Three Horsemen and the Ghostbusters
Jan 26, 2006
Andy Xie (Hong Kong)
Financial markets have a tight consensus on goldilocks: Investors now have a powerful consensus on the continuation of the goldilocks scenario – low inflation, low interest rates, ample liquidity and strong growth. Under this scenario, investors expect Asia and commodities to outperform.
Three expectations drive financial markets: Expectations of Chinese revaluation, a Japanese growth boom, and ever-rising commodity prices are the three horsemen driving asset prices today. I believe all three are based on faulty logic and are simply expectation bubbles in a liquidity boom. The current speculative cycle should end with inflation, deflation, or a shock: The current cycle is led by financial markets, which have pushed down risk premiums, and is likely to end with trends or events that trigger the risk reduction trade and rising risk premiums. Surging oil prices, overcapacity, or a random shock could trigger the trade, in my view Summary & Conclusions At Morgan Stanley’s MacroVision seminar last week, investors expressed wholehearted conviction in macro stability and the continuation of the goldilocks scenario of low interest rates, low inflation, ample liquidity and good growth rates in 2006. Even the spectre of a dollar crash one year ago was replaced by a benign scenario of a moderate dollar decline. The major central banks in the world, the Fed in particular, appear to have banished all ghosts from the financial markets. It seems that bubbles, imbalances, surging energy prices, terrorism, bird flu, and so on, are no longer deemed worthy of serious discussion. Into the fourth year of the bull market, the New Year resolution in some quarters looks to have been ‘don’t think, just long’. Expectations of Chinese revaluation, a Japanese growth boom, and ever-rising commodity prices are the three horsemen driving financial markets. The lingering worry over a weak dollar amplifies the liquidity that feeds these three horsemen. I believe that 2006 will turn out much tougher than 2005. Global liquidity is no longer rising, even though the level is still very high. The major central banks are worried about adding liquidity to fuel asset bubbles but are unwilling to withdraw the excess liquidity already in the system to burst these asset bubbles. Current asset prices already reflect the high level of liquidity. I think further asset inflation will be hard to achieve. From a longer-term perspective, the central banks may have won a pyrrhic victory. They have used liquidity to inflate asset prices to offset deflationary pressure – mostly benign deflation from productivity growth due to technological progress and globalisation. Instead of tolerating price declines in line with productivity growth, the central banks have engaged in credit inflation, creating a massive asset inflation party that would cause inflation in the absence of deflationary pressure. The asset inflation party is not costless, I believe, and will be followed by a burst or an extended period of slow growth. Inflation due to commodity inflation, deflation due to overcapacity, or a shock should mark the turning point. I see the cycle turning down in 2006, for four reasons. · First, unskilled labour in OECD countries has increased debt to sustain consumption, even as globalisation has decreased earnings. The surging credit problems in this segment mark the end of this debt-led cover-up of the income problems in the OECD economies, in my view. · Second, property prices have peaked in most markets. While the price declines may not be sufficient to trigger a recession, they will no longer be able to boost growth as before. The growth disappointment could expose financial distress and trigger the risk reduction trade. · Third, the commodity bubble and China’s surging overcapacity are clashing. The surge in China’s fixed asset investment from US$445 bn to US$1 trillion between 2001 and 2005 fuelled commodity demand. However, China will need to slow down investment as overcapacity causes product prices to decline. I expect the commodity bubble to burst in 2006 due to weak demand. Even in the event that enthusiasm over the ‘long-term’ value of the hard commodities sustains the bubble, the resulting inflationary pressure could cause the Fed to tighten more and longer than the market expects. In this case, the resulting liquidity decline could burst the bubble. · Fourth, prolonged weakish data from Japan could burst the sentiment bubble over Japan’s growth boom. Japan is out of deflation. It has solved its overcapacity and bad debt problems. Even if prices decline due to globalisation or productivity growth, it is not bad. However, Japan has a declining population and does not have a big output gap. It is irrational, I believe, to expect a big growth boom in Japan. When the bubble bursts, the debts that have accumulated during the period of rising asset prices could hurt badly as nominal GDP grows slowly. The major central banks may be tempted to cut interest rates again. However, it may not work if debt levels have already maxed out. The global economy could then experience low inflation, low interest rates and low growth rate for two to three years. The Triumph of the Ghostbusters At Morgan Stanley’s MacroVision Seminar to gauge the outlook for 2006 last week, the participating investors showed strong confidence in macro stability and a continuation of the goldilocks scenario of low interest rates, low inflation, ample liquidity and buoyant growth. The ghosts of 2005 – the property bubble, the hedge fund bubble, the commodity bubble, the credit bubble, the derivatives bubble, the China bubble, the ‘everyone wants to be trader’ bubble, a dollar crash, rising US interest rates, and so on – appeared to have been completely banished. The mood among investors wasn’t exactly euphoric. The sense was more that ‘good times are just business as usual’. Investors were quick to skip over macro discussions and on to moneymaking ideas that assumed a continuation of the goldilocks scenario. In my view, such sentiment reflects a triumph by the major central banks, the Fed in particular, which have convinced the financial markets to adopt a ‘don’t worry, be happy’ mentality. The central banks seem to have banished all ghosts from investors’ thoughts, convincing the financial community that they have the wherewithal to deal with problems as they arise. In the movie “Ghostbusters”, Bill Murray and Dan Aykroyd banished ghosts with what looked like souped-up fire extinguishers. Unfortunately, the ghosts in the financial markets and the global economy are real and are unlikely to be contained so easily. The Three Horsemen Charge Ahead Property markets are languishing everywhere. This pillar of the global economy is running out of juice. However, the reversal has been moderate so far. Vanishing transaction volumes allow speculators to believe that prices have not fallen much. The central banks are maintaining loose liquidity conditions, affording speculators the luxury of not having to sell. Hence the property bubble has not collapsed. Instead, the languishing property market has redirected liquidity into other markets for speculation. Asia and commodities have become focal points of speculation again, and with a vengeance. The three horsemen – expectations of Chinese revaluation, Japan’s growth boom, and ever higher commodity prices – are charging forward at full throttle. ChinaRevaluation: the Power of Imagination China’s revaluation story is one of the most remarkable in financial history. There has been massive speculation over a major China revaluation for three years. The Chinese currency has budged by 2.7%. The appreciation has not caught up with the negative carry loss stemming from the lower Chinese interest rate vs. the US. The negative carry, at 300 bps, is now painful in today’s low interest rate environment. Nonetheless, speculation refuses to go away. Normally, investors adjust their expectations after three years of failure. Somehow, China’s revaluation story is a rare exception. Wave upon wave of speculators keep coming – and keep losing money. In the meantime, China’s foreign exchange reserves have tripled. This story conjures up an alternative economic development model – in other words, all a country needs do to obtain free money is to hint at currency revaluation. Under such a scenario, the world could soon be rid of poverty if all the countries in Africa decide to play the same game! To save the world, perhaps Bono should become a currency strategist … Commodity Bulls: Imaginary Shortage The commodity story is as fascinating as the China revaluation story. There are new theories on why prices should be high and keep rising every day. Gold is the latest fashion. There are at least three theories on why the gold price should keep rising: ‘China buying to diversify from dollar reserves’ is what the financial markets believe. ‘Wealthy Middle Eastern investors buying’ is a prevailing view among Hong Kong speculators. ‘Rising jewelry demand from China and India’ is cited by many journalists. It seems there is a theory to suit everyone – and as long as people believe in one of the stories, they will buy. Gold is small beer in the context of global commodity markets. The juggernaut is oil. At today’s price of US$65/bbl for Brent crude, the consumption of oil at 83.3 mn bbl/day is worth US$5.4 billion/day or US$2 trillion per annum (5% of global GDP). Compared with the average price of US$24.9/bbl for Brent crude in 2002, oil producers are making US$3.3 bn/day or US$1.2 trillion extra (55% of China’s 2005 GDP) per annum. Global property values may be US$15 trillion above historical average levels, but oil is making over US$1 trillion extra every year. To be comparable with the property bubble, one needs to discount the net present value of US$1 trillion. I believe the two bubbles may be comparable in size. Books are written on why oil prices should be US$100/bbl and stay there – similar, in my view, to the books written on why the Dow was going to 36,000 during the dotcom bubble. The demand news for oil has been bad for 12 months. The IEA just revised down 2005 demand by 90,000 barrels per day and concluded that demand rose by 1.3% in 2005. Nevertheless, like everyone else, the IEA expects demand to boom in 2006 on a demand rebound in China and the US. I say good luck. It seems that the inclination across the board is to welcome the good news, and disregard the bad. When China announces weak oil imports, investors don’t believe it; when China announces a big number on industrial production, everyone is impressed. Oil production capacity is expected to rise by 2.6 mn bbl/day on average in 2006, based on the existing projects that should come onstream. Against this, oil demand grew by 1.2 mn bbl/day last year and, I believe, may grow by a similar amount in 2006. Is there an oil shortage? Still, many pension funds and other long-term investors are putting money into commodities. Because many companies that produce commodities have hedged, their stocks have underperformed commodities in a rising market. Many investors are frustrated and have increased their positions in the commodity markets directly. As commodity demand and supply are not elastic in the short term, demand from financial investors can drive up prices rapidly. In the 19th century, there were many commodity bubbles during liquidity booms. As commodity demand and supply are not elastic in the short term, demand from financial investors could drive up prices rapidly. The participants then understood that they were bubbles to rob the people who had to use the stuff. The participants today have fancy theories. The most popular one is that Chinese and Indians need that stuff in the future and financial investors are just front-running them, in other words being smart. Japan’s Growth Boom: Can an Aging Society Rock? Japan is out of deflation. It has solved its bad debt and overcapacity problems. Its property prices have adjusted sufficiently. Japan’s economy is normal again. Even if prices still decline a bit, it is passing productivity gains to consumers via lower prices rather than higher wages, which should cause no anxiety at all. Japan’s recovery story is real in that regard. Markets are positioning for a growth boom, which I believe is misguided. Japan’s real GDP rose by 2.3% in the first three quarters of 2005 and nominal GDP by 1%, similar to what happened in 2004. I don’t see the future being drastically different. These numbers are very good for Japan. Based on current trends, the difference in population growth rates between the US and Japan is 1.2 ppt. Japan’s current growth rate is comparable with the US’s adjusting for different population trends. The key is nominal growth – the source of sustainable earnings growth. I believe it is possible for Japan to achieve nominal growth of close to the real growth rate. However, it is unlikely that Japan’s nominal growth rate will be substantially higher than its real growth rate in the long term, since significant inflation is hard to achieve with an aging population. This suggests that Japan’s nominal GDP growth rate – a proxy for earnings growth rate – will be half of that of the US in the long run. However, Japan’s stock market is trading at a 20-30% premium to US valuations on consensus earnings forecast. True, further restructuring could increase earnings without revenue growth. However, even assuming that Japan’s RoE catches up with that of the US through restructuring, valuations would still not look cheap. Hence I believe investors are overly bullish on Japanese asset prices. How Many Potential Speculators Are Left? ‘The fools are dancing, the bigger fools are watching’, remarked my ex-colleague, Barton Biggs, during the tech bubble. It feels the same now. For a bubble to last, central banks need to be accommodative and there must still be people ready to be sucked in. The former is quite likely. No central bank wants to tighten too much for fear of tipping the applecart. However, it is possible that we are running out of people who want to speculate. My former colleague, Barton Biggs, once remarked during the tech bubble that fools were dancing, but the bigger fools were watching. If the same is true today, how many would-be speculators remain on the sidelines? Asian households are already in gold in force. Some are already in coffee. How far are we away from Joe Kennedy’s fabled shoeshine boy? One investor found a novel way to call the top: He noticed that I was still around, and that some investors still believed me and were not in the market. He told me that the peak would be when I was fired, and everyone had piled into the market. The Real Ghosts of 2006 Despite the best efforts of the central banks to banish ghosts from the minds of investors, these ghosts exist. They are the growth headwinds in 2006. When growth slows, financial distress resurfaces, which may make investors rethink about current low risk premiums. First, the victims of globalization – unskilled workers in high-income countries – have been defending their lifestyles with debt, but may not be able to do so in 2006 due to higher interest rates and the surfacing credit problems in this segment. Globalization has appeared a win-win for everyone so far. This is just a perception. Stagnant income growth among unskilled workers in high-income economies is a telltale sign. This should not be surprising, as unskilled workers in rich economies now compete against workers in developing economies that are muscling their way into the global economy. The global economy has paid no price for this income shortfall, because financial innovations have provided this population segment with debt to defend their lifestyle. We saw this situation in Korea three years ago, with its credit card debt explosion. Taiwan is experiencing a similar problem on a smaller scale. I believe the US may run into credit quality problems in this segment, which would cause a pullback of liquidity in this market and decrease consumption demand. Second, languishing property prices remove one major source of demand growth. Property prices appear to have peaked in most markets, and have declined moderately. This has the appearance of a global soft landing. The positive spin is that prices have risen so much that a modest decline should not affect consumer behaviour. This argument supports an outlook of stable consumption. However, when wealth is declining at the margin, we can hardly expect consumption to rise as before. Third, liquidity flows into emerging economies look set to decline in 2006. The IIF estimates that capital flows into emerging markets were US$358 bn in 2005. The emerging economies had a combined trade surplus of about US$400 bn. Hence the total flow of about US$760 bn into emerging economies was over 7% of their GDP. China accounted for 30% of that amount. Real interest rates in the US have risen above those in Asia. The switch usually leads to less liquidity inflow or even outflow in Asia. 2006 could repeat the story, in my view. Fourth, China’s capex is likely to slow down in 2006 due to overcapacity. Most industries in China suffer from serious overcapacity. China reported Rmb 8.9 trillion in fixed asset investment (FAI) and Rmb 18.2 trillion in GDP for 2005. No matter how the data are revised or presented, FAI has accounted for the bulk of China’s domestic demand growth in this cycle. Surging export income has made its financing possible. Hence China’s overcapacity problem could cause a substantial slowdown in global growth. Growth momentum is the key to risk premium, I believe. A rising tide covers up many problems. Debt has risen much faster than income in this cycle. This increasing leverage has boosted growth, which has decreased financial distress and, in turn, lowered the cost of borrowing. This virtuous cycle reverses when growth momentum shifts downwards. Inflation, Deflation, or Shocks The current cycle has been driven by financial markets in the form of declining risk premiums. I believe it will likely end with risk premium rising due to the risk reduction trade driven by either trend concerns or a shock. Considering how extended the financial system is in moving up the risk curve, the risk reduction trade could be quite chaotic, which could cause major disruption to the real economy. The risk reduction could be triggered by inflation, deflation or shocks. Inflation forces central banks to decrease liquidity. When investors see a major inflationary event, they could decrease their risk exposure. The main inflationary threat is rising oil prices, in my view. As pension funds and charity endowments move into commodity markets directly, oil prices could swing significantly in either direction. If they stay high or even rise substantially from here, the Fed may be forced to tighten by more than the market expects. Deflation decreases earnings expectations and increases credit risk. It could trigger the risk reduction trade also, but not as surely as inflation. Investors may expect more central bank easing should deflationary pressures emerge. However, as assets are richly priced everywhere, a deteriorating earnings outlook would make the risk reduction trade likely. Previous emerging market booms have ended with balance of payment crises. Most emerging economies, with the notable exception of India, are running current account surpluses. So, in theory, India could be the culprit. However, I doubt that, when so many are so enthusiastic, there will be enough speculators who want to short the Indian currency on its current account problems. Nobody seems bothered about Australia’s gigantic current deficit. When it comes to current account problems, the financial markets are fixated on the US. If a shock ends this cycle, it is not likely to be a balance of payment crisis, in my view. I would expect it to be driven instead by overcapacity and/or speculators running out of risk appetite, as was the case with the tech bubble. The former is already present. I believe the latter is not far away. Happy Chinese New Year (if you are Chinese or want to be)!
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Can the Slowdown be Denied?
Jan 26, 2006
Denise Yam CFA (Hong Kong) and Andy Xie (Hong Kong)
Real GDP growth at 9.9% in 2005: China’s economy slowed only marginally in 2005, registering real GDP growth of 9.9%, down from 10.1% in 2004. Upward revisions were made to the quarterly growth figures for the first three quarters of the year, in line with those implemented on annual GDP figures from 1993; growth rates were lifted to 9.9% (from 9.4%) for 1Q, 10.1% (from 9.5%) for 2Q and 9.8% (from 9.4%) for 3Q. Growth in 4Q05, at 9.9%, was surprisingly stronger than that in 3Q05, contradicting the reported slowdown in exports and fixed investment. Nominal GDP for 2005 totalled Rmb18.23 trn, up 14% from 2004, in line with expectations. In US dollar terms, China’s economy has expanded to US$2.22 trn. Our slowdown call remains intact: We remain convinced that China has entered a down phase in its economic cycle; this current deceleration and economic adjustment should last for at least a couple more years. Statistics Bureau Chief Li Deshui emphasised that overcapacity and deflation are the biggest threats to China’s economy. Fixed investment is still regarded as excessive and sub-optimally structured, limiting growth efficiency. Li recommended policymakers maintain a tightening bias and foster the necessary economic rebalancing. We forecast 7.8% GDP growth in 2006. Stay alert for downside surprises: Our team’s forecast for steady global growth is rather dependent on asset price resilience supported by loose monetary policies and speculative risk appetite. Deviation from this central case could be triggered by a change in growth and inflation expectations in China upon the recognition of deflationary pressure. It may not be long before we start talking about policies to support rather than curb growth in China. A gradual deceleration remains our central case for China for this year and next, but staying alert to negative surprises could certainly pay off, in our view. 2005 GDP Expanded 9.9% on Revised Basis China’s economy slowed marginally in 2005, registering real GDP growth of 9.9%, down from 10.1% in 2004. Upward revisions were made to the quarterly growth figures for the first three quarters of the year, in line with those implemented on annual GDP figures from 1993; growth rates were lifted to 9.9% (from 9.4%) for 1Q, 10.1% (from 9.5%) for 2Q and 9.8% (from 9.4%) for 3Q. Growth in 4Q05, at 9.9%, was surprisingly stronger than that in 3Q05, contradicting the reported slowdown in exports (+21.7% YoY in 4Q vs +29.1% in 3Q) and fixed investment (+26.8% in 4Q vs +28.5% in 3Q). Nominal GDP for 2005 totalled Rmb18.23 trn, up 14% from 2004, in line with expectations. The YoY change in the implied GDP deflator, which we suspect had served as a buffer for under-reporting real GDP growth over the past couple of years, narrowed to 3.8% in 2005, from 6.9% in 2004. In US dollar terms, China’s economy has expanded to US$2.22 trn, level with the UK, and is now the fourth largest economy in the world (before PPP adjustment), trailing only the US, Japan and Germany. Our Slowdown Call Intact National Bureau of Statistics Chief Li Deshui emphasised at the press conference today that overcapacity is one of the biggest threats to China’s economy. It is expected to lead to deflation, corporate losses and bankruptcies, and could affect labour market stability. Steel, aluminum and auto sectors were specifically highlighted as plagued by overcapacity. Fixed investment is still regarded as excessive and sub-optimally structured, limiting the efficiency of economic growth. Li recommended policymakers maintain a tightening bias and foster the necessary economic rebalancing. We remain convinced that China has entered a down phase in its economic cycle, and as with the previous cycles that are typically long, this current deceleration and economic adjustment should last for at least a couple more years. Sustained capital inflows and effective management of monetary and liquidity conditions, nevertheless, could keep the economy on a steady and orderly slowdown path, preventing it from landing hard. We forecast 7.8% real GDP growth in 2006. Investment and Trade Slow Towards Year-end… Buoyed by abundant liquidity and effectively managed by the government, urban fixed investment growth has barely budged throughout 2005, maintaining a remarkably stable YoY pace of around 26-29%. The gain did, however, slip to 24.2% YoY in December, from 29% in November, bringing the year total up 27.2%, little changed from 27.6% in 2004, to Rmb7.51 trn. Total fixed investment (including rural) grew 25.7% in 2005 to Rmb 8.86 trn, maintaining virtually the same pace as in 2004 (+25.8%). Investment in central (+32.7%) and western (+30.6%) regions outpaced that on the eastern coast (+24%), in line with policy stance. Looking ahead, we remain convinced that increasing pressure from overcapacity and slowing asset price gains will bring down investment. The trade sector saw another strong year, but growth momentum has slowed noticeably since 2H05 (see our report, New Trade Record, But Clearly Slowing, January 11, 2006). After sustaining 35% growth for 1.5 years, export growth dipped to an 18% pace by the last two months of the year. We expect export growth to continue to normalise to a more sustainable pace of 12-15% ahead, due to (a) deteriorating profitability, and (b) saturation of outsourcing (see our report, Export Normalization Arrives, December 13, 2005). Meanwhile, as investment turns down, import growth will also slow, and China’s large trade surplus appears to be here to stay for at least a few more years. Demographic characteristics resulting from the one-child policy and the lack of accessible public services mean that Chinese households should continue to maintain a high savings rate. The large external surplus will not, however, change China’s currency policy, in our view. We continue to believe that China needs a stable and relatively weak currency to support the low-income rural population that is yet to be urbanised and integrated into the global labour force. … But Industrial Output Growth Stays Strong Value-added industrial output maintained a stronger-than-expected pace of 16.5% YoY in December, down only marginally from 16.6% in November. This contrasts with the slower gains in exports and investment in the month, but detailed breakdown of the data is not yet available for deciphering the key driver for growth. For the full year, output at enterprises with annual sales exceeding Rmb5 mn gained 16.4% to Rmb6.64 trn, slipping gradually for the second year from 16.7% in 2004 and 17% in 2005. We see output growth dipping to 13% in 2006. Consumption – Full Potential Yet to be Unleashed While we agree with many investors that China represents a promising consumer market, and that domestic consumption will become a key economic growth driver, we believe this is only to be realized several years from now. In the near term, domestic consumption remains structurally weak due to income inequality, low overall household wealth and the high savings rate in response to demographic trends and lack of access to public services. Retail sales grew 12.9% in 2005 (+12.5% in Dec vs +12.4% in Nov), slowing from 13.3% in 2004, again lagging behind that for the overall economy (nominal GDP +14% in 2005 and +17.7% in 2004). Expenditure-based GDP breakdown is not yet available, but we believe that household consumption probably fell below 40% of GDP in 2005 (41.4% in 2004), another record low. Capacity Expansion Eases Inflationary Pressure Though picking up marginally in December due to the low base effect (primarily in food), inflation in China is mild and falls short of causing concern. Consumer prices were 1.6% higher than a year ago in December, picking up from 1.3% in November. For the full year, consumer inflation averaged 1.8%, below our earlier forecast for 2%, easing significantly from the 3.9% rate in 2004. The biggest contribution to the drop in inflation was of course in food, where price hikes eased from 9.9% in 2004 to just 2.9% in 2005. Recreation and education services saw a pickup in price increases in 2005 to 2.2% (+1.3% in 2004), while living costs (primarily housing rent and utility costs) rose 5.4% (+4.9% in 2004). Consumer goods continued to see mild deflation. In our view, there is still upside risk to CPI inflation in the near term due to (a) price reforms, where utility and service providers will finally be allowed to pass on higher costs to consumers amid milder inflation in other categories in the CPI basket, and (b) revision of weights in the CPI basket – lifting weight for services and energy. Therefore, we currently forecast a pickup in inflation to 2.5% in 2006. Nevertheless, emerging overcapacity already sounds the alarm for deflation ahead. We maintain a conservative outlook on inflation over the medium term. Producer price inflation has been declining steadily since 4Q04, reaching 3.2% at the end of 2005, from the peak of 8.4%, averaging 4.9% in 2005 vs. 6.1% in 2004. We may already have seen the worst in terms of margin squeeze for downstream producers, as reduced cash flow at the downstream level eventually hurts demand for upstream supplies and forces a correction in prices. Policy Direction – From Tightening to Stimulus? While our team forecasts steady growth in the global economy this year, we remain wary that global growth is rather dependent on asset price resilience supported by loose monetary policies (with the exception of the US) and speculative risk appetite. Deviation from our central case (of stable global growth) will likely be on the downside, which could be triggered by a change in growth and inflation expectations in China upon an eventual realisation that the expansion of China’s productive capacity may already be outstripping US consumption growth. The revival of deflationary pressure in China could trigger an end to the current speculative cycle. It may not be long before we start talking about policies to support rather than curb growth in China. When export and investment growth slows further, the government will likely step up measures to support domestic consumption, e.g. in terms of boosting incomes and development in rural areas, and preventing income and wealth inequality from worsening further, potentially threatening social stability. A gradual deceleration remains our central case for China for this year and next, but staying alert to negative surprises could certainly pay off, in our view.
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Party On
Jan 26, 2006
Sharon Lam (Hong Kong) and Andy Xie (Hong Kong)
Strong Momentum Set to Continue: Korea reported preliminary 4Q05 GDP growth at 5.2% YoY (vs. +4.5% in 3Q), indicating the economy continued to recover. We believe the economy will pick up further in 1H06 as both external and internal demand are on an uptrend, though they differ in magnitude. We expect the BoK to raise rates by 25 bps in February, and look for rates to reach a neutral level of 4.5% by year-end. This implies monetary conditions will remain accommodative in the near term. Exports Should Hold Up in 1H06: The world economy is seeing an extended period of strength. Won appreciation is less of a concern now as Korean products can be priced at a premium due to their brand value. We believe exports will continue to lead the economy in 1H06 before cooling off in 2H06. Consumption Recovery Not Yet Broad-based: Private consumption growth came in slightly below expectations in 4Q05. This is because Korean consumers have seen strong wealth growth but not yet significant income growth, causing the consumption recovery to lag. Wealth growth tends to limit consumers to purchasing luxury goods only, and Korea needs to see income growth from an improved labour market before the recovery extends to all consumers. Capex the Wildcard in 2006: Facility investment surprised significantly on the upside in 4Q05. The relatively lower cost of investment compared with market value and the desire to expand growth could be factors causing corporates to unleash their export earnings accumulated in the past two years. If strong capex is sustained, we could see GDP growth above trend through 2007. Yet, recent concerns on won appreciation and oil prices may hamper capex again. Capex is a big swing factor for Korea in 2006, in our view. Riding on an Uptrend: 4Q05 GDP at 5.2% Korea reported preliminary 4Q05 GDP growth at 5.2% YoY, up from +4.5% in 3Q, indicating that the economy continued to recover towards the year end. On a seasonally adjusted QoQ basis, 4Q GDP rose 1.7%, down marginally from 1.9% in 3Q. Trade continued to make the biggest contribution to overall growth in 4Q. On the domestic side, capex surprised significantly on the upside in the last quarter, posting the strongest quarterly growth since the boom year of 2000. Private consumption, on the other hand, picked up in 4Q but the growth number came in slightly below expectations. For the full year 2005, Korea’s GDP growth came in at 4%, down from 4.6% in 2004, yet slightly higher than our and market expectations (our estimate: +3.8%; consensus: +4%). As we had thought it would, growth slowed in 1H05 despite a sudden rebound of sentiment at the beginning of last year. Confidence soon deteriorated towards the middle of last year as fundamentals were weak. The twist came when global capex demand picked up in the summer, Japan recovered, and China continued to post robust growth. Meanwhile, oil prices also softened supporting global demand. Korea’s export growth therefore reaccelerated in 2H after a temporary lull in 1H. We have been advocating this export-driven growth story since 3Q, while the market’s focus remained on consumption. Looking at the industry breakdown data, we can see that the manufacturing sector outperformed all others in 2H05. Looking forward into 2006, we expect exports to remain the major growth driver in 1H. In addition, we had pointed out in 4Q05 that a possible upside risk could come from capex as it has lagged export earnings for two years. It now appears that this upside risk is being realised. As exports and capex are expected to remain firm, we believe the manufacturing sector, especially capital goods (machinery and electronics), will outperform in the coming months. Meanwhile, we expect consumption to pick up further due to the wealth effect from stock market gains, but do not expect strong consumption growth unless the labour market improves, which is not likely to happen until 2H06. We maintain our 2006 GDP forecast at 4.5%, which is Korea’s full growth potential, in our view. Exports - Rosy Global Outlook in 1H06 The global economy is experiencing one of its longest stretches of growth. As the world’s leading producer of semiconductors and electronic products, the Korean economy will thus likely remain robust in the coming months. Global capex demand appears bullish, particularly given demand from the US and Japan. Europe has also become an increasingly important export market for Korea. Indeed, the EU has surpassed the US to become Korea’s second-largest export market after China. The EU sources mainly electrical machinery and precision equipment from Korea. Our global team is forecasting accelerating growth for the US, Europe and Japan this year. A China slowdown remains the biggest downside risk to Korea, although the latest GDP data reported by China (+9.9% YoY in 4Q05 vs +9.8% YoY in 3Q05) shows that its economy has not slowed. In fact, China continues to take in more Korean-made automobiles and electronic products. Nevertheless, our team believes a correction of the overinvestment problem in China will be inevitable this year. Macro factors in China are one risk for Korea, while micro factors in China also pose downside risk as we believe the Korean products may start to see more pressure from the Japanese competitors in the Chinese market. Meanwhile, Korea’s material exports such as chemicals and steel products are on the downturn, possibly affected by lower prices from China. All in all, we are confident that the global economy will remain buoyant at least through 1H06, thereby benefiting Korea’s external sales. The market is concerned about won appreciation stalling Korea’s export growth, yet we believe the currency is less of a threat to Korea’s export growth today due to the change in the competitive landscape. Unlike the 1990s, Korean products can now be priced at a premium due to their brand and design. Price is becoming less and less of a factor for Korea’s share in the global market. At the same time, strong global demand should help offset the decline in corporate profits caused by currency appreciation. Domestic Corporate Spending - the Wild Card in 2006 Towards the end of last year, we pointed out the possibility of an upside surprise on capex (see 2006 Outlook: Solid, Not Striking, December 6, 2005) and this could be happening. Facility investment soared 9.8% YoY in 4Q05 in real terms, contributing almost 20% to GDP growth in that quarter. This was the strongest gain since the boom year of 2000 and well above the trend average (6.5%) of the past five years. As the stock market continues to rally, it is now more profitable for companies to invest in capital, as their market value is increasing. Meanwhile, investment and corporate strategy could also be changing. In an environment of rising interest rates, dividend yield is becoming less important to investors. Operating margin is still important, yet capital restructuring appears to be reaching a mature stage. Growth and balanced development is likely to gain investors’ attention once again, in our view, therefore causing corporates to unleash their export earnings accumulated in the past two years. Indeed, Korea has successfully completed corporate restructuring after the financial crisis, and the next logical step would be to invest and explore new businesses. If this is the case, then capex recovery could become a trend again for the next two years and could keep the economy growing above trend through 2007. Nevertheless, it is still too early conclude whether the phenomenal capex growth of the last quarter was due to expansion or replacement. Meanwhile, won appreciation, though not hurting Korea’s export competitiveness, could pose short-term downward pressure on corporate earnings and therefore hamper capex recovery. We will need to monitor this closely – yet, without doubt, capex could be a huge swing factor for Korea in 2006. Consumption - Lagged due to Diverging Wealth and Income Effect Private consumption grew 4.6% in real terms in 4Q05, up from 4% in 3Q05. Although this indicates that consumption continues to recover, the growth rate was a bit below expectations. We had expected consumption to grow above trend in 4Q due to the Christmas shopping frenzy seen in the last quarter, yet it in fact only grew at the trend average. On the other hand, we have seen very strong department store sales data in December and November. How do we reconcile this with the relatively soft private consumption growth? We believe the answer lies in the fact that the consumption recovery so far has not been broad-based, due to diverging wealth growth and income growth in Korea. Korean consumers are enjoying a hefty increase in wealth from equity investment, but income growth is still relatively weak due to the stagnant labour market. According to economic theory, the marginal propensity to consume from increased wealth is lower than that from extra income, and this explains why the consumption recovery has lagged overall growth and failed to meet expectations. The wealth effect, which is usually unanticipated, prompts consumers to spend more on luxury goods. This is evident in the sales of luxury goods in department stores, which rose 23% YoY in December, exceeding overall growth of 19% YoY. We believe not all consumer-related companies will benefit equally from this consumption recovery. Those selling and producing premium products are likely to be winners in this cycle. We see clear signs that consumption has bottomed out and will continue to recover. Our Korea strategist Chanik Park expects further upside to the KOSPI, so the wealth effect could remain in place. Can consumption growth meet the market’s high expectation? The answer depends on whether there will be income growth. The labour market is always a lagging indicator. We have recently seen some positive signs in the labour market, as productivity has begun to pick up, which could translate into higher income growth in 2H06. Yet we are uncertain of the strength of the potential income growth, as Korea’s labour market is more challenged today than before, namely by the hollowing-out of manufacturing. There is no controversy on the direction of consumption growth, in our view, but only on how much it has been priced in by the market. Strong Momentum to Continue in 1H06 All components of the economy are on an uptrend, though they differ in magnitude. Korea’s recovery should continue, and we expect growth to be above trend in 1H06, before falling back to trend in 2H06, as exports could cool off due to an expected softening in global and Chinese demand. The Bank of Korea will likely continue to tighten and the next rate hike could possibly come on February 9, the next monthly policy meeting. We expect 25 bps in February, and another 50 bps for the rest of this year, meaning interest rates would be brought back to the neutral level of 4.5% by end of this year. This implies monetary conditions would remain accommodative in the near term.
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December IP Deceleration But No Cause for Worry
Jan 26, 2006
Deyi Tan (Singapore) and (Hong Kong)
No cause for worry despite December Deceleration: The industrial production index expanded a significantly lower 5.1% YoY in December (vs 21.5% YoY in November). The deceleration was underpinned by the 23.9% contraction in the usually volatile biomedical segment after a 60.4% YoY expansion in the August-November period. The broader electronic segment maintained its strong position (+20.7% YoY vs +20.1% YoY in November) on the back of firming global electronic demand. Manufacturing, excluding biomedical, rose 15.0% YoY (vs +16.9% YoY in November). 2005 a shade paler than 2004: Meanwhile, for 2005, manufacturing rose only 9.2% YoY, compared with the 13.9% YoY in 2004 as production remained weak until as late as 3Q05. The bulk of the slowdown came from the electronics segment (+8.7% YoY vs +14.8% YoY in 2004) and biomedical (+10.7% YoY vs +25.7% YoY in 2004) although the latter still held up at above the headline growth number. Declining electronics share should smooth cyclicality: We reiterate our view that ongoing diversification is strengthening the industry structurally. The value-added share of the electronics cluster declined from 47.8% in 1999 to 31.6% in 2004 and the better part of this is captured by biomedical growth. The electronic industry is highly cyclical and a share decline should smooth cyclicality in the industry. Meanwhile, though the non-cyclical biomedical industry injects a lot of short-term volatility, it offers more stability from a long-term perspective. We believe recent initiatives to increase R&D into new niche areas such as water and environment technology continue this structural strengthening.
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