The Heavy Lifting of Chinese Rebalancing
March 05, 2007
By Stephen S. Roach | New York
The rebalancing of any economy is never easy. Nor is there a boilerplate recipe for such a transformation. For a state-directed Chinese economy, the challenges are very different from those in a market-based economy like the United States. China is now taking an important first step on the road to rebalancing – moving to rein in the excesses of an investment boom and a stock market bubble. A key question for the National People’s Congress as it gathers this week in Beijing: What comes next?
Most believe the answer lies with the Chinese consumer. The numbers are compelling: Private consumption in the world’s most populous nation currently accounts for only about 35% of its GDP – half the elevated share in the US, well below portions elsewhere in the developing world, and quite possibly the lowest consumption share of any major economy in modern history. There’s obviously nothing but upside to the case for the Chinese consumer. It is widely billed as one of the great hopes and opportunities of global rebalancing – capable of picking up the baton of support from China’s overheated investment sector and from an equally over-extended export sector. I wish it were that easy. Centrally-planned or not, China can’t simply push a button to bring its vast consumer sector into play. Consumer cultures, in many respects, are the DNA of market-based capitalism. China has taken only baby steps in that direction. With over 60 million layoffs traceable to the state-owned enterprise reforms of the past decade, job and income insecurity is rife amongst the Chinese workforce. The lack of a nationwide social safety net – especially social security, pensions, and unemployment insurance – only compounds that problem. As such, Chinese households are predisposed toward an inordinate amount of precautionary saving – saving motivated by fear of uncertain economic prospects. Reflecting such high levels of personal saving, China’s national saving rate is currently close to 50% – the highest for any major economy in the world and reflective of a major stumbling block on the road to the development of a vibrant Chinese consumer culture. The results of the latest Gallup Poll of China underscore the serious obstacles that the consumer still presents to a rebalancing of the Chinese economy. We have just obtained access to the results of a tally conducted in October 2006, covering a comprehensive sample of some 3,500 Chinese households (2,500 urban families and 1,000 rural units). Three key findings emerge from this survey that are pertinent to the Chinese consumption outlook: (1) Fully 65% of Chinese households remain dissatisfied with their ability to save – consistent with a powerful precautionary motive to increase saving further. While this is down fractionally from the 68% found by Gallup to be similarly dissatisfied in 2004, it is higher than the dissatisfaction reading of 61% evident in 1997. (2) Widening income disparities are also inhibiting the expansion of a broader base in Chinese consumption. This shows up in both urban and rural areas, where the Gallup tally shows that the difference between the upper and lower quintiles of household incomes increased by about 40% in 2006 relative to that prevailing in 2004; these are the largest increases in income inequality in the 10-year history of Gallup’s China Poll, especially for the rural population. (3) The lifestyle benefits of urbanization are concentrated in China’s “Top 10” cities; by contrast, citizens in “Middle China” – medium-size urban centers – remain very much on the outside looking in. The latest Gallup tally shows that income disparities in China’s 10 largest cities increased in 2006 by only half the amount evident in the entire urban population – implying that the deterioration of income gaps was much worse in medium-size urban centers. These findings are not lost on Chinese policymakers, who are very focused on a pro-consumption rebalancing of the Chinese economy. The 11th Five-Year Plan enacted by the National People’s Congress a year ago addressed two of these issues head-on – the need for a national safety net and the imperatives of tempering rising income inequalities. Greater priority was placed on support for the woefully under-funded National Social Security Fund, which currently holds just RMB 300 billion, or roughly US$30 per capita. Emphasis was also placed on rural income support – especially tax incentives and improved medical and educational allowances. In addition, the latest Five-Year Plan was explicit in identifying China’s relatively undeveloped service sector as a new and important source of job creation in the future. With downsizing in manufacturing-based state-owned enterprises likely to continue for the foreseeable future, Chinese leaders recognize the need to draw increased support from labor-intensive tertiary industries – especially those involved in distribution and delivery, like wholesale, retail, and trans-national shipping. On balance, the 11th Five-Year Plan is probably the most pro-consumer effort ever put forth by the Chinese leadership. But it underscores how far China needs to go in removing the obstacles that currently inhibit the development of a flourishing nationwide consumer culture – a challenge I suspect will be actively debated at this year’s national People’s Congress. China’s consumer-led rebalancing is only just beginning. I believe it will take at least 3-5 years for these efforts to bear fruit. Similar constraints are evident in China’s saving and capital allocation mechanism – and in the financial-sector reforms that such breakthroughs would require. China has made major progress in the areas of banking and capital markets reforms in the past five years. But these initiatives have effectively started from “ground zero.” The public listing of three of China’s largest banks was a very important step in the creation of a new financial system – especially in instilling the shareholder-value culture that will ultimately drive profitability and discourage lax lending practices. But, here as well, this is a long and arduous road for China – especially the transformation of legions of former government bureaucrats into discriminating bank lending officers. In the end, the integrity of a prudential lending function – and the competence of lending officers – is the essence of a market-based credit culture for any economy. Through strategic alliances with several major foreign banks, China is making progress in this area, but the heavy lifting in the personnel, systems, and risk management areas of Chinese banking reforms has only just begun. Two other obstacles compound the capital allocation problem in China – the currency regime and a lack of progress on broader capital market reforms. I am not a believer in the notion that China’s currency policy is a threat to global trade. I feel, instead, that many in the developed world – especially the saving-short United States – are treating RMB-related issues as scapegoats for their own macro shortcomings. I worry more about China’s quasi-fixed currency regime as a source of its own domestic instability – largely in fostering massive speculative capital inflows and a build-up of foreign exchange reserves that then have to be recycled into dollar-based assets and neutralized through a massive “sterilization” exercise. To the extent that China’s undeveloped domestic debt market makes such sterilization difficult, then excess liquidity undoubtedly spills over into its banking system. The latest trends in bank lending underscore this problem: Despite a series of recent hikes in bank reserve ratios, RMB loan growth accelerated from 13% y-o-y in June 2006 to 16% in December. With China’s policymakers trying to clamp down on excessive investment, curtail an equity bubble, and limit a new wave of nonperforming bank loans, the persistent excesses of bank lending growth continue to complicate the macro control problem (see my 28 February dispatch, “China Squeeze”). An equally glaring shortcoming is China’s lack of capital market development – especially the low level of activity in its corporate bond market. In 2006, China’s domestic capital markets -- equity and bonds, combined -- accounted for only about 18% of total funds raised by the business sector; equities accounted for the bulk of that total, whereas corporate bond issuance made up only about 3% of overall funding. Banks, on the other hand, accounted for fully 82% of total credit intermediation. That underscores yet another obstacle on the road to rebalancing: China’s fragmented and still largely unreformed banking system has long been focused on funding a vast network of inefficient and largely unprofitable state-owned enterprises. In the past, this has led to a massive surge of nonperforming loans – a problem that could well resurface once the dust settles on the current bank-funded investment boom. Over-reliance on still inefficient banks, in conjunction with the lack of a capital-markets-based discipline, underscores the serious risks of a misallocation of Chinese saving and resources. China is at a critical juncture. Over the past 15 years, its powerful investment- and export-led growth model has been driven by bank-directed recycling of its massive pool of domestic saving. Coupled with aggressive and unprecedented reforms of its state-owned enterprises, China’s transition to “market-based socialism” has been nothing short of spectacular. But this model is now in danger of outliving its usefulness. The investment sector has gone to excess and the export dynamic is in danger of triggering a protectionist backlash. The lack of a vibrant consumer sector, in conjunction with the legacy effects of state- and bank-directed capital allocation, are critical obstacles that must be overcome if the Chinese economy is to move to the next level. China’s unbalanced macro structure is also presenting its leadership with major cyclical control problems. Lacking in well-developed market-based systems, China recently upped the ante in opting for “administrative controls” to cope with its mounting imbalances (see “China Squeeze” cited above). The latest such actions – state-directed equity selling and a clampdown of short-term foreign borrowing by domestic Chinese banks – may well have played a key role in sparking a worldwide equity market correction in late February. In my view, they were not one-off developments. Based on Premier Wen Jiabao’s opening speech to the National People’s Congress, these actions may only be the first salvo in a broader tightening campaign. Yet this approach is not without its own shortcomings. Administrative actions not only underscore the state-dominated mindset that still pervades the China model, but they also are stop-gap measures that circumvent market-driven solutions. In my view, the only viable answer is an acceleration of reforms – focusing both on the nascent consumer as well as on an embryonic financial system. A successful rebalancing of the Chinese economy is essential to avoid the boom-bust cycles that were so prevalent in the past. Yet until the obstacles to rebalancing are removed, China’s overheated investment sector and over-extended exports pose increasingly serious risks to sustainable and stable growth. Brilliant as its success has been since the early 1990s, China can no longer afford to stay the same course. A new direction is essential – and the sooner the better. As the National People’s Congress now meets in Beijing, the obstacles to Chinese rebalancing – and the tactics to overcome these obstacles – could well be at the top of its agenda.
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Liquidity, Volatility and Financial Markets
March 05, 2007
By Richard Berner | New York
Strongly growing liquidity and declining volatility have supported financial markets and the global expansion over the past few years. In turn, a resilient global economy has reinforced booming liquidity, promoting widespread investor complacency. But at the start of 2007, it appeared to me that macro, or funding, liquidity from both official and private sources would ebb over 2007, and that market volatility would increase, courtesy of mounting uncertainty about the outlook and dwindling market liquidity (see “Critical Macro Investment Themes for 2007,” Global Economic Forum, January 3, 2007). That was then. Barely two months later, liquidity has ebbed more dramatically than I thought likely and volatility has suddenly spiked, turning complacency into caution and taking down risky asset prices globally. Assessing how far the meltdown will go involves investor emotion: Caution probably must turn into fear and capitulation before this market correction begins to bottom. To guess how far the liquidity and volatility pendulums might swing back, it is also important to understand what were the sources, how persistent are the triggers for the recent reversal, and whether one can separate the cyclical from the secular forces at work. First, it’s useful to distinguish between two aspects of liquidity. The macro aspect, or what is commonly called funding liquidity, reflects credit availability provided by central banks or private sources. The micro dimension, or market liquidity, reflects the extent to which participants can rapidly execute large-scale transactions with little impact on prices. It’s worth stating the obvious: Each of these separate but closely related dimensions to liquidity can reinforce the other; for example, tighter monetary policy raises the cost of trading and absorbs the resources needed to effect large trades. Likewise, there are two aspects to volatility — fundamental volatility resulting from unexpected changes in the key drivers of price, and transitory volatility that results “when the demands of impatient uninformed traders cause prices to diverge from fundamental values” (see Larry Harris, Trading & Exchanges: Market Microstructure for Practitioners, Oxford University Press, 2003, p 413). These two aspects of volatility are closely related, and each can reinforce the other. For example, the subprime mortgage meltdown changed perceptions about all lenders in varying degrees and triggered a rush to sell by investors previously complacent about credit risk. And of course, an erosion of market liquidity boosts volatility, while large demands for liquidity by impatient traders prompt the suppliers of liquidity to lower bids. Importantly, the transitory component of volatility tends to reverse, indicated by strong negative correlation in successive (serial) price changes. So how do these factors play out in the current context? In my opinion, the global expansion and the associated rise in commodity prices fueled macro or funding liquidity. That aspect of liquidity is now gradually fading as the growth in private sources of liquidity — from high-saving Asian economies and oil and other commodity producers — continues to slow. The renormalization of monetary policies is just as critical; the Fed remains on hold and central banks abroad are either moving toward restraint or maintaining rates relatively high compared with inflation. How to measure such macro liquidity? As I see it, disintermediation, securitization, and globalization have rendered the monetary aggregates — which largely represent the liabilities of depository institutions — less useful measures of overall financial liquidity than in the past. I’m sympathetic to the idea that with Japanese rates at just 50 basis points, the yen remains the funding currency of choice for global carry trades — but I have no idea how to gauge their importance. Instead, I would look to four other macro proxy metrics for US and global liquidity, which on net are beginning to show signs of deceleration. First, the share of liquid assets relative to debt for nonfinancial corporations is still close to a forty-year high, but has declined by about 100 bp in the past year. Second, commercial banks over the past six months reported in the Fed’s Senior Loan Officer Survey that they have stopped easing their lending standards. Third, Morgan Stanley industry analysts report that credit conditions deteriorated in January and February, although small businesses reported that credit has been no harder to get over the past five months. Finally, the growth in reserves in oil-producing and non-oil developing countries decelerated to about 18% in November, down sharply from 30% a year ago along with the flattening in commodity prices. China’s successive moves to rein in its mounting economic and financial imbalances were one factor igniting global growth fears. Now that such concerns are depressing commodity prices, it is likely that this source of macro liquidity is fading further. As for the micro dimension of liquidity, a long period of financial market calm, the perception that it would persist, and the explosive growth of new and untested risk-management tools encouraged a benign market consensus and increased risk taking. Now, the emergence of credit events — notably the subprime mortgage meltdown — and that slow withdrawal of funding liquidity are eroding market liquidity. In the subprime mortgage arena, the bid-asked spreads on the ABX BBB- 07-01 index reportedly have widened to 8-10 bp as wild swings in investor sentiment undermined the willingness of traders to commit capital. And I agree with my colleague Jim Caron that the widening of swap spreads — the benchmark funding spread for banks and other intermediaries — as Treasuries rallied is a sure sign of eroding market liquidity. Ten-year swap spreads have widened by ten bp over the past month to 58 bp. Conversely, whether swap spreads narrow as the flight to quality ebbs would be a test of the market’s resilience. Turning to volatility, at issue is how much of the prior volatility compression was secular and how much was cyclical. Three secular factors reduced volatility for a couple of decades. The volatility of economic activity and inflation has steadily declined in what is called the “Great Moderation.” Financial innovation has spread risk more broadly across market participants; the growth of the structured credit market suppressed volatility by enabling market participants to lay off risk ever more easily in liquid markets. And central banks have become more transparent about goals and their strategy to achieve them, while becoming more explicit about the likely path of interest rates consistent with their objectives. The secular factors won’t go away quickly, so a major reversal in volatility’s trend isn’t likely. To the extent that central banks continue their explicit guidance, moreover, volatility and “term premiums” — the compensation for moving out the risk-free yield curve — will correspondingly stay depressed. That implies permanently flatter yield curves than in the past (see “Will Volatility Rebound?” Global Economic Forum, September 11, 2006). However, two cyclical factors also depressed volatility over the recent past. Believing the secular story, and experiencing moderate but steady GDP growth over the past few years, investors increased their appetite for risk. And many market participants seeking to enhance yield expressed their volatility view by selling it in liquid markets. Those cyclical factors are now changing quickly as uncertainty about the economic, credit, and monetary policy outlooks increases. The interplay of weak economic data, fears of a credit crunch, lingering inflation risks, and rising energy prices, combined with the reduction in liquidity discussed above are producing rapid changes in asset prices. And I sense that those factors are promoting a watershed change in investor perceptions; market participants may be deciding that the volatility they’ve been selling is now cheap. So while the VIX falling to 12 seemed to reassure investors of a benign outlook, a VIX spiking to 19 makes them much more nervous. Balancing those forces, a return to the volatility levels of ten or fifteen years ago seems highly unlikely. But the unwinding of the cyclical factors does seem likely to promote a further pickup in volatility from current levels. Financial market turmoil has promoted a flight-to-quality rally in Treasuries, but ebbing liquidity and rising volatility likely will boost term premiums and contribute to a steeper yield curve. Just as declining term premiums contributed to both lower long-term yields and an inverted yield curve, and ironically increased financial stimulus, so now should rising term premiums boost long-term relative to short-term yields, producing a gradual tightening in financial conditions. Market participants now believe that sinking markets will force the Fed to come to the rescue, pricing in an easier monetary policy as soon as June. But Fed officials are signaling that the “Greenspan put” ended when he left office; they do not intend to bail out markets with monetary ease. Chairman Bernanke indicated last week that the outlook had not materially changed; he probably agrees that the economy isn’t as sensitive to changes in financial conditions as many market participants believe (see “Does Market Turmoil Change the Outlook?” Global Economic Forum, March 2, 2007). New York Fed President Geithner implied that building strong financial shock absorbers was the right tool for the job of safeguarding markets and the economy from financial shocks. To be sure, events are moving quickly: If the consequent tightening in financial conditions began to turn into a credit crunch that would threaten the expansion, Fed action could follow. But it most likely would take the form of supplying funding liquidity on a case-by-case basis rather than lowering interest rates. Lower inflation and inflation expectations are the key factors that will prompt officials eventually to ease. And while the recent developments are disinflationary, it will take time for them to affect inflation. Risks to this scenario abound. Downside economic risks are now marginally higher because financial conditions are slightly less growth-supportive. In the extreme, uncertainty about the economic and credit outlook will continue to weigh on markets and could turn the virtuous circle of ample liquidity, low volatility, and strong growth into a vicious one. Uncertainty about who holds the risks in a securitized, structured credit market may reinforce those developments. Another risk, highlighted by my colleague Steve Roach, is that the leftward swing in the political pendulum could intensify latent protectionism. Protectionism and diversification away from the dollar could serve as potent catalysts for still higher volatility. Conversely, while risk aversion is rising among market participants, market risks may now be slightly lower because the price action has taken some of the froth out of equity and credit markets.
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Review and Preview
March 05, 2007
By Ted Wieseman | New York
Treasury yields plunged to their lowest levels since early December the past week, the market’s strongest since the immediate aftermath of Hurricane Katrina in 2005, and the curve steepened sharply on a huge flight to safety bid from turmoil of varying degrees — but in any sort of longer-term context mostly nothing too significant — in various markets. Treasury strength wasn’t just flight to safety, however, as investors still apparently believe in the old ‘Greenspan put’ and also moved to price in a high probability of a near-term Fed rate cut, despite the current Fed Chairman’s indicating clearly that nothing of the sort was under consideration, describing the market as “working well, normally” and saying that “there is really no material change in our expectations for the US economy”. It’s hard to imagine even former Fed Chairman Greenspan, who didn’t get tarred with the ‘Greenspan put’ reputation without some justification, considering riding to the rescue after a 4% stock market drop, much less the seemingly much more level-headed Chairman Bernanke. That certainly didn’t stop the market from pricing such a response, however. The economic data calendar was quite busy over the past week, but had limited market impact given the focus on activity in other markets, especially stocks, with Treasuries trading virtually tick-for-tick with the S&P 500 (both cash and, in overnight trading, futures) for much of the week. There were some sharply divergent results among the key reports, but overall the data were market supportive, providing at least some fundamental basis for the plunge in yields. A terrible durable goods report that led us to slash our 1Q investment forecast more than offset stronger-than-expected consumption numbers in the personal income and spending report and led us to reduce our 1Q GDP forecast to +2.2% from +3.0%. Another miserable jobless claims report led us to cut our non-farm payrolls forecast — certainly the key fundamental focus in the upcoming week — to just +25,000 from +50,000. We expect construction payrolls to be particularly ugly, and a collapse in both new home sales and spending on new home construction reported the past week further emphasized the ongoing weather-driven payback in housing after the artificial lift to activity late last year raised false hopes of a bottoming out in the sector. But, on the positive side, the factory sector returned to growth in February according to a significantly better-than-expected ISM report, suggesting that while the housing recession drags on, the manufacturing downturn is at least easing after the apparent trough in auto assemblies in January, made further likely by better-than-expected motor vehicle sales results in February. Despite the ongoing collapse in sales and starts, home prices continue to decelerate only very gradually, helping to insulate consumers, who appear on track to spend their way to another sharp gain in consumption in 1Q and, at least according to the Conference Board’s survey, remain quite upbeat. And arguing strongly against the market’s belief that Fed rate cuts are right around the corner, the extended period of sub-par growth continues to do nothing to get inflation back to acceptable levels, with an acceleration in January to just below the cycle high in core PCE inflation. On the week, benchmark Treasury yields plunged 13-25bp and the curve steepened significantly. The 2-year yield fell 25bp to 4.55%, the 3-year yield 24bp to 4.475%, the 5-year yield 21bp to 4.45%, the 10-year yield 17bp to 4.51%, and the long bond yield 13bp to 4.65%. The resulting 12bp steepening in 2s-30s to +10bp, a high since October, certainly gave the move a ‘flight to safety’ feel, as did a significant widening in swap spreads, with the benchmark 5-year spread rising about 5.5bp and the 10-year 4bp. On the other hand, the move was also accompanied by just as dramatic a repricing of the Fed in the futures market, where the likelihood of a cut in the funds target to 5% is seen by the June FOMC meeting, 4.75% by year-end, and 4.50% by early 2008. In the fed funds futures market, the May contract rallied 6bp to 5.185% and the July contract 15.5bp to 5.06%, putting the odds of a rate cut by the May FOMC meeting at about 35% and by the June meeting at 75%. A move to 4.75% by year-end is seen as certain, as eurodollar futures gains were led by a 28bp surge in the Sep 07 contract to 4.935% and 27.5bp gain in the Dec 07 contract to 4.795%, respectively, while a further move to 4.50% in the first part of 2008 is also now fully priced in, with the Mar 08 contract gaining 24.5bp to 4.70% and the June 08 contract 21.5bp to 4.665%. That 4.50% level is the expected trough at this point, down from the 4.75% low seen a week prior, with the low rate Sep 08 contract ending at 4.65% after 19.5bp rally. TIPS had a very good week, continuing their recent impressive performance. The 5-year TIPS yield fell 23bp to 2.05%, actually outperforming the nominal 5-year by 2bp, an astounding performance in such a big rally. The 10-year TIPS didn’t do quite as well, but was still very strong, with its yield down 15bp to 2.15%, trailing its nominal counterpart by just 1bp. All this was in response to such relatively minor corrections in markets that had been in non-stop rally mode for months and months. The S&P 500 ended down 4% on the week after having rallied almost continuously since the middle of July by a cumulative 18%. Credit spreads widened meaningfully on the week, but also by relatively modest amounts considering their prior runs. The current series 7 5-year Hi-Vol and investment grade CDX indices widened about 16bp and 7bp, respectively on the week. But this followed a major narrowing over the same period that stocks were ramping higher. The older series 5 Hi-Vol and investment grade indices had previously tightened about 40bp and 20bp, respectively since mid-July through the prior Friday’s close. The yen rallied significantly, rising to 117 from 121, but this just left it around the middle of the range it’s been in since the fall of 2005. Did this signal some big carry trade unwind? As Stephen Jen has often noted, most of the FX investors he talks to seem to believe that there’s a huge amount of yen carry trades out there even though none of them actually seem to be in these trades themselves. Ironically, the small sector of the market that helped kick off this whole mess, sub-prime mortgages, actually rallied on the week. The ABX BBB- 07-01 index initially continued plunging, falling another 9% from Friday through Tuesday on top of the 30% plunge over the prior month. But this marked, at least for now, the trough — the index rallied Wednesday, Thursday and Friday to more than reverse the prior losses and actually close up slightly on the week. Are we seriously to believe that minor corrections in stocks and credit markets after huge prior rallies, some stop outs in the FX market, and an actual rebound in the previously focused on sub-prime mortgage market threaten the financial system and economy enough to warrant a near-term Fed ease in the face of accelerating inflation? We’re not exactly talking about the 1987 stock market crash or the 1998 LTCM/Russia fixed income market meltdown here. A number of reports released the past week bearing directly on GDP growth led us to further reduce our estimate for 1Q to +2.2% from +3.0%, with the awful durable goods report the predominant influence. This would match the downwardly revised +2.2% reading for 4Q (down from the advance estimate of +3.5%). Both the overall result of the 4Q revision and the component details were very close to expectations and thus had no impact on our outlook for 1Q. After a non-stop series of cuts to our first quarter forecast from the high just below 4% after the wholesale trade report was released on February 8 to a low of 2% early this past week on the durables report, we at least finally got a break from this depressing pattern later in the week when the personal income and spending report led to a slight upward adjustment. Durable goods orders plunged 7.8% in January. While a 60% drop in the volatile civilian aircraft component contributed to the downside, underlying details were nearly as weak and downside was broadly based, with ex transportation orders down 3.1% and the key core gauge — non-defense capital goods ex aircraft — plummeting 6.0%. Weakness in core orders was seen in sharp drops in both machinery (-9.3%) and high tech products (-7.8%), the latter led by a plunge in telecom equipment (-19%). Non-defense capital goods shipments fell 2.7% in January on top of a downwardly revised 0.8% drop in December, much worse than we had assumed, pointing to continued softness in 1Q investment. Incorporating these results, we slashed our estimate for 1Q equipment and software investment to 0% from +8%. Personal income surged 1.0% in January and spending rose 0.5%. BEA included a big boost to wage and salary accruals in 4Q in the GDP revision to account for surging bonuses and stock options, which will show up (apparently in equal monthly amounts based on the January details) in actual payments in 1Q. This is apparently helping to keep consumer spending rolling along after the 4.2% jump in 4Q. With the overall PCE price index up 0.2% in January, real spending gained 0.3%. This was slightly better than we expected, and December was revised up to +0.4% from +0.3%, providing a stronger starting point for the first quarter. As a result, we boosted our 1Q consumption forecast a half point to +3.8%. Netting this upward adjustment to consumption against the downside to investment from the durables report, we cut our 1Q GDP forecast to +3.0% from +2.2%. This result also included a slightly more conservative assumption for inventories (which we have adding a bit less than half a point to 1Q growth after subtracting nearly 1.5 points in 4Q) after the better-than-expected motor vehicle sales results for February — 16.6 million unit annual rate versus 16.7 million in January, with positive mix shifts between cars and trucks and domestics and imports — led us to build in a larger drag from continued heavy motor vehicle inventory destocking. There was a lot of housing-related data released the past week that, following the previously reported collapse in January housing starts, further confirmed that the improvement seen in various housing data last year was almost certainly merely a result of the unusually warm weather and that a big payback is underway now that winter has finally arrived. New home sales plunged 16.6% in January to a 937,000 unit annual rate, a four-year low, as the upside late last year that was likely solely a result of the unusually warm weather was more than reversed. Meanwhile, existing home sales gained 3.5% in January to a 6.46 million unit annual rate. Existing home sales are counted at closing and new home sales at contract signing, so the lagging upside in the former reflects sales initiated during the very warm early part of the winter. Existing home sales will likely follow this renewed weakness in new home sales (though to lesser extent most likely, given the lesser volatility in the existing numbers) with a lag in the months ahead. The supply of unsold new homes fell for a sixth straight month for a cumulative 6.5% drop, but with the much lower sales pace, the months supply jumped to 6.8 from 5.7. Still, after the sharp drop in starts in January, inventories should resume moving back into better balance in the months ahead. The construction spending report similarly reflected plummeting homebuilding in January. Overall construction spending fell a slightly larger-than-expected 0.8% in January, but December was revised up significantly to +0.6% from -0.4%. But backing out a ridiculous surge in home improvement spending (note that BEA ignores the home improvement spending data in this report in estimating the corresponding component in GDP) the results were significantly worse than they first appeared. Spending on new single and multi-family homebuilding plunged 3.9% in January, the biggest monthly drop in the 14-year history of these data. The net result of this report was no impact on our GDP forecast, but a changed mix among the components. The upward revision to December pointed to stronger business investment in structures (combined with our flat estimate for equipment and software we see overall business investment rising about 1%) and government spending in 1Q, but this was fully offset by a weaker trajectory for residential investment. Indeed, we now see 1Q residential investment plunging 20%, slightly worse than the 19% annualized decline seen in the second half of last year. Against all this housing gloom, a bright spot was home prices. Home price gains continued to decelerate only gradually in the fourth quarter. The OFHEO House Price Index — the best available measure since it measures repeat sales and thus is not distorted by shifts in the mix of homes sold — rose 1.1% sequentially in 4Q for a 5.9% year/year gain, down from +7.9% in 3Q. This was the smallest annual increase in seven years and down from a peak of +13.8% recorded in 2Q05. This relatively solid result appeared to help spark the rebound in the ABX index seen in the latter part of the week. The weather-related housing payback should be a major contributor to what we expect to be an ugly employment report on Friday. Following another terrible weekly jobless claims report — with particular focus on a 134,000 surge in continuing claims to the highest level since December 2005 during the survey week for the February employment report — we cut our estimate for February non-farm payrolls to +25,000 from +50,000. This would be the worst outcome since job growth finally resumed in mid-2003. We expect a particularly nasty result for construction jobs, which jumped a combined 32,000 in January and December, likely just as much an artificial result of the unusually warm weather as all the other housing data that showed upside late last year and have since collapsed with the arrival of cold temperatures. Note that the survey week for January employment report fell during the warm early part of the winter, so February will be the first report to reflect normal cold weather. A big payback in construction jobs seems quite likely to us. While the housing recession shows no signs of letting up, the economy’s other weak leg, manufacturing, seems to be on the mend as the auto recession may be bottoming out following the apparent trough in assemblies in January and the upside in February sales. According to the ISM, factory sector growth resumed in February, as the ISM composite diffusion index jumped 3 points to 52.3, a five-month high. Upside was led by strong gains in the orders (54.9 versus 50.3) and production (54.1 versus 49.6) gauges. The employment index (51.1 versus 49.5) posted a smaller rise but still moved above the 50-breakeven level for the first time since October. The smaller weighted supplier delivery (50.8 versus 52.7) and inventory (44.6 versus 39.9) measures were mixed and largely offsetting. Growth was broadly based, with 13 of 18 industry groups reporting expansion, a high since June and up from only 7 in January. With our current +2.2% 1Q GDP estimate, we seem now to be into our fourth straight quarter of sub-par growth, and yet inflation refuses to budge, remaining stubbornly near the cycle high and above the Fed’s comfort zone, making any near-term easing in rates unlikely. After a +0.25% reading for the core PCE price index in January (just barely rounding up to +0.3%) after two straight +0.1% outcomes, the annual rate reaccelerated, ticking up to +2.3% from +2.2% in December. This was just below the cycle high of +2.4% seen in August and September and actually higher than the +2.0% recorded last March before the start of the current period of below-trend growth. Fundamental news focus (if there is any) will be on Friday’s employment report through the coming week. In the meantime, there will be a number of Fed speakers as well as the Beige Book Wednesday as we approach the March 20-21 FOMC meeting, another two-day meeting to allow for another extended discussion in the Fed’s interminable review of its communications policies. The reopening of the 10-year note will be announced Thursday for auction the next Tuesday, with an unchanged US$8 billion size likely. In addition to the employment report, notable data releases include the non-manufacturing ISM Monday, revised productivity and factory orders Tuesday, monthly chain store reports from most companies Thursday, and the international trade report Friday: * We expect 4Q productivity to be revised down to +1.5% and unit labor costs up to +6.5%. The downward revision to 4Q GDP is expected to lead to a similar adjustment to productivity growth relative to the original reading of +3.0%. Factoring in the expected 4Q change, as well as some modest adjustments to hours worked implied by the annual revision to the labor market data, implies a 4Q/4Q productivity growth rate that should also be in the neighborhood of +1.5%. Meanwhile, based on the revised compensation data for the fourth quarter – which included a whopping US$50 billion of wage accruals related to bonuses and option exercise – we expect to see a significant upward adjustment to unit labor costs relative to the original figure of +1.7%. And, the year/year reading for ULC should be around +3.7% — nearly a full percentage point higher than previously reported. However, it’s worth noting that the spike in compensation reflects special one-time factors and we are likely to see a pullback in 2Q. * We look for a 3.5% plunge in overall factory orders in January, as the sharp drop in the durables component implies a signification fall-off in overall bookings. Meanwhile, both shipments and inventories are expected to edge up 0.4%. * We forecast a 25,000 rise in February non-farm payrolls. The recent movements in both initial and continuing unemployment claims suggest that the arrival of winter weather conditions across parts of the nation will lead to a well below-trend rise in payrolls. In particular, the construction sector appears likely to show significant job loss in February. Meanwhile, the unemployment rate is expected to tick up to 4.7% – the highest since August, but still within the relatively narrow range that has prevailed since the start of 2006. We’re tempted to forecast a weather-related downtick in the average workweek, but this gauge appeared to be unaffected by the severe winter storm that hit during the survey period last February, and we are assuming a similar outcome this time around. Finally, average hourly earnings were surprisingly soft in January given the minimum wage hikes that were implemented in many large states (including New York, California, Ohio, Pennsylvania and Missouri). We look for some catch-up in this report. * We look for a marginal widening in the January trade deficit to US$61.4 billion, with exports and imports both little changed. Based on factory shipment and aircraft industry figures, capital goods exports should be flat, with a semiconductor-led rebound in high-tech products offsetting a pullback in other equipment. Meanwhile, auto exports should be down, in line with the sharp drop in North American assemblies seen in January. And there will likely be some price-related softness in industrial materials. On the import side, a sharp fall in oil prices points to renewed downside in petroleum products after the December bounce. Also, autos should reverse much of last month’s surge. However, a sharp acceleration in Chinese export growth suggests that the timing shift of the Chinese New Year front-loaded some imports into January.
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Benign Economic Fundamentals Will Reign
March 05, 2007
By Stephen Jen | from the Netherlands
Summary and conclusions This is an uncertain environment; many things can indeed go wrong in the global economy and we could see discrete price changes in the financial markets. But my own view remains structurally constructive, as I believe that global economic fundamentals will remain positive and the risky asset prices, in general, should continue to be biased to the upside, even though some previously over-valued markets may not recover. After the dust settles, risk-taking will fully recover, I expect. The sell-off in the sub-prime mortgage market and in some over-valued emerging equity markets is a healthy development, in my view, as it reflects valuation adjustments toward levels better aligned with the economic fundamentals. While further portfolio adjustments may lead to continued volatility in the financial markets for some time, my structural outlook for the global financial markets remains positive. Global liquidity is abundant and the global economy robust. Exchange rates will continue to be driven by cyclical factors, and ‘greed’, not ‘fear’, will dominate in the not-too-distant future. However, the dollar should stay on its back foot as long as the US is in its soft patch. My thoughts on the market movements this week I have the following thoughts on the recent market price action. 1. The sell-offs in the US sub-prime mortgage market and in some emerging equity markets are healthy developments. Watching from a distance, my thoughts on the US sub-prime mortgage market are: (i) why has it taken so long for this to happen; and (ii) if there was a ‘weak link’ in the global financial markets when the US housing market slowed and there had been excessive lending, the sub-prime market would be that link. The credit spread between the good and the bad borrowers is overly compressed and a correction is healthy. Dick Berner usefully drew the distinction between spread widening and ‘credit crunch’ — that as long as the more credit-worthy borrowers have no problem getting credit, we don’t have a credit crunch. To the extent that there is flight to quality, better differentiation between different types of borrowers should actually improve the price at which good borrowers can access credit. Similarly, some of the emerging equity markets had been (and still are) over-valued: our China Equity Strategist Jerry Lou points out that the unweighted P/E average for the Shanghai A-Shares market is still around 36. Corrections in these markets are healthy, and are not a reflection of investors adopting a particularly negative outlook on the global economy; these are merely valuation adjustments. 2. Wholesale contagion is unlikely. I don’t believe that there should be severe and protracted contagion across markets or sectors, though modest amounts of portfolio adjustments may have their expected effects. Incidentally, investors are by no means complacent. Even though ‘greed’ may have dominated their investment strategy in the past four years, they have all ‘lived in fear’, easily spooked, and quick to take profits. Recall what happened last May/June. The simultaneous sell-off in unrelated equity markets earlier this week was a good illustration of how quickly investors unwound risk, when they were spooked, even though it was not clear why a correction in an obviously over-valued Shanghai A-Shares market would/should push down the major indices. In any case, this is what I meant in My Thoughts this past Monday when I compared this event to the ‘Iceland Scare’ some time ago. Recall that there was a certain period when global investors weren’t sure what would happen next. As it turned out, risk eventually returned and the whole episode was put into context. As long as the real fundamentals of the global economy remain robust, I don’t see how we could see a severe and sustained bear market. AUD, NZD and CAD may be good indicators of investors’ risk tolerance. 3. Comparing to last May/June… Two thoughts. (i) The experience of last May/June is regrettable. First, the motivation was psychological, i.e., the whole thing was in our minds. The market erroneously thought that the Fed had fallen behind the curve. This false expectation in turn drove the global sell-off in risky assets. But those who had sold regretted their decision three weeks later. The market has more than reversed since. (ii) This time around, I think that the concerns about the sub-prime mortgage market are genuine, rather than psychological: these sub-prime markets had been over-valued. To the extent that this also raises the issue of valuation in some other markets as well, we could see the corrections in the sub-prime and other over-valued markets be more sustained than back in May/June. In other words, the May/June episode was psychological and global, while the current episode is real and sectoral. 4. Euroland is looking great compared to the US, for now. The growth divergence between these two economies is stark, and will probably persist for several months. Data out of the US are likely to remain on the weak side, while those out of Euroland should continue to surprise on the upside. This could help explain why the dollar performed so poorly in the past week, relative to the EUR; this is not yet the time to buy the dollar. Having said this, we should remember that Chairman Bernanke, back in May 2006, already predicted that the US would fall into such a soft patch, but would reassert itself in 2H. The original release of 4Q GDP confused the market (including myself), but Mr Bernanke’s original scenario seems to be playing out nicely. I am patiently waiting for the dollar to reassert itself in 2H, particularly against the EUR. The ‘Dollar Smile’ only partially working The risk-reduction witnessed earlier this week led to some dollar strength against most emerging market currencies, consistent with my ‘Dollar Smile’ framework. (The USD did not rally hard against the AXJ currencies partly because of the fact that Asia is seen to be less-coupled to the US than before: the more tightly coupled is Asia to the US, the stronger the Dollar Smile effect.) However, in my view, the failure of the dollar to rally hard against the EUR and the JPY has to do with ‘risk-reduction’ rather than wholesale ‘flight to safety’, in addition to the growth divergence I mentioned above. In other words, the sell-off of risky assets in the world was not deep enough to trigger a full-blown dollar smile. Specifically, if the sell-off were driven by a sharp deterioration in global (not just the US) economic fundamentals, I think that the dollar would have rallied against most currencies, not just the emerging market currencies. In any case, I maintain my central case view that the US economy is going through a benign and necessary soft patch, and will reassert itself by 2H. In the meantime, the rest of the world could recover and partially catch up with the US. Bottom line Ultimately, the real US/global economic fundamentals will drive financial prices and risk-taking, in my view. The latest round of risk-reduction is, by and large, healthy. I maintain a structurally constructive outlook on risky assets, based on the opinion that the global economy will remain benign and the global liquidity conditions favorable.
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A Survey of Inflation Risks
March 05, 2007
By Serhan Cevik | from New York
Disinflation is not an idiosyncratic development, but we still need a map of risks. The consumer price index increased at an annual rate of 10.2% in February, slightly higher than 9.9% in the previous month and 9.7% at the end of last year. But there is nothing surprising or distressing in the latest figures, as we had expected inflation to remain in a tight range in the first quarter of the year, before starting to decline in the second quarter. In fact, despite the stickiness in the headline figure, core measures of inflation (such as the CPI excluding energy, unprocessed food, tobacco and gold prices) posted promising readings in recent months, easing to an annualized rate of 5.3% over three months from 7.8% in December and the peak of 13.4% last June. Though we are confident about the extent of disinflation later this year and especially in 2008, we still need a map that could highlight potential hurdles along the way and help us better predict the future path of interest rates. This is why we conducted a survey of qualitative risk assessments that turned out to be one of the most comprehensive of such attempts, covering more than 700 academicians, investors and policymakers. A sudden depreciation of the lira is the major threat to disinflation dynamics. We can bundle certain risks together, as their expected effects on inflation work via the common channel of currency volatility and pass-through to domestic prices. This is indeed a powerful transmission channel in Turkey, given the extent of dollarization, dependence on imports of capital and intermediate goods, and the long history of macroeconomic instability. As a result, on the top of the list (especially of resident participants in our survey) is political risks that may possibly lead to an abrupt dislocation in portfolio choices and thereby currency depreciation. Actually, after last year’s volatility shock, residents have stayed away from lira-denominated assets and accumulated foreign currency-denominated instruments. However, the behavior of foreign investors has been just the opposite, especially in recent months. Foreign holdings of equities and domestic government debt increased to US$67.5 billion, even exceeding last year’s peak before the eruption of financial volatility and thereby supporting the lira’s valuation (see Turkey: Carry-Trade Magnet, February 9, 2007). Consequently, Turkey’s inflation outlook remains sensitive to the changes in global risk appetite and liquidity conditions that could weaken the exchange rate, push up import prices, disturb adaptive expectations and distort pricing decisions, although the lira’s weakness may well turn out to be another short-lived episode. Higher commodity prices are a significant burden on Turkey’s import-dependent economy. The second most quoted risk to inflation is energy prices and external imbalances. Indeed, the surge in oil prices increased Turkey’s energy imports from US$11.6 billion in 2003 to US$28.2 billion last year. Even if we ignore other commodities and their indirect effect on the prices of intermediate goods, higher oil prices alone accounted for 60% of the widening in the current account deficit and put significant pressure on inflation in the past couple of years. Accordingly, the recent correction is good news for the Turkish economy. A US$10 drop in the price of crude oil would cut the current account deficit by US$3.6 billion on an annualized basis; and a 10% decline in lira-denominated fuel prices is likely to lower consumer price inflation by about 80bp (see Turkey: Barrel by Barrel, January 24, 2007). However, oil prices have risen once again to US$60 a barrel in recent weeks, pushing domestic fuel prices higher. Although Morgan Stanley expects a period of stabilization this year and a further decline in the oil price next year, geopolitical constraints are likely to keep presenting serious challenges for the external account, as are efforts to bring inflation within the price stability range. The volatility in unprocessed food prices has become a burden on the disinflation process. The third obstacle on our map of inflation risks is yet another supply shock: the effect of global warming on soft commodity prices. Weather anomalies could occasionally have wider economic consequences including lower agricultural output and higher food prices, but what we have seen all around the world in the last two years is beyond sporadic shifts in climatic conditions. As the global surface temperature has increased to the peak, Turkey, just like many other countries ranging from China to Mexico, has experienced volatile conditions and a sustained increase in food prices (see Turkey: No Rain, No Gain, February 5, 2007). In our view, lower production and Europe’s higher import demand for farm products have pushed especially fresh fruit and vegetable prices higher. Therefore, even though the CPI excluding unprocessed food prices kept declining from 10.5% last July to 9% February, the volatility of food prices represents a threat to disinflation. Election economics could hurt public finances and destabilize inflation expectations. Since fiscal imbalances were at the heart of Turkey’s economic problems, the normalization of public finances has played a fundamental role in reshaping inflation dynamics. The unprecedented correction of the budget deficit – from 16.5% of GDP in 2001 to 0.7% last year – has reduced fiscal dominance and supported rapid disinflation from an average of 77.5% in the 1990s to the single-digit territory. This is why the fourth risk on our list is election economics that could potentially weaken the anchor of fiscal consolidation and delay the convergence of inflation expectations towards the central bank’s multi-year targets. Although we do not expect significant deviation from the key fiscal parameters, a reshuffling of public expenditures would not be surprising in the election year. Especially, wage increases in the public sector are still an important threat to policy credibility – à la the appointment of the new central bank governor last year – as are managing highly adaptive, backward-looking inflation expectations. Moreover, changes in administered prices (like electricity and natural gas) and tax rates could strain the central bank’s efforts to bring inflation down and normalize interest rates. The strength of inertia in non-tradable prices has slowed the pace of disinflation. The great majority of participants in our survey do not have a long list of risks to the underlying inflation trend. Similar to the central bank’s assessment, most observers highlight the strength of inertia in non-tradable prices as a critical obstacle to further disinflation. Indeed, the prices of certain services have kept increasing at a stubborn rate, without showing much response to monetary tightening. For example, services posted an annual inflation rate of 12%, compared with a 6% increase in tradable goods excluding energy and unprocessed food. While education and healthcare prices have exhibited a remarkable degree of convergence towards price stability, others (especially with strong sensitivity to oil prices and currency volatility) have limited the extent of disinflation. The most curious case is possibly the behavior of rental prices. Against an average inflation rate of 8.8% in terms of the headline index, the rent component of the CPI basket has recorded an annual inflation rate of around 20% in the past three years. In our view, there are various factors contributing to this phenomenon that may not correct in the near future. First, the housing sector is going through a relative price adjustment, especially given the low level of rental yields in Turkey compared with its peers. Second, supply constraints – reflecting regulatory changes after the earthquake and the 2001 crisis – have resulted in a gap vis-à-vis the marked increase in demand. Third, structural changes in the agriculture sector have lowered rural employment and led to additional demand in urban housing. Although the lagged effect of higher borrowing costs and the completion of new housing projects should lead to a correction in the rental market, the annual rate of inflation is likely to remain high relative to other components of the CPI. Underdeveloped monetary transmission channels present a challenge to the central bank. The last and most important hurdle on our map of inflation risks is the behavior of domestic demand. The central bank’s ultimate objective is to influence domestic demand and inflation expectations with changes in short-term interest rates. Unfortunately, after decades of distortions, monetary transmission channels in Turkey, albeit rapidly evolving, remain underdeveloped. This is why monetary tightening can have a delayed and weaker effect on the behavior of domestic demand. Indeed, our analysis showed that the sense of stability – measured by exchange rate volatility – has an overwhelming influence over borrowing and consumption decisions (see Turkey: Secrets of Consumption Dynamics, September 4, 2006). Nevertheless, we should not ignore the lagged effects of monetary tightening. With the rise in household debt from 7.5% of disposable income in 2003 to 27.5% last year, higher interest rates already lowered the real growth rate of consumer loans from 18.6% in 1H06 to 2.4% in 2H06. In the meantime, with unemployment still above its equilibrium rate, real wages have lagged behind productivity improvements, limiting the scope for discretionary spending and widening the output gap. The central bank will maintain the current policy stance until inflation moves towards the target. Judging from the pace of disinflation in the past five years, one might have thought that lowering inflation is a piece of cake – all gain without inflicting any pain. Nothing could be further from reality. Look all around the world, one would see that achieving and maintaining price stability is a challenging task, even in developed economies. This is why Turkey now needs to move beyond macroeconomic normalization and accelerate progress on micro areas (see Turkey: The Microeconomic Limits of Disinflation, February 18, 2000). In the near future, however, we still expect consumer price inflation to move within the uncertainty band and below 6% by the end of this year. This should allow the Central Bank of Turkey to start cutting short-term interest rates at a gradual, cautious pace in 2H07.
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Japan’s Credibility Gap
March 05, 2007
By Robert Alan Feldman | Tokyo
It’s not how far you fall; it’s how high you bounce. -- Anonymous. As global investors try to make sense of the sharp market correction, a key piece of evidence has come from the relative declines of different markets. Japan has been hit worse that other industrial country equity markets. The question is why? One part of the explanation is that the Japanese economy is tied more closely to China, the immediate source of the current downdraft, than are the other industrial countries. Hence disturbances in China — in particular a clear effort by the Chinese authorities to cool the Chinese economy — leave Japan and Japanese company earnings more exposed than other countries. However, China is far from the whole story. Indeed, many investors around the world are viewing events in China as a mere trigger to an adjustment that has deeper roots. Of course, global liquidity and incessant harping on the carry trade are global parts of the story. In Japan’s case, however, there are a number of domestic roots as well. It all comes down to credibility. Japan’s first credibility problem concerns the business cycle. There has been a run-up in inventories recently, quite unlike earlier parts of the current upswing. As a result, industrial production is likely to slow over the coming months. I am optimistic. One need not panic that Japan is going into a long downturn; on the contrary, a rapid production response to inventory build-up is healthy. However, over the next few months, the production data are likely to be a touch weak, and thus will raise questions about the sustainability of Japan’s recovery. Japan’s second credibility problem is monetary policy. Having dramatically refused to hike rates in January, the BoJ Policy Board reversed itself in February, and hiked rates with an 8-1 majority. What changed? Not much. Yes, GDP data for 4Q06 showed a recovery in consumption but hardly more than that. Moreover, the BoJ has softened its rhetoric on the outlook for higher prices. Investors around the world have trouble seeing how the BoJ is linking economic fundamentals to interest rate policy. Until the BoJ’s behavior becomes predictable, Japanese monetary policy will have a credibility problem. On this matter, I am not optimistic, in light of the BoJ’s oft-demonstrated ability to confuse. The third credibility problem is corporate reform. Investors around the world have been expecting an acceleration of M&A activity, in light of changes in the rules on triangle mergers. However, noises from business organizations have been discouraging. Until the matter is settled, when the Ministry of Justice publishes the rules (this must happen by May, when the triangle merger system for foreign firms is set to start), investors will be skeptical. My view is optimistic. The introduction of Japan Drawing Rights and the loosening of merger approval rules by the Japan Fair Trade Commission should augment merger activity a lot. But investors need evidence. The fourth credibility problem is reform policy. PM Abe’s formation of many competing study groups is a huge step forward. These groups institutionalize the progress made in the Koizumi years. However, investors have yet to see much concrete economic legislation as a result. In addition, PM Abe’s slippage in public opinion polls raises questions about the outcome of the July Upper House election. Once again, I am optimistic. Much of the criticism of PM Abe is, in my view, shallow, and the election is likely to come out well. However, investors need evidence. A fifth point on credibility concerns the yen. A large share of recent profit gains appear to stem from the weakness of the yen. Even after the correction this week, the yen remains weak. If a large yen correction were to occur, so goes the argument, would not the Japanese economy be damaged? Of course, a strong yen would hurt export sector earnings in the short run. However, it is important to remember that Japanese firms have a long history of dealing with a strong currency, and thus would not be hurt too badly for too long. Moreover, much of the economy benefits from a strong yen. On this point, I am optimistic as well. A strong yen gives investors an opportunity to buy good domestic firms, and to buy exporters on dips. Thus, on these five areas of credibility, I am optimistic on four, but pessimistic on one. That said, the evidence to support my relatively optimistic view has yet to emerge. It will take several months for this evidence to emerge, and in the meantime, investors across the world may have doubts about the Japanese economy and equity markets. The overall implication is to buy equities on dips, but not too quickly. If my optimism on most of these points is justified, Japan will bounce well after its fall. But the bounce may take time, because the evidence will take time.
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What Marching Orders for Monetary Policy?
March 05, 2007
By Elga Bartsch | London
Anything but a hike in the main refinancing rate by 25bp to 3.75% by the ECB this coming week would be a major surprise. Another gradual rate hike, which would mark the seventh consecutive increase in the refi rate since December 2005, was clearly signalled by ECB President Trichet in the February press conference. The move would bring the euro area policy rate to the mid-point of a 3.5-4.0% range, which we would regard as neutral. With the ECB interest rate hike being widely anticipated, the focus of financial markets will likely be on the subsequent press conference. Markets will try to get a sense of the ‘marching orders’ for monetary policy beyond the March meeting. On balance, we expect another interest rate move before the ECB’s summer recess in August. After having been called back to Frankfurt last summer, Council members might want to enjoy their holidays without an interruption this year. The easiest way to ensure that is to get another refi rate hike out of the way before they depart on their well-deserved summer breaks. This view is corroborated by our refi-meter model. The refi-meter is a statistical model, which estimates the probability of an ECB rate hike based on a number of macro variables, such as the business climate, inflation expectations, money supply and loan growth (see EuroTower Insights: When Will the ECB Stop?, October 10, 2006). The refi-meter currently sees the probability of an ECB rate hike climbing above the critical threshold as early as June. While we do not tie our forecasts to a statistical tool, the timing suggested by the refi-meter is in line with our perception that the pace of tightening should slow down this year. On the whole, we expect the ECB to become more data-dependent as the tightening process progresses. As the recovery is now viewed as being self-sustaining, the emphasis will likely gradually move to indicators that help to assess emerging bottlenecks in the euro area economy, such as the rate of capacity utilisation and the unemployment rate, to mention two. Clearly, the wage developments are a wild card. A potential downshift in growth during the spring, signalled by some of our survey-based indicators, would be another. In the absence of a regular press conference in August, the earliest that the ECB could hike interest rates in the autumn would probably be October — unless it goes out of its way in order to communicate a coming move to the markets in advance in some other shape or form. At the March press conference, there will be a couple of clues on the ECB’s thinking, we believe. First and foremost, we will be looking out for any changes to the ECB’s assessment of its policy stance as being accommodative. We would not be surprised to see some qualification added here. It is important to note, however, that a change does not necessarily mean that the ECB isn’t going to hike further. Some Council members seem to think that an economy as strong as the euro area no longer needs an accommodative policy stance. A gradual tweaking in the language describing the monetary policy stance as accommodative would pave the way for a further adjustment after the subsequent rate hike to 4%. At a refi rate of 4%, it would be increasingly difficult to argue that monetary policy is still accommodative, we think. That said, the ECB bases its assessment of the monetary policy stance also on money and credit dynamics, thereby going beyond traditional considerations based on the level of interest rates relative to a neutral level alone. Its verdict on this is more balanced. Another important clue will be the Council’s assessment of the risks to price stability in the context of the broad-based economic analysis and in the context of the monetary analysis. Regarding the first element, the Council will have a fresh set of staff projections to ponder. The staff projections, which are not underwritten by the Council, will likely show a slight upward revision in 2007 GDP growth from the previous 2.2% and potentially also a slight downward adjustment in the 2007 inflation outlook from the previous 2.0%. However, ECB President Trichet has already made it clear that this year’s inflation is considered ‘water under the bridge’ by the ECB. Hence, the focus should be on next year’s estimate, which stands at 1.9%. Bear in mind that the estimates “for the year after” tend to be biased to the downside because they don’t include increases in indirect taxes and administrative prices. These increases have added on average 0.25 percentage points to headline inflation over the last few years. Government-induced price increases might become less prevalent going forward because better budget deficits make the need to refill government coffers less pressing. Last but not least, the ‘traffic-light’ system of well-established codewords to signal the timing of the next move could provide important hints. We would not be surprised if the Council immediately reverts back to “monitoring risks very closely” like it did in December, rather than to just “monitoring risks closely”. Historically, the former wording implied that the ECB could hike interest rates within the next two meetings. Keeping the option open to hike as early as May might make sense for the ECB because metal-sector wage talks in Germany should gain momentum in late April/early May (see Clearing the Decks, February 23, 2007). As it did in January, the ECB Council can then choose not to elevate the language to “strong vigilance” at the subsequent meeting(s).
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