Rebalancing Made in Japan?
Feb 10, 2006
Stephen Roach (New York)
Investors tell me that Japan is on fire. And on the surface, it certainly seems white hot -- a stock market that is up some 50% since the spring of 2005 and an economy that our Japan team believes surged by at least a 7% annual rate in the final quarter of calendar year 2005. If that Chinese-style growth outcome comes to pass, Japan would instantly qualify as the fastest growing economy in the industrial world -- an extraordinary reawakening for Asia’s long-slumbering giant. The global implications of this development cannot be minimized: Can the world’s second-largest economy lead the way in the rebalancing of a still unbalanced global economy?
In answering that question, it helps to know where Japan has come from. Significantly, the recovery in the Japanese economy has not materialized out of thin air. After more than a dozen years of 1% real GDP growth, the economy first moved into a 2-3% growth channel beginning in 2003, and then accelerated to a 3.9% average annual pace in the first three quarters of calendar 2005. If our Japan team’s 4Q05 estimate is even close to the mark, the steady increase in momentum now seems to have moved into rarified territory. According to Takehiro Sato, our resident Japan watcher, the gains in the period just ended showed a Japanese economy firing on all cylinders -- external as well as internal demand, with the latter driven by especially impressive gains in private consumption, residential construction, and business capital spending (see his 31 January dispatch, “Japan: On Top of the World”). For my money, the most important element in this equation is Sato-san’s estimate that Japanese consumption growth may have exceeded 5% in the period just ended, pushing the year-over-year growth rate in real consumer demand to 3.6%. It would be one thing if Japan’s reacceleration were driven largely by external demand or autonomous investment. But when the consumer finally steps up, it’s a different matter altogether insofar as multiplier effects to other sectors of the economy are concerned. A sustained pickup in Japanese consumption could also be a very welcome development for the global economy. The key here is the import side of the Japanese growth equation -- the transmission of domestic growth to any country’s trading partners -- and whether Japan’s revival of internal demand is sourced mainly at home or partly through foreign production. Historically, Japan has been a very closed economy. The import share of its GDP averaged only about 7% from the mid-1980s thorough the mid-1990s -- about half the shares in the rest of the industrial world over this period. In recent years, however, Japan has done a dramatic about-face in embracing the efficiency solutions of low-cost offshore production. The import share of its economy has moved up appreciably in response -- rising above 12% in late 2005. Rising import penetration holds out the hope that a revival in Japanese internal demand spells heightened export impetus to the rest of the world -- moving Japan to center stage as potentially a new engine of global growth. But there has been an important shift in the mix of Japanese imports in recent years that has altered the transmission mechanism between Japanese internal demand and its traditional trading partners. As recently as 1999, the US had the largest share of Japanese imports -- implying that America would benefit the most from accelerating Japanese growth. That is no longer the case. The US share of total Japanese imports has fallen from close to 25% in 1999 to only about 13% today. The reason -- a stunning surge of Chinese imports. Japan’s purchases of goods from Greater China (the PRC plus Hong Kong) have risen from just 5% of its total imports in the early 1990s to about 22% today. The share of Japanese imports coming from Europe has also drifted down in recent years to about 11%, but it has been on a much gentler downward trajectory than the rapidly plunging US portion. The shifting character of Japan’s imports -- both their increased share in overall Japanese GDP as well as the rebalancing of the import mix away from the US toward China -- has important implications for the broader global economy. Import channels don’t change over night. A lot of effort goes into the establishment of supply chains, distribution networks, and service operations -- underscoring the inertia of foreign sourcing patterns. It is hard and very costly to rip out one system (i.e., the low-cost China link) and replace it with another (i.e., the higher-cost American option). That means that the mix of Japan’s import demand is likely to remain something quite close to its current configuration in the years immediately ahead. Consequently, to the extent that Japan is able to sustain its recovery in domestic demand -- and in the import content of that demand -- most of the incremental benefit would undoubtedly flow to China and Asia’s increasingly China-centric supply chain. By contrast, that would leave US and European exporters largely on the outside looking in with respect to their opportunities to share the spoils of Japan’s economic recovery. This has the potential to be a very important development on the road to global rebalancing. On the surface, Japan’s gathering recovery is good news for an unbalanced world. And it comes just in the nick of time. With the asset-dependent American consumer starting to fray around the edges as the US housing market cools, a restarting of the growth engine of the world’s second-largest economy is an especially welcome development. Yet, ironically, Japan’s long-awaited economic recovery may do little to temper the world’s largest and most serious imbalance -- America’s gaping current account deficit. That’s because American exporters have suffered a stunning loss of market share in Japan to China’s ever-ubiquitous producers. As a result, the import content of recovering Japanese domestic demand seems likely to be made increasingly in China rather than in the US. This underscores what has long been the single most worrisome aspect of America’s current account imbalance -- that there is little hope for a fix from the export side of the equation. With US imports currently running nearly 60% greater than exports, an export-led fix for the US current account problem was always a stretch. The loss of market share in Japan by American exporters makes that even more of a stretch. That underscores the obvious -- that import compression is the only realistic hope for a meaningful US current account adjustment. And, of course, the obvious way for that to happen would be through a sharp reduction in the excesses of asset-dependent US consumption -- the one economic development that the rest of the world dreads the most. Japan’s turnaround is nothing short of stunning. As the momentum of its economic recovery builds, the world economy will benefit from a long-overdue restarting of another growth engine. But don’t count on Japan to fix the world’s imbalances. That’s a task that remains very much in the court of the most unbalanced economy of all -- the United States.
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Business Conditions - Consolidation or Slowdown?
Feb 10, 2006
Shital Patel (New York) and Richard Berner (New York)
Our monthly analysts’ canvass to assess business conditions presented a web of disconnects in early February. Following a dip in January, the headline Morgan Stanley Business Conditions Index (MSBCI) declined another 4 points to 54%, a level last seen in June, and advance bookings slipped. But capital spending and hiring plans rose sharply, pricing and credit conditions improved, and the breadth of business conditions was unchanged. Judging by the headline result — which is derived from a separate question about business conditions and is not a composite constructed from subindexes — business looks softer. And while the less-volatile three-month moving average edged down by only one point to 60%, still above the long-run average of 58%, this decline certainly challenges our outlook for above-trend growth in 2006. Nonetheless, we think it represents a temporary consolidation in business conditions, and not a new downtrend in growth. Here’s why. Fundamentally, a consolidation at this point shouldn’t come as a surprise. Following the shock from the hurricanes and spike in energy quotes, demand-side and production data show that business recovered strongly through December and into January. To some extent, that rebound’s vitality was unsustainable. And recent geopolitical uncertainty may have been the catalyst for a pause. Consequently, our surveys are a mix of bad and good news. Let’s start with the bad news: Future activity appears to be under pressure according to our advance bookings index. While the 16-point decline in that gauge is ominous on the surface, we would not place too much emphasis on the February reading. First, part of the decline is purely seasonal (in systems and PC hardware) and part is due to the long-awaited and overdue deceleration in mortgage originations. Second, the composition of the sample this month also contributed to the decline. Several analysts use company guidance which is provided once a quarter to determine whether bookings are higher, lower, or unchanged. During the interim months, most analysts respond “I have no data on advance bookings for the companies I cover” which we count as a non-response. Such a treatment yields big swings in our results, as occurred in the summer of 2004— when the economy grew strongly. Now for the good news: Supporting our thesis that there is pent-up corporate capex demand, fully 61% of analysts reported that companies under their coverage plan to increase capital spending over the next three months, the highest percentage in the history of the question. Of these, nearly one-third plan to increase by 6% or more. While plans to increase capex may only benefit certain sectors such as industrials and IT, the spenders are spread broadly across industries, and these plans echo the rise in CEO confidence in future business activity. Indeed, the Conference Board’s measure of CEO confidence rebounded by 6 points to 56% in the fourth quarter. Likewise, our canvass showed improved hiring plans in early February. In addition, pricing power remains solid for the industries covered in our survey, as the pricing conditions index edged up one point to 70%. More important, the largest percentage of analysts in the history of the question noted that companies under their coverage raised prices charged compared to a year ago. And the balance between prices charged and costs improved: Only 33% of respondents noted that unit material and/or labor costs have outpaced prices charged at companies under their coverage over the past three months; down from 41% last month. Given those factors, we were mildly surprised that fewer analysts reported that margins increased compared to a year ago — 30% versus 44% in January. While pricing power is a key ingredient in our forecasts of earnings and margins, it apparently wasn’t a factor this month; more likely, margins are slowly flattening as operating leverage fades. The breadth of business conditions was virtually unchanged in early February: 32% of analysts noted improved business conditions, up from 31% last month. However, 23% noted deteriorated conditions, up from 17% in January. By industry, only four of 10 sectors had improved business conditions compared to last month, while five had unchanged conditions. Conditions improved on the margin for the financials, industrials, and materials sectors, and improved outright for the consumer discretionary group. Conditions deteriorated for the IT sector, but as noted, some of that is seasonal. More interesting, the services sub-index sank to 48% from 57%, below the 50% threshold. The manufacturing index, representing slightly over one-third of the sample, fell five points to 53%. Bookings: Missing Pieces? The advance bookings index sank 14 points to 54% in early February. This comes as quite a surprise since recent data on capital goods (excluding defense and aircraft) and other orders came in stronger than expected, the ISM manufacturing new orders index has also remained strong, and anecdotal evidence seemed robust. However, comparing our advance bookings to these indicators may be misleading. In our most recent survey, services accounted for nearly 60% of the sample; correspondingly, the new orders index in the January ISM non-manufacturing survey declined 5.5 points to 54%, the lowest level since April 2003. However, we believe that nonresponses exaggerated the decline in our canvass and plan a solution for next month’s survey. Groups that noted lower bookings included financials and IT, while consumer discretionary, materials, industrials, and telecom services noted higher orders. Financing: Easier Despite Fed Tightening In our view, financial conditions are still highly supportive of growth, despite Fed tightening, and our survey results offer evidence. The financial conditions index increased one point to 55%. Also, only 5% of the respondents note that financing has become more difficult to obtain, down from 18% last month; 14% noted that financing was easier to obtain. This squares with the Fed’s most recent Senior Loan Officer Survey, which reported a further net easing of lending standards to large and middle-market firms. Capex Plans Robust Capex plans in our survey are finally supporting our thesis that pent-up demand for capital spending is still strong. In early February, 61% of respondents reported that companies under their coverage plan to increase capex over the next three months, up from 54% last month. Fully 30% of these groups plan to increase spending by 6% or more. Plans to step up spending were strongest for the industrials, energy, utilities, telecom services, materials, consumer staples, and IT sectors, although all sectors had at least one group with plans to increase outlays. The energy exploration and production, trucking, and Internet, PC software and interactive entertainment companies plan to increase capex by 10% or more. Hiring Plans Recent hiring trends remained virtually unchanged in early February as the percentage of groups that hired over the past three months declined only one point to 30%. 20% of the groups were still cutting payrolls, near the December and January levels. Significantly, however, the percentage of groups with plans to hire over the next three months increased nine points to 34%, while the percentage of groups with plans to cut declined by one point to 14%. Plans to hire were most notable in the industrials and IT groups. Challenges: Pricing Power Remains but Margins Flattening Slowly The pricing conditions index increased one point to 70% in early February. While this is six points below the peak reached in October 2005, that high level largely reflected surging energy and building materials quotes; these data confirm that pricing power is still alive and well. In fact, 64% of respondents noted that prices charged increased from a year ago, the highest percentage in the history of the question. The magnitude of increases also improved as a full 34% of respondents noted that prices increased by 3% or more, also the highest level in the history of the question. However, the dispersion of price changes is increasing, partly offsetting the price hikes. Nearly one-quarter of respondents noted that prices have declined compared to a year ago; this is the highest percentage since June 2005. While price declines were mostly confined to the IT and telecom sectors, the survey shows that auto and auto-related manufacturers, retail softlines, and mid-cap banks also suffered from pricing losses. As pricing power remained strong, the balance between prices paid and received improved last month. While the percentage of respondents noting that prices charged outpaced unit costs over the last three months remained virtually unchanged at 35%, the share of analysts noting that material and/or labor costs are outpacing prices declined to 31% from 40% in January. Nonetheless, the percentage of groups with higher margins compared to a year ago stood at 30%, down sharply from 44% in January. Similarly, the percentage of analysts noting that margins were lower increased to 39% from 29% last month. Fading operating leverage or a slowing in volume, as measured by the advance bookings index, may be part of the cause. Margins were generally higher for the industrials, healthcare and materials sectors. But margins appear to be under pressure for the consumer discretionary, consumer staples, financials, IT, telecom services, energy, and utilities groups. The consumer discretionary, consumer staples, and utilities sectors are suffering from margin compression. Labor costs are outpacing prices charged at the telecom services companies. Analyst Commentary by S&P Major Sector Consumer Discretionary: Business conditions continued to improve for the consumer discretionary group. Financing was more difficult to obtain for the publishing groups although bookings were higher and companies plan to increase hiring notably over the next three months. Although prices charged increased for over half the groups, margins were lower compared to a year ago for all groups except restaurants. Over the past three months, unit material costs have risen faster than prices charged for most groups. Consumer Staples: Conditions remained unchanged for the consumer staples sector this month. No groups plan to expand payrolls, although there are plans to increase capital spending. Prices charged increased compared to a year ago. Margins were flat to lower for the sector, and unit material costs have outpaced prices charged over the past three months. Energy: Conditions were unchanged for the exploration and production companies. While they have no plans to increase hiring, companies are planning to increase capex by 10% or more over the next three months. Prices charged increased by 3% or more compared to a year ago although margins were lower. However, over the past three months, prices charged have increased faster than unit costs. Financials: Business conditions improved marginally for the financials sector. Conditions improved for the brokers and asset managers, multifamily REITs, non-life insurance, emerging specialty finance, and financial guaranty companies, but deteriorated for large- and mid-cap banks, processing banks, life insurance, and mortgage finance companies. Both the brokers and asset managers and multifamily REITs plan to increase both hiring and capex over the next three months, while the retail REITs and mid-cap banks plan to increase only capex. Although “prices charged” increased over the year for most groups, higher interest rates have squeezed margins. Margins have increased for the brokers and asset managers and non-life insurers as they raised prices and commissions. Over the past three months, there was an equal distribution of groups that had higher, flat, and lower margins. Healthcare: Conditions remained unchanged for the healthcare group. Over half the groups plan to increase hiring somewhat over the next three months, although biotechnology was the only group planning to increase capex. Compared to a year ago, prices charged increased by 3% or more for over half the groups and margins are flat to higher. Pricing conditions are unchanged over the past three months, as all groups noted that margins are flat to higher. Industrials: Business conditions improved on the margin in early February and bookings increased for the business services and machinery companies. Two-thirds of the groups have plans to increase hiring over the next three months while all plan to increase capex. The machinery and trucking companies have plans to increase capex by 6% or more. Prices charged and margins are higher for all groups compared to a year ago. However, performance over the last three months is mixed. Prices charged have increased faster than unit costs for the railroads and electrical equipment manufacturers, and they increased at the same pace for the machinery and trucking companies. Information Technology: Business conditions deteriorated from improved conditions last month, and only two groups noted higher bookings (semiconductors and IT services). However, hiring and capex plans improved compared to last month. Half of the groups plan to increase hiring, and slightly more than half plan to increase capex over the next three months. Prices continue to decline for over half of the groups compared to a year ago, and costs are beginning to catch up. In January most groups noted that margins were higher compared to a year ago. This month, all but one group noted that margins were either flat or lower. Over the past three months, margins have been flat for most groups. Materials: Business conditions were improved on the margin for the materials group. Only the US coal companies plan to hire over the next three months, while all groups except the homebuilders plan to increase capex. Prices charged have increased by 3% or more from a year ago for all groups, although these price increases were only able to cover increases in costs for the US coal companies and homebuilders; margins were flat for the specialty and commodity chemicals manufacturers. However, over the past three months, prices charged are outpacing unit costs for all groups with the exception of the coal companies. Telecommunications Services: Business conditions were unchanged in early February from deteriorated conditions. While the sector has no plans to increase hiring, both wireless and telecom services companies plan to increase capital spending. Prices charged continue to decline for the group. Simon Flannery notes that margins are only rising at companies that have participated in M&A activity. Utilities: Conditions were unchanged again for the electric utilities. Higher input costs are beginning to squeeze margins at the electric utilities.
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Will the BoJ's Ending QE Cause a Collapse in USD/JPY?
Feb 10, 2006
Stephen Jen (London)
No, Is My Short Answer In this note, I examine the monetary mechanisms associated with the prospective policy changes by the BoJ and assess the likely implications for USD/JPY. In theory, termination of QE should not have any effect on USD/JPY. However, ending ZIRP could be a JPY-positive event, given certain circumstances. First, Our Central Case View on Timing According to our Japan economist Takehiro Sato, the BoJ may terminate QE at their monetary policy meeting on April 28, but ZIRP will not be ended until a year later − Q2 2007. Cold Turkey Versus Gradualism In ending QE, the BoJ has essentially two choices: do this ‘in one go’ or pursue a gradual approach. However, it is almost certain that the BoJ will opt for a more gradual approach, rather than running the risk of shocking the system. If they opt for gradualism, then ending ZIRP could not be an option within the next six months, because it would take that long just to get the high-powered money to a position to allow the BoJ to tighten. Understanding the Basic Effects of QE The primary goal of QE was to commit to ZIRP being kept in place for a sustained period of time, rather then creating broad money. To see what could happen when QE is lifted; it may be useful to think through the balance sheets of the BoJ and the banking system. On the assets side of the BoJ, the two key components are JGSs and bills. On the liability side, we have the CAB, banknotes and others. CAB is composed of required reserves from the banking system, deposits from the Japan Post and, the leftover, excess reserves. The issue is when and how to purge excess reserves. On the asset side of the banking system’s balance sheet, there are loans, JGB holdings and other asset holdings, such as equities. The key component on the liability side consists of deposits. What Happens When QE Is Terminated? • Point 1. The pure policy effect. Ceteris paribus, if the BoJ ends QE by running down its short-term JGS holdings, it would be withdrawing liquidity from the market as JGS would need to be absorbed by the rest of the economy. General deposits at banks may decline, but certainly not one-for-one. This then implies that part of the asset side of the banking system’s balance sheet would need to be offset by more loans or JGS holdings. The ‘substitution’ effects between different assets that banks hold should be more powerful than the effect of a shrinking balance sheet for the banking system. If the long-term bond yield in Japan does not rise too much, it is difficult to see a definitive effect on USD/JPY. • Point 2. What if the economy continues to grow? Now, adding an increase loan demand, the substitution effect should be most dominant. If loan demand recovers fast enough, we could see banks switching away from JGBs into loans. The yield curve steepens in Japan. USD/JPY may come under downward pressures in this case. But the intensity of these pressures will depend on Japanese investors’ appetite for risk In sum, if QE ends before the demand for loans really starts to grow, as it seems to be the case, there should be minimal downward pressures on USD/JPY. However, if the BoJ is behind the curve, which seems unlikely, we could see downward pressures on USD/JPY. • Point 3. The market’s presumptions are also important. After the BoJ’s adoption of QE, there was a prevalent, but erroneous, view in the market that excess liquidity must be negative for the JPY. Many investors tried to buy USD/JPY on this false logic. If investors still believe the notion that ending QE is monetary tightening, some may try to short USD/JPY. This will be the number one risk to USD/JPY in the next couple of months. Since USD/JPY is overvalued, downside risks could be meaningful. • Point 4. Ending ZIRP is a more serious issue for USD/JPY. Removing excess liquidity should not have a major impact on USD/JPY, except for the possible psychological effects. However ending ZIRP will be an important event for USD/JPY, both mechanically and psychologically. Raising the opportunity cost of cash, in an environment where demand for loans is growing, would be genuine monetary tightening and be negative for USD/JPY. Bottom line Ending QE should not, in theory, lead to a strong JPY. But the fact that USD/JPY is overvalued and investors may treat ending QE as ‘monetary tightening’ means we could see modest downside risks to USD/JPY. Any fall in USD/JPY will only be significant and sustained if Japanese investors fundamentally alter their view about foreign bonds.
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Misreadings
Feb 10, 2006
Serhan Cevik (London)
Cold weather and the rise in energy prices pushed the headline inflation rate higher. The consumer price index posted a month-on-month increase of 0.8% in January, bringing the annual inflation rate from 7.7% at the end of 2005 to 7.9% at the beginning of this year. The latest reading, a touch higher than the consensus estimate of 0.6%, is in line with our forecast profile and reflects just a temporary pause in disinflation. Adverse weather conditions, pushing the food component of the CPI basket by 1.3%, and the lagged effect of higher crude oil prices made a significant contribution to the pick-up in inflation rates. In addition to seasonal and weather-related upward pressures on food prices, administrative decisions led to a 4.7% increase, following a 27.9% rise last year, in the prices of alcoholic beverage and tobacco products. Similar to the behaviour of consumer prices, the increase in agricultural prices and higher energy quotes resulted in a 2.0% surge in the producer price index that pushed the year-on-year inflation rate from 2.7% at the end of last year to 5.1% in January. However, these are one-off factors, in our opinion, and do not alter Turkey’s secular disinflation process and the direction of interest rates. Core price indices continue presenting a benign — indeed, encouraging — inflation outlook. The latest set of price indices shows no indication of either supply- or demand-side inflationary pressures in the Turkish economy. As argued above, administrative price adjustments (such as a 9.7% increase in tobacco prices) and higher energy quotes around the world (which resulted in a 17.7% increase in electricity and natural gas prices in Turkey) account for more than two-thirds of the increase in ‘headline’ inflation rates. Indeed, core price indices continue presenting an encouraging inflation outlook. For example, the ‘core’ CPI, excluding food, energy and administered prices and indirect taxes, posted a 0.2% month-on-month drop that lowered the year-on-year reading from 6.6% in December (and 9.9% at the end of 2004) to 6.3% in January. Therefore, beyond the adverse — and hopefully temporary — effects of cold weather and higher energy quotes, core price indices remain in line with the central bank’s multi-year inflation targets. The globalisation of disinflation cushions against the energy shock. Although the intensity and duration of the energy shock has been extraordinary, the more interesting development is its limited effect on other prices. We reason that the emergence of new economic powerhouses around the world has led to a breakdown in ‘traditional’ links between commodity and energy quotes and consumer prices. In the case of Turkey, the deepening integration with the global economy and the normalisation of the macroeconomic landscape have created fierce competitive pressures that force companies to keep a tight lid on unit labour costs (see The Wal-Mart Effect Without Wal-Mart, January 30, 2006). For example, clothing prices in the CPI basket posted a year-on-year decline of 1.4% in January, down from 7.7% at the end of 2004. Of course, inflationary inertia and relative price adjustments in sectors close to competition limit the pace of disinflation and bring new challenges. Nevertheless, structural shifts and the moderation of business cycles keep Turkey’s disinflation process on track towards price stability. Investment growth and productivity improvements keep expanding the production frontier. The spectacular drop in inflation from an average of 77.5% in the 1990s to less than 8% of late is not an illusion but an outcome of prudent policies and structural adjustments in the economy. One of the key factors driving this ‘miraculous’ process is fiscal consolidation, which has finally made the Treasury a net debt payer. As expected, the end of fiscal dominance, gauged by public-sector borrowing requirement, has reversed the crowding-out effect and now supports robust investment growth in the business sector. In other words, given the state of the labour market and growing influence of global supply chains, the rise in Turkey’s capital/labour ratio should keep expanding the production frontier and the growth rate of labour productivity at an above-trend pace. And, unsurprisingly, the resulting output gap and drop in unit labour costs should outweigh inflationary pressures stemming from higher energy prices and drive inflation lower. The structural break in Turkey’s inflation history will lead to further compression of interest rates. Central banks, unlike market participants, should always be cautious, but that does not mean overlooking fundamental changes for the sake of tradition. The Central Bank of Turkey is a good case in point. Despite the trauma of political and economic shocks, it has acknowledged the structural break in inflation dynamics and responded by lowering short-term interest rates from 44% at the end of 2002 to 13.5% last year. Arguably, the pace of monetary easing could have been faster, but the policy rate now stands at an appropriate level, in our view. Looking forward, the monetary policy path depends on a set of possible exogenous factors as well as economic fundamentals. However, we believe that the spike in energy prices will not have lasting effects and Turkey’s inflation rate will come down to 4.5% at the end of 2006. That should allow the central bank to keep the policy rate steady at 13.5% in the first half of this year and then start lowering towards 12.0% by the end of the year.
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