The Year of Recoupling
February 11, 2008
By Richard Berner | New York
Despite market turmoil, investors remain complacent about spillovers from a US-led slowdown to other markets and economies. In our view, Europe and Japan are most at risk, Latin America is next, while Asia (excluding Japan), Russia, and the Middle East are least vulnerable. At work will be the interplay between trade and financial shocks that will depress growth around the world. Assessing those shocks, the underlying domestic strength of particular regions or economies, and the policy actions aimed at countering their impact will be critical for investment strategy.
This “recoupling” contrasts sharply with what appeared to be a decoupling of the world’s economies from the US slowdown last year. And it appears to contradict the notion that growth outside the US can cushion the US downturn. In reality, as our colleague Gray Newman notes, the “decoupling” thesis only emerged after five years of above-trend global growth that lifted virtually every boat in the industrial and emerging economies. That strength merely delayed rather than eliminated the spillovers from the US to overseas markets. Apart from Japan, however, recessions are unlikely outside the US. Critically, recoupling will come in many shades, and history may not be a good guide to distinguish which economies will be most affected. To assess vulnerability, we analyze two channels through which the spillovers may spread as well as the underlying health of each region. Consider four factors: First, weak US demand may spill into overseas economies through a traditional trade channel, as slower growth in US imports will directly or indirectly affect exports in other regions. Under the trade umbrella, we include the cross-border flows of profits resulting from direct investment in the US. Second, financial channels are probably more important today; financial shocks that began with rising US mortgage defaults are now spilling over into a global credit squeeze, deleveraging of balance sheets, and tighter financial conditions in many markets. Third, the ebbing tide of US and global growth is exposing domestic weakness in economies that had been masked by the global boom of the past few years, so understanding domestic economic health is critical. Finally, while we aren’t bearish on commodities, it’s important to assess the effects on commodity producers of slower growth in demand. Trade shocks Which regions are most or least vulnerable to trade shocks? The slowdown in US imports has much further to go as pullbacks in US consumer and capital spending affect US demand for goods and services sourced from abroad. Not surprisingly, America’s NAFTA neighbors — Canada and Mexico — are most exposed to US weakness through trade because they directly provide more than a quarter of US imports. The impact elsewhere will likely be different from past recessions because prolonged economic booms mean that the US matters less to global growth and trade than previously. According to IMF data, the US now accounts for about 14% of world imports, down six percentage points in the past eight years. In contrast, Asia now accounts for 20% of the global import total, up by four percentage points during the same period. As a result, a given percentage decline in US domestic demand will have a smaller impact on global growth than it did in the past. Correspondingly, those differences have radically altered the pattern of trade for individual regions. For example, as an export destination, the US accounts for just 12% of European Union (EU) exports to countries outside the EU, down fully one-third from 2000. Asia ex Japan and OPEC now account for half of EU exports. To be sure, increased globalization actually works to strengthen the trade channel, partly offsetting America’s shrinking role in the global economy. That’s because US outsourcing of production abroad and the creation of far-flung global supply chains mean that a given percentage change in US demand will create ripples in venues from Canada to China. However, the net of these two factors —a smaller US role and increased interdependence of trade — supports our view that no one is immune from a US recession, but that the bang for the buck today will be smaller than in the past. Earnings shocks “Trade shocks” through the income side of the ledger will also matter, because a US profits recession will hurt the earnings of foreign affiliates based in the US. Due to a downturn in operating leverage and a corresponding squeeze on margins, we expect a 4.5% contraction in US after-tax “economic” profits in 2008. But such results will include a positive contribution from earnings at US affiliates abroad, masking an even sharper (9%) contraction in US domestically generated earnings. The UK and the rest of Europe likely are most exposed to the downturn in earnings at their US affiliates, based on their shares of direct investment in the US. According to Commerce Department data, in 2005, UK residents or companies owned one-sixth of foreign investment in the US, residents/companies elsewhere in Europe owned 52%, and Japanese owners held 11.6%. Financial shocks even more important Trade represents the traditional linkage, but financial shocks may be the most important driver of recoupling in this global slowdown. Financial globalization has knit markets together even more closely, and financial shocks spread more quickly than trade shocks. We think financial shocks put Europe and the UK most at risk. The liquidity and credit shocks that began last summer have promoted a procyclical reintermediation of the European banking system as in the US, and rising credit issues in the EU and the UK are making lenders more cautious (for an update, see Huw Van Steenis and Solveig Babinet, “What if Funding Costs Remain Gapped Out?” February 6, 2008). In many European countries, including the UK, Spain and Ireland, house prices have risen by even more than in the US over the past decade. While housing markets are local, the banking crisis is global, and European banks have started to tighten lending standards for housing loans. David Miles and the UK team note that the UK’s slowdown is not primarily the result of knock-on effects from the US slowdown on UK exports; rather, falling house prices, high leverage, and lender restraint have put the economy on a similar slowdown path (see “The UK Economic Outlook,” February 6, 2008). Dysfunctional markets still hobble securitization, and lenders need more capital. Combined with past currency appreciation and restrictive monetary policies, we think that’s a recipe for slower growth. To be sure, as our European economists Eric Chaney and Elga Bartsch remind us, there is no evidence so far that the credit crunch has started for real in Europe, despite some serious casualties in the banking sector. And inflation is stickier than one might have thought. So while the ECB is no longer talking of tightening, they are adamant that market hopes for ease are entirely premature. That view was echoed in this weekend’s G7 meeting, at which policymakers indicated that using fiscal stimulus was not an option either. Outside of Europe, high levels of participation by foreigners in Japanese markets increase the vulnerability of Japan to financial shocks from abroad. In contrast, the improved terms of trade and strong capital inflows into external surplus countries in Asia and in the Middle East have reduced their vulnerability to such shocks. Exposing domestic weakness The slowdown in US growth and in global trade will expose domestic differences among economies and markets. It will expose domestic weakness in economies like Japan that previously swam in the high tide of strong global growth. While the strength of AXJ demand will support Japan, slower US growth will hurt it, and self-inflicted wounds are raising the chance of a Japanese recession. Moreover, Japan has little scope for policy stimulus (See Takehiro Sato, “Be Prepared for Dual Recession,” February 8, 2008). In the middle are emerging markets in South Africa, Turkey, Hungary, Poland and Latin America that have strengthened domestic demand but are heavily exposed to a global slowdown through large external deficits. In particular, Michael Kafe and Andrea Masia believe that South Africa’s 8%-of-GDP current account deficit leaves it vulnerable to a drying up of portfolio capital inflows that would hurt the rand and tighten financial conditions. Gray Newman and the Latin American team observe “the principal drivers of better growth in the region have been a series of external factors reflected in a period of favorable financial and credit conditions, strong global demand and a remarkable surge in the terms of trade.” Moreover, they note, “Latin American policy makers have not ensured through appropriate policies the basis for sustainable, long-term growth.” Consequently, a reversal in those external factors will promote a significant slowing in LatAm growth, and the team would pick winners from losers based on their progress on economic reforms. An imported soft landing for China At the other extreme, China and some commodity producers, especially the GCC countries with their huge external surpluses, welcome an “imported soft landing” that will lower the risks of overheating but – courtesy of sustainable domestic demand and income gains – leave overall growth intact. As Qing Wang notes, it is important that the credit crunch was policy-induced in China [so that policy makers can now take their foot off the brake] but was market-driven in the industrial world (see “China Economics – Journey into Autumn: An Imported Soft Landing in ’08,” December 8, 2007). And Chetan Ahya and team argue for a “soft decoupling” in many Asian economies, as Asia ex Japan is less dependent on the US than in the 2001 downturn and domestic fundamentals are much stronger today. In particular, strong national balance sheets reduce the vulnerability to external financial shocks; private income and consumption are growing strongly; officials and businesses are directing investment towards infrastructure and domestic construction; and policymakers have the wherewithal to use fiscal stimulus if the external environment turns vicious (see “Limited Recoupling Ahead,” December 13, 2007). Finally, the Fed’s easier monetary policy translates into easier monetary conditions for those emerging-market countries who have pegged their currencies to the dollar, cushioning the blow from external financial shocks. We would include the GCC countries in that group. Commodity price downdraft unlikely Commodity prices and the income to commodity producers may be at risk from the slowdown; after all, slower global growth is typically bad news for commodity demand and prices. Nevertheless, there are two mitigating factors. First, we expect growth to continue to be strongest in the EM economies whose consumption is most commodity-intensive. Food is a case in point: it accounts for a third of household budgets in most EM economies, double the share of the industrial world. Rapidly rising living standards in EM economies have triggered stronger demand for protein (see Robert Feldman and Hussein Allidina “Land to Mouth: How to Profit from the Food Chain in Food,” January 15, 2008). Ditto for energy. And the infrastructure buildout in EM continues to fuel commodity and energy demand. The second factor is on the supply side: Investment takes time and has strained the capacity to install it. Thus, according to Hussein Allidina, costs are rising as fast as commodity prices, limiting both the prospective returns on such investment and the decline in commodity prices to the level of marginal production costs. Beyond the domestic sources of weakness in the US economy, slower growth abroad will feed back to the US in two ways. First, it will limit growth in US export demand. Second, it will undermine US earnings from abroad, which now account for a third of the total. The combination will hobble US capital spending and employment. What’s the trade? Recoupling will reinforce several of our strategy calls: The dollar will bottom and slowly rebound against the euro but continue to decline vis-à-vis AXJ currencies and the yen. We prefer European bonds to US bonds, expect real (and thus nominal) transatlantic spreads to reverse, and expect a steepening in European yield curves. We expect additional steepening in the US yield curve, but more from the back end, as markets price in Fed efforts to reflate. We think bear markets persist in risky assets, but we are bullish on EM equities and expect a bear-market rally in European equities. We would still avoid Japan. With much of the bad news on losses and defaults in the price, we are looking for opportunities in investment-grade credit. Conclusions We think investors remain overly complacent about recoupling risks. While markets and policymakers have priced in much of the US-centric risk to growth, the risk is that they are underestimating the spillovers to the rest of the world’s economies. However, markets have already begun to price in those spillovers, and while there is more to come, opportunities to invest in attractively-priced assets will arise when they show up fully in economic activity. Recoupling also implies that monetary and fiscal policy makers outside the US will increasingly join the reflation bandwagon, thus setting the stage for a return of the inflation theme further down the road.
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Business Conditions: Not a Recovery Yet
February 11, 2008
By Shital Patel | New York
The Morgan Stanley Business Conditions Index hit a 4-month high in early February, increasing seven points to 36% on a seasonally adjusted basis. Unadjusted, the MSBCI jumped 17 points to 43% with nearly a quarter of respondents noting improvement in their industries, up from 3% in January. But credit restraint — the key driver of the downturn — showed virtually no improvement from last month. Three-quarters of lenders continue to tighten standards while half of the borrowers are facing tighter standards. Our credit conditions index, which looks at the ability to get financing compared to three months ago, edged up five points to a still-weak 33% in February. The uptick in assessment of business conditions may be the result of several recent events. First, the broad acceptance of an economic growth slowdown has reduced some of the uncertainty surrounding the outlook and lowered the bar for improvement. Second, to help an ailing economy, the Fed has eased more aggressively than we expected even a month ago. Since the January survey, the Fed has cut the Fed funds target rate by 125 basis points and we now expect a trough of 2.50% versus 3.50% previously. Third, the fiscal stimulus package — including tax rebates and business investment incentives — which was just enacted by Congress may have boosted confidence that the downturn will be short and shallow. As we’ve noted in the past, one month’s improvement in the MSBCI is essentially noise, and not a signal of improvement. Even though the index improved seven points, the index is still below average by more than one standard deviation. Forward-looking survey details improved but remained at weak levels. The business conditions expectations index increased eight points to 33% while the advance bookings index posted a gain of seven points to 50%. Hiring plans remained weak, with only 24% of the groups planning to increase payrolls over the next three months and 26% planning to cut payrolls. As we expected, January’s surprising jump in plans to increase capital spending over the next three months proved unsustainable; they plunged by 16 points to 45%. The pricing conditions index also fell six points, off the two-year high of 71%. That could be a harbinger of eroding pricing power. Meanwhile, other surveys of business activity have been getting a lot of media attention. The typically non-market moving non-manufacturing ISM index sent stocks falling and Treasuries rallying after its stunning 8.6 point plunge to 44.6. This came in sharp contrast to the surprising 2.3 point increase in the manufacturing ISM measure. Over the past year, our own manufacturing and services sub-indexes have moved in tandem although the manufacturing measure has been consistently higher. Other measures including the NFIB small business optimism index and the Conference Board’s CEO Confidence measure have hit multi-year lows. CEOs’ expectations for their own industries were also weak, with only 17% expecting improvement over the next six months, according to the Conference Board. Even the most cursory internet search of the word “recession” pulls up over 66,000 news articles. However, according to estimates prepared by US equity strategist Bill Smith, MS analysts are slow to fold in the impending recession in their earnings estimates, although they are still ahead of Street analysts. MS bottom-up earnings growth estimates for 2008 have come down from 13.5% in early January to a still-lofty 9.8%, mostly due to a large downward revision to financials estimates. Bottom-up consensus estimates have remained high at 13.0%. Consequently, we and our strategy team believe that analysts will be reducing their earnings estimates. Our own forecast for 2008 after-tax “book” profits growth is down 5.2%. Analysts do seem forthright about the risks: Risks to earnings estimates remained roughly unchanged from last month, with nearly 70% of analysts continuing to expect downside risks to their estimates. Of these, 52% believe the risk is from worse domestic results, 28% from worse domestic and foreign growth, 14% from margin compression, and 10% from worse than expected growth abroad. Only 31% of analysts see upside risks to earnings estimates. The margin outlook remained virtually unchanged this month, with 38% of analysts expecting margins to expand in 2008 at companies under their coverage. We have long noted that the dollar would have a lagged impact on earnings. This month, over half of the analysts reported that the dollar has contributed to bottom line results. 40% believe the weaker dollar has contributed 1-3 percentage points while 12% believe the depreciation has contributed 3 percentage points or more. Special survey questions also reveal that the election outcome and its potential implications for investors are not yet a concern. We asked analysts whether companies under their coverage are changing their dividend policy or capital structure in anticipation of a change in dividend or capital gains taxation (e.g., offering a one-time dividend now, or emphasizing buybacks over dividends). Surprisingly, only two analysts reported that companies are reacting to possible changes in tax policy. Furthermore, neither CFOs nor investors seem to care about the impact of any potential changes. A full 86% of respondents noted that neither groups have been asking questions about the impact of tax policy changes. According to US strategists Abhijit Chakrabortti and Nicole Davison Fox, key election year issues with market implications also include healthcare reform and clean energy.
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Review and Preview
February 11, 2008
By Ted Wieseman | New York
The Treasury curve saw another huge steepening move the past week on big gains at the front end and significant losses at the back end, as incoming economic data – highlighted by a collapse in the non-manufacturing ISM – continued to indicate that the economy has entered recession and as financial conditions deteriorated badly. Stocks reversed their significant rebound seen the prior week. And, more notably, credit markets, which didn’t see any sort of recovery when stocks had their bounce, continued to deteriorate badly, with the investment grade CDX index getting pounded to a series of new all-time wides through the week. The leveraged loan LCDX index extended its horrible recent performance. Fears in the commercial mortgage market appear to be rising sharply, with the CMBX market in freefall all week. And the Fed’s senior loan officer survey confirmed that bank credit availability and pricing across business, consumer and residential and commercial real estate loans has worsened dramatically in the past three months. The broad and severe deterioration in financial conditions combined with the weak economic data prompted a major further dovish repricing of the Fed in futures markets, boosting the front end. A near-complete boycott of the 30-year auction by final investors, however, made clear that as bad as the near-term economic outlook may be, it still doesn’t make lending money to the government for 30 years at less than 4.5% an attractive proposition. Meanwhile, on top of the worsening in equity, credit and other markets, interbank lending pressures resumed worsening. A marginal decline in 3-month LIBOR on the week did not come close to keeping pace with the big dovish repricing of near-term Fed expectations, sending LIBOR/expected fed funds spreads significantly higher after what had been a significantly improving trend since early December. For the week, the Treasury curve steepened to new highs since September 2004, with 2s-10s up 21bp to 172bp and 2s-30s up 27bp to 251bp. This was the sixth straight week the curve steepened – every week so far this year – and the biggest weekly move so far in this run. The 2-year yield fell 15bp to 1.93% and the 5-year 6bp to 2.70%, while the 10-year yield rose 5bp to 3.65% and the 30-year 12bp to 4.44%. TIPS outperformed slightly, with the 5-year TIPS yield down 5bp to 0.53% and the 10-year up 4bp to 1.35%. There was a big further dovish repricing of the Fed, most of which came in response to the plunge in the non-manufacturing ISM and ensuing stock market plunge Tuesday. Odds of another inter-meeting cut continued to be raised, with the February fed funds contract rallying 3.5bp to 2.915% (and note that effective fed funds so far this month has been quite volatile but on average has run close to the 3% target). If not inter-meeting, at least another 50bp rate cut to 2.50% is expected by the March FOMC meeting, with about a one in three chance seen of a 75bp move to 2.25%, as the April contract gained 15bp to 2.425%. The May contract gained 12bp to 2.265%, July 12.5bp to 2.10%, and August 16.5bp to 2.01%, lowering the expected trough fed funds target to 2% from 2.25%. There was a huge steepening in the eurodollar futures market, with 16.5bp rallies by the low-rate Sep 08 and Dec 08 contracts to 2.31% and 2.355%, respectively, and 20bp losses among the longest-dated contracts. The 2009 red contracts gained from 14.5bp by the Mar 09 contract to 1.5bp to by the Dec 09 contract. Somewhat more tightening was thus built in next year of the low in rates seen this summer or fall, with the Sep 08 to Sep 09 spread rising 11bp to 62bp and the Dec 08 to Dec 09 spread 15bp to 78.5bp. A funds target no higher than 3%, though, is still expected into early 2010 based on the Dec 09 contract ending the week at 3.14%. Financial conditions saw a broadly based and substantial deterioration over the past week. The S&P 500 fell 5% to just about fully reverse a 5% rise the prior week. Credit markets, which didn’t see the strength stocks did the prior week, just continued to get much worse. In late trading Friday, the 5-year investment grade CDX index was 23bp worse on the week at an all-time wide of 130bp. The IG index was actually more high volatility than the HiVol index, which moved a relatively smaller 34bp wider to 283bp, an all-time worst close, though not quite as bad as intraday wides hit just before the Fed’s 75bp inter-meeting cut last month. The leveraged loan LCDX index continued to perform terribly, widening 41bp on the week through midday Friday to an all-time wide of 500bp. As bad as the moves in stocks, credit and leveraged loan indices were on the week, probably the most striking meltdown was in the commercial mortgage CMBX market. The subprime ABX market that was such a focus last year worsened in the latest week, but has been relatively steady at severely beaten levels over the past month or so. Instead, investor concerns about the next leg of bank losses appear to shifting to the commercial mortgage space. Every CMBX index hit an all-time wide over the past week, but the freefall among the highest-rated indices was most striking, with the AAA index, which was trading near 65bp at the beginning of the year, widening 82bp to 224bp, the AJ (junior AAA, which used to trade with just a small spread over the AAA) 160bp to 507bp, and the AA 200bp to 634bp. According to our CMBS team, cash AAA spreads are now 75-80bp wider than at the worst of the LTCM market meltdown in 1998. Our banking team expects that commercial real estate losses this year will rise significantly, but it doesn’t seem like by enough to fundamentally justify this sort of freefall. They see losses on 2007 commercial real estate loans reaching 3-3.5%, versus close to 0% losses experienced so far on loans made in recent prior years. This would clearly be a significant deterioration, but far from the historical peak of 8% losses seen on 1987 loans (see Banking –Large-Cap Banks: Commercial Real Estate Call Recap: Coming Deterioration Supports Our Higher Loss Estimate, by Betsy Graseck and team). Apparently, reintensifying pressures in the banking system are again showing up in worsening interbank lending conditions. 3-month LIBOR did reverse some early week upside to end marginally lower on the week at 3.09%, but this clearly came nowhere near keeping pace with the repricing of the Fed. As a result, the 3-month LIBOR/3-month OIS spread rose 15bp on the week to 51bp, hitting the highest levels in a month during the week after what had been a steady and substantial improvement from the worst levels above 100bp hit in early December. It was a light week for economic news, but what incoming data there were continued to indicate that the economy is in recession. By far the biggest market-moving economic release was a plunge in the non-manufacturing ISM survey to a recessionary level. The new composite diffusion index in this survey – an equally weighted average of the business activity (the former headline series), orders, employment and supplier delivery indices – plunged well below the 50-breakeven level to 44.6 in January from 53.2 in December, the lowest reading in the ten-year history of the data. The business activity (41.9 versus 54.4), orders (43.5 versus 53.9) and employment (43.9 versus 51.8) components all tumbled well into contractionary territory, while supplier deliveries (49.0 versus 52.5) posted a smaller decline. Only three industries reported growth in January and 14 contraction. Meanwhile, the jobless claims report further confirmed that the run of very low readings for initial claims through most of January was a seasonal adjustment problem if any further confirmation was needed after the massive disconnect seen between very low claims during the survey week for the January employment report and the actual decline in payrolls. After spiking sharply higher last week following that three-week run of suspiciously low readings, initial jobless claims pulled back 22,000 in the week of February 2 to 356,000, close to where we think the underlying pace is at this point, which we expect to trend higher going forward. Continuing claims in the week of January 26 surged 75,000 to 2.785 million, a high since October 2005 in the aftermath of Hurricane Katrina. Weekly consumer confidence also tanked, with the ABC News/Washington Post consumer comfort index falling 6 points in the latest week to -33, significantly worse than at any point in the 2001 recession. This survey is reported on a 4-week moving average basis, so a one-week 6-point drop is an extreme move. On the slightly positive side, chain store sales results in January remained very weak in absolute terms but posted a decent sequential improvement from particularly abysmal December numbers and this against a relatively tough comparison last year, suggesting some upside in general merchandise and clothing store results in the upcoming week’s retail sales report. We see overall ex-auto sales ticking up 0.2% in January after the 0.4% drop in December, but the plunge in auto sales results points to significantly worse overall sales. More importantly, we see an outright decline in broader real consumer spending in January as likely after the flat reading in December, putting 1Q real consumption on pace for a marginal gain at best. The release of the factory orders and wholesale trade reports for December filled in some more of the missing data for which the BEA had to make assumptions in preparing the advance estimate of 0.6% GDP growth in 4Q. Results for the two reports overall were only slightly negative, and we continue to see 4Q growth being revised down marginally to +0.5% from +0.6% as a result of previously reported worse results for December construction spending (with the downside concentrated in government outlays) than the BEA assumed. We continue to see 1Q GDP on track for a 0.7% decline. In the factory orders report, non-defense capital goods ex-aircraft shipments were revised down marginally in December (+1.9%) and November (+0.1%), pointing to slightly softer capital spending growth in 4Q. And overall inventories gained 0.8%, with durables (+1.0%) revised down a bit and non-durables (+0.3%) rising much less than BEA estimated. These negatives were offset, however, by upside in wholesale inventories, which surged by even a bit more in December (+1.1%) than the BEA assumed, on top of an upward revision to November (+0.8% versus +0.6%). Most of the rest of the key information pertaining to the first revision to 4Q GDP (due out February 28) will be released in the coming week in the retail sales, business inventories and international trade reports. That sharp gain in wholesale inventories in December came within an overall weak report for what had been an exceptionally strong sector previously. After having surged 14% in the year through November, wholesale sales fell 0.7% in December, the first decline in almost a year. Combined with the surge in inventories, which apparently was not intended, given the significant drop in sales, the I/S ratio rose to 1.09 from the record low 1.07 hit in November. Outside of food and energy products, sales declines were widespread in December, with particularly notable drops in motor vehicles, furniture, construction materials and business equipment. The key event in the coming week is an appearance on Thursday by Fed Chairman Bernanke at a Senate Banking Committee hearing on the economy and financial markets, which will front-run his semi-annual monetary policy testimony by a couple of weeks. The Fed appears to be having trouble communicating its policy strategy at this point or at least having the market accept that it will follow its apparent strategy (which wouldn’t be completely unreasonable, given how willing the FOMC seems to have been to immediately respond to ever increasing demands for more easing from stock market investors), an issue the Fed Chairman might address in his remarks. The FOMC has front-loaded a lot of easing ahead of what it believes is a rising risk of a significant deterioration in the economy, meaning that if the data do in fact deteriorate as anticipated or at least feared, it wouldn’t necessarily imply much in the way of additional easing. If this is the strategy, it has not been clearly communicated to or accepted by the market, which continues to price in another 100bp of rate cuts, including at least another 50bp and possibly 75bp by the upcoming March FOMC meeting. The most notable economic data release in the coming week is the retail sales report on Wednesday. Other key reports due out include the Treasury budget Tuesday, business inventories Wednesday, the trade balance Thursday and industrial production Friday (which has an early close ahead of the long Presidents’ Day weekend): *We expect the federal government to report a budget surplus of US$20 billion in January, about US$18 billion less than in the same period a year ago. Timing differences account for much of this swing, but further significant deterioration is anticipated over the course of the coming months. We look for a deficit of US$400 billion (or 2.8% of GDP) for the fiscal year as a whole. *We look for a 0.2% decline in overall retail sales in January and a 0.2% increase ex-autos. Unit sales of motor vehicles tumbled to the second-lowest selling rate in the past ten years. This should lead to a significant drop-off in the auto dealer category. Also, the gas station category, which has experienced some large price-related swings in recent months, should flatten out in January. Meanwhile, chain store results appeared to be on the soft side, but the comparisons with the year-ago period appeared to be quite difficult. For example, the apparel category of retails sales posted a solid 2.3% jump in January 2007. Thus, our translation of the reported company comps to monthly sequential changes actually points to a fractional rise in non-auto retail sales: *We forecast a 0.5% increase in December business inventories. The results for the manufacturing and wholesale sectors point to a rise in overall stockpiles that is a bit larger than seen in prior months. Still, the outcome appears to be close to that assumed by the Commerce Department in its initial assessment of 4Q GDP. The inventory-to-sales ratio is expected to tick up slightly to 1.25. *We look for the trade deficit to narrow about a half billion dollars in December to US$62.5 billion, with exports up 0.4% and imports flat. Most of the export gain is expected to be in capital goods, in line with the upside in shipments and aircraft industry data. Softness in industrial materials and autos should provide a negative offset. Imports are likely to be restrained by some moderation in petroleum products after the surge to a record-high last month. Note that our estimate is somewhat worse than that assumed by the BEA in its preliminary assessment of 4Q GDP. *We forecast a 0.1% increase in January industrial production, with all of the anticipated fractional increase attributable to a weather-related advance in utility output. The key manufacturing component is expected to be unchanged for a second consecutive month, with sizeable declines in sectors such as textiles, furniture and electrical equipment being about offset by gains in aerospace and computers. Auto assemblies appear to have been little changed during the month but, based on the latest production plans, are poised for some slippage in both February and March.
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Contingency Planning and the UK Mortgage Market
February 11, 2008
By David Miles | London
It is clear that the near-term UK economic outlook has worsened. To a significant extent this reflects the continuing fallout from the sharp turnaround in conditions in debt markets that began last August – the ‘credit crunch’. The implications of this – in terms of duration and severity – remain very unclear. That creates a set of difficult policy challenges for the government, analysed in some detail in the Green Budget, a collaboration between the Institute for Fiscal Studies and Morgan Stanley. One of the risks is that funding for mortgage lenders in the UK could remain very difficult for many months. There have been very few issues of mortgage-backed securities or UK covered bonds since last August. One often hears it said that these wholesale markets are effectively closed – which really means that the price (or yield) which would now be acceptable to potential buyers of debt backed by mortgages has risen so much relative to the likely return on mortgage assets that issuance is not commercially viable. There are broadly two ways to view this: either it is a return to more reasonable pricing of debt – in which case the yield on mortgages needs to rise to reflect the (now more sustainable) cost of funds; or the price (yield) at which lenders could now issue mortgage-backed securities has drifted away from what is reasonable, given an informed assessment of the risk with the underlying assets. There may be something to the second view. Fear of risks with UK mortgage-backed securities may to some extent be fuelled by an inappropriate read-across from securities backed by US sub-prime mortgages. If that is the case there is a form of market failure, and one that could have substantial (negative) impacts on the economy. There are probably now around £200 billion of mortgage-backed securities issued by UK lenders outstanding. If we add in covered bonds we get to around £250 billion of funding. That debt rolls over fairly frequently so that just to keep the stock constant might require £50-80 billion of issuance a year. If issuance this year were instead close to zero, and lenders looked to retail deposits to fill the gap, it would require a net rise in deposits that could be close to 10% of household income. If that were to be feasible, it is plausible that rates offered on savings will need to be high and that the cost of loans would also have to move higher. There is the potential for these effects to confirm some of the most pessimistic beliefs about the health of the mortgage market. In other words, the situation could become self-fulfilling. It is far from clear that this pessimistic scenario is likely to happen. But the government needs to think about what it could do if things played out this way. One option is to do nothing and wait, and hope, for the wholesale market to unfreeze. More proactive action could involve some form of public sector lending. This could be undertaken by the Bank of England. This would be a major extension of the action undertaken in a coordinated way with other central banks in December. But having the Bank of England undertake massive lending of this sort puts the central bank in a difficult position because it looks more like a support operation for the banking sector than an attempt to preserve order in the money markets. And the scale of lending would potentially need to be very large – far greater than the facility announced on December 12. And if a massive extension in Bank of England lending were clearly done on behalf of the government, it could be seen to threaten Bank of England independence – which has great value in the sphere of setting interest rates. Having another agency, and not the Bank of England, undertake lending may be the better way to deal with an emergency. How might this work? An agency could either buy, or lend against the collateral of, mortgage-backed securities. Lending for a given period (perhaps initially 12 months) against the collateral of mortgage-backed securities – a repo arrangement – has the advantage that the agency could apply haircuts, i.e., set a safety margin between the amount lent and the market value of the collateral. The repo route has many advantages: it reflects the temporary nature of the assistance; it means that the agency does not need to take a view on the right price to pay to own securities; and it means that the agency can have conservative lending criteria without forcing institutions to so outright selling at ‘fire-sale’ prices. It is far from clear whether such a large-scale repo facility is really warranted. And it needs much more careful analysis of current pricing of mortgage-backed securities to decide whether it reflects a well-functioning market (albeit with low transactions) or something closer to panic. But is has to be worth considering these issues right now.
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Be Prepared for a Dual Recession
February 11, 2008
By Takehiro Sato | Tokyo
GDP in US and industrial production in Japan are decisive factors The risk of a dual recession is mounting. Our US economics team is already calling for capex-induced negative GDP growth in successive quarters (Jan-Mar, Apr-Jun), for a technical minor recession in the first half of the year by definition. We are forecasting that Japan will cling on to a modicum of growth in the Oct-Dec 2007 quarter, boosted by external demand, but there is a possibility that, like the US, this quarter will mark the peak and the economy will retreat in Jan-Mar. Future data for industrial production will tell us if this is the case. If industrial production drops in Apr-Jun, Japan will also be in recession The US economic cycle is defined by GDP data, but in Japan the cycle can be straightforwardly linked to the industrial production stats. We hone in on industrial production because the coincident index of business conditions (or more precisely its historical DI), which is used to officially assess the economic cycle, contains a large number of production-related components. As many as six of the ten items that make up the coincident index are production data, or closely linked to such: the index of industrial production, the index of producers’ shipments, large industrial power consumption, overtime hours in manufacturing industries, index of producers’ shipment of investment goods, and sales by small and medium-sized manufacturers. The direction of the coincident index therefore roughly matches the trend of industrial production. Incidentally, in Japan’s case, quarterly GDP data are too volatile to be a suitable criterion for calling the economic cycle. This is clear from the GDP trend in past recessions. Yet while GDP has at times been positive when the economy is in retreat, industrial production has consistently mirrored the downward path of the economy. It seems reasonable to say that the critical factor for assessing the economic cycle is simply the direction of industrial production. Japan industrial output to drop in Jan-Mar METI forecasts indicate that industrial production is likely to drop in the Jan-Mar quarter. Cuts led by the steel, non-ferrous metals, electrical machinery and transport equipment sectors are poised to reduce output from the manufacturing sector overall in successive months, by 0.4%M in January and 2.2%M in February. Even a flat March would leave production for the quarter down 1.5% sequentially for the first drop in four quarters. IT-related industries such as electronic components and devices are planning to curtail output in January and February after increases in December. Over-extended production forecasts for general machinery (+4.4%M in January) and IT/telecom equipment (+12.8%M) also suggests that plans may not be met. As the outlook for declining output in Jan-Mar becomes clearer, the key question becomes whether this will carry over into the Apr-Jun quarter. If it does, the economy may prove to have peaked last year in Oct-Dec, and more specifically in October, supporting the view that Japan and the US entered a period of recession at the same time. Automobile production may correct Our auto industry analyst Noriaki Hirakata has highlighted the risk that an imbalance between inventories and shipments in North America may result in output cuts in Apr-Jun. This point has important implications for Japan’s industrial production outlook. Automobile inventories in the US were up sharply year on year at the end of January, and Hirakata believes that if automakers were saddled with surplus inventories around the turn of the year, they could well start cutting production from March, and during the Apr-Jun quarter in earnest. According to the production forecasts in the METI survey cited earlier, the transport equipment industry is already facing consecutive output cuts in January and February. This is ominous, even though the lunar new year in Asia has some impact on February. The transport equipment sector, which contains automobiles, has an 11.3% weighting in the industrial production statistics even when steel ships and railway carriages are excluded, and a 15.0% share of shipments. Its tentacles extend to many related fields, such as electronic components, steel, plastics and glass & ceramics. Cutting back auto production would obviously depress industrial production as a whole, albeit with some time lag. This means there is a risk that things will turn nasty for Japan and the US at the same time in the Jan-Mar and Apr-Jun quarters. How long would a recession last? The debate about decoupling/recoupling of the leading economies and emerging markets has ended with the recoupling view predominating in the markets. Even if economic performance has decoupled, the performance of the markets has been closely interlinked, whether in developed or emerging countries. And while Japan’s ratio of exports to the US has nominally sunk below 20%, it is still above 30% when exports routed via other Asian nations are factored in, and the argument that Japan’s economic performance is still decoupling from the US is unconvincing. As the risk of the onset of a simultaneous downturn in Japan and the US mounts, talk will move on from whether or not there will be a recession to how bad and how long the recession will be. As the stimulus from the tax cuts and massive Fed easing filters through, the US economy should get a lift in the summer, and our US economics team is forecasting a healthy 4.5% annualized growth rate in the Jul-Sep quarter. That would make for a mild and short-lived recession in the US. What about Japan? Despite the imminence of a general election, Japan does not have to fiscal wherewithal to bring out a package of stimulus measures like that in the US, and with only 50bp to play with in cutting the policy rate, macro policy traction will be limited even if there is a rate cut during Apr-Jun as we are forecasting. The signs of a recession in Japan are still incipient, so it is probably too early to start talking about the timing of the recovery. If the US stimulus package bails out Japan by allowing industrial output to pick up in Jul-Sep, the domestic recession like that in the US would fizzle out in just two quarters. In that event, it might not even earn the official designation of a ‘recession’, and instead be characterized as a ‘soft patch’ like the hiccups in early 2003 and the second half of 2004. Whether we do get a full-blown recession probably depends more on trends in the US economy than on domestic factors, and especially on whether US housing prices crash as commercial banks and the household sector are slammed with balance sheet adjustments on the scale seen in Japan. If there is balance sheet deflation in the US, there is no guarantee that the recession there would end with two mild quarters of negative growth. Besides which, what happens in China may have a lot more impact than is currently recognized. Is China a risk? Our China economics team has been harping on the theme of an ‘imported soft landing’ due to a slowdown in exports. A deceleration in external demand could actually be a welcome coolant for China’s economy, where domestic demand is overheating chiefly in response to investment in fixed capital. But there does nevertheless seem to be growing downside risk for the Chinese economy now, with snow damage coming just as measures to rein in aggregate demand such as the cap on bank lending are starting to bite. Our China team believes that if signs of a pullback appear, the authorities could loosen their tight monetary policy, and that there is still ample scope for fiscal stimulus. The problem though is that taking macro measures once demand has already headed down is like pushing on a string, and frequently fails to achieve the intended effects. If China does fare worse than expected, the risk that a dual recession could escalate into a triple recession would come into play.
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