Japan
PM Kan's Policy Speech: Points Unconnected
June 15, 2010

By Robert Alan Feldman, Ph.D. | Tokyo

Dots unconnected: PM Kan's policy speech. PM Kan's policy speech last week contained a myriad of points still unconnected. Most elements of the speech reflect well-known parts of the DPJ's approach under PM Hatoyama; others are new, and in some case suggest evolution toward a more coherent growth strategy. That said, how the parts fit together - the mechanics and arithmetic of PM Kan'­s approach - remains to be clarified.

Continuity: Much of PM Kan's policy speech relating to the economy continued both the rhetoric and policies of former PM Hatoyama and former Party Secretary Ozawa. The bulk of the speech encouragingly dealt with economic issues, but there was disappointingly little (although not nothing) beyond the DPJ's December growth strategy document. The approach to growth is ‘national strategy through problem solving' (kadai kaiketsu gata kokka senryaku) with only vague statements on how the parts relate to each other, and no quantification.

A key continuity was the view on productivity and employment: although not explicit, the basic undertone of the speech implied that productivity growth is a threat to employment. This approach asserts that productivity improvement policies have hurt employment over the last 20 years. The key sentence is, "Although support for productivity improvement is necessary, it is more important to expand demand and employment simultaneously." PM Kan does recognize the importance of productivity - a major change from the DPJ manifesto and Policy Index of 2009. However, the assertion that demand is lacking in the key areas he mentions, such as care for the aged and environmental technology, is highly questionable. There is enormous demand in such areas; the realization of such demand has been blocked by excess regulation and misallocation of government spending. To the extent that PM Kan intends to "create demand" by revising regulations and reallocating public spending, the outcome will aid the economy. However, if he intends to "create demand" while implementing his fiscal goals through the standard big government policies (i.e., more spending and even higher taxes), then the impact on the economy is unlikely to be positive - because deficits are more likely to rise than to fall, and because incentives for efficient resource allocation will fall, as firms react by locating even more activities offshore.

It is encouraging to see PM Kan clearly state that fiscal consolidation, growth strategy and social security reform must all be considered as a package. It was hard to see what this package will look like, especially given the lack of quantification in the speech.

It was also encouraging to see that PM Kan explicitly mentioned ending deflation, and the need for the BoJ and the government to work together. It was hard to see any progress from the statements on this matter that were made three months ago. Using monetary policy as a means to offset the necessarily contractionary impact of fiscal reform proposals has yet to take its rightful place in the policy package that PM Kan is proposing.

There were also some disappointing omissions from the speech. First, there was no reference to immigration policy, which must play a crucial role in any growth strategy with prospects for success, in our view. Second, although there were generalized statements on starting public debate on tax reform, there was no specific mention of the consumption tax or corporate taxation - or any of the many other elements of tax reform needed to implement a credible growth strategy.

The issue of postal reform is also important. Despite stating that the DPJ would not ‘turn back the clock' toward the old system of bureaucracy, PM Kan's speech explicitly said that the bills to reverse postal reform would be reintroduced as soon as possible. This reversal would revert the structure of the postal system to a three-firm form, thus impeding incentives for efficiency. It would also give a special upper limit to deposits in the Post Bank, and thus de-level the playing field.  It is important to note that the pressure to reverse postal reform does NOT come solely from the DPJ's coalition partner, the People's New Party (PNP). Rather, a very substantial part of the DPJ itself, including General Affairs Minister Haraguchi and newly appointed Nation Strategy Minister Arai, also favor reversal of the postal reforms. Thus, even if, after the upcoming elections, the small PNP is no longer in the coalition, the reversal of postal reforms is likely to proceed.

New elements:  Despite the many elements of continuity in the speech, there were some new elements.

First, the term ‘regulatory reform' appeared. Hitherto, this idea has largely been shunned by the DPJ, as part of what PM Kan identified as ‘the second way' - which he asserts (incorrectly, in our view) only led to deflation and stagnation. In this speech, however, PM Kan advocated regulatory reform in two contexts, selling Japanese infrastructure technology to Asia and R+D policy.

Second, PM Kan's approach to fiscal policy is clearer. He starts with the ‘Jefferson Principle', i.e., that initiatives requiring long gestation periods start as soon as possible. He applies this principle to the inevitably long period that stabilizing the debt-to-GDP ratio will take. Third, PM Kan stated explicitly that growth strategy is the key to successful fiscal reform, an assertion lacking in the debate since 2006. Fourth, he stated that budget spending programs will be prioritized on the basis of their impact on employment. Fifth, he called for a bipartisan effort with the LDP in fiscal reform. Sixth, he stated that efforts to introduce a taxpayer ID will continue. Finally, he vigorously stated that civil service reform and waste reduction will continue.

Conclusion: Although PM Kan's speech did include these innovations, the main message was continuity with PM Hatoyama's economic policies. Investors are likely, in our view, to welcome the innovations, but to remain skeptical of the overall philosophy. Moreover, until numerical meat can be added to the philosophical bones of the fiscal/growth/social security strategy, investors are likely to be wary of prospects for success.

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United Kingdom
Fiscal Risks: OBR
June 15, 2010

By Melanie Baker, CFA & Cath Sleeman | London

We are finally about to find out (at least in broad terms) what the new government has in mind for the UK's fiscal finances.  We already know that it thinks that "the most urgent issue facing Britain today...is our massive deficit and our growing debt".  We also know that it aims to "significantly accelerate the reduction of the structural deficit".  We currently assume that after the Budget on June 22 we will be looking at sharp cuts in real government spending over the next few years. This is a key reason why we maintain a below-consensus forecast (by nearly 1pp) for UK GDP growth of only 1.2% for 2011. 

Two Key Fiscal Events in Two Weeks

The Office for Budget Responsibility (OBR) reports on June 14.  The Budget will be held on June 22.  We will get growth and borrowing forecasts from the OBR on June 14 (based on ‘existing policy').  Then, in the Budget, the OBR will produce updated forecasts and it also makes a judgment on whether the government has a better than 50% chance of achieving ‘the fiscal mandate' (which will also be announced at that time).

June 22 Is Still the More Crucial Date: We Need to Know the ‘Mandate' Before We Know What Lies Ahead

The OBR will produce growth and borrowing forecasts on Monday.  The central GDP growth forecast will likely be lower than the previous government's, we think.  The borrowing figures will then tell us what the OBR thinks the deficit would look like, on existing policies, with this weaker growth profile plugged in. We think the deficit will be higher than on the previous government's forecasts.  However, without knowing what the ‘fiscal mandate' is, we can still only make educated guesses as to how much government spending will need to be cut over the next few years and how much taxes will need to be raised.  We need to know what the new government is aiming for, e.g., a 2% of GDP deficit by 2014/15 or government debt falling as a percentage of GDP by 2014/15?

OBR Forecasts: Likely Lower Growth, but Not Necessarily Higher Borrowing

In whatever form they actually come in, we expect lower growth forecasts and a higher borrowing projection on the OBR's projections than on the previous government's, but the deficit may not be much higher.  There are offsetting factors to a lower growth rate that may be incorporated into the projection.

- Lower GDP growth: We think that the OBR will show lower real GDP growth for most, if not all, of this parliament (i.e., through to 2014/15).  The previous government's GDP forecasts are significantly more optimistic than our own and consensus forecasts for 2011 in particular.  However, in the years beyond 2011 the previous government's forecasts showed real GDP growth growing above 3% through to 2014/15.  We don't think that this is implausible, we just think that it looks optimistic. 

- Borrowing may not rise: All else equal, a weaker real growth profile would mean a higher deficit path.  We think this is most likely what the OBR will show as a central case. However, there are at least three potential offsets here: 1) the actual budget deficit in 2009/10 came in much better than was predicted in the Spring Budget by the previous government (to the tune of about £10 billion).  That better ‘starting point' reduces the deficit, all else equal.  2) Given recent inflation outcomes, we think there is a good case for suggesting that the previous government's inflation forecasts were too low for 2010/11.  A higher nominal GDP level would reduce the deficit as a percentage of GDP all else equal.  And 3) the government has already announced £6 billion of spending cuts for 2010/11.  If these are included in the OBR's projections, this should also reduce the deficit.

Two Scenarios for the OBR Forecasts

It isn't necessarily the case that the OBR will increase the deficit forecasts.  We show two (of many plausible) scenarios for the OBR central forecast (assuming that an explicit central case is published):  1) We start with the previous government's forecasts.  2) We then show how the figures improve on our simple fiscal model if one includes the better-than-expected 2009/10 outcomes. 3) OBR scenario 1 - we then also build in the 2010-11 £6 billion spending cuts already announced and show how the numbers look if we ‘plug in' our own economic forecasts (weaker real growth, but higher inflation).  4) OBR scenario 2 - we do the same exercise, but with a more conservative set of economic forecasts (cutting growth by 1pp in each year from 2011/12, unchanged inflation forecasts compared to the previous government and adding 200K to unemployment estimates which then plateau at those high levels). 

We think that an upward revision to borrowing is the most likely outcome:

1)         The OBR may not incorporate the £6 billion of spending cuts announced for 2010-11 by the new government;

2)         While consensus forecasts for GDP growth are lower than the previous government's in 2011, consensus forecasts for inflation are lower than on our central forecasts;

3)         The OBR may continue with the conservative assumption of the previous government that after rising further, unemployment would plateau at elevated levels rather than decrease over the later years of the parliament (i.e., the numbers may look more like ‘OBR scenario 2').    

Budget Outcomes Uncertain

The likely outcomes for this Budget are more uncertain than usual.  We will know what growth assumptions will be used in the budget projections after the OBR report on Monday. But we won't then know what deficit the new government will effectively target and by when.  We assume, given that the coalition wants to see a significantly accelerated reduction in the structural deficit, that this will translate into a significantly accelerated reduction in the overall deficit too.

We show very tentative figures for what this might look like.  This assumes that the growth forecasts used are the same as in ‘OBR scenario 2' (i.e., 1pp lower real GDP growth every year from 2011/12).  We assume the government plans to reduce the deficit to 2% of GDP by the end of the parliament and that most of this reduction is done through lower spending.  In this scenario, total spending is some £40 billion lower than the previous government's forecast (where spending settlements were already set to be tough). 

Office for Budget Responsibility: What it Is and Why it Matters

The coalition government has established the OBR with the aim of improving the perceived credibility of government fiscal forecasts.  As well as producing forecasts, the OBR will comment in the Budget on whether the government's policy is consistent with a better than 50% chance of achieving the government's fiscal mandate - although the mandate is one of the key unknowns.  It is too early to judge whether or not the OBR will achieve the government's aim with respect to credibility.  However, we note that it will not guarantee more accurate forecasts and is no panacea. 

New government establishes OBR to improve credibility of forecasts: One of the new government's first actions was to establish an Office for Budget Responsibility (OBR).  The OBR has been charged with making an independent assessment of the public finances and the economy for each Budget and Pre-Budget Report. The government believes that "the independence of the OBR's judgments will ensure that policy is made on an unbiased view of future prospects, improving confidence in the fiscal forecasts".  The new government has claimed that "the potential incentive to optimistically forecast lower borrowing and higher growth...led to scepticism over the credibility of the government's forecasts". 

The OBR will publish two sets of forecasts: The Treasury has published a Terms of Reference for an Interim OBR, which will act until the official OBR is established: 

- June 14 (10am): The Interim OBR's first set of forecasts will be based on "existing policy".  We also expect the OBR to provide an initial discussion of public sector liabilities and their implications for the public finances.

- June 22 (3.30pm): The Interim OBR will produce a second set of forecasts for the Budget, incorporating the impact of policy measures announced at the Budget.  The OBR will also make a judgment on whether the government's policy is consistent with a better than 50% chance of achieving the government's fiscal mandate. The Interim OBR will also take a role in beginning an independent assessment of the public sector balance sheet and fiscal sustainability, including assessing the impact of ageing, public service pensions and PFI contracts.

There's still plenty we don't know: In relation to the second set of forecasts, the government has said that the Interim OBR will have discretion over what material is published. Beyond forecasts for growth and borrowing, it is unclear whether other forecasts will be shown and what horizons they will extend to.  There is also uncertainty over how exactly the government will use the forecasts of the OBR, particularly those for borrowing.

The key unknown is the mandate/target of the OBR: The ‘mandate' will be released in the Budget and is one of the most important unknowns.  The Chancellor has stressed that he will "retain responsibility for fiscal policy and will set the fiscal mandate, his target for fiscal policy".  This will presumably dictate the speed of the reduction in the deficit.  It will also provide a benchmark for markets against which to judge the success of any fiscal tightening. 

The Conservative Party first described its idea for an OBR in September 2008. In this document, it laid out the following mandate:

1.         Falling debt as a percent of GDP

2.         A balanced current budget, adjusted for the cycle

In the government's coalition agreement, the two parties agreed to a more general statement: "to significantly accelerate the reduction of the structural deficit over the course of a Parliament".  The new government has also made reference to the target being "forward-looking".

Can the OBR replicate the BoE's success? The establishment of an independent group to aid fiscal policy bears close resemblance to the establishment of the Monetary Policy Committee to conduct monetary policy.  The latter's credibility and broad success in maintaining price stability may lead some to conclude that the OBR will ensure the same success for fiscal policy.  However, several important differences may affect the OBR's perceived success.

1.         The OBR doesn't have a ‘bank rate' to adjust. The most important distinction between the two organisations is that the OBR lacks an instrument.  It has no powers over taxation for example.  The reason for not giving the OBR control over fiscal policy is clear: elected officials who represent the public set fiscal policy.  But this may, nevertheless, affect the OBR's perceived success.

2.         Accountability for achieving the fiscal mandate is unclear. The second key distinction between the OBR and MPC relates to accountability.  The bank is solely accountable for achieving the inflation target.  We can't imagine that the same would be true of the OBR in regards to the government's fiscal mandate.  This is because the government could contribute to the mandate being missed, for example by underestimating the amount of revenue raised by a change in tax policy.  Because of this possibility, it may be difficult to gauge the credibility of the OBR based on any hit or miss of the government's mandate.   

Will the OBR work? The key question is whether the OBR will achieve the government's aim, namely enhancing the credibility of the fiscal framework.  While it is too early to come to a decisive view, we consider below two issues that will likely affect the OBR's success.

1. The OBR's forecasts won't necessarily be better. Delegating forecasts to an independent agency would remove any temptation to ‘fiddle the figures'. However, it does not guarantee that the forecasts will be unbiased or indeed any more accurate; biased forecasts are not necessarily deliberate.

To illustrate this point, we compare the forecast errors on GDP growth made by the government (published in the Budget) and by independent forecasters over the last ten years.  A positive error represents an overestimate of growth.  Errors from independent forecasters and the government have been similar: for forecasts one year ahead, the absolute average error on the government's forecasts was 1.38pp, while for the independents' forecasts it was 1.31pp.  If independents, rather than the government, had produced the forecasts, they would have also overestimated growth in the last two years and would not have been substantially more accurate.

2. The OBR will likely improve the credibility of the fiscal framework, but it's no guarantee. It has been noted that governments may have an incentive to run budget deficits; this is referred to as the ‘deficit bias'.  The argument runs that a current government will not necessarily have to deal with repaying the debt it runs up (since it may lose the next election) and the voices of a few interest groups or ministers may prove louder than the many who have to bear the resulting cost.  

The simplest approach to addressing the deficit bias is to impose a fiscal rule or target on the government.  The weakness of fiscal rules is that politicians may find ways to circumvent them.  International evidence on their effectiveness is mixed.  Independent fiscal agencies discourage a government from circumventing a rule by revealing its ‘budget tricks' to the public. It is crucial therefore that the fiscal agency has a sufficiently wide remit to comment on the government's actions in this respect.  However, even then, an agency may not be successful.

For details, see UK Economics & Strategy: Fiscal Risks: OBR, June 11, 2010.

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United States
Review and Preview
June 15, 2010

By Ted Wieseman | New York

A recently rare week of fairly calm trading conditions across markets left Treasuries little changed, stocks and credit markets a bit stronger, swap spreads tighter and conditions in dollar funding markets again less strained, and the dollar weaker and commodity prices higher.  Helping to allow the stabilization was a run of reasonably well-received debt offerings from fiscally strained (to differing degrees) eurozone members, Portugal on Wednesday, Spain on Thursday, and Italy on Friday.  Given the size of its economy, the high level of concern in the market about the state of its banking system and economy, and a heavy schedule of debt redemptions coming up in July, Spain has widely come to be seen as the key country to watch for now in the European debt situation, and its spreads over Germany hit new wides on Tuesday after a month of persistent widening that had been leading to some investor speculation about whether the July redemptions would be able to be refunded without assistance from the EU/IMF support programs.  But this pessimism eased after Portugal's auctions went smoothly Wednesday and then Spain itself had no problems issuing debt in the market Thursday.  Still anxiety certainly remained quite high at week-end, with Spain's 2-year spread over Germany seeing widening upside Friday, taking the euro down again too after a strong rebound Thursday, to end the week 10bp higher at 240bp, 7bp below Tuesday's peak.  Clearly, this situation will remain in sharp focus going forward.  Spain will be back in the market on Thursday with 10-year and 30-year auctions, and Ireland will also be selling debt on Tuesday.  The recently rare positive week for Europe was coupled with a recently unusual week of softer domestic economic data that helped Treasuries end Friday on a strong note after digesting longer-end supply mid-week.  The retail sales headline results were a lot worse than the key underlying details, but these too were sluggish, causing us to lower our 2Q consumption estimate to +2.9% from +3.2%.  The trade balance in April was right in line with expectations, but the annual revisions released with the report pointed to a stronger pace of import relative to export growth through the first part of 2010, pointing to slightly more negative net exports in 1Q and 2Q.  And inventory results at the wholesale and retail levels shifted a bit of output into 1Q but at the expense of 2Q.  Netting these impacts, we still see 1Q GDP running at +3.0%, but we lowered our 2Q forecast to +3.6% from +4.0%.  To the extent that the European situation is settling down, however, and risks of severe systemic spillover impacts look increasingly remote at this point, we continue to see the risks to the medium-term US outlook as tilted to the upside and the risks of a double-dip as minor. 

Treasuries wound up not much changed on the week after big back-and-forth swings Thursday and Friday, posting minor net losses along the curve.  The 2-year yield rose 1bp to 0.73%, old 3-year 2bp to 1.17%, 5-year 3bp to 2.01%, 7-year 2bp to 2.66%, 10-year 2bp to 3.22%, and 30-year 2bp to 4.13%.  Treasury bills initially didn't participate in the big rally in the rest of the market that started in April aside from a few days in early May, but they have suddenly been very strong, likely being helped by looming quarter-end and expectations of sizeable reductions in supply during the rest of this month.  The 4-week bill yield plunged 8bp for the week to just 0.03%, 3-month 5bp to 0.07%, 6-month 5bp to 0.16, and 1-year 4bp to 0.29%.  This opened a sizeable gap between short bill yields and repo rates that has started to put downward pressure on the latter, with the overnight Treasury general collateral repo rate averaging 0.18% Friday, down from 0.23% the prior Friday.  With the dollar index pulling back 1% with the rebound in the euro to $1.210 from $1.197 (and the Australian and Canadian dollars also rebounding sharply against the US dollar), and commodity prices seeing good upside - 4% in July oil and the LMEs base metals composite - TIPS performance was surprisingly bad, with breakevens at the long end flat and the shorter end actually down.  Apparently, investors were not looking forward to what's going to be another bad CPI report for TIPS investors on Thursday with the recent pullback in retail gasoline prices at the time of year when they should have been hitting their seasonal highs.  The 5-year TIPS yield rose 5bp to 0.34%, 10-year 2bp to 1.24%, and 30-year 1bp to 1.77%.  The stability in dollar interbank funding markets stretched towards a third week, making the risks of a global liquidity squeeze developing from the ongoing European strains along the lines of what happened in 2007 look increasingly remote.  3-month Libor has set near 0.54% every day since May 24 now.  The 3-month Libor/OIS spreads climbed slightly on the week to 33bp, but only because effective fed funds moved a bit lower, as the plunge in bill yields pulled repo rates lower.  Forward Libor/OIS spreads continued narrowing and showing increasingly little fear of upward pressure going forward.  The September Libor/OIS spread is now down to 45bp from the peak of 71bp hit in late May, December is down to 47bp from 73bp, and March is down to 43bp from 62bp.  This helped swap spreads post a good narrowing on the week.  The benchmark 2-year spread plunged 9bp on the week to 39bp. 

Mortgages extended an excellent recent performance, outperforming Treasuries by nearly a quarter point among lower-coupon issues, leaving current coupon yields near 4% after they had rallied towards historical lows of 3.9% mid-week.  Rates market volatility was rather steady at low levels over the past week - having held at relatively low levels throughout this European episode - and investors seemingly are finding mortgages to be attractive carry in an environment when rates are widely expected to stay at low levels for some time.  Also important is the slow level of prepayments relative to the level of rates.  With current coupon yields nearing all-time lows this week, the average conventional 30-year mortgage fell to just 4.72% according to Freddie Mac's survey, only 1bp from a record low.  And while refi applications have been rising recently, with a 50bp plunge in rates in the past two months to a near-record low, the upside has been very muted relative to what one might have seen five years ago as a result of much tighter credit standards and negative home equity.

The minor Treasury market losses had their converse in small risk market gains on the week.  Indeed, the intraday and day-by-day correlation between Treasury yields and stocks has been becoming increasingly tight recently.  For the week, the S&P 500 gained 2.5%, with the energy and materials sectors substantially outperforming.  While rates volatility has stayed low during the past couple of months, equity volatility certainly hasn't, but the VIX did see a good drop in the past week, falling to 28.8 from 35.5, a low in a month.  Credit performance was more muted.  The investment grade CDX index tightened 2bp to 124bp, but the high yield index was also only a couple of basis points tighter at 660bp.  This lagging performance by HY credit was even more pronounced in subprime and commercial real estate, which fell on the week.  The AAA ABX index was off 1%, AAA CMBX 1%, junior AAA CMBX 2%, and AA CMBX 4%.  The HY CDX, ABX and CMBX markets had occasionally been able to outperform over the past couple of months when investors ignored Europe and focused on stronger US economic news, but that got flipped around this week a bit with the mildly better tone in Europe and softer couple of days of US data.  The somewhat less pessimistic outlook on peripheral Europe also did not spillover onto concerns about the finances of American states, with the muni bond MCDX index staying at its wides for the year, as Spain and other focus eurozone countries tightened after Tuesday.  Late Friday, the 5-year MCDX index was trading 25bp wider on the week and 50bp wider in the past two weeks, at 213bp. 

The past week's light economic data calendar was a modestly negative break in the several months' long run of strong numbers, pointing to somewhat slower 1H GDP growth than we expected coming into the week.  Incorporating results from the international trade, retail sales and business inventories reports, we continue to see 1Q GDP at +3.0%, but we now see 2Q tracking at +3.6% instead of +4.0%, so about a quarter point slower for the first half as a whole.  The contribution from net exports looks to be about a quarter point lower in both 1Q (-1.0pp versus -0.7pp) and 2Q (0.0pp versus +0.2pp), mostly as a result of annual revisions to the international trade figures that created a more negative trajectory for imports relative to exports coming into this year - strong growth in both, just more so in the former relative to the latter now.  The retail sales report was a lot weaker in the headline numbers than in key underlying details, but we still cut our 2Q consumption estimate to +2.9% from +3.2% on disappointment in key discretionary categories.  On the other hand, underlying details on capital goods imports and exports in the trade report pointed to stronger 2Q investment, and we raised our forecast for 2Q estimate for equipment and software investment to +12% from +6% and overall business investment to +9% from +5%.  Meanwhile, the business inventories report pointed to a bigger boost from inventory accumulation in 1Q but with an offset in 2Q.  Retail ex auto inventories rose a larger-than-expected 0.4% in April after a big upward revision to March (+1.1% versus +0.4%), while wholesale inventories also rose 0.4% in April after a bigger gain in March (+0.7% versus +0.4%).  Incorporating these results, we look for the 1Q inventory contribution to be adjusted up to +2.0pp from +1.6pp - but we then see this added 1Q boost being given back in 2Q, with the contribution now estimated at -0.5pp instead of -0.1pp.  Beyond this modestly negative GDP arithmetic of the past week's incoming data, we continue to see medium-term upside risks to growth, particularly now as the most acute spillover risks of the European situation seem increasingly remote, and we see the risks of a double-dip as remote.  Still strong global demand - well illustrated by China's extremely strong May trade report reported Thursday - handoff to domestic strength through accelerating income (one small silver lining of the sluggish retail sales report is that as strong as real income growth was, the savings rate is going to move a lot higher in May), and the lingering impact of fiscal stimulus, especially in infrastructure outlays, should all continue to be supportive of the recovery going forward. 

Retail sales plunged 1.2% in May as auto sales fell 1.7%, much worse than the upside in unit sales, building materials tumbled 9.3% after surging 17% over the prior two months as ‘cash for appliances' money ran out in most states, and gas stations fell 3.3% on the seasonally very unusual decline in gas prices this May.  The key ‘retail control' grouping that excludes these categories wasn't nearly as weak but was still sluggish at +0.1%.  Results from clothing (-1.3%) and general merchandise stores (-1.1%) were particularly disappointing after solid May chain store sales reports.  It's possible there were seasonal adjustment problems with the very late Memorial Day.  We'll have to wait for next month's report to see if there is offsetting upside, and at this point are not assuming anything unusual.

The trade deficit was little changed at US$40.3 billion in April, with exports (-0.7%) and imports (-0.4%) both posting small declines after surges in March.  Most major export categories were little changed, with some price-related upside in industrial materials offset by a pullback in food and a flat reading for capital goods a positive sign for domestic investment.  Capital goods imports posted a good gain, an additional positive indication for investment, while consumer goods imports were softer and petroleum products held steady as a pullback in volumes offset higher prices.  We now see net exports being neutral for 2Q GDP growth after an expected downward revision to the negative 1Q contribution.  We continue to expect strong global growth - notwithstanding the problems in Europe; in addition to the strength in China's trade numbers, we had a stunning example the past week in Brazil's 11%+ sequential 1Q GDP growth - to lead to trade being supportive for US growth over the medium term, but over 1H10, US import growth has been quite robust outpacing the export strength, though only temporarily, we expect.

The economic calendar is somewhat busier in the coming week, but the main releases don't seem too likely to be significant market movers.  There was some kind of sporting event going on Friday that seemed to be attracting interest on the FX side of our interest rates/FX trading floor here in New York, so we're not sure if that will have any impact on trading volumes in the coming week.  Notable releases due out this week include PPI, housing starts, and IP Wednesday and CPI and leading indicators Thursday:

* We look for a 0.7% decline in the headline producer price index in May and a 0.1% rise in the core.  A double-digit plunge in gasoline prices is expected to lead to a sizeable decline in the headline PPI.  Otherwise, quotes at the wholesale level are expected to register a fractional gain - right in line with the trend seen in recent months.

* We expect housing starts to fall to a 625,000 unit annual rate in May.  Unusually mild weather and the impact of the expiring homebuyer tax credit contributed to a sharp 6% jump in starts during April.  We look for a 7% pullback in May.  However, inventories of new homes available for sale are quite lean and we should see a gradual - and more sustainable - improvement in new construction going forward from here.

* We forecast a 1.0% surge in May industrial production.  Industry figures point to a sharp rise in motor vehicle assemblies during May.  And the employment report showed a big gain in hours worked across the manufacturing sector. So we look for a sizeable jump in factory output in May led by the aforementioned rise in the auto industry, together with advances in sectors such as: metals, machinery, electrical equipment and chemicals.  Finally, the tragic situation in the Gulf is not expected to have a noticeable impact on overall production this month but could be a more significant factor going forward.

* We look for the headline consumer price index to decline 0.2% in May and the core to rise 0.1%.  An estimated 6.5% drop-off in gasoline prices should lead to a second-consecutive decline in the headline CPI.  Meanwhile, the core is expected to register a ‘high' 0.1% rise, driven mainly by the ongoing elevation in the education category, another jump in hotel rates, and a likely bottoming in rent and OER.  On a year-on-year basis, the core CPI is expected to just barely tick up to +1.0%.

* After the slight dip in April that interrupted the best one-year run since 1984, the index of leading economic indicators should get back on track with a 0.7% surge in May.  Significant positive contributions should come from the money supply, yield curve and manufacturing workweek.  Stock prices will likely be a negative.

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United States
Cyclical Scorecard: On Track for Sustainable Growth
June 15, 2010

By Richard Berner | New York

Investors continue to fret over the sustainability of the global and US recoveries...  Small wonder: Worries that ongoing deleveraging will handcuff US domestic demand, the potential contagion from the European sovereign credit crisis, a deceleration in Chinese and emerging market growth, and uncertainty about financial regulatory reform and future tax increases are a few of the secular and cyclical headwinds challenging the outlook.

...but are according too little respect to the tailwinds that are winning the cyclical tug-of-war. Four factors are critical in that regard.  First, we think that monetary policy remains ultra-accommodative, and central banks are eager to immunize economic growth from contagion by delaying or tempering their exit strategies.  Second, aggressive fiscal tightening is not on the agenda for most large economies, and in those nations where officials are implementing public austerity, it may even ‘crowd in' private spending.  Third, lower energy quotes and lower mortgage rates that have resulted from double-dip fears will give consumers an extra boost.  Finally, we think that those daunting secular headwinds are more likely to depress the future trend rate of growth rather than to abort the cyclical expansion.

Cyclical scorecard supports breadth of recovery. Indeed, a detailed examination of cyclical indicators testifies to the moderate recovery underway.  Such a moderate rebound may be more vulnerable to shocks than a vigorous one.  But the fact that many aspects of the rebound are tracking - or are ahead of - cyclical norms, together with the increasing breadth of the expansion, should give investors confidence in its staying power.   Breadth matters; if the expansion is broadly based, it is less vulnerable to shocks that might hit some parts of the economy but leave others unscathed, such as the potential contagion through funding markets from Europe's crisis.

Overall cyclical comparisons still lagging. By comparison with the past, this rebound has been clearly subpar in many respects.  For example, GDP has risen 2.7% from the presumed trough in 2Q09; in contrast, output rose by an average 4.2% in the first three quarters of the past seven recoveries.  That bland performance is especially noteworthy when compared with the severity of the just-ended recession, in which output plunged by 3.7% over six quarters - by far the deepest and longest post-war contraction.  While this expansion is easily beating the lackluster rebounds of 1991 and 2002, it falls well short of cyclical norms: Had it been a typical post-war recovery, GDP would have already passed the previous peak and then some.

Other indicators that are lagging cyclically include four famously tepid performers:

•           Non-farm payrolls remain 1% below their level of mid-2009, when we presume the recession ended;

•           Housing starts are 15% above their trough, but typically they are up 20-25% at this stage of recovery;

•           Structures investment - always the last economic segment to recover - is 13.2% below its level at the recession trough, compared with a norm of -5.6%; and

•           State and local government budget woes have until very recently crushed their outlays; nominal state and local construction outlays still lie 7.1% below their level in mid-2009. 

Vital areas of outperformance. But several metrics are on par with or well beyond cyclical norms: The rebound from the trough in core capex orders and factory production, exports, and real manufacturing and trade sales are all ahead of schedule.  Non-defense capital goods orders excluding aircraft are 10.3% above their trough; factory output has risen 7.4% since the recession ended; real exports are 20.4% above their June 2009 lows; and real business sales (through March, the latest reading) are 5.9% above the trough.  The dichotomy between the lagging indicators and those making the grade or excelling fits our script of a two-tier economy: Strong demand from abroad is still boosting exports and overseas earnings, but domestic demand remains much more sluggish. 

Sine qua non for sustainability is domestic demand.  In our view, sustainability requires that the push from an export- and policy-driven recovery makes a successful handoff to an expansion reliant on domestic demand.  That passing of the baton must happen through the time-honored channels of production catching up to final demand, rising income to support consumer outlays, and the kicking in of the ‘accelerator' mechanism that will drive capital spending. 

Metrics of comfort. As we see it, three additional yardsticks should give investors comfort around that thesis, although none is yet conclusive.  First, inventory-sales ratios continue to decline toward record lows, as the pace of sales far exceeds the turn to inventory accumulation that is just now starting.  Not surprisingly, this deep recession involved the mother of all inventory cycles: Real manufacturing and trade stocks plummeted by 7.4%, or half again as much as in the severe 1981-82 recession.  With sales up as described earlier, I/S ratios are on track to signal that inventories are too lean.  Indeed, small businesses in the NFIB survey are planning to add to inventories for the first time since November 2007.  And respondents to the ISM canvass report that customer inventories in May matched a record-low level.  The bottom line is that production is still catching up to demand, and the idea that the inventory cycle will peter out is in our view a myth.

Second, courtesy of a half-hour surge in the private workweek in the past eight months, hours worked in non-farm business (apart from self-employed and part-time workers) are 1.2% above their mid-2009 trough and up 2.1% in the past seven months.   The latter increase translates into the equivalent of private job gains averaging 321,000 monthly over the past seven months, versus the 70,000 monthly average in current data.  That surge in hours, which we estimate will translate into nearly a 4% annual rate in 2Q, has begun to contribute significantly to ‘core', or real, after-tax wage and salary income.  We estimate that such income will grow at a 4% annual clip in the first half of 2010 - more than the pace needed for a sustainable recovery. 

Finally, the ‘accelerator' - the connection between the change in output growth and the advance in capital spending - is only now reaching a peak.  The flexible accelerator model of investment implies that business investment will respond with a lag to changes in the desired stock of capital in relation to output.  Managers will tend to extrapolate a pick-up in business activity into brighter expectations of future growth, higher perceived returns from investing, and an increased need to invest.  As a result, even a slower decline in economic growth will boost growth in investment, and a recovery will make it soar.  The lag between the change in capital stock and the resulting investment is critical because the past acceleration of the economy - a positive ‘second derivative' - will continue to boost capital spending until next year, even after current growth rates peak.  For example, on a year-over-year basis, we estimate that the acceleration (second derivative) of the economy will only peak in 3Q at 9.8%.  That's especially ironic today, because investors are currently frightened by an emerging zero or negative ‘second derivative' in other economic data.  The positive accelerator effect may even help end the collapse in commercial construction.  We expect further weakness, but advance indicators of architectural billings hint at improvement.

Metrics of breadth. The time-honored business cycle metrics of depth, duration and dispersion suggest that the current recovery, while moderate, likely has staying power.  As noted above, evidence for that claim is especially critical now that equity markets are fearful of a negative ‘second derivative' trade.  Recoveries represent the move from the trough of recession into an economic expansion.  Just as recessions are defined in terms of their depth of decline, duration and dispersion across industries, recoveries are defined by the magnitude of the increase, its duration, and the dispersion or breadth.  Monitoring the indicators of breadth and the forces promoting strength is critical to assess strength and duration.

Diffusion indexes are helpful summary indicators of how widespread are changes in direction in economic activity.  Statisticians compile them either from surveys or official government data spanning many industries.  In the former, the number crunchers aggregate into indexes the responses from surveys of business activity such as those from the purchasing managers (ISM) or professional associations like the National Association for Business Economics (NABE).  The ISM centers its indexes on 50% (above 50 they show expansion and below 50 contraction) as the calculation adds half the percentage who respond that business is the same to the percentage noting improvement.  In contrast, NABE calculates the net of positive and negative responses, so their indexes are centered on zero and are more volatile than a pure diffusion index.  The Bureau of Labor Statistics and the Federal Reserve construct diffusion indexes from payroll employment and industrial production data that are similar to the ISM indexes.  Likewise, we compute the proprietary Morgan Stanley Business Conditions Index (MSBCI) based on the responses of our equity research analysts to an internal canvass that we administer each month.  These three series reflect the percentage of industries showing growth plus one half of those unchanged.

The verdict now: Most of these measures show that the current recovery is moderate but broader than many past upswings.  The May manufacturing ISM index has remained near the 60% level, a level attained only ten times in the past 50 years.  Factory production has surged 7.4% from its June 2009 trough, and the three- and six-month diffusion indexes for industrial production, at 67% and 64.7%, respectively, are only a short distance from record territory.  The MSBCI presents a slightly more opaque outlook.  Since climbing to all-time highs after the end of the recent downturn, the headline index has sharply declined to contractionary levels in recent months.  However, this metric has been extremely volatile historically, and the forward-looking components of the MSBCI remain optimistic.

Of course, these diffusion indexes really only tell us what we already knew about manufacturing.  What about broader gauges that cover the entire private economy?  The NABE canvass is only quarterly, but the April survey surged to 51.5% in all industries and 60% in goods-producing industries - not far from record highs.  More timely employment diffusion indexes tell a similar story.  Although the one-month overall diffusion index fell to 54.1 in May, we believe that calendar quirks affecting the timing of the survey week, as well as the weather, distorted those data.  The three-month employment DI slipped by less than one point to a robust 63.4%.  Likewise, the three-month manufacturing employment DI increased to 62.2% - the second-highest reading since 1998.

Moreover, there are less widely appreciated indicators pointing to strength.  Industrial operating rates have already soared by 570bp to 70.8% in manufacturing, and we think they will rise to 75-76% over the next 12 months as companies continue to trim capacity.  The stronger the rebound in operating rates, the greater the benefit to profit margins.  While the rise in margins may be slowing, we don't think that it's over, and the time-honored relationship between operating rates, margins and capital spending suggests that investment will continue to increase through 2011. 

A close look at the US cyclical scorecard in our view paints a picture of moderate growth, but one that is more sustainable than market participants fear.  Time-honored metrics of breadth are critical to that judgment.  Investors should focus on these measures as well as those of current strength and duration to assess sustainability.

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