United States
Business Conditions
Jan 13, 2006

Shital Patel (New York) and Richard Berner (New York)

Our index of business conditions continues to be volatile, but the underlying message is one of slightly moderating but sustainable growth.  The Morgan Stanley Business Conditions Index (MSBCI) declined 11 points to 58% in early January — a point above November’s level — but the less-volatile three-month moving average edged down two points.  Monthly headline results have fluctuated between a high of 72% in August 2005 and a low of 57% in November, but the smoothed index has remained at or above 60% since August.  These data seem to refute our thesis that growth will accelerate early in 2006 and will remain both above trend and above the consensus.  In our view, strong advance bookings and capital-spending plans in the MSBCI signal sustainable growth.  In fact, they may be the best indication that the deceleration in the MSBCI is temporary and that business conditions are poised for renewed strength.

Certainly, hurdles lie ahead.   For example, our survey confirms that rising costs and a potential margin squeeze are challenges to corporate performance.  While the consensus of sell-side analysts believes that 76% of companies in the S&P 500 will see rising margins in 2006, we think profit margins will flatten this year.  In support of that belief, 44% of our analysts noted that profit margins increased compared to a year ago, down from 47% last month, while 29% noted that margins were lower, up from 27% in December.  Furthermore, over the past three months, a full 41% of analysts noted that unit material and/or labor costs outpaced prices charged, thus squeezing margins. 

But top-line growth will likely exceed expectations: Corporate pent-up demand is still strong, in our view, and CFOs are looking for growth in plans to reposition and/or acquire.   While our advance bookings index declined two points, it remains at a hearty 68%, suggesting still-strong demand.  Moreover, the percentage of respondents who say companies under their coverage plan to increase capital spending increased to a strong 54%.  Three-quarters of respondents plan M&A transactions.  Contrariwise, the percentage planning to increase hiring declined to a 7-month low of 25%, and some are cutting pension and healthcare benefits to rein in costs. 

The breadth of business conditions, another indication of sustainability, moved back towards a more normal distribution in early January.   The percentage of analysts reporting improving business conditions decreased to 31% from 44% last month.  Moreover, 17% of analysts reported deteriorating conditions, up from 9% last month.  The ratio of analysts reporting improved conditions to those reporting deteriorating conditions was 2:1, down notably from 5:1 in December. 

By industry, our results echo those seen in popular diffusion gauges like the ISM manufacturing and non-manufacturing indexes.  Six of 10 sectors had improved business conditions compared to last month.  Conditions improved for the energy, consumer staples, industrials, IT, materials, and consumer discretionary groups, while conditions deteriorated somewhat for the telecom services grouping.  Improvement in both the manufacturing and services sub-groupings moderated in early January.  The manufacturing index decreased by 19 points to 58% while the services index decreased 6 points to 57%.

Bookings: Moderating, but Still Growing

The advance bookings index slipped two points to 68% in early January.  While this is the second monthly decline, it remains above the 3-year historical average of 66%, suggesting that demand is still growing.  The consumer discretionary, energy, materials, IT, and industrials groups all noted higher orders.  The financials group was the only sector noting lower bookings.

Financing Still a Tailwind

The recent rally in stock prices and in credit markets, the decline in the dollar, and ample credit availability helped improve financial conditions in early December as the financial conditions index increased three points to 54%.   Importantly, the tails of this distribution are fattening, hinting that credit quality is peaking: 15% of respondents noted that financing has become easier to obtain over the last three months compared to 13% last month, while 18% noted that credit was more difficult to obtain, up from 11% last month. 

Hiring Plans Continue to Disappoint…

Recent hiring trends remained tepid in early January as the percentage of groups that hired over the past three months remained at 31%.  More ominously, the percentage of groups with plans to hire over the next three months declined to 25% from a weak 30% last month.  While recent payroll data have also disappointed, we believe that unusually cold weather may have depressed the December figures, and pent-up demand for hiring will eventually result in an acceleration in hiring.  Still, 15% of groups plan to cut payrolls over the next three months, down from 16% last month.  Plans to hire were most notable in the energy, industrials, and IT groups.

…but Capex Plans Picking up the Slack

On the bright side, we believe that Corporate America’s discipline over the past four years has created pent-up demand that will last through 2007.  Coupled with still-easy financing conditions, that is supporting plans to increase capital spending in early January.  54% of respondents reported that companies under their coverage plan to increase capex over the next three months, up from 49% last month.  Furthermore, 31% of these groups plan to increase spending by 6% or more, down from 36% last month.  Plans were most notable for the energy, utilities, telecom services, industrials, materials, and consumer discretionary sectors, although all sectors had at least one group with plans to increase.  The oil services and machinery companies plan to increase capex by 10% or more.

Lots of M&A in the Pipeline

Thanks to easy financing, M&A activity in 2005 rebounded to a five-year high, and bankers expect 2006 to surpass 2005.   According to our survey, 73% of groups are planning some sort of M&A transaction.  Few are planning to shed noncore businesses while most plan to rescale their existing business and acquire new business lines.  All sectors contain at least one industry group with plans to participate in an M&A transaction, but plans are most prevalent in the consumer discretionary, energy, utilities, industrials, IT, materials, and telecom services groupings.  The financial and healthcare groups also have several industry groups planning M&A transactions.

Challenges: Pricing Power Remains but Margins Flattening

Lower input prices have helped moderate overall price increases in recent months.  The pricing conditions index slipped another two points to 69%, but remains at a historically strong level.  54% of analysts noted that prices charged at companies under their coverage increased from a year ago, down from 62% last month.  Yet only 17% noted that prices declined from a year ago, down from 20% last month.  As in December, the breadth of price increases remains widespread across all sectors except IT and telecom services.  Not surprisingly, in that context, margins continue to climb for the industrials, energy, healthcare, and industrials and materials (with some exceptions) groupings.

Nonetheless, the percentage of groups with higher margins compared to a year ago stood at 44% this month, down from 47% in December.  Similarly, the percentage of analysts noting that margins were lower compared to a year ago at companies under their coverage increased to 29% from 27% last month.  Margins have come under pressure at consumer discretionary, consumer staples, financials, IT, telecom, and utilities companies.

The culprit: rising costs.   Over the past three months, 41% of analysts noted that unit material and/or labor costs are outpacing prices charged at companies under their coverage, up from 36% last month.  While 34% were able to expand margins, up slightly from 32% last month, 25% were able to increase prices at the same pace as costs. 

Focus on Retirement Benefits

With several companies in the US and UK announcing that they are altering their defined-benefit (DB) pension plans, freezing accruals for existing workers and denying entrance to new workers, we asked a series of questions on retirement benefits.   According to our survey, 44% of analysts responded that companies under their coverage have a DB plan and 19% contribute to a multi-employer plan.  Of these, 19% (4) have frozen accruals.  Of those in our canvass who have not frozen accruals, just one is planning such a freeze.  But 30% of respondents whose companies have DB plans are already denying entry to new workers, and of those that now allow new workers into the plan, two respondents say they plan to deny them entry. 

Corporate actions on retiree healthcare costs are more aggressive: Half of respondents noted that companies under their coverage offer retiree healthcare coverage, but 21% said their companies have stopped allowing new workers into the plan, and 69% of respondents are taking steps to bring down these OPEB costs for current retirees. 

Analyst Commentary by S&P Major Sector

Consumer Discretionary:   Business conditions were somewhat improved in early January and bookings were higher for the auto and auto parts, lodging, and publishing groups.  While only the retailers plan to increase hiring over the next three months, most groups plan to increase capex.  Both the lodging and retail groups plan to increase capital spending by 6-10%.  Most groups except the retailers are planning on participating in M&A deals to either shed non-core businesses or acquire new business lines.  Although prices charged have increased for most groups compared to a year ago, margins have either remained the same or declined over the same period.  Over the past three months, unit material costs have outpaced prices charged for all groups except the lodging companies.

Consumer Staples:   Conditions remained unchanged for the consumer staples sector this month, although conditions were somewhat improved for the tobacco group.  No groups plan to expand payrolls and the household and personal care companies actually plan to cut payrolls over the next three months.  The beverage manufacturers plan to increase capex by a slim 0-3% and the tobacco companies are planning M&A transactions to rescale their existing businesses.  While prices charged have increased compared to a year ago, all groups with the exception of tobacco noted that margins have declined.  Over the past three months, unit material costs continue to outpace prices charged. 

Energy:   Conditions continued to improve noticeably for the oil services companies.  Bookings were higher and companies plan to increase hiring by 3% or more and capex by 10% or more over the next three months.  Financing is also easier to obtain.  Prices charged have increased by 3% or more compared to a year ago and margins are higher.  Over the last three months, prices charged have continued to outpace unit costs. 

Financials:   Business conditions were mixed for the financials sector.  Conditions improved for the multifamily REITs, non-life insurers, and financial guarantors but deteriorated for the mortgage finance companies and large- and mid-cap banks.  Conditions were unchanged for the remainder of the groups.  Advance bookings were lower for several groups including the life insurers, mortgage finance, and large- and mid-cap banks.  The majority of groups don’t plan to increase hiring or capex.  Exceptions include the non-life insurers and brokers and asset managers, which plan to increase hiring somewhat, and multifamily and retail REITs, which plan to increase capex; mid-cap banks plan to increase both.  Nearly half of the groups are planning or are rumored to be contemplating M&A transactions.  Roughly one-quarter of the groups have increased prices charged compared to a year ago, although margins were lower over the same period for half of the groups.  Margins were higher for the brokers and asset managers and life insurers.  Over the last three months, margins have been flat to lower for all groups.

Healthcare:   Conditions were unchanged from improved conditions last month for the healthcare group.  Outside of the biotechnology group, hiring and capex plans are flat for the sector.  However, capital expenditure increases are beginning to slow after a robust 2005 for the biotechnology group.  Most groups are planning M&A transactions.  Prices charged increased for more than half the groups compared to a year ago, helping increase margins.  Over the last three months, prices charged have increased faster than costs.  Pricing is still decelerating for the managed care and health insurance companies although at a slower pace than medical costs. 

Industrials:   Business conditions were improved on the margin although most groups reported unchanged conditions in early January.  Our machinery analyst Steve Volkmann notes that business is still strong at his companies but is no longer accelerating.  The airlines and aerospace/defense companies noted higher bookings.  Over half of the groups have plans to increase hiring over the next three months while all except the airlines have plans to increase capex.  The machinery companies have plans to increase capital spending by 10% or more.  Nearly all groups are planning M&A activity, mostly to rescale their existing businesses.  On the margins front, prices charged have increased from a year ago for all groups except aerospace/defense and margins have increased for all groups except trucking.  Over the past three months, labor costs are squeezing margins at the trucking and business services companies.  Pricing is still outpacing costs for nearly half of the groups. 

Information Technology:   Business conditions continued to improve in IT and most groups noted that bookings were higher.  Hiring and capex plans have weakened compared to last month.  The semiconductor manufacturers and specialized IT services were the only two groups planning on increasing hiring and capex over the next three months.  While both hiring and capex buildup will mostly occur offshore for the specialized IT services companies, Julie Santoriello notes that there are more plans to hire locally compared to last year.  All groups within the IT sector are planning some sort of M&A activity.  Reasons include rescaling their existing businesses and acquiring new business lines.  Although prices continue to decline for half of the groups compared to a year ago, margins are higher for most groups since unit costs have declined at a faster rate.  Margins are beginning to flatten over the past three months as material and/or labor costs are increasing faster than prices charged for half of the groups.  Unit costs continue to fall faster than price declines for the communications equipment group.

Materials:   Business conditions were improved on the margin for the materials group, although both the commodity chemicals manufacturers and homebuilders noted somewhat worse conditions.  No groups plan to hire over the next three months and the paper and forest products and steel companies plan to cut payrolls.  However, all groups except the homebuilders plan to increase capex and participate in M&A transactions.  Companies are looking to acquire new business lines, shed non-core businesses, and rescale their existing businesses.  Prices charged have increased from a year ago for over half the groups although these price increases were only able to cover increases in costs for the commodity chemical manufacturers and homebuilders.  Margins were lower for the paper and forest products and steel companies.  However, over the past three months, prices charged are outpacing unit costs for over half the groups.  Margins were squeezed only for the paper and forest products group.

Telecommunications Services:   Business conditions deteriorated in early January.  Although the telecom services companies plan to cut payrolls over the next three months, they do plan on increasing capex by 6-10%.  Both groups plan on participating in M&A activity: The telecom services are interested in rescaling their existing businesses, and the wireless services would like to acquire new business lines.  Prices charged declined compared to a year ago and margins are flat to lower.  Similarly, over the past three months, costs are falling at the same pace as prices charged for the wireless services, and unit labor costs are outpacing prices charged at the telecom services companies. 

Utilities:  Conditions were unchanged again for the electric utilities.  The 1-3% increase in prices charged from a year ago helped keep margins flat although higher fuel costs are squeezing margins for the regulated electric utilities over the last three months.

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UK
Are Pensions A Factor Holding Back Investment?
Jan 13, 2006

David Miles (London) and Leon Michaelides (London) and Melanie Baker (London)

UK corporate pension issues have been heavily in the news since the start of the year.  This week, Scottish Power announced plans to close its final salary pension scheme to new members and raise employee contributions for existing staff.  Within the last few weeks Rentokil, Arcadia and the Co-op announced measures to reduce the future cost of their defined benefit (DB) pensions.  DB pension schemes in aggregate remain in deficit in the UK and may have implications for consumer spending and yields, but also for investment (see ‘Answers to the Capex Puzzle’ D Miles, L Michaelides, G Secker et al, 15 December 2005).  Here we consider the potential link with capex.

Investment by UK companies has appeared weak in recent years and pension deficits may have been a factor.  Aggregate pension deficits for FTSE corporations may be somewhere between £50 billion and £150 billion, depending on which valuation method (FRS17 or buyout) is used.  Although there is limited evidence that pensions deficits, and uncertainty surrounding future contributions, have been a big factor across the board, they are likely to be an influence for a small number of companies with very large deficits and may continue to hold back their spending.

Business investment growth should be higher given high returns on capital relative to the cost of capital.   On our analysis, the weighted cost of capital (for UK private non-financial corporations) is significantly lower than the rate of return on capital.  The gap between them of around 5 percentage points is now probably higher than at any time in the period since the early 1990s.  This suggests strong incentives to invest.  Despite this, corporate capital expenditure has not been particularly strong over the past few years. 

Corporate balance sheets may be part of the explanation.   It may be that while the flow of profit looks healthy, and the rate of return high, the balance sheet position of the corporate sector is less healthy, and companies may be holding back on spending to repair those balance sheets. 

Corporate balance sheets look a lot less healthy once pension liabilities are considered part of an assessment of balance sheets.   The obligation to pay defined benefit pensions is the company’s.  Therefore, we could assess balance sheet strength by treating corporate pension liabilities as entirely analogous to corporate debt held directly on the balance sheet.  Net debt from the corporate pension fund is then measured as the total value of pension liabilities minus any debt-like assets held against them.  This is then added to explicit (corporate balance sheet) net debt to generate a wide measure of corporate gearing.  Using aggregate economy data, this measure of ‘wide’ gearing is higher (at 20%) than ‘narrow’ gearing (at 41%) by about 50%.  On this measure, the increase in corporate gearing since 2000 has been very substantial.

Funding of pension deficits may need to increase.   Last reported pension numbers for the FTSE 100 showed an aggregate gross deficit of approximately £54 billion (on an FRS17 basis).  We estimate that this deficit improved slightly by the end of December 2005 to approximately £49 billion due mainly to the performance of equity markets.  Even though we forecast this slight improvement in the deficit at year end, the markets are unlikely to generate such strong improvements going forward and at some point companies may need to increase funding of these deficits.

But the link between investment and pensions can only really be analysed convincingly at company level.   At the aggregate level it is not easy to measure pension positions; more importantly pension positions are diverse within the corporate sector.  We know that pension deficits are unequally distributed within the corporate sector.  So we think the link between investment and the corporate pension position can only be analysed convincingly by looking at company level data.

The pension problem is concentrated and capex spend has fallen more for these companies …   It is important to note that the pension problem is really concentrated within a small number of companies.  Ranked by pension deficit as a percentage of market capitalization, the 10 FTSE 100 companies in the tenth decile had deficits averaging 26.3% of market capitalization in 2004.  This compares to deficits of 6.4% of market capitalization in the eighth decile and only 2.1% in the fifth.  Over the last four years capex spend has fallen more for companies in the ‘tenth decile’ than it has for the rest of the FTSE 100.  We think a likely explanation of this trend is that these companies are concerned about having to make additional contributions to their pension schemes and are holding back on cash spending.  Uncertainty about new pension regulations that have been introduced in the UK may also be part of the explanation. 

… but this concentration means that pensions are less likely to be an issue constraining capital investment in aggregate.  We do not believe that pension obligations are a reason why the majority of companies have cut back on capital spending, as the significant shortfalls are concentrated among a few companies.

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Spain
Challenging Four Mainstream Views (Parts I)
Jan 13, 2006

Vincenzo Guzzo (London) and Javier Rodriguez (London)

This the first part of an excerpt from a joint report with Morgan Stanley analysts Pablo Beldarrain Santos and Davide Serra.  Part II will follow in Monday's edition of the Global Economic Forum.

Another strong year ahead

Spain has now done better than the euro area for 12 years in a row.  The GDP growth differential probably widened to a full two percentage points last year, while final domestic demand expanded nearly four points faster on average than on the continent.  While this gap might narrow somewhat in 2006, we think that the country will continue to outperform by a wide margin; our current GDP forecast for this year stands at 3.3% versus 2.1% for the euro area.

The lesson from 2005

In 2005, we learned that migration plays a far more prominent role than previously expected in the Spanish success story (see V. Guzzo, P. Beldarrain, D. Serra, Europe’s Favorite Destination, June 10, 2005).  One in three immigrants entering the European Union picked Spain as their final destination in 2004.  National Statistics (INE) estimates that immigrants entered Spain at an annual pace of 18,000 in 1995–96.  Over the following three years, this number more than trebled to 64,000 before soaring to 450,000 in 2000–04.  In 2004, the last year for which information is available, 646,000 immigrants registered as residents.

At the heart of a virtuous circle

We might have anticipated these big numbers through anecdotal evidence.  Yet, when last May statisticians published the first annual accounts based on the new 2001 Spanish Census, which incorporated the acceleration in migratory flows, they literally re-wrote Spanish economic history.  All of a sudden, we found out that between 2000 and 2004, Spain grew in real terms half a percentage point more than previously believed.  At current prices, Spain’s GDP level is now nearly 5% higher.  In response to huge migratory flows, the Spanish economy has not only been able to create jobs at a fast rate, but it has been also flexible enough to let migration exert substantial downward pressure on wages.  This is the source of a virtuous circle made of more jobs, more demand, more profits, and so on, that we think is likely to continue over the next few years. Against this background, it is an increasingly common view among investors that several forces will take the current long cycle to a halt: a collapse in migratory flows, continued loss of competitiveness, a crashing housing market and, last but not least, the reduction in the EU structural funds.  While we acknowledge risks to our optimistic view of the country, we do think that some of the concerns surrounding the prospects for the Spanish economy are overblown.  In the following sections, we will explain why.

I. Migration

Are these migratory inflows sustainable?

The key question is how long these kinds of flows will continue.  To address this point we first need to take a closer look at the source of migration.  Not surprisingly, the main contributor is Latin America with more than 25% of the total flows observed in 2004.  Eastern Europe follows by a close margin with around 22%, while Africa contributes to nearly 14% of the total.  Barring the case for unexpectedly tighter migration policies, this composite mix of generally low-income labour supply — British and German immigrants heading towards sunny shores are the only notable exception — is unlikely to fade in the near term.

The numbers of a success story

The issue is more on the demand side of the labour market, i.e. on the ability of the economy to absorb such a growing labour force, but even on this front we remain constructive.  Results so far have been impressive.  In just over 10 years, the unemployment rate has dropped significantly from a peak of nearly 25% in 1994 to a 26-year low of 8.4% in 2005.  Spain’s labour force has gone up by nearly five million workers over the same period.  In a decade, the mix of sustained immigration and falling unemployment has led to the creation of nearly seven million jobs, a 55% rise.

Excessive share of temporary workers may backfire …

Spain has managed to absorb such a high number of immigrants and put them to work owing to a large share of temporary positions — what we call second-best flexibility — and noticeable wage differentiation.  Things could even go better if the country moved to first-best flexibility, by lifting some of its firing rigidities.  More than one-third of the jobs added since 1994 are temporary positions.  We have always said that these temporary and part-time jobs are Europe’s corporate response to protective labour market legislation and lack of political efforts, but Spain seems to be an extreme example on the European map.  The excessive use of these contracts — three times as many as elsewhere on the continent — is a by-product of the country’s high firing costs and may backfire at some point.  Employees may feel even more insecure about their future prospects than in those economies where firing rigidities are low, the first-best labour markets.  Such a widespread use of temporary workers has also weighed adversely on productivity and may exacerbate Spain’s loss of competitiveness in the medium term.

… but Spain is reforming its labour market again

Yet, signals have been encouraging recently.  In an effort to try to raise job flexibility, the government is pushing through measures that would make it easier to dismiss employees on permanent contracts.  The reform will have to strike a fine balance between reducing the use of temporary contracts and lowering firing costs.  Even more important is the role played by wage differentiation.  The labour market has been flexible enough to let migration exert substantial downward pressure on wages so far.  The recent 5% increase in the minimum wage should not jeopardize the current virtuous circle — only further significant upward adjustments would.  Barring this extreme scenario, labour demand should continue to support robust migration. 

II. Competitiveness

Strong domestic demand behind falling net exports

Another often cited weakness is that, despite strong domestic demand, Spain’s external position is deteriorating rapidly owing to a significant loss of competitiveness.  Soon, the economy will have to pay a toll on these growing imbalances, the skeptics say.  This is not straightforward, we think.  True, between 1998 and 2003, Spain’s net export contributions subtracted on average one percentage point a year from annual GDP growth.  In 2004, this number went up to 2.2 points and a similar result is in store for 2005.  However, we would argue that this is nothing but a by-product of Spain’s strong domestic demand.

Export performance is not deteriorating (unlike Italy)

Over the last 10 years, Spanish final domestic demand has grown by a cumulative 54%, which is 45% more than the rest of the euro area.  Meanwhile, its trade coverage ratio, i.e. exports over imports, has deteriorated by only 13%.  In fact, exports themselves have not deteriorated at all, accounting for a stable 13% of overall EMU trade.  Growing imports are behind the decline in the coverage ratio.  The bottom line is that Spain’s external demand is not deteriorating.  It is merely outpaced by growing imports.  Spain’s export performance, measured as the ratio between export volumes and export markets for goods and services, offers a similar conclusion.  After a period of sizeable market share gains, the country’s performance on export markets has simply stabilized.  This is at odds with the structural erosion exhibited by Italy, for instance.

The productivity cost of a growing labour market

Another argument often raised to support the case of a deteriorating external position is Spain’s productivity stagnation.  The real exchange rate deflated by unit labour costs last year was more than 10% higher than in 1999 for the economy as a whole and nearly 15% higher for the manufacturing sector.  There is no doubt that further investment in infrastructure, human capital and innovation would have a favorable impact on total factor productivity.  Yet, we should not underestimate the dramatic transition taking place in the labour market.  It is no surprise to us that the creation of nearly seven million jobs in only 10 years came at the expense of labour productivity, thus inflating unit labour costs.  As the country approaches low-unemployment equilibrium, chances of a rebound in labour productivity are high, we think.

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Currencies
Four Stars are Aligning for AXJ Currency Appreciation
Jan 13, 2006

Stephen L. Jen (Singapore) and Charles St-Arnaud (London)

AXJ Currencies Expected to Show Definitive Uptrend

We believe the stars will likely align this year for us to see a definitive appreciation in the AXJ currencies against the USD.  Cumulative strong global growth, synchronization of policies between the various Asian central banks (mainly driven by China’s CNY policy), saturated reserves positions and a more progressive exchange rate policy are the four key factors that we believe will allow the long-awaited correction in USD/AXJ to take place this year.  As a result, we are revising our forecasts to show more AXJ currency strength.

Why We Still See Net Negative Pressure on USD/AXJ

Asia is a leveraged play on the global economy and globalization.  As long as global demand remains robust, and the process of globalization continues, Asia’s real economies should perform well.  This should, in turn, provide a favourable backdrop for the Asian equities to perform well.  Capital inflows, if un-hedged, should lead to currency strength.

We believe that downward pressure will re-emerge in 2006, though it may not be as intense as in 2003 and 2004.  First, as long as global equity markets are buoyant, it is likely that Asia will be a net recipient of foreign equity inflows.  Second, to the extent that Asian interest rates further close the gap with US interest rates in the period ahead, yield-sensitive capital outflows may be affected.  Third, from the perspective of global imbalances, a ‘balance up’ scenario should be positive for the Asian currencies.

Four Stars Aligning for a Less Currency-Hawkish Asia

In our view, what makes 2006 ‘special’ for USD/AXJ, compared to the previous years, is that four key conditions are likely to be in place this year to persuade the Asian policy makers to permit the AXJ currencies to appreciate.

•            Star 1.  Cumulative robust global growth.  The large economies that matter to Asia are all expected to continue to do well.  With sources of demand being so ‘broad-based’, Asia in a sense faces a more ‘diversified’ external demand and should be less sensitive to the exchange rates.    

•            Star 2.  The CNY could synchronize the currency policies in Asia.  A key obstacle for any country to let their currency appreciate is the risk that competitors would not do the same.  A critical factor in this consideration is the fate of the Chinese RMB.  As argued in The Year of the CNY (January 5, 2006), we expect daily variability to be significantly increased compared to 2H05. USD/CNY itself will likely decline more than most people expect, which in turn should lead to greater tolerance for currency strength by the other Asian central banks.  

•            Star 3.  Asian central banks may have come to a view that they have enough foreign reserves.  To us, Japan’s decision in early 2004 to refrain from currency intervention may have reflected its realization that the balance between the ‘marginal benefits’ and the ‘marginal costs’ of accumulating large foreign reserves had shifted.  Other Asian central banks with large foreign reserve holdings may also have serious reservations about buying more foreign reserves. The SAFE of China’s announcement on January 5, 2006 may also suggest a prospective slowdown in the pace of SAFE’s accumulation of reserves in 2006 and would be consistent with a lower USD/CNY. 

•            Star 4.  It is possible that several Asian central banks have become somewhat sympathetic to a more progressive view on exchange rates and growth.   For decades, Asia has had a mercantilist bent in how it sees exchange rates.  However, stronger currencies could help weed out inefficient companies and operations that survive on low margins and cheap currencies.  This view, that a stronger currency could encourage companies to climb up on the value-added ladder, may be winning more support in Asia. 

The Risks to Our New Forecasts

There are four key risks to our positive outlook for the AXJ currencies.  First, global demand needs to remain robust for Asia to outperform.  Second, USD/AXJ is not really misaligned, from a valuation perspective.  Therefore, massive and sustained exchange rate movements do not seem probable.  Third, USD/JPY could be a source of volatility for USD/AXJ.  The nominal yield differential between the US and Japan is simply too high for USD/JPY to remain on a steady path.  Equity capital flows are likely to be an important factor in this story.  We assume no major corrections in equities anywhere.

Bottom Line

We believe that in 2006 we have the best chance yet to see the AXJ currencies appreciate.  Sustained and robust global growth is positive for Asia and for the AXJ currencies.  What is more important is that the Asian central banks are likely to adopt a much less hawkish stance toward exchange rates.  This USD/Asia trade that investors have been awaiting for years should materialize in 2006.

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China
US$100 billion Trade Surplus. So What?
Jan 13, 2006

Andy Xie (Hong Kong)

Bottom Line

Big trade surplus won’t change the yuan policy: China is a combination of a modern economy with 20% of the population and a subsistence economy with 80% of the population.  For political stability, the macro policy is set for the 80% of the population with low productivity.  This is why the trade surplus will not, in my view, make China shift to a strong currency policy.

The big trade surplus may last to 2008: The savings rate has increased sharply due to cyclical factors.  As investment slows, the savings rate is declining more slowly, causing a big savings and trade surplus.  The situation may last for another three years based on the experience from the cycle 10 years ago.

The data improvement may account for half of the increase in the 2005 trade surplus: The discrepancy between the customs and balance of payment data widened from 2002-04.  It narrowed in 2005, which could explain half of the increase in the trade surplus – i.e., China’s trade surplus has not increased as much as many might think.

Summary & Conclusions

China’s US$102 billion trade surplus in 2005 and the reported changes in China’s foreign exchange reserve management have raised expectations of a substantial yuan revaluation in 2006.   Don’t hold your breath!  Not much is going to happen, just like in 2005.  The return of the yuan revaluation story is just to fill an emotional void in the market.  Speculators need something to speculate about.

The surging trade surplus reflects weakening investment, I believe, similar to what occurred in the cyclical downturn 10 years ago.  China is experiencing significant deflationary pressure in 2006 due to overcapacity in most industries.  A major revaluation would push China into serious deflation.  It would be irrational for China to do this.

Furthermore, China must keep financial stability by maintaining the expectation of currency appreciation without actually doing it in order to maintain low interest rates when the US interest rate is much higher.  A substantial revaluation would destroy the appreciation expectation.  It would force China to increase interest rates, which would be destabilizing, as Chinese companies have high leverage and low profit margins.

I believe that China will move the yuan spot rate up bit by bit to sustain the revaluation expectation.  Yuan appreciation of 2% against dollar in 2005 is likely.  A 3% appreciation is possible but not likely, in my view.

Why is the trade surplus rising?

China’s trade surplus is not rising by as much as many might think.   The improvement in customs data could explain half of the surplus increase.  The discrepancy between customs and balance of payment data widened in recent years.  From 2002-04, China reported an US$88 billion trade surplus in its customs data but US$148 billion in its current-account data.  The difference was 68% during this period compared with 27% in the preceding 10 years.  In the first half of 2005, the difference was 35%.  It seems that the customs data have improved.

The balance of payment data for the second half of 2005 have not come out yet.  I believe that the difference between customs and current-account data was similar to that in the first half.  That would imply that about half of the increase in the trade surplus is due to improvement in the customs data.

Aside from the data issue, China’s trade surplus did increase in 2005.  I believe that this was due to decelerating fixed asset investment (FAI) and the consequent slower growth in demand for imported equipment.  China’s data still showed 27.8% growth in fixed asset investment for the first 11 months of 2005 compared with 28.9% for the same period of 2004.  I think that the 2005 data may be overstated.  Foreign direct investment (FDI) in the first 11 months of 2005 actually declined to US$53.1 billion from US$54.1 billion for the same period in 2004.

Overcapacity had already begun to plague many major industries like steel and auto at the beginning of 2005.  The sentiment towards property began to cool in the middle of 2005.  It is quite hard to believe that the FAI kept going at the same pace despite the negative environment for investment.

China’s FAI in 2005 probably surpassed US$925 billion.   A minor FAI slowdown could easily lead to a US$32 billion increase in the 2005 trade surplus – the increase after adjusting the data problem.

Big trade surplus should last for three years

China’s macro-economy is highly unusual.   It is a low-income economy with an extremely high savings rate.  China’s gross savings rate was probably 46% in 2005 after taking into account the recent upward revision in GDP.  There are demographic, structural, and cyclical reasons for the high savings rate.

First, the urban one-child policy has led to an unusually high and rising savings rate among the urban population, which accounts for about 60% of national income.  This policy-induced savings trend is unique in the world.

Second, the Chinese government pays little for social services.  The social safety net is limited to ex-state-owned enterprise (SoE) workers.  Schools and hospitals, though government-owned, collect from students and patients for funding.

Third, Chinese government revenue correlates with FAI rather than the profitability of such investment in future.  This revenue rose by 17.5% per annum from 2001-05, and the share of the revenue in GDP rose by 2.6 percentage points.  The revenue growth has gone mostly into decreasing the fiscal deficit and funding investment – i.e., boosting savings.

Four, the property boom and commodity inflation have redistributed income to state-owned monopolies, property companies and local governments, which invest their income.  The increased household expenditure on property purchases is a form of forced savings.  Rising prices have scared the households into buying early.  Coal, oil and property may have accounted for 5.3% of 2005 GDP for such distribution.  Other commodities like iron ore and alumina have also contributed to the inflation tax.

The third and the fourth are cyclical factors.  They contributed to 80% of the 9.6 percentage-point increase in the gross national savings rate, I believe.  While the investment growth rate is decelerating, the cyclical increase in savings rate is not receding at the same pace.  The difference is the large savings and trade surplus.

The current cycle resembles the cycle 10 years ago.  The trade surplus in the previous cycle peaked in 1998.  If the same pattern is followed, China’s trade surplus should peak in 2008.

Yuan won’t revalue substantially

The Chinese currency is not going up substantially.  The bottom line is that China does not allow recession to shake out bad businesses, because it is worried about social instability from a significant economic downturn.  A strong currency would inevitably lead to a shakeout in China’s economy.  It might be a good thing for China in the long term.  But for now, it is up to the politicians, and therefore a big yuan revaluation is just the market’s wishful thinking, I believe.

Another way to understand China’s macro-economy is to think of it as two economies.  About 20% of the people in China have joined the global industrial economy.  They are productive and create all the country’s value.  However, 80% of the people are still in the low-productivity rural and subsistence service economy.  China’s currency value would be much higher if there were no political pressure to look after the 80% of the low-productivity people.  But, the political imperative is that China must set its macro policy for the low-productivity, not high-productivity people.  This is why the country needs to keep currency cheap and the interest rate low.

China’s currency is likely to crawl up bit by bit this year, because it would be good for the country’s stability.   The stock of hot money in China, even though the inflow has stopped, is very high (probably 15% of GDP).  China’s six-month deposit rate is 2.07%.  After deducting the 20% tax on interest income, the effective six-month deposit rate is 1.66%.  The six-month LIBOR is at 4.74%.  The spread between the yuan and the dollar deposit rate for speculators is a negative 3.08%.  Without the revaluation expectation, not only would the hot money leave, but also there would be capital flight.  Even though China has capital account control, the large changes in capital flows suggest that the capital account is very porous.

To sustain the revaluation expectation, official chat is important.  When American officials are talking up the yuan, Chinese officials do not have to do anything.  When American officials stop talking about the yuan, Chinese officials have to talk it up themselves.  Of course, talk is cheap.   To back it up, the yuan spot rate needs to crawl.  But, China cannot move the yuan up abruptly, because this would kill revaluation expectation and trigger capital outflow.

I believe that the yuan spot rate will inch by 2% this year; 3% is possible but not likely.  This sort of creeping would be consistent with China’s stability.

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Japan
Metabolism and Markets
Jan 13, 2006

Robert Alan Feldman (Tokyo)

Conclusion

Policy metabolism is accelerating, due to political factors. Progress on the reform agenda will accelerate, and raise potential growth.

What’s New

Under pressure from the PM, new signs of cooperation among government agencies are emerging. Meanwhile, the race to succeed PM Koizumi is heating up. The race will be defined by candidates’ attitudes on fiscal and structural reform.

Market Implications

Faster, more aggressive reforms will support equity and real estate markets. Better growth will also support fiscal reform and limit bond yield increases. FX markets are still fixated on interest rate differentials, but attention may turn to growth differentials. If so, the yen would strengthen.

Risks

The succession battle could stall reform debates, as candidates jockey for position. Moreover, the lack of a viable political opposition makes in-fighting in the ruling LDP more likely.

Faster Metabolism

There has been an acceleration of policy movement over the last few weeks in a number of areas. In the medical area, the Ministry of Health and Welfare is moving close to the proposal from the Council on Economic and Fiscal Policy, concerning an overall ceiling on health care costs. This is a key change, because it recognizes the need for top-down control on medical costs. Only microeconomic reforms can hit the macro target, and so micro-reforms will accelerate. Separately, Economic Minister Yosano tried to calm the criticism of the Bank of Japan from some Diet members, in order to set the stage for a more cooperative creation of a new framework for monetary policy

History Repeats

These developments are similar some of the most successful actions of the early Koizumi years. At that time, using the bully pulpit, PM Koizumi was able to change the game among government bodies. In earlier years, different entities could defend their positions by blaming others for failure. PM Koizumi forced cooperation on goals that he defined. Financial system reform was the first example. By appointing Minister Takenaka to the financial reform portfolio and putting BoJ Gov. Fukui in his current position, with the explicit demand that the government and the BoJ work together, the PM speeded the structural reforms of the financial system. Postal reform was another example. Initially regarded as impossible, postal reform passed a reluctant Diet, because PM Koizumi forced all parties to work toward the goal together, and backed his pressure with popular support.

Opportunity and Threat

Now, another set of reforms is on the agenda, and PM Koizumi’s methods are the same. However, there is one big difference. PM Koizumi will be in office only 9 more months. The deadline is both a threat to the reform schedule and a spur to it.

The threat comes from the ability of anti-reform forces to use foot-dragging as a technique to delay reforms, hoping that the next administration loses interest. The importance of this threat was emphasized a few weeks ago, when PM Koizumi angrily admonished some of his ministers for inadequate proposals on reform of government financial institutions. The result was more aggressive on reform than expected.

However, not all issues get to the PM’s level. Inflation targeting is a good example. There are many complex issues, such as how to create a better consumer price index, how to model the relationship of actual inflation expectations to official inflation targets, how to measure actual GDP and potential GDP, etc. With the clock ticking, it is easy for bureaucrats to work slowly, and avoid changing anything. On the other hand, the ticking clock makes the administration more impatient with foot-dragging, and imposes shorter deadlines.

Moreover, PM Koizumi has cleverly transformed the battle for succession into a battle over who has the best reform plans. The PM has indicated that he may endorse a candidate. His high support ratings (now back to about 60%) imply that his endorsement matters. However, he also said that he would look at the policy platforms of the declared candidates as the key criteria for his selection. Indeed, he chose his current Cabinet largely to set up the competition for succession to focus on reform. That stratagem is working as he expected.

Elections Still Matter

Elections matter too. True, the LDP has such a large majority in the Lower House now that the Upper House can only be a delaying problem. The Constitution says that bills that are (1) passed in the Lower House, then (2) rejected by the Upper House, can (3) be sent back to the Lower House for reconsideration. If (4) passed again by the Lower House with a majority of 2/3 or more, then (5) the bill becomes law. Since the LDP and its coalition partner the Komeito together have a 2/3 majority in the Lower House (see Exhibit 1), the Upper House is not an impediment to reform at this time.

That said, the Upper House election of July 2007 looms very large in the minds of politicians. If the LDP loses a significant number of seats (e.g. more than 10), then it will be morally harder for the Lower House to simply override Upper House rejections. Hence, in order to do well in the July 2007 Upper House election, the next PM must have strong public appeal. In order to do so, he/she must have a credible philosophy and track record on reform. In order to be viewed as having such a record, the new PM must have PM Koizumi’s blessing. A precursor of the battle was the November 2005 election for mayor of Osaka. PM Koizumi campaigned aggressively for incumbent Mayor Seki, after the latter had pushed aggressive revival plans for Osaka based on structural reform, deregulation, and fiscal reform.

No Threat Is Big Threat

Perhaps the biggest problem in the Japanese political landscape is the lack of a viable opposition. The largest opposition party, the Democratic Party of Japan (DPJ), is deeply split. On one hand, there are the old Socialists, who are doves on foreign policy (e.g. on Article 9 of the Constitution), want redistributive economic policy, and prefer obstructionist tactics. On the other hand, there are the new liberals, like party leader Nakahara (43 years old), who are “hawks” on foreign policy (i.e. want to amend Article 9), like growth-oriented economic policies, and prefer to compete with the LDP on reform plans. The foot soldiers for DPJ campaigns are often left-wing union members, who do not like the new liberal leadership. Moreover, the party tactics in the last election smacked of obstructionism, rather than suggesting constructive alternatives. The DPJ must rebuild trust with the voters. With such weak opposition, it is easier for the LDP to devolve into bickering.

Market Implications

The key implications of a faster policy metabolism for equities, bonds, and real estate are clear. Equities and real estate will benefit from faster, more certain growth. Ironically, the bond market will suffer some from faster economic activity but the concomitant rise of tax revenue should ease the fiscal squeeze. Hence, any rise of bond yields is likely to be subdued.

The hard part is forex. Fast structural reform does not have any clear implication for the yen. This is because currency markets are usually dominated by a single model of thought. At the moment, interest rate differentials dominate thought about the yen. Opinions may differ on what the Fed will do, what the BoJ will do, and when they will do it. However, the framework for analyzing information focuses on the model that says, “currencies follow interest rate differentials.”

Faster policy metabolism challenges the interest rate-differential model of exchange rates. Indeed, at times in the past, the current account balance was the overwhelming topic among forex players. At other times, capital flow debates held sway. The next swing could be toward growth gap models. There have been times in the past when growth differentials have been a key topic for forex players. It is reasonable to expect “model rotation” this year. If this occurs, the growth gap model is a good candidate. And if the growth gap model begins to dominate, then the countries with the fastest structural reform will have the most growth acceleration, and hence the strongest currencies. This is particularly important for Japan, since the trade weighted yen is at a 20 year low, despite the remarkable growth reversal of the last two years. This observation supports the view of our currency team, which sees the yen strengthening over the course of the year.

Conclusion

In short, the metabolism of Japanese policymaking has accelerated. Political forces are spurring faster decisions on many key topics, even while anti-reformers and gradualists seek to slow the process. In the end, the Koizumi government will likely use the deadline of the PM’s departure as a tool to force decisions. The race for succession will be designed to make the reform process permanent. As a result, PM Koizumi’s departure from office will have a more modest effect on policy than now assumed. As reform remains robust, the equity and real estate markets should strengthen, while bond market weakness is minimized. The yen should strengthen, especially if model rotation among forex participants shifts toward use of a growth differential model.

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