It may seem somewhat peculiar that as investors fret about a global double-dip, concerns about inflation pressures appear to be building up in Singapore following the impressive 2Q10 GDP advance estimates (+19.3%Y). Unless there is a supply shock, with Singapore being the most open economy in the world in terms of export share to GDP, it seems to us that investors can either be worried about a global double-dip or inflation pressures, but not both. That said, inflation worries in Singapore are not totally without basis. Headline inflation crept up to 3.2%Y in May and 2.7%Y in June. This is not high by regional standards but is relatively high compared to Singapore's long-term average range of around 1.5-2.0%Y.
Yet despite the relatively high headline, we still have not seen a lot of signs of demand-pull pressures in CPI, even with the low unemployment rate of 2.2% in 1Q10 and a pick-up in wage growth. Indeed, about 60-70% of the CPI headline in May and June was driven by the transport segment, and by our guesstimate, the bulk (roughly 55-60%) of the CPI headline was driven by the increase in prices of COE (Certificate of Entitlement) for cars. This is as policymakers reduce the quota for new supply of COEs in a bid to ease traffic congestion. Meanwhile, MAS' underlying inflation (which excludes accommodation and private transport) rose by 1.7%Y in June (versus +1.7%Y in May), pretty much in line with the long-term trend. Between the tradables and non-tradables, inflation is now led more by tradables, which rose 4.0%Y in June 2010 versus non-tradables, which rose 1.3%Y. The latter is a more representative indicator of domestic-led inflation.
How Real Is the Inflation Threat?
The June inflation data that was released last Friday showed a deceleration to 2.7%Y from 3.2%Y in May. Does this fly in the face of inflation worries or is it just an aberration? We think a few factors matter as to the direction of the inflation trajectory going forward. In periods when inflation was higher than 2% in Singapore, one or more of commodities (food and transport), housing and/or wages were typically the key drivers. In our view, a few crosscurrents will likely be at work in 2010 and 2011. In this regard, we struggle to make a case that inflationary risks will turn into a real overheating threat as in 2008, when inflation reached 6-7%. However, we think inflation could stay higher than the 1.5%-2.0% long-term average range. Here's why:
(1) Global ‘soft landing' and labor market disconnect help lessen likelihood of an inflation flare-up.
Investors worried about inflation point to policy measures such as the rollback in jobs credit scheme, the increase in foreign workers' levies and the upcoming increase in employer CPF (Central Provident Fund), which would add to costs at time when the economy is rebounding strongly. We recognize this. Yet, the extent that cost pressures are passed through to consumers or whether they eat into bottom line depends on the slack in the economy. The 16% GDP growth expected for 2010 is clearly above potential growth, which by our calculations has ranged between 3% and 6% in this decade. However, we think the sub-par growth of 1.8%Y in 2008 and -1.3%Y in 2009 and, consequently, the slack in the labor market and capacity at the starting point of this recovery, offers some buffer against demand-pull pressures in the interim.
Moreover, we do not expect the double-digit momentum to persist into 2011. Singapore is a high-beta economy and the expected 16% growth for 2010 reflects multiple factors such as a cyclical recovery that was amplified by the global restocking trend, upward biomed volatility and pockets of new economic activity. The overheating episode in 2008 in Singapore followed several years of above-trend growth both on a global and a local basis that coalesced with strong asset market reflation, both in terms of a broad-based commodity price rise and a real estate boom. This time around, on growth, amid the global macro moderation (not a global double dip) in 2011 to 4.2%Y from 4.8%Y in 2010, we expect the economy to move back to potential growth trend of 6% by 2011.
A disconnect in the labour market also has implications for how quickly demand-pull pressures would manifest, in our view. We have pointed out in previous research that the last downturn in 2008 and 2009 had been ‘job-rich'. Net employment creation has been higher compared to past recessions despite the steeper peak-to-trough GDP decline. On the way up, there has hardly been a payback. Net employment creation stayed at a higher level compared to similar phases in past recoveries, likely due to new pockets of economic activity, a healthy construction sector and strong hiring in sectors such as community, social and public services. Consequently, the unemployment rate has also been lower compared to similar stages in past recoveries.
This should bode well for income growth. Strong wage growth is the mechanism in which a tight labor market translates into inflation, except that the disconnect is wage recovery (+3.7%Y in 1Q10), which at this stage of the cycle has actually been only in line with past recoveries despite the much sharper wage cutbacks during the downturn and stronger employment throughout. Moreover, the distribution of wage recovery has also been a lot more uneven. Perhaps a testimony to ongoing capacity additions even during the trough of the cycle, the highest wage growth is in construction (+7.9%Y). However, the trickle-through to inflation from here is decidedly lower, given the low wage foreign labor base. Manufacturing wage growth did well (+5.6%Y), but services, which employs 68% of the labor force, saw relatively lower wage growth of 3.3%Y. Within services, certain pockets are also still seeing negative YoY earnings declines. Interestingly, despite the opening of the integrated resorts and anecdotal evidence of staff poaching, earnings in the hotels and restaurant segment still saw a decline of 0.6%Y in 1Q10.
(2) Commodities - Manageable food inflation; rate of price change will slow for oil.
Inflation is about the rate of price change, and the slow/slower rate of change in commodity prices is another factor why we think that an ‘overheating' scenario is unlikely. Commodity prices such as food and oil matter because food and transport constitute about 22% and 16% of the CPI basket, respectively, and healthy demand raises the risk of commodity inflation leading to second-round effects. Food inflation in neighbouring ASEAN countries such as Indonesia has risen due to weather conditions. However, although Singapore imports almost all of its food needs, diversified sources have helped to keep food inflation manageable. Indeed, so far, food inflation in Singapore has been low at 1.2%Y in June 2010. Moreover, restaurants and hawkers typically do not pass on the full increase in fresh food prices, providing another layer of buffer for consumers. Meanwhile, the CRB food index also suggests that food inflation seems to have peaked recently.
On oil, with prices hovering around US$78/bbl recently and latest oil futures pricing in US$80/bbl by YE2010 and US$84/bbl by YE2011, we think that oil inflation has also already peaked. Indeed, for oil inflation to sustain at the peak of 78%Y in February 2010, oil prices would need to rise to ~US$140/bbl by year-end, which seems unlikely to us.
(3) Housing - Rentals to continue rising through 2011.
Having said that, where inflation may pick up is in the housing segment. Inflation is a lagging indicator and the housing CPI lags even more. This is because rental contracts are typically of one to two years duration and it takes time before the rental resets for the entire CPI accommodation basket reflect the rental price change that has happened at the margin. Historically, the rental index typically has a four-quarter lead on accommodation CPI. In the latest 2Q10 numbers, the private residential rental price index not only troughed, but moved into positive territory of 9.2%Y (versus -2.3%Y in 1Q10). With local interest rates likely to stay conducive (3M SGD SIBOR at 0.6% for YE2010 and 1.3% for YE2011), given the easy policy stance in the developed world, our property analyst expects residential rentals to continue rising through 2010 and 2011. We expect this to correspondingly filter through to the housing CPI component with a lag going forward.
(4) COE prices - Policy-induced inflation.
Another policy-induced idiosyncrasy that may buoy inflation is in the transport sector. As we highlighted earlier, transport inflation has been due to COE prices, and we suspect this may sustain. Barring another global growth shock like the one in 2008, the inverse relationship between COE supply and prices should hold as quota supply sees further declines. According to figures by the Land Transport Authority, the COE quota supply will continue to slow from a monthly quota of 4,238 in Apr-Jul 2010 to 3,844 in Aug 2010-Jan 2011. This is on the back of a lower allowable growth rate of 1.5% for the car population and a new methodology announced earlier in the year to reduce the COEs supply over-projections.
To What Extent Is Higher-than-Normal Inflation a Concern for Policymakers?
In a nutshell, for 2010 and 2011 we struggle to make the case that Singapore will see an overheating scenario of 2008 when inflation reached 6-7%, as the double-digit growth is not sustainable and GDP is likely to slow to around potential growth of 6% in 2011. Moreover, the rate of change in commodity price inflation, particularly in oil, has already peaked. However, we expect headline inflation to average higher than the 1.5-2.0% long-term average on the back of the lagged effect of housing CPI filtering through and strong COE prices amid quota cutbacks. We are also taking this opportunity to make minor adjustments to our 2010 and 2011 inflation forecasts. We now expect 2.6% for 2010 and 2.8% for 2011 (versus 2.6% and 2.3% previously) as we take into account the latest macro data, rental figures and oil futures.
Comparing now to the initial phase of the last recovery cycle in 2004, GDP growth is stronger now and headline inflation is higher (+2.7%Y in June 2010). However, MAS underlying inflation (excluding private transport and accommodation) (+1.7%Y in June) has been in line with the historical trend. We suspect that the divergence between the headline and MAS' underlying inflation could hold into 2011 as COE prices rise and the rental increase filters through to accommodation CPI. Both of the latter are excluded in MAS' underlying inflation. Indeed, while headline inflation for 2010 and 2011 is expected to stay higher than the historical average trend at 2.6% and 2.8%, respectively, we expect underlying inflation (ex private transport and accommodation) to come within the average historical trend of 1.5-2.0%.
In the April semi-annual monetary policy review, policymakers made the dual move of an upward recentering of the midpoint and a shift from zero appreciation to gradual appreciation stance. The SGD$NEER had gapped upward and has since moved within the upper half of the band. In our view, SGD$NEER policy may not be the best tool to counter COE inflation from quota cutbacks and rental price increases. To the extent to which MAS has already moved aggressively in the April review, and given that we still expect underlying inflation to be in line with the long-term trend, our base case is for MAS to maintain the status quo of a gradual and modest appreciation in the October review.
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Slowdown - Comfort or Caution?
July 28, 2010
By Gray Newman | | New York
Just when you thought that the pace of Brazil's growth had somehow accelerated to an Asian pace, something odd has happened: the economy has begun to show signs of a marked slowdown. Just a month ago, Brazil's economy seemed to be at risk of overheating: GDP had risen by 11.4% in real terms in the first quarter. The central bank, which had first warned of "signs of overheating" in April when it hiked its policy interest rate by 75bp, repeated its diagnosis of overheating in mid-June when it followed up with another 75bp hike to 10.25%.
We moved our Brazil GDP forecast for 2010 up to 6.8% in late April and again to 7.9% in June, citing signs of a "red hot" economy (see "Brazil: Red-Hot" and "Brazil: Going Strong" in This Week in Latin America, April 26 and June 14, 2010, respectively). The market consensus also climbed sharply month by month this year.
After GDP grew at an annualized pace of 11.4% in the first quarter, real GDP growth seems set to slow to closer to 4-5% in the second quarter. The most striking evidence came from the central bank's relatively new monthly GDP proxy, which showed that the economy stalled out in May, posting no growth (0%) compared to the previous month - the first such monthly reading after an uninterrupted string of sequential positive readings during nearly a year-and-a-half.
Reason to worry? I've been told not to worry by almost everyone I have spoken to in Brazil where I've spent the first half of the month. When I raised the subject of an unusually pronounced slowdown forming, I've received pushback on three fronts.
A Valid Proxy?
The first pushback I received is from those arguing that there simply wasn't much evidence of a slowdown. After all, if you look at May's GDP proxy, it rose by 9.8% compared with the previous year. Year-over-year comparisons, however, are of little value if faced with a turning point ahead and a deep downturn and recovery from the previous year. A more sophisticated version of this first pushback questions the validity of the GDP proxy. After all, the argument goes, it is only one data point.
I'd be very hesitant to highlight the central bank's May GDP proxy if it appeared to be an isolated data point - but it isn't. Instead, there are mounting signs that activity - at least among industrialists - suffered a downturn in May that appears to be repeated in June. Industrial output was flat in May (0%) and that came after a 0.8% decline in April. The weakness in output stands in sharp contrast with a largely unbroken series of sequential improvement. (The only other negative reading during the past year-and-a-half took place in November 2009, and that appeared to be due to a refinery that was out of service.) May's IP weakness showed up in refining again, but also spread to other areas such as food processors.
Is there a risk that the central bank's GDP proxy exaggerates the importance of (more easily identifiable) sectors such as industrial production over (more difficult to measure) sectors such as services? This is certainly a persistent problem, not only in Brazil, but also throughout many emerging economies. Still, a review of the series' relatively short life-span suggests that the GDP proxy matches up fairly closely with the quarterly GDP report by Brazil's national statistics institute and, more importantly, the GDP series showed a much less pronounced decline in late 2008 and a much more rapid recovery in 2009 than did industrial output. The two series are not mere mirror images.
Indeed, even retail sales, while up 1.4% in May (compared with April), had still not recovered to March levels - after a sharp 3.1% drop-off in April. Again, this is the first such bout of weakness in the series since the time of the Great Recession a year-and-a-half ago.
And the first signs of activity in June suggest another weak month, with monthly GDP possibly even turning negative. Corrugated paper, used for packaging and closely linked to manufacturing shipments, fell by 3.4% in June, as did auto production. Other indicators for the month - from traffic on toll roads to electricity usage - suggest a sluggish June at best.
Of course, while a handful of the first warnings signs are emerging on the production side, consumer confidence - buoyed by wage gains and good employment growth - remains high in the latest surveys released in July.
Fiscal Stimulus Withdrawn?
The second pushback I have received regarding my concerns over the second quarter slowdown is that it is temporary and a one-off result of a removal of fiscal stimulus during 1Q10. At the beginning of the year (for white goods) and then in March (for automobiles), the authorities ended special tax incentives which had been designed to help lessen the blow to Brazil's consumer during the weakness of 2009. If you open the headline retail sales data, it seems clear that consumers brought forward their purchases of white goods; moreover, in the broader retail sales measure (which includes automobile purchases), there is a clear drop in auto sales in April after the tax breaks ended. There seems little doubt that consumers anticipated the end of the tax incentives and accelerated consumption in 1Q. That, in turn, may have contributed to some of the robust pace in 1Q when GDP accelerated to post an 11.4% annualized pace, up from a 9.3% pace in 4Q09.
If GDP were tracking 8% or 9% in 2Q, I'd be more inclined to accept the notion that the 1Q report was an aberration. But when the pace of activity moves from 11.4% in 1Q to closer to 4% or 5% in 2Q, I'm skeptical that the move can simply be explained away by the end of a handful of tax incentives. The tax incentives removed in the first months of 2010 accounted for roughly R$15 billion or 0.5% of GDP.
More importantly, the overall fiscal stance of the government remains stimulative, even with the end of certain targeted tax relief programs. If you look at revenues raised and spending executed, there has been no meaningful slowdown in fiscal stimulus. Indeed, overall spending in May was higher whether measured in local currency terms or as a percentage of GDP. And a combination of a new 7.7% hike in pensions in July along with other transfers seems set to produce ample fiscal stimulus during the second half of the year, despite such restrictions on spending in 2H in the run-up to the elections.
Indeed, a review of industrial output suggests that the slowdown is spreading among sectors. A diffusion index shows a steady deterioration in recent months - the number of sectors posting positive growth peaked earlier this year and is slowly declining. The broadening of the number of sectors not showing an uptick in growth suggests that something beyond white goods and autos is driving the slowdown.
Don't Worry, Be Happy
Finally, I hear that the slowdown is precisely what Brazil needs: a turn away from the risk of overheating that was mounting late last year and appeared to come to the fore during 1Q. I'd be much less concerned if I thought I understood what was driving the apparent sharp slowing in growth. If it was simply a result of fiscal stimulus being withdrawn or the response to some other policy action, then I'd agree with the assessment that the move to slower growth is laudable. But the fact that the slowdown is taking place even as overall public spending appears to be as stimulative in the second quarter as it was at the end of the previous year leaves me puzzled.
Could it be that we are seeing some sign of a global synchronization of business cycles? I don't want to push this point until I've had a chance to study the evidence of what explained weakness in other major emerging economies during the course of 2Q. It is interesting to note that business confidence in Brazil appears to have turned down sharply in July. According to the most recent survey by the manufacturing association (CNI), the drop, at 2.6 points, to 63.4 was the largest one-month drop since the beginning of the downturn in 2008 (and stands in contrast with upbeat consumer confidence surveys).
Another business survey, with data through June, shows that while Brazilian businesses remain upbeat regarding current conditions, there has been a steady deterioration regarding expected conditions later in the year and into next year. It is conceivable that Brazilian companies have looked at international developments and decided that the recent inventory build-up, while adequate if demand remains strong, could turn excessive if global conditions continue to deteriorate. That kind of softening in production could morph into a self-fulfilling prophecy.
Ch-Ch-Ch-Changes...
I'm not willing to change our full-year GDP estimate at the present. Because of the double-digit 11.4% reading in 1Q, it will take an important slowing of the pace of growth to reach our 7.9% forecast for average growth in 2010. But perhaps more importantly, I'm keeping our growth forecast for 2010 unchanged at this time because I am puzzled as to what is driving the sudden slowing seen in 2Q.
I suspect that an important part of the move in GDP growth from 9.3% in 4Q09 to 11.4% in 1Q10 can be explained by an acceleration of purchases, particularly on the auto and durable goods front. That acceleration undoubtedly played some role in the slowing in 2Q. But I also suspect that Brazil's business cycle is showing that it is more closely linked to the global cycle as well.
And that may mean that the conventional wisdom in Brazil - split between those that ignore the slowdown and those that see it as policy-induced or temporary but a healthy move to ‘Goldilocks' - could be disappointed. At the very least, a careful examination of the real economy data in the coming months is warranted.
However, a change to our interest rate forecast is inevitable after the central bank hiked the policy Selic rate by only 50bp to 10.75% on July 21, pitting the central bank against virtually all of the economists who had called (as did we) for a 75bp hike to 11% this past week. Indeed, up until the week before the central bank's decision, the interest rate market was almost unanimous in calling for a 75bp hike. (An unusual ‘quiet period' saw a sharp change in market pricing - but not economists' forecasts - towards a 50bp move during the course of five trading sessions.)
While we will get greater clarity with the release of the minutes on Thursday, July 29, I suspect that the central bank will pave the way for a 25bp move at the time of its next decision on September 1, bringing rates to 11%. We have previously thought the year would end with a 75bp hike in July (50bp were delivered) and 75bp in September. The sudden change in the central bank's pace - the June quarterly inflation report and statements by the central bank all pointed towards a 75bp move in July - suggests, I suspect, a rethinking of the pace of growth in Brazil. Like us, the central bank is likely to be puzzled and is likely to point to the combination of better inflation prints of late, a slowing in growth and continued uncertainty in external demand to bring to a close the rate-hiking cycle in 2010 at a lower pace. We now expect the policy rate to end 2010 at 11% (versus our previous call for 11.75%). We still expect the central bank - that is, the next central bank once new leadership is appointed by the new administration in January - to have to restart interest rate hikes in 2011, with rates heading to above 12%.
Bottom Line
After the overheating scare at the beginning of the year, I'd like to be the first one to welcome the newly uncovered evidence in recent weeks that the pace of growth is slowing in Brazil. A slower pace of growth should ease both inflation pressures and the scope of central bank tightening. It also should reduce the risk of a greater imbalance in Brazil's external accounts. There is only one problem: it is not clear precisely what is driving the slowdown.
While the conventional wisdom in Brazil seems to be forming that this is either a temporary blip or a much-needed response to policy tightening, I find neither explanation fully convincing. Until we have a clearer understanding of what is driving Brazil's slowdown, the slowing in the pace of growth in Brazil remains part mystery and hence reason for caution as much as for comfort.
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