The Missing Link to Global Rebalancing
April 23, 2007
By Stephen S. Roach | New York
Financial markets are giddy over the prospects that a $51 trillion global economy has once again displayed Teflon-like resilience in coping with a major problem. There are signs that a benign global rebalancing could well be at hand. A downshift in the US economy has been largely offset by improved economic conditions in Europe and Japan. Meanwhile, the dollar has resumed its five-year downward trajectory – tilting the world’s relative price structure against the mother of all external deficits. My advice is to keep the champagne on ice – there is a critically important piece to the global rebalancing puzzle that has yet to fall into place.
A subtle change is now emerging in the mix of global growth. This shift has been concentrated in the three main economies of the developed world. The US growth engine is, indeed, slowing. Over the four years ending in 2006, average GDP growth of 3.2% in the US economy accounted for about 0.6 percentage point of world GDP growth based on the IMF’s purchasing power parity metrics. Our forecast of a 2% increase in the US in 2007 would add just 0.4 percentage point to global growth – a reduction of 0.2 percentage point from the growth contribution of the prior four years. By contrast, Europe’s global growth contribution is inching up – going from an average of 0.4 percentage point per annum over the 2003-06 time period to an estimated 0.5 percentage point in 2007. We are projecting a similar fractional increase in the Japanese contribution to 0.2 percentage point of global growth in 2007 versus an anemic 0.1 percentage point average impetus over the 2003-06 period. While the shifting mix between the US, Europe, and Japan hardly points to a major realignment in the composition of industrial-world growth, at least the wheels are turning in the right direction. Economic growth in the developing world is expected to continue at its recent rapid pace and thereby not play a major role in driving any meaningful shifts in the mix of global growth this year. At 48% of PPP-based world GDP, our forecast of 6.6% growth in developing world GDP for 2007 adds 3.2 percentage points to global growth – accounting for fully 70% of the 4.5% growth in world GDP we expect in 2007. While this is down a bit from the 3.5 percentage point contribution in 2006, this reduction is largely an outgrowth of our call for a deceleration of Chinese GDP growth from 10.7% in 2006 to 9.3% in 2007. In light of the outsize 11.1% increase in 1Q07 Chinese GDP, the risks to our China forecast are very much on the upside. This suggests that the developing world contribution to global GDP growth in 2007 is likely to be quite similar to the strong impetus evident during the prior four years. I have long argued that global rebalancing cannot occur without a meaningful shift in the mix of global consumption – more specifically, cutbacks in excess US consumption accompanied by increasing consumer demand elsewhere in the world. Here as well, there is evidence of small shifts in the right direction – especially in the developed world. Our baseline forecast calls for a modest slowing of US personal consumption growth to 2.8% in 2007 – down 0.5 percentage point from the 3.3% average annual pace of 2003-06. This is expected to be offset by an acceleration of private consumer demand elsewhere in the industrial world, with consumption growth in the advanced economies, excluding the US, projected at 2.3% in 2007 versus a 1.9% average pace over the preceding four years. In my view, this is only a down-payment on the major realignment that is needed – both in the mix of global consumption as well as in the related mix of global saving. But, here as well, at least the shifting composition of global consumption is headed in a constructive direction. By now, global rebalancing has become part of the mainstream thinking on the global economy – a far cry from the initial reception that greeted my first missive on the subject nearly five years ago (see my 21 May 2002 dispatch, “Global Rebalancing”). Conventional wisdom has it that the currency mechanism lies at the heart of the coming rebalancing of the world economy. Leading academics have long argued that it will take at least a 30% decline in the dollar’s real effective exchange rate to correct the principal imbalance of an unbalanced world – the record US current account deficit (see, for example, Maurice Obstfeld and Kenneth Rogoff, “The Unsustainable US Current Account Position Revisited,” November 2005). I still don’t buy that line of reasoning. The broad trade-weighted dollar index is now off 16% in real terms from its early 2002 highs – slightly more than half the 30% decline that the models deem necessary for rebalancing. Yet, the US current account deficit has barely budged – holding steady at around 6.5% of GDP over the 2005-06 period, although edging down to 5.8% in the final period of last year. Moreover, with goods imports still more than 70% larger than exports, America’s trade imbalance remains very much an outgrowth of a serious excess consumption problem. With personal consumption currently at a record 71% of GDP, high and rising import propensities underscore the structural aspects of the US trade problem. Consequently, I continue to think it will take a lot more than another 15 percentage point decline in the dollar to reduce the US trade gap to manageable proportions. Yet, the global powers that be have little appetite for such a “mega dollar correction” scenario, in my view. In short, don’t count on the dollar to be the principal instrument of global rebalancing. From the start, my take on global imbalances is that they are much more an outgrowth of saving-investment disequilibria than currency misalignments. America’s gaping current account deficit didn’t just appear out of thin air. It is an unmistakable outgrowth of an extraordinary deficiency of domestic US saving – a net national saving rate that plunged to a record low of just 2% of GDP over the past three years. Lacking in national saving, the US, with its penchant for strong growth, had no choice other than to import foreign saving from abroad – and run massive current account and trade deficits to attract the foreign capital. As seen from that vantage point, the prospects for global rebalancing should be more dependent on a shift in the mix of global saving rather than on a realignment of the world’s relative price structure through currency adjustments. This is especially the case in the United States, whose record current account deficit easily qualifies as the major imbalance of an unbalanced world. To the extent I’m right and America’s external gap is directly traceable to an extraordinary saving anomaly, it should hardly be surprising that a tidal wave of US wealth creation has encouraged a substitution of asset-based saving for income-based saving. How else can you explain a record 71% consumption share of US GDP juxtaposed against an income-based personal saving rate that has now been in negative territory for two years in a row for the first time since the early 1930s? Or, how else can you explain record household debt service burdens in a low interest rate climate? To me, this all hinges on America’s love affair with the culture of the Asset Economy. To the extent that the wealth effects of the US housing boom have depressed income-based domestic saving, America’s gaping current account deficit emerges as a key by-product of an asset-dependent real economy. That has led me to conclude that the US current account adjustment will eventually have to be driven more by corrections in asset markets than by realignments in foreign exchange markets. That suggests that the ramifications of the ongoing contraction in the US housing market could well be the acid test of the asset-led rebalancing hypothesis. To the extent American homeowners cut back on the equity they extract from their housing investments, they will need to return to more of an income-based mindset in shaping their saving and spending decisions. I will confess that I am surprised this has not yet happened – especially since the property-driven wealth effects have already gone the other way. According to Federal Reserve estimates, net equity extraction has now fallen from a high of more than 8% of disposable personal income in early 2006 to a little over 5% by the end of the year. Yet the income-based personal saving rate has stayed in negative territory to the tune of -1.2% in early 2007. My guess is that US consumers won’t wake up to the urgency to rebuild income-based saving until they face some sort of a shock that raises questions about job and income security. As long as the unemployment rate hovers near its cycle low – precisely the message from a 4.4% reading for the jobless rate in March – that won’t happen. But if and when the unemployment rate starts to rise – as I fully expect will be the case in the second half of 2007 when long-deferred construction sector layoffs finally kick in – then consumers will need to come to grips with the excesses of asset-based spending. If that prompts an increase in income-based saving, as I suspect, then America’s overall domestic saving position will also improve – thereby limiting US demand for foreign saving. A US current account adjustment would then be a perfectly normal outgrowth of such a development – a major breakthrough on the road to global rebalancing. So it all boils down to the macro question of the hour – the consumption response to the bursting of the US housing bubble. Not only does this hold the key to the US current account adjustment but it is also the linchpin of the US growth prognosis, as well as the global decoupling debate (see my 9 April dispatch, “Spillovers versus Linkages”). Global rebalancing can’t occur without a US current account adjustment. As I see it, it will take the negative wealth effects of a post-housing bubble shakeout to trigger the sustainable saving and current account responses that global rebalancing requires. Contrary to widespread perception, the dollar is a bit player in all this. If, however, US consumers remain unflinching, imports will remain excessive and any cyclical tendency toward global rebalancing will quickly be short-circuited. A lasting global rebalancing cannot occur unless the excesses of the Asset Economy are finally unwound.
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Explaining the Capex Conundrum
April 23, 2007
By Richard Berner | New York
There’s been scant change in the outlook for US business capital spending since I last looked; it has remained weak, and most indicators for it and some key drivers seem to be pointing towards ongoing weakness (see “The Capex Conundrum,” Global Economic Forum, March 9, 2007). We estimate that real nonresidential fixed investment rose by just 2.9% in the year ended in the first quarter of 2007, and that real outlays for equipment and software actually declined slightly over that period. Both would mark the weakest business investment performance in about four years, capping what has already been a subpar capital spending recovery by virtually every metric. Moreover, there’s no sign of an upturn in capital goods bookings or in business surveys. Among other drivers, sluggish economic growth and an uncertain business climate seem likely to prolong or even deepen the capex gloom. Yet some fundamentals seem to point towards at least a modest rebound, and the weakness is still something of a puzzle, so a review may be helpful. What are the headwinds and tailwinds facing capital spending and what is the likely prognosis? Capital spending is the biggest wildcard in the economic and inflation outlook. In my opinion, the headwinds are likely to dominate for now, keeping business investment spending weak. But some of the factors trimming outlays are fading, and the combination of stronger growth in exports, a moderate rebound in consumer spending, and a less-intense housing recession should provide improvement later this year and in 2008. Here’s why. To start, it’s worth recalling three themes related to capital spending in this expansion. Most important, what I’ve called “capital discipline” — the effort to boost or maintain high returns on invested capital (ROIC) — still dominates the corporate psyche. Such restraint has been a good thing for investors; they are rewarding CFOs who cleaned up the capex excesses of the 1990s that crushed ROICs and those who are now resolved to avoid them. And they are punishing the managers who are poor capital allocators, and who refuse to accept that growth for growth’s sake will destroy returns. Second, companies can invest anywhere in the world to grow, and with many perceiving that the true growth opportunities lie outside our borders, US capital spending may suffer by comparison. Finally, CFOs can build, buy or rent assets to invest in their businesses; the M&A boom under way testifies to the benefits and popularity of bolting on acquisitions to pump up growth quickly. Do those three themes individually or collectively explain the recent weakness in capital spending? All three are secular headwinds for capital spending that have prevailed for some time, so alone they aren’t informative on the recent past. But in combination with some cyclical developments, they could explain some of the recent weakness. First, the housing recession and the downturn in Detroit have promoted a sharp deceleration in economic activity, likely dimming expectations of future growth, the perceived returns from investing, and the need to invest. Such “accelerator” or “decelerator” effects typically kick in over several months’ time, and this one is right on schedule. The housing downturn promoted a 28% plunge in construction machinery shipments in the year ended February, and with bookings for such equipment down 39% over the same period, no pickup is likely soon. Overall nondefense capital goods orders dipped 1.9% below year-ago levels in February —the first such decline in four years. Business surveys are mixed: The just-released National Association for Business Economics Industry Survey indicates that the net percentage of respondents planning to step up capital spending over the next year fell by nearly one-third to 21%. But small businesses are more upbeat; a diffusion index of capital spending plans from the NFIB monthly canvass rose to a one-year high in March. Second, I acknowledge that some US companies might choose to invest abroad — especially in China or India — rather than in the US. But data to support the case for a recent radical substitution are hard to come by. BusinessWeek recently (April 23, 2007) claimed that “financial reports from more than 1,000 large and midsize U.S.-based companies show that global capital expenditures in the fourth quarter of 2006 were actually up 18.1% over the previous year,” or more than double the pace in the US. But US foreign direct investment (FDI) data, while they include much more than actual investment abroad, show an increase of just 1.9% over the past two years. Third, favorable market conditions continue to support an unprecedented M&A and buyout boom. First-quarter global transactions rose by 14% from a year ago to $1.1 trillion, which suggests that some companies are substituting buying for building. And financial sponsors continue to enforce discipline on CFOs by keeping them mindful of industry capacity in deciding whether to buy it, build it, or lever up. That last factor is evident in the retirement of a record $602 billion of equity (net of issuance) in 2006, with $436 billion in debt issued to do it. Anecdotally, however, some companies report a different secular/cyclical problem. They report that they can’t invest in new US capacity because they are constrained by a shortage of labor, especially of engineers. They don’t have enough skilled staff to design, build, and repair industrial plants in some US regions. The reason: Asian companies are luring engineers educated here back home. This “reverse brain-drain” is far from ubiquitous, but it may have promoted a shortage of engineers. Finally, a collection of “paybacks” from one-time factors has likely depressed outlays. The end of the “bonus depreciation” feature of the tax law depressed outlays starting last year. That depressing effect may soon be over, unmasking a firmer trend at least in outlays for “maintenance and repair.” New emission standards for heavy trucks triggered a race to buy 2006 models at the expense of 2007; heavy truck assemblies plunged 32% in March compared with a year ago. And the 2006 surge in structures investment has faded as rebuilding of Gulf Coast and Florida facilities damaged in the hurricanes winds down. There are also some investment tailwinds, which collectively make me think that this slump will be only temporary. First, there is still strong “pent-up” demand. Had standard models of investment behavior held, real equipment and software outlays would be nearly one-third higher today than their current levels. Moreover, over the past four years, the real stock of equipment and software rose by an average annual rate of 3.5%, or more slowly than GDP. And to achieve that, real gross investment in equipment and software rose at an average 6.6% rate, implying a need to get back to such investment growth rates to avoid a decline in the outstanding stock in relation to GDP. In addition, there is a sharp dichotomy between strong high-tech and weak low-tech outlays. Industrial production data, used to calculate investment in computers, show gains of 25% from a year ago. In contrast, the low-tech components are flat. In addition, cash flow and operating rates are still high, and financing is still supportive. Secular forces, such as an aging population, the productivity and infrastructure imperatives, and the rush to build alternative fuel facilities, are strong. The upshot: Incoming data suggest that the capital-spending headwinds are likely to dominate for now, keeping spending weak. But some of the one-time factors trimming outlays have faded, and the combination of stronger growth in exports and consumer outlays and a less-intense housing recession should provide improvement later this year and in 2008. If sustained, however, prolonged weakness in capital spending will intensify the debate over US productivity, potential output, and inflation risks, making a sluggish US economy appear more stagflationary. To me, that seems like the recipe for a bearishly steeper yield curve and a challenge to risky assets. The risks from ongoing capital-spending weakness are clear: The lack of any rebound would slash another half a percentage point from US GDP growth, leaving it at 2% for the balance of the year, even if the intensity of the housing recession soon fades. Such a backdrop could create the trappings of a vicious circle: Global investors may think that the pendulum of capital discipline has swung too far towards corporate anorexia, making the domestic portion of US businesses less attractive than their global peers.
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Review and Preview
April 23, 2007
By Ted Wieseman | New York
Treasuries posted significant gains across the board the past week, with the curve seeing only a small reversal of the decent curve flattening reversal that had been underway since the strong March employment report, as a much better-than-expected March CPI report was seen as giving the Fed the freedom to take down rates more and sooner. While we think that much of the downside surprise in core CPI in March reflected seasonal adjustment problems, most obviously with the hotels component, and expect a reversal in April, certainly the results at least temporarily are likely to be quite favorable relative to the Fed’s longer-term goals. We expect the core PCE price index to be flat in March, which would drop the year-on-year pace down to +2.1%, leaving it very close to the 2% rate we think is the Fed’s true target, whatever it may continue to say about a 1-2% ‘comfort zone’. If this were to be sustained, clearly it would give the Fed more freedom to respond to a more pronounced growth shortfall in the near term and would hasten the eventual move towards taking rates down to a more neutral level — probably a funds target of 4.50-4.75% with core PCE inflation steady at 2% — from the current slightly restrictive stance. But while we think that we have probably seen the cycle peak for inflation, inflation risks remain material, in our view, and will likely make the significant slowing in March inflation temporary and leave core inflation sticky above the Fed’s preferred 2% rate for a while, keeping policy on hold for a further extended period. We certainly do not think that the Fed will overreact to one month’s good data when cost pressures are rising from such a variety of sources and the economy continues to run at full capacity, providing business pricing power even with current slack domestic demand growth to push through some of these costs to final prices. Moreover, even as inflation surprised to the downside, the slowdown in 1Q growth now looks to have been less severe than previously thought, so the current mildly stagflationary episode looks a bit more benign at this point on both the growth and inflation sides. We raised our 1Q GDP forecast to +1.8% from +1.4% over the course of the week on upside in retail sales, retail inventories and housing starts and downside in headline inflation. And while we are not ready to make any adjustments at this point, our read of the latest auto assembly plans suggests upside risks to our 2Q GDP forecast of +1.7%. Benchmark Treasury yields fell 8-12bp the past week, led by the 3-year as the main adjustment in Fed expectations was to lower the expected 2008 trough in the funds target. The 2-year yield fell 11bp to 4.65%, the 3-year 12bp to 4.58%, the 5-year 11bp to 4.57%, the 10-year 9bp to 4.67%, and the 30-year 8bp to 4.845%. In response to the CPI surprise, the futures market significantly raised the amount of Fed easing expected in the near and especially medium term. In the short term, the July and August fed funds contracts gained 1bp each to 5.225% and 5.20%. Initially the market went so far as to price the likelihood of a rate cut as early as the September FOMC meeting, but thought just better of this Friday, shifting the first expected move out to the end of October meeting instead, with the October contract gaining 4bp to 5.13%. The Sep 07 eurodollar futures contract rose 5bp to 5.215% and the Dec 07 contract 10bp to 5.015%. Strongest gains in the eurodollar futures market were posted by the Sep 08 to June 09 contracts, which rallied 16-17bp, with the low rate Sep 08 contract gaining 16bp to 4.66%, shifting the expected trough in the funds target to 4.50% from 4.75%. So, broadly speaking, at this point the market is pricing in a 25bp cut in the funds target to 5.00% at the October 30-31 FOMC meeting, a second cut to 4.75% at the December 11 meeting, and then a final cut to 4.50% by the third quarter of 2008. We don’t have much argument with the last of these — we have the funds target at 4.75% at the end of 3Q08 — but think the market is pricing the first move significantly too soon and continue to see the Fed on hold through year-end. TIPS underperformed on the week, though not unusually so given the size of the rally in the nominal market, with the benchmark 5-year and 10-year inflation breakevens falling 6bp to 2.45% and 5bp to 2.41%, respectively, reducing the 5-year/5-year forward breakeven a few bp to 2.37%, near one-month lows for all three spreads. The consumer price index jumped 0.6% in March for a 2.8% year-on-year rise, as energy prices gained 5.9% on an 11% spike in gasoline. Excluding food and energy, however, the CPI only rose 0.1% (and just barely rounding up to even that, coming in at +0.06% to two decimals), dropping the year-on-year pace to +2.5% from +2.7%, a ten-month low. Three main items restrained the core. First, hotel prices fell 2.3%, as the typical March ramp-up in prices ahead of summer travel was much smaller than normal. This seemed to be inconsistent with industry data, and we think it will likely be reversed next month. The year-on-year rate of the ‘lodging away from home’ category plummeted 3 points to just 1.3%, while industry data sources are pointing to growth closer to 7%. Second, apparel prices fell 1.0%, and seasonal adjustment may also have been a problem here. March is a month in which unadjusted prices typically rise significantly as spring lines are introduced, and the timing of the CPI sample may have been a bit off. We think there is a good chance for some reversal in this component next month as well. Third, medical care goods prices (mostly drugs) fell 0.3%, an unprecedented fourth decline in the past five months. With prescription drug prices at the domestic PPI level and for imports having significantly accelerated, this softness seems unlikely to be sustainable. At least for March, however, when we translate the CPI and PPI results into a core PCE estimate, we get a flat reading (though actually at +0.03%, just marginally below the +0.06% core CPI result), which would result in the year-on-year pace dropping from the cycle high matching +2.4% hit in February to +2.1%, which would be the lowest reading in a year. Even with what we expect to be a significant rebound in core inflation in April, relatively tough base effects will likely keep core PCE inflation near this rate — and thus close to the 2% level we think is the Fed’s de facto target at this point — for several months, with monthly gains from April to June of last year having averaged +0.21%. But we still think the Fed will rightly remain focused on the sustainability of this moderation and worried about upside risks. Cost pressures are ramping up from any number of sources — labor costs, energy prices, food prices, consumer goods import prices, protectionism, the weak dollar and booming global conditions that are increasing the pricing power of exporters to the US (see Dick Berner’s article, Inflation: The Latest US Import?). And while the significant slackening in domestic demand growth will to some extent restrain business pricing power, limit cost pressure pass-through to final prices, and thus pressure margins, with the economy currently operating at essentially full capacity, there will likely be some pass-through. Most likely it will not be enough to lead to any significant acceleration in inflation — we expect that the cycle peak for core inflation has passed at this point — but enough to keep core inflation sticky at a somewhat elevated level and thus keep the Fed on hold, patiently waiting for a gradual moderation towards more sustainably acceptable levels, barring a much more severe downturn in growth than seems likely. And growth data released the past week suggested less reason for concern about immediate downside risks. First, consumer spending now looks to have been stronger in 1Q than we previously expected. Retail sales rose 0.7% in March, with auto dealers’ receipts rising 0.4% in contrast to the pullback in unit sales and ex auto sales gaining 0.8% on top of a significant upward revision to February (+0.4% versus -0.1%). Half of the gain in ex-auto sales reflected a price-related jump at gas stations (+3.1%); sales excluding autos and gas stations rose 0.4%. In line with the better-than-expected chain store reports, good gains were seen in general merchandise (+1.1%), clothing (+2.4%), and sports, books, and music stores (+1.1%). These big increases were partly offset, however, by a continued retracement in home electronics (-1.9%) after a very strong Christmas and a plunge in non-store retailers (-2.2%) after a surge in February (+3.6%) that appeared to reflect sample problems. The key retail control component gained 0.7% in March. This was less than the +1.1% we assumed, but this was more than offset by a significant upward revision to February. Moreover, the lower-than-expected March inflation figures subsequently led us to raise our forecast for March real consumption even with the downside in control. Taken together, we now see 1Q consumption rising +3.5%, up from our prior +3.0% forecast. In addition, retail ex auto inventories posted a larger-than-expected gain in February and January was revised a bit higher, pointing to a slightly larger (though still very small) add to growth from inventory accumulation. Finally, another upside surprise in housing starts led us to trim our forecast for the decline in March residential construction spending. Housing starts rose 0.8% in March on top of a 7.6% rebound in February to reach a 1.518 million unit annual rate. Single-family starts gained 2.0% to 1.218 million, leaving them 9% above the ten-year low hit in January, though still down 25% year on year. Meanwhile, the more volatile multi-family component was down 3.8% to 300,000. Multi-family starts have trended lower over the past year, but the March reading remained within the range that has prevailed for the past decade or so. Regionally, all the upside was accounted for by a 44.5% spike in the Midwest after some extraordinary weakness in the prior couple months. The other three regions were all down. Based on these results, we raised our forecast for 1Q residential investment a bit to -18% from -19%. Incorporating the upside to consumption, inventories and residential investment, we boosted our 1Q GDP forecast to +1.8% from +1.4%. We forecast a similar gain of +1.7% in 2Q. Key to our 2Q outlook is a pick-up in business investment growth after significant and, from our perspective, puzzling weakness in 4Q06 and 1Q helping offset a big, largely energy price-induced slowdown in consumption growth to just a +1.7% annual rate after gains averaging almost 4% over 4Q06 and 1Q. So certainly we will be very focused on Wednesday’s durable goods report for some signs of hope on the investment front after a string of bad results. One potential positive for 2Q is that a decent rebound in the struggling auto sector may be on tap. Our interpretation of the most recent assembly schedules suggests that the motor vehicle sector could add about three quarters of a point to growth in 2Q after subtracting more than a point in 4Q06 and we estimate about a quarter point in 1Q. At this point, we are only building in about a quarter point add to GDP in 2Q from the motor vehicle sector but will wait for more confirmation of an apparent April assembly upswing before making any changes in this baseline estimate. Looking ahead a couple weeks to the key initial April data, early indications released the past week for the upcoming employment and ISM reports pointed to relatively soft results. After the spike in initial claims last week that we thought was solely a result of inadequate seasonal adjustment for the typical first week of the quarter surge in filings, initial claims in the latest week, which was the survey week for the employment report, surprisingly barely fell at all. Some potential lingering distortions from the Good Friday holiday and the recent severe storms might have kept claims elevated, so we’d like to see another week’s data before concluding that there has been a significant underlying worsening in labor market conditions, but taking on board this latest much worse-than-expected result, we preliminarily look for a sluggish 80,000 gain in April non-farm payrolls. A key factor that seems likely to depress job growth in the near term is the housing market. So far, there has been barely any correction in residential construction payrolls despite the collapse in new homebuilding. Since the March 2006 peak, residential construction jobs have fallen less than 4%. Job losses seem likely to turn much more severe over the next few months thanks in part to very tough seasonal factors that look for a sharp ramp-up in hiring in the spring that seems quite unlikely to happen this year. Meanwhile, results from the key early regional manufacturing surveys pointed to another relatively soft outcome from the ISM. On an ISM-comparable weighted average basis, the Empire State survey fell to 52.7 from 53.3, while the Philly Fed held steady at 50.2. Pending the results of the remaining regional reports, we look for the national ISM to fall about a half point to 50.5 in April. The economic calendar is quite busy in the coming week, with main focus on the durable goods report Wednesday and GDP Friday. After a string of bad reports, durables had better start showing some improvement in capital spending trends or the downside risks to the outlook from the recent weakness in investment will become increasingly pressing heading into a 2Q, in which the big support to growth from consumption in 4Q06 and 1Q seems likely to be greatly diminished. The market will have to deal with significant supply, with an US$8 billion 5-year TIPS auction Tuesday and 2-year and 5-year note auctions Wednesday and Thursday. The TIPS size was slashed by US$3 billion, extending the string of recent coupon size reductions that we expect will continue in Monday’s announcement of the 2-year and 5-year issues, each of which we expect to be reduced by US$1 billion, to US$17 billion and US$12 billion. Even before we’ve seen much of the key April non-withheld tax payments, upside in withheld and corporate taxes is pointing to very strong revenue growth in April, indicating that our current US$210 billion budget deficit forecast for FY2007 will probably be coming down a fair amount soon. Other data releases due out include the Conference Board’s consumer confidence survey and existing home sales Tuesday, new home sales and the Fed’s Beige Book Wednesday, and the employment cost index and University of Michigan consumer confidence survey Friday: * We expect the Conference Board’s measure of consumer confidence to fall to 103.0 in April. The various surveys that have already been reported in early April point to a further decline in the Conference Board sentiment gauge, taking the index closer to the lows seen last summer. It’s no coincidence that this was last when gasoline prices were hovering near US$3/gallon. The widespread media focus on problems in the housing market is also no doubt having some impact on confidence. * We look for about a 3% pullback in existing home sales in March to a 6.50 million unit annual rate following the upside surprise seen in February. Such an outcome would be consistent with the recent performance of the pending home sales index, which has moved off its lows, but is showing little indication of any noticeable improvement. * We forecast a 2.4% gain in March durable goods orders. Company reports point to a surge in bookings for aircraft, which should help boost the headline. Meanwhile, the key core category — non-defense capital goods excluding aircraft — which registered very disappointing readings in both January and February, is expected to post a modest rebound (+0.8%). A slightly smaller advance is expected for the core shipments component. * We estimate March new home sales of 850,000 units annualized. The homebuilder sentiment survey has shown considerable volatility in recent months. This creates even more uncertainty than usual with respect to the near-term outlook for sales of newly constructed residences. However, improved weather conditions across parts of the nation should provide some support, and we expect to see a flattening out in March sales, following two months of declining activity. * We look for a further moderation in GDP growth in 1Q to +1.8%, reflecting the ongoing slippage in residential construction activity, some unexplained softness in business capital spending, and a renewed widening in the foreign trade gap. On the brighter side, the latest retail sales report suggests that consumption appears to have held up quite well (+3.5%), especially considering the steady escalation in prices at the gas pump over the course of the quarter. Inventories are expected to add 0.1 percentage point to GDP growth in 1Q, implying an anticipated 1.7% rise in final sales. Finally, the overall chain weight price index should show a sharp acceleration (to about +4.0%) with the key core PCE gauge rising 2.25%. * Based on our reweighting of the average hourly earnings data that is included with the employment report, we expect the ECI to rise 0.9% in 1Q, right in line with the results seen over the past few quarters. The component breakdown should show a 0.9% rise in wages, with the benefits category up 1%. Our 1Q estimate implies some further elevation in the headline ECI on a year-on-year basis — to +3.5%. Note that such an outcome would represent a significant acceleration relative to the +2.8% pace seen just a year ago.
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Presidential Election, 1st Round: A New Era in French Politics, Positive for Reforms
April 23, 2007
By Eric Chaney | Paris
Sarkozy and Royal selected for 2nd round Polls had correctly predicted the outcome of the 1st round: despite the rise of the ‘third man’ (Francois Bayrou, centre), Nicolas Sarkozy (moderate right, 30% of valid votes) and Segolène Royal (moderate left, 25%) have distanced others and will compete for the 2nd round (May 6). This was largely anticipated by the markets; hence, I would not expect any significant price action when markets open on Monday. However, this first round offered several important features for France. The French are interested in politics again At 85%, the turnout was the highest since the beginning of the Fifth Republic (1958). Following the vote that rejected the EU Constitution in 2005, the French want changes in their lives, see reforms as due (but do not agree on their content) and elections as the way to get them. A new era in French politics? The rise of Francois Bayrou (18% to 19%), who recently moved from centre of the right to centre of the left, but also the fact that, in her first reaction, socialist candidate Segolène Royal did not use the words ‘socialist’ or ‘left’ even once, indicate an inflection point in French politics, in my view. Reforms are no longer taboo and ideology matters less than platforms and personalities. The archaic and protectionist camp, i.e., the old socialist guard and the nationalistic far right, are the big losers of the first round. Sarkozy has a slight edge for the 2nd round Adding up left and right votes would give a clear advantage to Nicolas Sarkozy. However, Francois Bayrou’s voters will split their ballots between NS and SG, making the 2nd round a very tight contest. On balance, I believe that Sarkozy has a slight edge. On our analysis, his platform is a coherent pro-market reformist programme, which should enhance potential growth, while Royal’s propositions, in particular a large rise in the minimum wage, would hamper French competitiveness.
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When Everybody Loves the Shekel
April 23, 2007
By Serhan Cevik | London
The shekel’s appreciation is not just about the dollar’s weakness, in our opinion. The US dollar has long been on a depreciation trend, and our currency team expects cyclical adjustment to continue in the coming months. Although the dollar’s weakness has played a role in the shekel’s rise, we think that Israel’s own economic and structural features are more important in determining the value of its currency (see Net Gains, January 10, 2007). With fiscal normalization and greater specialization in higher value-added sectors, the Israeli economy has enjoyed a marked acceleration in real GDP growth and structural shifts in the balance of payments. The current account balance, for example, turned from an average deficit of 2% of GDP a year in the 1990s into an average surplus of 3% of GDP in the last four years (and as much as 5% of GDP in 2006). This improvement, especially against the headwind of higher commodity prices, represents the core of our argument for the shekel’s appreciation. However, although the shekel remains fundamentally undervalued, its recent move below 4.10 against the dollar has been much faster than even our out-of-consensus expectation and created a policy dilemma for the central bank. Currency pass-through has led to an episode of technical deflation. The consumer price index declined by 0.2% in the first quarter of this year, lowering the year-on-year inflation rate from -0.1% at the end of 2006 to -0.9% last month. The extent of deflationary pressures represents a significant shift away from price dynamics a year ago — when inflation was running at annual rate of 3.8% — and also shows a deviation from the central bank’s target range. We see one reason as really behind the prevailing deflation pressures, and that is not the lack of domestic demand in the economy. Instead, the shekel’s appreciation is the major culprit, driving dollar-denominated and -linked prices lower. The degree of exchange rate pass-through is exceptionally high in Israel, especially considering the low level of inflation. In our view, this is not so much because of changes in import prices, but reflects the behavior of non-tradable prices linked or denominated in dollars (see Technical Deflation, November 20, 2006). For example, Israel’s housing sector is almost fully dollarized and, with its 22% weight in the basket, has a significant influence over inflation dynamics. Hence, the 6.6% year-on-year drop in housing prices has pushed the headline inflation reading lower, while the inflation rate measured by prices unaffected by the exchange rate is now running at more than 2% on an annualized basis. As previously argued, interest rate cuts are not bringing an immediate correction. The Bank of Israel has responded by lowering short-term interest rates to weaken the shekel and thereby bring inflation within its target range. We have previously argued that this policy approach may not necessarily be effective in the short run, since the shekel’s appreciation is a result of fundamental improvements and structural changes in the economy. In other words, the economy has experienced a structural shift in the current account, while the composition of capital flows is not very sensitive to interest rates. Latest figures on foreign exchange activity show that even though non-residents poured more money into shekel-denominated bonds, the great majority of capital flows are either direct investment or strategic exposure in the equity market. Moreover, a cycle of monetary easing could also attract new investors and put even more pressure on the shekel. This is why we maintain the view that currency-driven deflation does not justify aggressive monetary easing. Indeed, instead of bringing stability, such a monetary policy orientation could lead to asset price bubbles and higher (exchange rate and inflation) volatility in the future. The economy is expanding faster than its potential growth rate. It is not easy to estimate the potential growth rate for an economy experiencing structural transitions, but our conservative calculations suggest a potential growth rate of 4-5% for the Israeli economy. This means that the actual rate of real GDP growth — reaching 8% on an annualized basis in the last quarter of 2006 — has been well above the potential growth rate and consequently narrowed the output gap. In our view, with the lagged transmission of interest rate cuts, these underlying dynamics will gradually bring inflation within the target range.
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