The Capex Recovery Confirmed by our Analyst Survey
Jan 11, 2006
Eric Chaney (London)
Steady business conditions
Business conditions for large European companies have not significantly changed since our previous European analysts survey (October 19, 2005). At 56, our synthetic index is roughly half a standard deviation above the break even 50 line, indicating a reasonable although not accelerating pace of expansion. The message here is slightly different from large sample manufacturing surveys, which have kept improving over the last months. However, since the index we derive from the Analyst Survey had sharply rebounded as soon as September, we suspect that the recovery had reached large listed companies before the wider universe of corporate Europe. Although our time sample is still too short for robust conclusions — we initiated this survey in June 2003 — this seems to confirm that the survey has a slight lead on the European business cycle. On this basis, we would expect that, on average, traditional surveys such as the Ifo will stabilize at their current levels in the next two or three months, a prospect consistent with our early GDP indicator, up 0.6% in Q1 2006, after 0.5% in Q4 2005. The fresh news brought in by the analyst survey is elsewhere. First, the capex recovery is confirmed; second companies have some pricing power although not much; third, risks to 2006 earnings seem skewed on the downside. A robust capex recovery, led by Energy and Utilities A rising majority of analysts reported an increase in their companies’ or sectors’ capex plans. The index rose from 38 in September to 43. The continuous improvement of capex prospects started back in 2004. With the benefit of hindsight, two factors are conducive to fixed investment. One is exogenous to companies: very friendly monetary conditions, i.e. close to zero real short-term interest rates since mid 2003. The other factor, the de-leveraging strategies that followed the 2001 stock market crash, is more endogenous. Now awash with cash and reassured by the stability of demand growth, companies spend more. As our equity strategists had long announced, the capex recovery is fuelled by IT spending as companies need to raise productivity in order to slash operating costs, and to innovate at a faster pace. In this edition of the Analysts survey, the “Big Spenders” remain Energy, Utilities, Telcos and Materials. More relevant perhaps, Consumer Staples, Energy, Healthcare and Technology reported the sharpest upward revisions. Pricing power is not dead but inflation remains low The median annual price increase reported by analysts decreased slightly, from 0.8% in September to 0.7% in December. Six months ago, we were close to deflation. Yet, pricing power is not strong enough to signal accelerating inflation: by any macro standard, a 0.7% inflation rate is very benign, especially against the backdrop of higher input prices. Besides, the survey indicates that higher non-wage costs (energy in particular) are the main threat to profit margins, an indirect evidence that pricing power remains quite limited. Risks are skewed to the downside, but there is hope Each quarter, we ask analysts to answer a topical question. Because 2005 was a better than expected year for corporate earnings in Europe, which contributed to the strong performance of European equity markets relatively to other regions, we asked our colleagues to make an assessment on risks for 2006 earnings. We selected six risk factors, non-wage costs, rising interest rates, labour costs, exchange rate, changes in regulation and global demand growth. All but the last one were considered as mostly negative risks, the most serious one being a potential rise in non-wage costs. This is indeed consistent with our risk assessment of oil markets: because the global refinery industry is insufficient to cope with either demand spikes or temporary shutdowns, the odds for another oil price spike remain as high as they were last summer. However, this 11th edition of the analyst survey ended on a brighter note: global demand was reported as a positive risk to earnings. A virtuous circle resulting from stronger domestic demand generated by companies (capital expenditure) but also by less thrifty consumers is a possibility that markets have not priced.
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From Copenhagen to Maastricht
Jan 11, 2006
Serhan Cevik (from Brussels)
After the start of accession talks, Turkey is on the way to meeting the Maastricht criteria. With the completion of a range of legislative reforms at a breathtaking pace to meet the Copenhagen criteria, Turkey has started accession negotiations with the EU. Over the course of the next ten years, the convergence with the acquis communautaire will move the country out of institutional backwardness and help internalizing liberal democracy and the rule of law. In our view, institutional improvements — fostering good governance and strengthening economic performance — are among the principal benefits of the accession process (see Law and Order, November 26, 2004), but Turkey will also experience nominal and real economic convergence fuelling a virtuous cycle of declining cost of capital, increasing investment rates and output growth, improving credit quality and further compression of real interest rates. Indeed, the economy is already on such a trajectory and steadily moving towards meeting the Maastricht criteria for becoming a member of the European Monetary Union (see Welcome to (Outskirts) of Maastricht, October 27, 2005). With secular disinflation, Turkey will achieve price stability in 2008. The consumer price index posted a year-on-year increase of 7.7% at the end of last year, down from 9.4% in 2004 and an average of 77.5% in the 1990s, thanks to far-sighted macroeconomic policies and structural changes raising the economy’s growth potential. This is in fact the lowest inflation reading in the past three and a half decades and, considering the adverse effects of higher commodity prices on Turkey’s import-dependent economy, reflects the strength of secular disinflation towards price stability. Our projections show that inflation is likely to come down to 4.3% this year and then to 3.5% by the end of next year. In other words, Turkey will achieve price stability and meet the EU’s inflation criterion in 2008. The budget deficit, narrowing to 2.8% of GDP last year, is already below the EU threshold. Prudent fiscal policies and structural reforms have produced an average primary budget surplus of 5.8% of GDP in the last six years, leading to a dramatic drop in interest rates. As a result, the Treasury’s interest payments declined from an enormous 23.3% of GDP (or 103.3% of tax revenues) in 2001 to 13.7% (or 55.9%) in 2004 and to 9.5% (or 37.5%) last year (see The End of Fiscal Dominance, November 8, 2005). And, not surprisingly, we have witnessed an astonishing correction in the central government budget deficit — from 15.2% of GDP in 2001 to 7.1% in 2004 and, on our estimates, to 2.8% in 2005. The data based on European accounting standards show even more impressive improvement in public finances, as the public-sector budget deficit narrowed from 29.8% of GDP in 2001 to 3.9% in 2004 and then below the 3% mark last year. Turkey’s public debt-to-GDP will move below 60% by the end of next year. Macroeconomic gains, coupled with soaring privatization revenues, have lowered the public-sector borrowing requirement from 16.4% of GDP in 2001 to 4.7% in 2004 and to a mere 0.8% last year. Accordingly, the public sector’s net debt-to-GDP ratio declined from 90.5% in 2001 to 63.5% in 2004 and, according to our projections, to 57.5% last year. Though the composition and maturity profile of the country’s domestic debt stock remain problematic, we expect further improvements in borrowing conditions and thereby a marked fall in the gross public-sector debt ratio — another Maastricht criterion — from the peak of 107.5% of GDP in 2001 to 61.2% this year and then to 54.2% by the end of next year. Interest rates will continue converging towards the European average. The last condition of the Maastricht criteria states that the level of long-term interest rates must not exceed by more than 2 percentage points the average of the three member states with lowest interest rates. Of course, this is going to take a long time to achieve but we believe that the Treasury’s diminishing borrowing requirement and Turkey’s progress towards the investment-grade status will keep long-term interest rates on a trajectory towards the European average (see Buy Bonds, Wear Diamonds a la Turca, September 26, 2005).
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Post-Industrial Bottleneck
Jan 11, 2006
Serhan Cevik (from Brussels)
Institutional shortcomings and microeconomic bottlenecks limit Turkey’s progress. Prudent policies and structural reforms — boosting productivity and moderating the volatility of real and financial variables — have paved the way for above-trend real GDP growth and secular disinflation towards price stability (see Breaking the Curse of Sisyphus, December 15, 2005). However, although we expect the continuation of non-inflationary output growth in the coming years, our macroeconomic optimism does not mean that the Turkish economy has reached nirvana with no more structural fragilities. As we have highlighted in our previous reports, Turkey’s post-industrial economy is still struggling with institutional shortcomings and microeconomic bottlenecks that are also partly responsible for external imbalances (see, for example, Technological Sclerosis and Productivity Divergence, April 19, 2005). Structural inefficiencies, not the lira’s strength, are behind sectoral difficulties. Turkish exports posted a respectable 53.6% real increase in the post-crisis period to 20.9% of GDP, whereas imports surged by 104.1% to 28.9% of GDP. As a result, the trade deficit widened from an average of 5.4% of GDP in the 1993-2003 period to 6.8% in 2004 and, on our estimates, to 8.0% last year. Some observers claim that the lira’s strength is the main reason for the ‘deterioration’ of the country’s international position. We, on the other hand, argue that the normalization of Turkey’s volatile economic landscape has led to a productivity revival and thereby driven above-trend output growth. And, coupled with higher commodity prices and pent-up consumer demand, the rise in capital spending has resulted in a wider trade deficit. Furthermore, the lira’s strength has merely exposed microeconomic weaknesses of Turkey’s emerging post-industrial economic structure. Even though the economy as a whole benefits from a significant acceleration in labour (as well as total factor) productivity growth, industry-level data show productivity divergences and increasing import dependency in certain industries. We believe that these underlying problems reflect organizational inefficiencies and technological sclerosis, especially, in traditional sectors. Turkey’s evolution from an agrarian economy to service-based economy remains incomplete. Services now account for 55% of the Turkish economy, with agriculture and industrial sectors generating 12% and 25% of GDP, respectively. However, apart from an underutilized tourism sector, Turkey’s service exports remain at a disappointingly low level. In our view, this awkward structure — leaving the manufacturing sector as the leading engine of exports — has become a critical bottleneck limiting the economy’s growth potential and leading to external imbalances. There is no quick fix for such a structural problem, but the authorities must move away focusing exclusively on manufacturing sectors in the policymaking process and start paying more attention to the needs of a post-industrial economy (see The Machine Fetish, June 28, 2005). The globalization of supply chains puts growing pressures on inefficient firms. Labour productivity in the manufacturing sector, after rising 23.5% on a cumulative basis in the 2002-2004 period, increased by 3.7% year on year in the first half of 2005 and 6.1% in the third quarter. However, the headline figure hides sectoral divergences stemming from micro-level flaws. As a consequence of technological backwardness, small firms — dominating traditional sectors of the economy — have lower productivity and consequently fail to deal with the challenges of a fast-changing environment. For example, productivity per hour-worked in the clothing industry declined by 3.1% in the post-crisis period, whereas technology-intensive sectors like electronics and automotive enjoyed gains of 87.4% and 108.2%, respectively. In other words, traditional sectors face much higher unit labour costs that are in fact the results of labour-market rigidities and deep-seated inefficiencies. This is why currency devaluation is no panacea for addressing problems that are structural in nature. In our view, what Turkey needs is a transformation from being a struggling player in low value-added manufacturing sectors to a modern service-based economy.
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