form of reserve requirement ratio (RRR) hikes and base interest rate hikes is unlikely before mid-2010, in our view. If, however, excess liquidity stemming from large external balance of payment surpluses were to emerge earlier than expected, we would not rule out the possibility of the RRR hike cycle starting as early as the beginning of 2Q10. Indeed, with inflationary pressures likely muted, the monetary policy priority in 2010 is likely to be on liquidity management through RRR hikes.

Specifically, we expect the PBoC to hike base interest rates in early 3Q10, when we expect CPI inflation to have exceeded 3.0%Y in some months. However, since we forecast CPI inflation to moderate in 2H10, we expect no more than two 27bp rate hikes over 2H10, the primary purpose of which is to manage inflation expectations. In view of the current de facto peg of the Rmb against the USD, the timing of China's rate hike will also hinge on that of the US Fed, in our view. In particular, we do not expect the PBoC to hike interest rates before the Fed does. Incidentally, our US economics team expects the Fed to raise interest rates in 3Q10 (see Richard Berner and David Greenlaw's Hiring Still Poised to Improve Early in 2010, November 9, 2009).

We maintain our long-standing view that the current renminbi exchange rate arrangement will remain unchanged through mid-2010. While we believe an exit from the current regime of a de facto peg against the USD may occur in 2H10, any subsequent renminbi appreciation against the USD is, in our view, likely to be modest and gradual (see China Economics: An Exit Strategy for the Renminbi? June 9, 2009 and China Economics: A Dialogue on the Renminbi, November 11, 2009).

Looking ahead, China is likely to repeat a situation similar to that during 2005-08, featuring strong expectations of renminbi appreciation, ‘hot money' inflows, abundant external surplus-driven liquidity (as opposed to the current abundant liquidity due to loose monetary policy), and the attendant upward pressures on asset prices.

Indeed, against a Goldilocks macroeconomic backdrop, coping with rising asset price inflation pressures will likely become an important challenge to policymakers in 2010. To this end, ‘containing financial leverage' in the economic system is likely to be a top policy priority with a view to minimizing systematic risks in the event of a bursting of an asset price bubble. This could entail a variety of measures:

•           Strict mortgage rules for homebuyers;

•           Enforcing restrictions on margin trading in the stock market;

•           Strict capital adequacy requirements for banks;

•           Asymmetric liberalization of external capital account controls that induce capital outflows (e.g., through QDII programs) and discourage capital inflows; and

•           Attempting to prevent one-way plays on the Rmb exchange rate against the USD that would induce hot money inflows.

China's Super-Cycle in a Globalized World Economy

The Goldilocks scenario in 2010 should be considered as a phase of China's super-cycle in a globalized world economy that comprises ‘overheating in 2007', ‘imported soft landing in 2008' and ‘policy-induced decoupling' in 2009.

The Chinese economy was overheating in 2007, with GDP growth of 13% and CPI inflation of about 5%. We envisaged an ‘imported soft landing' scenario in 2008, which hinged on two key calls:

a)         A US-led global downturn that would slow the rapid expansion of China's exports, thereby helping the economy to cool off; and

b)         A muddling-through style for macroeconomic management - i.e., as external demand weakened, domestic policy tightening would not be followed through consistently and would even be eased over the course of the year (see China Economics: Journey into Autumn: An Imported Soft Landing in '08, December 3, 2007).

The ‘imported soft landing' indeed played out in most of 2008. However, it was disrupted and derailed by the onset of the Great Recession, such that China's economy suffered a hard landing in 4Q08-1Q09 (see China Economics: Outlook for 2009: Getting Worse Before Getting Better, December 9, 2008). Indeed, when turmoil of such global scale hit, there was an initial, indiscriminately strong negative effect from the shock on every economy that is deeply integrated into the global economy.

The strength and speed of policy responses in the immediate aftermath of the turmoil were, however, quite uneven among countries, resulting in different patterns of post-crisis recovery. China is a case in point. The aggressive policy response by the Chinese authorities helped translate China's ‘strong balance sheet' into a ‘decent-looking income statement', which distinguishes China from those countries that either suffer from a paralyzed financial system or are unable to launch strong pro-growth fiscal or monetary policy responses due to weak fiscal and/or external balance of payments positions. This makes China the first major economy to recover from the global market turbulence with strong momentum, effecting a policy-induced economic decoupling between China and the rest of the world (see China Economics: Policy-Driven Decoupling: Upgrade 2009-10 Outlook, July 16, 2009).

Specifically, a ‘Goldilocks recovery scenario' has indeed played out: the government's growth-supporting policies enable asset reflation, which underpins consumer and investor confidence and prevents the harsh adjustment in domestic consumption and private investment (e.g., real estate) in 1H09 (see China Economics: Property Sector Recovery Is for Real, May 15, 2009). The shallower trough in the economic cycle is then followed by recovery in activity, initially spearheaded by fiscal stimulus (3Q09), and then by a tepid recovery in external demand (4Q09) (see again China Economics: Policy-Driven Decoupling: Upgrade 2009-10 Outlook).

In the aftermath of the Great Recession, if the strength of China's domestic demand in 2009 can be sustained into 2010 and meanwhile the recovery of the rest of the global economy were to remain tepid, it would make China a potential beneficiary of relatively low commodities prices for a relatively long period of time until other major economies - which compete for the same limited amount of supply of commodities - recover. This potentially creates a window of opportunity for China to deliver a Goldilocks scenario.

Sustaining the Goldilocks scenario beyond 2010 would be a tall order, however. Against the backdrop of a potentially stronger recovery in global economy in 2011, the balance between growth and inflation in the Chinese economy will be more difficult to strike. This is a key reason why we tentatively forecast a mix of lower growth and higher inflation for 2011, while noting the tremendous uncertainty at the current juncture.

Alternative Scenarios in a ‘Four Seasons' Framework

The Goldilocks scenario is our base case. The risk to this base case forecasts relates to two types of uncertainties: a) the economic outlook in G3 nations; and b) domestic policy stance. Along the two dimensions of uncertainty, we envisage four potential scenarios in 2010 by adapting the ‘four seasons' framework that we employed before.

Autumn features a combination of tepid G3 recovery and normalized policy stance in China that would deliver a ‘Goldilocks' scenario. We assign a 70% subjective probability to this scenario.

Summer features a combination of vigorous G3 recovery and normalized policy stance in China that would result in ‘Overheating'. If the G3 economic recovery in 2010 were to be much stronger than expected, China's export growth and thus industrial capacity utilization, as well as global commodity prices, could both surprise to the upside, likely resulting in higher GDP growth and stronger inflationary pressure if the policy stance were to remain unchanged. We think this is the most likely alternative scenario and assign a 15% subjective probability.

Spring features a combination of vigorous G3 recovery and aggressive tightening that would help achieve a ‘Policy-induced soft landing'. To realize this scenario, the timing and modality of policy tightening would be absolutely the key. However, this tends to be difficult to achieve in China. Administered interest rates and an inflexible exchange rate arrangement mean that the Chinese authorities have few available policy tools that allow for discretionary tightening with engineering precision. We therefore assign only a 5% probability to this scenario.

Winter features a combination of tepid G3 recovery and aggressive tightening in China that would lead to a ‘Policy-induced double dip'. The key headline macroeconomic indicators (e.g., the year-on-year GDP and export growth) may improve rapidly because of the low-base effect in the coming quarters. Policymakers may turn complacent and launch a round of aggressive tightening for fear of economic overheating despite a tepid G3 recovery. This would likely derail a recovery, causing a double-dip in economic growth. We assign a 10% probability to this scenario. On the other hand, the National Bureau of Statistics (NBS) has decided to start publishing quarter-on-quarter GDP growth rate data in 2010. If the official data release were to show a relatively low quarter-on-quarter growth rate despite a relatively high year-on-year growth rate in 1Q10, it would help guide the policy debate and therefore lower the risk of potential premature policy tightening, in our view.

A Post-Crisis Reflection on the Chinese Economy

It would be imprudent to call for a cyclical Goldilocks scenario in an economy built on a growth model that is structurally flawed. The typical concerns about the sustainability of China's economic growth are based on several key structural imbalances in the economy, including over-investment, under-consumption and large and persistent current account balances. Some China observers even predict that if these structural imbalances were left unaddressed, the Chinese economy would eventually implode.

However, in a post-crisis reflection on China's economy, we conclude that the popular concerns about such structural issues as ‘over-investment' and ‘under-consumption' in China are overdone and that the growth model is still generally sound.

First, with ‘over-investment' the current buzzword in the policy debate, much attention has been paid to the high investment-GDP ratio. However, we believe that a more important phenomenon in this regard is the high national savings rate in China. To the extent that the high investment ratio is a function of the high national savings ratio in China, discussing over-investment without discussing the high saving ratio loses sight of the big picture, in our view.

Second, China's high national savings rate is a generational phenomenon. It is primarily a function of such secular forces as Chinese demographics, largely shaped by China's ‘one-child' policy and slow adjustment in households' spending habits against the backdrop of rapid economic growth. The ‘one-child' policy artificially compresses the demographic evaluation in a window of some 30-40 years and lowers the dependence ratio sharply in a much shorter period of time in China than in other countries where aging is a natural, multi-decade process. The low dependence ratio substantially raises the saving ratio. While households' income increases rapidly in line with overall economic growth, personal consumption habits may take years and even decades to change. This results in a high savings ratio, which is often attributed to ‘cultural factors'. While other structural factors such as lack of social security and policy at SOEs may have also contributed to the high saving ratio in China, we view their impact as either marginal or an indirect reflection of the abovementioned secular forces (see China Economics: The Virtues of ‘Over-Savings': A Post-Crisis Reflection on Chinese Economy, September 27, 2009).

Third, a popular argument of ‘over-investment' in China is the high growth rate of fixed-asset investment. However, the rapid investment growth is driven primarily by infrastructure investment rather than investment in manufacturing sectors that suffer from overcapacity. Infrastructure investment actually lagged other types of investment by a wide margin in the past few years. Moreover, the investment projects mainly involve railways, intra-city subways, rural infrastructure, low-income housing and post-earthquake reconstruction, which are quite different from the infrastructure projects that were carried out in the context of the Asian Financial Crisis a decade ago.

Both rounds of infrastructure investment boom helped boost domestic demand in the face of negative external shocks in the short run. However, their medium-term implications are quite different: while investment in the immediate aftermath of the Asian Financial Crisis laid the foundation for a subsequent takeoff in China's manufacturing sector and hence exports, the current investment boom should facilitate urbanization and help to lay the groundwork for a potential consumption boom in the years to come, in our view (see again China Economics: The Virtues of ‘Over-Savings': A Post-Crisis Reflection on Chinese Economy).

Fourth, much of the concern about over-investment is based on the notion that investment is derived demand (e.g., investment to build a factory that produces widgets) instead of final demand (e.g., consumer demand for the widgets). When final demand like private consumption or exports is weak, it will eventually translate into weak investment demand. However, the line between derived demand and final demand is blurred when it comes to such urbanization-related infrastructure investment as intra-city subways, rural infrastructure and low-income housing. For a rapidly growing, low-income country like China, the nature of these investments is final demand, as faster and more convenient travel is as desirable now as more food and clothing, in our view.

Fifth, we argue that a more meaningful cross-country comparison in this regard should be about the capital-labor ratio in the economy. On this score, China's capital-labor ratio, or the capital stock per capita, is, not surprisingly, way below that in more advanced emerging market economies (e.g., Korea, Taiwan), let alone the industrialized economies (e.g., US, Japan), suggesting much upside for investment expansion. A key question in this underestimation of service consumption in China is the consumption of housing, in our view. Based on official statistics, we estimate that consumption of housing accounts for only about 3-4% of personal consumption in China. This seems to us too low to be even close to the reality. As a comparison, consumption of housing represents about 16% of personal consumption expenditure in the US and 6.6% in India. We think that an important reason for the seemingly low housing consumption in China is that the imputed rent of owner-occupied housing is not appropriately accounted for. In other words, the statistical methods used in the US and China to estimate the consumption of housing are quite different. The fact is that the house ownership ratio in China is over 80%.

Another important source of underestimation of service consumption in China is personal spending on healthcare, in our view. While the share of spending on healthcare in the US is 15-16% of total PCE, this share in China is only about 6%. However, there is no shortage of anecdotal evidence suggesting that there are substantial gray and black markets in health spending in China - which are not captured by official statistics.

Actually, the underestimation of the importance of the service sector was more serious before the substantial upward revision of GDP in 2005 following completion of the first nationwide economic census. In the 2005 GDP revision, China's 2004 GDP level was revised up by 16.8%; 93% of the increase stemmed from a substantial upward revision in the service sector, such that its share was lifted from about 32% to 41%. In explaining the revision, the NBS noted that China had long been using the Material Product System (MPS), which was developed under the centrally planned economic system in its national accounts statistics until the 1980s, resulting in ‘very weak' statistics for the service sector.

The second nationwide economic census has reportedly been completed this year and the key results will likely start to be released next year. The potential revision of the historical national account data will likely result in another significant upward revision of the share of the services sector in GDP, in our view. Incidentally, the first nationwide economic census was completed in 2004 and the revised national data (e.g., GDP) were released in December 2005. With the benefit of hindsight, there appears to have been a re-rating in the H-share stock market, as investors realized that the structural imbalances in the economy were less serious than indicated by the pre-revision data.

Market Implications

Goldilocks cyclical conditions, together with structural soundness, should be positive for risk assets, in our view. Morgan Stanley's Asia/GEMs strategist, Jonathan Garner, gives China the biggest country Overweight (see Asia/GEMs Strategy: 2010 GEMs Outlook: Headwinds Building but Further Upside Likely, November 9, 2009). Moreover, Morgan Stanley's China equity strategist, Jerry Lou, is also bullish, citing potential further upward re-rating from the current fair levels as earnings accelerate (see China Strategy: 2010 Outlook: Equities in Transitional Goldilocks, November 11, 2009).

Challenges in the Long Run

Notwithstanding our generally positive outlook for the Chinese economy in the near term, we are also mindful of various challenges facing the Chinese economy over the long run. We believe that China's economy has and will likely continue to experience high growth and relatively low inflation with a cushion against external real or financial shocks, as long as the high savings ratio persists (see again China Economics: The Virtues of ‘Over-Savings': A Post-Crisis Reflection on Chinese Economy). We do not subscribe to the notion that there are serious structural imbalances in China's economy.

However, the ‘over-savings' is not a permanent phenomenon but a function of China's demographics. Population aging in China will likely kick off around 2020, according to projections made by the United Nations. The key challenge facing the Chinese economy is how to seize the window of opportunity of ‘over-savings' to create quality wealth for the nation, in our view. The priority for China's economic development is not about rebalancing the economy but rather improving the quality of investment, or wealth creation, in our view.

To this end, China must get the structure of pricing and other incentives right by:

a)         Deregulating the prices of energy and natural resources;

b)         Deregulating interest rates;

c)         Allowing unfettered adjustment of the real effective exchange rate (either through more flexible nominal exchange rate or domestic inflation, or a combination of both);

d)         Deregulating the land market;

e)         Deregulating sectors that are still subject to state monopoly (e.g., services); and

f)         Encouraging private capital outflows.

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Canada
Forecasting an Acceleration
December 18, 2009

By Yilin Nie & David Cho | New York

Revving Up the Growth Engine

After four quarters of contraction, Canada emerged from recession in 3Q.  Growth eked out a small gain last quarter, but we look for GDP to accelerate going forward into 2010.  Economic growth is shifting from being export-driven to relying more on domestic demand.  In that regard, the Canadian consumer is well poised to carry the baton of growth. 

From our perspective, both growth and inflation risks lie north of the Bank of Canada's current forecasts.  We believe that the bank will need to hike before its conditional commitment to keep rates low until June 2010, and before the Fed.  Our forecasts show the first BoC hike in April 2010, coincident with the release of the Monetary Policy Report.  Below, we offer a more detailed discussion of the factors driving our fundamental outlook.

Consumer in Focus

3Q growth was something of a disappointment, but since then, we have seen consistent improvement in the domestic data that make us optimistic about the trajectory ahead.  We look for a sharp pick-up in GDP in 4Q to give way to above-trend growth throughout 2010.

The composition is heavily weighted towards final domestic demand.  In particular, three key factors make us increasingly constructive on the Canadian consumer.  First, the labor market has shown signs of healing after the worst of the job losses earlier this year.  Full-time employment is growing and hiring intentions are back on the rise (as reported in the BoC Business Outlook survey).  We also illustrate that the unemployment rate is showing signs of peaking.  As the labor market continues to improve and support wage growth, the consumer should see increased spending power in the months ahead.  Second, the Canadian housing market is an important differentiating factor.  Not only did Canadian real estate avoid the housing collapse seen across the border, but the latest prices, starts and permits data consistently point to renewed strength in the housing sector.  Finally, echoing the trend of higher-beta assets, Canadian equities have also turned a corner.  The performance of the financial sector has been especially noteworthy, with the major Canadian banks beating consensus expectations in last quarter's earnings.  Foreign demand for Canadian securities and stocks has reached record-highs this year.  Taking these factors into account, we believe that personal net wealth should continue to grow and drive final domestic demand higher in the coming months.

One of the Bank of Canada's key concerns is that net exports will detract heavily from growth, similar to what we saw in 3Q.  Our forecasts reflect this effect in the coming quarters, but to a less severe degree than the bank forecasts.  While the strong CAD is an important input in our forecasts, we believe that the pick-up in global demand and the recovery in the US will help to offset some of the negative impact.  Notably, the revival of the US auto sector on the back of the cash-for-clunkers stimulus had positive spillover effects on the US's major trading partners.  Canada's 3Q GDP report actually showed a notable upturn in export demand that was overshadowed by the growth in imports.  We expect import growth to continue, but exports should catch up, particularly as the recovery in the US economy is positive for Canadian manufacturers and exporters.  And if the global recovery continues along a reasonably strong path as Morgan Stanley Research expects next year, the open nature of the Canadian economy is well suited to benefit from the demand increase.  

Finally, as the Canadian economy pulls out of the recession, inventories should shift from being a drag on growth to being a positive contributor.  Inventories have been running lean through the growth slowdown, but the pick-up in domestic demand should prompt restocking in the coming quarters.  The bounce-back in business investment in 3Q is also an encouraging indicator.  As the growth cycle turns, businesses should respond positively to the rising consumer.  

Inflation Normalization

Mirroring the growth profile, we also see an upward trajectory for inflation.  We forecast CPI to return to the 2.0% target by 3Q10, a faster normalization than what the bank forecasts.  Canadian inflation took a sharp dive in late 2008 against the backdrop of the financial turmoil, decline in commodity prices and weakening of the CAD.  But the majority of these factors have reversed, and we detect other price pressures building in the pipeline. 

The trade-weighted CAD has appreciated nearly 20% from weak levels this year, alongside the run-up in energy prices.  Meanwhile, wages are back on the uptick and home prices are rebounding sharply.  This latter factor is significant as the recent price increases are not fully captured in the inflation data yet.   Home prices tend to be reflected in CPI in a delayed manner, and the uptrend in those data suggests there are upside risks for inflation ahead. 

We are already seeing a re-emergence of price pressures.  In the latest CPI report, StatCan reported increases in six out of the eight components, with shelter being one of the two declines, which we expect to catch up to the other housing indicators.  Another interesting trend that has persisted is the divergence between core and headline inflation.  As we noted in our previous research, core CPI has proven much stickier than headline, suggesting that underlying price pressures may be greater than what the bank perceives.  Indeed, StatCan revealed upside surprises in both the September and October core CPI, suggesting that 4Q inflation is likely to print above the bank's projections.  Finally, the BoC Business Outlook survey also measures inflation expectations, which are shifting more in favor of higher price pressures ahead. 

BoC Outlook

Based on our assessment of growth and inflation, we believe that the BoC will need to begin removing excessive monetary stimulus before June 2010.  We expect a hike at the April 2010 meeting, which coincides with the release of the Monetary Policy Report that gives the bank an opportunity to justify a policy change.  This is an out-of-consensus call, with the forwards curves only pricing in about a 30% probability of a hike in April.  Following the first hike, we would expect the BoC to normalize rates rapidly to reach 2.25% by end-2010. 

CPI will be the key guidepost to monitor.  Although the bank continues to reiterate its commitment to low rates for now, the current stance is completely contingent on the inflation risks, which are shifting, in our view.  If 4Q CPI ends up surprising above the bank's forecasts, the bank will need to revise its outlook and remove accommodative policy sooner (the next MPR Update is due on January 21, 2010). 

On the growth front, the bank already acknowledges that the "main risks are stronger-than-projected global and domestic demand" (December 8 statement).  Notably, our projections for both global growth and domestic demand are both higher than the bank's forecasts.  If the growth trajectory unfolds as we expect, Canada will experience more upside than what the BoC is currently expecting.    

Risks to Our Forecasts

There are a few risks to our forecasts stemming from global and domestic factors:

1.         Slower global growth. Our forecasts assume that the global growth rebound will be robust next year (4.0%, see Global Forecast Snapshots, December 9, 2009, for more details).  If global demand slows or remains sluggish next year, the Canadian economy will be sensitive to the slowdown. 

2.         Slower US growth.  The US growth path is especially important, given Canada's strong trade exposure.  Our economists are forecasting 2.5% growth in the US next year.  If growth surprises to the downside and the US consumer retrenches, Canadian exporters will be disproportionately affected.

3.         Commodities.  Another macro risk factor is commodities, which present two-sided risks.  Our commodities team is currently forecasting WTI crude to reach US$85/bbl by end-2010.  This run-up should support Canada's terms of trade and, through the income effects, bolster domestic demand.  However, excessive commodity price rises could stoke inflation concerns.  Meanwhile, softer prices would present downside growth and inflation risks for Canada and give the BoC more room to stay on hold. 

4.         Productivity growth.  On the domestic side, a risk stems from productivity growth, which has been persistently sluggish over the past decade.  The low productivity could be problematic for Canada's long-term capacity use.  Weaker productivity could also raise inflation concerns, even if growth disappoints. 

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Japan
Loose Money and a Turn Towards Fiscal Discipline
December 18, 2009

By Takehiro Sato, Robert Alan Feldman & Takeshi Yamaguchi | Tokyo

Mild dip expected in 1H10.  Japan has begun to recover in 2009 along with other nations, but the recovery momentum faces several short-run barriers. On the fiscal side, we expect changes in the composition of expenditures to slow public works investment from Jan-Mar 2010. We also expect adverse conditions to persist in the employment and earnings climate. In manufacturing, we anticipate cuts of surplus production capacity and of regular employment.

Signs to the downside are already evident in economic indicators. The current conditions DI (diffusion index) in the November Economy Watchers' Survey recorded the worst MoM decline since the survey began. This DI leads the economy by about three months, so it suggests another soft patch starting in Jan-Mar.

Given our outlook for a growth lapse in Jan-Mar 2010, manufacturers' performance will likely deteriorate. However, we do not think the impact on F2011 (ends March 2011) corporate earnings will be so significant. We look for profit to grow 15% in F11 and 10% in F12 due to strict cost control. That said, the profit decline in F09-F10 was very substantial, so we do not believe that corporate earnings will recover over the next two years to the F08 level.

Additional monetary easing is likely.  At the special Monetary Policy Meeting (MPM) on December 1, the BoJ announced a re-expansion of special lending, which it had previously cut when it terminated the facility for corporate financing at the October MPM. Now, the BoJ will provide three-month term money at a fixed rate of 0.1% and up to JPY10 trillion, thereby eventually forcing down term money rates.

The BoJ indicated that it could opt for further measures depending on economic developments. In this sense, we doubt that the December 1 special MPM marked the end of new easing measures.  With the economy at a standstill, we expect that any improvement of the output gap will be delayed, keeping 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.

Given the above, we expect more accommodative policy ahead, including (1) enhanced provision of funds, (2) repeated rollover of JGBs held by the BoJ and stepped-up Rinban operations (JGB purchasing), (3) unsterilized FX intervention, and (4) stronger commitment to policy duration and rate cuts. We think the first two measures are quite likely, and 1H10 is the probable timing. However, the market may well regard this as insufficient, if the government is serious about tackling deflation. On the other hand, we expect the exit timing for Japan to slip beyond Jul-Sep 2011. Indeed, the BoJ itself anticipates deflation to continue for three years through F12 in its Outlook Report from October 2009.

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 are 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 tilt towards a weak yen policy, in line with the monetary easing options listed above. A policy of strengthening the home currency during deflation would be a contradiction. The macro stance consistent with escaping deflation is a combination of further monetary easing and a weaker home currency. We expect Japan's macro policy to turn in this direction in 2010.

Credible commitment to mid/long-term fiscal discipline is essential.  For fiscal policy, the prospect of a huge shortfall in tax revenues has spread concern about the sustainability of Japan's fiscal situation. However, we do not believe that Japan faces an imminent fiscal collapse, even with the larger fiscal deficit and debt load. We have confidence that 2% long-term yields, a level that has rarely been breached in the last ten years, remains a firm resistance level, so long as fiscal reform policies are clarified soon.

To regain investor confidence, mid/long-term targeting of the primary balance is key to averting a debt crisis. In 1H10, the government will work on preparing a medium-term fiscal framework of revenue forecasts and outline expenditures for 2011-13. These forecasts for revenue and spending will then form the assumptions in drafting a budget to cover multiple years from F12. This has the potential to significantly alter the budget compilation process from a bottom-up exercise to more of a top-down one. Earlier attempts were made under the LDP to formulate a broad budget framework based on macro forecasts of the Council on Economic and Fiscal Policy, but this time we think the chances of success are greater, given that politicians are taking a guiding role in the budget drafting process. If revenue projections in the medium-term forecasts act as a ceiling for budget spending as a whole, fiscal discipline could be enhanced to a greater extent than under the practice up to now of compiling the budget at the level of individual ministries.

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EMEA
CEEMEA: Rebounding, Still Far from Tightening
December 18, 2009

By CEEMEA Economics team | London, Johannesburg & Dubai

This is an excerpt from the Global Macro Preview 2010, published on December 17, 2009.

•           We expect a broad, but in most cases still weak, recovery across the CEEMEA region in 2010.  For Poland, Russia and Ukraine, we expect stronger growth in 2010 than in 2011.

•           For Russia, South Africa, Romania and Hungary, we expect no policy rate hikes until 2011.  Only in Turkey and the Czech Republic do we see average inflation accelerating already in 2010. 

•           For Ukraine and most of Central Europe, elections will complicate the 2010 economic outlook, but in most cases we expect market-positive results.

Russia: No Exit Yet

In Russia, we remain positive on the near-term outlook for growth recovery, driven primarily by large and late policy stimulus.  Effective easing only began around mid-2009 and we expect exit also to come later than in most of the rest of the world.  With our team's average 2010 oil assumption rising to US$82, we have raised our 2010 real GDP growth forecast to 5.3%.  Short-term inventory and gas demand normalization have further to run, we think.  Fiscal spending will surge more than usual in December 2009, and 1Q09's fiscal contraction is unlikely to be repeated in 1Q10.  January's public sector wage freeze will be partially compensated by December and January's state pension hike, worth around 3.1% of GDP in 2010, financed from the National Welfare Fund and purely stimulative.  We also expect federal spending and government wages in particular to be raised in mid-year if oil prices remain above around US$70, and expect household savings rates to fall further.  Nevertheless, we still see near-term inflation surprising on the downside, slowing to around 5.5%Y by mid-2010, boosting real household income.  Given political pressure on the CBR, and a likely resumption of RUB appreciation, we expect at least 200bp of further policy rate cuts.  We expect the government to cut back planned external debt issuance, raising OFZ issuance, while pension fund demand is likely to move towards local corporate debt. 

Whether these factors translate into strong, sustainable growth in the longer term independent of energy price rises looks so far more doubtful.  A recovery in industrial production outside the gas and oil sector remains elusive.  We expect RUB appreciation to resume in 2010 - our end-2010 basket forecast remains at 33.0.  In the likely absence of effective capital controls or aggressive withdrawal of international liquidity, interest rate differentials will likely drive capital inflows.  Even with a strong import recovery, we expect the current account to be in surplus as long as oil is above US$65.  While exporters should remain relatively immune, the impact on domestic producers competing with (particularly Chinese) imports may prove painful.  The real effective exchange rate is already only 2% from pre-crisis levels.  Political concern over the impact of appreciation on uncompetitive firms may see commitment to a free float retreating further, with FX intervention rising and more downward pressure on rates.  While we expect growth to be accompanied by low inflation for much of 2010, we see inflation reaccelerating in 2011 as the impact of excess liquidity and still-weak competition combine.  The long-term environment for investment thus remains fragile.  We do not expect a banking crisis, but narrowing margins and still-rising non-performing loans and restructured debt indicators suggest that any credit resumption is likely to be slow.  Longer-term downward pressure on European gas prices remains a major concern.  There have been promising indications on privatization and openness to foreign direct investment, but whether liberalization lasts will also depend on a still-unresolved debate about candidacies for 2012's presidential election.  With fiscal policy set to be tightening in 2011, notably with a sharp rise in wage taxes, our GDP forecast for 2011 is a weak 2.8%. 

South Africa: Cautious Consumer

For South Africa, our 2010 GDP forecast of 2.7%Y is only marginally above consensus, thanks largely to our cautious outlook on the domestic consumer. Importantly, we expect household income and spending propensities to be capped by a mundane recovery in job creation and real disposable incomes, high debt service costs and tight lending conditions under the recently imposed National Credit Act of 2007.  And while our analysis shows that recent interest rate cuts and above-inflation wage awards have no doubt boosted the cash flow position of a decent minority of households at the top end, our view is that spill-over to the broader population will be a long, drawn out process.  Even so, we believe that our GDP forecast risk is skewed to the upside, with potential outperformance coming from a faster-than-expected recovery in inventory accumulation and domestic capital formation.

With regards to the currency, we are constructive in the short term (3-6 months), but maintain our relatively bearish outlook for 2H10. We believe that the unprecedented momentum in inward capital flows this year could be sustained for another quarter or two as global risk-love remains strong and assuming commodity prices recover. Our fair value model also shows that, at a current spot value of 7.55, USDZAR is some 10% overvalued relative to its 4Q09 fair value estimate of 8.35. However, the model suggests that USDZAR is likely to appreciate by some 6% in 1Q10, before weakening over the remainder of 2010 to close at 8.60. Officially, we forecast the rand at 7.40 by end-2009, with a further appreciation to 7.00 by March, before weakening to 8.70 by December 2010, as a recovery in consumer spending in 2H10 leads to a widening of the current account deficit, at a time where the momentum in capital inflows is likely to have slowed or even turned negative. The country's weaker fiscal position is also likely to weigh on the currency at some point next year.

Inflation should follow a relatively sticky profile over the course of 2010, in our view, falling back into target on a sustainable basis in 2Q10, and closing the year at a still-high 5.5%Y. 2011 should usher in a further moderation, to some 5.3%Y by year-end. Our average inflation prints for 2010 and 2011 show a declining profile from 5.7%Y to 5.4%Y. Consensus CPI estimates are 5.8%Y for 2010 and 5.9%Y for 2011, and the quarterly profile shows a trough of 5.6%Y in 2Q10 before rising to 5.9%Y by year-end. We believe it is this rising CPI trajectory over 2011 (as opposed to our declining profile) that informs the consensus expectation of 150bp of policy tightening, with some analysts pricing in tightening from as early as 3Q10. In fact, our own forecast, which is similar to the SARB's, points to a stubbornly rigid but declining inflation profile over 2010/11, allowing the SARB to look through any stickiness over the course of 2010 and delay the timing of policy normalization until early 2011 (see "South Africa: Policy Outlook", EM Economist, November 20, 2009). We therefore continue to believe that current market pricing of policy normalization by 3Q10 presents a trading opportunity.

Turkey: Worst Is Over but 2010 Will Be Nearly as Challenging

Our forecast for real GDP growth is 3.5%Y for 2010, which points to a modest recovery from our forecast of -5.2%Y in 2009. While a gradual pick-up in external and domestic demand would help start the growth, the main reasons behind the recovery will be the inventory cycle and the base effects. The financing outlook for 2010 suggests a tight borrowing schedule. Essentially, we see a delicate balance such that there seems to be little room for error on the fiscal front. Based on the Turkish Treasury's cautious assumptions on privatization and the primary deficit, and also assuming that some TRY8 billion worth of bonds held by the CBT that are due to mature next year would be fully rolled, the domestic debt rollover rate is targeted at 99.5%.  As part of the program, the Treasury will be targeting to issue US$5.5 billion of Eurobonds. While we see the financing program as realistic, we also believe that any slippage on the fiscal side (i.e., higher primary deficit), weak privatization performance and/or global risk-aversion would easily result in the rollover ratio exceeding 100%. One of the main implications of such a high rollover rate is that it leaves a limited amount of funds available for credit expansion, i.e., the crowding out factor that is leading to a lower growth potential. This had been the case in 2009 as well, except in 2010 the profit potential on government securities seems much less for local banks. The prospects of lower profits on trading and the rising non-performing loans mean that the banking sector might end up with a low appetite for loan growth.

As we have been stressing for some time, especially taking into account that the yields on government securities had been looking less attractive, the added pressure of a high rollover rate in the initial months of 2010 does not suggest a further decline in yields, but quite possibly the opposite. While the uncertainty surrounding the future of a possible Stand-By Arrangement with the IMF continues, it is exactly due to the crowding out factor that a deal is needed to secure better growth in 2010, in our view. That is, access to less-expensive and ample funding from the IMF seems the easiest way to ease the rollover ratio and free up resources for credit growth. According to our calculations, for each US$10 billion (cash) received from the IMF in 2010, the rollover ratio would decline by around 8pp. That would free up cash for the use of loan extension and clearly provide upside potential for growth.

The output gap, mild recovery in demand and stable currency outlook suggest that inflation will be under control in broad terms. However, on the back of base year effects and improving demand conditions, as well as rising commodity prices, we expect inflation to be higher at 6.7%Y at end-2010 versus 6.2%Y at end-2009. On the back of this, as well as the possible narrowing of policy rate spreads with other central banks, we expect the CBT to start tightening in 3Q10. We pencil in a total hike of 150bp and at this juncture we believe that the risks might be equal in both directions; on one hand, inflation and growth suggest higher rates, while on the other, global growth jitters have not dissipated.

We expect fiscal policy to be broadly unchanged from 2009, especially from a non-interest expenditures perspective. However, we expect the cyclical improvement in revenues to improve the overall deficit by 1-1.5pp of GDP to bring it down to 5%. Debt to GDP should continue to rise mildly and stabilize at around 49%, according to our projections. The recent sovereign rating upgrade by Fitch might be followed by the other rating agencies in 2010, especially if the fiscal rule is legislated in 1Q10.

On the external front, a slight rise in the current account deficit should be broadly offset by lower amortizations in 2010 and hence the financing picture is likely to remain manageable even without any IMF funding. In fact, we expect FDI and private sector borrowing to pick up and the overall financing picture to remain somewhat better than in 2009. Central bank FX reserves are likely to remain broadly stable.

CE-3: Intra-Regional Divergence Should Narrow, Poland Should Still Outperform

One of the defining characteristics of 2009 was the severe GDP losses in relatively more open economies in CEE (the Czech Republic, Hungary), whereas Poland performed far better, thanks to its more closed nature, less severe credit crunch and more supportive fiscal policy. We think that aggressive destocking has come to an end, and inventories' contribution to growth will swing into positive territory in the coming quarters. We expect all countries to return to positive growth in 2010, but Polish outperformance should continue (3% GDP expansion versus 2.3% in the Czech Republic, 0.8% in Hungary and 1.1% in Romania). The inflation environment should remain mixed, with disinflation likely to prevail in 1H10 in Poland and Hungary, due to base effects, a better outlook for regulated prices and still-tame domestic demand (Hungary). In the Czech Republic, base effects are rather different and inflation will continue to gradually trend towards the 2% target, which should be reached by 3Q10. The rate cycles are not synchronized, so there may be some degree of policy divergence during the year. In countries where monetary easing started later, from a higher level, and the central bank felt more constrained by shaky global risk appetite (such as Romania and Hungary), we see risks of further easing into the early part of the year. In countries where the central banks acted pre-emptively (the Czech Republic) or the growth outlook does not suggest there is much slack left in the economy (Poland), we think that some rate tightening is a reasonable working assumption.

Fiscal risks intersect with political events. The deterioration in fiscal balances is certainly not unique to Central Europe. Here, too, the picture is quite varied. Hungary has been correcting its fiscal imbalances for three years already, and now has one of the healthiest structural fiscal positions in the whole of the EU, although its debt stock remains a challenge. The Czech deterioration has been severe, although some modest fiscal tightening has been put in place for next year. Romania is following the austerity measures prescribed by the IMF, but the lack of a parliamentary majority has derailed its efforts. Finally, Poland has thus far allowed the deficit to widen and delayed any structural tightening. However, with the debt ratio potentially set to exceed the crucial 55% of GDP level in 2010 barring strong privatization proceeds, we think that some fiscal measures will be on the agenda already during the year.

Unpopular fiscal tightening, in Poland as elsewhere, is going to prove particularly difficult in an election year. In Hungary, parliamentary elections will take place in April, with center-right Fidesz likely to win a landslide. Its policies are unclear, but at least in theory it favors lower taxes and smaller government, though it will seek to work within the IMF framework, we think. We expect no sweeping reforms in the first year of office, however, especially as the growth outlook remains weak and the fiscal situation (especially the high debt ratio) is problematic. There is also an added risk that Fidesz runs a fiscal audit and reveals the ‘true' size of the fiscal gap, incorporating losses at some off-budget state-owned enterprises. In Poland, there will be presidential elections in October, with current PM Tusk looking favorite to win against incumbent Lech Kaczynski. If that happens, the government would not have to fear the president's veto on major reform legislation, and would be in a position to accelerate on reforms (though note that parliamentary elections take place in 2011). The Czech elections in May 2010 should resolve the current impasse, though it is hard to say who will prevail and the risk of yet another hung parliament is real. And finally, the Romanian situation remains very fluid after Basescu's narrow win in the presidential elections. The danger now is that no government can be found and the IMF/EU program remains on hold, with no further disbursements. Early elections in February/March would follow, in that case, barely a year after the last ones.

Ukraine: Elections Positive, Eventually

For Ukraine, the outlook is dominated by upcoming elections.  We expect Victor Yanukovich to win a close second round presidential vote on February 7.  We also expect either realistic candidate eventually to reach a new deal with the IMF.  We are concerned, however, that this may take several months, during which time the fiscal and reserve positions are likely to be worsening rapidly.  We think the chances of an IMF deal before the election are very low, despite claims to the contrary from the government.  Indeed, any such disbursal might also meet accusations of political bias.  In the meantime, the fiscal position is clearly serious.  The government no longer publishes its Treasury balance, but its deposits at the NBU at the end of October were already at UAH 3.5 billion, a six-year low.  We do not expect debt default, despite some resistance by the NBU to accelerating monetary emission and allowing the government access to FX reserves.  A UAH 1.8 billion sovereign bond matures at the end of December, but there are no Eurobond maturities until December 2010.  Accelerated monetary emission looks probable, but with deflationary pressure still strong and FX reserves still a comfortable US$27.3 billion, this may be sustainable for several months without triggering an FX crisis.  Challenges to a narrow election result are a significant risk.  We also expect that if Yanukovich wins he will choose early parliamentary elections in May.  While the result is likely to be eventually very positive in terms of finally creating a coherent government, it risks making an IMF deal difficult before mid-year.  In the meantime, rising inflation and falling FX reserves are likely to keep perceptions of risk high. 

UAE: The Impact of Dubai's Debt Restructuring

The announcement of an additional US$10 billion in funding into Dubai Financial Support Fund from the Abu Dhabi government, part of which will be used to repay US$4.1 billion in Nakheel bond obligations, has mitigated the impact of the Dubai World restructuring.  Nevertheless, significant uncertainty remains due to the dearth of information regarding the scale and scope of the emirate's debt problems. Recent events have shone the light on Dubai's fiscal standing against the background of its significant public sector debt.  We estimate that Dubai's total public sector debt currently stands at around US$118 billion. This includes US$28.7 billion in direct government debt, or around 37% of the emirate's GDP. Going forward, we believe that the Dubai government will need to tap credit markets for additional funding. This may be necessary in order to finance development expenditures and shore up the standing of some of the emirate's most strategic government-related entities (GREs). However, the ability of the Dubai government to raise additional debt on somewhat favorable terms will depend on how successful it is in managing the current debt restructuring process. It is difficult to over-emphasize the need for a timely resolution of Dubai World's debt problems. A protracted negotiation process that leaves creditors with a significant loss would not be in the emirate's interest. Neither would be the lack of timely disclosure of other potential debt challenges affecting Dubai's GREs. We believe that a clear and well-communicated government strategy to deal with the debt situation is imperative at this stage in order to quell rampant market speculation and limit the long-term reputational damage to the emirate's credit standing. Moreover, ring-fencing the troubled debt of various GREs would help to limit the impact of the current crisis on entities that have solid business models and are able to shoulder additional debt.

The impact of Dubai's debt restructuring on the UAE's near-term economic prospects will likely be negative. For one, it is unlikely that we will see a significant pick up in credit growth following recent events. Access to foreign credit - which had increasingly been used by the non-bank sector to finance growth - will likely become more restricted. Moreover, credit growth may by curtailed by the domestic banks' need to consolidate their balance sheets, given their lingering exposure to the real estate market and emerging exposure to Dubai's GREs. Second, domestic expenditures will likely remain flat in 2010, shored up mostly by public spending in Abu Dhabi. The rest of the UAE will likely be hampered by: (i) weaker consumer confidence; (ii) lower investment spending by both the private sector and the quasi-public entities; and (iii) with the exception of Abu Dhabi, fiscal budgets that are constrained by the higher cost of financing and the rising level of public debt. On the positive side, domestic output will likely be supported by continued government spending in Abu Dhabi and strong external demand for goods and services. The latter is based on our projection of continued strength in oil markets and a steady global recovery. We also protect that the UAE's fiscal and external balances will register surpluses in 2010, on the back of continued strength in oil markets.

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Euroland
An Economy in Transition
December 18, 2009

By Elga Bartsch | London

In 2010, the European economy should transition towards a more sustainable, albeit still sub-par recovery.  This economic transition will be reflected by a shift in the engines of growth from a swing in the inventory cycle towards an ongoing recovery in domestic demand and net exports.  This transition is unlikely to be smooth, though.  Hence, investors should brace themselves for potential setbacks in the course of the next few quarters.  Our own quarterly forecast profile suggests a gradual slowdown in growth momentum over the course of next year.  Until some domestic demand dynamics start to materialise, the European economy remains in what could be coined as the no man's land of the business cycle. 

Monetary and fiscal policy decisions to move from triage treatment towards long-term rehabilitation, we think.  Thus, exit strategies will likely be a focus for financial markets.  With few exceptions (the UK, Spain, Ireland), we don't expect any meaningful fiscal policy tightening next year.  Hence, the fiscal policy issue is mainly about preparing the budgets for 2011 and beyond.  These are likely to bring more meaningful tightening in order to ensure a return to fiscal sustainability over the medium term.  As such, they will be key in shaping medium-term growth expectations too.  Monetary policy, by contrast, will likely start exiting its current ultra-expansionary stance in late 2010.  The anticipation of the new tightening cycle should cause higher bond yields, flatter yield curves and wider country spreads.

From an inventory-led bounce in industrial activity to a broader demand-based recovery.  As expected, the European economy emerged from recession in mid-2009.  The ignition was triggered by a turnaround in the inventory cycle, a normalisation in global trade flows and a policy-induced stabilisation of the financial system.  With the global economy clearly having turned the corner courtesy of buoyant growth in emerging markets, and with the euro's unrelenting ascent having been stopped for now, a revival in external demand is already coming through in the quarterly GDP reports.  The key question for 2010, however, is whether the initial spark that ignited the engine will translate into a broader domestic demand recovery.  Until these domestic demand dynamics materialise, the European recovery remains vulnerable.  There is no mistaking the considerable headwinds still faced by both consumers and corporates.  After a steep decline in 2009, we therefore look for what probably is best described as a stabilisation in domestic demand. 

Investment spending still struggles with subdued capacity utilisation and, what companies argue, are tight financing conditions.  Yet, rising business confidence and rebounding corporate profits should suffice to create a small rise in machinery and equipment investment - consistent with repair and replacement and possibly some rationalisation projects - in the course of the year.  Construction investment is a much more diverse story, driven by local property prices, public infrastructure projects and excess capacity issues.  Public construction investment aside, we expect construction investment to lag behind capital goods investment next year.  For the year as a whole, investment spending will likely stagnate due to a negative statistical overhang from 2009.

Consumer spending is to be dampened by a rise in unemployment, modest gains in wages and an increase in inflation.  True, in terms of their debt load, balance sheets and savings rate, European consumers are in better shape than their US and UK counterparts.  But, the lower number of layoffs recorded in Europe since the start of the recession suggests that part of the labour market adjustment is still to come - after all, activity shrank more sharply on this side of the Atlantic.  Thus far, tighter employment legislation, voluntary labour hoarding and government-sponsored short-shift programmes have prevented an adjustment in labour costs.  We see payrolls being trimmed further and expect the EMU unemployment rate to rise well into 2H10.  Against the backdrop, and factoring in the expansionary fiscal policy measures taken by several governments, we forecast broadly stable consumer spending for 2010.  After what likely will be a marked contraction in 2009, a stabilisation can already be regarded as an achievement in itself.

After a marked growth rise in the divergence between countries in 2009, we expect to see some renewed convergence in 2010.  We expect export-oriented countries with sizeable industrial sectors, such as Germany and Sweden, to outperform in terms of headline GDP growth.  However, the bigger bounce-back partially reflects that they were hit harder by the global trade slump than many of their counterparts.  We expect other countries such as Spain and Ireland, who were hit hard by the financial crisis, to continue to underperform as they work their way through the aftermath of a property price bubble, a construction boom and a saving-investment imbalance.  Both are making good progress though in rebalancing their economies and should be able to return to positive GDP growth in 2011. 

We expect the ECB, the BoE and the Riksbank to start raising rates gradually in 2H.  In total, we expect the ECB to and Riksbank to hike by 50bp and the BoE by 75bp by the end of next year (see UK Economics: Later Rate Rises, December 2, 2009).  In conjunction with raising rates, central banks will also begin to unwind their quantitative easing (QE) measures.  This unwinding might at least partially precede the first interest rate hikes but will unlikely be completed before the start of the new interest rate tightening cycle (see EuroTower Insights: Executing the Exit, November 11, 2009).  The details of the unwinding of QE are largely determined by the QE strategy pursued during the crisis.  The ECB and the Riksbank have resorted to passive QE via their various refi/repo operations.  Hence, unwinding QE will affect the banking system directly and asset markets indirectly.  Meanwhile, the BoE pursued a strategy of active QE, where it purchased assets directly in the open market.  Unwinding these measures would thus likely affect markets more directly and banks more indirectly. 

At this stage, there has been little indication that unwinding of QE or rate hikes are imminent.  The ECB signalled that it is no longer willing to offer one-year funding at a fixed rate of 1% - instead opting for a tracker rate reflecting the average refi rate in 2010 - and that it will phase out its one-year and its six-month LTROs next year.  The cornerstone of the ECB's QE, the fixed-rate tenders with full allotment (which allow the banking system to draw down unlimited funds from the ECB), will remain in place for as long as it takes though - at least until spring 2010.  Under this operational set-up, the overall liquidity entirely depends on the bids submitted by banks - unless, of course, the ECB takes additional action (e.g., reverse tenders).  Where the EONIA overnight rate and the EURIBOR money market rates trade relative to the ECB refi rate therefore depends on these bids too.  Hence, in addition to the two factors that would normally drive EONIA - the ECB's decision on the refi rate and/or the deposit rate and the ECB's liquidity provision (notably the decision to drain liquidity from the system via conducting reverse tenders or by issuing debt certificates) - we have a third risk factor: banks' bidding behaviour.  Thus far, overbidding by the banking system caused excess reserves to swell and pushed market rates well below the policy rate.  But this bidding behaviour could change, potentially causing the market rate to jump higher.

The unwinding of QE will likely have marked effects on money markets, bond markets and country spreads.  The heavy use of the ECB's refi facilities allowed banks to become big buyers of bonds. Since the start of the crisis, euro area banks have added about €330 billion to their holdings - effectively indirect QE via the banks. These purchases have likely helped to lower benchmark bond yields. But the main beneficiary probably was the EMU periphery.  Less generous liquidity provision next year is likely to have repercussions on the euro area government bond markets.  After intra-EMU spreads were characterised by a high degree of co-movement during the crisis, reflecting systemic concerns, we think that country-specific factors are likely to play a bigger role again in 2010.  The start of another ECB tightening cycle should also contribute to wider spreads across the board, as it has done historically.  Eligibility for the ECB's collateral pool, which is scheduled to revert back to A- at the end of 2010, could become another country-specific concern for investors. 

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United States
The Fed Will Exit in 2010
December 18, 2009

By Richard Berner & David Greenlaw | New York

Slow exit initially means steeper yield curve.  The Fed will begin the gradual exit from its ultra-accommodative monetary stance in 2010.  Three forward-looking factors will drive policy decisions: Inflation expectations are starting to rise, slack in the economy is narrowing, and the outlook for inflation will begin to change by mid-2010.  We think officials will implement the exit strategy in two stages: First, the Fed will start to drain reserves when Large-Scale Asset Purchases (LSAPs) end.  Second, it will begin raising the policy rate in 3Q, to 1.5% by year-end and 2% in 2011.  Normally, the start of a tightening cycle will flatten the Treasury yield curve.  Not this time, at least initially.  We agree with our colleague Jim Caron that forward yield curves are too flat because the market expects the Fed to tighten aggressively (see 2010 Global Interest Rate Outlook: the World Is Uneven, November 30, 2009).  While we expect more tightening by year-end than is in the price, we think the Fed's gradual exit, a rise in private credit demand and a significant shift to coupon issuance will boost Treasury yields by as much or even more than the policy rate by year-end.  With growth risks tilting from balanced to somewhat higher, the rising rate scenario may unfold sooner rather than later.

US Forecasts at a Glance

(Year-over-year % change)	2009E	2010E	2011E
Real GDP	-2.5	2.8	2.8
Inflation (CPI)	-0.3	2.6	2.5
Core Inflation (CPI)	1.7	1.4	1.9
Unit Labor Costs	-0.1	-0.0	1.1
After-Tax "Economic" Profits	-7.5	16.7	8.3
After-Tax "Book" Profits	-6.0	17.6	7.7

Source: Morgan Stanley Research     E= Morgan Stanley Research Estimates

Fed commentary reinforces the notion that any rate increases, at least through mid-year, are more likely to be at the back end of the yield curve than at the front.  Fed officials have yet to indicate any change in their extremely accommodative policy stance.  They have made their intentions abundantly clear in post-FOMC meeting statements, in the minutes of FOMC meetings, and in speeches.  At the November FOMC meeting they affirmed that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period".  With inflation likely to stay below the Fed's preferred level for some time, and the growth outlook improving but still uncertain, the costs of moving too soon are probably higher than those of being somewhat late, so Fed officials would rather err on the side of accommodation.  Thus, at the upcoming FOMC meeting on December 15-16, officials likely will acknowledge the improvement in the economy, but probably will make only minor changes to the language in the statement following the meeting.  More significant changes are likely in early 2010 when there will be additional signs of progress toward recovery in the labor market and inflation expectations have likely edged up a bit more.

Starting the exit still leaves the stance of monetary policy extremely accommodative.  While officials are ready in an operational sense to implement their exit strategy, implementation is several months off.  Indeed, far from exiting, quantitative easing will continue to add stimulus for the next few months.  Barring any change in the current timetable, the Fed will continue to purchase about US$250 billion more RMBS and agency securities in its LSAP programs through the end of March 2010.  The additional purchases will boost the Fed's overall balance sheet to US$2.5 trillion from US$2.25 trillion currently, and we assume that as a byproduct the Fed will also allow excess reserves to rise to about US$1.3 trillion from US$1.1 trillion.  In addition, the timetable for exit is conditional on the outlook.  As discussed below, the Fed is closely monitoring three criteria for exit, and we expect them to be met gradually.

However, ending the LSAPs does not mean that broadly defined monetary policy will suddenly become more restrictive.  The LSAPs were aimed at boosting economic activity by keeping longer-term private interest rates lower than they would otherwise be.  As Brian Sack, who runs the Fed's Open Market Desk, noted last week, the process works for Treasuries by narrowing the term premium, or the expected excess return that investors receive for their willingness to take duration risk.  For mortgage-backed securities, the LSAPs remove the negative convexity of MBS associated with prepayment risk from the market, keeping rates lower than they would otherwise be.  These portfolio balance effects operate through the levels of Treasuries, MBS and Agencies held on the Fed's balance sheet as a result of the LSAPs.  To be sure, the purchases themselves, or flows of those securities, might also have an impact on rates.  But the important point is that the impact on interest rates will persist after the purchases end, and will only fade slowly as the portfolio passively runs off.  While the Fed could sell securities from its portfolio to reverse those effects, officials have given strong indications that such actions would constitute an extremely aggressive move toward restraint that is unlikely to be needed. 

We assume that the Fed will implement the exit strategy in two stages.  First, using large-scale reverse repurchase operations, officials will begin to drain excess reserves (held primarily on deposit at the Fed) from the banking system at the end of 1Q.  The purpose is to bring the fed funds rate up to the level of the interest rate paid on excess reserves.  As the LSAP portfolios begin to run off, reducing the asset side of the Fed's balance sheet, the volume of reserves in the banking system would not change unless the Fed takes such action.  The gradual draining of reserves will also signal that policy will eventually be moving towards restraint.  The second stage of the exit strategy will involve raising the policy rate: Assuming that the criteria for exit are satisfied, we expect rate hikes will start in 3Q, with the policy rate going to 1.5% by year-end and to 2% in 2011. 

What are we and the Fed watching to trigger exit?  Three related criteria will set the timetable for exit: Changes in inflation expectations, and changes in the outlook for slack in the economy and for inflation itself.  In our view, all three are starting to change.  An ultra-accommodative monetary policy and its adjunct, a weaker dollar, have begun to boost inflation expectations; capital exit is helping to lift operating rates, and growth will soon move above trend.  So, while core inflation itself will decline for the next few months, these factors should promote a bottoming in inflation and a change in the inflation outlook.

Exit scorecard.  Inflation expectations are gradually rising; 5-year 5-year forward breakeven rates have moved up close to 2.5% in recent weeks, and 5-10 year median inflation expectations measured by the University of Michigan's consumer surveys have drifted up to 3%, or the high end of the recent range.  That gentle rise is far from alarming.  But it does reflect an incipient tension between the current stance of monetary policy and the improving economic and inflation outlook, and we believe that inflation expectations will continue to rise until the Fed signals a shift in policy.  Economic slack by any measure is still at record levels, with the ‘output gap' at more than 6% of GDP.  Industry operating rates have risen from their lows to 70.7%, but are still below previous record lows, and the unemployment rate at 10% is still at a 26-year high.  Meanwhile, we think core inflation is headed lower in the near term, thanks to the slack in labor and product markets, including housing.  From current levels of 1.7% (CPI) and 1.4% (personal consumption price index), we expect core inflation to decline to 1% by early in 2010.  But an improving economy will narrow all three measures of slack, and together with the ongoing rise in commodity and import prices, that change should alter the inflation outlook for the second half of 2010 and 2011. 

The case for sustainable growth.  Four factors should promote sustainable growth through 2011: 1) Monetary policy has fostered improving financial conditions and market healing; 2) fiscal thrust is poised to translate into fiscal impact; 3) strong growth abroad will lift US exports and earnings; and 4) economic and financial excesses are abating.  On the last point, housing and inventory imbalances are diminishing, companies have slashed capacity, and employment is now running below sustainable levels.

Healing in financial markets, credit crunch abating.  We think that the combination of aggressive policy stimulus, the dramatic improvement in the functioning of financial markets, higher prices for risky assets, and the recent slower pace of tightening bank lending standards will increase the chances for sustainable recovery.  To be sure, the Fed's Senior Loan Officer Survey indicates that banks were still tightening lending standards in October, but at a slower pace, and it's pace that matters for growth.  Tight lending standards are still depressing the level of lending and thus output, but their effect on growth is abating.  We find that a 10-point drop in the proportion of banks tightening standards allows a one percentage-point increase in bank lending growth (see Calibrating the Credit Crunch, November 20, 2009).

Lasting fiscal impact.  A second support for sustainable recovery comes from fiscal policy.  We have emphasized that there are significant lags between fiscal thrust and fiscal impact, so that the effects of fiscal stimulus will not soon peter out as some have argued.  Measured by the change in the cyclically adjusted federal deficit in relation to potential GDP, fiscal thrust should fall to about zero by the middle of 2010, and if the Bush tax cuts sunset as scheduled on December 31, thrust could turn into significant fiscal drag.  However, we suspect that there are lags of 3-9 months between thrust and impact, so that fiscal impact will remain positive well into 2011.  That is especially the case for infrastructure outlays, which at the state and local government level are only starting to show improvement in monthly data through October.  Signs of relief are also showing up in state and local government jobs; they have risen by 35,000 over the past two months after declining by 143,000 in the previous year.  In addition, there is upside risk to fiscal thrust itself, as Congress just enacted an extension to and expansion of the first-time homebuyer tax credit through April, plus increased jobless and Cobra benefits, and prospects have improved for a tax credit or other measures to boost employment.

Strong growth abroad.  A key narrative in our global recovery story is the notion that growth in the emerging market economies will continue to outstrip that in the developed world.  Strong EM growth is part of the reason why we believe US exports and earnings will grow vigorously.  That is far from conventional thinking, as we are conditioned to believe that the US economy will be the engine for global recovery.  Yet EM economies now account for 36% of world imports, up from 24% in the 2002-3 recovery.  Contributing to our forecast of 3.7% aggregate global growth in 2010, EM economies are growing at a 5-6% pace, three times the pace of DM economies. 

Exiting excess.  Progress on reducing four areas of excess also increases the odds for sustainable recovery (see Exit from Excess: Setting the Stage for Sustainable Growth, September 14, 2009).  First, housing imbalances are shrinking.  Single-family homeowner vacancy rates declined from their peaks of 2.9% to 2.7% in 3Q, and further declines likely occurred this quarter; the inventory of unsold new homes dropped to 6.7 months' supply.  We do worry that rising foreclosures could increase housing imbalances and the pressure on home prices, given the ‘shadow inventory' of yet-to-be foreclosed homes, reckoned by some to be 5-7 million.  But the bust in housing starts has slowed growth in the housing stock to less than 1%, and with demand improving, fundamental imbalances are dwindling (see Assessing Housing Risks, November 30, 2009). 

Second, inventory liquidation peaked in 2Q, and while companies continue to shed inventories that remain high in relation to sales, a slower pace of liquidation will add to growth through 2010.  The swing in inventories added 0.9 annualized percentage points to growth in 3Q, and we estimate that it will add almost two percentage points at an annual rate to 4Q growth.  That support won't end quickly, as production is still catching up with demand; in 3Q, GDP was still 1.1 percentage points below the level of final demand.  We expect the production-demand gap to close over the course of 2010, adding 0.6 percentage points to 2010 growth through a slower pace of inventory liquidation, and a shift to inventory accumulation should add about 0.4 percentage points to growth in 2011.

Third, companies are reducing excess capacity at record rates: Capacity in manufacturing, excluding high-tech and motor vehicles and parts industries, has shrunk by 1% over the past year - a pace far exceeding the post-tech bubble bust.  And capacity in another industrial subaggregate - including primary metals, electrical equipment and appliances, paper, textiles, leather, printing, rubber and plastics, and beverages and tobacco - has contracted by a whopping 2.7% over the past year.  As a result, operating rates are rising again, up 250bp from their spring lows, helping to arrest the decline in inflation and laying the groundwork for renewed capital spending gains. 

Jobless recovery less likely.  Finally, we've argued that past aggressive payroll cuts make a ‘jobless recovery' less likely.  Rising jobs and income are critical to promote a self-sustaining recovery.  Rising income is needed to support consumer spending and to reduce debt/income and debt service/income ratios.  It will also raise ‘cure' rates for delinquent mortgages and help consumers qualify for a loan. 

In our view, past job cuts have virtually eliminated what were minimal hiring excesses and are likely now creating some pent-up demand.  To gauge excess, we cumulate the errors made by a relatively standard relationship used to forecast labor hours worked and employment; positive cumulative differences suggest a labor overhang.  After moving to zero in 2Q, the cumulative errors are now sharply negative.  Moreover, early estimates indicate that non-farm payrolls were 824,000 lower in the year ended in March 2009 than currently estimated.  That implies, if those revisions were all in private payrolls, that the current private job tally is 650,000 lower than at the trough in the last recession in July of 2003.  As we see it, that implies some underlying pent-up demand for labor that should materialize in 1Q10. 

That move to positive payroll growth may now be underway.  Non-farm payrolls declined by just 11,000 in November, and with revisions, the 87,000 average decline in the past three months was the smallest since February 2008.  Three other signs of solid improvement in labor markets emerged in November: a 52,000 surge in temp hires, typically a leading indicator of labor demand; a 12-minute jump in the private workweek, also a classic early sign of improved demand; and a partial reversal of October's jump in the unemployment rate, which now stands at 10%.  A 0.6% surge in hours worked helped boost weekly payrolls (wage and salary income) by 0.7%, the biggest gain in two-and-a-half years.  It's important to note that this improvement in labor markets has to go much further to assure recovery, especially to bring the jobless rate down close to full employment.  But the recent rebound has been just as rapid as was the plunge when the recession began - an encouraging sign.

Don't get us wrong: There is still pain out there for consumers and lenders, and other headwinds to growth.  But tracing the chain from rising growth abroad to US output, employment and income demonstrates that there is more to this recovery than cars, housing and other spending. 

The case for higher real yields.  Four factors should boost real longer-term rates significantly over 2010: 1) the circumstances surrounding the Fed's exit strategy, which will trigger a repricing of the likely path of the policy rate; 2) sustainable growth that will begin to lift private credit demands; 3) massive Treasury borrowing and a shift to coupons; and 4) uncertainty over fiscal credibility and inflation, which will lift term premiums.  

Currently, fed funds and eurodollar futures are pricing in an 88bp move up in rates by end-2010, and a cumulative move by end-2011 of 205bp.  While that is significantly more than what markets expected a few weeks ago, it is less than what we expect through end-2010.  As a result, we think the market has more repricing of the yield curve to do.

Looming supply-demand imbalance and shift to longer maturities will push yields higher.  Rising private credit demands and higher Treasury coupon issuance will push real yields higher in 2010 and 2011.  Private credit demands will revive when businesses' external financing needs - at a record-low -2.5% of GDP in 2Q - turn positive and when household deleveraging gives way to new mortgage and other borrowing, if only at a moderate pace.  When companies switch from inventory liquidation to accumulation, and when capital spending revives, corporate spending will outstrip cash flow again. 

Although the US federal budget deficit may have peaked in F2009 (both in dollar terms and as a percentage of GDP), Treasury coupon issuance will continue to be pushed higher. This reflects an attempt to gradually boost the average maturity of the Treasury debt outstanding from its current level of about 4 years up to 6-7 years. Such a swing would take the average maturity from a historically low level at present to a level that is historically quite high. Thus, not only is gross coupon issuance poised for another sharp jump in F2010, but the average maturity of the issuance will have to move higher if the Treasury is to move toward a 6-7-year average maturity for the outstanding debt.

In short, we expect upcoming auctions to tilt steadily toward longer maturities, much as has occurred in the most recent announcements.  The shift from 20-year to 30-year TIPS also supported efforts to boost maturities.  The trend to longer maturities is likely to continue through mid-2010.  Beyond that point, we suspect that short-dated issuance (2s and 3s) may be reduced while longer-dated supply remains elevated.

Why does the Treasury want to lengthen the duration of its debt?  Treasury bill issuance soared in recent years and the average maturity fell, as is typical when there is a sharp and sudden spike in the borrowing need.  The Treasury now wants to rein in the bill supply and begin to normalize the maturity profile.  Why is it planning to go beyond historical norms?  Treasury officials appear to want to create a cushion of borrowing capability at the front end of the curve in case there is a sudden need for short-term funding.  Also, even though the Treasury's public position is that it is not an opportunistic borrower - i.e., it doesn't try to time the market - it appears advantageous to attempt to lock in low long-term borrowing costs at present.

One downside, two upside risks to growth outlook.  We see one potential downside risk and two upside risks to this outlook.  Rising mortgage foreclosures may threaten home prices, wealth and credit availability.  We are not sure if the ‘shadow inventory' of yet-to-be-foreclosed homes is as high as the most pessimistic estimates have it.  But even if the number of pending foreclosures is half that size, they will add to a looming supply overhang of unoccupied houses, and such additions may promote renewed declines in home prices as they come on the market in the spring.  On the other hand, there are two important upside risks: Quantitative easing may have improved financial conditions more than we think, as hinted in risky asset prices and issuance volumes, and Congress is already adding further fiscal stimulus, which may take effect as the economy is gathering significant strength.  For example, the recent extension and expansion of the first-time homebuyer tax credit will last through April 30, 2010, and other fiscal initiatives to boost employment are possible. 

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Global
Exit Strategies for the Global Central Bank
December 18, 2009

By Manoj Pradhan | London

Faced with the prospect of a deepening global recession and strong deflationary forces, the Global Central Bank (GCB) delivered unprecedented monetary easing in 2008 and 2009. Rates were pushed down faster and lower than they have ever been in many parts of the world, and unconventional easing was employed when the zero bound for interest rates precluded further conventional easing. Even if the decisions were not made collectively, the policy stimulus spoke with one voice. And asset markets and the global economy responded.

The next challenge for the GCB, naturally, is to take away excessive monetary stimulus at the appropriate time, i.e., when the recovery is sustainable, and in a way that keeps inflation and inflation expectations on a benign path. National and regional differences are likely to be a dominant theme going forward, and divergences in policies of national central banks will likely be scrutinised closely. However, there is little doubt that the global monetary impetus unleashed by ultra-expansionary monetary policies will be a common theme in the exit strategy for practically every national central bank.

Peloton still holds firm: The common ground that central banks share because of global liquidity is curiously similar to strategies of a cycling peloton (see "The Peloton Holds Firm", The Global Monetary Analyst, November 4, 2009). Cyclists usually cluster together to collectively fight wind-drag. Huddling together has spillover benefits to the entire group. Front riders usually have a lot more flexibility but then battle the most with headwinds, while riders at the back have to react sooner to unexpected changes in speed or conditions. Central banks too have been clustering together to get the benefit of excess liquidity spillovers. Early movers like the Bank of Israel, the RBA and the Norges Bank have had to deal with the dual headwinds of currency appreciation and insufficient traction in their domestic debt and equity markets, both of which are linked to their counterparts in the major economies. Excess liquidity is likely to remain in place for the foreseeable future, which means that central bank strategies are also likely to be impacted by the dynamics of the monetary peloton.

G10 versus EM: One reason why excess liquidity will continue to play a dominant role in exit strategies is the difference between the growth profiles of the G10 and EM (especially AXJ) economies. The ‘BBB' (bumpy, below-par and boring) recovery in the G10 will keep central banks there from hiking aggressively, and will almost certainly mean that policy rates will remain below their neutral levels for all of 2010. Our team expects the Fed and the ECB to hike rates starting in 3Q10, both ending the year with policy rates at 1.5%. The BoE is expected to raise rates in 4Q10 by 75bp to 1.25%, and even this forecast is contingent on the outcome of the election in early/mid-2010. In Japan, the election in 2009 and the fiscal consolidation that the new administration is likely to espouse are partly responsible for the technical recession that our Japan economics team expects in 1H10. Consequently, the BoJ's next move is likely to be a cut rather than a hike, with the policy rate likely to be lowered by 5bp to 0.05% in 2Q10. A first hike is expected only in 3Q11.

Both the rate cuts and expected rate hikes focus strongly on the growth challenges to the economy. It is important to keep in mind that the extent to which central banks cut rates was a function of both the starting point as well as the zero bound. New Zealand and Australia policy rates were at 8.25% and 7.25% before the recession, while many of the other G10 economies effectively hit the zero lower bound when they cut rates. On the way out, central banks appear to be keenly focused on the growth prospects for their respective economies, but will be aware of the growth as well as the monetary policy spillovers from the major economies.

But policy rates are not the only kind of monetary easing that have to be unwound:  Active QE continues to expand central bank balance sheets (ceteris paribus) as asset purchase schemes at the Fed, the ECB and the BoE slowly near their targets. In contrast, again, the BoJ could actually step up its purchases of JGBs to combat what seems to be another bout of sustained deflation. Reducing their respective balance sheets will mean either successfully absorbing the liquidity at the disposal of commercial banks consistently over time, selling some of the assets purchased, or issuing securities to mop up liquidity. None of these options is without side-effects or risks. Just like policy rates, unwinding QE too quickly will risk a strong market reaction and risk economic recovery, while waiting too long creates inflationary risks (see "QE2 - Size Matters", The Global Monetary Analyst, March 25, 2009 and "Reversing Excessive Excess Reserves", The Global Monetary Analyst, October 28, 2009). It is important to note, however, that there are significant differences among central banks as far as unwinding QE is concerned - for more details see Berner/Greenlaw (The Fed Will Exit in 2010, December 7, 2009), Bartsch ("Executing the Exit", The Global Monetary Analyst, November 11, 2009) and Baker/Sleeman ("UK: Later 2010 Rate Rises", The Global Monetary Analyst, December 2, 2009).

Central banks in emerging markets have slightly different issues to deal with: Major EM economies are racing ahead, and the risk is that central banks there could hike sooner than expected. Strong growth in the EM world means that economies with flexible exchange rates face currency appreciation as well as more capital inflows as they talk of higher rates, while economies with fixed exchange rates import easy monetary policies from the major central banks, which also bring with them capital inflows. The end result for both is that a meaningful monetary policy tightening would imply more rate hikes than usual, something that most EM central banks are probably unwilling to do. Mostly unencumbered by a patchy recovery, this doubly easy monetary policy in EM is a strong basis for expecting continued economic and asset outperformance.

The central banks of China, India and Brazil are all focused on upside risks to economic growth and asset prices, which could hasten their exit. The PBoC is expected to use tools such as reserve requirements in addition to its policy rate instrument to tighten policy. The policy rate itself is expected to be hiked just twice over 2010, taking rates from 5.31% to 5.85% in 2H10 and keeping them on hold thereafter throughout 2011. Brazil is likely to exit a shade earlier, raising rates by 50bp in 2Q10 to 9.25% and then further to 11% by the end of 2011. The RBI, on the other hand, has been worried about inflation problems for a while now and is expected to raise rates in 1Q10. Being an early mover in the peloton, it is well aware of the currency appreciation issues as well as possible ‘perverse' capital inflows that may be attracted to rising yields. Finally, the Central Bank of Russia is still in easing mode. Our Russia team is looking for 150bp of rate cuts in 2010 and a first rate hike only in 1Q11.

Exit from ultra-expansionary policies does not mean a move to neutral: Barring a major policy error, the exit from ultra-low interest rates should not mean a removal of accommodative monetary policies. The GCB is unlikely to move rates back to neutral in 2010 - and there appear to be no dissenters on this ‘vote'. As the experience of front riders in the monetary peloton has shown, sharp interest rate hikes when major central banks are still in expansionary territory creates headwinds via currency appreciation and reduced policy traction in asset markets. Very few of the smaller economies will be able to hike aggressively, given these headwinds and weak export sectors in 2010, while monetary policy in the larger economies will be constrained by the BBB recovery. Thus, the ‘AAA' liquidity cycle (ample, abundant, augmenting) is likely to remain largely intact in 2010. The slow exit to a relatively less expansionary stance and the arrival of a sustainable recovery will be a key combination that will support growth and asset prices, in the G10 and even more so in emerging markets.

The major players in the peloton will begin to assert themselves - with implications for others: Excess liquidity supplied by major central banks will continue to be a driving force in 2010, and other central banks have little choice but to be highly cognisant of the changing dynamics. As the major central banks start to tighten in 2H10, the rest of the world will likely inherit rising bond yields and likely softer equity markets. This is nothing short of a de facto tightening for other central banks, most of whose economies and financial markets are linked to the major ones. There are at least two implications that arise from this move. First, the front riders who are already a pace ahead will be reined in as the peloton catches up, probably requiring that the early hikers pause or at least slow down their tightening campaign. Second, central banks that are likely to tighten around the same time as the major central banks will have to be nimble, tightening by less if the major central banks are more aggressive than expected, or vice versa. Both of these implications will have an impact not only on market pricing of policy rates, but also on currencies. Interestingly, investors may view these as plays on the smaller economies, or an alternative and probably less crowded way to play moves by major central banks.

However, inflation risks will slowly emerge as a worry: As growth shows signs of being sustainable, goods prices should find some support and markets will likely start worrying about the inflation-output trade-off. On three occasions in 2H09 (the dovish response of central bankers to the pricing in of rate hikes in August-September, the dovish statement after the previous FOMC meeting and Fed Chairman Bernanke's speech on November 16), the rally in front-end rates was accompanied by a widening of long-term breakeven inflation rates. 2010 is likely to see more of the same since central banks are unlikely to be aggressive in their exit strategies.

In the G10, the decline in potential output growth complicates monetary policy in two ways. The accompanying decline in the natural rate implies that policy rates have less room to go upwards before they reach neutral territory. This is likely to make central banks more cautious as the level of rates goes meaningfully above their current values of near-zero. Second, a fall in potential output growth directly implies that the output gap could close at a brisk pace as the recovery becomes entrenched, taking away some of the headwinds that inflation currently faces. Further, in an earlier note we have argued that inflation expectations are not well anchored. This is evidenced by the strong divergence in views among investors and even professional forecasters (see "Priced for Perfection... For Now!" The Global Monetary Analyst, November 18, 2009).

Emerging markets also face inflation risks, particularly those with fixed exchange rate regimes. These economies import the expansionary stance of the major central banks via the fixed exchange rate. In the absence of nominal exchange rate flexibility and aggressive interest rate hikes, macroeconomic adjustment is likely to happen via the real exchange rate, i.e., by pushing up prices in EM faster than in the G10. In a nutshell, until the ultra-expansionary monetary stance - through traditional policy rate tools as well as unconventional measures - is successfully reversed, inflation risks will likely remain in the system. Not because central banks cannot act aggressively, but because they may not.

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Global
Global Forecast Update: 2010 Outlook: From Exit to Exit
December 18, 2009

By Joachim Fels, Manoj Pradhan & Spyros Andreopoulos | London

This year was all about the exit from the Great Recession - and, as we had expected at the start of the year, it worked courtesy of massive global policy stimulus. Next year will be all about the exit from super-expansionary monetary policy - we expect the major central banks to start exiting around mid-2010. Yes, they will likely be cautious, gradual and transparent. However, the prospect and process of withdrawal may have unintended consequences: we think government bond markets will be the first victim. While we believe that the exit will be the dominant macro theme next year, we identify five important economic themes in our global economic outlook that, in our view, will be highly relevant for investors in 2010. 

A tale of two worlds: We forecast 4% global GDP growth in 2010, up only marginally from three months ago (see the previous Global Forecast Snapshots: ‘Up' Without ‘Swing', September 10, 2009).  True, if this turns out to be about right, it would be a fairly decent outcome, especially compared to the widespread doom and gloom earlier this year. However, it falls short of the close to 5% growth rate in the five years prior to the Great Recession, and it will be the product of unprecedented monetary and fiscal stimulus, which poses substantial longer-term risks on various fronts. Moreover, our 4% global GDP growth forecast masks two very different stories. One is a still fairly tepid recovery for the advanced economies - the ‘triple B' recovery we discuss below. The other is a much more positive outlook for emerging markets, where we forecast output to grow by 6.5% in 2010 (China 10%, India 8%, Russia 5.3%, Brazil 4.8%), up from 1.6% this year. A rebalancing towards domestic demand-led growth in EM is well underway. Moreover, as our China economist Qing Wang has been pointing out for a while now, the official statistics are likely to vastly underestimate the level and growth rate of consumer spending in China. In short, we think that the theme of EM growth outperformance has staying power and has even been bolstered by the crisis.

A ‘triple-B' recovery in G10: In contrast to our upbeat EM story, we forecast barely 2% average GDP growth in the advanced G10 economies in 2010 - a triple B recovery where the three Bs stand for bumpy, below-par and boring. On our estimates, GDP growth has averaged around 2% in the G10 in the second half of this year and won't accelerate much from that pace next year - hence our ‘up' without ‘swing' characterisation from three months ago remains valid. The two reasons why we think the recovery in advanced economies will be of the ‘triple B' type are that it is likely to be creditless and jobless. Creditless recoveries - defined as a situation where banks are reluctant to lend and the non-bank private sector is unwilling to borrow - are the norm following a combination of a credit boom in the preceding cycle and a banking crisis; and creditless recoveries typically display sub-par economic growth as credit intermediation is hampered. Moreover, we expect a jobless G10 recovery, with unemployment in the US declining only marginally next year and rising further in Europe and Japan. Unemployment may well stay structurally higher over the next several years in the advanced economies as many of the unemployed either have the wrong skills or are in the wrong place in an environment where the sectoral and regional drivers of growth are shifting.

More growth differentiation within the G3: Beneath the surface of what we call a lacklustre ‘triple B' recovery in the advanced economies lies a differentiated story for the three largest economies within this block - the US, the euro area and Japan.  We expect significant growth differentials between these countries in 2010, which may well become a topic for currency, interest rate and equity markets again. We see the US as the growth leader among this group next year, with output expanding by 2.8% in the annual average of 2010. The euro area economy looks set to grow by less than half that rate (1.2%), while Japan should hardly grow at all (0.4%) next year and is forecast to actually fall back into a technical recession in 1H10. One reason for relative US outperformance is that the creditless nature of the recovery affects the US private sector by less because banks (as opposed to capital markets) play a smaller role in financing the economy than in Europe or Japan. Another reason is that US companies have been much more aggressive in shedding labour this year than their European or Japanese counterparts, so the US labour markets looks set to recover (albeit slowly) next year, while we expect unemployment to rise further in both Europe and Japan.  Further, European and Japanese exporters should feel the pain from this year's currency appreciation, whereas US exporters should benefit from this year's dollar weakness.

Crawling towards the exit, but triple A liquidity cycle remains intact: As stated above, we expect the beginning of the exit from super-expansionary monetary policies and its implications to be the dominant global macro theme in 2010. We will discuss details of the likely monetary exit strategies across countries in next week's year-end Global Monetary Analyst. Here, it suffices to say that we expect the Fed, the ECB and the PBoC to move roughly in tandem and raise interest rates from 3Q10, with the Bank of England following in 4Q. Some, like the central banks of India, Korea and Canada, are likely to move earlier, while others, such as Japan, will lag behind. Generally, given the remaining fragility in the financial sector, central banks are likely to approach the exit in a cautious, gradual and transparent manner, so any hikes will likely be telegraphed well in advance, partly through appropriate twists in the crafted language, and partly through some cautious draining of excess bank reserves. Importantly, while the end of easing and the beginning of the exit can be expected to cause wobbles in financial markets, and this is one reason why we see bonds selling off sharply next year, we point out that official rates are likely to stay well below their neutral levels (even factoring in that these themselves are likely to be lower now than they have been in the past) throughout 2010 and, probably, also in 2011. Hence, monetary policy is only expected to transition from super-expansionary to still-pretty-expansionary. This would leave what we have dubbed the ‘triple A' liquidity cycle (ample, abundant and augmenting), which we have identified as the main driver behind this year's asset price bonanza and economic recovery, fairly intact next year. The metrics we follow to validate or refute this view is our global excess liquidity measure depicted in the chart below, which is defined as transaction money (cash and overnight deposits) held by non-banks per unit of nominal GDP. This measure exploded this year and we would expect it to rise further, though at a much lower pace, through 2010.

Sovereign and inflation risks on the rise: Fifth, but not least, we think that sovereign risk and inflation risk will be a major theme for markets in 2010. The current issues surrounding Greece's fiscal problems are only a taste of things to come in many other advanced (note: not emerging) economies, in our view. We note that fiscal policy looks set to remain expansionary in all major economies next year, as it arguably should be, given the ‘triple B' recovery which still requires support. However, markets are likely to increasingly worry about longer-term fiscal sustainability, and rightly so. Importantly, the issue is not really about potential sovereign defaults in advanced economies. These are extremely unlikely, for a simple reason: most of the government debt outstanding in advanced economies is in domestic currency, and in the (unlikely) case that governments cannot fund debt service payments through new debt issuance, tax increases or asset sales,  they can instruct their central bank to print whatever is needed (call it quantitative easing). Thus, in the last analysis, sovereign risk translates into inflation risk rather than outright default risk. We expect markets to increasingly focus on these risks in the year ahead, pushing inflation premia and thus bond yields significantly higher. Put differently, the next crisis is likely to be a crisis of confidence in governments' and central banks' ability to shoulder the rising public sector debt burden without creating inflation.

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Global
2010 Outlook: From Exit to Exit
December 18, 2009

By Richard Berner | New York & Joachim Fels | London

This year was all about the exit from the Great Recession. Next year will be all about the exit from super-expansionary monetary policy - we expect the major central banks to start exiting around mid-2010. The prospect and process of withdrawal may have unintended consequences: we think government bond markets will be the first victim.

A tale of two worlds. We forecast 4% global GDP growth in 2010, but this masks two very different stories. One is a still fairly tepid recovery for the advanced economies. The other is a much more positive outlook for emerging markets, where we forecast output to grow by 6.5% in 2010. In short, we think that the themes of global rebalancing and EM growth outperformance have staying power and have even been bolstered by the crisis.

In the pieces that follow, our global economics team presents its views on how each region will fare in the coming year as the world continues to recover.  This is the final edition of the Global Economic Forum for 2009.  We will resume regular publication beginning in the first week of 2010.

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