Review and Preview
January 15, 2007
By Ted Wieseman | New York
In our monthly economic forecast update published Monday morning, we asked the question, “Is the ‘Growth Recession’ Ending?” (see the report of the same name by Richard Berner and David Greenlaw). By Friday’s close the answer, at this point, seems to be an unequivocal yes.
Building in upside in international trade and retail sales, and even after incorporating significantly more conservative assumptions for inventories, we boosted our 4Q GDP estimate to +2.9% from +2.5%. And given the better ramp coming into 2007 provided by the upside in the incoming data for late in 2006 combined with what we estimate to be a much more positive mix of final sales versus inventories in 4Q — we see final sales surging 4.5% and inventories subtracting a full point and a half — GDP growth in 1Q07 at this very early point looks to be on track for a rise of at least 3.5%, a full percentage point higher than our estimate coming into the week; and a 4 handle appears far from out of the question if mild weather continues and energy prices sustain their recent plunge. This rapidly improving growth backdrop and the implications for Fed policy weighed heavily on the Treasury market over the course of the week, with yields rising every day to make it six straight losing sessions going back to employment report Friday, sending yields to their highest levels since October. In the futures market, hopes for a Fed rate cut by May were abandoned, prospects for a move by June nearly given up on, and the bulk of a full 25bp rate cut was removed from the now quite shallow rate-cutting cycle seen extending into 2008. If the recent positive trajectory of the data continues, and if we were to see any renewed upside in core inflation — with the CPI release on Thursday the key release in the coming week — investors might have to begin seriously contemplating the risk that, far from cutting rates, the Fed might actually be forced to act on its long-held tightening bias. Benchmark Treasury yields jumped 12-14bp over the past week, with the 3-year underperforming slightly, tracking a particularly poor performance by the red (Mar 08 to Dec 08) eurodollar futures contracts. This was the market’s worst week since early December and second worst since June. The 2-year yield rose 12bp to 4.88%, the 3-year 13bp to 4.80%, the 5-year 11bp to 4.76%, and the 10-year and long bond 12bp each to 4.77% and 4.86%. The market’s big recent correction continued to be entirely driven by higher real rates, as benchmark 5-year and 10-year TIPS yields rose 12bp on the week, leaving inflation breakevens little changed. Since the market peaked on December 1 in the aftermath of the sub-50 November ISM reading, the nominal 5-year yield has risen 38bp and the 5-year TIPS yield 41bp; the nominal 10-year yield has increased 33bp over this period and the 10-year TIPS yield 40bp. At the time of that December 1 Treasury market peak, the fed funds futures market was pricing in a 70% chance of a rate cut by the March 20 FOMC meeting. By the end of the latest week, hopes for a cut by May had been all but abandoned and even a move by June was seen as quite unlikely, with the April fed funds contract off 1.5bp to 5.245%, the May contract down 3.5bp to 5.225%, and the July contract off 9.5bp to 5.18%. Nearly a full 25bp rate cut was taken out of the increasingly delayed and shallow rate cutting cycle the market now expects to begin sometime in the second half of the year. The worst losses in the eurodollar futures market were 19-20bp plunges by the Sep 07 to Sep 08 contracts. The Mar 07 to Mar 08 spread steepened 16bp to a more than 11-week high of -36.5bp, with the former losing 3bp to 5.355% and the latter 19bp to 4.99%. The low rate Sep 08 contract fell 19bp to 4.94%, shifting the expected trough of the anticipated rate cutting cycle to 4.75% from 4.50%. Coming into the past week, we had pegged 4Q GDP growth at +2.5%, with final sales gaining a solid 3.6% and a slowdown in inventory accumulation, centered in autos, knocking about a point off growth. After significantly better-than-expected international trade and retail sales reports and some adjustments to our estimates of government spending, we boosted our final sales estimate all the way to +4.5%, raising our estimate of the contribution of net exports to +1.5 percentage points from +1.0pp and upping our consumption forecast to +4.3% from +4.0%. Actual incoming data on inventories in November were offsetting, with upside in the wholesale sector offset by lower-than-expected results in retail. But in light of the greater softness we now project in 4Q imports and concerns about the potential magnitude of the auto sector drag in the quarter after the odd positive contribution BEA reported in 3Q, we decided to be significantly more conservative with our inventory forecast and cut our expected contribution to 4Q growth from a one percentage point subtraction to a point-and-a-half drag. Netting the upside in final sales and projected downside in inventories, we boosted our 4Q GDP estimate to +2.9% from +2.5%. Importantly, the significantly stronger mix of demand versus inventories we now see unfolding in 4Q has notable positive implications for the first quarter, when we think inventories could swing back to a significant net positive. Based on our current estimates, all that would really be required for a big positive swing in the inventory contribution would be for auto sector inventory destocking to moderate from massive in 4Q to just very large in 1Q — hardly a heroic assumption, given current production schedules that indicate that October probably marked the trough in North American assemblies. Combined with the potential additional positives of collapsing energy prices and continued mild weather, we would conservatively peg 1Q growth as tracking — at this very early stage — near +3.5%, a full percentage point higher than our estimate coming into the week, and it would not require any big stretches in our assumptions to come up with a notably better number than that. Note that this positive potential outlook for 1Q incorporates another full percentage point subtraction from residential investment, where we are far from convinced that the recession is over despite the much improved recent tone of housing-related data. The trade balance surprisingly narrowed from US$58.8 billion in October to US$58.2 billion in November, a 16-month low, with exports jumping 0.9% and imports ticking up 0.3%. We now estimate that real exports will rise at a robust 11% annual rate in 4Q, and real imports will decline 2%, with net exports adding 1.5 pp to GDP growth. Export strength in November was led by services and aircraft, the latter surging to a record high. On the import side, good gains were seen in autos (as North American assemblies improved from the October trough), consumer goods and capital goods, led by computers. But these gains were largely offset by a sharp fall in non-oil industrial materials that was led by metals, natural gas and forestry products. Retail sales gained 0.9% in December, with auto sales up only 0.3% despite the significant rebound in unit sales, but ex auto sales surging 1.0%. Although the ex auto gain was supported by a price-related 3.8% jump at gas stations, sales excluding autos and gas were still up 0.7% in December on top of a 0.5% rise in November, combining for a very solid holiday shopping season. Upside in December was broadly based. Sales at electronics stores posted another 3.0% surge on top of the 5.8% spike recorded in November. General merchandise (+0.9%), restaurants (+2.3%), drug stores (+1.2%) and furniture stores (+0.7%) were all up solidly. Even clothing stores (+0.6%) managed a decent gain despite the unusually warm weather. The key retail control grouping that feeds into GDP jumped 1.3% in December on top of a marginally downwardly revised 0.8% jump in November. Incorporating these numbers into our forecasts, we boosted our estimate of 4Q consumption to +4.3% to +4.0%. This assumes only a 0.2% gain in real PCE in December, as we have built in an unusually low rise in spending on services as a result of an assumed plunge in spending on utilities because of the unusually warm weather. The upcoming holiday shortened week has a very busy economic calendar. The key data release will be Thursday’s CPI report, where we look for a return to a more trend-like +0.2% reading for the core after the very benign past couple of months. An upside surprise here could obviously be very bad news for a market already reeling from repeated positive surprises in the growth data. The Fed will also be in focus, with Chairman Bernanke testifying Thursday to the Senate Budget Committee and the Beige Book prepared for the upcoming January 30-31 FOMC meeting released Wednesday. A number of other Fed officials are also scheduled to speak a week ahead of the start of the traditional pre-FOMC meeting quiet period. It is already time to start looking ahead to the early round of key January data due out at the beginning of February. The Empire State and Philly Fed surveys on Tuesday and Thursday will help set initial expectations for the January ISM, while initial jobless claims this week will cover the survey week for the January employment report. Other data releases due out include PPI and IP Wednesday, housing starts and leading indicators Thursday, and the University of Michigan consumer confidence report Friday: * We forecast a 1.2% surge in the headline producer price index in December, but a flat reading excluding food and energy. Another sharp jump in quotes for energy-related items should help push up the headline PPI in December. Meanwhile, the core is expected to flatten out following the wild gyrations seen in recent months. Indeed, it’s becoming increasingly apparent that the most meaningful aspect of this report is the core PPI excluding motor vehicles, since significant measurement problems continue to plague the car and truck components. We look for the core excluding vehicles to be +0.1% in December. * We expect headline industrial production to be flat in December, with a fractional rise in manufacturing output being offset by a modest weather-related decline in the utility component. In fact, we are somewhat surprised that indicators of electricity usage don’t point to an even sharper pullback, given the abnormally mild weather conditions that prevailed across much of the nation. Based on the labor market data, we look for upside in sectors such as apparel, electrical equipment and computers, countered by declines in wood products, metals and textiles. Meanwhile, motor vehicle assembly schedules point to a slight rise this month, appearing to confirm that October will represent the trough for vehicle production. * We forecast a 0.5% gain in the headline consumer price index in December and a 0.2% rise excluding food and energy. A rebound in energy prices following the subdued readings of recent months is expected to help push up the headline CPI this month. Meanwhile, we look for the core CPI to return to trend following on the heels of the much lower-than-anticipated readings seen in October and November. Specifically, the shelter component — which accounts for more than 40% of the overall core — is expected to post another 0.4% rise. And while we are likely to see another price drop for apparel items and used cars, the recent sharp declines in categories such as new vehicles and air fares are not expected to be repeated. Finally, we expect the core to hold at +2.6% on a year-on-year basis, although the risk is tilted toward it rounding up to +2.7%. * Although we believe that the correction in homebuilding still has a way to go, the labor market report indicated that hours worked within the construction industry posted a solid gain in December. No doubt this is tied to the unusually mild weather conditions that prevailed across much of the nation. So, we look for December housing starts to post a modest 1% rise to a 1.60 million unit annual rate. We continue to expect starts to bottom at around a 1.40 million unit pace in mid-2007. * The index of leading economic indicators is expected to rise 0.2% in December, its fourth consecutive monthly advance, with positive contributions from jobless claims, stock prices and the money supply more than offsetting the negative impact associated with a flatter yield curve and a dip in consumer confidence.
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The 2007 Story Is Not Yet Written
January 15, 2007
By Eric Chaney | London
Quite wisely in my view, ECB’s President Jean-Claude Trichet crushed expectations of a refi rate hike at the next Governing Council Meeting, at the press conference that followed the January 11 meeting. Because markets had become accustomed to the ECB hiking by 25bp every other month, the traders’ community was betting on a continuation of this metronomic normalisation. The reasons why the ECB needs more time to take a decision are clear: the impact of the German VAT rate hike, both on prices — the ECB’s main goal — and the real economy — the ECB’s contingent goal — will still be unclear at this date. A minimum of two months of observations of the German CPI, but also of business surveys such as the Ifo tally, is required to make a reasonable assessment of the impact of the VAT hike. At this stage, a 25bp rate hike looks likely, as my colleague Elga Bartsch wrote in her post ECB meeting note, Mark Your Diaries for March. As Elga notes, Jean-Claude Trichet used the coded words “we will monitor the risks to price stability very closely” (without using the other coded word “strong vigilance”), which seems to indicate that the Council has in mind a rate hike in the near future, although not immediately. This makes sense, in my view. By any measure, monetary policy remains growth-friendly, with real short-term rates around 2%, i.e., below average GDP growth in the last two quarters (2.3% quarterly annualised on our rather conservative estimate: a surprisingly strong 4Q German GDP, i.e., above 4%, is a distinct possibility), and long-term rates only a quarter of a point higher, despite the recent rise in bond yields. Besides, loans to the private sector were still on a double-digit slope last November (11.2% year on year), with housing loans slowing only marginally, from 10.4% to 10.2%. As I mentioned in last week’s Weekly International Briefing, euro area manufacturers are anticipating a rather smooth transition into 2007, after a very buoyant end of year (Towards A Smooth Transition into 2007, January 5, 2007). On the other hand, risk premia are still desperately flat, attracting ever more leveraged capital into ever-riskier assets. A lot of theories are competing to explain why risk premia, including the term premium on long government bonds, are so low, some of them arguing that the explosive development of ‘over-the-counter’ or tailor-made structured products such as CDOs could make central bankers impotent. Although these ideas are interesting, the evidence is still scarce and I would understand why the ECB, which has to manage a financial system that has never been stress-tested in real life, is willing to quiet down the markets by using its sole tool, the refi rate, provided that the real economy is robust enough to absorb higher rates. However, nothing is written in advance. More than ever, uncertainties are quite high, and I am not talking about the US economy, commodity markets or geopolitical risks. Uncertainties are generated by factors internal to the euro area. I see three items, two directly related to the German VAT, one only partially. As already mentioned, the impact of the German VAT hike on retail prices is, for the time being, pure guesswork. Even more importantly, its impact on the real economy will remain uncertain for several months. According to German producers, demand at the end of last year was growing as fast as in 1990, the year when Eastern Germans’ purchasing power was boosted by conversion of the Eastern Mark, which resulted into white hot demand for Western German goods. Our suspicion is that, this time, this could be explained by massive purchases of durable goods ahead of the VAT increase. If this explanation holds, then demand might contract dramatically in the first months of this year. The next factor of uncertainty is one that matters a lot for the ECB, namely the behaviour of consumers’ expectations on inflation. Measured through the consumers’ survey compiled by the EU Commission (and quantified by a simple regression on past inflation, until the introduction of euro banknotes), inflation expectations have increased since early 2005, after having plummeted in the aftermath of the conversion of retail prices in euro terms. Meanwhile, actual inflation was relatively stable, fluctuating between 1.5% and 2.5%, and perceived inflation (by the same consumers) was even more stable. In pre-euro years, perceived and expected inflation were both closely correlated to actual inflation: consumers took stock of the inflation trend and extrapolated it. This is no more the case. Even more at odd with the past, expected inflation has increased over the last five months, while actual inflation was declining, thanks to lower energy prices. A possible explanation is, again, the German hike, that was largely publicised in Germany several months ago. But the truth is that we do not fully understand what is driving inflation expectations in the euro area, precisely at the time when some important changes are taking place. In conclusion, I would urge caution for traders and investors regarding the future path of monetary policy. We cannot exclude a temporary ‘hard landing’ of final domestic demand after the December boom. Also, risks to inflation seem tilted to the downside, with crude oil prices close to breaching the US$50/bbl target that we had set for … 2008, on the downside. Normally, core inflation should rise, as a result of the VAT hike. On the other hand, headline inflation could well drop to 1.5% in the next few months, if commodity prices continue to fall. This would create some difficulties for ECB hawks, who have done their best to discredit the concept of core inflation last year. In short, a rate hike in March is likely but it is by no means a done deal at this stage.
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Stability Brings Complacency
January 15, 2007
By Gray Newman | New York
With the nervousness seen in markets at the start of the year, it might seem overly naïve to be upbeat on the prospects for Latin America for 2007. After all, the region has produced super-sized returns for investors in recent years as it has benefited from a period of unprecedented Chinese demand which in turn has boosted prices for commodities and contributed to a prolonged bout of above-trend US growth and low interest rates. Commodity prices have now begun to tumble, with oil off by nearly 10% in the first week of the year to its lowest level in 18 months. Meanwhile, the US economy has slumped in the post-housing-bubble shakeout and there are still questions over the extent of the fallout on US consumer spending. And interest rates have been on the rise. What then makes us upbeat on Latin America in 2007? It is the arrival of macro stability and a dose, however partial, of certainty. In a region where growth has frequently been punctured by crises which have brought down currencies, economic models, central bank governors and heads of state, the mere fact that 2007 should mark the fifth year of good growth and low inflation is an important accomplishment. Is it enough? I would argue most certainly not. Most of the region’s inhabitants still suffer from glaring shortcomings — from inadequate healthcare and education to an irregular regulatory framework — all of which have limited stronger growth in productivity and ultimately incomes. But after decades in which certainty was often the scarcest resource in the region, I would argue against underestimating the power of a dose of stability. Brazil: A dose of stability
Perhaps nowhere is the change that the region is undergoing clearer than in Brazil. Just four years ago, Brazil watchers were engaged in a debate over whether the country was on a path leading to debt default and capital controls. Today, Brazil’s net public external debt (net of international reserves) has turned to a net asset position, its domestic debt is declining and inflation is hovering not far from that seen in the US. My optimism on Brazil might seem mistaken. Indeed, Brazil’s disappointing growth record has prompted calls from within the global economics team at Morgan Stanley to strip Brazil of its place within the BRICs (see Hitting a BRIC Wall, in WIB, week of October 2, 2006.) But I would argue that this is precisely the wrong moment to disqualify Brazil from its place within the BRICs. I suspect that Brazil is on the verge of much stronger growth in 2007 and in the coming years as it delivers continuity on the macro front of the sort that we have seen in recent years. My upbeat assessment on Brazil’s growth path in 2007 is predicated on significant interest rate reductions in Brazil. Indeed, perhaps nowhere in the emerging markets is the case for a reduction in rates stronger than in Brazil. Inflation in Brazil has plummeted even as real rates have remained largely unchanged. And that, I believe, sets Brazil up for an important bout of monetary easing in 2007 as real rates begin to decline at a pace previously reserved for nominal rates. We are forecasting the Selic interest rate to fall to 11.25% by the end of 2007 and to fall further still in 2008. With real rates set to fall to their lowest level in decades, I think it will not be difficult to see Brazil’s growth path surprise on the upside. But I would warn against confusing good growth in 2007 with a long-term path of stronger growth. This year Brazil should benefit from lower rates. However, to sustain even more robust growth, Brazil needs a stronger investment platform and that means changes in the regulatory environment, improved infrastructure and a healthier public sector. And on that front, the signals from the administration have been mixed. A long-awaited program of economic reform measures was postponed repeatedly in late December and while the final program is now set for release on January 22, it does not appear that Brazil’s policymakers will make much, if any, progress in reforming Brazil’s fiscal quandary, which includes an inadequately funded social security program and an ever-increasing spiral of current expenditures and tax burden. The good news is that the authorities are likely to take advantage of some of the current fiscal windfall coming from lower real interest rates to boost public investment in critical areas of infrastructure. Unfortunately, it is not clear that they will also use the improved fiscal accounts to help fund a reduction in the tax burden which remains very high or try to sort out the ever-burdensome weight of pensions on the public finances. Until Brazil tackles some of its fiscal challenges and makes further progress on the micro reform front, I am afraid that the recovery in 2007 will fall short of what could be a period of even more robust growth. Stability in Brazil unfortunately appears to be breeding complacency. Mexico: No crisis, no relief
Like Brazil, Mexico is unlikely to make significant progress on a host of items needed to boost competitiveness and the long-term prospects for stronger growth. Indeed, Mexico continues to suffer from a form of ‘convergence curse’ — the inflows that it enjoys are so strong that they have robbed the policymaking class of a sense of urgency on the reform front. If you are looking for a case in which stability produces complacency in Latin America, you can find it in Mexico. But as is the case in Brazil, I still believe that there is room for progress on a stealth reform agenda. Low inflation — core inflation after all has been running within Banco de Mexico’s target range for the past four years — has begat a dramatic extension of the yield curve, the rebirth of mortgages and credit to those who had long been beyond the reach of financial intermediaries. That trend is likely to continue uninterrupted in 2007 and provide a significant cushion to a slowing export-based manufacturing sector. The difference is that in 2007 Mexico is unlikely to benefit from an unusually favorable trio of positive shocks that helped to boost growth in 2006. Last year, Mexico enjoyed new record-high oil prices, a strong US economy at the beginning of the year and what was an unprecedented election spending spree. This year, we expect more modest US growth, a correction in oil prices and the absence of election spending to produce growth much closer to 3.3%. A warning of what 2007 is likely to represent for Mexico came just days into the new year as the price of Mexico’s oil mix fell to just over US$1 above the US$42.80 oil price assumption for the 2007 budget. Just a little over a month ago, Mexico’s oil assumptions were seen as conservative. The budget team had built in a drop of nearly 20% in the price of oil and added a 10% decline in oil export volumes relative to 2006. After three years in which oil prices continued to surprise to the upside, Mexico is now facing the risk that oil revenues could disappoint. And that makes us cautious on the pace of growth in 2007. Argentina: No landing in sight
But perhaps nowhere is the link between stability and complacency greater than in Argentina. With the fastest-growing economy in the region has come a distortionary policy mix ranging from price controls and negative real interest rates to a heavily managed real (and nominal) exchange rate and export regulations and taxes that are tweaked, sometimes on a monthly basis, to control inflationary pressures. I doubt that the policy mix is sustainable in the long term, but I also doubt that the long term is likely to arrive in 2007. Even in the most vulnerable sector — electricity generation — Daniel Volberg and Luis Arcentales do not see major problems in 2007. In fact, we expect the economy to keep powering ahead, albeit at 7% rather than the 8.5% or 9% growth of the past four years, with domestic consumption doing most of the heavy lifting through expanding credit, a real estate market boom and real income growth. Bottom line
I am fairly upbeat on the prospects for Latin America’s major economies in 2007. If our global team is right and the world sees good, albeit slower, growth, Latin America should post another above-trend result. Now, five years into the current growth upturn, I have seen little of the excesses of past upturns in the region. The current cycle has produced neither the ballooning trade and current account deficits fueled by consumer spending seen in the past nor the widening fiscal deficits nor the spectacle of central banks burning through reserves to prop up woefully overvalued currencies. More importantly, the region is in better shape than in the past to deal with a downturn in the global economy. If the world slows by more than we expect, so should Latin America. But I suspect that the risks of Latin America being set up to crash in a down year are greatly reduced. With its fiscal and monetary houses in better order today than in decades, most Latin American economies should fare well in 2007 whether global growth surprises on the upside or the downside. What concerns me the most, however, is whether Latin America’s new-found stability prompts a new wave of muc- needed micro reforms to boost competitiveness and provide for much stronger growth. On that front, I am not optimistic.
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