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Concerns Continue to Fester: December Tankan Preview
December 09, 2010

By Takehiro Sato | Tokyo

Improved Outlook for Industrial Production Has Allayed Fears of a Coming Slowdown Somewhat

Industrial production data for October, despite a fifth straight month of reduced output, indicated a pick-up ahead, causing fears of a double-dip for Japan's economy as stimulus effects fade to abate slightly. The future conditions DI in the October Economy Watchers Survey also pulled out of its decline, and indicates that the current conditions DI for November will pick up. The latter is a leading indicator of the economy's direction by about three months. PMI data from around the world released on December 1 also showed broad improvement, as manufacturing performance perks up globally.

As a counterbalance to these encouraging developments for domestic and overseas manufacturing, sovereign debt problems in Europe have flared up again and inflation concerns in emerging markets are clouding the outlook for the global economy. In this context, we expect headline number in the December Tankan (TBA at 8:50am JST on December 15) to mark time. In the September Tankan, the outlook DI pointed to deterioration relative to current conditions for the first time since the Lehman shock, and we expect the same pattern in the December survey. The point to watch will be how companies react to somewhat encouraging economic developments centered on manufacturing globally.

We do not expect this Tankan to spark fresh policy moves, as it comes just as the BoJ is about to finally embark on the risk asset (equities, etc.) purchasing outlined in its October framework for comprehensive easing. But BoJ Governor Masaaki Shirakawa has not denied that the scale of the purchasing fund could be enlarged depending on the state of the economy, and we believe that comprehensive monetary easing could be stepped up as early as Jan-Mar 2011, with exchange rate movements a potential spur.

Forecast for Business Conditions DI: Headline Number to Be Flat, with Outlook Reading Again Below Current Reading

We look for improvement in the headline business conditions DI for large manufacturers to peak out for the first time in seven quarters (our rough calculations, based on the Reuters Tankan DIs published on December 7, put forecasts for large enterprises in the BoJ Tankan at 6 for manufacturers (-2pp from Sep) and 1 for non-manufacturers (-1pp). Tankan forecasts must also consider factors like production, inventory, exports, share prices and corporate earnings, so we do not automatically use these results as our actual forecasts), in reaction to the ongoing slowdown for exports to Asia and fading of policy-stimulated demand in Japan. We also expect the outlook DI to show a lower reading than the business conditions DI, reflecting the risks above. This would repeat the pattern from the September survey, which saw this happen for the first time since December 2008, immediately after the Lehman shock.

For large non-manufacturing companies too we expect the business conditions DI to show a modest deterioration for the first time in seven quarters (at present the usual practice is for economists to publish the BoJ Tankan forecasts immediately after the Reuters Tankan, but normally there is a gap between the two announcements of over a week. Meanwhile, survey responses from firms are likely to keep coming in after the official late-November (November 29) deadline. This means that in highly volatile times such as now, responses about the outlook can change with the prevailing market environment), reflecting the retracement of consumption in Oct-Dec from healthy summer levels buoyed by government stimulus. Similarly, we think that the outlook DI may show a lower reading than the current DI.

We expect the DI for SMEs (small and mid-sized enterprises) to show improvement in sentiment peaking out, since the headline in the leading indicator Economy Watchers Survey continued to fall in November, and the headline in the Shoko Chukin monthly survey of SME conditions fell for the third straight month in November. The outlook DI has already dropped three times in a row since the antepenultimate survey in March, and this, in particular, is likely to make grim reading in the December Tankan.

Our Forecast for F3/11 Management Plan Revisions (Large Enterprises)

1) Upward Revisions for F3/11 Sales and Profit Plans

Upward/downward revision rates have stayed within 2pp for sales plans in past December Tankan reports, besides F3/02. While sales targets are often raised during economic growth periods, companies reduced projections in 2002-03. For reference, F3/11 TSE-1 consolidated company outlooks in light of 1H results currently project 6.6%Y sales growth and were roughly unchanged from the initial plan with just a 0.2pp increase. Although 1H sales exceeded plan targets, companies appear to be taking a cautious stance in 2H plans due to yen advances and other changes in external conditions. We expect a similar trend in the BoJ Tankan report, besides the consolidated and parent difference.

Profit outlooks, meanwhile, differ significantly for economic expansion and recession periods. While companies sharply lowered profit targets in the 2001 and 2008 recessions, they generally raised outlooks by about 3% in expansions. For reference, F3/11 TSE-1 consolidated company outlooks in light of 1H results currently project sharp 44.4%Y profit growth, including an 8.8pp upward revision from the initial target. We predict a similar trend in the BoJ Tankan with the possibility of a 5pp boost, though the above-mentioned results cannot be directly applied because of a large profit gap at consolidated and parent levels.

While domestic companies have been gradually improving export profitability (versus the strong yen), they have not sufficiently caught up with recent spot-rate fluctuations. We estimate that the exports break-even rate for all manufacturing industries has improved about ¥3 from the Jul-Sep level to roughly ¥86/$ in Oct-Dec. The current lower 80-yen range is actually undervalued in terms of the real effective rate versus April 1995. Yet the central point is currency stability because of the difficulties for domestic companies in responding to sharp short-term moves. This discussion only addresses domestic operations. We think that the consolidated break-even rate has improved even more as hedges against currency exposure via expanded overseas production pay off.

2) F3/11 Capex Plans Likely to Be Roughly Unchanged from the September Tankan Report

Past update patterns for December Tankan reports show modest upward revisions in economic expansions and fairly large downward revisions in recessions. Companies are likely to raise their consolidated capex plans as GDP data for Jul-Sep 2010 confirmed a four-straight-quarterly recovery for capital investments. For example, the Nikkei capital investment survey raised the listed-company capex growth rate to 11.5%Y, an increase of 0.3% from the previous survey in April. Yet, this survey includes overseas manufacturing subsidiaries. This upward revision is also owing much to the upward revision of overseas capex by 3.8%. We think that the upward-revision margin is likely to trail the average pattern for past recovery phases as the Tankan report covers domestic entities and almost no companies are aggressively increasing domestic capex due to recent strong-yen advances.

Although domestic capital investments have already dropped below depreciation costs, we do not foresee a robust recovery. We expect all-industry large enterprise plans to target a 2.4%Y increase (revision rate: -0.1pp), with almost the same as the past average revisions pattern, comprising 2.6% for manufacturing (-1.4pp) and 2.3% for non-manufacturing ( 0.6pp).

Factors contributing to a more sluggish capex recovery than normal include the consolidated and parent gap and anemic rebound in facility utilization rates. We expect the Oct-Dec facility utilization rate to fluctuate around 70%, the past average for recession periods. Production capacity, on the other hand, appears to be headed upward, rather being downscaled.

Policy Implications: Reinforced Monetary Easing

The BoJ presented a comprehensive easing framework at its October 4-5 policy meeting that includes 1) moving to a band range for the unsecured call rate target (0-0.10%), 2) strengthening the commitment to the policy duration, and 3) establishing an asset-buying fund worth ¥5 trillion. It disclosed details for the asset-buying program at subsequent meetings on October 28 and November 4-5.

The first item essentially confirmed the status quo since the bank left its interest rate on excess reserves at 0.1%, and the unsecured call rate has not changed much since the policy update. However, the BoJ's emphasis on "returning to a zero interest rate policy" has effectively ended the policy approach of targeting interest rates. We consistently stressed the possibility of a rate cut throughout the post-Lehman shock recovery and withdraw this prediction in light of the bank's adoption of comprehensive easing.

Monetary policy is likely to focus on expansion of the ¥5 trillion fund, and BoJ Governor Shirakawa has already repeatedly mentioned the possibility of expanding the fund size based on economic conditions. We expect the bank to initially expand asset purchases, primarily for JGBs. However, the fund's structure (allocating ¥3.5 trillion (out of a total of ¥5 trillion) to JGB purchases with ¥1.5 trillion going toward JGBs with less than two-year duration and the remainder for T-bills) is not a good fit for the core policy goal of pushing longer interest rates downward and reducing the market risk premium to encourage an asset effect. This reality, along with political pressure, is likely to move the bank toward a program expansion centered on risk assets. The most likely choice for increased purchases among risk assets is ETFs from the standpoint of market size.

Below we review our scenario for the timing of increases in asset purchase value.

1) Jan-Mar 2011: Repatriations by domestic institutional investors favor a seasonally strong yen. With book-closing near, the government is also sensitive to share prices. The BoJ could respond reactively to currency/share price trends.

2) Jul-Sep 2011 and after: Revision of the formula for measuring consumer prices is scheduled for end-August. The new CPI is likely to indicate prolonged deflation. The rising likelihood of missing the government target of positive consumer price growth during 2011 could also increase political pressure on the BoJ.

3) 2H11 overall: The Fed's QE2 is expected to continue through end-June, but the government bond purchase program could continue if rebounds in employment and share prices are not satisfactory. Monetary easing competition among foreign central banks could spur renewed activity at the BoJ.

We think that any increase in expectations that share purchases by the BoJ and the Banks' Shareholding Purchase Corporation (BSPC) can partly offset selling pressure from the unwinding of cross-holdings that will inevitably emerge over the next three years is also likely to create expectations for tighter supply/demand conditions for Japanese equities.

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United States
Tax Deal Could Boost Growth to 4% Next Year
December 09, 2010

By Richard Berner, David Greenlaw | New York

Breakthrough tax deal?  President Obama has announced a ‘framework' agreement with Republican Congressional leaders that could, if enacted, boost growth over the four quarters of 2011 by 1-1.2pp relative to our baseline forecast of 3%.  Some of the provisions would last two years, but others would expire after 2011 and thus would pull growth forward into 2011 at the expense of 2012.  As a result, following a significant boost to growth in 2011, this package could reduce growth in 2012 by about half a percentage point. 

Framework details.  While many details have yet to be announced, the deal involves:

•           A two-year extension of all expiring tax cuts, including those for upper-income taxpayers;

•           A two-year extension of other expiring tax provisions, including a fix for the alternative minimum tax;

•           A new, 12-month, 2% payroll tax cut for employees;

•           100% expensing of business investment outlays in 2011; and

•           A 13-month extension of emergency unemployment benefits. 

The deal does not include an extension of the Making Work Pay tax credit; it substitutes the payroll tax cut for that credit.  The estimated revenue impact of these provisions adds up to more than $1 trillion over two years. 

In our baseline outlook published last Friday, we assumed that tax cuts would be extended for lower and middle-income taxpayers, that EUC unemployment benefits would be extended for six months, that business expensing would be allowed for 50% of investment outlays, and some other expiring provisions, such as the AMT fix, would be extended.  Thus, this proposed deal includes significant new stimulus from the payroll tax cut, expanded business expensing, the longer EUC benefits extension, and tax cuts for upper-income taxpayers. 

Our estimates of the impact on growth of the deal, if enacted, rest heavily on our baseline assumptions.  Our estimates may vary from those of other analysts who may have assumed more or fewer of these provisions in their baseline.  Moreover, there could be two intangible benefits from such a deal that are hard to quantify.  First, it would reduce the uncertainty around the tax issue; clarity could be a plus for growth.  Second, it could boost investors' risk appetite, which would further ease financial conditions.

Tax cuts and EUC benefits likely to be extended.  While the outlook for enactment of this deal is unclear, we think that the tax cuts for all income groups and unemployment benefits are highly likely to be extended.  Ironically, many Democrats have strong reservations about the proposal, while many Republicans have expressed support.  As a result, the prospects for the deal will only become clearer after Congressional representatives caucus and work on a strategy to move key elements toward legislation. 

Shift in policy mix: Monetary policy implications.  Such a deal, if enacted, would shift the burden of policy stimulus from monetary to fiscal policy, exactly what Fed officials have hoped.  Conditional on the outcome, this deal or one broadly similar to it has implications for monetary policy.  While the Fed is committed to complete the $600 billion Large-Scale Asset Purchase program announced in November (QE2), the shift to fiscal stimulus - and of course, the expected improvement in the economic outlook over the next few quarters - imply that officials would be less inclined to extend the current LSAP program beyond 2Q11.

Budget and financing implications.  If the proposal based on the agreement reached between the White House and Congressional Republicans were enacted, we would take our F2011 deficit forecast up by $160 billion, to $1.295 trillion (or 8.6% of GDP).  And, we would adjust our F2012 deficit estimate up by a similar amount, to $1.11 trillion (or 7% of GDP). 

These changes largely reflect the impact of three proposed measures - the payroll tax cut, business expensing and extended unemployment benefits.  Most of the payroll tax effect hits in F2011, while we are assuming that the bulk of the impact associated with the expensing provisions would hit in F2012.  Also, it's important to note that the near-term outlays associated with the proposed expensing provision merely represent a timing shift - the total $150 billion or so of estimated tax breaks during the F2011-12 period would be entirely recouped by 2020.

Of course, the higher budget deficit would imply some associated impact on the volume of Treasury borrowing.  This would likely take the form of a delay in the anticipated reduction in coupon auction sizes and a smaller cutback in bill issuance than in our current baseline.  In that baseline, we expect issue sizes for the 2-, 3- and 5-year notes to begin to move modestly lower by mid-2011.  Under the proposal, we would anticipate that these cutbacks would not occur until later in the calendar year.  Overall, in F2011, we would boost expected coupon issuance by about $60 billion and bill issuance by about $100 billion relative to current estimates.  So, if the proposal were enacted, we would look for gross coupon issuance of $2.06 trillion in F2011 - implying net issuance of about $1.4 trillion.  We would still anticipate a net paydown in bills over the course of the coming year, but less than in the baseline outlook.

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