United States
A Perfect Soft Landing?
Jan 09, 2006

Richard Berner (New York) and David Greenlaw (New York)

	2005E	2006E	2007E
Real GDP	3.6%	3.8%	3.4%
Inflation (CPI)	3.4	2.8	2.2
Unit Labor Costs	2.3	2.0	2.2
After-Tax “Economic” Profits	7.9	8.4	2.8
After-Tax “Book” Profits	32.5	7.4	3.1

Source: Morgan Stanley Research     E = Morgan Stanley Research Estimates

 

Incoming Fed Chairman Bernanke could hardly have hoped for a better backdrop to usher in his tenure beginning on February 1: The expansion seems solid and sustainable, inflation is low and seems stable, and monetary policy is now neither accommodative nor restrictive.  For their part, investors are celebrating the idea that the Fed has pulled off a perfect soft landing for the US economy and thus an end to Fed tightening by piling into risky assets around the globe.  Equity and credit markets have rallied significantly over the past three weeks, while the dollar has slipped 3-5% in a benign and orderly way as market participants rerated the prospects for monetary policy at home and abroad.  Can it be that easy?  What are the challenges to this benign setting and what are their implications for financial markets? 

Three factors will challenge the outlook and investors, in our view: First, a slowdown in housing activity and in the growth of home prices will probably dent output and limit consumers’ ability to dip into housing wealth to finance spending.  Many thus fear that the economy is poised for substantially slower overall growth; we disagree and believe that the risk is for above-consensus growth.  Second, despite strong, secular disinflationary forces, cyclical factors will promote a gradual rise in core inflation; if so, the Fed would have to tighten further.  Finally, fading operating leverage and gradually rising costs will flatten profit margins and limit earnings growth, which could come as a disappointment to investors generally expecting continued gains in profits. 

In our view, fears of a US economic slowdown are premature, investors are too complacent about inflation and the Fed, and earnings will post decent gains — a mix that on balance should be positive for risky assets.  To begin, we believe that US economic growth will surprise to the upside, notwithstanding the incipient deceleration in housing activity and home prices.  That’s partly because neither the decline in housing activity nor the slowing in home price gains is likely to be sharp, and partly because we believe that factors other than housing wealth, such as growth in overall income, will support consumer spending in particular and the economy more broadly. 

To be sure, the outlook for housing activity and home prices is deteriorating: Measures of housing affordability stand at 14-year lows thanks to the runup in prices, and pent-up demand has ebbed.  Favorable demographic trends are starting to fade: The immigration boom has cooled since 9/11, and the growth in households of prime home-buying age has slowed.  Home sales are turning down from nosebleed levels and inventories of unsold homes have risen to 9-year highs.  These same factors, together with valuations that appear frothy in many markets, augur a significant deceleration in home prices.  But we think housing activity will decline gradually and home prices will decelerate without crippling the consumer, and the squeeze on discretionary spending power from resets on adjustable rate mortgages awaits is not expected until late 2007 or 2008.  In our view, it would take soaring interest rates or declining employment to produce a bust (see “Housing Wealth and Consumer Spending” and “Home Sweet Home,” Global Economic Forum, October 7, 2005 and December 15, 2005).

Equally, four factors are likely to buttress overall economic growth and thus a faster pace of jobs and incomes, both critical for sustaining the expansion.  First, pent-up demand for both capital spending and hiring is still strong, in our view, as Corporate America’s restraint in each of the four years of the current expansion has created a reservoir of demand that should last at least into 2007.  While bookings for nondefense capital goods apart from transportation equipment have slipped lately, the weakness seems largely to be the product of price declines in IT hardware, especially for communications equipment.  Moreover, booking are soaring for fuel-efficient airplanes and trucks, courtesy of rising energy quotes and prospective changes in fuel efficiency requirements.  And companies likely will soon respond to the rise in operating rates back to or above historical norms and record returns by investing for expansion.

Likewise, while some see tepid US hiring as the response to globalization, we believe that the hiring discipline that emerged to purge the hiring excesses of the 1990s has been a more important force suppressing job gains.  In addition, an acceleration in the “fixed” costs of health and pension benefits amplified CEOs’ resolve to limit hiring and pay.  In 2006, however, we believe that will change as the resulting pent-up demand for hiring spurs both hours and employment.  Concurrently, productivity gains likely will slow to about 2% as job growth catches up with the economy.  But that acceleration clearly has yet to begin.  Hurricanes Katrina and Rita devastated the Gulf Coast and its tourist industry, and although immediate job losses resulting from the disasters seemed minimal, they may have totaled 100,000 or more over the past four months.  Even allowing for that factor, however, job gains have clearly disappointed; monthly increases averaging 114,000 over the past 4 months are 100,000 below where they should be to support consumer wherewithal sufficiently to maintain spending and concurrently rebuild saving. 

Yet, the recent deceleration in payrolls, apart from the direct effects of disasters, probably also reflects the effects on output of the summer jump in energy quotes; after all, GDP growth likely slowed by 100 basis points in the summer to 3.2% in the final quarter, and employment is a lagging indicator.  And in December, we believe that bad weather may have depressed both hours and payrolls. We fully expect a re-acceleration in coming months.  Until that happens, the good news is that wages are finally beginning to accelerate in response to elevated inflation expectations, firmer labor markets, and a slower pace of benefits growth.  Moderate further acceleration in take-home pay is likely (see “Will the Real Wage Measure Please Stand Up?” Global Economic Forum, January 6 2006).  Thus, nominal wage and salary income is growing at an underlying 4-4½% rate.  If energy prices are roughly stable in the next several months, with gasoline quotes likely to rise but natural gas prices likely to decline, real “core” income gains will accelerate to a 2-2½% annual rate. 

Recently easier financial conditions are a second factor that will support US economic growth at least for the next several months, despite 325 basis points of Fed tightening since June 2004.  While market participants fret over the implications for growth of an inverted yield curve, and some doves at the Fed are concerned about not overdoing tightening, in our view those worries are overblown.  The bull flattening in the yield curve, courtesy of declining term premiums, has made the level of interest rates along the maturity spectrum more, not less, stimulative (see “Yield Curve Angst,” Investment Perspectives, November 23, 2005).  And the recent rally in stock prices and in credit markets, the decline the dollar, and apparently more-than-ample credit availability suggests that far from declining, credit-sensitive spending could well remain stronger than expected in the next few months.

An improvement in overseas demand is also likely to support US growth over the next several months.  Unlike in 2003-2004, domestic demand in many US trading partners is the driver for this pickup.  Coupled with a pending reversal in the dollar, that bodes well for US exports.  Growth in the Eurozone — and in Europe more broadly — picked up smartly in the third quarter to a 2.4% annual rate, and our European colleagues believe that “the lagged impact of zero real short term rates will continue to support final domestic demand, the fundamental variable that really matters in the euro area.”  While Japanese growth slowed in the summer quarter, that consolidated a first half boom, and our colleagues in Japan believe that structural reform, monetary accommodation, and pent-up demand all likely mean that the Japanese recovery is real and sustainable.  Similar stories are playing out in varying degrees in other regions — Latin America, Asia ex-Japan apart from China, and in our two major trading partners, Canada and Mexico. 

Finally, modestly greater fiscal stimulus is a fourth factor likely to give overall US growth a boost in 2006.  Moderate increases in Federal support for hurricane evacuees that continues through the first quarter will underpin incomes.  More intense rebuilding activity following the cleanup and recovery in the Gulf Coast seems likely to add to economic activity.  And the torrent of cash flowing into state and local government coffers as revenues outpace the economy is enabling officials to spend money on unmet needs accumulated over the past four years. 

What about inflation, the second of our three challenges?  We expect that core inflation will rise to 2.6% over the four quarters of 2006 from today’s 2.1% measured by the CPI and to 2.2% measured by the market-based core personal consumption price index.  The rise, as we see it, will reflect both cyclical fundamentals and the unwinding of statistical quirks that have suppressed it in 2005.  Longer-term inflation expectations at 3.1% in late December have stayed slightly but firmly above their average of the past seven years.  Capital discipline promoted a 700 basis point increase in operating rates over the past four years — a surge that aided the rebirth of pricing power for many industries, as both the change and the level of such operating rates influence pricing power and inflation.  Recently, tighter labor markets have promoted an acceleration in wages.  And last but not least, the unwinding of statistical distortions that lately depressed two components of housing inflation — owner’s equivalent rent and hotel room rates — that together account for one-third of the core CPI may add 0.2% to that price gauge this year.

The third challenge for the outlook involves earnings growth.  The threat comes from the unfolding flattening in profit margins, in turn driven by the fading of operating leverage, the dollar’s rise over the past year against the euro and yen, a rise in unit material costs, and the coming acceleration in unit labor costs.  Indeed, although S&P 500 operating earnings per share may have finished last year with a double-digit gain, those factors have already begun to cap the rise in after-tax “economic” profits measured in the National Income and Product Accounts, which  likely slowed to about 8% in 2005, following an 11.3% rise in 2004.  As we see it, however, solid top-line growth in 2006 will deliver at least GDP-like earnings growth despite the risks to margins.  Improved pricing power as well as solid volume gains will be key ingredients in that result.

For investors, these developments will have powerful implications.  Fueled by Fed comments that their concerns about inflation have eased, markets are priced to just one or at most two more Fed tightening moves, and subsequently to some easing in the second half of 2006.  In contrast, if we are close to the mark, the Fed would have more work to do and easing is unlikely until well into 2007 when inflation pressures probably will ease.  Indeed, with monetary policy now dependent on the economic outlook and the incoming data that shape it, we have no doubt that the Fed will respond to any threat of rising inflation.  Meanwhile, an unexpected rise in yields could also challenge equity and credit markets notwithstanding solid earnings and fundamentals.

As always, risks to the outlook abound.  Higher energy quotes are an omnipresent threat to strong growth, although the global economy’s resilience in the face of surging energy prices over the past three years validates our belief that the threat is not catastrophic.  On the other hand, investors should not ignore potential upside risks to the growth and inflation prognosis.

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United States
Review and Preview
Jan 09, 2006

Ted Wieseman (New York) and David Greenlaw (New York)

Treasuries ended narrowly mixed over the past week (small front-end gains, minor long-end losses), with a resulting steepening reversing the 2’s-10’s inversion that had been the main item of interest during the quiet Christmas to New Years interlude.  After the market initially reacted exuberantly to a weaker than expected ISM report and indications in the FOMC minutes that the rate hiking cycle was nearing an end, it then backed off a bit on thinking just how soon it might end after the unemployment rate unexpectedly dropped below 5%.  The employment report was mixed overall, but, surprisingly given the market’s recent penchant for keying onto the bad news in incoming data and ignoring more positive indicators, the results sparked a front-end-led sell-off on Friday as investors downplayed the significantly lower headline payroll gain than expected for December and instead focused on the drop in the rate, the upward revisions to prior months’ payrolls, and the apparent negative weather impact on the December results.

A key part of the minutes that was initially largely ignored suddenly seemed much more important, with the dip in the unemployment rate to 4.9%, moving beyond the roughly 5% level that would probably be the general consensus for full employment.  While the Fed did suggest that not many more rate hikes were likely to be necessary, at the same time FOMC members fretted about the possibility of rising inflation pressures from “further increases in resource utilization”, of which a falling unemployment rate is certainly one notable indication.  The dip in unemployment apparently brought more focus to these negative risks identified by the Fed, and the futures market decided that the FOMC was more likely than not to take the fed funds target to 4.75% in March, after previously deciding that this month’s nearly universally expected move to 4.50% would be the likely peak after the minutes’ initial release.  With the focus on the minutes, employment and the ISM report, positive signs on consumer spending released the past week — a strong rebound in motor vehicle sales and solid chain-store sales results — were largely ignored, but their implications should become of much greater interest in the coming week, with the key data release being an expected sharp advance in December retail sales on Friday.

Having been posting solid front-end-led gains heading into Friday’s key employment report, Treasuries ended the week narrowly mixed after a significant post-employment sell-off.  On the week 2’s-30’s steepened 6 bp, with the two-year yield down 4 bp to 4.36% and the long bond yield up 2 bp to 4.565%.  Having sparked a significant buzz the prior week by flipping in and out of marginal inversion, 2’s-10’s held in positive territory all week (though with the front-end-led nature of Friday’s sell-off, wound up flatter than where they were most of the week), ending at +2 bp, as the 10-year yield fell 2 bp to 4.38%.  The inversion at the shorter end of the curve remained firmly in place, but at least didn’t get any worse, as the three-year yield fell 4 bp to 4.36% and the five-year yield fell 3 bp to 4.32%.  In the aftermath of the FOMC minutes, the market initially decided that the Fed’s prediction that the amount of additional tightening would “probably would not be large” meant only one more rate hike, as the April fed funds contract rallied to below the 4.625% breakeven for pricing in a March move to 4.75%.  This was just barely reversed on Friday, however, with the contract ending at 4.63%, a 2 bp rally on the week.

Whatever tiny doubts there might have been about the Fed’s likelihood of hiking the funds target to 4.50% on January 31 were scaled back even further on Friday, with the February fed funds contract closing the week at an all-time high rate of 4.485%, up from the 4.47% it closed the prior week (which was right about where it had traded throughout December).  As has been the persistent recent pattern, however, pricing in nearer-term tightening was accompanied by pricing in a quicker and larger shift to rate cuts in mid 2006.  The June 06 to June 07 eurodollar spread flattened 2 bp on the week to -13 bp (just off the all-time low of -14 bp hit December 27), with the former contract rallying 6 bp to 4.785% and the latter gaining 8 bp to 4.655%.

The FOMC minutes from the December 13 meeting that were released in the past week reinforced the strong likelihood that the Fed will hike rates again at the January 31 meeting, but hinted that going forward from there, the course of policy will be dependent on the incoming economic data.  Moreover, most members believed that, “given the information now in hand, the number of additional firming steps required probably would not be large”.  Still, the minutes explicitly stated that “views differed on how much further tightening might be required”.  The more dovish camp felt that “the Committee would need to be mindful of the lags in the effect of policy firming on the economy”.  This sentiment reflected a concern that the Fed might overdo it — as it has often done in the past — though, if the Fed were close to having overdone it at this point, this would be at the least restrictive policy stance at which we could ever identify a previous over-tightening (e.g., the current real fed funds rate versus core PCE inflation is near 2 1/2%, while at the end of the last three tightening cycles ending in 2000, 1994 and 1989, it was around 4 3/4%, 3 3/4%, and 5%, respectively).

Meanwhile, the more hawkish camp stressed that policymakers “would also have to take account of the effects of the sustained period of favorable financial conditions on asset prices and aggregate demand, as well as the resulting possibility of further increases in resource utilization and pressures on prices”.  In other words, policy has been so easy for so long and the economy is operating so close to full normal capacity that the tightening campaign might have to go beyond the point of neutrality in order to rein things in.  Whatever the internal debate, it seems clear that the Federal Reserve is transitioning to a more data-dependent policy mode, and therefore incoming reports on employment, inflation and other key indicators will take on added significance going forward.

Economic data released the past week were mixed.  On the negative side, the manufacturing ISM posted a surprisingly large decline in December, reversing a run of sharply elevated readings that followed Hurricane Katrina.  The decline came despite a second straight sharp retracement in the prices paid gauge — which had been cited as a serious problem by survey respondents previously — and generally positive comments in the text of the report and in the commentary from ISM officials.  Given this odd dichotomy, the results of the non-manufacturing ISM, in which the headline business activity gauge rose from 58.5 to 59.8 with the same tone of positive comments from survey respondents, seemed to make a lot more sense.

Two releases bearing on our 4Q GDP estimates, construction spending and factory orders, had mixed results but no net impact on our forecast.  The November gain in construction spending was quite a bit lower than expected, but this was fully offset by sharp upward revisions to prior months.  Meanwhile, manufacturing inventories rose a less-than-expected 0.2% in November, on what appeared to be mainly price-related weakness in the non-durables component.  The already very strong recent readings for capital goods shipments, however, were revised up a bit further, providing an offset.  With non-defense capital goods shipments rising 2.2% in November on top of a 4.5% surge in October, 4Q appears poised for the strongest advance in real equipment and software investment in over a year.  Taken together, these two reports had no impact on our 4Q GDP estimate, and we still see growth running near +3 1/4%.

Positive economic news came from the early indications for December consumer spending.  Motor vehicle sales posted a significantly stronger rebound than expected in December to the highest level since July, while overall chain-store sales results were solid, pointing to a decent gain in non-auto sales.  Taken together, we look for a 0.9% jump in overall December retail sales and a 0.4% gain ex autos, which we would expect to translate into a 0.6% rise in total real consumer spending in the month, building on the strong 0.7% increase in November.  However, having started the quarter in such a big hole after the collapse in auto sales from July to October, the strong expected sequential advances in real PCE in November and December would only leave 4Q overall with barely positive consumption growth.  But — reversing the 4Q pattern — it should provide a very strong starting point for 1Q.  If our December estimates are on the mark, it would only require relatively meager sequential gains in consumer spending from January to March to reach a 4%+ consumption growth rate for the quarter as a whole.  And the ongoing collapse in natural gas prices and its eventual impact on utility rates — with the February contract falling 14% during the past week for a cumulative decline of almost 40% since the mid-December peak —is certainly mitigating what had been seen as the key downside risk factor to winter consumer spending.

Of course, with the key employment report Friday, aside from a positive reaction to the ISM, little of the past week’s other data had much market impact.  Given how bearish this market has persistently been on the growth outlook, the sell-off that followed the disappointing headline payroll result was a bit surprising, but certainly quite reasonable when the report was viewed as a whole.  Offsetting the disappointing December payroll gain were significant upward revisions to prior months, a surprising dip in the unemployment rate, and continued acceleration in earnings growth.  And the lower-than-expected December employment gain certainly showed that indications have been artificially depressed by bad weather.  The household survey series that we use as a rough proxy for weather effects showed significant elevation.  The number of individuals “not at work due to bad weather” stood at 253,000 in December — about 100,000 above the December average over the prior five years and the highest reading for that particular month since 1985.

We stress that this series is merely a proxy for weather effects; it does not feed in any way directly into the payroll calculations. 

However, if weather conditions return to normal in January (and it’s certainly been unusually warm in these parts recently as we head into the survey period for the January employment report next week), we would expect to see some recovery in jobs.  The employment report was a minor disappointment overall, but was not nearly weak enough to alter the near-term course of Fed policy — especially since, over the next week or so, we expect to get a strong December retail sales report and, in the following week, to see some further modest upside in core inflation in the CPI data (we forecast +0.2% in December and +2.2% year on year).  The dip in the unemployment rate to a 4-handle (any 4.x%), particularly accompanied as it has been by a notable acceleration in wage growth recently, was also unlikely to have been welcomed by a Fed worried about pressures on resource utilization.  Beyond the near term, keep in mind that we will get two more employment reports before the March 28 FOMC meeting.  Our view continues to be that the economy will surprise to the upside during 2006 and this will eventually prompt the FOMC to push the funds rate to 5%.

Key data releases the past week were ISM, construction spending, motor vehicle sales and employment:

* The manufacturing ISM composite diffusion index fell to 54.2 in December from 58.1 in November, reversing a run of sharply elevated readings seen in the aftermath of Hurricane Katrina.  The key orders (55.5 vs. 59.8), production (57.0 vs. 60.6) and employment (52.7 vs. 56.6) indices all showed significant slippage even as the prices paid gauge plunged 11 points (for a 21-point drop the past two months) to 63.0, reversing all of the post-Katrina upside.  Unlike the data, the text of the report was actually quite upbeat, with a number of positive anecdotal comments from survey respondents, particularly highlighting the favorable impact of lower energy prices after skyrocketing quotes for energy-related items had been cited as a major problem in prior months.

* Construction spending rose a less-than-expected 0.2% in November, but the downside was fully offset by significant upward revisions to September (+1.3%) and October (+0.8%).  The lower-than-expected November gain reflected a flat reading for residential spending that was fully accounted for by a plunge in the highly volatile home improvements category (-4.1%).  Single-family home construction (+1.5%) continued to post sharp gains.  Meanwhile, private nonresidential spending (+0.6%) posted a solid rise led by commercial projects, while government spending (+0.3%) moderated after a surge in October.  Gulf Coast rebuilding efforts are likely to add significantly to government spending going forward.

* Motor vehicle sales surged to a 17.1 million unit annual rate in December, the high since July, from 15.7 million in November and the abysmal 14.7 million recorded in October.  The December rebound left overall sales for the year at 16.9 million, unchanged from 2004.  Almost all of the upside in December sales reflected a sharp recovery in recently ailing domestic trucks, with sales of domestically produced trucks rising to 8.2 million from 7.0 million in November, likely boosted in part by the recent sharp retracement in gasoline prices as well as the expiration of state sales tax deductibility.  A significant increase in truck incentives by the Big Three in the month, however, was probably the main driver of the improved sales pace.

* Nonfarm payrolls rose a less-than-expected 108,000 in December, but there were significant cumulative upward revisions to November (+305,000) and October (+25,000) totaling 71,000.  There were indications that unusually cold weather held back job growth, as a relatively high number of people said they were not at work because of bad weather, and weather-sensitive construction payrolls (-9,000) were particularly weak.  Lower seasonal hiring than normal in the retail sector (-16,000) also held back payrolls.  On the positive side, the unemployment rate dipped a tenth to 4.9%, and average hourly earnings gained 0.3%, leaving the six-month growth rate at +3.4%, a significant pickup from the +2.8% recorded over the prior six-month period.

The upcoming week’s economic data calendar is back-end loaded.  All the notable releases are out on Thursday and Friday (which has an early close ahead of the Martin Luther King Day holiday), with a focus on retail sales and PPI on Friday.  Earlier in the week, attention will be more on supply and Fed-speak.  On Monday, the Treasury will announce a five-year (the last mid-month issue before the shift to month end in February) and 10-year TIPS for auction Wednesday and Thursday.  We look for unchanged sizes of $13 billion and $9 billion, respectively.  Corporate supply will also likely be a major focus, building on the flood of issues that came to market in the second half of last week.  January is typically one of the biggest months of the year for corporate issuance and this year is certainly starting off strong, with over $10 billion in issuance on Thursday alone.  Meanwhile, Fed officials are apparently back from their holiday breaks, with a significant number of speakers scheduled in coming days, including Kansas City Fed President Hoenig, Cleveland Fed President Pianalto, New York Fed President Geithner, Chicago Fed President Moskow, and Dallas Fed President Fisher. 

In addition to retail sales and PPI on Friday, other data releases due out include the trade balance and Treasury budget on Thursday:

* After surging to consecutive records in September and October, we look for the trade gap to narrow by $3.4 billion in November to $65.5 billion, with exports flat and imports down 2%.  On the export side, overseas aircraft deliveries look to have been about flat after the post-Boeing strike surge last month and soft ex-aircraft capital goods shipments point to little change in other capital goods.  Softer commodity prices (particularly energy) are also likely to restrain industrial materials and food.  On the import side, the bulk of the weakness should be attributable to a partial retracement of the record surge in energy goods posted in October, with both prices and volumes of petroleum products and natural gas likely to fall significantly.  The strange spike in auto imports in October, which contrasted with both weak sales and lower North American assemblies, should also be unwound.

* Another impressive jump in corporate tax payments should swing the federal government’s budget balance to a $10 billion surplus in December, about a $13 billion improvement relative to the same month a year ago.  For the fiscal year as a whole, we look for a budget deficit of $400 billion (or about 3% of GDP).

* We look for a 0.9% rise in overall December retail sales and a 0.4% gain ex autos.  Strong vehicle sales should provide a significant boost for the overall headline reading, while the chain-store results point to solid gains in discretionary categories such as general merchandise and home electronics.  Meanwhile, results at apparel outlets and drug stores were on the softer side.  And gas station receipts should flatten out following some sizeable price-related swings in prior months.  One of the major wildcards in this report will be the hardware store category, which has been on an unsustainable tear (20%+ annualized growth) for the past several months.  Some of this upside was no doubt related to hurricane effects, and we expect to see a gradual moderation in the coming months.

* We forecast a 0.4% rise in the overall December producer price index and a 0.2% gain ex food and energy.  After plunging 4% in November, energy prices appear likely to post a modest rebound in December.  Much of this upside is related to the seasonal factors — for example, a modest 1% uptick in actual gasoline prices during December translates into a 10% surge after seasonal adjustment.  Also, the farm price report points to a rise in quotes for a number of food items this month. 

Meanwhile, we expect the core to show some mild elevation as motor vehicle prices post a modest rebound on the heels of the declines seen in October/November.  Otherwise, core price gains should be a bit below the recent trend.

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Japan
Is the "Golden Combination" Sustainable?
Jan 09, 2006

Takehiro Sato (Tokyo)

Key points — what’s changed:

Domestic investors were treated to a golden combination of rising stock prices, a weak yen and a stable bond market in 2005.  We anticipate a continued benign market environment in 2006.

Conclusions:

We think the following three factors will support sustained euphoria: 1) continuation of a real negative interest rate due to an increase in the anticipated inflation rate; 2) joint occurrence of improved nominal wages and corporate earnings and price stability amid a quiet productivity revolution; and 3) rising external investments with the recovery in domestic asset markets and expansion and stabilization of domestic and overseas (real) interest rate gap.  We expect the growing probability of an inflation target to strengthen the combined effect of these factors.

Policy implications:

We think there is a reasonable chance of the administration and BoJ agreeing to inflation targets as a policy guideline with an effect of raising the anticipated inflation rate.

Risks:

Simultaneous advances by all three markets are only possible when various positive conditions fall in place.  The “golden combination” similarly is not permanent.  Japan’s real negative interest rate measured by the core CPI rate might end in a relatively short amount of time and disappoint investors.

Detail — 2005’s golden combination an exception, not the norm

Domestic investors were treated to a golden combination of rising stock prices, a weak yen and a stable bond market in 2005.  However, higher stock prices typically result in yen strength and weaker bond prices, making 2005 an exception to the regular pattern.  We anticipate a continued benign market environment in 2006 and have a strong foundation for projecting a second year of this unusual combination. 

Three factors supporting our outlook for continued market euphoria in 2006

The first is the Japanese economy entering its first-ever period of a negative real policy interest rate, besides a short-lived exception during the oil shocks.  This was confirmed statistically by the core CPI rate turning positive in November.  However, we think the market’s anticipated inflation rate had already moved into positive territory from summer 2005 when the administration declared that the economy was no longer on a plateau, and played a role in last year’s market euphoria ahead of the core CPI rate.  Our forecast projects that ZIRP (zero interest rate policy) will remain in place until early F2007, helping sustain euphoria with a negative real interest rate during 2006.  This is favorable for stock prices and should not hurt bonds, though it is not necessarily positive.

The second is the economy’s ideal growth pattern of rising wages and corporate earnings accompanied by relatively stable prices.  We think a quiet productivity revolution, mainly in the public sector and services industries, is supporting this trend.  Higher wages typically squeeze profits and apply upward pressure to finished goods and services prices as companies transfer additional costs to product prices in an effort to maintain margins.  Yet this classic dynamic of wage inflation has not played out in major economies.  We must resort to productivity gains as an explanation of the abnormal stability of general prices under recent nominal wage and corporate profit conditions.  Strong productivity advances, exceeding our expectations, are restricting upward pressure on prices.  Improved productivity also implies that Japan’s potential growth rate might be higher than our 1-1.5% assumption.  This is good news for stock prices.  It has positive implications for the bond market too since higher potential growth limits inflation at faster growth rates and might offset upward pressure on the nominal long-term interest rate from the higher anticipated inflation rate.  We believe the same mechanism explains the unusual stability of long-term rates, despite monetary tightening, in the bond markets of major economies. 

The third is a recovery in the risk preference of domestic investors backed by rising asset prices that it has contributed, together with widening gap between domestic and overseas real interest rates, to yen weakness, despite stock price gains.  We expect this trend to continue.  Some observers might disagree.  The new year started with a “triple gain” on January 3 as stock and bond prices advanced while the yen strengthened modestly amid speculation that the US rate hike campaign might be nearing an end.  We are not concerned, despite appearing to be out on a limb.  There is a tendency to sell dollars as rate hikes widen the interest rate gap, and the dollar receives support from a pick-up in capital outflow from domestic investors once rate hikes finish and the gap stabilizes.  Last year’s dollar popularity during a rate-hike cycle was an exception to past experience.  We think capital repatriation by US companies following the US Homeland Investment Act influenced the outcome.  We expect a genuine phase of expatriation for Japanese capital if the US rate-hike campaign is truly nearing an end, as depicted in proceedings from the December FOMC meeting, removing monetary policy as a destabilizing factor in the US bond market. 

Anticipated inflation rate might increase, even with a low CPI

There are always uncertainties.  Simultaneous advances by all three markets are only possible when various positive conditions fall in place and lack sustainability.  Similarly, the “golden combination” is not permanent.  Japan’s real negative interest rate measured by the core CPI rate might end in a relatively short amount of time.  The government’s F2006 budget proposal finalized at the end of last year incorporates new factors with an impact on prices, including deregulation and spending cutbacks.  Our analysis suggests that the net impact will push prices lower in F2006.  We hence anticipate a slowdown of the core CPI rate after peaking in Jan-Mar and even the risk of a return to negative year-on-year territory in 2H F2006.  These conditions would seem to derail our outlook for sustained euphoria based on a real negative interest rate.  

Yet the real negative interest rate emboldening stock investors relies on a prolongation of ZIRP.  In other words, these investors were originally frustrated with ZIRP on the basis that banks could not improve their margins, but are now betting on a real negative rate.  How can this contradiction be explained?

We think it stems from whether the real interest rate is measured in terms of the core CPI rate or the anticipated inflation rate.  Theoretically, the real interest rate should be measured by subtracting the anticipated inflation rate from the nominal interest rate.  Yet the realized inflation rate is used out of convenience due to the practical difficulties of measuring the anticipated inflation rate.  We therefore respond to the above-mentioned contradiction by asserting that the anticipated inflation rate will remain positive even if a decline in broadly defined public service fees causes a technical dip back to a negative rate for core CPI.  We also expect a lift in the stock market valuation if the government sets an inflation target as an economic goal, from a rise in the anticipated inflation rate that boosts the present value of future corporate cash flow streams and reduces risk premiums with improved economic conditions.  Looser monetary conditions (MCI) from yen weakness should also help maintain a rally. 

Increased likelihood of an inflation target

We think there is a reasonable chance of Japan setting an inflation target.  Toshiro Mutoh, a BoJ Deputy Governor, commented in a December 27 interview with the Nikkei that “the policy duration effect of quantitative easing will be ending” and “some type of replacement should be adopted”.  He also indicated that the BoJ is reviewing possible options, explaining that “we will be discussing whether this can be accomplished with a specific number or a less rigid method.  This point deserves careful consideration”.  We think the overall environment is still following our scenario. 

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Global
Global Currencies
Jan 09, 2006

Stephen L. Jen (London)

A much more interesting year for CNY

Early this year, I expect Beijing to allow more genuine currency flexibility.  As a result, CNY should meaningfully appreciate against the USD.  More relevant for investors, perhaps, is the spill-over effect this prospective appreciation in the CNY will have on the AXJC currencies, particularly NE Asian currencies such as KRW and TWD.  

What I expect to see

Our year-end forecast remains unchanged at 7.80 for USD/CNY.  I now believe this is a minimum target and expect USD/CNY to be more energetic.  Since USD/AXJC is linked more to USD/CNY than USD/JPY, I expect USD/AXJ to have a meaningful sell-off as well.  Foreign investors’ interest in the AXJC equity markets remains strong, and the implicit negative carry is significantly less than that for the JPY.  This makes it more tempting for foreign equity investors to reduce their hedge ratios.  More evident downside risks to USD/CNY will provide the political justification for countries in Asia to let their currencies appreciate.  USD/JPY will be a laggard, primarily because of its super-low yields. 

Preamble

Even though my view is now more aggressive than six months ago, I continue to reject many of the popular notions in the market about CNY (for example, that Beijing will ‘throw the US another bone’ by introducing yet another step revaluation). 

Further, I note that the real effective exchange rate of the CNY rose by 11.6% in 2005, primarily reflecting the strength of the dollar.  However, as the dollar experiences a gentle depreciation this year, it should give some room for CNY to appreciate in bilateral terms but not so much in effective terms. 

Finally, I would also stress that the call on the likely timing of major changes to the CNY regime is highly influenced by political considerations, particularly between different policy apparatuses in China. 

Why this more aggressive outlook for CNY?

Four key factors support my more aggressive outlook for USD/CNY.

First, China’s official reserves continue to grow at a rapid pace.  The PBoC’s official reserves reached US$794 billion at end-November.  Including the funds transferred to the state banks, China is probably already the largest reserve holder in the world.  While I do not believe China wants to stop intervening, as the MoF has done, the trade-offs between ‘marginal cost’ and ‘marginal revenue’ of having more reserves may be tilting, in the minds of some policymakers.  In the short run, there is of course a ‘chicken-and-egg’ problem whereby expected currency appreciation could draw in more speculative flows.  However, I believe that, with the cooling of the property market and the opening of outward investment, this threat is substantially lower than, say, in 2004. 

Second, international politics are likely to be an even more important issue this year.  Regarding currency politics between China and the US, the issue has always been ‘compromises’. 

The US Treasury and Beijing have now come to a good mutual understanding.  The US Treasury’s hint that it expected more action from Beijing is therefore a more reliable signal, to me, of what will actually happen. 

Third, China needs more currency flexibility.  Chinese policymakers agree on this point.  Beijing has so far not exhausted the daily trading band of ±0.3 percent, not because it is ideologically opposed to it.  Rather, Beijing might not be convinced that the institutional framework that would provide a market for hedging is adequately established for (i) market participants to utilize the hedging instruments and (ii) the spot and forward rates to be meaningful representations of market pressures.  However, structural changes, including the one announced on January 5, will keep going on.  There is no obvious point in time when China will be ready for more currency flexibility.  Instead, what we do know is that this will be a ‘chicken-and-egg’ process that will facilitate the development of the CNY market. 

Fourth, global demand is likely to stay strong.  I think the global environment is likely to remain positive in 2006 to permit China to accept some currency strength.  Protectionism remains a risk, and greater CNY flexibility could be seen as an ‘insurance payment’ against the risk of protectionism from China’s key markets. 

This will not solve the global imbalances problem

Even if the other Asian currencies (together accounting for some 40% of the Fed’s dollar index) move in synchrony, I doubt that this will reverse the global saving-investment trends. 

What are the risks to this scenario?

I see four key risks: (1) China slows; (2) the US housing market crashes; (3) the US makes an explicit threat (Bill 295 by Senator Schumer) to force China to move; (4) the USD strengthens across the board. 

Bottom line

I believe one key theme for 2006 will be the Chinese yuan.  Greater flexibility will lead to greater CNY strength, which should help propel USD/AXJC lower.

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