United States
Financial Obligations - Misleading Metrics?
Jan 27, 2006

Richard Berner (New York)

The Federal Reserve’s measures of household debt service and financial obligations have been rising sharply in relation to income over the past decade, hinting at looming financial stress for the American consumer.   For example, the debt service ratio jumped to a record 13.8% in the third quarter from 13.2% a year ago; if accurate, that’s the functional equivalent of a $46 billion tax hike.  And while the broader “financial obligations ratio” (FOR) — which includes a variety of other “committed” expenses such as rent, property taxes, homeowners’ insurance, and auto leases — is below its peak late in 2001, the recent 50-basis point climb looks ominous. 

Closer inspection of these data, however, paints a rather different picture.  In fact, I’ve long thought that these gauges overstate consumer financial burdens, that compositional shifts mean that the aggregate data are misleading indicators of the typical consumer’s financial strength, and that these ratios must be interpreted with care (see “Is Consumer Debt Service More Daunting?” Global Economic Forum, October 24, 2003). Now the Fed staff present some hard evidence for credit-card borrowing that backs up my case.

Make no mistake, these measures are aimed at the right target: It is debt service — the scheduled repayment of principal and timely payment of interest — rather than debt that matters in evaluating consumer health.   But that’s just the theory; in practice, analysts make critical simplifying assumptions and face a daunting lack of detailed data to reflect the myriad financial decisions that are washed out in the averages in such aggregate measures. 

Dissatisfied with existing measures, the Fed a little more than two years ago introduced new ones in a serious effort to improve debt-service metrics.  They recognized the shift of consumer lending from banks to other intermediaries and used new data sources for loan maturities and interest rates.  Fed staff also created the financial obligations ratio (FOR) to help analyze a broader range of household financial commitments and differentiate between those for homeowners and renters (see Karen Dynan, Kathleen Johnson and Karen Pence, “Recent Changes to a Measure of U.S. Household Debt Service,” Federal Reserve Bulletin, October 2003).

But those improved measures failed to capture some changes in the composition of debt over the past two decades that have reduced servicing costs for every dollar of debt outstanding.  As I see it, three factors are relevant in examining that shift.  First, “convenience credit” that is a substitute for cash and incurs no interest makes up a large part of credit-card debt.  Second, the actual interest rates paid on such debt may be far below those in the official data.  Finally, the surge in homeownership rates, especially among younger families, has raised aggregate mortgage debt levels in relation to aggregate income, and thus biases FORs higher.  But the typical homeowner may have no more debt — or debt servicing costs — than in the past.

Recent Fed research on credit-card debt documents for the first time the scope of some of these and other distortions to the data (see Kathleen W. Johnson, “Recent Developments in the Credit Card Market and the Financial Obligations Ratio,” Federal Reserve Bulletin, Autumn 2005).   First, the author finds that the explosion in ‘convenience credit’ accounted for about 1 percentage point (about 10%) of the annualized growth in credit card debt over the 1992-2001 period.  My hunch is that the desire to accumulate airline miles and other perks has at least sustained that pace.  Second, another 9% of the growth in credit card debt since 1989 resulted from lenders’ willingness to lend to riskier borrowers.  Lenders’ use of credit scoring and risk-based pricing made them more confident about managing and being rewarded for a riskier portfolio, and has effectively increased the supply of credit.  Finally, lenders have been willing to price credit-card credit more attractively for more creditworthy borrowers, and dropping the price has stimulated demand.  That expansion also added about 10 basis points annually to credit growth.  To be sure, those factors increase lenders’ risks, but they also have boosted lenders’ returns.  The author estimates that adjusting for those three factors collectively reduces the overall FOR by about 1 percentage point, accounting for all of the rise in that gauge over the past decade; the adjusted measure is essentially trendless.  Thus, while the existing data don’t lie, they overstate the financial vulnerability of the typical consumer. 

But that’s not the whole story; the Fed’s new research does not address what I think are other key shortcomings in the data.  As mentioned above, I think that ignoring the use of ‘teaser’ rates implies that the FOR data overstate debt service.  The zero-interest-rate loan popularized by Detroit’s captive finance companies was only the most visible example.  More subtly, most retail chain stores routinely still offer one-year or more zero-interest rate loans on consumer durables.  Credit card lenders just as routinely offer “teaser” loan rates — say, 0% for the first eighteen months — to attract new accounts.  In addition, there is a discrepancy in the treatment of mortgage interest.  The data implicitly capture the massive swap over the past four years from high-cost, non-tax-deductible consumer credit to mortgage debt, because the FOR is based on loans outstanding.  But the data are calculated on a pretax basis, so they overlook one of the reasons for the switch, namely the tax-deductible nature of mortgage interest payments.

Moreover, for mortgage credit, three factors imply that the FOR calculations overstate pretax mortgage debt service and thus the FOR by another 40 bp or more.   First, the Fed uses an effective interest rate on outstanding mortgage debt that statisticians at the Bureau of Economic Analysis calculate from current mortgage pool securities and shares of fixed- and adjustable-rate mortgages.  They reckon interest payments as the product of each period’s mortgage originations and the average interest rate on those flows and cumulated over time.  Each vintage of originations is “aged” or worked off using prepayment speeds from mortgage pools.  But typically higher-coupon mortgages prepay faster and lower ones more slowly, so using an average prepayment rate may bias the weighted average higher.  For the third quarter, the BEA rate stood at 6.24%.  But taking a weighted average of outstanding coupons from the universe of agency mortgage debt, Morgan Stanley mortgage analyst Ambika Bisla calculates an effective rate of 5.78% — 46 bp lower. 

A second factor implies that even the lower effective rate may overstate the truth.   The BEA appears to derive a weighted-average mortgage interest rate for ARMs that assumes each ARM vintage resets on the same schedule.  But that assumption overlooks the growing use of hybrid mortgages which have comprised up to half of ARM originations in recent years, few of which are in agency pools.  A “5/1” hybrid ARM at origination carries a rate 60-80 bp higher than a 1-year ARM, but the rate is fixed for 5 years.  Thus, using the recent runup in 1-year ARM rates as a proxy for all ARMs will overstate interest payments. 

Third, the calculation of the scheduled repayment of principal uses a shortcut that, while theoretically sound, relies on the assumption that all loans of a certain type have the same remaining maturity as the weighted average.   As with rates, the maturity data are derived from loans in securitized pools.  But the heavy volume of refinancing activity in nonconforming mortgages that lenders choose to hold on their books may mean that the weighted maturity is longer, and therefore debt service is lower, than that assumption implies.  For example, each additional year of mortgage debt maturity lowers the debt-service ratio by 30 basis points.  At the extreme, interest-only loans, popular in the jumbo market, have no principal repayment for at least five years. 

For investors, this scrutiny of the data has important implications.  Careful analysis of consumer debt service and financial obligations ratios reveals a healthier American consumer than commonly thought.  That throws some cold water on the pessimists’ slowdown story, because presumed household balance-sheet fragility is the lynchpin for that scenario.  If I’m right about the prospects for improving job growth and wage gains, moreover, my colleague David Greenlaw and I think the housing bust scenario that many investors fear is far fetched.  In our view, it would take soaring interest rates or declining employment to produce a bust (see “Housing Wealth and Consumer Spending” and “Home Sweet Home,” Global Economic Forum, October 7, 2005 and December 15, 2005).

As always, there are risks to the story.  The American consumer isn’t invincible; for example, even moderate levels of debt and debt service can turn into vulnerabilities in the face of shocks such as supply-induced energy price hikes.  Contrariwise, however, if energy prices stabilize and job gains improve moderately, overall growth may be stronger, inflation risks higher, and monetary policy may tighten further than is currently in the price.

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Korea
Uptrend to Continue
Jan 27, 2006

Sharon Lam (Hong Kong) and Andy Xie (Hong Kong)

Production Growth Trend Stayed Solid.   While   Korea’s industrial production growth declined 2.6% in December on a seasonally adjusted MoM basis, the comparison is with an exceptional +5% gain in November.  We pay more attention to YoY growth as it better reflects the trend.  On a YoY basis, production growth came in at +11.3%, down only slightly from +12.1% in November.  For the full year 2005, output growth concluded at +6.4%, down from +10.4% in 2004.  Looking back, output slowed significantly in 1H05 (+3.9%), but the turnaround came in the summer when global capex picked up, and Korea’s output growth accelerated in 2H05 (+8.8%).  We believe the manufacturing sector will continue to gather pace in 1H06 as global demand remains robust.  Meanwhile, the domestic market is picking up, particularly on capex, further strengthening the production of machinery and electronics. 

Watch Out for Capex Upside.   Equipment investment soared 13.1% YoY in December, the highest in three years (excluding January and February for the Lunar New Year effect).  Korea’s capex has been flat since 2001 despite impressive export growth as companies have opted to invest in the low cost economies, mainly China.  Yet, given the stock market rally, it has become more profitable for companies to expand capex again.  Meanwhile, Korea’s FDI into China dropped 17% YoY in 2005, implying that the production relocation phrase could be approaching a mature stage.

Happy Xmas Shopping but What Next?  As forecast, retail sales in December gained extraordinarily, especially compared to Xmas 2004 when sentiment was at its gloomiest.  Retail sales jumped 7.4% YoY in December, the sharpest since 2002.  Wholesale growth, however, eased to +2.2% from +4.5% in November, prompting concern that this could mean slower sales growth in the coming month.  Korean consumption remains capped by insufficient strength from income growth.  The labor market may not improve meaningfully until 2H06, in our view.

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Japan
US-Style Core Turns Positive
Jan 27, 2006

Takehiro Sato (Tokyo)

The December nationwide core CPI (excluding only perishables) came in at +0.1% YoY, which was in positive territory for the second straight month, as expected. Also, the U.S.-style core CPI (excluding food and energy), which is officially calculated by MIC, improved to +0.1% YoY, supporting the administration’s rush to declare an end to deflation. We expect the core CPI to be solidly positive over the next half year, but a number of factors bolstering and weighing on prices has become apparent. On balance, we see them weighing on prices in F2H06.

Basically, we see the core CPI reaching 0.4-0.5% in January-March on higher gasoline and kerosene prices and electricity/gas rates because of the jump in crude oil prices. We then expect the impact of these factors to diminish in April-June and contribute to a slide in the core CPI from 0.2% in April-June to 0.1% in July-December and then 0% in January-March 2007.  We would note that this core CPI forecast is before the revision coming up in August 2006. On a revised basis, we see the decline in the core CPI widening to 0.1-0.2%. The downward impact could be as great as 0.4ppt including the impact of the deregulation and the spending cut, which raises the possibility of the core CPI turning negative again in F2H06.

However, this is not to say that we expect another onset of deflation. Prices should be stably low in the near future mainly because of the prospects for improved productivity in the public sector, broadly defined. Or, as a result of productivity improvements, the economy's potential growth rate could be higher than the BoJ's assumption of 1.0-1.5%. Otherwise, with prospects for a third straight year of 2-3% growth, it becomes difficult to consistently explain the virtual lack of response in general price levels.

We forecast general price trends using top-down approach, as well. If we plot a simple Phillips curve, the slope of the curve in Japan's case changes considerably when unemployment is at 3%. In other words, the portion of the curve corresponding to unemployment in excess of 3% is almost flat, indicating a dramatic drop-off in the sensitivity of prices to labor supply and demand. Conversely, the slope of the curve corresponding to unemployment of less than 3% is sharp, meaning that prices are very sensitive. On this basis, we would intuitively say Japan's NAIRU is 3%. The Phillips curve has also likely shifted to the left because of productivity improvements from increasing globalization. With unemployment at the upper end of the 4% range, we optimistically forecast a dip in economic growth in F2007 to only around 3.5% at most. If so, then a sustained rise in prices could still be a ways off.

Another look at monetary policy scenarios

We peg an end to quantitative easing at April 28, and we see no reason for the decision to be postponed to May or later, because the first condition for a move away from quantitative easing has already been met. As it has already formally suggested, the BoJ intends to maintain ZIRP even after moving away from quantitative easing, until April-June 2007, by our estimate. Also, if the CPI does turn negative several months after a move away from quantitative easing, as we expect, then there would be diminished rationale for rushing to raise rates and conditions would remain difficult for justifying a early rate hike. We assume a rate hike could be delayed into mid-2007 because a government declaration that deflation has ended would likely come after official confirmation of 2% nominal growth in F2006.

As for the inflation targeting, the BoJ Governor Fukui was somewhat negative on the idea at a January 20 regular press conference. If prices weaken after a move away from quantitative easing, however, the BoJ may have to come up with a new commitment to prices to defend the organization because of the credibility it would lose. A defense of the organization would seem very much like an attempt to gloss over the failure of the lift of ZIRP by adopting the quantitative easing.

Financial market trends

Just as in the days of ZIRP, it would be difficult to predict whether short-term money market rates stay at their ultra-low levels following a resumption of ZIRP. Short-term rates could be allowed to fluctuate within a certain range, as in March 2001, when the BoJ initiated quantitative easing. It is also uncertain whether market transactions would resume smoothly because the short-term money market has effectively stopped functioning under five years of quantitative easing. What is likely to happen, in our view, is that the short-term money market may respond readily to changes in the supply and demand for funds as a result of financial institutions' reluctance to lend, and even with current account deposits at the BoJ well above the required amounts, the unsecured overnight call rate could rise from 0%, although it might not be consistently. In other words, a move away from quantitative easing is likely to exacerbate volatility in the short-term money market, which could also affect long-term yields because the policy duration effect would be abandoned. As a result, we expect both short- and long-term rates to be unstable after a move away from quantitative easing and see long-term rates as vulnerable to a temporary rise.

If a move away from quantitative easing leads to weakness in the bond market, we would consider it a buying opportunity because we see more of a downward than upward bias on general prices emerging in F2H06. We would be on the lookout for a decline rather than temporary rise in long-term yields in F2006.

Finally, if the BoJ adopts inflation targeting and has the market's confidence in how it intends to achieve the inflation target amid disinflation, then the long end of the yield curve would likely steepen. The short end would likely go back to close to 0% on a discounting of the difficulties of achieving the target near term and diminished expectations for a rate hike. However, if the BoJ only has an inflation target but no clear ways to achieve it, or the market perceives this to be the case, then the central bank would only lose credibility and the bond market would ignore such moves. We think it is difficult to achieve an inflation target with monetary policy only and under disinflationary conditions, and without some sort of government commitment, the bond market would likely react coolly.

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Global
A Soft Capex Cycle
Jan 27, 2006

Eric Chaney (Paris)

Bullish economists, bearish investors

Global capex cycles are long-term stories.   The last two cycles, 1983-1992 and 1994-2001 lasted eight years on average.  Since the burst of the information technology bubble, followed by a large fall in the global capacity utilization rate, companies around the industrialized world have been busy at cutting capacity overhangs, by pruning new investment, closing redundant factories or simply by going out of business.  With global production re-accelerating somewhat and capex at a standstill, operating rates rose sharply in 2004, announcing a pick-up in corporate investment.  This is at least what economists expected.  Corporate investment did recover in 2004 but failed to gather further momentum in 2005, casting doubts about the recovery.  Last year’s hot macro debate about the low level of real long-term interest rates was actually connected to the global capex cycle: whether low real yields were the consequence of a “saving glut” or a fixed investment shortage is unclear but one thing is sure: ex-ante, savings were in excess of fixed investment projects.  At our MacroVision conference held in New York, on January 20, the global capex cycle was the most popular theme among investors and corporate executives.  On behalf of Morgan Stanley’s macro teams, I made the case for a long lasting but moderate capex cycle and will elaborate on it in this note.  However, investors and executives were dubious: “I haven’t met a CEO recently who told me his company was to build a new plant” said the manager of a well connected hedge fund in one of our workshops, summarizing the view from most attendees. 

The agreement: capex revival yes, but with qualifications

Between the macro analysis, derived from beautiful theories à la Samuelson or Tobin and the feedback from the real corporate world, there seemed to be a large gap.  However, a consensus emerged from our exchanges: Yes, a global capex cycle lasting several years is a reasonable scenario, but with important qualifications: capacity expansion was unlikely in high income countries, where investment will aim at raising productivity and foster innovation; China and India will continue to attract a growing share of the world producing capacity (manufacturing and some services); energy, energy efficiency and environmental concerns (water, waste management) should be the key beneficiaries of capital flows.

The macro case: three key drivers

The points made by investors and executives deserve attention, all the more so that 2005 was not particularly brilliant for corporate investment.  If, as my colleague Andy Xie thinks, China is currently building large overcapacities, then the global capacity utilization rate might decline this year, not a good omen for capex growth.  However, the long-term macro case cannot be easily dismissed.  I think that three key drivers are underpinning the resurgence of the global capital expenditure cycle.  First, the capacity overhang has been eliminated and demand is growing above trend.  Second, the micro angle: hurdle rates have declined.  Third, the rise in energy prices is permanent and calls for various targeted investments.

Calling Samuelson at the bar

Paul A. Samuelson, one of the builders of the MIT economics Department with Robert M. Solow, earned his Nobel award in 1970 for multiple contributions to macro theory, from revealed consumers’ preferences to international trade.  However, he remains popular among practitioners for a simple and robust model, the “capex accelerator”.  In short, companies would adjust the stock of producing capital to demand trends: If demand rises, then the optimal stock of capital should be higher and thus capex growth, the second derivative of the stock of capital, should accelerate markedly.  Facts fit well with Samuelson’s model: for a given stock of capital, rising operating rates are signaling that the stock of capital is growing slower than demand and capex accelerates.  Conversely, when operating rates fall, as they did in 1990-1991 or in 2001-2002, the stock of capital is growing too fast for a weaker demand trend, and capex growth turns deeply negative.  Then, the key question is to gauge the growth rate of producing capital.  Unfortunately, there is no easy way to measure the stock of producing capital and data reported by National Statistical Institutes are highly dependant on key but hardly observable parameters such as depreciation rates.  Fortunately, there is another way to gauge the stock of capital, thanks to business surveys.  In most industrialized countries, manufacturing companies report their own operating rates, or capacity utilization rates, in monthly or quarterly surveys (by the Fed in the US or Ifo in Germany, for instance).  When companies answer that they are operating at 80% of their capacity, it makes sense to assume that full capacity is 25% higher than actual production.  It results that if productive capital is difficult to measure, producing capacity is less elusive.

G-10 Capacity is now below trend. 

We have made these calculations for eleven manufacturing platforms, from the US to Asian Tigers, and aggregated the results.  We find that the level of global capacity is now below its long-term trend, after four years of sub-par growth.  More importantly, the current apparent growth rate of manufacturing capacity is 2.0% (as of Q3 2005) while the long term trend rate of growth is 2.9%.  If the world was accurately described by this group of 11 industrialized economies, the conclusion would be straightforward: a powerful global capex boom would be in the offing.  In reality, manufacturing capacity is now expanding much faster in China than in the G-10, as production is progressively shifted from high income countries to China.  The most striking example of this shift is provided by Korea, where the average annual rate of growth of manufacturing capacity was 8.8% from 1980 to 2000 but only 4.4% since 2001.  By contrast, manufacturing capacity is expanding by 15% per year in China, a number we take with caution, for lack of reliable data on operating rates.  However, even assuming that capacity would continue to grow by 15% in China, it remains that global capacity, including China, would grow slightly below trend (2.8% on our estimates, vs. 2.9% for the long-term trend).  Since global capacity is now below trend, companies need to accelerate the growth rate of capacity in order to meet with future demand.  Interestingly, capacity is already growing above trend in Germany, which is not known as a low cost manufacturing platform.

The micro angle: lower hurdle rates

While Samuelson’s theory still works reasonably well at the macro level, investment decisions taken by companies are not correctly explained by changes in demand expectations.  From James Tobin’s famous marginal q to modern corporate finance theory, many parameters have been introduced.  One of the most popular among corporate managers is the “hurdle rate”, i.e. the rate of return in a discounted cash flow analysis above which investment pays off.  During the previous capex cycle, high long term nominal interest rates justified high discount rates.  Things have dramatically changed since then, but companies have been so far reluctant to change normative assumptions.  With (apparently) permanently lower corporate bond yields, due to lower government bond yields and risk premiums, hurdle rates calculated at the company level should decrease quite significantly, thus freeing up investment projects that were so far judged unprofitable.  Whether risk premiums will stay permanently lower than they were during the previous cycle or not is debatable, and hotly debated.  However, the reality is that, for the time being risk premiums have been much lower than anybody had expected, and this has not been unnoticed in the corporate world.

Capital to energy substitution

Last, the large rises in oil and gas prices recorded since 1999 — a three-fold increase in USD terms — are not only the consequence of strong demand but also from scarce supply, as new large fields discoveries become rare events.  We think that the long-term equilibrium price of crude oil, long considered to be somewhere between $12 and $25/bbl has shifted to a range between $40 and $60, under relatively conservative assumptions.  The experience of the 1973 and 1979-80 price shocks is clear on one point: price signals do work.  Practically, the oil intensity of GDP in oil importing countries started to decline soon after the second oil shock, as investment flowed into other sources of energy and energy saving processes.  In recent years, investors were quick to pick investment targets linked to alternative sources of energy.  But there is another, less understood, macro dimension: higher oil and gas prices do not imply only that capital will go to other sources of energy. In fact, higher energy prices are conducive for capital spending in general, beyond the cyclical impact of higher costs.  To see why, it is convenient to think of a global production function with three inputs: labor, capital and energy.  In the long term, these inputs are partially substitutable, depending on relative prices.  The sharp rise in energy prices implies a reduction of the relative cost of capital which, in return, is positive for capital expenditure.  Practically, producing the same goods and services with less energy (or other sources of energy) requires investing in new, energy efficient, technologies.

A soft, but robust capex cycle

In conclusion, I believe that the case for a long capex cycle is alive and well, with the important qualifications made by the MacroVision consensus: 1/ capacity will grow at a much slower pace than in the previous cycle in high income countries while expanding rapidly in business friendly emerging markets; 2/ productivity and innovation will be more important drivers than mere capacity; 3/ energy substitution and energy saving will attract more capital than in the previous cycle.  Provided that one takes a long term view, these conclusions are robust, I believe.  For instance, if a large supply disruption sent crude prices above $100 for a long period, the global economy would probably experience at least a growth recession.  But this would not last, i.e. the capex cycle would be merely postponed, and even more capital would go to energy substitution and energy saving.

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