V-Shaped Recovery
March 23, 2010
By Daniel Volberg l New York|
Argentina has returned to the spotlight with news that the authorities may be closer to their goal of regaining access to debt capital markets. Last week the Argentine authorities announced that they had filed a revised annual report with the SEC in Washington. But, the authorities have already submitted the same filing with the SEC on four occasions in the past five months. Indeed, the SEC has signaled that what keeps it from approving the Argentine filings remains the data underlying some of the disclosures. We remain cautious on Argentina's access to debt markets.
While the prospect of renewed access is once again a central focus of Argentina watchers, there has been a positive development as well within Argentina: a much sharper rebound in growth in recent months. Indeed, in line with better incoming data over the past few months, we are revising our macroeconomic forecasts for 2010 and 2011. We are revising GDP growth to 4.6% (from 3.3% previously) in 2010 and to 2.4% (from 4.2% previously) in 2011.
Stronger growth in economic activity in 2010 in turn helps improve Argentina's fiscal accounts. We are revising the fiscal balance to -1.1% of GDP (from -2.9% previously) in 2010 and to -1.1% of GDP (from -1.9% previously) in 2011. In addition to - and in line with - these core changes, we also adjust our forecasts of inflation, external accounts, interest rates and international reserves.
V-Shaped Growth
Our upward growth revisions reflect recent data that suggest a V-shaped recovery in recent months. While there are significant discrepancies between official (Indec) estimates and our own, both our series as well as that of Indec show a sharp recovery in activity in recent months after a meaningful slowdown last year. Indeed, according to the official 4Q GDP report released last week, Argentina's economy slowed to just 0.9% in 2009 after posting 6.8% growth in 2008 and an average 8.8% growth during the five years through 2007 (before the onset of the global recession). Of course, while our estimates show similar growth rates for much of the series, our growth estimates suggest that the downturn last year was deeper. We estimate that Argentina's economy contracted by 4.5% in 2009. But both official data and our estimates suggest that in the final months of last year the economy has begun a rapid rebound. Indeed, after seasonally adjusting our data we find that the sequential pace of growth in the three months through February has reached 13.7% annualized. Official data are available through December and, once seasonally adjusted, show a three-month trend growth pace of 13.1% annualized.
But while the recovery has been stronger than we anticipated, it remains narrow and externally driven. The recovery appears to be concentrated in export-oriented sectors such as manufacturing and agriculture. In particular, two factors seem key to Argentina's growth recovery in recent months.
First, Argentina is a direct beneficiary of the robust recovery in the Brazilian economy. Brazil is Argentina's largest trade partner, accounting for near a third of all Argentine exports and imports, and, in our view, has played a key role in lifting Argentina's industry. After all, exports to Brazil grew on average near 45% on average in December and January while overall exports grew near 18% in the same period. And given Brazil's importance as a destination for Argentina's manufacturing output, the strong domestic demand driven growth in Brazil has been a boost.
Second, growth benefits from a dramatic recovery in agricultural sector on the back of a rebound in agricultural commodity prices as well as better weather conditions. After all, agricultural production was severely affected last year by the worst drought Argentina has had in near half a century. In contrast, the current agricultural season - starting late last year - has proved favorable with abundant sun and rain. Meanwhile, the price of agricultural commodities - such as soy, corn and wheat that are key Argentine exports - has staged a sharp recovery over the course of last year. In turn, forecasts of agricultural production made by the USDA suggest that Argentina's core agricultural output (soy, corn, wheat and sunflower) is set to rise near 55% year on year in 2010.
Business Climate Clouds Recovery
But while recent growth data has proven strong, we would warn against mistaking Argentina's cyclical bounce-back from a depressed base with sustained growth. The external factors driving Argentina's rebound are likely to fade in the quarters ahead: our Brazil economist Marcelo Carvalho expects Brazil to slow in 2011 as the authorities tighten monetary policy and Argentina's agricultural sector is unlikely to see significant upside, given the recovery in prices and the near-record volumes expected for this year. And we suspect that domestic engines of growth are likely to prove limited due to the adverse business climate and intensified policy heterodoxy of the past 18 months. In particular, we see two main challenges for domestic growth to take up the likely slackening in external drivers.
First, we see limited prospects for private investment in Argentina due to intensification of policy heterodoxy over the past 18 months. A key turning point occurred in October 2008 when, in the aftermath of the nationalization of the private pension fund system, the authorities inherited large equity stakes in virtually every large Argentine corporation. Since then, despite initial denials, the authorities have named board members to the boards of directors of many of the largest companies in Argentina, including in the energy, banking and manufacturing sectors. And further heterodox measures cannot be ruled out. Indeed, over the past few months the authorities have added conflicts with the central bank, Congress and the Judiciary to the already long list of issues weighing on business confidence (see "Argentina: What Lies Beneath the Central Bank Turmoil", This Week in Latin America, January 11, 2010). As a result, investment was the hardest hit component of growth during the downturn, has remained subdued in the recovery and, we suspect, may remain limited in the quarters ahead.
Second, the negative business climate may mean a more inflationary environment - and a headwind for private consumption growth - as firms restrain supply. Indeed, inflation has been a key challenge - our estimates show that even in the midst of the deep downturn observed last year inflation remained elevated, slowing from near 23% in mid-2008 to near 14% by the end of last year. And with activity recovering, inflation risks are on the rise. In turn, rising inflation may spell trouble for consumers. After all, if we deflate nominal wage growth by our estimates of inflation, rather than the official figures, we find that real wages are growing at a modest 2.4% year on year in the three months through January. That contrasts with the average near 6% real growth in the four years through 2007 when domestic demand played a key role in driving economic activity. And while we acknowledge that real wage growth could rise in the near term as organized labor may be successful in getting 20-30% wage hikes, we suspect that rising inflation may quickly erode this boost to consumer balance sheets. Indeed, median 12-month ahead inflation expectations have risen to 25% in February-March from near 20% at the turn of the year, just as organized labor hardened demands for salary hikes.
In sum, we see robust economic growth in the near term but suspect that the rebound may eventually fade. Still, we suspect that if global conditions remain supportive, Argentina will have a strong rebound in 2010. And even though growth may eventually fade, we expect the growth recovery to help, at least temporarily, ease some of Argentina's key macro challenges.
Fiscal Outlook
We continue to see fiscal deterioration as Argentina's principal macro challenge. Last year Argentina posted a deficit for the first time in six years as tax revenue growth came in significantly lower than the pace of spending. While the drop in revenue relative to expenditure has been seen across the region, we are concerned that in Argentina the issue may be more structural in nature. The underlying driver for this fiscal deterioration is that expenditure growth is driven by public sector wage growth, pensions and, especially, subsidies, and requires extremely aggressive rates of revenue growth to maintain a surplus. Indeed, our modeling work shows that Argentina would need GDP growth in excess of 8% in order to raise revenue growth enough to reverse the fiscal deterioration seen last year. Therefore, with growth prospects likely constrained by policy heterodoxy, the fiscal slippage in Argentina may not be cyclical in nature.
But the cyclical rebound helps. Our upwards growth revision has eased the size of the deficit we forecast for this year and next - we now expect a deficit of 1.1% of GDP in both 2010 and 2011, rather than our previous forecast of -2.9% this year and -1.9% in 2011. The key change is better tax revenue growth - with the bulk of revenue driven by income and VAT taxes, the income stream is closely linked to activity. Still, while we see lower deficits this year and next, we suspect that, in a break with the past years of good growth, Argentina's fiscal accounts will remain in the red.
Financing Needs
Our upgrade to the fiscal outlook means even more manageable financing needs this year and next. Despite our expectations of significant fiscal slippage, we have maintained our view that Argentina's financing needs are manageable in the near term. With the improved fiscal outlook, we now expect this year's financing needs at around $8.4 billion, a dramatic improvement from our previous estimate of near $15 billion. And for next year, we expect the financing gap at $13.8 billion.
While the reduction in our estimate of financing needs is significant, the fundamental problem remains largely intact - if the authorities are unable to issue debt, the resources they directly control may be insufficient to cover all of the financing gap for this year and next without generating significant macro stress. We suspect that the authorities may rely on near $5 billion in transfers from the central bank if they maintain last year's policy of a near 10% currency depreciation and can count on a fraction of the near $18 billion in public sector deposits in the banking system. But a significant withdrawal of public sector deposits would erode the deposit base of the banking system and raise the risk of significant financial stress. Meanwhile, the $5 billion transfer on currency depreciation comes in December, while significant debt payments must be made starting in August. In our view, this means that in order to make the $22.2 billion in debt service obligations over the next two years, the authorities must either issue new debt or tap Argentina's biggest internal source of liquidity - the central bank's near $48 billion in international reserves. Indeed, the authorities have tried to do just that. But they have faced stiff domestic resistance in their attempt to use $4.4 billion of international reserves to help service this year's debt obligations. The key factor may be the opposition's desire to restrict the government's resources in order force it to make the necessary, but unpopular, fiscal adjustment and bring down spending growth. The authorities have signaled their unwillingness to take that route. Therefore, while under our new fiscal outlook the financing needs appear significantly more manageable, we remain concerned that there remains a risk of coordination failure that may lead to unintended consequences.
Bottom Line
With the economy in the midst of a surprisingly strong cyclical rebound, Argentina's macro deterioration may be less than we had previously expected. Despite better growth, we suspect that fiscal slippage remains the principal challenge, but the deterioration may be less alarming. Still, we would caution against confusing an externally driven cyclical bounce with long-term sustainable growth. From fiscal deterioration to inflation to continued deterioration in the business climate, Argentina's challenges remain significant. The positive note, however, is that in the interim between now and 2011 when investors continue to expect an end to policy heterodoxy (coinciding with a new administration), the economy may be in better shape.
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Budget Preview: More Pre-Election Positioning
March 23, 2010
By Melanie Baker & Owen Roberts l London|
The Chancellor is scheduled to make his Budget speech on March 24 at 12.30pm.
Pre-election positioning and probability weighting: This Budget is likely to come a matter of weeks before the dissolution of parliament and a bit more than a month ahead of a general election (the most likely date for that is still May 6). Hence, more than in even the Winter's Pre-Budget report, the Budget projections should be ‘probability-weighted'.
We don't expect major forecast changes: It seems unlikely that the Budget will reveal any dramatic changes in forecasts compared to the Pre-Budget. The deficit forecast is still likely to (a bit more than) halve by 2014-15.
It is unlikely that the government will announce major additional near-term fiscal tightening or loosening: The economy is looking a bit healthier and market concerns on the fiscal situation should be strong enough to prevent the latter. Going for significantly more near-term fiscal tightening, on the other hand, would seem to go against the grain of Labour's stance on fiscal policy going into the election.
Nevertheless, it is also likely that we will get a few (not too expensive) additional spending measures - i.e., not all of any likely ‘windfall' from better-than-expected incoming fiscal numbers will be saved.
What would surprise? None of this seems likely to come as much of a surprise to market participants. What would probably be more of a surprise (and isn't out of the question) would be no additional spending and a firm commitment to use all ‘windfalls' to pay down debt (alongside therefore a much more significant improvement in the fiscal forecasts).
Tracking a better-than-expected deficit: The public sector net borrowing (PSNB) measure of the deficit is ‘tracking' about a £12 billion undershoot versus the Pre-Budget forecast. At close to 1% of GDP therefore, if that undershoot were fully incorporated into the budget figures, it could imply a significant improvement in (at least) the near-term deficit projections. However: 1) March is normally a month where you see relatively big deficits, so the Treasury may well assume a smaller undershoot in its figures for the full fiscal year than we are currently ‘tracking'. 2) The monthly data we get to inform our ‘tracking' number for the deficit is for the PSNB measure, not the Budget's ‘headline' ‘PSNB-ex' measure.
After the February public finances data, we assume that the Budget shows something close to a £5 billion undershoot in PSNB-ex for 2009-10 (i.e., £172 billion compared to the Pre-Budget's £177.6 billion forecast) and 12.3% of GDP (compared to 12.6% forecast). Similarly, we tentatively look for PSNB-ex of about 11.7% GDP in 2011-12 compared to the 12.0% in the Budget.
The public finances will still look unhealthy: We still think that the government should aim to reduce indebtedness (specifically the public sector net debt/GDP ratio) faster. The existing government forecasts already embody a significant fiscal tightening. However, the deficit on these forecasts will still be at 4.4% of GDP by 2014-15 and public sector debt, as a percentage of GDP, does not start declining until 2015-16 (from a level of around 80% of GDP, depending how you measure it). Such high debt levels would leave the UK vulnerable to being unable to boost fiscal spending significantly should another crisis hit, for example. The GDP growth forecasts used in the Treasury's profile continue to look on the optimistic side to us.
Our fiscal forecasts: Whoever wins the election, we face a significant fiscal tightening over the next few years. Our tentative medium-term forecasts show the debt/GDP ratio peaking at a similar level and at a similar time to the Pre-Budget projections. However, given our weaker GDP assumptions, these forecasts already assume more aggressive cuts in total real fiscal spending. These average just under 1% a year between 2011-12 and 2014-15 compared to the government's current forecast of flat real spending on average over the same period. While we would like to see the government debt to GDP ratio come down faster, we are not convinced it will do so.
For more detailed fiscal analysis, see UK Economy, Fiscal and Gilt Market Outlook 2010, January 18, 2010.
Revised Net Funding Figures Support Being Long Gilts
The DMO's financing remit for 2010-11 will be published as part of the Budget on March 24. The government is on track to undershoot its 2009/10 Pre-Budget Report (PBR) Public Sector Net Borrowing (PSNB) forecast by around £5 billion, following a particularly large £4.3 billion downward revision to January's net borrowing figure. While this has not impacted gilt issuance in the current fiscal year - the lower figure has resulted in less net T-Bill issuance - we would take the development as a positive for gilts: the data suggest that the UK's fiscal position is not quite as bad as previously feared and reduced net bill issuance, all else being equal, will lead to lower gilt issuance at some stage in the future. While the improvement is modest against the overall funding backdrop, on the margin it supports our recommendation to be long gilts, in particular 30y gilts versus Bunds.
Key 2010/11 Remit Features
Turning to the details of the Remit, the key features we expect from the DMO are:
1) Maintain the current distribution of conventional gilt issuance split 38% Shorts, 36% Mediums and 26% Longs.
2) Continue with the supplementary methods of issuing gilts and reduce the size and/or number of conventional gilt auctions.
3) Increase the proportion of inflation-linked gilts issuance from 13% to 16% to about £35 billion (versus £29 billion) by maintaining the size and number of inflation-linked gilt auctions and increasing the number of index-linked syndications and mini tenders.
Steep Yield Curve to Encourage Continued Shift to Nominal Shorts
Since 2008, the DMO has significantly reduced the duration of conventional gilt issuance to about 10 years. We expect the duration of issuance to remain at about 10 years in 2010-11 as the DMO takes advantage of the steepness of the yield curve to reduce funding costs. Short-dated issuance is also a relatively low-risk funding option, especially given renewed buying by foreign central banks and the historical dearth of supply to the front end. We therefore expect conventional issuance to be split 38% Shorts, 36% Mediums and 26% Long (for more analysis, see UK Economy, Fiscal and Gilt Market Outlook 2010, January 18, 2010). The DMO can afford to do this as average maturity of debt is very long, about 14 years (versus Germany at about six years and US approximately five years).
Remit Flexibility to Aid Auctions Following the End of BoE Support
We also expect Syndications, Mini Tenders and the Post Auction Option Facility (PAOF) to continue in F2010/11, adding flexibility to DMO's traditionally rigid schedule.
We believe that these supplementary methods of issuing gilts have been successful and, as a result, auctions in 2009-10 have performed much better than in previous years. While having the BoE as a buyer in the market has undoubtedly helped, we note that auctions have actually performed better since the BoE paused its gilt purchases; with the average tail (the spread between the average accepted yield and the highest accepted yield at each auction) in 2009-10 at 1bp (with 1bp variation) compared to 2008-09 at about 1.3bp (with 2.5bp variation).
Reflecting this shift to a more flexible programme, we forecast only 55 auctions, raising £166 billion, in the next fiscal year, in contrast to 58 gilt auctions in 2008-09 and 59 in 2009-10, totalling £146 billion and £183 billion, respectively. The success of supplementary methods has given the DMO more flexibility with its usual auction process. We think that the DMO now has the option of reducing the number of auctions and/or decreasing the size of each auction in the coming fiscal year. Although we expect both, we think the DMO will lean towards reducing the size of the auctions (option 2) to maintain flexibility should the remit be upsized at a later date.
Index-Linked Gilt Issuance to Rise, Subject to Market Conditions
Index-linked (IL) gilts issuance increased by £10 billion during 2009-10, but the proportion of IL issuance fell from about 25% to 14% of overall gilt issuance. Given the recovery in market inflation expectations, and the success of some of the syndicated linker deals in the current fiscal year, we expect an increase in the supply of index-linked gilts in F2010-11.
However, we think it is unlikely that linkers will make up 25% of total expected 2010-11 issuance, as this would put index-linked issuance at a whopping £55 billion, versus £29 billion in 2009-10 (itself a record). While UK defined benefit pension fund demand for inflation protection should provide the UK government with a large buyer of its IL gilts for many years to come, their willingness to take down paper is affected by their solvency position (in turn affected by the level of real yields as well as equity returns), as well as the speed and timing with which trustees make investment decisions.
Therefore, while our central case is for the proportion of index-linked issuance to rise to about 16% of the total issuance, which will increase annual issuance to £35 billion from £29 billion. This figure is uncertain: strong equity markets and higher long-dated real yields would enable the DMO to sell significantly more long-dated linkers at attractive prices, but we suspect that they would not want to rely on this demand being there, given that few other investors would have appetite for the paper. We would expect the majority of this increase to come from syndications and mini tenders, which could be altered through the year in response to market conditions.
Floating-Rate Gilts Still a Possibility
We mentioned in our year-ahead publication that we expected the DMO to at least consider introducing floating-rate gilts. We think this is less likely now that the FSA has postponed implementation of the liquidity regime to at least 4Q10. The FSA regime may provide an important source of demand for floating-rate gilts should the FSA accept these as part of banks' required Liquid Asset Buffer (LAB). If they are to be accepted, then we could still see an introduction of floating-rate gilts in F2011/12.
Auction Distribution Summary
We conclude that gilt issuance during 2010-11 is likely to be distributed as shown in our full report. We would draw attention to the following comparisons between F2010-11 and F2009-10 in particular (numbers do not add due to rounding):
1. We expect that total gross gilts sales will fall by about £6 billion for the year and total gilt sales at auction will fall by about £17 billion, thanks to the increase we expect in the use of supplementary issuance methods and the improvement in public finances.
2. Gross conventional gilt issuance should fall by £7 billion, and conventional auctions by about £20 billion.
3. Gross index-linked issuance should rise by about £7 billion, but index-linked auctions by only £1 billion or so.
Supply Forecast 1Q F2010/11
The auction timetable for the first quarter of the fiscal year (calendar 2Q) will not be decided until after the DMO's consultation meeting with end investors and the GEMMs (Monday, March 29). Based on our annual estimates, we map out a possible calendar for the first fiscal quarter.
We expect the DMO to continue tapping 2.75% 2015, 4.75% 2020, 4.5 2034, 4.25 2039 and 4% 2060 up to benchmark size and issue two new benchmarks during the first fiscal quarter, July 2016 and July 2020.
Two syndications in the first fiscal quarter are likely, one long conventional and one long index-linked gilt. While a certain level of demand is practically guaranteed for these deals from tracker funds and investors committed to asset allocation switches, the relatively muted demand shown for Mar-40 IL gilt indicates one shouldn't assume that placements in excess of £3 billion can always be achieved. The DMO may give guidelines as to when it intends to hold a syndication following the consultation meetings but will only announce the details of the syndicated gilt a few weeks in advance of the offering. The experience in 2009 suggests that the optimal timing would be close to a quarter-end during which equities have performed well (so as to take advantage of portfolio rebalancing).
Investment Conclusions
We expect the new remit to be supportive of gilts, thanks to lower auction sizes and perhaps lower total issuance than previously planned. There's also a chance that a post-election supplementary budget by a conservative government could result in further fiscal tightening, and so a further reduction in total issuance.
This is a further argument in favour of the 30-year gilts-Bunds spread narrowing argument we made last week in UK: Re-Positioning Ahead of the Election, March 12, 2010.
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Review and Preview
March 23, 2010
By Ted Wieseman l New York|
The recent sluggish market environment continued the past week, with Treasuries not moving much in mostly light trading, though small short-end losses and modest long-end gains did cause the curve to move to near its flattest levels of the year. Lack of much of any movement also continued in equity and credit markets, and both interest rate and equity market volatility plunged to about two-year lows late in the week before seeing a bit of upside towards the weekend. As was widely expected, the FOMC yet again predicted "exceptionally low levels of the federal funds rate for an extended period" and didn't otherwise make any material changes to its policy statement. This repetitive extreme dovishness certainly seems to be feeding into rising complacency among investors that is helping fuel the plunge in volatility. Despite the lack of any further rhetorical movement by the Fed towards the exit from its super-easy monetary policy, the impact of its initial moves to draw down excess liquidity did continue to be felt in short-term funding markets, which spread into some pressure on shorter-dated Treasuries and supported the curve flattening. Overnight repo rates ran near 0.20% through much of the week and effective fed funds just below that on average after having held near 0.12% for a significant stretch before recent pressures started building up in late February when the ramping back up of the SFP program began draining significant amounts of excess reserves and adding substantially to the supply of collateral in the Treasury repo market. As this upward pressure initially built up, the term interbank markets weren't reflecting and extrapolating the upside in overnight rates, but this has started to shift in recent days and has further to run if expectations of persistently higher fed funds rates become more entrenched. 3-month Libor rose 2bp on the week to 0.28%, a five-month high, but the spot 3-month Libor/OIS spread held little changed near just 6bp, about 5bp below what are probably the lowest sustainable levels near pre-crisis norms. On top of the mild upside in spot 3-month Libor, shorter-dated eurodollar futures also saw significant losses later in the week to reverse some of an unsustainable compression in forward Libor/fed funds spreads seen after an initial rally in eurodollars in response to the dovish FOMC outcome.
We continue to expect that this initial tightening up in liquidity and short-term financing conditions in the wake of the SFP revival will be accompanied by the beginning of large-scale reverse repos and term deposits in the summer and then rate hikes in 3Q. And we think that the FOMC's language will start to shift at the FOMC meeting at the end of April ahead of this. The Fed's current language seems hard to justify, in our view, in light of the vastly improved economic and financial backdrop since the current emergency policy stance was put in place at the depths of the crisis. After what is shaping up to be a strong run of economic data through April, we think that a prediction of "exceptionally low levels of the federal funds rate for an extended period" will appear more clearly inappropriate on April 28. The recent run of economic data indicating that the economy had more underlying resilience in February than expected, allowing it to come through the severe February weather disruptions with significantly less downside in activity than seemed likely a month ago, continued in the past week's run of numbers. After surprisingly solid previous reports for February ISM, employment and retail sales, the past week saw better-than-expected results for industrial production and housing starts during February despite the weather disruptions. As we move into next month and the reporting of March data, we expect that this better underlying picture in February plus a weather-related rebound in March should lead to a run of strong data. In the initial run of key March figures due out in a couple of weeks, we look for a 300,000 gain in non-farm payrolls, a steady ISM at a robust 56.5 and, based on initial industry reports, a surge in auto sales to their best pace in a year-and-a-half outside of the peak of cash for clunkers.
On the week, 2s-30s flattened 9bp to 358bp, low since early January, with the 2-year yield up 4bp to 1.00%, 3-year 5bp to 1.56% and 5-year 4bp to 2.45%, 7-year yield flat at 3.15%, and 10-year yield down 2bp to 3.69% and 30-year 5bp to 4.58%. The upside in overnight rates continued to feed through into bills (and to a significant extent is being driven by surging bill supply as SFP bill issuance ramps up). The 4-week bill yield rose 3bp to 0.13%, 3-month 0.5bp to 0.15% and 6-month 2bp to 0.24%, highs since August. TIPS performed poorly for the week, particularly the front end, after a significant sell-off Thursday and Friday when the dollar index surged back from a six-week low hit Wednesday to a three-week high by Friday. The dollar upside was concentrated against the euro, with a rally to $1.354 from $1.374, as investors were surprised by renewed political wrangling in Europe over whether Germany would support an EU support program for Greece, which in addition to weighing on the euro broadly sent the Greece 2-year government yield spread over Germany soaring over 70bp Thursday and Friday to near 412bp by the end of the week after the spread had reached an eight-week low Wednesday. The dollar rebound sent commodity prices down significantly late in the week and pressured TIPS after they had traded in line with nominals through Wednesday. For the week as a whole, energy and industrial metals prices only ended down slightly, but there was a significant negative reversal from a rally to ten-week highs hit Wednesday. For the week, the 5-year TIPS yield rose 15bp to 0.35% and 10-year 4bp to 1.49%, while the 30-year yield fell 3bp to 2.11%. The big dollar and commodity moves were the main drivers, but some softness in headline inflation was also not helpful for TIPS, though at least core inflation readings returned to prior subdued trends after last month's surprising decline in the core CPI. The consumer price index was flat in March, lowering the year-on-year pace to +2.1%, restrained by softness in gasoline prices that lowered energy costs by 0.5%. The core CPI ticked up 0.1%, which lowered the annual rate to +1.3% from +1.6%. All of the deceleration in the core continued to be driven by the heavily weighted shelter component, which was flat in February for a 0.4%Y decline, an all-time low in the almost 60 years of data and down from a prior cycle high of +4.3% in January 2007. This has more than explained all of the slowing in core inflation since then, as ex shelter core inflation has accelerated. Meanwhile, the producer price index plunged 0.6% in February (but was still up 4.4%Y), as energy prices (-2.9%) turned lower on a pullback in gasoline. Excluding food and energy, the core PPI gained 0.1% (+1.0%Y), in line with the well established trend, as the unreliable car and truck components that often cause meaningless month-to-month gyrations in the core flattened out.
Mortgages slightly underperformed Treasuries on the week, with the level of current coupon MBS yields extending a run of stability seen through most of the year - ending the latest week near the middle of the 4.3-4.4% seen through most of the past couple of months, which has kept 30-year mortgage rates very close to 5% over this period - and spreads versus Treasuries remaining near the tight end of the post-bubble ranges. To this point there has been no indication that this market is going to be in significant trouble when the Fed stops buying at month-end. Fed purchases have been slowing significantly ahead of the winding up of the US$1.25 trillion of purchases, slowing to just US$10 billion a week recently from nearly US$25 billion in September, US$15 billion in November and December, and US$13 billion in January. Helping the MBS market hold in so well has been the major decline in volatility. Normalized 3-month X 10-year swaption volatility fell to 90bp Wednesday, low since November 2007 and down from 127bp at the end of last year and a 2007 high of 207bp hit in June. As rates markets were somewhat rattled late in the week by the weakness in short-dated eurodollar futures, there was some reversal up to 95bp by Friday, still not far from post-crisis lows.
Clearly this plunge in volatility in interest rates has also been ongoing in risk markets, with equity and credit markets seeing another week of little day-to-day or intraday volatility. The lack of realized volatility continues to pressure implied volatility much lower, with the VIX hitting a nearly two-year low of 16.6% Thursday before rising slightly to 16.9% Friday. For the week, the S&P 500 gained 0.9%, and there weren't any big divergences among major sectors aside from some modest weakness in energy on the late week reversal in oil prices. Credit markets lagged stocks, with the investment grade CDX index 4bp wider on the week at 87bp, with almost all of this move coming in a widening move Friday after a run of nine straight trading sessions with either an 83 or 84bp close. The high yield index widened about 15bp on the week to near 520bp, having also barely budged before Friday since early in the month. As equity and credit markets were pulling back a bit late in the week, the commercial mortgage CMBX market held on to most of a strong rally seen early in the week, which went a good way towards reversing a terrible prior run for the year. On the week, the AAA CMBX index was flat to sustain a 2% year-to-date gain, but the junior AAA index gained 4% for the week and AA 6% to pare their losses for the year to 5% for each.
It was a light week for economic news, with industrial production and housing starts the main releases of note aside from the inflation figures. Both these reports extended the run of prior February data showing a better-than-expected performance during weather and other disruptions, suggesting better-than-expected underlying momentum. Industrial production ticked up 0.1% in February on top of a 0.9% surge in January, a solid performance during weather disruptions and temporary Toyota plant shutdowns. A 2.0% surge in mining boosted overall IP, while manufacturing dipped 0.2%. A 4.4% pullback in motor vehicles and parts as assemblies fell 7% accounted for the manufacturing softness. Toyota shutdowns accounted for much of this, but this is scheduled to be reversed in March. Ex-auto manufacturing output rose 0.1% despite the severe weather. A rebound from this drag should lead to good upside in ex-motor vehicle production in March on top of the likely autos rebound. Meanwhile, housing starts fell 5.9% in February to a 575,000 unit annual rate. Coming after a significantly upwardly revised reading for January (611,000 versus 591,000), this left activity a bit stronger than in December, a surprisingly resilient result during the severe February weather. Underlying activity was better, with almost all of the downside in the volatile multi-family component, which plunged 30,000 to 76,000, the second-lowest reading ever. Single-family starts only fell 0.6% to 499,000 units annualized, a level they have held very close to since the middle of last year. We are also continued gradually nudging up our 1Q GDP forecast. Building in early industry reports of a big gain in March auto sales and a lower forecast for the February PCE price index than we were previously assuming based on the flat CPI reading, we raised our 1Q consumption forecast a few tenths to +3.5%, which lifted our GDP estimate to +2.6% from +2.5%. We had cut this to 2.0% from 3.0% during February, but have since been steadily moving it back up as the impact of the February storms seems to have been largely offset by better-than-expected underlying activity. We still think 2Q GDP could accelerate to +4% as the weather improves.
The upcoming week's economic calendar doesn't seem likely to knock markets out of their recent torpor, with Treasury market focus likely to be largely on supply much of the week, with US$118 billion in 2s, 5s and 7s being auctioned Tuesday to Thursday. There are a number of notable economic releases, but they are comparatively minor ahead of the following week's initial run of key reports for March. The coming week's data releases include existing home sales Tuesday, durable goods and new home sales Wednesday and revised GDP Friday:
* We expect existing home sales to fall to a 4.90 million unit annual rate in February. Lousy weather across parts of the nation and the lingering hangover from the feared expiration of the homebuyers' tax credit are expected to lead to a further 3% decline in resales this month. However, extremely high affordability and the impetus associated with the latest version of the homebuyer credit should lead to a sharp pick-up in activity during the key spring selling season.
* We forecast a 1.0% gain in February durable goods orders. Company data point to another sharp jump in the volatile aircraft category. Moreover, we look for a rebound in bookings of machinery items following the usual seasonal weakness that has become increasingly evident in the first month of the calendar quarter. So the key core component - non-defense capital goods excluding aircraft - is expected to be up 1.2%. These factors should more than offset a modest pullback in the defense sector, which registered an outsized gain in January.
* We expect new home sales to rise marginally to 310,000 units annualized in February. Sales of newly constructed residences have plummeted over the last three months. But the homebuilder sentiment index showed a modest gain in February, so we look for sales to stabilize.
* Downward adjustments to construction and inventories should lead to a slight downward revision to 4Q GDP growth to +5.7% from the +5.9% that was previously reported.
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The Rebirth of Pricing Power
March 23, 2010
By Richard Berner l New York|
Cyclical rebirth of pricing power coming. For the past year, we've argued that core US inflation would decline towards 1% through mid-2010, but then begin to turn up again as the year progressed. At first blush, however, it appears that our story of limited declines in core inflation is on life support. Core inflation in the year ended February sagged to 1.3% measured by the CPI, and likely 1.1-1.2% measured by the Fed's preferred price index, the core personal consumption price index (PCEPI). And with slack in the economy still wide, the disinflation camp seems to have the benefit of the doubt.
We disagree. In our view, core inflation will edge somewhat lower, towards 1% in the next few months. But as we see it, the fundamentals for pricing power are gradually improving. Slack in housing, goods and labor markets is peaking or has peaked, companies continue to cut capacity, demand continues to improve, and the Fed remains committed to fighting disinflation. And advance indicators of inflation, such as prices at early stages of the processing pipeline, support the story of an eventual turn to higher, not lower, inflation. To be clear, we think core inflation by 2011 will head back towards 2% - not an alarming pace by any means, but one utterly inconsistent with a federal funds rate in the current 0-25bp range.
Pushback: Déjà vu all over again. We understand that many of our colleagues and clients think we're simply wrong or even nuts about inflation. We're not fazed; we've been down this road before. In 2002-04 we put forth our views on pricing power in a series of pieces, the first of which had the same title as this one. In our view, the main risk to this call some seven years later is that we could be a little early. But the forces driving the call are in motion, and - as then - we'd rather be early than late.
Reviewing analytics. Before examining the fundamental factors behind a return to pricing power, it's important briefly to review our analytics. There is broad agreement that near-record economic slack has promoted lower inflation. But in our view, the associated downside risks are now limited for three reasons: First, the slack-inflation relationship is looser than in the past and slack itself is narrowing. Second, strong global growth is pushing up US and import prices at early stages of the processing pipeline. Finally, we believe that inflation expectations will rise again.
Limiting the downside: A flatter Phillips curve. It's especially important to review the inflation-slack relationship. Two factors have loosened the slack-economy link over the past two decades: globalization, which has changed pricing behavior, and monetary policy, which has both anchored and put a floor under inflation expectations. Indeed, the workhorse ‘markup over cost' model has proven increasingly less reliable, courtesy of those factors and changes in firm pricing behavior.
Moreover, we believe that inflation responds to changes in slack as well as to the level. That such ‘speed effects' affect inflation makes intuitive sense. A trough in operating rates or a peak in the jobless rate will trigger a change in direction in businesses' and consumers' outlook for the factors that drive inflation. It may be reinforced by the fact that cyclically sensitive prices, like those for food and energy or other commodities, will rise in recovery. Consequently, such effects are strongest for wholesale or producer prices, but in turn we believe that they matter for consumer prices for goods and services.
In addition, a peak in housing-market slack should begin to stabilize rents. That's especially important because shelter costs (excluding hotels and insurance) figure importantly in inflation gauges, accounting for 40% of the core CPI and 18% of the core PCEPI. Indeed, by our reckoning, the decline in core inflation has entirely been a product of the sharp deceleration in tenant and owners' equivalent rents. The upshot: In our view, even high unemployment and low operating rates won't crush inflation.
Evidence that slack is peaking. What does the evidence say about slack in housing, goods and labor markets? In housing, there is still substantial slack, evidenced by the high levels of rental and homeowner vacancy rates; nationwide, in the fourth quarter they stood at 10.7% and 2.7%, respectively. And there is a not-insignificant risk that rising foreclosures will increase the stock of vacant homes. Importantly, however, both rental and homeownership vacancy rates have declined from their peaks.
In product markets, companies continue to cut capacity aggressively, contributing to the 440bp rise in industry operating rates over the past eight months - the fastest eight-month jump since 1983. That is the product both of the export-fueled production rebound in manufacturing and of efforts to rein in capacity. Measured by the Fed's capacity data, capital exit has taken overall industrial capacity down by 1.2% over the past year, the fastest pace on record. With production growing and capacity shrinking, we see factory operating rates up another 400bp to 73-74% by the end of 2010. And finally, in labor markets, we believe that the unemployment rate peaked last October at 10.1%.
Evidence of pricing power. Those dynamics are starting to result in a reversal of the forces that pressured inflation lower. Indeed, four pieces of evidence suggest that a turnaround is probably underway. Rents appear to be stabilizing; commodity, crude and intermediate materials prices are rising again; non-energy import prices are increasing; and diffusion indexes of price change are turning up.
That progress is beginning to show up in apartment rents. The National Association of Homebuilders has since 2003 compiled quarterly diffusion indexes on asking and effective rents; the former are ‘list' prices, while the latter include discounts and concessions, such as a month's free rent. Those data show that, while asking rents were still headed lower in 4Q09, effective rents actually bottomed in the second quarter (after seasonal adjustment). Moreover, surveys of apartment rents are beginning to show signs of stability, reflecting rising occupancy rates in stronger regions such as the Northeast, although markets that entered the recession later, such as Seattle, and those with larger problems, like Phoenix, California's Inland Empire, and Tampa, are still showing weakness. With job growth reviving, we expect that rents will stabilize further and slowly turn higher over the next two years as leases roll over. Given the significant role of rents in any price gauge, such a development should help arrest the decline in core inflation soon.
Strong global growth is offsetting US slack. Strong growth and diminishing economic slack is beginning to push up inflation or prevent it from falling in some emerging market and developed economies. That strength has pushed up US commodity, crude and intermediate materials prices. Excluding fuels, quotes for imported industrial materials prices have accelerated to a 15% rate over the past six months. Measured by the US PPI, core intermediate materials quotes have accelerated to a 5% annual rate over the same period; such pricing bellwethers typically lead finished goods prices by 5-6 months. Diffusion indexes of price change are turning up: Both the manufacturing and non-manufacturing ISM price indexes have moved over 60% in February. And our own business conditions survey showed that in early March, "with the exception of telecommunication services, a majority of respondents from every other sector reported that their companies' prices had either risen or remained the same relative to a year ago".
Factors influencing inflation expectations. Finally, as the Fed makes explicit following each FOMC meeting, inflation expectations matter for the inflation outlook. That inflation expectations - now hovering at around 2.5-2.75% by either market- or survey-based measures - are stable is good news; it suggests that inflation is unlikely to move significantly higher any time soon. Equally, however, the stability of such expectations suggests little risk of substantial disinflation any time soon. We believe that market-based measures of inflation expectations, such as 5-year, 5-year forward breakevens, came off their peaks on worries about the sovereign crisis in Greece and fears that US growth is slowing. As those concerns fade, we believe that inflation expectations will begin to rise again.
Risks lie in rents, expectations. Although it now appears that rents are stabilizing, renewed declines represent the biggest downside risk to our inflation outlook. A surge in foreclosures could widen housing imbalances and pressure both home prices and rents. But there are upside inflation risks as well. Factors that could promote increases in inflation expectations represent the biggest upside risks: Significantly faster growth, intensified protectionism or perceptions that the Fed is overstaying its welcome would all begin to put greater-than-expected upward pressure on inflation expectations and eventually inflation itself.
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