United States
Betting on Sustainable Growth
Feb 06, 2006

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

Forecast at a Glance

	2005E	2006E	2007E
Real GDP	3.5%	3.6%	3.3%
Inflation (CPI)	3.4	2.7	2.2
Unit Labor Costs	2.3	2.0	2.9
After-Tax “Economic” Profits	9.2	11.7	2.9
After-Tax “Book” Profits	34.8	9.7	3.0

Source: Morgan Stanley Research    E = Morgan Stanley Research Estimates

Job and income growth now seem to be accelerating, and for us, that’s a watershed development for the US economy as it makes the transition to a mature and sustainable recovery.  Courtesy of rising wealth, US consumers have been able to dip into saving to defend lifestyles as rising energy prices drove energy outlays to a larger share of consumer budgets over much of this expansion.  If income is now accelerating, as we believe, it will lower a key hurdle to sustainability: Consumers will be able to maintain moderate spending gains while rebuilding saving. 

Thus, while many expect that slowing home price gains will keep the economy growing at trend or below it, we think that the incipient pickup in income growth is one of several factors that will promote and sustain a strong economic rebound to an above-trend, 4% pace over 2006.  That’s actually a tenth stronger than we expected last month; the downward revision in our year-over-year forecast for 2006 from 3.8% last month to 3.6% entirely reflects the hurricane-cum-energy-shock-induced weak pace in the final quarter of 2005.

To be sure, it is early days for the acceleration in income.  Rising energy quotes hammered real “core,” or wage and salary, income for much of 2005, and while post-Katrina relief from energy prices has nurtured a 5.6% annualized gain in the past 3 months, gasoline and other energy prices are rising again.  But two factors seem likely to yield strong gains in coming months.  First, reflecting our thesis of “pent-up demand” for hiring, companies and governments have begun to step up the pace.  A recent deceleration in the “fixed” costs of health and pension benefits — from a record 7.1% a year ago to 4.1% over 2005 — likely lessened CEOs’ resolve to limit hiring and pay and has unleashed some hiring demand by reducing its cost.  Job gains over the past four months, which included fallout from the three major hurricanes, averaged 181,000, or the fastest pace since July.  Other indications of labor-market strength corroborate the acceleration: The breadth of hiring gains, measured by a so-called diffusion index of payroll gains across 278 private industries, jumped to 67.6%, the second-highest reading in this cycle; breadth is often a harbinger of strength.  Consumers’ assessment of whether jobs were plentiful hit a six-year high in January.  And the plunge in benefit cost growth likely augurs faster future job growth.

The second factor likely to boost income growth is that pay gains are rising as labor markets firm, so that real wages are beginning to catch up with inflation.  One wage metric, average hourly earnings of private production workers, rose by 3.3% over the past year, a three-year high, while the wage and salary index in the Employment Cost Index may have bottomed out at 2.5%.  Both gauges are flawed, but the direction is now unmistakable (see “Will the Real Wage Measure Please Stand Up?” Global Economic Forum, January 6, 2006).  With the unemployment rate declining to 4.7%, a further acceleration in pay seems likely.  Already, a proxy for private wage and salary income has accelerated to a 6% clip over the past year — the fastest pace since 1999 — and official data likely will soon follow.  Indeed, upward revisions to payrolls and to hourly pay since August hint that past official wage income data may likewise be revised higher.

As important as are job and income developments, they are not the whole story — far from it.   Four other factors likely will support growth in demand.  First, pent-up demand for capital spending is still strong, in our view, as Corporate America’s capital discipline in the current expansion has created a reservoir of demand that should last at least into 2007.  Rising operating rates and the returns and pricing power that accompany them have reached the point where investing to add capacity makes sense; investors are starting to reward managers for growth as well as returns; and the surge in energy prices has made “old capital” obsolete and spurred the need for new, more energy-efficient equipment and facilities (see “Bullish On Capex,” Global Economic Forum, January 23, 2006). 

Moreover, financial conditions have turned easier recently, despite 350 basis points of Fed tightening since June 2004.  Some market participants still worry that an inverted yield curve augurs much slower growth or recession, and even Fed centrists don’t want to over-tighten monetary policy.  But in our view those worries are overblown.  Courtesy of declining term premiums, the bull flattening in the yield curve has in our view made the level of interest rates along the maturity spectrum more, not less, stimulative (see “Yield Curve Angst,” Investment Perspectives, November 23, 2005).  And the rally in stock prices and in credit markets, the decline in the dollar since November, and apparently more-than-ample credit availability suggests additional support for credit-sensitive spending over the next few months.  As evidence of credit availability, C&I lending exploded at a 19.6% annual rate over the past 13 weeks, a new cycle high, and banks probably eased lending standards a bit further in the past three months.

Third, an improvement in overseas demand is also likely to support US growth over the next several months.  Unlike in 2003-2004, domestic demand in many US trading partners is the driver for this pickup, boding well for US exports.  Finally, a pickup in government spending — especially in the first quarter—likely will boost overall US growth in 2006.  Defense outlays deferred late in 2005 will soon show up, and Federal outlays for hurricane evacuees and rebuilding activity are running at a $5 billion monthly pace.  And a river of cash flowing into state and local government coffers as revenues outpace the economy is enabling officials to spend money on unmet needs accumulated over the past four years. 

To be sure, the 5½% clip we expect for current-quarter real growth isn’t sustainable.  Unseasonably warm winter weather is adding to gains and a payback is likely in the spring quarter (see “Rebound: Is it Real or Just the Weather?” Global Economic Forum, February 3, 2006).  And even if weather gives housing activity a temporary lift, housing fundamentals are fading.  Housing is sliding under its own weight, as rising prices have undermined affordability.  New and existing home sales are well off their recent peaks, homebuilder traffic is down sharply, inventories of unsold homes are rising swiftly, and housing starts fell sharply in December.  But as we see it, as long as job and income growth improve, a rapid slide in either housing activity or home prices is unlikely.

The difference between growth below and above trend is critical for the inflation prognosis: Slower growth would ease operating and jobless rates and help contain inflation.  But because slack has dwindled in both product and labor markets, and capacity is growing slowly, growth above trend will intensify already-rising pressure on resource utilization and tend to boost inflation risks.  Put simply, as slack dwindles, companies have more pricing power, and more leverage to pass along cost increases.  Against that backdrop, the acceleration in wages, the dip in the jobless rate, and the relentless rise in operating rates raise a yellow inflation warning flag.  What’s more, while monetary policy is no longer accommodative, it isn’t yet restrictive.  Inflation expectations have edged back down to 2.9% in late January, but that is still slightly above the level of the past two years.  And while productivity growth likely will snap back sharply this quarter following a dip in the fourth trimester, we think gains in productivity could dip below their 2½-2¾% trend as job growth catches up with the economy.  As a result, a cyclical rise in core inflation, to 2.6% measured by the CPI, is still likely over the next few quarters.

Robust data have eroded market hopes for a quick end to Fed tightening; after the past week’s move to a 4½% Federal funds rate, Fed funds futures now price a March hike as almost a sure thing and a 60% chance of a further move to 5% in either May or June.  If anything, market participants have thus caught up to, and maybe passed our modestly bearish stance on the front end of the yield curve.  We believe a 5% rate is likely later in the year.  Yet, while they are less bullish than a couple of weeks ago, bond-market participants still cling to the notion that the Fed will reverse course soon after tightening ends.  The spread between June ’06 and June ’07 Eurodollar yields remains negative, although it has narrowed from over 20 bp to 13 bp today.  In addition, there is a “fear factor” — perhaps mimicking the UK experience — that the combination of pension-driven duration demand and only a modest increase in long bond supply will drive bond yields lower.

As a result, the yield curve has inverted almost completely; the yield spread from bonds to 2’s dipped by 15 bp to 5 bp over the past week, while the 10-year-2-year spread has gone negative.  Our colleague and interest-rate strategist Graig Fantuzzi believes that the “fear factor” premium will keep the long end bid over the next few months, and we’ll concede that such a bid could hold for the very long end of the yield curve.  But in our view, that only makes financial conditions more supportive of growth.  We think that rising -term premiums fueled by a less-telegraphed monetary policy stance and unfolding upside inflation risks will re-steepen the Treasury yield curve, sending 10-year yields towards 5% (see “The Term-Premium Case for Higher Yields,” Global Economic Forum, January 23, 2006).

The main risk to our scenario, and one that would re-steepen the yield curve significantly, continues to be from a very different ‘”fear factor,“ namely a supply shock to energy prices that would undermine growth and risky assets even more significantly.  Geopolitical risks are rising; escalating rhetoric between the West and Iran and other oil producers (notably Venezuela), unrest in Nigeria, and Islamic outrage at recent newspaper cartoons may all combine to move oil prices higher as market participants anticipate a cutoff in oil exports from hostile producers.  Such supply shocks threaten global growth.  Contrariwise, if energy prices stabilize or revert to long-term levels, the risks of a stronger-growth, higher-inflation outcome are not insignificant.

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Japan
Holding Tight (Part II)
Feb 06, 2006

Takehiro Sato (Tokyo)

Decoupling of the economy and prices

The Japanese economy looks to be in excellent condition. In revising our data forecasts based on monthly indicators, we found that 4Q real GDP appeared to rise 7.6% SAAR, by far the fastest rate of growth among advanced economies.  Our estimate is at the top end of market forecasts, but the consensus is for nearly 5% growth. So, this is merely a question of degree; there is little disagreement that the Japanese economy gave an excellent performance. Meanwhile, the core CPI inflation rate was finally positive for two consecutive months, but excluding the impact of broadly-defined public charges, the baseline nationwide CPI inflation rate shows, if rounded, year over year change of 0% for seven straight months.

The Japanese economy has already seen growth rates of around 2-3% continue for three years since 2003, and not only did it have average annualized growth of 3.9% from 1Q to 3Q in 2005, rapid growth on par with the US, but to date prices have not shown a major response. We believe that this decoupling between the economy and price performance means that the output gap has not contracted much because of an upward shift in growth potential. If this hypothesis is correct, it means it is possible to enjoy the fruits of continued ideal economic growth under conditions of disinflation. The implication for asset markets of continued high growth and low inflation is a continued goldilocks state of buoyant equity and stable bond markets.

Is the potential growth rate truly 1%?

The government and the BoJ’s economic/price outlooks assume a potential growth rate of about 1-1.5%. If the potential growth rate is calculated from the Cobb-Douglas production function, then indeed the potential growth rate appears to currently be around 1.5%. However, because there are substantial measurement errors for potential growth rates, it is in fact difficult to determine whether the true potential growth rate is 1% or close to 2%. So, we turn to Okun’s Law. Okun’s Law points to the relationship indicated by the linear best fit between the change in the unemployment rate and rate of GDP growth. According to this, the unemployment rate generally begins to fall once real GDP growth tops roughly 3%.  Conversely, the unemployment rate tends not to fall even if real growth expands, at up to roughly 3%. In addition, the falling unemployment rate in a broad sense can be seen as implying a shrinking output gap.  However, the idea that the jobless rate won’t decline until GDP growth tops 3% conflicts with the popular view including that of the BoJ that potential economic growth in Japan is hovering at around 1%.  Thus, Okun’s Law actually suggests potential economic growth in a high range, at around 3%. So, if potential growth was at 3% and real growth at 3%, the output gap would not be shrinking.  In other words, we still cannot anticipate any significant impact on prices from a slight decline in the unemployment rate with growth at 3%.  This can be confirmed by Japan’s Phillip’s Curve model as well. 

Quiet productivity revolution

From this perspective, the implications for prices are completely different depending on whether the potential growth rate is seen as 1% or 3%, and we believe that potential growth rates can be surprisingly responsive to economic conditions, such that the possibility cannot be excluded that the potential growth rate has increased along with current improvement in general economic conditions. Productivity may hold the key. It is difficult to find a reason other than an increase in productivity for a simultaneous increase in corporate earnings and employee compensation, with prices for final demand goods stable besides. Indeed, lower broadly-defined public charges stemming from deregulation and fiscal spending cuts mean that prices seen from the bottom-up look unlikely to enter a sustained uptrend. Rate declines of this type, however, can be the fruits of productivity gain in the quasi-public sector generated by deregulation and fiscal spending cuts. Indeed, In Japan we believe that there continues to be quite progress in the productivity revolution.

The key lies with rents

Will prices fail to rise forever?  With the above top-down approach we determined that it would not be easy for upward pressure on prices to emerge so long as there continued to be rapid growth in productivity.

What are risk factors that could spark inflation from the bottom-up?  We believe that the direction of rents may hold the key. Currently, real estate prices are bottoming, primarily in urban areas, and rents are serving as an intermediary between these kinds of asset prices and general price levels. Furthermore, if imputed rent is included, the weight of rents in the consumer price index is quite high.

A look at the latest rent trends shows private rents down 0.3% YoY nationwide and down 0.7% for Tokyo. Despite residential properties in Tokyo clearly bottoming, it is fair to say that asset prices have not been reflected at all in rents. Rather, the trend actually seems to be for the rate of decline in private rents to accelerate. Because these kinds of rent trends reflect not only asset prices but also the supply/demand balance in the rental market, there can be considerable time lags before reversals in asset prices are reflected in actual rents. Nonetheless, the view that the increase in land prices will eventually show up in rents is not necessarily mistaken. Indeed, imputed rents for owner-occupied housing, which likely more accurately reflect asset prices, increased 0.2% and 0.6% YoY, respectively. Furthermore, the weighting in the CPI of imputed rents accounts for a large chunk of the rents category.

As such, based on quiet progress in productivity, we are markedly optimistic top-down about the outlook for prices. From a bottom-up perspective, we must be aware of the ripple effect on general prices of increases in asset prices, which could be a factor offsetting quasi-public sector price declines. 

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UK
Downside Risks to Trend Growth
Feb 06, 2006

David Miles (London) and Vladimir Pillonca (London) and Melanie Baker (London)

Economic growth has been relatively robust in the UK over the past few years, although it slowed substantially in 2005.  The UK Treasury expects the economy to pick up, with growth of between 2¾ and 3¼ by 2007 and the output gap closing in 2008-09.  We see several medium- and short-term risks to this outlook.  In the medium term, inadequate levels of UK saving, the risks of a slowdown in productivity growth and the unwinding of external imbalances are threats to steady growth.  In the shorter term, volatile investment, labour market developments and how conditions in the housing market evolve pose the main risks.  One particularly worrisome medium-term risk is that productivity growth remains disappointing and its low level poses a risk to both future growth and inflation.

Productivity growth is a key determinant of increases in living standards.   Persistent differences in the rates of overall productivity growth across economies can result in very large divergences in living standards over time.  The Treasury assumes that the trend rate of growth of the economy 1Q01-4Q06 is 2¾%.  Of this, 2.15% arises from labour productivity growth (output per hour worked) and 0.6% reflects the assumed growth rate of working age population.  Productivity is assumed to continue rising at 2.15% per year beyond this.

Labour productivity — the UK’s Achilles heel.   Year-on-year growth in UK output per worker slowed sharply in 2005.  Four factors may be important:

•     the mix of public- and private-sector jobs and differences in measured productivity between them.  However, the public sector’s labour share tends to move in small increments over time, and has barely moved in recent quarters;

•     trends in capital per worker;

•     changes in underlying labour productivity — sometimes called pure technical progress; and

•      cyclical, and therefore temporary, shifts in the intensity of work. 

Dissecting UK economic growth and its drivers.  The latter three potential factors behind slower productivity growth can be analysed by pinning down the longer-term determinants of growth in per-capita UK GDP.  Using a simple economic framework, we decompose growth in per-capita GDP into three fundamental drivers:

•     changes in the amount of labour in the economy;

•     changes in the amount of capital per worker (capital deepening); and

•      technological progress — changes in output that do not come about because of more inputs. 

Favourable labour market conditions have boosted economic growth — but this trend is probably not sustainable.   We think that growth in overall GDP per capita has been enhanced by beneficial developments in the labour market, whose effect is likely to be much smaller in the future.

•     TFP growth — where over long enough horizons, technical progress (TFP) is often believed to be the crucial driver of economic growth — has failed to accelerate despite an unusually stable economy and a host of government measures to boost it.  Instead, trend TFP growth appears to have slowed markedly since 2003. Our decomposition suggests that trend total factor productivity growth has slowed to around 1% in recent quarters.

•      The declining contribution of capital deepening is a cause for concern.  The contribution of capital deepening has been declining steadily in recent years in the UK. 

•      Labour market developments and rising participation in particular, have boosted GDP growth per capita in the UK in recent years, compensating for the lack of acceleration of TFP growth and the declining contribution from capital deepening. 

•      But unemployment is already at historical lows and is unlikely to fall much further.  With an ageing population, the percent of the overall population available for work (which is our definition of participation) is unlikely to rise for much longer. 

Downside risks to our estimate of potential GDP growth.   Assuming the effect of rising labour supply gradually converges towards zero (a level consistent with its historical contribution) or at least moderates from recent levels, longer-term sustainable GDP growth per capita could easily fall below 2%.  This suggests that there are downside risks to our estimate of potential aggregate GDP growth (around 2.4%).

This has implications for fiscal policy.   Any assessment of whether the golden rule has been met or not is heavily dependent on the dating of the cycle.  To do that, we need an estimate of potential, or trend, output and its rate of growth.  “The Treasury’s neutral estimate of the economy’s trend output growth rate for the 2005 Pre-Budget Report is 2¾ percent a year to the end of 2006, slowing to 2½ percent thereafter due to demographic effects.” Our estimates suggest the recent output growth deceleration has dragged the potential rate of economic growth lower.  Our projections imply a potential growth rate of around 2.3% for the next three years and a gradual convergence towards 2.4% by 2009-10, but we think that there are downside risks to this estimate given the analysis above.

Our conclusion.  There is limited spare capacity in the economy and future trend growth may fall slightly below a rate consistent with average GDP growth of 2.5%.  If this is true, even if growth barely rises above 2%, the scope for cuts in interest rates will be limited.

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Germany
The Consumer Conundrum
Feb 06, 2006

Elga Bartsch (London)

You can always count on the German consumer to humiliate most forecasters, except for the full-fledged doomsayers.  Contrary to upbeat survey evidence from the retail sector, anecdotal evidence of satisfactory Christmas sales, and solid gains in consumer confidence, this past week, the German statistics office reported a 1.4%%M drop in narrow retails sales volumes in December.  Our preferred measure, broad retail sales including car sales, posted an even bigger decline of 2.5%M, leaving the average for the fourth quarter 1.1%Q below the third and putting the retail sector on a steep negative ramp of 1.6%Q going into 2006.  At face value, however, the report would suggest that consumer spending likely contracted for a fourth consecutive quarter in late 2005.

The retail sales report sparked a sharp from the Association German Retailers, HDE, who disputes the validity of the official data as their own statistics show a much more robust picture of retailing trends in Germany.   Likewise, macro economists have doubts whether these retail sales data can be trusted on the latest data.  Not only did the trends in official retail sales data and in the retail survey of the Ifo Institute diverge further.  The plunge in broad retail sales also seems to be at odds with decent car registrations recorded in December.  Hence, we would take the December retail sales report with a pinch of salt and patiently wait for more robust revised data. 

The retail sales report wasn’t the only bad surprise out of Europe’s largest economy this past week.   The labour market report also showed some unexpected weakness when January unemployment was reported to have increased 69K, December employment to have declined 10K and January vacancies to have decreased 17K.  The upside surprise in unemployment can be traced back to one off factors, such as unusually cold winter weather, a shift in the sampling date and a looming legislative change which will tighten unemployment benefits for older job seekers from February onwards.  The latter might also spill over into February data, as the cut-off date for the count of registered jobseekers is typically around mid-month. 

Underneath the nasty headlines, however, employment subject to social security contributions — lets call it core employment — might be about to turn.   In November, the latest available data point, these types of jobs were standing a mere 102K below the level a year go, while in October the year-over-year decline was still given at 205K.  In seasonally adjusted terms is likely corresponds to a stable sequential reading.  Taking into account continued cutbacks in full-time government-sponsored job-creation as the focus moved towards mini-jobs and one-euro jobs, significant share of the decline can be traced back to labour market policies.  Looking at the trends in core employment, a recent study by the Institut fuer Arbeitsmarkt- und Berufsforschung finds that of the 13% decline since 1991 about one third can be attributed to weak economic growth.  Another quarter is due to structural shifts between sectors and between different forms of employment. 

Going forward, however, we expect both the labour market and the retail sector to rebound.  Aggregating the employment components of the recent round of business surveys pushed our employment indicator to a new high suggesting that companies hiring intentions have improved noticeably in the past few months.  This assessment is also shared by households who have further revised down their unemployment outlook in January and now see the harmonised unemployment rate to drop from 8.9%% at present to 8.5% later this year.  Similarly, the retail sales seem set to rebound smartly in January according to the Ifo retail sentiment, which at an equal split between those retailers being bullish on the outlook for the next six months and those bring bearish has reached the highest level since late 2000.  Hence, potential downside risks to Q4 GDP growth will likely to be more than offset by the upside risks to the Q1 GDP estimate.  As a result, the economy recovery will likely even be steeper this year than previously anticipated.

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US
Review and Preview
Feb 06, 2006

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

A run of economic data that both further raised expectations for a sharp rebound in first quarter growth after the disappointing Q4 results — at this very early point we see Q1 GDP on pace for a +5.5% gain — and also set off alarms on the Federal Reserve’s warning of rising “resource utilization,” along with a massive Friday grab for duration as expectations built for heavy demand at the upcoming auction of the revived long bond, combined to dramatically flatten the Treasury yield curve over the past week, leaving 2’-5’s, 2’s-10’s, and 2’s-30’s all at new cycle lows at Friday’s close. Though the Fed appeared to be aiming to leave its options open at the March FOMC meeting in its policy statement released a day before incoming Chairman Bernanke was sworn in by merely noting that further rate hikes “may be needed” after Tuesday’s universally expected hike in the funds target to 4.5%, the futures market by the end of the week had not only moved to price a March hike as almost a sure thing, but, on top of this, had priced in the likelihood of a further move to 5% in either May or June. Much stronger than expected results for January motor vehicle and chain store sales pointed to a robust gain in January retail sales, which on top of extremely strong, back-to-back 0.9% gains in real consumption in November and December, put Q1 consumer spending easily on pace for a 4.5% to 5% gain. And the sharp reacceleration in growth this consumption revival has led out of the brief post-hurricanes/energy price shock retrenchment has continued to lead to the “increases in resource utilization” — with the unemployment surprisingly falling to a new cycle low in January — that the Fed has identified as the primary risk going forward. While this economic news had the market rushing to price in a significantly more hawkish near-term Fed profile all week, the strong initial reception the upcoming 30-year met with apparently led to a rush to buy duration ahead of Thursday’s auction in trading on Friday after the employment report was out of the way, with the already significantly richer than initially expected WI 30-year issue gaining even more ground against the current long bond and pulling the whole long end sharply higher along with it, cranking the curve massively flatter.

Through most of the past week, the Treasury curve was seeing a decent bearish flattening move, with losses across the curve that peaked after the stronger than expected employment report on Friday morning. But at around 9:30, the long end suddenly caught a huge bid led by the WI 30-year, with the current long bond yield plummeting more than 10 bp in two hours to move into positive territory on the week. At Friday’s close the net result was a 14 bp collapse in 2’s-30’s to a new cycle low of just 5 bp, with the 2-year yield up 10 bp on the week to 4.59% and the long bond yield down 5 bp to 4.63% (after having traded above 4.73% in the wake of the employment report). 2’s-10’s and 2’s-5’s similarly moved to new lows, the former crossing back decisively into inversion, with the 10-year yield up 3 bp to 4.53% and the 5-year yield up 6 bp to 4.495%. With the market pricing in both a more hawkish near-term Fed and a less dovish medium-term policy, the 3-year performed relatively poorly on the curve, with its yield up 10 bp to 4.55%. Regarding Fed pricing, a more hawkish near-term posture was priced in every day through the week.

By Friday’s close, the April fed funds contract had sold off a cumulative 2.5 bp, putting the odds of a hike in the funds target in March to 4.75% at nearly 90%. The July contract lost 10.5 bp to end at 4.895%, placing the odds of a final hike to 5% in May or June at about 60%. Through most of the week, this more aggressive near-term Fed pricing was accompanied by a lessening of the easing priced in during the mid-2006 to mid-2007 timeframe, but this was largely reversed in Friday’s wild curve move. At week end, the June 06 to June 07 eurodollar spread was at -13 bp, (after reaching a six-week high of -10 bp Thursday), up 0.5 bp on the week, as the former contract lost 10 bp to 5.00% and the latter 10.5 bp to 4.87%. The Sep 06 to Sep 07 spread (now the maximum negative spread since June 06 to Sep 06 recently moved out of inversion), also steepened a half bp to -14 bp.

This much more aggressive near-term Fed posture expected by investors was certainly not what you might have expected following an FOMC statement that tilted somewhat to the dovish side, certainly not at the time promising the March rate hike that the market now considers all but a done deal. As universally anticipated, the FOMC hiked the funds rate target by 25 bp to 4.50% at Chairman Greenspan’s final meeting. The accompanying statement provided somewhat greater policy flexibility going forward. Specifically, the portion of the statement issued in December that indicated “some further measured policy firming is likely to be needed” was altered to read “some further policy firming may be needed.” Such a rewording was widely anticipated and reflected that the real funds rate (at about 2 1/2% relative to the core PCE price index) is near its long-term average, which may be consistent with a long-run “neutral” policy stance. So the future path of the federal funds target will become much more data dependent going forward. The section of the statement that described the current state of the economy did not contain an explicit reference to the disappointing GDP data released on Friday, but did note that recent data have been “uneven.” Still, the expansion was described as “solid.” Core inflation continued to be described as “relatively low” but with upside risks from possible increases in resource utilization as well as elevated energy prices.

Based on our near-term economic forecasts — a sharp rebound in Q1 GDP and a gradual drift higher in core inflation — we continue to believe that the Fed will have sufficient ammunition to hike the funds target to 4.75% at the March 28 meeting, and this was certainly supported by the employment report. Moreover, with incoming data pointing to just the resource pressures the Fed fears, a move to 5% in May is becoming more likely.

While the market’s initial reaction to the FOMC’s statement may have seen somewhat overdone given the much more open-ended guidance on future policy, Friday’s employment report certainly showed the most high profile measure of “resource utilization” tightening significantly, consequently making further rate hikes that much more likely. Nonfarm payrolls rose a less than expected 193,000 in January, but all other aspects of the report showed significant strength. There were sizable upward revisions to payroll growth in December (+140,000) and November (+354,000) totaling 81,000. The unemployment rate fell two tenths to 4.7% — the low since July 2001 — on a 418,000 surge (adjusted for the annual population revisions) in the household survey’s measure of employment. A 4.7% unemployment rate would almost certainly be below the economists’ consensus of where normal full employment is (for example, the Congressional Budget Office currently uses 5.2% as its full employment estimate in its long-term economic and budget forecasts). And tightening labor markets seem to be having a marked impact on long-time languishing, but now suddenly sharply accelerating, wage gains. Average hourly earnings rose a well-above recent trend 0.4% in January for a second straight month, lifting the year/year rate to +3.3%, a two-year high. So in this report we directly saw one high profile measure of “resource utilization” notably tightening. The details of the report suggested another will do so as well in January. Based on the hours worked figures, along with motor vehicle and other industry specific data from other sources, we expect manufacturing output to jump 0.8% in January, which we predict will lift the manufacturing capacity utilization rate — which had already risen slightly above its roughly 79.5% long-term average in late 2005 — another half point to 80.1%. The unusually warm weather is likely to lead to a sharp drop in utility output and thus a much smaller increase in both overall IP and the total industrial capacity utilization rate — but this is clearly just a temporary impact.

And with other economic data released the past week providing yet more evidence of a sharp ongoing acceleration in economic activity that we expect to lead to a big rebound in GDP growth in Q1 — our preliminary forecast is +5.5% — the economy looks set to continue heating up and resource utilization — and attendant business pricing power — to continue rising. Consumer spending looks to be a key driver of the expected upswing in current quarter growth. After the auto-driven plunge in spending from July to October, when real PCE fell at a 5.4% annual rate, demand has picked up dramatically in the most recent three months.

The past week’s personal income and spending report showed real PCE up 0.9% in both November and December — leaving the level of real spending in December already a whopping 3.7% annualized above the Q4 average. And this recovery appears to have extended into January, with both motor vehicle and chain store sales results surprising significantly to the upside. In sharp contrast to an expected drop to a 16.4 million unit annual rate, January auto sales instead jumped to 17.6 million from 17.1 million in December. While much of this appeared to reflect fleet sales to businesses — which would boost investment rather than consumption — consumer sales seem to have posted at least a modest gain. Meanwhile, chain store results from the various national companies overall came in similarly strong. A weighted average we compute of the 30 or so biggest general merchandise, clothing, and drug stores showed aggregate comp-store sales at +5.0%, up from +3.4% in December and the strongest gain since June. Excluding drug stores, sales were +4.8% in January v. +3.1% in December. Industry consensus had been for sales gains of only +3.5% to +4.0%. These sales results pointed to strong gains in categories such as general merchandise and clothing in the January retail sales report, which along with a gain in autos and some price related upside in gas stations, point to a strong January retail sales report. We forecast a 1.1% gain in overall retail sales in January and a 0.8% gain ex autos. Such results would put Q1 consumption on track for a gain of 4 1/2% to 5%, even with only marginal gains in spending in February and March. Combined with likely rebounds in government spending and business equipment and software investment and a much smaller expected drag from inventories as a result of the much lower than expected Q4 inventory outcome, 2006Q1 is on a path to be the second strongest quarter of the entire expansion, lagging only the 7.2% GDP surge in 2003Q3, when the recovery finally moved into high gear a year and half after the official recession end.

There’s very little on the economic calendar in the coming week, and the only key releases, trade and the Treasury budget, aren’t until Friday.

So focus in the Treasury market for most of the week will be on the refunding auctions. Sentiment certainly seems to have shifted on the outlook for supply, at least at the long end. As the Treasury market was getting pounded across the curve the past few weeks amid a flood of corporate, asset backed, and Treasury supply, investors were naturally concerned about how the market would handle the significant amount of duration it would have to take down at this refunding, with the return of the long bond in place of the 5-year. And these fears may have contributed to Treasury’s decision after its primary dealer meetings and consultations with the borrowing advisory committee to come with a refunding package that was more tilted towards the shorter end than we expected — $21 billion 3’s (up $3 billion from November), $13 billion 10’s (unchanged), and $14 billion 30’s (we had expected $20/$14/$15).

But any fears investors or Treasury may have had about demand for duration at the auctions were probably assuaged by Friday. The WI 30-year right out of the gate on Wednesday traded significantly richer than initial expectations, 11 to 12 bp lower in yield than the current long bond. And this premium got even bigger on Friday, when a mad dash for duration starting shortly after the post-employment report sell off massively rallied the long end of the market, with the current long bond rallying 11 bp in two hours Friday morning, even as the WI outperformed to close the day with the roll near -12 3/4 bp.

What to do with bond auctions in 2007 was the only significant new issue raised at the refunding. Treasury indicated that it is sensitive to problems that only having a February/August bond schedule could cause for the STRIPS market and said it will look for ways to address this by possibly (in our view, likely) adding or rotating with a May/November schedule. This could be done in a number of different ways, as discussed by Treasury and noted in the minutes of the borrowing committee meeting.

There could be a shift to four auctions a year. There could be a move next year to a May/November auction schedule. Or next year they could keep the February/August schedule, but issue a 30 1/4 year issue in February (with a May 15, 2037 maturity). The last of these seems the most likely outcome to us, but Treasury indicated they will consult with market participants and wait until the August refunding to announce its plans for 2007 30-year issuance (note that they were clear that there will be no change to this year’s schedule of a new issue in February followed by a reopening in August). If we do end up seeing extremely strong demand for the new issue Thursday, and this continues in the months ahead, a shift to increased issuance in 2007 could become more likely, particularly if 10’s-30’s inverts. The WI 10-year and WI 30-year ended Friday almost right on top of each other, so an inversion could certainly happen as we roll into the new benchmarks next week.

The data calendar in the upcoming week is quite light, with the most closely watched releases likely to be claims Thursday and trade Friday.

The international trade numbers and wholesale trade report on Thursday will continue to fill in the missing data that BEA had to estimate in preparing the advance Q4 GDP report. Based on stronger-than-expected results from the construction spending — with December up 1.0% and November revised up to +0.5% from +0.2% — and factory orders (primarily in nondurable inventories) reports released the past week, we currently see Q4 GDP growth as likely to be revised up to +1.4% from +1.1%. In addition to trade, the Treasury budget will also be released Friday:

* We look for the trade gap to widen marginally in December to $64.5 billion, with imports and exports each up 0.5%. On the export side, most of the upside is expected to come from a rebound in services, which showed an unusual drop in November on sharp declines in travel related categories. Otherwise, the durable goods report pointed to significant gains in non-aircraft capital goods exports, but industry data suggest this should be mostly offset by normalization in aircraft after the post-strike surge seen the prior two months. On the import side, overall energy imports are expected to show a modest further retracement as lower volumes of petroleum products are partly offset by price related upside in natural gas. However, this is expected to be more than offset by moderate gain in other goods imports implied by some acceleration in port activity. Note that our deficit forecast would be about $1 billion narrower than assumed by BEA in preparing the advance estimate of Q4 GDP.

* We expect the federal government’s budget surplus to rise to $15 billion in January from $9 billion a year earlier. A sharp jump in tax receipts appears likely to outweigh higher spending tied to hurricane relief (which is running about $5 billion per month) and the new Medicare prescription drug benefit. Indeed, January estimated tax payments by individuals posted another impressive gain (+18%). Growth in individual withheld and payroll taxes also appears to have accelerated during the month. All in all, it now looks like the budget deficit for the fiscal year as a whole is tracking near $375 billion (or 2.9% of GDP) — versus our prior estimate of $400 billion.

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Korea
Worried about Strong Won?
Feb 06, 2006

Andy Xie (Hong Kong)

Summary & Conclusions

The appreciation of the Korean Won against the dollar is partly normalization from the financial crisis-induced devaluation.  China’s overheating has exaggerated Korea’s trade surplus and contributed to the Won’s appreciation.  Post-crisis normalization may explain two-thirds of the Won’s gain against the dollar in the past three years and China’s overheating another one-third.

Won appreciation against yen and NTD is due to competitiveness gains and is permanent, I believe.  Indeed, I see more room for the Won to appreciate against both currencies in the coming years.

The strong currency has not affected the recovery of capex and consumption in Korea, and the country’s economic cycle remains on an upswing.  But, the strong currency is negatively affecting Korea’s SME sector, and is also complicating the central bank’s monetary policy.

While the central bank may delay rate hikes tactically to discourage currency speculation, I believe it should raise interest rates to neutral levels (4.5-5%) before the year end.  The low interest rate environment may have nurtured an asset bubble, and if the bubble expands too quickly, as in the UK and Australia, the long-term cost could be severe.

Why is Won Appreciating?

Korea’s household or business sector has a low appetite for foreign assets, like Japan, but unlike the Greater Chinese economies.   Hence, the trade balance has a significant effect on Korea’s currency value.

Korea has experienced two waves of sizeable trade surpluses in its history.  The first followed its devaluation of the Won in 1998.  The surpluses were used to pay down foreign debt and shore up its foreign exchange reserves.  The devaluation was the main reason for the surpluses.

The second wave began in 2002 when the global economy began to pick up after the tech bubble burst in 2000.  Korea’s trade surplus surged from 1.5% of GDP in 2002 to 3.8% in 2004 and remained at a high level of 2.9% in 2005.

In addition, the improving returns on capital have been attracting foreign capital into Korea’s stock market.  Its financial account balance had an average surplus of 1.2% of GDP between 2003 and 2005.

The combined surpluses of trade and financial account dropped to 3.3% in 2005 from 5% in 2004.  But, the level is still high enough to exert upward pressure on the currency.

Funding for the trade surplus has mainly come from low investment levels due to an aging population that has decreased investment in job creation and outsourcing opportunities.  Also, the bursting of the credit bubble depressed consumption during the subsequent adjustment period.  These are cyclical reasons for the savings surplus that has funded the surging trade surplus.

Is the Won too strong?

Despite its 22% appreciation from average levels in 2002 when the global economy began to turn up, the Won appears reasonably valued against the US dollar.  In real terms, the current Won/US$ rate is 13% above the average between 1996 and 2005, and 3% below the average between 1986 and 1995, and slightly below the level right before the financial crisis in 1997.

The Won’s appreciation against the dollar in the past three years may mostly reflect the post-crisis normalization; Korea no longer has to discount to raise cash to repair its balance sheet, and its bad debt ratio has fallen to pre-crisis levels.

The global monetary boom has exaggerated demand from China and the US.  Greater China and the US accounted for 46% of Korea’s exports last year.  Obviously, cyclical overshooting in Korea’s biggest customers would exaggerate its trade surplus and put upward pressure on its currency.  This factor could account for one-third of the Won’s appreciation against the dollar in the past three years, I believe.

The Won’s sharp real appreciation against competitor currencies, mainly the yen and New Taiwan Dollar (NTD), deserves serious consideration.  Japan and Taiwan are Korea’s biggest direct competitors.  A major shift in the relative currency values among competitors must be justified by micro fundamentals.  Otherwise, it could lead to serious economic damage to the economy with an appreciating currency.

The real value of the Korean Won vs. the yen is 26% above the average between 1996 and 2005 and 22% above the average between 1986 and 1995.  Similarly, the real value of Korean Won/NTD is 23% above the average between 1996 and 2005 and 25% above the average between 1986 and 1995.

Currency value ultimately depends on the competitiveness of an economy.  Cyclical factors, such as trade and commodity cycles, can affect the currency value temporarily.  Such cyclical factors could not affect the average value of the currency of an economy over the long term.  The Won’s strength against yen and NTD is supported by relative changes in competitiveness among these economies, I believe.

Structural Reasons for a Strong Won

Competitiveness is the same as quantity productivity theoretically but cannot be measured as accurately.   The calculation of labor productivity is easier when improvement is based on rising output quantity per worker per unit of time. 

For example, suppose an economy has a shoe factory and a shoe shop with one worker in each.  The shoe factory makes two pairs of shoes and the shoe shop sells them.  Since the two workers make the same wages in a competitive market, there should be no productivity difference between the two workers.  Let’s assign one unit of productivity to either making or selling one pair of shoes.  The productivity for two workers is 4.

One day, the shoe factory moves to China.  The worker who makes shoes also moves over to sell shoes.  China-made shoes are much cheaper and the demand increases as a result.  Say, the two workers could sell 6 pairs of shoes.  Using the old productivity metric, their productivity is 6 or a 50% increase from the previous situation.

A substantial portion of US productivity gains is the type described above.  This is why productivity studies in the US find so much productivity growth in the country’s retail sector.

When Samsung Electronics makes better mobile phones or Hyundai Motor improves the quality of its cars, it is much more difficult to measure domestically.  The domestic market is saturated with both and the sales are driven by replacement rather than new demand.  Hence, the domestic sales do not rise with improving quality, that is, both quality and price are not sensitive to quality improvement.

In the export market, the quality improvement should be accompanied by market share gains.  But, such gains cause a trade surplus and currency appreciation.  The latter offsets the quality improvement and reverses the market share gain.  Over time, statisticians cannot find any way to measure the quality improvement.

Financial markets have learned to arbitrage capital returns to find the equilibrium currency value when competitive landscapes are changing.  When Korean companies have a much higher profitability than their Japanese counterparts in similar businesses, the currency market will lift the value of Korean Won against yen.  The equilibrium is achieved when the profitability gap becomes too small to matter to alter financial flows.

Cyclical Reasons for a Strong Won

China is the most important cyclical reason for the strong Won.  Korea’s surging trade surpluses could be attributed entirely to China’s boom.  Korea’s trade surplus with Greater China (Mainland China, Hong Kong, and Taiwan) increased from US$16.6 billion in 2002 to US$39.7 billion in 2005, while the trade balance with the rest of the world went from -US$6.3 to -US$16.2 billion during the same period.

Korea’s success in China is due partly to its competitiveness gains.  The Korean discount was never a major issue in China.  As China grows larger, Korea’s pricing power improves on average.  A big part of Korea’s China success is cyclical.  The booming demand for expensive Samsung mobile phones, POSCO’s steel, or Hyundai’s cars is due partly to China’s credit boom that its export success and hot money inflow have fueled.

I believe that China’s overheating may have contributed to one-third of the Won’s strength against the dollar in the past three years.

No Need to Panic

The negative effect of a strong Won has been limited so far.  Corporate profitability remains quite high, exports are still experiencing healthy growth rates and the threat of deflation is still distant.  Further, consumption and capex are both recovering from the depressed levels in the past two years.  It will lead to import acceleration and, hence, reduction in the trade surplus.  The pressure on the currency, hence, should ease in the coming months.

The tension is most pronounced among Korea’s small- and medium-sized enterprises (‘SME’s’).   A vast number of Korea’s SMEs engage in international trade.  Unlike the large companies, they have not improved their competitiveness and, hence, cannot deal with the currency appreciation by raising prices or increasing production efficiency.  Their leverage is high.  One-quarter of Korean SMEs may already be having trouble making interest payments on their debt.

The Korean government obviously intervened in the currency market in January.  Korea’s foreign exchange reserves jumped US$6.5 billion in the month compared to less than a US$1 billion increase per month in 2005.

I believe that intervention in the currency market is justifiable under some circumstances.  When speculation threatens to change the trajectory of an economy, the intervention is necessary.  However, intervention must be done convincingly and should not be a half-hearted effort that only delivers speculators more profits.

The strong Won is not yet disruptive to the Korean economy, I believe.  The SME problem is a serious political issue, in my view, but, as capex and consumption recover, there will likely be employment opportunities for workers to shift to the big business and service sectors.  In the end, Korea’s SME sector will need to become smaller and more competitive to survive the global competition.  Keeping the Won low to offset this sector’s weakness may be counterproductive in the long run.

Complications for Monetary Policy

The strong currency has complicated Korea’s monetary policy.  Korea’s interest rate should be much higher at around 4.5-5% compared to 3.75% currently.  The adverse result of the low interest rates is not inflation, but rather asset bubbles, I believe.

According to EIU, Seoul has surpassed Hong Kong and Singapore to become the most expensive city in Asia ex-Japan.  While this cost of living index is biased for expatriates, its sudden surge often indicates a bubble situation.  The price of Seoul properties is already above those in Singapore and similar to prices in Hong Kong or Tokyo.  These comparison cities have wages 50-100% above Seoul’s.

Low average inflation and surging prices for products and assets that rich people enjoy are hallmarks of asset bubbles.  Asset bubbles are difficult to sustain in a high inflation environment due to the diversion of money supply into the real economy.

The bursting of Korea’s credit card bubble kept interest rates low, which contributed to the expansion of the property bubble, I believe.  Seoul’s apartment prices increased by 10% YoY but rent dropped by 3.6% YoY in 2005.  While the data is not yet alarming, the trends are worrying.  If interest rates are kept low, the situation could get out of hand, as in the UK or Australia.

As consumption and capex recover, the Bank of Korea has a great opportunity to normalize interest rates at 4.5-5% as quickly as possible to keep asset prices stable.  But, the Won’s strength deters the central bank from raising interest rates too quickly.  The currency market could become too speculative if the interest rates rise too rapidly.

Tactically, it is reasonable for the central bank to delay raising interest rates when the Won is appreciating too quickly.  However, the central bank should raise interest rates to neutral levels before the end of the year.  The long-term cost of an inflating asset bubble is just too high to tolerate.

The asset bubble or at least exceptional buoyancy results from low interest rates and ample liquidity.  The high trade surpluses, due to a combination of strong global demand and surging competitiveness, have caused the bubble-prone liquidity environment.

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