Business Conditions: Subdued by Services.
June 14, 2007
By Shital Patel | New York
The Morgan Stanley Business Conditions Index (MSBCI) improved for the third consecutive month in June, increasing three points to 51%. This is the first reading over the 50% threshold since May 2006; a reading over 50% indicates improvement in business conditions. The smoothed 3-month moving average of the MSBCI also increased three points, to 48%. Our survey’s two key forward-looking indicators — the advance bookings index and the business conditions expectations index — remained strong in June. We’re holding our breath, having seen false starts before, but those forward-looking indicators hint that the improvement this time finally may be sustainable.
A technical note: In April, we began seasonally adjusting the MSBCI using the X-11 ARIMA method. We noted that the process could revise seasonal factors historically. This month’s adjustment revised May’s reading upward from 46% to 48%, meaning the improvement in seasonally adjusted conditions in May was greater than we reported last month. The adjusted MSBCI in April was 45%. However, this does not change the fact that conditions have been improving over the last three months, nor that June was the first reading over 50% in over a year. Official statistics strongly suggest that the economic environment has improved vastly compared to this time last month. While the BEA cut its estimate of 1st quarter GDP growth from 1.3% to 0.6%, our tracking estimate for 2nd quarter growth nearly doubled from 2.4% to 4.1%. Among the strong data, nondefense capital goods ex aircraft orders posted two months of strong growth, while net exports were indicative of stronger growth abroad. The consumer has also remained strong in the face of high gas prices — May non-auto retail sales excluding gas stations were up a much better than anticipated 1.0% over the month. In contrast with these strong incoming data, the MSBCI remains relatively sedate. The breadth of business conditions has yet to improve significantly. In early June, the percentage of groups noting that conditions were unchanged compared to a month ago jumped to 63% from 39% in May. This was the highest unchanged share since March 2006. Conditions deteriorated for only 16% of the groups, down from 32% last month, and improved for 21% of the groups, down from 29%. By sector, conditions improved for the materials sector along with the retail softlines, biotechnology, electrical equipment, communications equipment, PC systems and hardware, and electric utilities groups. Not surprisingly, given the ongoing subprime mortgage issues, the financials and homebuilders reported deterioration. So did semiconductor capital equipment companies and airlines. The aforementioned advance bookings index remained strong, edging down only one point to 67%. The advance bookings index has been a good predictor of moves in the MSBCI, so this 2nd consecutive month of strength could lead to strength in the headline MSBCI. Bookings increased most for the industrials and IT sectors. Similarly, the business conditions expectations index dipped two points to a still-strong 58%. Analysts expect conditions to improve over the next six months for IT, industrials, materials, energy and utilities companies. Manufacturing outpaces services. This month we took a closer look at the performance of the manufacturing sector versus services. Somewhat surprisingly, and in contrast with the ‘two-tier’ economy theme characterizing our view since last autumn, the weakness lately has been confined to the services sector. The services MSBCI has posted sub-50% readings since February; in June it edged down two points to 43%. Much of the weakness is concentrated in the financials sector, thanks to the inverted yield curve crimping margins and mortgage credit woes. It’s thus important to note that the services MSBCI ex-financials gained ten points in June to 53%. The recent ‘disinversion’ of the yield curve could lead to improvement in the financials sector and thus in the MSBCI as a whole, although the backup in yields may hurt some. Likely reflecting strong overseas growth, the manufacturing sub-index has been above the 50% threshold since February; it jumped eight points to 61% in June. We also split out the advance bookings into two subindexes. The best news is that the advance bookings index for services was a strong 73% in June, while the manufacturing sub-index was a formidable 63%. Given these factors, the MSBCI may be poised for a strong rebound in coming months. Credit conditions still favorable. Although interest rates bottomed in February, we canvassed analysts just before the jump in yields over 5% that began a little more than a week ago. That jump in 10-year Treasury yields could add financial restraint to the outlook. According to the survey, credit conditions have just slightly worsened, decreasing five points to 49%, just barely below the 50% threshold. This relatively high reading does not surprise us for several reasons. First, the Fed’s Senior Loan Officer survey from April showed that banks are still, on net, easing standards for C&I loans to large and medium firms. Second, a weaker dollar, still-tight credit spreads, and higher equity prices are helping keep financial conditions favorable. Also, according to our survey, the bulk of the deterioration in credit conditions is concentrated in the financial sectors. The credit conditions index ex-financials was 53% in June. Dollar weakness largely constructive. As mentioned before, the decline in the dollar remains a tailwind for companies’ top and bottom lines. This month we asked analysts whether the recent decline in the dollar has affected earnings growth expectations for companies under their coverage. A full 36% of respondents said that the dollar was constructive for 2007 growth. The only group where the dollar is a headwind to growth is the oil exploration and production companies. In this instance, goods sold abroad are priced in US dollars, but their costs are often denominated in foreign currencies, thus squeezing margins. For 21% of the groups, the dollar is constructive for 2007 earnings growth on the order of 1-100 basis points (bps), while it will boost earnings by 101-250 bps for another 12% of the groups. The household and personal care group was the only group where the dollar will increase earnings by 250 bps or more. Inflation risks contained. While stronger than expected growth has roiled Treasury markets, inflation risks also remain a market concern. Yet, upside risks to inflation may be abating, according to our survey. The pricing conditions index fell eight points to 59% in June. The percentage of groups that raised prices from a year ago stood at 42%, down from 56% last month, while the percentage decreasing prices remained virtually unchanged at 23%. Several groups, including lodging, beverages, multifamily REITs, managed care, and healthcare services and IT, have increased prices by 3% or more from a year ago. Conversely, prices have declined by 3% or more for several IT companies and the telecom services group. On the margin front, expectations for 2007 margin growth remained unchanged this month. More than half — 56% — believe margins will expand, while 21% believe margins will shrink. Sectors with the most upside to margins are healthcare, industrials, consumer staples, IT, telecom services, energy and utilities. Over the last three months, prices charged have risen faster than unit costs for 24% of the companies, unchanged from May. Material and/or labor costs outpaced prices charged for only 34% of the companies, down from 47% last month. Hiring plans remain sluggish. A key component of our economic outlook is that job gains will support income growth and thus consumer spending; May’s strong payroll report reaffirmed this. However, survey results among this sample of respondents suggest that hiring plans remain sluggish. Only 30% of the groups plan to increase hiring over the next three months, down from 37% in May and the lowest reading since last October. More worrisome, a full 21% of groups plan to cut payrolls, up from 15% last month and matching the high in May 2006. Capex strength may be trimmed. Our US strategy team has noted that companies are beginning to allocate record levels of cash to capex after several years of capital discipline and returning cash to shareholders through buybacks. In their 1H07 CFO Survey conducted between mid-January and mid-February,, our strategy team concluded that CFOs were signalling a greater willingness to deploy balance sheet cash to M&A and buybacks. They were less enthusiastic about capital spending prospects. That has changed: They now estimate that S&P capex growth (including outlays abroad) is tracking over 20% on a year-over-year basis. According to our survey, that brisk pace may be at risk: The percentage of groups with plans to increase capex over the next three months declined to 49% from 54% in May, but still above the historical average of 47%. Capital spending plans have remained above-average since December..
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The Istan-Bull Paradox
June 14, 2007
By Serhan Cevik | London
Turkey is in a period of uncertainty, but markets are paying little attention to this. Over the past five years, despite a long list of geopolitical and financial shocks, we have maintained a constructive assessment of Turkey’s economic normalization and valued its institutional convergence towards Europe no less than fiscal consolidation and disinflation. Indeed, the sustainability of macroeconomic gains depends critically on institutional predictability and credibility, as much as on prudent policies. Unfortunately, recent events have sparked significant institutional and political uncertainty, making us uneasy about the country’s prospects for the first time in years. However, financial markets have so far presented a curious response to the re-emergence of long-forgotten institutional and political risks. Dismissing the events following the military’s venture into politics, the lira has become stronger, and interest rates keep declining. Turkey has, of course, become less vulnerable to ‘fat tail’ events, thanks to economic normalization and structural progress, but that is still not enough to explain the prevailing sense of enthusiasm in financial markets. In our view, the paradox of higher institutional/political uncertainty and rising asset prices is largely a result of global liquidity and the lure of carry trades. The abundance of global liquidity has an overwhelming influence on Turkish markets. Notwithstanding our concerns about institutional and political challenges, we still believe that the economy is strong enough to absorb shocks and grow at a robust pace. The latest indicators — ranging from export growth to disinflation — confirm our assessment. Nonetheless, the decisive factor for international investors is still the abundance of global liquidity and the resulting attraction of high interest rates. Channeling ‘excess’ liquidity in low-yielding currencies into higher-yielding markets is not surprising in today’s liquidity-driven world, as even central banks and sovereign wealth funds accumulate risky assets; however, the unprecedented extent of capital flows creates valuation and policy dilemmas in developing countries. Foreign holdings of equity and domestic debt have reached an all-time high in Turkey. Markets may undergo occasional abrupt fluctuations, but volatility (measured by the CBOE index) dropped from an average of 20.1 between 1990 and 2002 to 12.8 so far this year. In our view, the feedback channel between the moderation of volatility and risk appetite has supported leveraged bets, especially on higher-yielding currencies. Turkey, for example, is such a point of attraction in the sea of global liquidity. Foreign holdings of equity and domestic debt surged from US$15.1 billion in 2003 to US$54.6 billion at the end of 2005 and then US$59 billion in April 2006, just before the global volatility shock. After a brief period of adjustment, higher interest rates, coupled with strong economic fundamentals, have attracted even more foreign capital into Turkish markets. Although the lira’s sudden depreciation last year altered the behavior of residents (who then accumulated US$30 billion in foreign currency-denominated instruments), foreign investors have become even more enthusiastic. According to the latest data, foreign holdings of equity and domestic debt increased to US$81.5 billion, especially as non-residents accumulated 21 billion lira in domestic debt since last summer. As a result, non-residents own more than 70% of free float in the equity market and 37% of non-bank holdings of domestic government debt. Changes in global risk appetite remain a risk, but the lira is unlikely to weaken dramatically. With the strength of global risk appetite, cross-border capital movements have kept credit spreads low, boosting markets like Turkey that offer higher returns. Of course, even though the quality of external financing has improved in recent years, Turkey is still exposed to liquidity-driven portfolio flows and thus vulnerable to the unwinding of carry trades. However, the lira’s downside is limited, in our opinion, for four key reasons: (1) the Turkish economy stands on a stronger footing; (2) residents already have long dollar positions; (3) interest rate differentials limit the extent of carry erosion; and (4) tight liquidity conditions in the domestic money markets provide reasonable support. Even so, we do realize that monetary variables cannot shield against the deepening of political uncertainty, which could suddenly corral the Istan-bull.
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The Authorities Appear Poised to Initiate a New Round of Macro Tightening
June 14, 2007
By Qing Wang & Denise Yam, CFA | Hong Kong
Conclusion: The Chinese authorities appear poised to initiate a new round of macroeconomic tightening. Potential policy measures include stricter administrative measures to curb investment growth, more aggressive monetary tightening (e.g., rate hikes) and a broad-based cut of the VAT rebate rates for exports. What’s new: The Chinese official press reported late on Wednesday evening that the State Council has concluded a meeting called to discuss several “outstanding” problems with the current economic situation, including overly rapid industrial production growth, an excessive trade surplus, persistently strong fixed-asset investment growth, excess liquidity, growing inflationary pressures and a serious challenge to the energy conservation effort. The State Council has emphasised the need to give high priority to these issues and to guard against the risk of overly rapid growth turning into general economic overheating. In particular, it believes that monetary policy should turn “appropriately tight” and comprehensive measures should be employed to ease the excess liquidity situation, including “financial and tax measures”. Implications: We reiterate our call that monetary tightening of some form is now imminent, perhaps in a matter of days. This could take the form of interest rate hikes and/or another RRR hike. Since “tax measures” are identified specifically as a way to help tackle excess liquidity, an effective hike of deposit rates could be the immediate next move via reduction or elimination of the tax levied on interest income earned on bank deposits. The current tax rate is 20%; reducing it to zero would equate to a hike of about 60bp in the one-year time deposit rate. The press report was conspicuously silent on the stock market. However, we think that an effective deposit rate hike via a reduction or removal of interest income tax would signal unambiguously the authorities’ discomfort with the current levels of the stock market.
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Globalization, Capitalism and Inequality
June 14, 2007
By Madhava Kumar | Mumbai
“If those who are better off do not act in a more socially responsible manner, our growth process may be at risk, our polity may become anarchic and our society may get further divided. We cannot afford these luxuries.” – Dr. Manmohan Singh (Prime Minister of India) India’s Prime Minister, Dr. Manmohan Singh, made these comments in a recent speech at a conference on the subject of “Inclusive Growth — Challenges for Corporate India”. His speech has again highlighted the rising inequality in recent years and related challenges facing the political environment. The Prime Minister suggested that corporate India should come forward to form a new partnership and implement a social charter in making India’s society more humane and just. We believe that the social pressure arising from widening inequality has increased in the last few years, driven by globalization and the rise of capitalism. Globalization and capitalism have been the two key drivers of India’s GDP growth acceleration over the last five years. There has been a pick-up in the pace of India’s economic integration with the global marketplace, as reflected in fast-rising trade and capital inflows to GDP. Trade to GDP increased to 49.6% of GDP in 2006 from 27.8% in 2000 and 17.4% in 1991. An even more powerful factor supporting India’s growth acceleration has been the trend in integration of its capital markets with the global financial markets. Indeed, if we take the starting point for India and China as the year in which they initiated reforms (i.e., 1991 for India and 1978 for China), India’s trade to GDP is largely tracking the trend for China. However, due to stronger capital market infrastructure, capital inflows to GDP in India have been persistently higher than those in China since their respective starting points. A simultaneous shift from a socialist to a capitalist framework is also supporting the acceleration in growth. The business environment is changing, allowing entrepreneurial spirit to flourish. This trend is reflected in the divergence in corporate profit and wages relative to GDP. Over the last five years, retained corporate operating profits (gross of capital charges) to GDP have shot up to an estimated 9.1% in F2007 from 3.7% in F2002, while wages to GDP have declined to an estimated 28.7% from 31%. Poverty levels — falling, but still high These two trends (globalization and capitalism) have helped accelerate India’s GDP growth to an average of 7.6% over the last five years from 5.7% in the 1990s and 5.8% in the 1980s, helping address the serious challenge of poverty. Typically, a reduction in poverty is dependent on income growth in a country and the extent to which that income growth is distributed among the poor. In India, acceleration in growth has been the key factor that has enabled a reduction in poverty levels, even as distribution has remained uneven. Poverty (i.e., the share of the population living below US$1/day in PPP terms) reduction has accelerated in India since liberalization. India has been able to lift 1.3% of its population per annum from poverty over the last 13 years (post reforms era). According to World Bank data, India’s poverty rate dropped from 45% (413 million) in 1994 to 34.3% (371 million) in 2004 as the reform process gained critical mass. This compares with virtually unchanged poverty rates in the preceding decade. Despite this improvement, absolute poverty levels are still very high. India faces a considerable challenge in managing child survival and health. About 47% of children in India suffer from malnutrition, compared with 8% in China. India accounts for 1.9 million (18%) of the 10.5 million global deaths among children under five years of age. This is the highest for any single nation. Of every 14 children, one dies in the first five years of life. In comparison, China experiences 0.47 million deaths among children under five years, implying that one in every 37 children dies in the first five years of life. Inequality is widening The concerning aspect of the trend in globalization and capitalism is the rising social challenges on account of increasing inequality. We believe that the rise in inequality when absolute poverty levels are still very high poses a major political challenge. Although recent data are not available, the World Bank gauges that income/consumption inequality (as measured by the Gini Index) increased to 30.5% in 2004 from 27.7% in 1994 (the point from which growth started accelerating) in rural areas and to 37.6% in 2004 from 33.3% in 1994 in urban areas. We believe that this is likely to have increased further over the past three years. (The Gini Index measures the extent to which the distribution of income or consumption expenditure among individuals or households within an economy deviates from a perfectly equal distribution.) The inequality gap in wealth is even starker. There are no official data on the increase in household wealth, but our analysis indicates that India has witnessed an increase in wealth of over US$1 trillion (over 100% of GDP) in the past four years — and that the bulk of this gain has been concentrated within a very small segment of the population. The three key sources of wealth accretion have been the equity market, property and gold. Stock market capitalization has increased from US$120 billion as of March 2003 to US$1 trillion as of May 2007. Adjusted for foreign ownership, the implied overall gain for domestic shareholders is US$690 billion. Per the Securities Exchange Board of India, only 4-7% of the population own equities. Even within this group, the ownership is likely to be highly concentrated as almost US$ 470 billion of the increase is accounted for by promoters (controlling stakeholders). Similarly, in our view, household wealth creation through residential property will have been at least US$300-500 billion. However, only an estimated 47% of the population own a ‘pucca’ house (i.e., a house wherein walls and roofs are made of stable construction materials, such as cement, bricks, metal and wood). Even within this segment of ‘pucca’ housing, the higher-income classes own a large proportion of the area in terms of square feet. The other significant asset that is held by Indian households is gold. On our estimates, the market value of India’s stock of gold has increased by approximately US$200 billion since March 2003 to US$370 billion currently. The gains under this asset class, though unequal, should have been more widely distributed than those related to equity and property. According to a survey of household assets conducted by the National Sample Survey Organization (NSSO), as of June 2002, the top 34% of households (in terms of wealth) held 71% of the value of consumer durables (including gold and jewellery). Should inequality matter? As mentioned earlier, strong growth rates are helping to reduce poverty rates at an accelerated pace. Hence, from a pareto efficiency (optimality) perspective, acceleration in the incomes of some sections of the population without the rest of the population being worse off would be welfare-enhancing. However, as Amartya Sen argues, “a society can be pareto optimal but still be perfectly disgusting”. Apart from this social justice and morality argument, there are a number of research papers arguing that, in the long run, a high level of inequality can hurt growth on account of socio-political tensions. More importantly, as the United Nations Development Program (UNDP) points out, reduction in absolute poverty also tends to be significantly influenced by inequality of income, health and education. Political rhetoric is rising The political consequences of these trends are triggering a policy response from the government. The government has already initiated affirmative action by providing for quotas in higher education. It has also suggested that the corporate sector voluntarily introduces quotas for the poor caste population. With 17 state elections and the general election due over the next two years, we see a rising risk of further government intervention in this context. Albeit gradually, a new agenda is emerging to address the issue of increasing inequality — between rich and poor, between urban and rural areas and between upper and lower castes. The government has already intervened with the intention of redistribution. The ruling UPA government has initiated programs providing for quotas in higher education institutions for the scheduled caste and scheduled tribes (the section of population considered to be under-privileged). Similarly, the UPA government has also suggested the implementation of quotas for jobs in the private sector. Although the government’s stance is supportive of ‘voluntary’ quotas, there has also been talk about making the quotas mandatory. The government has only refrained from more extreme measures following a commitment to voluntary affirmative action from key industry bodies. Recently, the government was forced to intervene in the case of agricultural land acquisitions for Special Economic Zone (SEZ) development. Farmers feared that they would not get a fair price for their land and that these acquisitions would lead to a further widening of inequality. These developments led social and political upheaval across the country, threatening to put the entire SEZ program into disarray. More such measures and challenges are likely to be faced in the coming years as the issue of widening inequality comes up for debate in the 17 state elections and the general election due over the next two years. Improving public institution capabilities is crucial We believe that a more effective solution to address the trend in inequality would to ‘balance up’, with the government initiating policy measures to benefit the poor rather than enforcing affirmative action. To be sure, over the past three years, the UPA has initiated various measures, such as the National Rural Health Mission (to improve access to quality healthcare for the rural population), the National Rural Employment Guarantee Act (NREGA, which promises employment to every rural household), the Bharat Nirman Program (a four-year program aimed at improving rural infrastructure) and implementation of an education cess for augmenting revenues to fund education (especially primary education). However, to improve the effectiveness of this effort, there is a need to shift to outcome-based investment allocations by the governments. Although the Central Government and Planning Commission are making an effort to move to outcome-based budget allocations, the impact of this approach has yet to be seen. We believe that India also needs gradually to decentralize the implementation of welfare schemes, with greater responsibility and authority transferred to local institutions after installing the right checks to follow the outcome-based approach.
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