|
Singapore
Upgrading GDP Forecasts January 05, 2010 By Deyi Tan, Chetan Ahya & Shweta Singh | Singapore What's new? As per the PM's New Year Message for 2010, the 4Q09 GDP advance estimate released by the MTI today shows that the economy expanded by 3.5%Y (versus an upwardly revised +0.9%Y in 3Q09). Although the peak (1Q08) to trough (1Q09) GDP contraction of -9.4% had been significantly worse than the 1998 (-4.5% over four quarters) and 2001 (-6.4% over three quarters) cycles, the subsequent sequential rebound in early 2009 means that 2009 now looks likely to end with a contraction of -2.1%Y (versus our forecast of -2.5%Y). This is marginally better than the -2.3%Y seen in 2001 and a tad lower than the -1.7%Y in 1998. Yet, we note that the macro deceleration in the downcycle had been spread over two years, with 2008 (+1.1%Y) bearing part of the slowdown impact as well. GDP now stands 3.4% below the 1Q08 peak. On a sequential seasonally adjusted basis, however, 4Q09 headline GDP contracted 6.8%Q saar as manufacturing momentum pulled back. What's in the details? The headline %Y acceleration masks a few underlying trends. Manufacturing momentum is expected to decelerate to +1.0%Y (versus +7.9%Y in 3Q09), primarily on the back of biomed volatility. As suggested by the higher-frequency construction progress payments, construction momentum has slowed slightly to +11.2%Y (versus +12.8%Y in 3Q09) but still stayed in double-digit territory, given the lagged nature of such investment. Services is the only segment which has shown a pick-up in pace to +3.7%Y (versus -2.2%Y in 3Q09). Addressing a few issues: 1) Does the sequential contraction in 4Q09 raise the possibility of another technical recession? We see another technical recession as unlikely. Recall that Singapore had entered into a recession in 2Q08 and exited from it in 2Q09. A double-dip global recession is not our base case, given the global policy support still in place. We think that rather than being symptomatic of renewed weakness, the QoQ decline in 4Q09 simply reflects payback from the strong sequential momentum seen in the +21.6%Q saar in 2Q and +14.9%Q saar in 3Q, due to the biomed segment. In other words, the notoriously volatile biomed segment that boosted manufacturing momentum in 2Q and 3Q is now mean-reverting, which explains the sequential contraction. Excluding biomed, we believe that the underlying trend is likely one of continued improvement. We calculate that GDP ex-bio momentum saw a sharper acceleration to +4.7%Y (from -2.1%Y in 3Q09) compared with headline GDP which went from +0.9%Y in 3Q09 to +3.5%Y in 4Q09. Additionally, given the capital-intensiveness of the biomed segment, just as we were of the view that the strong biomed upsurge was unlikely to have had massive labour market implications, the correction now similarly is unlikely to have a meaningful impact on the labour market in the opposite direction. 2) What's the impact on our macro views? We are upgrading our 2010 GDP and 2011 GDP estimates to 5%Y from 4.0%Y and 4.5%Y, respectively, following today's data release. Morgan Stanley's assessment of the world economy has turned more positive over the last few months, with global GDP growth revised upwards from 3.7%Y in 2010 and 2011 to 4% and 3.9%, respectively, in our last Global Forecast Snapshots (see 2010 Outlook: From Exit to Exit by Joachim Fels, Manoj Pradhan and Spyros Andreopoulos, December 9, 2009). As a result, we have factored in higher trade numbers as well as a positive spillover onto domestic demand. Moreover, today's data release has also come in higher than the numbers embedded within our -2.5% full-year forecast for 2009. Given the higher-than-expected entry point in 2010 and with the extremely low base effect for 1Q10, we calculate that even with zero sequential growth in 1Q10, the %Y for 1Q10 is likely to come closer to 6-7%. Beyond the cyclical rebound, however, we think that the global multi-year rebalancing process means that it will be harder for the export-oriented economy to extract growth beta compared to before. As we have highlighted previously, the Singapore economy is unlikely to return to the 8.2% CAGR seen in the last cycle between 2004 and 2007. Indeed, the global economics team does not expect the world to return to the close to 5% pace seen back then, which was premised on the imbalanced formula of debt supercycle and consumer leveraging in the developed world and a giant export machinery in the current-account surplus Asia. As it is, policymakers are in the process of devising a roadmap for new growth drivers which would be announced closer to Budget time. Continued efforts at policy renewal should yield better growth prospects but policy diversification takes time and we suspect that a lower level of 5% growth looks likely to be the medium-term trend for Singapore going forward. 3) How will the central bank react in April? To recap, during the downcycle, the S$NEER exchange rate policy had been adjusted several times. In Oct-08, the central bank shifted from an appreciation stance to a zero-appreciation stance with no recentering or change in S$NEER bandwidth. In Apr-09, the midpoint of the bandwidth was recentred downwards to the prevailing level of S$NEER but the zero appreciation stance and bandwidth were maintained. The policy stance was kept unchanged in the latest Oct-09 review. Going forward, we suspect that a zero appreciation stance could be maintained throughout 2010. Indeed, in the period since 2001 when official policy review statements were released, growth conditions in monetary policy reviews when the MAS shifted to or maintained a gradual appreciation stance tends to average around 8%Y in the 3-6 months preceding the monetary policy reviews. As a comparison, we expect GDP growth to come in at 5%Y for 2010. If at all, appreciation pressures in the S$NEER pushing against the upper bound of the bandwidth would be vented via a one-off centering upwards, rather than a change to an appreciation stance. Regarding the need to manage inflation/asset reflation, we expect 2010 inflation to still stay relatively benign. However, asset markets, particularly the property market, have reflated strongly despite below-trend macro conditions. This could continue to pose a dilemma to policymakers, in our view. Rather than using the exchange rate tool, which is a blunt one, we suspect that price pressures are likely to be managed via administrative measures. Recall that policymakers have already taken a series of demand and supply-side measures such as the removal of the interest-absorption loans and interest-only loans and the release of more land sites in a bid to manage the property price acceleration.
China
Fear of Inflation to Intensify; Launching Inflation Tracker January 05, 2010 By Qing Wang | Hong Kong & Steven Zhang | Shanghai First Up, a Recap of Our Inflation Call We forecast average CPI inflation at about 2.5% in 2010. Specifically, the inflation rate turned positive in November 2009 and will start to rise rather rapidly to about 2.4%Y by end-1Q10 and 3.6%Y by end-2Q10, as the lag effects of strong true M2 growth in 3Q09 and 4Q09 are only partly offset by continued weak exports. However, CPI inflation will likely start to moderate to average 2.9%Y in 3Q10 and 2.1%Y in 4Q10, as the pick-up in export growth since 2Q10 will add to inflationary pressures despite some moderation in M2 growth (see China Economics: A Goldilocks Scenario in '10, November 22, 2009). In this context, 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 that 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 Morgan Stanley's commodities research team expects commodities prices to rise steadily in 2010, it does not foresee significant spikes in prices. It projects average prices for 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 trajectory of CPI inflation for 2010 that is similar to the one derived from demand-side analysis (see China Economics: Inflation Outlook in 2010: A Supply-Side Perspective, November 1, 2009). Fear of Inflation to Intensify As concerns about downside risks to the growth outlook appear to be easing, capital market participants have of late become increasingly sensitive to any sign of inflationary pressures, especially given the very loose monetary policy stance in both China and other major economies in the last 12 months. We forecast that headline inflation indicators such as the year-over-year CPI and PPI will register rather rapid increases in 1Q10. Specifically, as mentioned earlier, headline CPI inflation could rise to about 2.4%Y by end-March 2010 from the latest actual reading of 0.6%Y in November 2008. In the meantime, PPI inflation could surge to 7.3%Y by March from -2%Y in November 2009. It should be noted, however, that the seemingly rapid rise in the headline year-over-year inflation rates has in part reflected the low base effect, because prices in 1Q09 were depressed when activity collapsed amid the Great Recession. For instance, we estimate that the carry-over or low base effect contributes 1pp of the 2.4%Y increase in headline CPI and 4.5pp of the 7.3%Y increase in PPI forecasted for March 2010. Nevertheless, these forecasts, if they materialize, will likely intensify the concern of high inflation among capital market participants, in our view. This is because many capital market participants are already on high alert to the risk of high inflation, despite levels of actual inflation remaining relatively moderate. In this context, any significant uptick in headline inflation rates, technical or real, will only serve to reinforce existing strong expectations of inflation, in our view. Expectation by Extrapolation Indeed, if the inflation rates we forecast for 1Q10 were to materialize and market participants choose to formulate their inflation expectations for the rest of the year by simply extrapolating from the trends in 1Q10, the resultant expected inflation rates would be much higher than we have forecasted under the baseline scenario. While being keenly aware that the balance of inflation risk is likely tilted toward the upside, we caution that such extrapolation would substantially overestimate the risk of inflation. One way of extrapolating could be based on the monthly change in the headline year-on-year inflation rates. Under our baseline scenario, the headline year-on-year CPI and PPI inflation will increase by an average of 0.45 and 1.8pp, respectively, per month during 1Q10. If one were to assume that this pace of change, or the delta of inflation rates, is sustained for the remainder of the year, both CPI and PPI inflation rates would surge, reaching 6.6%Y and over 20%Y by year-end, respectively, as illustrated by Alternative Scenario I. However, Alternative Scenario I overstates the risk of inflation, because it fails to discount the change in headline year-on-year CPI inflation in 1Q10 that reflects the carry-over effect. This is because the carry-over effect is not constant over the course of the year, and the change in the year-on-year inflation rate caused by the carry-over effect in 1Q10 tends to be larger than that for the rest of the year. In fact, the carry-over effect will start to decline in 2H10 and phase out towards year-end, helping to lower the headline year-on-year inflation rates. We estimate that when the carry-over effect is appropriately accounted for, the year-on-year CPI and PPI inflation would increase at a substantially slower pace, even using the linear extrapolation method, as illustrated by Alternative Scenario II. Another way of extrapolating is to forecast the headline year-on-year inflation rates by assuming that the sequential month-over-month change in inflation rates in 1Q10 will be maintained for the rest of the year, or apply the same month-over-month change for the rest of the year. This is illustrated by Alternative Scenario III, under which the average CPI and PPI inflation would be 3.6% and 7.5%, respectively. However, extrapolating inflation rates for the rest of 2010 based on the sequential change in inflation in 1Q10 tends to overestimate the expected inflation, in part because it fails to take into account the seasonality in 1Q, namely prices tend to register faster month-over-month increases in 1Q than in the rest of the year. We estimate that the seasonal factor for CPI usually helps to explain an additional 0.2-0.3pp in the sequential month-over-month inflation rates in 1Q. The exercise above illustrates that if one were to extrapolate inflation rates for the rest of the year from the potential trends of headline inflation in 1Q10, based on either the pace of increase in the headline year-on-year inflation or the sequential month-over-month inflation rates, the resulting expected inflation rates could turn out to be much higher than the forecasts we have made under our baseline scenario. In addition to the reasons for overestimation of inflation risk which have already been discussed above, it should be noted that our baseline inflation forecasts are based on a modeling framework which factors in the course of policy action envisaged for the year - featuring in particular a significant deceleration in M2 growth in 2010 from the high level in 2009 - and forecasts of a tepid export recovery and steady rise in international commodity prices (e.g., average crude oil price at US$85 per barrel). That said, to the extent that one's expectation of macroeconomic policy stance and/or global economic outlook differ meaningfully from the corresponding calls that are reflected in our baseline scenario, one may not have as strong conviction of a benign inflation outlook in 2010 as we do. In this context, it should not be a surprise if the potential trends of inflation in 1Q10 will greatly influence inflation expectations formed by some market participants in the way as we have discussed. Market Implications Inflation expectations will likely re-emerge and even get stronger in the coming months, despite our view that actual inflation levels will remain relatively moderate,. At the same time, the timing of the anti-inflation policy response in China will likely be a function of actual inflation rates, in our view. And we expect headline CPI inflation to start to exceed 3% by mid-year, which may trigger the first hike of the base interest rates in early 3Q10. Between now and mid-year, we think there will likely be a significant ‘disconnect' between the actual inflation rate and thus policy stance on the one hand and strong inflationary expectations on the other. In this context, inflation play trades in the equity markets, which feature long sectors/companies with pricing power and short those with high risk of margin squeeze due to cost pressures, will likely become a useful investment theme, in our view. And this investment theme may remain popular at least through mid-2010 when the monetary authorities are getting close to initiating monetary tightening to contain inflationary pressures, in our view. Launching China Inflation Tracker In light of intensified fear of inflation, we launch the China Inflation Tracker (CIT), a weekly research publication in which we provide updates of our latest forecasts of CPI and PPI inflation for the next month based on detailed high-frequency price data from various sources. Our inaugural CIT indicates that the CPI and PPI inflation prints in December 2009 may have been 1.6%Y (versus 0.6% in November) and 1.9%Y (versus -2.1% in November), respectively. Specifically, we construct two indices - one for Edible Agricultural Products and the other for Industrial Products - to help track the underlying food CPI and PPI inflation, respectively, on a weekly basis. Each of the two indices is constructed by aggregating the price indices of a number of specific product sub-categories. The price data for these specific product subcategories are available on a weekly basis, and this therefore allows for a weekly update of the two indices. We will continue to revise our forecasts of food CPI and PPI inflation for the next month, when each additional data point in the two indices is available every week of that month. The non-food CPI is then estimated based on a functional relationship between PPI and non-food CPI. The overall headline CPI is a weighted average of food and non-food CPI.
Euroland
Transition Towards a Tepid Recovery January 05, 2010 By Elga Bartsch & Daniele Antonucci | London An Economy in Transition 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 the year. Until some domestic demand dynamics start to materialise, the European economy remains in what could be called 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 a few exceptions (the UK, Spain, Ireland and Greece), we don't expect any meaningful fiscal policy tightening in 2010. 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 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 trigger was 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 is probably 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 in 2010. 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 this 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 divergence in growth 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, which were hit hard by the financial turmoil, to continue to underperform as they work their way through the aftermath of a property price bubble, a construction boom and a savings-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 and the Riksbank to hike by 50bp and the BoE by 75bp by the end of 2010 (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 market turmoil. 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 will 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 during the 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: the banks' bidding behaviour. Thus far, overbidding by banks has caused excess reserves to swell and pushed market rates well below the policy rate. But this bidding behaviour could change going forward, 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 turmoil, 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 this year is likely to have repercussions on the euro area government bond markets. During the credit crunch, intra-EMU spreads were characterised by a high degree of co-movement, 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 in 2010. Key Surprises for the European Economy Our base case for the euro area economy in 2010 is that of a lacklustre, sub-par cyclical recovery, subdued consumer price inflation and a hesitant removal of policy stimulus in 2H10. We and the consensus expect the European economy to expand by around 1% this year, thus recovering only some of the ground lost when the currency union plunged into the deepest recession in post-war history. With capacity utilisation still extremely low and unemployment set to rise until 2H10, domestic demand dynamics will likely remain rather muted. Overall, we believe that the risks to our baseline forecasts are broadly balanced. We consider four potential macro surprises that could challenge our outlook and the market consensus. The main surprise element is the qualitative direction in which they would affect the macro outlook, not necessarily the quantitative measure in which they occur. As such, they are not part of our base case and only some are among the factors underlying our bull and bear scenarios. However, none of these surprises seems to be priced into financial markets or much talked about by macro thinkers at this stage. The potential surprises include: 1. A late-cycle credit crunch seriously curtails access to bank lending in the non-financial sector. 2. Brisk growth in emerging economies and/or renewed supply setbacks cause another surge in commodity prices. 3. Ample liquidity helps to keep government bond yields subdued, notwithstanding massive debt issuance. 4. Country-specific political risks replace systemic risk concerns in driving intra-EMU spreads, but matter less than expected in the UK. Surprise #1 A late-cycle credit crunch seriously curtails access to bank lending, causing the recovery in investment spending to falter. A year ago, everyone (ourselves included) talked about the credit crunch as a serious risk to the economic outlook. But, what we were debating at the time should probably have been more accurately labelled a liquidity crunch for banks and corporates in funding markets. Since then, credit spreads have contracted sharply, corporate debt and more recently equity issuance have surged, and financial institutions have been propped up by a variety of government measures. Lately, euro area and UK banks have projected looser credit standards. Effective interest rates on loans have been falling for a while. Our banks team believes that the provisioning cycle has likely peaked. We ourselves have played down the fact that bank lending is falling on a year-on-year basis, arguing that much of the drop is due to a fall in demand. At this stage, this is probably largely true. But, it could change when the recovery in corporate spending gets underway. While companies will initially be able to draw on internal cash flows, eventually they will likely need external funds to bump up investment spending - even if it is largely to repair and replace - and possibly also for re-stocking. If they cannot obtain these funds, the rebound in activity following a turnaround in the inventory cycle could quickly reverse. At this (vulnerable) stage of the recovery in euro area domestic demand, the yet-to-be crystallised write-downs, timid recapitalisation and excessive reliance on ECB funding might backfire in a financial system that is still largely bank-based. Such a credit crunch could potentially be a particular problem in Germany, which ironically is the only large euro area country that deleveraged in recent years and which - as its current account surplus shows - enjoys a funding overhang from domestic savings. A credit crunch would spell bad news for growth in the near and medium term and would likely hit investment spending hard. More prolonged feedback effects between bank profitability and economic growth in bank-based financial systems could make the credit crunch a constant feature weighing on euro area growth in the coming years. In contrast to the earlier liquidity crunch, there would be little that the ECB could do, for it cannot boost banks' equity capital buffers. This would need to come from either governments or private investors. Without decisive government action, we would not be able to rule out that euro area banks just shrink their loan books. Surprise #2 Emerging economies expanding at a brisk pace and/or renewed supply setbacks fuel another surge in commodity prices. In this scenario, a surge in commodity prices would put additional pressure on companies' profit margins, eat into consumers' purchasing power and potentially force central banks to hike interest rates earlier than expected if higher commodity price inflation spills over into higher inflation expectations. As a result, the composition of nominal growth would likely become more much stagflationary again, at least initially. The commodity price surge could be triggered by further upside surprises on growth, especially in EM, on the back of the unprecedented monetary and fiscal stimulus that has been put into place globally, or by a disruption in the supply chain, say, due to geopolitical events. For example, the price of oil might rise noticeably through the US$100/bbl mark, in line with our commodity strategists' bull case and above the US$81/bbl implied by the forward curve. Such an overshoot would hit commodity importers particularly hard, such as virtually all the European countries with the exception of Norway and (to a much lesser degree) the UK. Although this implies stronger European exports to commodity producers, the overall effect on economic activity would be detrimental, for three reasons. First, European companies would face significant pressure on profit margins, which are already under stress, as employment and hence labour costs have not fallen a great deal. Second, European consumers would need to tighten their belts even further, as was the case during the 2008 commodity-driven inflation shock. Third, the feed-through of higher commodity prices into inflation might push inflation expectations - which have remained relatively well-behaved for now - higher. As a result, central bankers could be forced to move earlier and more boldly than our base case forecasts show. If central bankers didn't act to anchor inflation expectations, a sharp rise in bond yields could equally derail the recovery. In this scenario, money markets would probably start to price in earlier and more aggressive tightening, and risky asset markets would probably be affected too. A sharper tightening of monetary policy - especially if coupled with faster fiscal consolidation in the face of rising interest payments - might well push the European economy into another (this time policy-induced) recession. Eventually, the commodity price shock would likely add to renewed deflationary pressures. Surprise #3 Ample liquidity keeps government bond yields subdued, notwithstanding massive debt issuance. Consensus is forecasting benchmark ten-year Bund yields to reach 3.8% in late 2010, some 60bp above the current level of 3.16%. We are even more bearish on bonds and forecast ten-year Bunds to break above 4% in 2H10. Our interest rate strategy team would be short the long end and long forward-curve steepeners (see 2010 Global Interest Rate Outlook, November 30, 2009). The reasons for rising bond yields are not difficult to find: ongoing economic recovery, abating deflation risks and tightening monetary policy (through traditional interest rate hikes and unwinding unconventional quantitative easing). The wildcard in all of this is to what extent the unprecedented excess liquidity created by central banks globally in the past year and still sloshing around the global financial system could find its way into the government bond market. In the euro area, additional demand has come largely from banks, which have added €330 billion to their government bond holdings since October 2008. With monetary policy still expansionary and policy rates potentially staying low for longer than our base case forecasts show, government bonds might actually be better bid. Additional demand for bonds could come from asset reallocation away from risky assets and from looming bank regulation on liquidity buffers (the latter particularly likely to provide a natural buyer of bonds in the UK). Finally, if a credit crunch causes deflationary concerns to resurface, bond yields could potentially fall further from current levels - as they did in Japan in the 1990s. Surprise #4 Country-specific political risks replace systemic risk concerns as a driver of spreads in the euro area. In 2009, spreads in the euro area periphery were characterised by a very high degree of co-movement, suggesting that systemic concerns were the main driver. In 2010, the focus could swing towards country-specific issues. None of the euro area countries has the option of inflating their way out, something that is still possible for EMU ‘outs'. We would argue that the ability of countries to address the fiscal policy challenges ahead crucially depends on the institutions. Of course, these challenges also differ between countries, depending on their fiscal position before the crisis, how hard they were hit by the crisis, and the size of subsequent stimulus packages. But to what extent they can be tackled successfully will very much depend on the institutional set-up. For starters, the extent to which the electoral system generates clear political mandates to rein in budget deficits is important. Where the system generates fragmented coalitions or hung parliaments, matters become more complicated. Whether a clear mandate can be executed also depends on the degree of administrative centralisation. Countries with a federalist structure - one that grants financial independence to lower levels of the administration - might find it harder to successfully implement their budget plans (Germany, for example). In our view, rich developed countries would only experience a sovereign debt crisis if they became unable to act because of a political stalemate or unwilling to act because the costs of doing so were deemed higher than the benefits. The latter is especially relevant within the euro area, where the disciplining effect of a potential currency crisis is absent. In this case, often a sizeable share of securities held in other euro area countries and substantial spill-over effects onto the borrowing costs of other countries create incentives for looser policy. Outside the euro area, a sovereign debt crisis could call the independence of the local central bank into question. Within the euro area, the ECB's independence might be put to the test if the government debt of one country were to become in danger of not making the A- cut-off for eligible collateral when it reverted back to the pre-crisis pool at the end of 2010. In this case, the ECB would face a very difficult decision indeed. Germany - Taking a Breather Before the Budget Savings Start In 2010, Germany is likely to outperform most other European countries. We expect Europe's largest economy to expand by an above-trend 1.9%, compared to only 1.2% for the euro area. Our forecasts are a tad above the current market consensus (1.7%). But contrary to many other forecasters, we expect the recovery to lose momentum into 2011, when we project growth to ease to the trend rate of 1.2%. The absence of further gains in business expectations and a marked correction in orders and production in October suggest that 3Q09 might already have been the strongest quarter in terms of growth. Germany's outperformance is partially a mirror image of it being hit much harder by the global recession due to its greater export-orientation and its bigger industrial sector. Having contracted a total 6.7% from its 1Q08 peak, German GDP will likely recover a cumulated 3.1% by 4Q10. This would leave activity still 3.6% below the peak and would close most of the gap to the euro area, where GDP should stand 3.2% below the peak, despite a more muted recovery outside Germany. The outperformance also reflects a larger fiscal support package, which was upped again by another €8.5 billion just before Christmas and now totals 2.3% of GDP - an increase of 0.8pp over the stimulus already implemented in 2009. In addition to cutting income taxes and social security contributions, raising child and healthcare tax credits and investing more in public infrastructure, the new centre-right government decided to lower corporate taxes, raise child benefits further and extend short-shift subsidies. As a result, the budget deficit will likely increase from around 3% in 2009, to more than 5% in 2010 - which would still make Germany's budget deficit one of the lowest in the euro area! While the stimulus will help to support domestic demand, brisk headwinds still lie ahead. These stem most notably from the labour market. Thus far, the labour market has held up surprisingly well, thanks to a massive extension in short-shift subsidies and, also, some voluntary labour-hoarding by companies that are concerned about a shortage of skilled workers. The main adjustment came via a marked reduction in the hours worked per employee. As these reductions weren't matched by wage cuts, unit labour costs surged. Looking ahead, we expect a marked reduction in payrolls by a total of 1.4% and a perceptible moderation in wage increases. From an inventory-led bounce in industrial activity to a broader demand-based recovery. The lack of labour cost cutting, very low capacity utilization rates and a renewed moderation of export demand suggest to us that the recovery in investment spending will likely be muted. This holds in particular for investment in machinery and equipment, where only the phasing-out of the more favourable depreciation rules at end-2010 add a temporary boost to an otherwise anaemic recovery. Similarly, consumer spending will likely be held back by ongoing job losses, a renewed rise in inflation and the prospect of a multi-year fiscal consolidation starting in 2011. Even leaving the pay-back from the car scrapping scheme aside, purse strings will likely remain tight and savings elevated. Domestic demand should expand only moderately, after a sharp contraction in 2009. The main risk to the outlook is a credit crunch as discussed in the previous section. German policymakers will have to make tough decisions. For starters, the draft budget for 2011 due in July will have to reconcile the election promise to cut income taxes noticeably with the need to rein in the budget deficit. Substantial budget savings are needed to comply with new constitutional ‘debt brake' and the European Stability and Growth Pact (SGP). In addition, policymakers will have to fend off pressure to revive the car industry, which will likely see sales falling after the end of the car scrapping scheme. Finally, the financial sector, notably the state-owned Landesbanks and savings banks, have to be put back on a healthy financial footing. France - Saved by Consumers The French economy held up better than the euro area as a whole during the turmoil and is likely to outperform in 2010 too, although to a smaller degree relative to the previous year. This resilience is due, at least in part, to a more rigidly regulated economy. However, this will likely hamper France's long-term growth prospects. We are more bullish than the consensus for 2010, but expect the economy to decelerate in 2011. The two main themes for this year are: 1. Domestic demand will continue to face several headwinds - but will remain more robust than in the euro area as a whole: A housing market correction is now underway. We do not anticipate prices to fall as much as in hotspots such as Spain and Ireland, but with lending conditions still tight and unemployment rising, the risks are skewed to the downside. More broadly, France is the major euro area country showing the biggest discrepancy between firms' assessment of order books and inventories. We believe that this gap will close in the coming quarters. This can happen in two ways. The first possibility is that demand starts to improve more visibly, in line with our base case. The second is that firms start seeing their stock of inventories less optimistically. Clearly, there are grounds to remain cautious. However, relative to the other major euro area members, as well as the consensus, we think that the stimulus put in place and some new fiscal measures augur for a better outlook, especially on the consumer front. 2. Fiscal policy will remain expansionary and aggravate the deficit - tightening to start in 2011: Given the size of the budget deficit, fiscal leeway will be limited in 2010. At the same time, we don't expect a tightening either, at least while the economic outlook remains uncertain. A national loan plan called the ‘Grand Emprunt' will be put in place in early 2010. The amount is around €35 billion. Almost €13.5 billion in state aid repaid by the banks will be used to finance the loan. This means that approximately €22 billion will be raised by tapping the market. The loan aims to fund investment in sectors that could strengthen France's competitiveness and growth potential in the long term, ranging from higher education and research to renewable energies and digital technologies. France is pursuing supply-side policies that could even help reduce the deficit, thanks to the future ‘economic dividends' of a strengthened economy. In the short term, however, the loan will weigh on France's public finances. Of course, the investments will be spread over several years, thus affecting the 2010 budget only to a limited degree. We think that the impact on government debt will amount to slightly less than 1% of GDP this year. We expect a debt-to-GDP ratio of 82.3% in 2010 and 88.5% in 2011. Although there is no indication of eventual tightening plans, we think that 2011 is likely to see the beginning of fiscal restraint. Italy - The Aftermath of the Crisis Like other advanced economies, Italy is now expanding again. However, the main issue for 2010 relates to how quickly and to what extent the country will recover, for three reasons: 1. Trend growth will be lower than before the crisis: We think that the economic fallout of the financial turmoil damaged both labour productivity and the labour force (see Italy Economics: Assessing the Damage, October 26, 2009). We estimate that Italy's potential growth rate will be negative this year, and average 1% between 2011 and 2014 - below our pre-crisis estimate of 1.2%. The main takeaway for investors is that extrapolating into the future the pre-crisis growth rate of potential GDP might be too optimistic. If the recession lowered the pace at which the Italian economy can sustainably expand, as we believe, the rate of growth of aggregate corporate profits, over the long term, will be lower too. 2. Period of disinflation ahead, but price pressures might emerge sooner than later: Lower trend growth implies a smaller output gap relative to the pre-crisis baseline scenario. Indeed, the standard measures of the output gap, taken at face value, point to outright deflation. We disagree with that view. If the economy's productive capacity has been damaged by the recession - as we believe - the output gap might not be as big as these calculations suggest. In turn, this implies weaker deflationary pressures. We do believe that the country is likely to go through a prolonged period of disinflation. However, we expect price pressures to emerge sooner rather than later and we maintain our above-consensus call on inflation. 3. Limited ability to carry a higher debt load, but Italy's fiscal prudence during the crisis augurs well: We think Italy's likely return to a slight primary budget surplus, i.e., a surplus in the budget balance excluding interest payments, will help sustain a high and rising debt burden. However, for a swifter reduction of the debt-to-GDP ratio, the rate of nominal GDP growth should be higher than the interest rate that Italy has to pay on its debt. With potential growth even more subdued than before, bringing down the public debt to an acceptable level will be more difficult. The good news is that markets don't seem excessively concerned about Italy's fiscal situation - owing to the fiscal prudence the country showed during the market turmoil. Of course, none of this means that Italy will not continue to recover: we expect an expansion of around 1.2% in 2010, some 0.4pp above the consensus view. The short-term outlook, however, remains challenging. After considerable disappointment in the industrial production numbers over the past couple of months, an economic ‘double dip' at the turn of the year cannot be ruled out. Indeed, while this is not our central scenario, our GDP indicator - which is based on a numbers of indicators ranging from industrial production to the yield curve - does suggest that this is a real possibility. Spain - More Rebalancing and Retrenching Ahead We have five reasons for thinking that Spain will contract outright in 2010 - unlike other major European countries - and expand far slower than the euro area in 2011 (see Spain Economics: Finding a Balance - Where We Are, What's Next? November 25, 2009): 1. Stabilisation in the construction sector still far off: The construction sector is still unlikely to stabilise any time soon. With house prices overvalued by as much as 30% on some metrics, we don't expect a return to positive growth rates in construction investment until end-2011. 2. Consumer spending likely to remain anaemic: Although the job shakeout will be sharper but shorter in Spain than in the rest of the euro area, we think that a revival in consumer spending this year is too much to hope for. With wage growth set to slow further, private consumption will lack support. 3. Private sector deleveraging to weigh on the economy: Private sector deleveraging will continue for quite some time. The pass-through of lower official and market interest rates to mortgage and corporate loan rates might provide some relief, but it is unlikely to prevent a period of belt-tightening altogether. 4. Constraints to credit availability to remain in place: Credit will continue to remain a scarce resource over the next two years. With still considerable uncertainty over potential losses, banks may remain reluctant to lend, even if the government ensures that they are well capitalised. 5. Fiscal stimulus to be scaled back this year: With a ballooning budget deficit and long-term sustainability problems in its public finances, Spain looks set to be one of the first countries in the euro area to scale back its stimulus measures. Tax hikes are on the agenda as early as this year. The good news is that Spain's adjustment is happening at a fast pace. With GDP contracting less than employment, labour productivity growth has accelerated. If sustained, these gains will lower Spain's unit labour costs and boost export competitiveness. With export demand likely to be subdued even in our best case, this might prompt an export-led recovery further down the line and help the rebalancing of an economy that has been driven primarily by domestic factors during the boom years. The main takeaway for investors is that, with its economy still out of balance, Spain has to endure a structural adjustment. While most of its European neighbours have been affected by the same cyclical headwinds - from the commodity-driven inflation shock last year to the economic fallout of the financial turmoil in 2009 - they do not have to simultaneously address imbalances of the same scale. Spain looks set to be one of the last economies in the euro area to emerge from recession. Sweden - Still the Best Show in Town On our updated 2010 forecasts, we expect Sweden to deliver the strongest growth in Western Europe. Sweden returned to positive growth in 2Q09. Since then the recovery has gained momentum, most notably in 4Q09. In our view, Sweden is in better shape than most other European countries when it comes to the drivers of growth in 2010. For starters, the policy stimulus in Sweden is very sizeable both for monetary policy and for fiscal policy, with the Riksbank aiming to keep its repo rate at 0.25% until late 2010 and the government implementing additional discretionary fiscal stimulus of 1.2% of GDP in 2010. In addition, an undervalued currency boosts export demand along with the revival in the global economy. Given that industry accounts for nearly a quarter of the Swedish economy - a considerably larger share than in the UK or US - this is a key reason for the outperformance. That said, export demand is likely to be less buoyant than previous recoveries - thanks to an appreciating SEK and relatively sluggish growth in the rest of Europe. Hence, most of the momentum will come from domestic demand. Consumer spending is being supported by low interest rates, robust real estate markets and additional income tax cuts. In addition, government spending has been upped, notably at the local level. Balance sheets, especially in the household and the government sector, are healthy and banks weathered the storm reasonably well - despite their Baltic exposure. One notable difference with the euro area is that consumer bank lending is still expanding robustly in Sweden. Sweden has experience in successfully handling a financial crisis as it eventually emerged strongly from the banking crisis of the early 1990s. This experience should have a positive impact on consumer/corporate sentiment and on policymakers' willingness to take bold actions, if needed. Inflationary pressures will likely stay low, allowing the Riksbank to continue its extra-expansionary policy. Unemployment will likely rise further, albeit at a slower pace, and is likely to stay elevated for quite a while. With the output gap remaining wide, pricing power will likely stay low, also for trade unions representing workers in the upcoming wage talks. In addition, a stronger SEK will likely cap imported inflation pressures. Only once the Riksbank starts to hike interest rates is headline CPI likely to pick up noticeably due to the impact on the mortgage interest rate payments. The Riksbank will only gradually remove some of its policy stimulus in autumn 2010. We expect it to start raising rates in September 2010, slightly ahead of what its own repo rate forecast shows. As two out of six executive board members continue to expect an earlier tightening, we see little reason at this stage to alter our call for the tightening to start in 3Q10. Subsequently, we expect the bank to nudge rates gradually higher by another 25bp in 4Q10. The Riksbank conducted its unconventional policy measures via its lending to the banking system. These measures will reverse quasi-automatically once the loans mature. Initially loans were offered at three- and six-month maturity and later at one-year maturity as well. The Riksbank still offers these loans at a variable rate that is tracking the repo rate, but decided to stop offering fixed-rate loans at the December meeting. For variable-rate loans, the Riksbank has presented a timetable until the end of February. We expect the Riksbank to gradually reduce the amount of liquidity in 2010 by allowing the existing loans to roll off. Indeed, the bank has already phased out some emergency measures. After receiving no bids in its corporate CD facility, the bank stopped it. It also ended its USD auctions against Swedish collateral. Finally, it raised the spread for its variable rate auctions in early November, when the bank decided to raise the spread over the repo rate from 15bp to 25bp for maturities below one year and to 30bp for one-year loans. The outstanding loans to the banking system have created a structural liquidity overhang of around SEK 300 billion until the fall.
United States
Review and Preview January 05, 2010 By Ted Wieseman | New York After a modest two-day long-end-led recovery, Treasuries resumed sinking in Thursday's shortened and very illiquid New Year's Eve trading session - wrapping up a terrible year for the Treasury market on an appropriate note - as a much-better-than-expected jobless claims report offset month-end-related buying and any general bid the market may have had as market participants moved into safer assets to close their books for 2009. The year-end bid was very much in evidence at the very short end, though, as an extreme squeeze in the financing markets managed to make 0% T-bill yields look cheap. Month-end demand did also help the long end significantly pare larger losses seen after the claims report, while the shorter and intermediate ends of the curve stayed nearer the lows, leaving the curve somewhat flatter on the day. Seasonal adjustment problems often lead to big moves in claims during holiday weeks, but we had thought that the seasonal factors biased up initial claims during Christmas week. So, we were quite surprised by another big drop that extended the continuous run of declines in the four-week average to four months. Continuing claims also saw another big drop, even including extended benefits. The new data were all after the survey period for the employment report, but they certainly suggested perhaps even bigger healing in labor market conditions than we had thought, leaving investors looking ahead to a possible positive payrolls number next week. Our forecast is for a 25,000 decline in December non-farm payrolls, but we will reassess this, with a positive bias, after Wednesday's ADP report. Note that the standard error on payrolls is about +/- 100,000, so with our forecast we wouldn't be at all surprised to see a positive print just from random sampling error beyond any possible upward revision we might make to our forecast. On the day, benchmark Treasury yields rose 4-7bp, with the 5-year the worst performer and the long end holding in best after a reversal of a good part of the post-claims plunge. The 2-year yield rose 6bp to 1.14%, 3-year 6bp to 1.68%, 5-year 7bp to 2.68%, new 7-year 6bp to 3.38%, 10-year 6bp to 3.84% and 30-year 4bp to 4.64%. This wrapped up a terrible year for the Treasury market, at least the nominal part of it, with the total return from buying the then on-the-run 10-year note at the end of last year and holding it through 2009 near -8.5%. TIPS, on the other hand, outperformed to finish up an excellent year, reflecting both how distorted the market was in the depths of the market turmoil late in 2008 and also rising inflation expectations since mid-year. On the day, the 5-year TIPS yield rose 6bp to 0.43%, 10-year 4bp to 1.43% - leaving the benchmark 10-year inflation breakeven, which ended 2008 barely above zero, at a new high since mid-2008 of 2.41% - and 20-year 1bp to 2.01%. TIPS outperformance versus nominals in 2009 was immense - holding the on-the-run 10-year TIPS as of the end of 2008 through 2009 returned about +10% versus the -8.5% loss on the nominal 10-year. Bill yields eased a bit as settlement moved past New Year's, with the 4-week yield up 4bp to 0.04%, but the crunch in financing markets reached extraordinary levels. In mid-afternoon trading just ahead of the 2:00 closes, the overnight general collateral Treasury repo rate was trading at -1.40% (and sinking by the minute), which actually made bills at near zero yields look quite cheap. Mortgages resumed sinking Thursday after a couple of days of upside to finish a terrible month, but at least lower coupons managed to outperform the Treasury losses. Fannie 4.5%s rallied back to par Wednesday, but current coupon yields were up near 4.55% after Thursday's sell-off, a 65bp loss on the month and also on the year. Freddie Mac's national survey showed average conventional 30-year mortgage rates at an 18-week high of 5.14% in the latest week after having reached a record low of 4.71% at the start of the month. Current MBS yields would be consistent with 30-year rates staying near 5.125%, still a very low rate from an historical perspective. The better relative performance by mortgages helped swap spreads narrow to finish up a year in which overwhelming Treasury supply helped them hit record lows, with the benchmark 5-year spread at 29.5bp, just above the all-time low of 28.25bp hit in mid-November. Risk markets were trading very slightly in the red as the interest rate market investors were heading home early, but the S&P 500 was still on pace to end just marginally below its best level of the year for a 2009 gain of 24%. The best sectors of the year were tech and basic materials with gains of nearly 50% and consumer discretionary with about a 40% rally. Financials recovered powerfully off the March lows, but the prior losses were so big that the sector was a laggard for the full year with about a 15% rally. In what little trading was actually going on, credit was also ending the year on a marginally softer note, but with the investment grade index looking to close near 85bp, the upside in 2009 relative to the 197bp close to 2008 was even more impressive than stocks. The high yield CDX and leveraged loan LCDX indices also had huge years, the former tightening over 600bp to just above 500bp and the latter tightening about 875bp to near 425bp. On the other hand, despite big recoveries off the lows, it was a rough year for the subprime ABX and commercial mortgage CMBX markets. The weekly jobless claims report was surprisingly strong, but seasonal adjustment is difficult for weekly data under normal circumstances and nearly impossible during major holidays, so we'll probably need to wait until we get into January to get a clearer picture. Still, our read of the seasonals suggested significant upside bias to initial claims this week, so the 22,000 drop to 432,000 in the week of December 26 seemed quite strong. This drop kept the very impressive run of declines in the four-week average alive, with a 17th straight drop, by 5,500 to 460,250, another low since mid-2008. Continuing claims in the prior week (pre-holiday, so a cleaner number) were also improved again, with a 57,000 decline to 4.981 million, a low since February. Note that continuing claims are improving even including all the emergency and extended programs. Adding these programs (which aren't seasonally adjusted) to non-seasonally adjusted regular continuing claims and seasonally adjusting the combined figure shows a decline to 9.65 million in the week of December 12 from the peak of 10.94 million the week of October 3. At this point we're still forecasting a 25,000 decline in December non-farm payrolls and a further 0.1pp dip in the unemployment rate to 9.9%. There appear to be upside risks to those forecasts, but we'll wait until the ADP report next week to finalize our estimate. |