United States
Business Conditions - Forward-Looking Signs Point to Improvement
Mar 17, 2006

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

Current business conditions deteriorated slightly in early March, according to our most recent survey of Morgan Stanley research analysts.   Extending the decline in business conditions since December, the headline Morgan Stanley Business Conditions Index (MSBCI) slipped one point to 53%, and the less-volatile three-month moving average declined by an even-steeper five points to 55%. 

It’s too soon to herald the much-sought-after soft landing, however.  We’ve long expected a spring “payback” in the pace of business activity for the strength late last year and early in 2006.  More important, four key details of our canvass suggest that business conditions are poised to rebound:

(1) The composition of results implies that conditions aren’t really “deteriorating”.  Only 11% of analysts noted that conditions actually deteriorated compared to a month ago while a record 68% noted that conditions remained unchanged.

(2) The 22 point surge in the advance bookings index portends an improvement in future activity. 

(3) Confidence in future conditions is echoed in plans to increase capex and hiring over the next three months.  Fully 62% of analysts noted that companies plan to increase capex while 36% noted plans to increase hiring.

(4) The inaugural edition of a business conditions expectations index registered a healthy 62%.   Moreover, 45% of analysts believe that business conditions will improve in their industry groups over the next six months.  We won’t overemphasize this single data point, but we will be monitoring it closely in the future. 

This pattern — soft headline results but stronger underlying details — echoes the early-March readings from the Philadelphia Fed’s Business Outlook Survey.

Pricing power remains strong for the industries covered in our survey, as the pricing conditions index fell two points to a still-sturdy 68%.   However, companies’ ability to pass along cost increases dwindled over the past three months.  Only 20% of analysts noted that prices charged increased faster than unit costs, down from 33% last month.  The implied margin compression is hardly surprising; we and our US equity strategy colleagues have been expecting it for more than a year.  Importantly, the Street’s sell-side analysts are starting to buy the story: They now expect that 64% of companies in the S&P 500 will see rising margins in 2006, down markedly from the 83% forecast in mid-October of last year. 

Looking across industries, business conditions were mostly unchanged in early March, with over two-thirds of respondents (68%) reporting that business conditions have not changed compared to last month.  This month, only 21% of analysts noted improved business conditions, down from 32% last month and a high of 52% last August.  But only 11% noted deteriorated conditions, down from 23% in February.  The improvement in business conditions was restrained by the services groups, which accounted for two-thirds of the sample this month: The services index increased by only four points to 52%, while the manufacturing index increased 10 points to 63%.  While most industry groups reported unchanged conditions, conditions improved at the margin for the consumer discretionary, consumer staples, healthcare, and materials sectors.  The energy group noted some deterioration in business conditions.

Bookings: Strong Rebound

The advance bookings index surged 22 points to 76% in early March, regaining all of the ground lost since November.  This recovery in orders suggests that the slowdown in business conditions may soon be over.  While we often compare our index with the manufacturing ISM diffusion gauge, that comparison may be misleading; the composition of our survey sample is generally two-thirds services and one-third manufacturing.  Like ours, the ISM non-manufacturing new orders index declined nearly eight points between August 2005 and February 2006.  Last month, the large cap bank group was the only one to note lower bookings, while bookings were strongest for the industrials and IT groups.  Last month, the IT group noted lower bookings.

Business Conditions Expectations: Tentative Strength

This month for the first time we asked analysts about their expectations for business conditions among the companies/industries they cover over the next six months.  In early March the diffusion index stood at 62%.  Moreover, 45% of analysts believe that business conditions will improve over the next six months, compared to only 21% who believe that business conditions have improved over the past month.  In contrast, 21% believe that business conditions will deteriorate.  While we hesitate to draw conclusions from a single data point, this business conditions expectations index, along with the rebound in the advance bookings index, is a positive development.  All sectors except energy, telecom services, and utilities expect conditions to improve.

Capex Plans Remain Robust

We think that pent-up demand for capital spending is still strong, and survey results this month confirm our thesis.   In early March, 62% of Morgan Stanley analysts reported that companies under their coverage plan to increase capex over the next three months, up from 61% last month.  Over one-third of these groups plan to increase spending by 6% or more.  Corroborating our results, a larger proportion of small business owners are planning to increase capital expenditures over the next three to six months.  In February, according to the National Federal of Independent Business, 35% of firms plan to increase capex, up from 29% in October. 

Plans to step up spending among firms our analysts cover were strongest for the IT, industrials, energy, utilities, telecom services, materials, and consumer staples groupings, although all sectors had at least one group with plans to increase outlays.  The oil services and drilling, machinery, steel, and Internet, PC software and interactive entertainment companies plan to increase capex by 10% or more.

Hiring Plans Gradually Strengthening

We also believe that pent-up demand for hiring persists.  As evidence, plans to hire increased two points in early March to 36%, whereas 19% of the groups plan to cut payrolls.  Plans to hire were most notable in the industrials, IT, energy, financials, and consumer discretionary sectors.  Recent hiring trends improved notably as the percentage of groups that hired over the past three months increased nine points to 39%.  The percentage planning to cut payrolls dropped to 17% from 20%. Results from other popular surveys, including the Manpower Employment Outlook Survey, buttress these data.  According to Manpower, 30% of surveyed employers plan to increase hiring, up from a low of 20% in 3Q03.

Challenges: Pricing Power Remains but Margins Flattening Slowly

The pricing conditions index decreased two points to a still-strong 68% in early March.   57% of respondents noted that prices charged increased from a year ago, down from 64% last month, while only 21% noted the prices charged decreased, down from 23% in February.  Strong pricing was prevalent in all groups except IT and telecom services.  We believe rising industrial operating rates, a lower jobless rate, and a narrowing gap between actual and potential GDP have helped US firms recapture pricing power, so substantial slippage seems unlikely. 

The slight moderation in pricing power may have hurt margins over the last three months.   Fully 40% of analysts noted that material and/or labor costs outpaced prices charged over the last three months, up from 33% last month.  Similarly, only 20% of respondents noted that prices charged increased faster than unit costs, down from 33% last month, while 40% of analysts noted that prices charged are increasing at the same pace as unit costs. Margins appear to be under pressure for the consumer discretionary, financials, IT, materials, and telecom services sectors.  However, over half of the groups (53%) had higher margins compared to a year ago, up from 30% in February.  Only 23% of analysts noted that margins were lower, compared to 39% last month. 

Higher Interest Rates: Friend or Foe?

This month we asked analysts whether higher long-term interest rates would affect business.   A full 43% of analysts noted that higher rates would hurt business, while only 19% said that higher rates would help.  Of the 38% of analysts that said there would be no effect, most noted that their companies are underlevered and others noted that companies have already locked in low rates.  Higher interest rates will help certain industries by either acting as a barrier to entry, as for the oil service and drilling companies, or increasing interest income on cash balances, particularly for the IT companies.  High interest rates will do the most damage to the consumer discretionary, industrials, materials, and utilities companies. 

Financing: Higher Rates Not Yet Taking Their Toll

The financial conditions index decreased three points to 52%, although higher long-term rates haven’t tightened conditions yet.  Only 6% of the respondents noted that financing has become more difficult to obtain and 11% noted that financing was easier to obtain.

Financial Leverage

It is no secret that leverage has been declining since mid-2002.   According to our credit strategy team, the median debt to LTM EBITDA (last 12 months earnings before interest, taxes, depreciation, and amortization) ratio has plummeted nearly 0.7pp to 1.84 in 4Q05 and our equity strategy team notes that only 5 industry groups had year-over-year rising leverage in 3Q05.  This month we asked analysts where they believe financial leverage is headed over the next six months.  For all the talk of levering the capital structure, CFOs apparently are staying conservative: Nearly a quarter (23%) of respondents said that financial leverage will go up while 17% said leverage will go down.  The industries taking on more debt were concentrated in the financials, consumer discretionary, healthcare, and IT sectors. 

Leveraged Buyouts and Private Equity Activity

Given the relatively small percentage of analysts who believe that financial leverage will increase over the next six months, we were surprised to see that a full 63% of analysts expect LBO and/or private equity activity to increase.  Only 26% noted that there hasn’t been any activity and will not be any over the next six months.  While all sectors have at least one industry that will likely participate in LBO or private equity activity, analysts expect nearly every group within the IT and healthcare sectors to have some activity.  According to FactSet, the communications, banking and finance, retail, brokerage, investment and management consulting, and leisure and entertainment industries have accounted for nearly 60% of total M&A activity so far this year.

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Euroland
The Insider Disease
Mar 17, 2006

Eric Chaney (Frankfurt)

It seems that politicians have short memories.   Almost exactly 13 years ago, a freshly elected cabinet tried to change the rules setting the French minimum wage so that young and low-skilled workers could be hired at a discount wage.  Soon dubbed the ‘minimum wage for youths’, it sent thousands of college and high-school students in the street and was quickly withdrawn by the then prime minister Edouard Balladur.  A remake of this bad movie is currently being shot in Paris: PM Dominique de Villepin is confronted with a new generation of students rejecting a law introducing a more flexible labour contract with a two-year trial period for young workers.  The endgame is likely to be the same as in 1993, in my view.

In both cases, the economics of these reforms look sound: that the French minimum wage is an entry barrier for low-skilled workers is a well documented fact; that companies are unwilling to hire young workers with no experience on a permanent basis is obvious.   The best evidence is that a majority of young workers (even graduates) start their working life with a series of internships, not always paid, followed by another series of short-term job contracts, before, if they are lucky, getting a permanent job or opting for the civil service.  In this regard, PM Villepin is right when saying that the flexible labour contract he is trying to enforce would improve the situation of young workers: a flexible job contract is certainly better than an umpteenth internship or three-month job contract.  Thirteen years ago, the same could have been said: better to get a job at a discount than no job at all.  So what is going wrong?

The popular explanation is that the so-called French ‘social model’ is so deeply entrenched in the genes of people living in France (French or immigrants) that no reform is possible, even when it would make people better off.   This is wrong and contemptuous, I think.  Everywhere in the world, workers want guarantees for their jobs.  When labour protection has become excessive and unaffordable, as it is in France, labour market institutions must be reformed.  Many European countries have done their homework, from the UK to Sweden and Denmark, in very different fashions: for instance, jobs are more protected in the UK than in Denmark, but unemployment benefits are much higher in the latter, where the motto is ‘protect workers, not jobs’.  In continental countries where reforms took place, they were the results of negotiations, not confrontations. 

The fundamental reason why attempts to reform the labour market in France have failed so far lies in what several economists, ranging from Prof. Gilles Saint-Paul of the University of Toulouse to Prof. Olivier Blanchard from the MIT, have named the “insider disease” — which I denounced back in 1995 (see ‘The Inside Worker Disease’, Inside the French Economy, December 1995).   In short, the French labour market is a two-tiered market with, on the one hand, highly protected workers (civil servants and holders of permanent contracts, mostly in large companies) and, on the other, highly flexible jobs (internships, short-term contracts, temporary jobs) for new entrants, immigrants and, more generally, unskilled workers.  The reason why college and high-school students are demonstrating, sometimes violently, is obvious: they strongly resent this situation as unfair — why would they accept reforms while nobody is questioning the privileges of the insiders? 

Unfortunately, the insider disease is not a French peculiarity.   My colleague Vincenzo Guzzo tells me that, in 2005, 50% of the new hires between 15 and 29 years old in Italy were hired on a temporary basis.  The underlying reason is the same as in France: laying off permanent workers is so difficult and costly that companies have a strong preference for temp jobs, even if it is at the expense of productivity (training new hires is a sunk cost).  In Spain, the success of temporary jobs is one of the reasons for the spectacular decline of unemployment, from 20% of the labour force to less 10% today.  However, further progress is not warranted, if the insider-worker model is not questioned.

Piecemeal reforms that do not question the status of insiders are doomed to fail, in my view, because they are opposed by insiders, who fear that they may be the next on the list, and outsiders, who consider them as discriminatory and continue to dream of becoming themselves insiders.   In the French case, the solution is to reform the generic labour contract itself and make it more flexible.  In this regard, the new job contract launched last year, with a two-year trial period, but restricted to small companies, was a step in the right direction.  Extending it to all companies would have been a much better idea than trying to design a labour contract for youths, I believe.  We will probably have to wait until next year’s elections to see real progress on the labour market reform front, I am afraid.

 

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China
The Ore War
Mar 17, 2006

Andy Xie (Hong Kong)

Summary and conclusions

China is taking a stand on the negotiations with major iron ore producers on the contract price for this year.  By pressuring importers not to pay high prices, the government hopes that the ore price will reflect the sharp decline in steel price last year.  This development may signal that China will organize itself to behave like one buyer in other raw materials markets.

The major challenge for China is that it has built up huge processing capacity with debt.  China’s producers have to generate cash to service their debt and have a weak hand in negotiating with suppliers of raw materials.  The government organizing buyers into one entity should help substantially.

In the longer run, we think China must establish a coherent and sound commodity strategy with four components.

1) China should review its huge build-up of commodity processing capacity.  It weakens the country’s bargaining power in price negotiations with so much capital sunk.  In some cases, it may be better for China to import processed commodities.

2) China should formalize national organizations that negotiate prices with foreign buyers.  China acting as a one buyer could limit price increases.  Further, it should establish an international buyers’ alliance that negotiates collectively to achieve fair prices.

3) China should counter the consolidation on the production side by investing in second-tier firms to expand production to increase production.  It should set up a fund for this purpose.

4) China should build up reserves of commodities such as ore to increase bargaining power in pricing negotiations.  The government should set up funds to finance such reserves.

Hitting back on ore prices

In February 2006, China’s steel contact price declined by 17% from last year.   Financial markets still expect the ongoing negotiations between China and the three major ore producers to result in a 15-20% increase in ore prices after a rise of over 70% last year.  For many steel mills in China, the ore price amount could mean the difference between life and death in 2006.

Despite the profitability problem, China’s steel producers have a weak hand in negotiating with the three global producers.   China’s steel production was 350 million tons in 2005 and may reach 425 million tons in 2006.  China is four times as big as the second largest producer — the US — in steel production.  However, its steel producers are relatively small and new.  They have many debts and must generate cash to service their debt.  Individually, they tend to pay ridiculous prices for ore just to keep production going.

China’s steel industry has taken off for three reasons.   First, the property and infrastructure boom has increased demand.  Many property developers saw the demand growth and went into the steel business.  Second, the equipment cost has declined due to localization.  The decreased capex requirement has triggered many new entrants.  Third, the export boom has led to a liquidity boom in China’s banking system.  All local governments have been tapping into it to create economic activities.  Building steel mills has been an easy way to increase investment and future economic activities.

The mad rush into building up the capacity has created a huge but fragmented steel industry.   Many steel mills did not even know how the ore market worked and were making cold calls to the three major suppliers.  With unproven finance, they were turned down by the major suppliers, went to the spot market, and pushed up the spot prices hugely.  That gave a good excuse for the major suppliers to negotiate for very large increases in contact prices for established steel producers.

The huge production, of course, has led to price declines.   Strong global demand has kept China’s steel industry afloat.  Chinese prices are lower than in other major markets, and Chinese mills have been exporting to keep domestic prices up.  If the global economy slows, the stress on China’s steel industry will multiply.  To hedge against the downside, China must keep ore prices under control.

Without government involvement, China’s industries cannot organize to negotiate down the ore price, because the industry is so new and fragmented.   Limiting import prices is a good choice, I believe.  If the negotiations with the major suppliers do not work out, China’s government should just dictate import prices for the whole year.

If China does unilaterally limit import prices, it would not affect supply that much.  The ore producers have huge profit margins and have to sell.  To whom would they sell without selling to China?

Of course, in our opinion, the best outcome is a negotiated settlement.   China is the ore producers’ largest customer.  A cooperative long-term relationship between ore suppliers and China would be beneficial to both.  But the ore producers may not look at it that way.  They want to maximize their short-term profits and keep their stock prices high.  China may have to play hardball to stop the ore producers bankrupting China’s steel industry.

The build-up of processing capacity may be unwise

China has been building up processing capacity in many industries.  The import data for petrochemical, edible oil and paper all show the same pattern — that China imports fewer processed products and more raw materials.  The availability of funds due to the export boom is the main reason for the capacity expansion.  But with the processing capacity in China and the raw materials elsewhere, China has become vulnerable.

The huge build-up of the soybean processing industry, for example, contains the same risks as in the steel industry.   Financial investors can push up the soybean price, keep it high and make profits, because they know that China’s processing industry has to buy to get their factories running, which is the only way to service their debts. 

The capacity build-up in China has attracted financial speculators into commodity markets.  When speculators believe that China has to buy at certain date, enough of them will support high prices until that date.  Chinese producers are not sophisticated in hedging and usually lose to financial speculators.

If China had not built up so much capacity and other countries had done so, in particular those with natural resources, they would have the fixed investment cost on their side and have to sell finished products to service their debts.   It would mean lower prices for China.

What has occurred is a major lesson for China.   The Chinese government should adopt policies to discourage capacity growth in commodity processing industries.

Towards a long-term commodity strategy

The rise of financial speculation is a shadow over China’s development.   Prices of natural resources could be pushed so high as to derail China’s development.  China has to develop a comprehensive strategy to safeguard China’s development cost.  I see four components in such a strategy.

1) Encourage processing capacity growth in countries with natural resources.   China should increase investment for such a purpose, in particular through joint ventures with companies that produce the natural resources.

For example, China could encourage steel companies to build steel mills in Australia, Brazil, and India in joint ventures with the ore producers there.  Of course, it would mean limiting the capacity growth of the steel industry in China.

2) The Chinese government should nominate nationwide organizations that represent industries in international negotiations on the prices of natural resources.  The government may have to implement import certificates issued from such organizations for natural resources.

3) China should invest in second-tier producers of natural resources to increase competition.  The consolidation in the commodity industry has worked against China.  The current players have incentives to keep production capacity down to sustain high prices despite high profit margins.  China should invest in small companies, which would force the big ones to invest also to protect their market shares.

4) China must sustain high reserves to increase bargaining power.  The government should create financial incentives or start a fund to finance such reserves.  For perishable products such as soybean, China should maintain reserves for finished products.

A comprehensive commodity strategy is possible and desirable for China; the most important aspect of it, in my view, is to scare away financial speculators.   When speculators retreat, such measures should be kept to ensure that financial speculators do not come back.

 

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Japan
KO Call on Deflation - and ZIRP - Could Come Early
Mar 17, 2006

Takehiro Sato (Tokyo)

The timing of a declaration by PM Koizumi that deflation has ended would be an important pointer for the course of monetary policy.   Such a declaration would provide the BoJ with a pretext for ending its zero interest rate policy (ZIRP).  But even after the demise of ZIRP, the price trend is likely to remain highly significant, since if price improvement stutters, the BoJ’s concept of price stability as understood by its policy board members may take on unexpectedly broad significance.  In this respect, regardless of the timing question, we think the market may be pricing in a larger hike than is likely. 

Near-term economic indicators create a tailwind for BoJ

The markets are expecting an interest rate hike to come earlier than had been predicted after the termination of quantitative easing (QE).   The key upcoming data for divining the course of future policy are (1) the March Tankan survey (due on April 3), (2) the BoJ Outlook for Economic Activity and Prices (on April 28), (3) January-March quarter GDP (May 19), and (4) the April CPI (May 26). 

We expect the Tankan (1) to show a steady improvement in corporate sentiment and evidence of more forward-looking business strategies for F2006, and think this will allow the BoJ to upgrade its outlook on the economy further.   A more bullish stance from the Bank could appear in its April monthly bulletin (April 11) and the monthly outlook report (2).  The latter report in particular is likely to provide theoretical ammunition for removing ZIRP and raising the policy rate to a neutral level in future, and while market expectations for a hike may be heightened, they are unlikely to recede dramatically.  The tipping point could be the GDP data (3).  Despite a slow start for household spending in January, real GDP for the January-March quarter looks unlikely to show much retracement from the high growth of October-December, and should confirm that domestic and overseas demand is expanding steadily. 

Koizumi wants to kiss deflation goodbye while in office

The question is whether the prime minister will respond by declaring the end of deflation at an earlier stage.   This does seem to be a real possibility.  If such a declaration were to come in May or June, ahead of the schedule envisaged, the BoJ would gain a freer hand as the government’s grounds for encouraging the Bank not to tighten would disappear.  The reason for thinking such a pronouncement might come early is that the government’s target of 2% nominal growth for F2006 looks as if it might be achieved a year ahead of schedule.  The release of January-March GDP in May, which will complete the data for F2005, is a potential catalyst for this.

There is a spanner in the works, however.   If PM Koizumi rushes to declare that deflation is dead in May or June, it would be a little too early to ensure a triumphal exit, and risks turning him into a lame duck for the remainder of his term.  There is also a strong likelihood that the critical GDP deflator will still be negative year on year.  But media reports suggest that the Cabinet Office is willing to back such a declaration even if the GDP deflator is still negative, grounding this in an overall view of the output gap and wages (more specifically, unit labour costs), allowing deflation to officially end on PM Koizumi’s watch.  This would give the BoJ a freer hand from May or June, and under these circumstances it would not be out of the question to look for the first rate hike (signalling the end of ZIRP) by the summer. 

Uncertain whether the government is united on this issue

Whatever the views of those close to the PM, the Ministry of Finance is likely to think that there should be no rush officially to declare deflation over.   This is because (1) the MoF in particular would be concerned by the impact on long-term interest rates of increased freedom to manoeuver for the BoJ; (2) even if nominal growth hits 2%, the GDP deflator and domestic demand deflator could well remain negative as explained above; and (3) the all-important price trend may prove surprisingly weak from the April-June quarter, and such a trend would likely be highlighted further by statistical revisions due in August.  In other words, the MoF may think that extolling the end of deflation would be no more than an excuse for PM Koizumi amid fanfare, and prefer to delay this pronouncement until just before the upper house election in the summer of 2007, in order to use this as an opening for a consumption tax hike campaign.  In any event, even if the BoJ opts boldly for an initial rate hike by this summer, it will continue to face political constraints. 

Economic and price trends will ultimately determine the scope of any rate increase

The price trend is likely to be pivotal for any assessment of future developments.   Productivity gains bestowed by restructuring over recent years mean that the risk of prices heading downwards has not gone away.  We expect the April CPI released on May 26 to show the impact of oil prices largely dropping out, and consequently the core numbers may show slightly narrower rates of year-on-year increase than in the January-March quarter.  The July CPI due out at the end of August will also see growth rates crimped by about 0.1-0.2pp due to statistical revisions, leaving prices from the July-September period running fairly low.  Under the new policy regimen at the BoJ, the commitment to core CPI has been waived in favour of a vague medium- and long-term commitment to a price concept that is not captured by either the headline or the core index.  This shifts the policy framework to a forward-looking mode, and in this sense the current price stagnation may be perceived as unrelated to policy management. 

A reading of the statements of the BoJ’s March 9 monetary policy meeting confirms this understanding.   However, events may not unfold along expected path.  If prices stutter, the BoJ may allow the concept of price stability as understood by its policy board members, which is neither a target nor a guideline, to take on a significance of unforeseen breadth.  In this context, regardless of the timing, we think the market is pricing in a larger hike than is likely.

We intend to update our official interest rate outlook soon.

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Currencies
Some Thoughts on the Global Liquidity Cycle
Mar 17, 2006

Stephen L. Jen (Los Angeles)

The ‘excess liquidity’ argument is flawed

The view that global asset prices have been driven primarily by the ‘excess liquidity’ generated through money printing by overly lax central banks has gained popular support.   Most of those who subscribe to this view are also sympathetic to the notion that JPY carry trades have been a key source of global liquidity.  As central banks, especially the BoJ, withdraw liquidity, global asset prices could be severely undermined. There is some truth in the argument; however, this is an overly simplistic view of the world. 

The ‘excess liquidity’ argument

First, let me lay out the basic ‘excess liquidity’ argument.    Following the bursting of the equity bubble in 2000, central banks, led by the Fed, were forced to ease monetary policy.  A direct consequence of huge money printing in the world was a sustained bull market, with the US being one of the major beneficiaries of this unsustainable and risky process.  The positive boost to the net wealth of US households has led to an economy that is temporarily more robust than it would otherwise have been, and unjustified resilience in the US dollar through a hawkish Fed.  If a turn in the global liquidity cycle is sharp enough, the whole process could reverse.  The global economy could be pushed into a recession and the dollar could finally collapse. 

Point 1.   Not much money has been printed

One of the key presumptions behind the ‘excess liquidity’ argument is that the G3 central banks have ‘printed a lot of money’ in the last three years.   Marshallian-k’s are normally used to show the ratio of money supply to nominal GDP, which is a proxy for money demand.  The US Marshallian-k has not risen, as many may presume.  In fact, it has been basically stable since 2001.  This contradicts the prevalent view that the Fed has fuelled one bubble after another with its ‘irresponsible’ money printing policy. 

Japan’s Marshallian-k, on the other hand, has risen sharply since 2001, consistent with the presumption that the BoJ has been aggressively printing money during this time.   However, even with this massive money printing, the Nikkei had basically remained flat from 2001 to May 2005.  It is not clear at all that money printing had any relationship with the Nikkei or other asset prices in Japan. 

Point 2.   Interest rates, not money, are more relevant

Much of the bank loans are extended to finance real activities (consumption, capital expenditures, government spending and/or trade), while leverage and credit extended outside the banking system account for most of the leverage in the financial markets.   This makes tracking M3 less useful in thinking about asset prices.  Rather, the yield curve (the opportunity cost of holding money) is likely to be more relevant for the financial markets.  If I am correct, since credit and leverage generated outside the banking system are beyond the central banks’ direct control — that is, any ‘excess liquidity’ has been the result of the participants of the capital markets’ own doing, rather than money printing by the central banks — it is not clear how the Fed could take the most blame for leverage in the non-bank capital markets. 

Point 3.   JPY carry trades have not increased

There is also the notion that, after the Fed began to raise the FFR in June 2004, the BoJ became the supplier of global liquidity.  However, Japan’s own broad money has not changed much in recent years.  Further, some investors may be focused on the JPY carry trades whereby Japanese investors fund their foreign asset holdings through JPY.  Even though the traditional JPY carry trades (Japanese investors’ holdings of foreign fixed income assets) have been large, these outflows have not accelerated since 2003.  Also, US$170 billion per year does not seem nearly big enough to be the primary support for global asset prices.

Point 4.   Central banks will be gentle

Central banks are by and large normalizing rates, not entering deep into restrictive territory.   Whatever they are doing, they do so gently, with ample forewarning.  Part of the reason why global asset prices look inflated is, in my opinion, due to the (still) low real interest rates in the world, which in turn reflects excess savings.  This is a real, not a nominal concept.  In addition to low real rates, globalisation, declining inflation risk and more diversified portfolios are all important reasons why financial volatility is so low and asset prices look high.  As central banks normalize monetary stances, some risky assets could indeed suffer.  But a generalized downturn is unlikely. 

Bottom line

I feel uncomfortable with the ‘excess liquidity’ argument.  It implies that what we have witnessed in the past few years was a nominal mirage created by massive money printing, and that a turn in the global liquidity cycle will bring a secular bear market.  I point out some serious flaws in this ‘excess liquidity’ argument.

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Singapore
Buoyant Electronics Undermined by Weakness Elsewhere
Mar 17, 2006

Deyi Tan (Singapore) and Denise Yam, CFA (Hong Kong)

Exports rose 30.1% year on year: Exports rose 30.1% year on year (YoY) in February (vs. 18.2% in January).  Meanwhile, imports expanded strongly at 39.6% YoY (vs. +10.0% YoY).  The trade balance stands at S$3.1bn (vs. S$5.1bn). 

Electronics undermined by pharmaceuticals: Stripping out the entrepot trade, which takes up 46% of total exports, we look at NODX, which is a better gauge of the true competitiveness of the economy.  NODX rose 16.5% YoY in February.  Though still representing 2.4% month on month (MoM) seasonally adjusted (vs. -1.8% MoM in January), this is a slight deceleration from January’s 17.5%.  This is due to the strong performance in electronic NODX (+30.5% YoY vs. +9.5% in January) being offset by a marked easing in the non-electronic segment (+5.8% vs. +25.4%).  The latter is underpinned by a retreat in pharmaceuticals momentum to 4.8% YoY following 200% growth in the January-December period.  Petrochemicals performance was, however, reasonable (+10.9% YoY).  Meanwhile, in the electronics segment, disk drives and PC (-8.9% YoY and -17.2%) remained weak.  ICs (+41.9% YoY), PC parts (+36.5% YoY) and telecoms (+64.8% YoY) were robust.

Reversal in US demand: In terms of markets, what is worth noting is the reversal in US demand (+7.9% vs. -2.0% in January-December).  Exports to the US have been in almost continuous contraction since 2Q05, save for a brief expansion in November 2005.  Meanwhile, the strongest momentum was seen in Northeast Asia — China (+30.6% YoY and +2.6pp), Hong Kong (+32.1% YoY and 1.9pp) and South Korea (+33.0% YoY and 0.9pp).

Expect a shallower export recovery and narrower trade surplus: We expect the rising growth trajectory to continue in 1H06, although the recovery might be shallower, given that semiconductor demand growth continues to normalize.  Meanwhile, the fact that import growth is beginning to outpace exports in February underpins our domestic demand story for 2006.  We reiterate our view that improving domestic consumption and investment conditions at home will cause the trade surplus to narrow in 2006.

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