CEEMEA
On the Road (Views from Our US Trip)
August 24, 2010

By Pasquale Diana & Chuan Lim | London

We recently met US clients in New York, Kansas City and San Francisco. Please find below some key takeaways from our discussions:

Global macro and risk view: The overall impression we got from our trip is that the majority of clients are confused about the macro outlook, with an overall bearish bias. The China slowdown and recent tone of US data are among the main concerns. Strong growth data in Germany in 2Q are not viewed as sustainable, and most expect some pullback in the coming quarters. The clients who do have strong macro views are overwhelmingly in the ‘double-dip' camp, and were clearly caught out by the recent move stronger in markets, EM bonds and FX.

Most of them agree with our strategy team's view that a wobble in risk appetite is likely in the coming weeks, but they struggle to identify a clear catalyst. In a lot of meetings, strong inflows and diversification from DM into EM funds were mentioned as a prime reason for EM outperformance. These forces are perceived to be so strong and secular in nature that even hedge funds with a very negative view of the world are reluctant to put on outright bearish trades. Some clients have adopted a ‘get carry and close your eyes' stance, waiting for major catalysts to move the market either way, perhaps a big move in commodities.

Overall positioning is fairly light, with most of the clients still preferring to receive rates, even though many agreed that there is little value left in the CEEMEA rates world. The main argument for receiving rates is that a growth slowdown, and subsequently low rates for long, remains the main theme over the next few months. There were several clients (mainly hedge funds) who also mentioned that they are more comfortable receiving rates in markets where rate hikes are priced in (e.g., Hungary, Poland and Turkey).

CEE macro/FX views: Most of the CEE macro discussion revolved around Hungary and Poland. Investors broadly agreed on our cautious/pessimistic stance on Hungary, though some pointed out that the new stance of the government is not that unreasonable and the IMF is being too strict. A few clients were more constructive on Hungary than us, highlighting that its short-term external debt is fully covered by reserves, and so a high external debt/GDP ratio is not a main concern of theirs. Several investors correctly observed that Hungary has been a growth underperformer for several years, and a sharp FX devaluation (accompanied by some restructuring of the FX debt) is the safest way to faster growth - though none of them were prepared to make this their central case for now. 

Investors also agreed that Poland is sometimes treated too kindly by markets, which tends to ignore the uncomfortable debt dynamics which show that Poland's fiscal path will converge to Hungary's unless action is taken. That said, despite it being a widely held position, most people fully agree with our constructive view on the zloty, and recognise that, for those with a longer time horizon (mostly real money), holding PLN bonds makes perfect sense, from a carry and especially FX perspective. Some clients also observed that too many hikes are priced into the short end, and are biased to receive rates.

Clients also found our long PLN/CZK trade interesting, though some pointed out that using the koruna as a funding currency has historically not been a rewarding strategy. For the Czech Republic, the majority of the PMs we spoke to like the front end, arguing that the Czech Republic is too exposed to the euro area for the CNB to contemplate hiking rates, and that CZK gains could pose a serious risk of more rate easing. 

Views on the rest of CEEMEA: On Turkey, most clients think that the CBT has done a good job managing monetary policy, and successfully calling for inflation to fall over the course of this year. A few clients did mention political risks in Turkey as a potential negative risk factor. Some New York hedge funds agreed that the TRY CCS curve is too flat, and prefer putting on forward-starting steepeners. Overall, most real money clients still perceive Turkey and South Africa as the more attractive markets to hold long positions in, as fundamentals remain solid in these countries, and the central banks are unlikely to hike rates anytime soon.

A new growth model: Equity clients were fully on board with the idea that the CEE region will experience much slower growth in the years ahead as credit conditions tighten, and the days of easy money are well and truly over. They were familiar with our equity analysts' view that CEE banks will experience lower growth and profitability in the years ahead. Some equity clients also expressed concerns over CEE's excessive dependence on Germany, and so favoured a bullish stance on closed economies with better banking systems and stronger domestic demand dynamics (Poland). The problem cited many times was the relative expensiveness of Polish equities relative to their peers.

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South Africa
Calculating the Probability of SARB Repo Rate Cuts
August 24, 2010

By Andrea Masia & Michael Kafe, CFA | Johannesburg

Summary

The Monetary Policy Committee (MPC) of the SARB meets from September 7-9, and the 1x4 FRA strip is currently pricing in close to a 60% probability of a 50bp cut at that meeting. We disagree with this view, and stand by our call that policy rates have bottomed in South Africa. Investors looking to exploit this divergence may consider paying the 1x4 FRA at current levels of 6.28% for a 22bp roll-up over the coming four weeks.

Our call is based on qualitative and quantitative analysis. After the July MPC meeting, we outlined our thoughts in detail as to why we thought policy rates would be left unchanged at the next meeting (see South Africa: September Rate Cut? We Think Not, July 22, 2010). In this note, we introduce our SARB EazyMeter model, based on an econometric probit analysis. The model uses output growth, inflation expectations, exchange rates and a proprietary measure of the inflation outlook to quantify the probability of rate cuts.

Based on our analysis, the probability of a rate cut at the upcoming MPC is a touch lower than 40%, which is admittedly high, but falls below the threshold of 50% that has been associated with rate cuts in the past. In conjunction with our qualitative analysis (a not-so-bearish assessment of the international backdrop, a likely upside surprise in 2Q10 GDP growth, and limited downside to the SARB's 2010 electricity price assumptions), we believe that the SARB is likely keep rates on hold next month.

Estimating the Probability of a Rate Cut

Models have their place in guiding our thinking. While we never rely exclusively on any analytical model, we do appreciate their importance - particularly the discipline they provide. In this note, we introduce our proprietary SARB EazyMeter model for predicting the probability of rate cuts based on the SARB's inflation-targeting framework. The model suggests that, for the upcoming September 9 MPC meeting, conditions that have been associated with rate cuts in the past (i.e., the combined effect of a benign inflation outlook, relatively well-anchored inflation expectations, deteriorating GDP growth prospects, an appreciating currency, etc.) are not at levels that would warrant further policy easing. 

Taken together, we estimate that the probability of policy action is a touch lower than 40% in 3Q10. This is below our threshold of 50%, and so does not force a rethink of our baseline on-hold forecast. Accordingly, we disagree with current market pricing for the September MPC, and suggest investors consider paying the 1x4 FRA at current levels of 6.28% for a 22bp roll-up over the coming four weeks.

First, although there are concerns about the durability of the global recovery and its implications for the domestic economy, we must point out that the SARB appears to have been more bearish than the markets about the pace of recovery when it surprised the markets with a 50bp cut as far back as March. We do not believe that the growth outlook has deteriorated significantly beyond the SARB's initial expectations to warrant another dose of policy action. If anything, it is our view that the SARB may have to again upgrade its GDP forecast at the upcoming MPC meeting, as we expect the 2Q10 GDP print that will be published on August 24 to come in a 0.9pp higher than the SARB's forecast of 3.2%Q. Were that to happen, it will be difficult - if not inconsistent - to justify a more accommodative policy stance when growth is persistently surprising to the upside.

The key risk to this view, however, is that, following two above-consensus outcomes in May and June, a technical downside correction is likely to be seen in the July manufacturing production print that will be released on the eve of the MPC decision. And with the NUMSA strike suppressing motor vehicle production in August, the SARB could well take a much dimmer view on 2H10 - and perhaps even 2011 - GDP growth.

Second, the 3Q10 inflation expectations survey is set for release on September 22, i.e., after the MPC meeting. This means that the MPC will have no surveyed expectations of inflation, and may be reluctant to rely solely on breakeven yields, which it knows can be distorted by market conditions.

Third, although the SARB's inflation forecast will probably print a little lower for 2011, on account of the downside surprise in 2Q10 inflation, it is important to note that the CPI undershoot in 2Q10 was largely driven by one-off factors that are likely to fall out of the wash in 2011, leaving the 2012 profile broadly unchanged.

This leaves us with only the nominal effective exchange rate as the one variable in the SARB's decision function that has improved somewhat (3.1% appreciation) since the last MPC meeting. Were the MPC to become overly concerned about the currency, placing the type of emphasis on its level as it did in 3Q04 and 2Q05, an additional 50bp cut may unfold. This is not our base case, however.

The SARB EazyMeter's Hit Rate

Our SARB EazyMeter's ability to predict downward adjustments in the policy rate is illustrated. In the 12 quarters that the SARB cut the repo rate since the adoption of inflation-targeting at the turn of the decade, our SARB EazyMeter correctly identified 10 of those periods (i.e., the estimated probability of a rate cut was higher than 50%). Further, the SARB EazyMeter has correctly called the quarters where rates were not lowered on all but two occasions (1Q05 and 4Q09). This implies a hit rate of 83% of the cuts, and 93% for the no cut outcomes. Of course, in some of the latter quarters, rates actually rose. In time, we will add to our model toolkit by estimating the probability of rate hikes.

We take the exercise a step further and compare our probability estimates with that of the market, as reflected in the FRAs. We compare our estimated probability of a rate cut in each quarter with the highest market probability at the start of each month during that quarter. We illustrate that the market missed five of the 12 quarters where rates declined over the past decade, and pointed toward three quarters of lower rates when rates did not fall. This implies a hit rate of 58% for cuts and 89% for no cut outcomes. For the upcoming MPC meeting in September, the SARB EazyMeter estimates the probability of a cut at no more than 38% (admittedly high, but still below the 50% threshold), while the market is pricing in close to a 60% probability. The last time such a divergence occurred was in 4Q02 and 1Q03, where rates were left on hold. Interestingly, since the introduction of inflation-targeting, market pricing has not correctly called a rate cut that was missed by the SARB EazyMeter.

Key Takeaways of the Model

Each variable in the SARB EazyMeter has three key measures of information that are worth highlighting: First, is the sign of the coefficients. For example, the GDP, inflation expectations and manufacturing production variables have a negative sign, suggesting that the estimated probability of a rate cut falls as these variables rise. Similarly, the inflation forecast dummy (assumes a value of 1 when the SARB's inflation outlook is target-friendly enough to allow for a rate cut, and 0 when it is not), and nominal effective exchange rate (NEER) variables are positively signed, suggesting that the probability of a rate cut is positively related to the movement in these variables.

Second, the z-statistics, which show that each independent variable is statistically significantly at the 95% confidence level.

Third, we show the marginal effects of an increase in each variable. Effectively, this measure provides us with the betas when all other variables are held at their respective means. For example, holding all other variables at their means, a 10bp increase in the GDP forecast reduces the probability of a rate cut by 15.3%, while a unit increase in the nominal effective exchange rate raises the chance of a rate cut by 0.4%. Also, for each MPC meeting that the SARB's inflation outlook remains target-friendly, the probability of a rate cut rises by as much as 39%. The overwhelming dominance of the inflation forecast dummy is not surprising, given the SARB's reputation as a credible inflation-targeting central bank.

Repeat of the Missed Signals?

The cuts we missed: To understand the forecast risk around the upcoming MPC, it would be useful to examine the periods where the model went wrong and consider whether those reasons apply today. In our view, the cuts we missed (3Q04 and 2Q05) boil down to the currency's excessive strength and the SARB's view on its implications for the export-leveraged sectors of the economy such as mining and manufacturing. We believe that the manufacturing and exchange rate variables must have played a disproportionately larger role at these meetings than history would otherwise suggest.

The cuts that never were, in 1Q05 and 4Q09, were down to two reasons: In 1Q05, the inflation forecast had actually improved, peaking just above the mid-point and decelerating thereafter - comfortably able to absorb another rate cut. A robust and rapidly expanding economy warranted an on-hold decision, however, as positive wealth effects and climbing debt levels drove a consumption boom, resulting in a widening current account deficit. The decision was a close call though, considering the MPC statement's unusual admission that "the MPC deliberated extensively on the appropriate policy stance at this particular point in time". In 4Q09, it appears that the heightened level of uncertainty surrounding the National Energy Regulator (NERSA)'s decision on electricity tariffs for the upcoming three years forced an on-hold decision. This uncertainty was eliminated in February 2010, however, when NERSA announced electricity guidelines that were lower than SARB estimates, effectively paving the way for lower rates at the very next MPC meeting in March.

The ‘cuts we missed' is clearly the more prevalent risk at the current juncture. However, we also believe that the SARB has now accepted the view that easing policy rates is not the solution to currency strength - a notion that we agree with fully.

Further, as we showed in our analysis of the sensitivity of South Africa's manufactured exports to European GDP, easing policy rates is the least effective measure to boost manufactured export volumes - the weakest link in domestic industrial production (see South Africa: Gauging Susceptibility to the Vagaries of European Growth, June 21, 2010).

Trade Idea

The 1x4 FRA strip is currently pricing in a 60% probability of a 50bp cut at the upcoming MPC meeting. We disagree with this view, and stand by our call that policy rates have bottomed in South Africa. Investors looking to exploit this divergence may consider paying the 1x4 FRA at current levels of 6.28% for a 22bp roll-up over the coming four weeks.

For a broader discussion and full details of our methodology and data description, see South Africa: Calculating the Probability of SARB Repo Rate Cuts, August 23, 2010.

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CEEMEA
Looking Back, Moving Forward
August 24, 2010

By CEEMEA Economics Team|

Following a short summer break, the CEEMEA Macro Monitor is back. We start with a focus piece on the region, providing an overview of the main changes in our views since January, including forecasts, the growth outlook, inflation, policy rates, the external picture and fiscal policy. For individual countries we include a brief summary of main data surprises seen over the past eight months that have affected our forecasts and forward-looking thoughts. We also provide our expectations for the rest of this year and into 2011, and draw attention to the key dates and risk events we think investors should consider.

In terms of the overall picture, a common theme for the region has been that the growth in 1Q and in some cases 2Q surprised positively, leading to an upgrade to our forecasts. With the exception of the Czech Republic and the UAE, which saw very minor downgrades in our growth forecasts, we now expect a stronger growth outlook for the region as a whole for both 2010 and 2011. That said, moderation in growth and in many cases deceleration in industrial production has already started to materialise (e.g., in Turkey, South Africa, Ukraine, the Czech Republic and Russia). This observation has been supported further by easing PMIs across our region.

On the monetary policy front, we have changed our rate calls significantly for some countries such as the Czech Republic, Turkey, Israel and the UAE on the back of extended weakness in external demand in most cases but also due to the monetary authority's approach to the currency. In the Czech Republic, we expect rates to remain unchanged until 2Q11, and a similar case for Turkey where we expect rates on hold in 2010, before likely rising in a measured fashion in 1Q11. In Israel, concerns surrounding currency appreciation remain despite rising prospects of inflation. We expect a much lower rate at year-end (2%) in comparison with our January view, implying only a 25bp hike. Nevertheless, we project continued normalisation of rates in 2011 in Israel. In the rest of the region, we maintain our view that the SARB will commence policy normalisation in 2Q11, which is earlier than consensus expects, and far more aggressive than market pricing of easier money by that stage. In the rest of Central Europe, we believe that central banks in Hungary and Poland will keep rates unchanged until year-end, but tightening in 2011 will commence sooner for the latter.

On the key dates and potential risk factors, we have the upcoming referendum on the constitutional amendment in Turkey on September 12 as the most immediate. Later on, in Hungary, we might witness some noise on fiscal matters, as well as future relations with the IMF, as October local elections arrive. Exactly the same might happen in Ukraine, with local elections coming up in October. Lastly, in Russia there will be parliamentary elections in December but we do not expect any noise.

Here are the details:

Turkey: Growth Still Intact with Loose Monetary Policy, but Moderation Has Already Begun

In comparison with last January, when we were projecting real GDP growth of 4%, we have raised our forecast by 1pp, mostly due to the faster-than-expected recovery in domestic demand while external demand has remained broadly weak. For most of 2010 we had a below-consensus growth forecast, which we attribute to our different perception of growth risks in Europe and the impact of that on Turkey's exports (of which some 57% is geared to Europe). We stick to our forecast for the time being as we have been witnessing clear signs of moderation in growth starting in 2Q and extending into 3Q. The industrial production data, consumer sentiment, business confidence and PMI all point to a deceleration in activity, and the ongoing weakness in the external backdrop clearly does not help. Our inflation forecast for end-2010 had been revised slightly downwards from 7.7% to 7% with food prices reversing course, although monetary policy remained looser than we were expecting. Our policy rate forecast of a 150bp hike at the start of this year has been revised downwards to zero and we expect a delayed response until 1Q11 (with risks skewed towards an even later date). This monetary policy shift was perhaps the most noteworthy surprise so far this year. Otherwise, we have remained sanguine about the external deficit (and the rather large financing requirement) as we believe that the widening in the current account in 2010 and 2011 will be satisfactorily financed via medium-term borrowing and to some extent with non-debt creating inflows. Nevertheless, we have been somewhat disappointed with the lack of sizeable FDI inflows. One of the strengths of the Turkish economy has been contained risks on the fiscal front and an improving budget performance. While this still remains the case, the recent decision to delay the implementation of the Fiscal Rule into 2012 did nothing but add more uncertainty to the risk profile, in our view.

Risks and events to watch: Looking ahead to the next six months, we consider the single most important event to be the referendum that will be taking place on September 12. Essentially, the public will be voting for or against a set of amendments in the constitution that the governing party, AKP, has proposed. The amendment includes various changes that would bring the Turkish constitution closer to EU standards in terms of democratic principals and individual rights; it broadly removes the influence of the military on day-to-day politics. While this seems like a straightforward matter, there are certain amendments regarding the judiciary that the opposition is against. Some of the changes proposed by the draft amendment package call for a significant change in the composition of the high courts as well as the appointment process for the future members - and it is this which has drawn criticism from the opposition. In the early stages of the parliamentary voting process one of the key changes in the draft package was rejected, and this was a first defeat for PM Tayyip Erdogan in terms of the proposed constitutional reforms. Essentially, the article in question was proposing to make political party closures, which resulted in some 26 closures in the past, very difficult. In early July, a second blow to the constitutional amendment motion came from the Constitutional Court, which annulled some aspects of constitutional changes that were designed to curb the powers of judges and prosecutors.

Political scenarios: At this juncture, the outcome of the referendum on September 12 is seen as a reference event that might give significant shape to the political climate, and hence affect the fiscal picture, heading into general elections scheduled for July 2011. In our view, there are four different scenarios that are worth examining: 1) If the referendum attracts strong support (i.e., >60%), the market is likely to take that as a cue for continued support for the governing party and to assume an AKP victory at the general elections. That would mean a single-party government which might suggest no accelerated election-related fiscal spending. From the markets' point of view that would be good news. 2) A narrow support (slightly above 50%) could result in a more or less market-neutral impact, with AKP capitalising on the success, albeit still having doubts regarding a sure-fire victory in the general elections. Hence, the market might stay sidelined but the fiscal risks would still remain in the background. 3) A narrow loss (slightly below 50%) would, in our view, indicate success on the part of the opposition and rising support for CHP (the main opposition party). In our view, the immediate impact of this would be market-unfriendly as it would raise fiscal concerns and bring post-election coalition scenarios to the foreground. 4) Strong opposition at the referendum (i.e., rejection with more than 60%) would clearly be market-unfriendly as it would surely be perceived as a sign of a lack of support for the government, raising the probability of a coalition government following the 2011 elections. The other assumption attached to this outcome would be to expect the government to potentially accelerate spending and resort to populist policies to counteract loss of power.

Poland: Still Outperforming, Potentially Leading the CEE Hiking Cycle

Our growth and inflation views in Poland have been largely vindicated this year. Growth outperformance has continued, and Poland managed to not only avoid recession altogether in 2009, but actually return to a 3% pace, which is not miles away from potential, we think. Industrial output is already back to the 2008 levels and retail sales growth, while more modest, never really reflected a recession (in contrast with the Czech Republic and especially Hungary). The inflation story has largely been tracking in line with our expectations also, except that the July trough was roughly 0.5% higher than expected at the start of the year, leaving us on track for inflation to climb to just below 3%Y by year-end. The most surprising event of the first part of the year, in our view, was the decision by the NBP to break with its ‘no intervention' policy in April, when EUR/PLN fell to around 3.83 (6% lower compared with January), and the NBP announced that it had purchased some FX in the market. We had always thought of the PLN as a ‘low intervention risk' currency. Evidently, the authorities objected to the pace of appreciation, though we still think they accept the secular medium-term appreciation trend for the zloty. The tragic loss of Governor Skrzypek in the April plane disaster, the change in risk appetite and subsequent move in PLN made the intervention debate rather irrelevant of course, but even under Belka's leadership we still think that fast PLN gains may attract either verbal or market intervention.

On the fiscal front, Poland has not made much progress. The busy electoral calendar (parliamentary elections in 2011) provides the government with an incentive to delay the inevitable tightening needed to cap the debt/GDP ratio at below 55% of GDP. According to the recently published fiscal plan, the deficit/GDP ratio should be brought under 3% in 2013 (no longer 2012), most of the consolidation in the budget will happen due to a 1% VAT hike, whereas the savings from the planned fiscal rule (discretionary spending up by inflation + 1%) look pretty modest. GDP growth is projected at 3.0% in 2010, 3.5% in 2011, 4.8% in 2012 and 4.1% in 2013 - perhaps on the optimistic side but not wildly so. Inflation is projected to gradually converge to the 2.5% target - again, this seems realistic if not too conservative. The state budget deficit (these are the monthly numbers released by the MoF, not the ESA-95 ones) drops from PLN 52.2 billion this year to PLN 30.0 billion in 2013; the borrowing needs drop even faster (from PLN 82.4 billion this year to PLN 38.6 billion in 2013), presumably because of privatisation proceeds, planned at PLN 30 billion in 2011-13. On the basis of these assumptions, the debt/GDP ratio stays a shade below 55%, a level which would automatically trigger pretty severe fiscal tightening. None of these assumptions seem outlandish; the only thing that we would stress is that everything needs to go pretty well (such as growth, privatisation and VAT receipts) for debt/GDP to stay below the crucial 55% threshold. Perhaps it was unreasonable to expect anything more aggressive than this during a busy electoral period, but Poland has chosen to walk a fine line on the fiscal front.

On the monetary policy side, our view is that Poland does not need fast rate increases, and the clear stance by the Fed and the ECB to keep rates low for long makes a strong case for central banks presiding over small open economies to adopt a similar line. That said, within CEE, Poland is a relatively more closed economy, with inflation headed back above target, lack of much slack in output and an improving labour market. It certainly does not appear odd that rates should be taken closer to neutral, even if the ECB and other regional banks stay on hold. That is why we maintain our long-standing forecast for 50bp of rate increases this year, most likely starting in October.

Hungary: Hostage to the Markets, Still Plenty of Risks, NBH Done with Easing

Earlier this year, we thought the defining event of 2010 would be the return to power of Fidesz and Mr. Orban. We viewed the potential for the discovery of ‘fiscal skeletons' as high, as any under-reported deficit could be attributed to the previous government. At the same time, we assumed that the new government would continue to work alongside the IMF and the EU. In the event, despite a lot of noise earlier this year, the government stuck to pretty much the same 2010 deficit target that had been agreed between the IMF and the previous administration (so, no major skeletons, after all). That said, the measures undertaken (i.e., the bank tax) and a disagreement over the 2011 target have meant that the IMF left Budapest in July without an agreement (see Hungary Economics: A Risky Bet, and the Odds Are Not Good, July 29, 2010). As we stressed in the past, Hungary's fiscal progress over the past few years has been excellent, and the country now boasts the strongest fiscal position in the EU. However, its high external debt stock, high private and public FX indebtedness, low growth, and its status as a high-debt country within the CEE make it still stand out as one of the weakest links across the region, in our view. So, while it is true that Hungary can fund itself from the market, it still faces around €9 billion of redemptions (plus of course net issuance) in bonds and external debt between now and end-2011. And of course, it has plenty of reserves (though note that some are just IMF money parked there) and an estimated €5 billion Min Fin funds in an account at the NBH. However, running down Min Fin cash and FX reserves in case markets seize up again hardly looks like an appealing strategy to us. In that sense, an IMF credit line, which we believe was on the table after the expiry of the current SBA in October, would have been a nice backstop facility to have if the markets turned sour.

The main pushback to these concerns that we have heard from investors is the view that "the IMF will be back. It cannot afford not to be". We agree with this; the only doubt we have is what would prompt the government to require IMF assistance again (i.e., a severe sell-off in HUF, for instance). The current posture of the Fidesz government seems to be that it can and wants to go it alone. Many assume that the tougher rhetoric towards both the Fund and the EU aims at gaining votes ahead of the October local elections. We are much less confident about this, and would highlight risks of a fundamental shift in policy: the new government has a two-thirds majority which offers many opportunities but also plenty of risks. Recent statements and decisions suggest to us that policymaking has become more erratic, which carries risks for investors. Recent ratings actions (S&P revised outlook to negative, Moody's placed Hungary for review) also seem to confirm this.

What could happen between now and the end of the year? Our strategists look for a correction in risk, which if it materialises is sure to adversely affect HUF. But domestic sources of risk could be: i) ratings action; ii) a convergence programme that shows a deficit well above 2.8% of GDP in 2011, the number initially agreed with the IMF; iii) the escalation of the conflict with Governor Simor, which has already caught the eye of the ECB, and possible official action by EU institutions against Hungary; and iv) signs that, even after the bank tax is collected, this year's budget deficit is still headed towards 5% of GDP, above the 3.8% target. In short, we think that the best-case outcome for Hungary is that markets remain as much in love with EM as they are now. But we see plenty of risks, and no room for complacency at all. Given this backdrop, and a likely upgrade to its inflation projection at the upcoming August meeting, we think that the NBH is set to remain firmly on hold here. But at this stage, we believe that the risks of a hike are higher than those of a cut. The bank's easing cycle has proceeded largely in line with how we had anticipated (just one more cut compared to the 5.50% trough we were expecting in January), but at this stage we see little room for more easing, if any.

Czech Republic: Near-Term Risks of Cut Still Exist

The Czech economy is the most manufacturing-intense in the whole of the EU and one of the most open. Earlier this year, we correctly anticipated that inventory accumulation and industrial output (therefore the external sector) would be the main growth driver this year. The economy accelerated to post a 0.8%Q growth rate in 2Q, following 0.5% in 1Q. We have found the resilience of car production a real puzzle, especially given lower euro area demand growth, but probably inventory rebuilding and strong EM demand (Asia) had a lot to do with it. Regardless, we are still on track for some moderation in 2H, and our full-year forecast for 2010 has not changed much since the beginning of the year (1.8% current versus 2.1% initially).

Where we have been truly surprised has been on the monetary policy front. At the start of the year, we expected some normalisation towards year-end, to see rates at 2%. Instead, we got another cut and the prospect of a long period at 0.75%. Clearly, the change in ECB rate expectations played a huge role here (Morgan Stanley forecast 50bp of ECB rate hikes in 2010 at the start of the year). And on the domestic side, the bank was less willing to accept CZK gains than we imagined, making dovish noises each time the currency gains accelerated beyond their subjective assessment of ‘fair' pace. The CNB is perfectly capable of hiking ahead of the ECB, but we think that the recovery is too tentative and muted and inflation is not really an issue for the CNB to want to take such a proactive stance. Confirming this, Governor Singer recently commented that the period of rate stability will be longer than previously assumed, due to a sluggish recovery. Our own forecast sees rates on hold until 2Q11, then rising gradually (75bp in 2011).

In the near term, we think if anything the risks are tilted towards another cut. We think the contribution from net exports will ease in the coming months (note the trade balance has already stopped improving), which means that the CNB's tolerance for a stronger koruna will certainly not increase. The CNB's inflation report gives us a useful benchmark: consistent with the inflation trajectory is a EUR/CZK level of 24.9 in 4Q10 and 24.1 in 4Q11. Therefore, we think a move in EUR/CZK below, say, 24 in coming weeks would change the risks around the inflation outlook enough to bring a rate cut back on the table.

Israel: Remains a Robust Story

We started the year with an upbeat view on growth and keep it intact with only a marginal upgrade of our real GDP growth forecast from 3.7% to 4%. Essentially, the loose monetary policy with negative real policy rates and the mild support from fiscal policy have kept the growth momentum broadly in place. The weakness in the euro zone placed a lid on export growth but nevertheless the current account remained in surplus and is unlikely to show a significant reversal in the near future. We keep our forecast of 2.2% of GDP for the current account unchanged. One of the key issues that we have drawn attention to in the past 12 months has been the record rise in FX reserves held by the BoI, which has been built up by the presence of a current account but more so due to the FX interventions of the central bank.

In our view, the BoI will continue its policy of occasional interventions in the market, especially closer to times of rate hikes, to stem the appreciation of the currency and provide support to exporters. However, we maintain our view that this is not a sustainable policy amid a process of rate normalisation. Hence, we expect the ILS to strengthen faster once the BoI gives up on artificially forcing the currency to remain weak.

Despite the highly accommodative monetary policy, inflation eased noticeably, and even performed better than we expected. However, the heating up of the housing market had been putting noticeable pressure on prices and we have turned more bearish regarding inflation in 2011 in comparison to early 2010. We expect average CPI inflation at 2.5%Y in 2010 and 2.9%Y in 2011. One of the reasons behind this has been the very slow ‘normalisation' of policy rates. We maintain our view that both nominal and real interest rates need to be raised as the economy clearly shows signs of robust growth and easing unemployment.

Russia: Higher Inflation and Slower Fiscal Consolidation Ahead

The economy had a better-than-anticipated start to 2010 and our GDP growth forecast is now marginally higher than that of January. Real GDP was up 5.2%Y in 2Q10, which translated into a 1.5%Q (sa) rise, compensating for the 0.9%Q decline in 1Q. Investment expenditure (the main driver of the contraction in 1Q) and consumption recovered in 2Q. Household confidence improved on the back of rising real incomes and the decline in unemployment. The contribution of net exports to GDP is likely to be less than we initially anticipated. Weakening of external demand (especially in EU) slowed down industrial production growth. Our 2010 real GDP growth forecast stands at 5.5%Y, but we acknowledge downside risks emanating from the weaker outlook for net exports and agriculture affected by the drought.

Inflation declined from an average 11.7%Y in 2009 to an average of 6.4%Y in 1H10, owing to a slow recovery in domestic demand and the lagged effect of the contraction of money supply, which had been in line with our expectations. We recently revised our average inflation forecast to 6.7%Y versus the 6.2%Y we expected in January. We expect increases in social spending this year, high money supply growth and a severe drought-damaged grain harvest to fuel inflation in 2H. We have revised our year-end CPI forecast from 7% to 8% in 2010 and from 9% to 9.5% in 2011.

The CBR's pace of cutting rates was slower and the easing cycle ended earlier than we expected at the beginning of the year, owing to mounting inflation pressures and the cautious approach of the central bank. We expect the CBR to stay on hold until the end of 2010 despite the likely acceleration in inflation in the coming months.

On the currency front, the weaker-than-expected global recovery and the outlook for oil prices led to a downward revision of our current account balance forecast, which led to a weaker ruble exchange rate forecast. We now see the year-end RUB/USD exchange rate at 29.4 compared to our January forecast of 28.8. We do not anticipate any strengthening of RUB in 2011.

Government finances improved this year with the gradual rise in oil prices. The consolidated budget deficit narrowed from 6.3% of GDP in 2009 to around 3.6% in 1H10 (trailing 12m rolling). We expect spending to accelerate in 2H as the December parliamentary elections approach. Hence, we leave our 2010 budget deficit forecast unchanged at 4.4% of GDP. Looking into the 2011-13 period, a slow fiscal consolidation seems to be the main plan on part of the Ministry of Finance. The budget deficit will shrink more slowly these years compared to the previous plan. Revenues are planned higher now due to tax hikes, but the spending plans have been increased even more, driven by the political cycle, with 2012 presidential elections and the government's modernisation initiative. We also see this as an attempt by the government to hedge against potentially weaker external demand. The Ministry of Finance has an ambitious privatisation plan worth RUB 883 billion for 2011-13. We expect privatisation to be a positive development for the state-owned companies as it may improve management efficiency and transparency.

Ukraine: More Growth and Fiscal Discipline

At the beginning of 2010, our GDP forecast was 4.5%, but owing to weak a 1Q print, we lowered our forecast by 1pp in mid-2Q. However, recent data, especially in 2Q, were well above our expectations: Ukrstat estimated 2Q real GDP growth to be up by 6%Y and 3.9%Q (sa). On the back of this, we are revising our GDP forecast from 3.5% to 4.8% for 2010 and from 3.5% to 4% for 2011. Essentially, this had been a result of the strong 2Q rebound. The absence of details on components in the data release limit our analysis to some degree, but we think that net exports contributed to GDP growth, driven by recovering external demand. Household consumption had been supported in 2Q by the growth in real wages and easing unemployment, in our view. We expect GDP growth momentum to slow down in 2H10, as net exports are likely to be affected by softening external demand. The high-frequency data already point to a moderation and a weaker start in 3Q.

Our inflation forecast for end-2010 has been revised downward significantly from 14% to 10.6%. Consumer prices have been restrained during the year by subdued consumer demand. The downward effect from the four recent deflation months (below our expectations) and growing inflation pressures from utility tariffs hikes as well as  higher food prices are likely to offset each other, in our view. Hence, we keep our forecast unchanged.

Meanwhile, balance of payment imbalances improved after the global crisis even faster than we expected. We now forecast a balanced current account compared to a 1% of GDP deficit forecast in January. The financial account also improved above our expectations. Helped by political consolidation and stability brought by presidential elections, financial account inflows recovered on the back of the improved confidence and optimism surrounding the IMF Stand-By Arrangement. This triggered appreciation pressures and a stronger UAH performance this year. Owing to this, our recent UAH forecast stood at 7 UAH/USD compared to 9 UAH/USD back in January. However, we observe continued NBU reluctance to let UAH trade stronger, despite the IMF requirement to gradually switch to an inflation-targeting framework, which has led us to revise our forecast for end-2010 to 7.7 from 7.0.

Earlier this year we saw risks of a breakdown in talks with the IMF on the 2008 SBA. At end-July it had been replaced with a new US$15 billion credit line. In our view, the IMF agreement is likely to lead to unpopular but clearly needed reforms. We now expect more fiscal discipline and a lower year-end budget deficit of 6.5% of GDP compared with 8% forecast in January.

Risks and events: Local elections will take place in October this year. Despite a high level of consolidation, parliament might be reluctant to take politically sensitive decisions required by the IMF SBA prior to elections. Also, Ukraine stays vulnerable to a decline in world steel prices and a protracted weakness in external demand.

South Africa: ZAR Strength Benefits Inflation, but Further Rate Cuts Unlikely

Our take on the South African macro is a little more optimistic than we had expected at the start of the year. Downside surprises in inflation outcomes between 2Q and 3Q10 have allowed for a more favourable inflation outlook, and pushed out our forecast of policy rate normalisation by a quarter or so, to 2Q11. For the year as a whole, our baseline GDP forecast is now 0.5pp stronger, at 3.5%. We have also upgraded our 2011 GDP forecast by a similar margin, to 4.0%. A stronger-than-expected, broad-based recovery in household expenditures and government consumption ahead of the 2010 FIFA World Cup has combined with a slower pace of inventory drawdown to inform our optimism on economic growth. Gross domestic capital formation remains weak, however.

Not surprisingly, the stronger growth environment has attracted significant amounts of capital inflows, leading to a much stronger currency than we initially anticipated. We have now revised our year-end target in the ZAR from 8.50 to 7.80, and from 8.80 to 8.20 for end-2011.  The 2010 upgrade is largely driven by significant capital inflows (R57.9 billion in bonds and R20.3 billion equities in the first eight months of the year - compared with a combined R90.9 billion for the whole of 2009). However, the moderate weakness priced into 2011 - mostly in 2H11 - is driven by revisions to the timing of global liquidity withdrawal (especially in the US), which we now expect to kick in for real only in 2H11. It is our opinion that, once liquidity withdrawal starts to take place, the exceptionally strong momentum in EM-destined portfolio capital flows from the rest of the world will likely slow. And given our view of a widening current account deficit in 2011 as consumer and investment demand gain sustainable traction, we expect the currency to soften somewhat. Our current account forecasts are currently pinned at -4.1% and -4.3% of GDP in 2010 and 2011, respectively. On the whole, our longer-term outlook on the ZAR remains one of moderate weakness.

The currency's strength during 1H10 had a positive impact on inflation. But ZAR strength through 1H was not the only factor that supported the improved inflation outlook and a concomitant 50bp rate cut in March. NERSA, the energy regulator responsible for approving electricity tariffs, had provided a guideline rate of increase of 24.8% in February, but ruled that municipalities could pass on only 15.33% to the consumer in 2010, in light of the fact that most municipalities had overcharged their customers in 2009. This resulted in downside risks to the SARB's earlier assumption that electricity tariffs would rise by 25% and created the scope for additional policy easing. Interestingly, a decent minority of investors that we spoke to at the start of the year explicitly highlighted the prospect of a downside surprise in electricity tariff increases. We were quite sceptical at the time.

Looking forward into the remainder of the year, we maintain our view that policy rates have bottomed in South Africa. In fact, in the second focus piece, "South Africa: Calculating the Probability of SARB Repo Rate Cuts", CEEMEA Macro Monitor, August 23, 2010, we present our proprietary SARB EazyMeter model which estimates the probability of policy rate cuts. In this, we estimate that the probability of a rate cut at the September MPC is a little less than 40% - i.e., below the 50% probability threshold that has reliably gauged MPC decisions in the past. Combining this with the qualitative reasoning that we presented after the July MPC meeting (see South Africa: September Rate Cut? We Think Not, July 22, 2010), we continue to disagree with market pricing of a 50bp cut at this meeting, and believe that investors can exploit this view by paying the 1x4 FRA at 6.28% for a 22bp roll-up in the coming three weeks.

The UAE: A Fragile Recovery, Despite Substantial Public Spending

The UAE's economic recovery in 2010 continues to be fragile, although the fiscal stance has been quite expansionary. We expect real GDP growth to be around 0.8% this year. However, to date there has been no release of official data on national accounts, public finances or balance of payment transactions for 2010. However, based on anecdotal evidence, we believe that economic growth in the UAE continues to be constrained by: (i) sluggish domestic demand, partly due to weak population growth and sluggish investment spending; (ii) weak supply-side growth caused by an expected further contraction in the construction sector and the continued retrenchment of Dubai's large quasi-public entities; and (iii) weak expansion of domestic credit (up by less than 2% during 1H10) as banks deal with the troubled assets on their balance sheets. Although public spending has increased significantly, its effectiveness may have been limited. Moreover, the apparent lack of a federally chartered fiscal policy and the limited fiscal resources available to northern emirates (including Dubai) has limited the effectiveness of the fiscal stimulus beyond Abu Dhabi, in our view.

Saudi Arabia: Steady She Goes

The economic climate continues to be fairly benign, although weak credit growth could be a headwind. We expect non-oil GDP to increase by about 3.8% this year - about 0.4pp higher than our October 2009 estimate. But the oil sector will likely expand at a weaker pace this year than previously projected, mainly as a result of lower-than-expected average oil production growth of about 1%, according our estimates. Going forward, the economic outlook for Saudi Arabia remains positive, catalysed by the government's continued expansionary fiscal policy. That said, should the weakness in domestic credit markets persist, it could weaken the recovery momentum. We believe that the main impediments to credit growth are the banks' excessive risk-aversion and the domestic investors' apparent low appetite for borrowing. Both of these conditions will likely ease over the near term, in our view.

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United States
Review and Preview
August 24, 2010

By Ted Wieseman | New York

The fallout from the shock dealt to market sentiment by the Fed's dovish policy shift at the August 10 FOMC meeting saw a major further extension in the past week of the powerful trends that began August 11 - huge gains at the long end of the Treasury market leading to a big flattening of the yield curve and resulting collapse in long-dated forward rates, a plunge in inflation expectations as TIPS continue to substantially underperform, and sizeable underperformance by the MBS market but still a strong enough showing in absolute terms to leave current coupon yields at near-record lows.  Minneapolis Fed President Kocherlakota tried to calm investors Tuesday, saying that he believed the market's view that the FOMC's actions indicated that the "economic situation in the United States was worse than they, the investors, had imagined" was "unwarranted".  This sentiment was quickly countered in the view of many investors by a speech and Wall Street Journal interview by St. Louis Fed President Bullard, whose comments indicated that he sees a significant risk of the US heading for a Japan-style deflationary morass.  In the eight trading sessions since the FOMC meeting, the 30-year Treasury yield has fallen 37bp, 10s-30s and 5s-30s have fallen 20bp and 34bp from record highs, the 10-year/10-year forward swap rate has plummeted almost 60bp, the 10-year TIPS inflation breakeven has dropped 25bp and the 5-year/year forward breakeven by about the same 25bp, and Fannie 4% MBS have lagged Treasuries by 25 ticks.  Other than a pause in a quiet Friday trading session, the bull-flattening and falling inflation expectations moves were only interrupted Tuesday in response to better economic data and a rally in equity and credit markets partly as a result of the better data.  Industrial production rose sharply in July, led by a surge in auto assemblies but with good upside also seen in a range of key manufacturing sectors and in oil and gas drilling.  Housing starts posted a small gain in July to halt the post-tax credit collapse, but the number of home completions and the number of homes under construction plunged to record lows, supporting eventual normalization in housing inventories and indicating limited further downside risk to new home construction, in our view.  And the producer price index extended a recent run of underlying acceleration, with the core ex motor vehicles having accelerated to a +0.2% trend since March from a +0.1% pace over the prior year.  These results were quickly forgotten, however, and the rising post-FOMC pessimism about the economic outlook and about the risks of deflation were given further impetus by weak results from the Philly Fed and jobless claims reports Thursday.  Based on the weak underlying results from the Philly and Empire survey, our initial forecast is for a 3-point drop in the ISM to 52.5.  We think that much of the upside in claims since mid-July, however, reflects the sharply accelerated pace of temporary census worker layoffs since mid-July rather than a severe sudden deterioration in the underlying job market.  Still, it appears that the prior improving trend in the labor market has stopped for now, and we look for 40,000 gain in ex census payrolls in August (+50,000 private sector and a further 10,000 drop in state and local government jobs on top of the July plunge).  While this would clearly be a sluggish gain in underlying payrolls, extending the recent disappointing trend to four months, taken at face value, the recent substantial upside in claims would point to a decline in underlying jobs this month, and that certainly seems to be the way the market is leaning at this point. 

On the week, benchmark Treasury yields fell 1-21bp and 5s-30s plunged 20bp, as the long end surged and the 5-year and 7-year were pressured by the weakness in the mortgage market and received no apparent offsetting support from the initial $6 billion in Fed buying of Treasuries in off-the-run 5s and 7s.  The 2-year yield fell 5bp to 0.49%, 3-year 4bp to 0.77%, 5-year 1bp to 1.45%, 7-year 1bp to 2.05%, 10-year 7bp to 2.61%, and 30-year 21bp to 3.66%.  TIPS performed terribly in comparison, with the 5-year yield up 10bp 0.16%, 10-year yield up 4bp to 1.01%, and 30-year down 5bp to 1.74%.  TIPS were unable to benefit from a bit of upside in underlying producer price inflation after ignoring the upside in core inflation the prior week.  The PPI gained 0.2% in July (lifting the year-on-year rate to +4.2% from +2.8%), with energy prices (-0.9%) down for a fourth straight month and food (+0.7%) reversing part of a near-record decline in June.  The core rose 0.3% (and almost rounded up to +0.4%), the largest rise of the year.  Volatile motor vehicle prices added to the gain, but the core ex motor vehicles still gained 0.2%, a pace it has been running near each month since March after a trend near +0.1% over the prior year.  Core consumer goods prices led the July upside, particularly a significant gain in drug prices.  Nominal curve and TIPS performance since the FOMC meeting represents a complete about-face from the trends seen for several weeks going into meeting, when money was persistently moving out of the long end and into 5s and 7s to benefit from carry and rolldown while real rates were falling and inflation expectations drifting gradually a bit higher. 

Mortgages had also been benefiting substantially for a good while from the low volatility, carry-focused environment before the FOMC meeting started the abrupt shift in expectations towards fears of a deflationary double-dip and away from a relatively benign prior outlook for a long period of low growth, low volatility, steady and moderate inflation, and no change in Fed policy.  Aside from a good bounce Thursday, MBS underperformance through the week remained persistently bad after having turned broadly poor (higher-coupon issues had been hurting for a couple of weeks on fears of a policy shift to ease credit standards for refinancings) after the FOMC announced its portfolio readjustment.  For the week, Fannie 4% MBS lagged Treasuries by nearly a half point even with a major bout of outperformance Thursday.  Thursday's bounce came as the prior run of post-FOMC underperformance had been bad enough that lower-coupon issues were looking cheap, and after Friday's renewed weakness, our desk thinks that lower-coupon mortgages are cheap enough to own going forward.  As bad as recent relative performance has been, with the general level of rates falling so much, MBS yields are still holding near all-time lows.  The current coupon Fannie Mae MBS yield plunged all the way down to a new low of 3.31% Thursday on our mortgage strategists' calculations and even after Friday's reversal was only back up to near a still extremely low 3.4%.  At this MBS yield level, 30-year mortgage rates should already be down to 4.25% or lower, and one of the bigger originators was seen offering rates of 4.125% late in the week.  The biggest originators, however, in an industry that became very concentrated during the housing bust (the two biggest companies accounted for nearly half of 1Q activity) are still offering rates well above that, amid capacity constraints as refis have started to ramp up, leaving the national average rate at 4.42% this week according to Freddie Mac's national survey.  If underlying MBS yields stay near these levels or move lower, mortgage rates being offered to consumers should continue to come down as originators ramp up their hiring.  Already, the MBA's weekly mortgage refinancing index gained 17% the past week, accelerating a recent move higher to reach the highest level since May 2009.  If 30-year rates head down to 4.25% or 4.125%, the big 4.5% MBS universe, which since it is based on mortgages extended in 2009-10 largely when credit standards were tight and home prices near their lows doesn't have the problems slowing refis in higher-coupon mortgages, should start to refinance at an accelerating rate.  This should provide additional momentum to the already substantial progress by consumers in repairing their balance sheets (see US Economics: Deleveraging the American Consumer: Faster than Expected by Richard Berner, August 20, 2010).

With good gains on Tuesday, equity and credit markets managed to finish down only slightly for the week as a whole.  The S&P 500 fell 0.7%, with energy, financial and healthcare stocks lagging.  The consumer cyclical and materials sectors performed well enough when stocks were rallying in the first part of the week to hold onto small net gains, and tech stocks also rallied slightly on the week.  The investment grade CDX index similarly only ended up 1bp wider for the week at 109bp, and the high yield index near 575bp was little changed (and comparatively quite stable on a day-to-day basis too).  Some recent softening in the muni bond CDS market continued in the latest week as European peripheral government bond markets came under some pressure, and the fiscal mess in California, which still doesn't have a budget in place for the fiscal year that began July 1, was back in the headlines as Governor Schwarzenegger began widespread forced unpaid furloughs for state employees Friday and the state Controller John Chiang warned that he was running out of cash to pay vendors and might soon need to start issuing IOUs instead.  For the week, the 5-year MCDX index widened about 5bp to near 225bp, high since mid-July and up from a low recent close of 197bp on August 3.  On the positive side, as agency MBS have been coming under major relative pressure, the non-agency mortgage and CMBS markets have been doing much better recently, with the AAA ABX index gaining 2% this week and AAA, junior AAA, AA and A CMBX all 1%.  There was some modest softening in the second half of the week in the broad risk market pullback, but the AAA ABX and CMBX had reached their best levels since May at Tuesday's close.

In a light week for economic news, the most notable release was industrial production, which surged 1.0% in July, for an 8.5% annualized gain since the June 2009 trough, as manufacturing continues to lead the recovery.  With a major automaker not taking normal summer downtime in order to try to rebuild depleted inventories, motor vehicle assemblies surged 14% to a two-year high and overall motor vehicle and parts output gained 10%.  This accounted for about half of a 1.1% gain in factory output, but manufacturing ex motor vehicles still rose a solid 0.6%, with good gains in machinery, fabricated metals, tech equipment, aircraft, petroleum refining and chemicals.  After this robust July for manufacturing output, early indications pointed to a slowdown in August.  On an ISM-comparable weighted average basis, the Empire State manufacturing survey fell 2 points in August to 50.3, a low since December, and the Philly Fed 4 points to 46.3, low since October.  These results clearly warn of some weakening in national manufacturing growth, but it should be kept in mind these two regions also were a lot softer in July than the national ISM at 55.5 or the surge reported in industrial production, partly because they don't have material auto industry activity that provided a big boost to activity in other parts of the country.  On a preliminary basis, we look for the national ISM to fall 3 points to 52.5 and will update our estimate as the rest of the major regional manufacturing surveys are released, including the Richmond survey on Tuesday and Kansas City on Thursday, both of which held up quite well in July, in contrast to the softer Empire and Philly readings. 

The economic calendar is fairly light in the coming week, with reports on home sales, durable goods and revised GDP.  The Richmond and KC survey and weekly claims report will also be in focus after the soft results the past week led to a pessimistic outlook for ISM and employment reports due out in a couple weeks.  A lot of supply will have to be taken down, with $109 billion in coupon auctions from Monday to Thursday - $7 billion 30-year TIPS reopening Monday, $37 billion 2-year Tuesday, $36 billion 5-year Wednesday, and $29 billion 7-year Thursday.  The Kansas City Fed's annual conference in Jackson Hole, Wyoming, starts Friday with a speech from Fed Chairman Bernanke on "The Economic Outlook and the Federal Reserves Policy Response", which will give the Fed chairman a chance to respond to the damage done to market expectations by the FOMC statement and subsequent Fed communications.  Key data releases due out include existing home sales Tuesday, durable goods and new home sales Wednesday, and revised GDP Friday:

* We forecast a dip in July existing home sales to a 5.30 million unit annual rate.  To qualify for the homebuyers' tax credit, contracts had to be signed by April 30, and closings originally had to take place by June 30.  But closings were experiencing delays as the backlog of deals swelled.  Before adjourning for the July 4 recess, Congress extended the closing deadline to September 30 (although contracts still had to have been in place by the original April 30 deadline).  So, the impact of the tax credit on the existing home sales series will linger for another few months.  But the NAR's pending home sales index registered a slight dip in June and thus we look for about a 1% decline in July resales.

* We look for a 3.5% jump in July durable goods orders.  Company reports point to a sharp spike in the volatile aircraft category this month.  Also, we should see some further upside in bookings of motor vehicles.  So, we look for a significant rise in headline orders.  However, the key core category - non-defense capital goods ex aircraft - is expected to register a 1.5% drop, continuing the bizarre pattern of declines in the first month of the calendar quarter (followed by bigger gains in the next two months) that has been evident for some time now.

* We expect new home sales to stabilize at a 330,000 unit annual rate in July.  Sales of newly constructed residences plummeted 37% in May following expiration of the homebuyer tax credit and then registered a 24% rebound in June (note that unlike the existing home sales series, the new home sales data are based on contract signings).  We look for the recovery to stall in July, reflecting the low level of homebuilder sentiment evident in the latest industry survey.  On the brighter side, the number of homes available for sale is near historical lows and thus the downside for homebuilding appears to be quite limited even if sales remain soft in coming months.

* We look for more than a one percentage point downward adjustment to 2Q GDP growth to +1.3% from the originally reported reading of +2.4%.  Almost all of the adjustment should be concentrated in two categories - inventories and net exports.  Indeed, final domestic demand is expected to remain at the original reading of +4.1%, which was the best gain in over four years.   

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United States
Deleveraging the American Consumer: Faster than Expected
August 24, 2010

By Richard Berner | United States

Grim legacy.  The bursting of the credit and housing bubbles triggered unprecedented retrenchment among American consumers.  Record debt, plunging housing and financial wealth, and significant income losses undermined wealth, wherewithal and confidence.  History suggests that recovery following financial crises is tepid at best, because it involves a long process of deleveraging balance sheets and rebuilding saving.  Efforts aimed at restoring a more sustainable relationship between household debt and consumers' ability to carry it mean that even growing income may not produce much spending bang for the buck.  The latest retailing data seem to confirm that these powerful headwinds to recovery are at work today. 

Closer to sustainable, but still a sea change.  We have long agreed with the basic deleveraging story.   But there is surprisingly good news: American consumers have deleveraged their balance sheets and rebuilt saving faster than expected.  While debt-to-income ratios and other measures of leverage are still elevated, household debt service is lower and saving higher than expected in relation to income.  We estimate that the deleveraging timetable is nearly a year ahead of schedule.  Looking ahead, the recent plunge in mortgage rates likely will push debt service still lower.   Consequently, in our view, the headwind to consumer spending from deleveraging is now a smaller risk to the outlook, as consumers can spend more of their income. 

Importantly, our story is optimistic only by comparison with the now-gloomy standard forecast.  In our view, the key tail risk is still lodged in housing and home prices, as about one in four homeowners with a mortgage owes more than the house is worth.  That is leading to a wave of ‘strategic defaults', in which borrowers who can otherwise afford to pay decide to walk away.  Whether through foreclosure or strategic default, more mortgage chargeoffs are coming.  We think that the sea change in consumer behavior wrought by recession will persist over the next several years, as dim prospects for gains in household wealth will maintain an elevated saving rate, limit the eventual recovery in household debt to below the pace of income, and cap real spending growth in a 2-2.5% range.

Grim standard metrics.  Even our subdued optimism may seem surprising, because the standard gauges of household leverage - ratios of debt to income, debt to assets, or mortgage debt to owners' equity in real estate - paint a bleak picture of the average household balance sheet.  While household debt in relation to disposable income has declined significantly from its peak of 123.6% in 3Q07, we estimate that it stood at 110.7% at the end of 2Q, or only back to 2004 levels.  Moreover, mortgage debt in relation to tangible assets remained at 44% by 1Q10, while such debt in relation to owners' equity stood at 163%, both more than double historical norms.  Those measures seem to imply that the deleveraging process - and episodic flirtation with retrenchment - could stretch out over several years. 

But other measures depict a much more sustainable picture.  The balance sheet snapshots just discussed are important, but in our view, they don't tell the whole story.  Other, flow-driven measures capture some of the dynamics of balance sheet adjustment.  One such measure of sustainability is the debt-service ratio - household payments of interest and principal on debt in relation to disposable income.  By that metric, consumers are already at the threshold of sustainability, thanks in part to lower interest rates and a recovery in income.  Debt service has declined from nearly 14% of disposable income in 3Q07 to an estimated 12.4% in 2Q10 - the lowest level in a decade.  Indeed, with mortgage rates tumbling to all-time historical lows, the prospect of further declines in debt service from additional refinancing of mortgage debt imparts downside risks to our estimates of the debt-service burden.

The other encouraging metric is the personal saving rate.  A year ago we thought saving might reach 6% of disposable income in 2011 from 2% in 2007.  Revised national income accounts show a saving rate fully two percentage points higher than previously thought, one that had already moved up to 6.2% - a 17-year high - in 2Q10. 

We'd be the first to acknowledge that a higher saving rate could manifest consumer hesitation - evincing the ‘paradox of thrift', in which too much saving weakens growth.  However, careful modeling of consumer spending (although it does not explicitly account for declining debt service) confirms our intuition that consumers have adjusted to the loss of wealth more rapidly than we expected.  Such analysis suggests that consumers adjust their outlays to a ‘target' level determined by wealth and after-tax income.  When spending is below that target, outlays will adjust higher and vice versa.  According to Macroeconomic Advisers, the deeper retrenchment that has already occurred and the higher income in these data suggest that the path of spending from here could be 25bp higher than previous estimates implied.  

Courtesy of rapid reductions in debt service, upward revisions to dividend income (which tends to be saved), and deeper spending retrenchment in the past, these data now depict a consumer who has adjusted to the shock in wealth faster than previously thought.  The combination of lower debt service, and thus more discretionary income, and a higher saving rate should limit downside risks to consumer spending. 

Calibrating consumer deleveraging.  How do we know whether consumers have delevered enough?  Our research strategy a year ago consisted of two steps.  First, we established what might be a sustainable level of consumer debt service in relation to income; our rough estimate is 11-12%, which might be associated with debt in relation to income of 80-100%.  Then we used base, bull and bear scenarios to estimate how long it might take to approach those ratios under different circumstances.  To link household debt and debt service to our economic scenarios, we estimated equations to describe the growth in mortgage and non-mortgage consumer debt, taking account of the factors that drive originations, repayments, refinancing and defaults.  We built on our earlier work on credit losses and deleveraging at lenders to try to achieve internal consistency between the economic scenarios and losses and to incorporate the feedback from the economy to growth in debt.  

Under any of the three scenarios, we thought that the 11-12% debt-service and 80-100% debt-to-income ratios might be attainable by 2011.  At the time, that sounded extraordinarily rapid.  But we pointed out that it would be anything but painless, as evidenced by key metrics in the deleveraging process, such as growth in debt, sustainable spending growth, and the personal saving rate. 

The forecasts have held up well: Our baseline scenario was - and still is - consistent with an 8% contraction in mortgage and consumer credit between 2009 and 2011, and real annualized personal spending growth of 2-2.5%.  Based on current data, it is also consistent with a personal saving rate of 6-6.5% in 2H10 and 5.3% by end-2011, reflecting our baseline assumption that taxes will go up for upper-income consumers.  But we still believe that over a longer time period, consumers will boost their saving rate to 7-10%, reflecting limited growth in household assets and correspondingly still-high leverage ratios. 

Additional implications of deleveraging.  It's worth reemphasizing that lower debt service confers additional benefits on consumers not captured by traditional analysis:

•           Lower debt service frees up discretionary spending power that does not show up in the personal saving rate, because that rate excludes the cash flow benefits of lower principal repayment. 

•           Lower debt service also makes consumers better able to service debt and more creditworthy.  It's no coincidence that delinquencies on consumer loans peaked a year ago.  That augurs a coming peak in loan charge-offs; meanwhile, the record pace of such write-downs is accelerating the clean-up of both lender and consumer balance sheets.  Perhaps that's why the Fed's July Senior Loan Officer Survey revealed that the highest proportion of banks in 16 years reported increased willingness to make consumer installment loans. 

•           Finally, once achieved, a higher saving rate enables consumers to maintain spending, continue to pay down debt, and accumulate wealth the old-fashioned way.

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