In This Issue

Japan April Fool, Two Days Late Europe Corporate Europe is in Great Shape, Say Analysts Mexico A Case of Peso Jitters View GEF Archive

•   What’s new:

The March Tankan headline suffered an unexpected decline. This was mostly due to deterioration in the terms of trade (the margin) so actual corporate sentiment hasn’t collapsed. Also, the non-headline DIs were solid, and companies were generally bullish on the prospects for F2006.

•   Conclusion:

All in all, Tankan results were good. Although there are concerns about margin squeeze, this can be offset by the volume increases brought by rising demand. Looking at the margin and ignoring the demand trend is akin to missing the wood for the trees. We don’t think that the March Tankan headline represents a peaking-out, and maintain our extremely bullish stance on the prospects for the economy.

•   Policy implications:

Labor supply is being squeezed more and more. The output gap DI (a combination of the manufacturing production capacity and the employment DIs) turned negative last Oct-Dec. When it lifted ZIRP six years ago, the BoJ attempted to justify an additional rate hike by using a substitutional measure for the output gap based on the Tankan DI. The BoJ has much more support now than it did then. We are still betting that ZIRP will be lifted sometime during the summer.

•   Risks:

Risks are that margin improvement may be slowed by the consistently high primary product prices and that the BoJ’s absorption of excess reserves from April may be interpreted as an attempt to reduce global excess liquidity. 

[Detail]

Content sound despite unexpected headline decline

The March Tankan headline suffered an unexpected decline. This was mostly due to deterioration in the terms of trade (the corporate margin), so actual corporate sentiment hasn’t collapsed. Also, this margin decline can be offset by the volume increases brought by rising demand. Looking at the margin and ignoring the demand trend is akin to missing the wood for the trees.

Also, the non-headline DIs were solid, and companies were generally bullish on the prospects for F2006. Of particular note is the increasingly apparent labor shortage. Going forward, personal consumption and capex are expected to improve still further due to the tightening of the labor market. The crimped labor supply and the easing of the sense of capacity surplus both suggest that the output gap has improved again.

We don’t think that the March Tankan headline represents a peaking-out, and maintain our extremely bullish stance on the prospects for the economy. Also, we expect the BoJ to raise its economic assessment on the basis of this Tankan. We expect the BoJ to make its bullish stance clear again at its Monthly Report of Recent Economic and Financial Developments (April 11) and its Outlook Report (April 28). We look for the BoJ to use the Outlook Report to lay the groundwork for its eventual ending of the zero interest rate policy (“ZIRP”) and hiking interest rates to neutral levels. The market’s expectations for a rate hike look only to strengthen going forward, and we don’t expect to see any major reversals here.

Results for major DI values

(1) Business conditions DI: The large manufacturing DI declined for the first quarter in 5 (-1ppt), but the assessment for large non-manufacturing firms improved as we had expected, at +1.  In large manufacturing, decline in materials industries (-4ppt) caused the current assessment to decline, and the processing/assembly industry DI improved by +1pp. Materials industries saw margins being squeezed due to surges in primary goods prices such as energy. Of course, a decline in the current assessment doesn’t necessarily mean a decline in the wider economy. In manufacturing industries, the volume boost from strong domestic/overseas demand has created an environment in which it is easier to generate profit thanks to lower break-even points, even with the higher variable costs from the surge in energy/primary goods. Fixed costs have also shrunk, reflecting efforts at structural reform. Also, firms have benefited from the effective lower-yen trend.

Source: Bank of Japan

Note that the outlook DI of the business conditions is normally higher than the current assessment. This pattern does not hold this time, however, with the outlook DI being higher than the current assessment DI for both large enterprises and SMEs. That the outlook DI overcame this statistical tendency and had a strong showing is likely indicative of the strength of corporate sentiment on the economy.

(2) Supply/demand & Inventory DI: The domestic/overseas supply/demand assessments both improved by 1pp, while the future assessments were flat.

By segment, the raw materials and processing/assembling industries improved in both domestic and overseas assessments. At first glance, this appears inconsistent with the business conditions DI. However, as we explain below, although corporate margin decline is a concern, we see this as a sign that firms are not especially concerned about the sustainability of volume.

On the other hand, the inventory DI for large manufacturing enterprises declined slightly (-2ppt). While raw materials was flat with the previous Tankan, processing/assembly improved (+1ppt). We think the weaker economic sentiment on display at the raw materials industries reflects these inventory levels.

(3) Output and input prices DIs: The output price DI for large manufacturing industries (-8) declined by 4pp, while the future DI (-11) declined by 3pp.  The input price DI (+34) declined 3pp as the upward trend in energy and materials prices paused, while the future DI dropped a whopping 9pp.  As a result, the corporate margin DI (defined as output price DI minus input price DI) worsened from the last Tankan (previous: -41), at -42 for the current but improved -36 for the future. This suggests that the decline in the Tankan Headline is due to the deterioration in manufacturing industry margin. This deterioration in manufacturing industry margins can be offset by the volume effects from increased demand. Looking at the margin and ignoring the demand trend is akin to missing the wood for the trees.

The non-manufacturing industry output price DI was -4, a 4ppt improvement, which we consider especially noteworthy. As a result, the non-manufacturing industry margin DI came in at -18 (previously -23) for the current and -17 for the future.

(4) Employment & Manufacturing production capacity DIs: The sense of the labor shortage has intensified across the board. The DI here has dropped for large enterprises to -6, and the outlook remained the same at -6. On the all-industries basis, the current DI was -7 and the future DI -8, giving an increasing sense of labor shortage. The sense of labor shortage that began in SMEs now seems to be spreading to major companies in earnest. This has major implications for the medium-long term capex trend. Thanks to the labor crunch caused by the retirement of the baby-boomers, nominal wages have already risen, and productivity will fall unless companies take steps. Even to maintain the current levels of productivity, and accepting higher personnel costs, firms will inevitably feel the need to increase capex.

Also, the manufacturing production capacity DI (large enterprises) declined 3ppt for the current (-1), as firms showed less and less confidence that capacity was excessive. However, the sense of surplus is not being eroded faster and faster, as is the case with labor situation, as shown in the employment DI.

F2005 management plan revisions and F2006 original plan

(1) Sales forecasts: Companies made upward revisions overall to their F2005 sales forecasts. Revisions were particularly steep for F2H05, when export revenues received a boost from strong overseas demand.

By contrast, F2006 forecasts at large enterprises are generally fairly modest at only about +2% YoY revenue growth. This seems overly conservative to us. We assume a nominal growth rate of close to +3% in F2006, and expect to see the economy move into an unprecedented stage in which firms benefit not only from expanded volume, but also higher prices (leading to higher margins). The average exchange rate assumed in F2006 management plans, at about ¥110.60/$1, also seems conservative to us given current forex trends. Accordingly, we see considerable upside potential to export sales.

(2) Recurring profit forecasts: Companies also made upward revisions overall to their F2005 profit forecasts. For F2006, large enterprises assume a cautious view, forecasting modest growth of +2.6% YoY due to margin deterioration and rising personnel costs. However, given the strong upside we see at the revenue level, as noted above, we believe there is considerable upside for recurring profit as well. We look for sales to grow by over 6%, but for personnel costs to rise by less than 2%, making recurring profit (MoF corporate statistics basis, companies capitalized at over ¥1 billion) growth of about +20% possible in F2006.

(3) Capex plans: Large enterprises trimmed F2005 capex plans only slightly. Compared to past March Tankans, revisions were very narrow, an indication of strong corporate appetite for capital investment.

F2006 original capex plans at large enterprises call for +2.7% growth, which is higher than our cautious outlook. Spending plans are concentrated in 1H (+10.7% YoY), with 2H forecasts running negative (-3.5%), as spending plans for the latter half of the fiscal year appear to still be tentative. F1H06 plans may also include carryover items that firms failed to implement in F2H05. Spending plans for F2H06 appear to be close to a blank slate at this point.

We had assumed that almost all planned capex has already been implemented, so our outlook for the capital investment cycle in the manufacturing sector was originally not very optimistic. However, there is some encouraging news in this regard. Our auto analyst has raised his forecast for F2006 capex in the industry from a slight decline to strong +8.2% YoY growth. The auto industry was the main driver of manufacturing sector capex in F2005 and it now appears that it will continue in that role in F006. This is expected to complement plant upgrade capex demand in the non-manufacturing sector. So all indications are that capex is to be a key demand driver in F2006 as well.

If we add software and exclude land to give a closer approximation of nominal GDP based capex, all enterprises expect +3.5% growth in F2006, which is higher than the headline.

Policy implications

As noted above, although the Tankan headline is something of an upset, the breakdown is actually encouraging, and based on this, we expect the BoJ to raise its economic assessment on the occasion of its Monthly Report (April 11). In its Outlook Report (April 28), we look for the BoJ to use the Outlook Report to lay the groundwork for its eventual ending of ZIRP and hiking interest rates to neutral levels. Specifically, we look for it to raise its view of the potential growth rate. We think its outlook for F2007 core CPI could well be quite bold. Announcing a high forecast for the potential growth rate is equivalent to a high outlook for the neutral interest rate that would be appropriate in light of the real economy and price environment. So the market’s expectations for a rate hike look to only strengthen going forward, and we don’t expect to see any major reversals here.

In regard to justifying lifting ZIRP, when it lifted ZIRP six years ago (Aug. 2000), the BoJ attempted to justify the additional rate hike by using a substitutional measure for the output gap based on the Tankan DI. In this vein, we have calculated the output gap DI from a composite DI based on the manufacturing capex DI and the employment assessment DI, as the BoJ did then. From this we can see that, in Aug. 2000, although the gap had shrunk, it had not gone as far as the bottom set in 1997; at present, however, this DI has already turned negative since last Oct-Dec and more recently has returned to its 1992 level.

Of course, it would not be appropriate to assume that because this DI has turned negative, the output gap is no more. It is more important to look at the change in this DI rather than the actual level. Still, the 2000 lifting of ZIRP was forced through under its battle cry that ‘concerns of deflation have been dispelled’, and this became a blemish on the history of monetary policy. In contrast, the current mood is, without doubt, less and less antagonistic to the BoJ.

Given the above, we are still betting that ZIRP will be lifted sometime during the summer. Specifically, we focus on the Monetary Policy Meeting on July 13-14. Other important dates to watch are in August and September. If rates are hiked at the August meeting (August 10-11), it would be the anniversary of the lifting of ZIRP six years ago, a bad omen, we feel. We think the September meeting (on the 7th and 8th) would also be inauspicious, following on the heels of the CPI basket revision and just before the LDP presidential election (around Sept. 20).

Risks

The main risk alluded to by the Tankan is that, while corporate margins are failing to improve due to consistently high energy/raw materials prices, the demand trend might weaken. However, the recent surge in primary product prices in one sense attests to the strength of demand. So here again, focusing solely on the margin would risk losing sight of the bigger picture.

Going forward, we think it possible that the absorption of excess reserves by the BoJ could be interpreted as a reduction of global excess liquidity. There have also been persistent cries that this could lead to unwinding of yen carry trades. We however cannot find any convincing evidence to suggest that surplus liquidity will be limited. However, it is still a risk that these concerns could spread and have a deleterious effect on the asset markets.

Europe
Corporate Europe is in Great Shape, Say Analysts
Apr 04, 2006

Eric Chaney (London)

Morgan Stanley's equity and credit analysts covering European listed companies reckon that business conditions have significantly improved over the last three months.  The synthetic index derived from our quarterly Analysts survey rose from 54.6 in early January to 61.5 at the end of March, that is, more than one standard deviation above 50, its long-term average.  The added impetus came from Industrials, Materials and Consumers Discretionary, joining forces with Technology, Financials and Healthcare.

A conundrum: why are soft and hard data diverging?

This piece of news is important in the current context, because the unexpected rise of the German Ifo index to a level unseen since 1991 triggered a substantial sell-off in EMU bond markets.  Taken at face value, the Ifo index is suggesting that German GDP growth might be currently accelerating to 3.5% to 4% from one year ago.  Because German data such as retail sales continue to disappoint, the gap between “soft” and “hard” data is widening.  The debate is far from over and is likely to be a key theme for investors this year: Is German domestic demand really taking off, after nine years of stagnation, or are there new biases in business surveys, possibly linked to globalization?  Bonds and also currencies and equities would behave very differently in each case.  We might have to wait further to get definitive answers.

The Analyst Survey is on the side of Ifo-like surveys

At first sight, the 12th edition of our Analysts Survey is leaning on the side of other business surveys.  Our London-based equity and credit analysts turned much more positive on business conditions in general, found that financing was easier than three months ago and reported an incremental upgrade of capex plans, the fourth one in a row.  Easier financing might seem at odds with the rise of interest rates, however, it is consistent with the healthy business environment reported by analysts covering the financial sector and with the acceleration of credit reported by the ECB.

The capex recovery is gathering steam

Apart from Energy, Telecom and Utilities, which have been big capex spenders for some time, major upgrades to capex were reported in Consumers Discretionary and Media.  From a broader perspective, the uptrend in capex plans reported in the last three surveys is a sign that European companies are weathering well the increase in energy bills.  The survey provides some clues to explain that.   First, restructuring is continuing: The net balance of analysts reporting headcount reductions vs. additions rose from 14% to 16%, the first rise since December 2004.  Insurance and Banks join Telecoms and Consumer Staples in the headcount cut camp.  Only the Property sector intends to hire personnel, not a surprise.  Second, pricing power improved:  The median increase in producer prices accelerated from 0.7% to 1.2%, a sign that companies are able to pass a part of the rise of input prices onto customers, the other part being born by cuts in compensation costs.

 

Cost outsourcing is far from being completed

Although depicting a healthy picture of corporate Europe, our survey is not fully conclusive regarding the European economy at large.  First, large companies are admittedly more sensitive to global factors than others.  They might thus benefit from growth in global markets.  Second, they have outsourced a larger share of their production than others, and this trend is not over: we asked analysts a particular question: “What is the share of outsourceable costs that has already been outsourced”.  The answer was unambiguous: 86% of analysts thought that less than 50% of such costs had been moved in their sector.  The most “outsourced” sectors seem to be Consumer Staples, followed by Energy and Financials, but even in these sectors, a lot of room is left.  With many industries entering into a period of consolidation, the outsourcing trend might even be accelerating.  That is why we suspect that the Ifo index, largely influenced by manufacturing companies that are moving platforms toward Eastern Europe and now China, might be upwardly biased.

In the end, evidence of the recovery in the heart of the euro area will have to come from domestic demand indicators.  This has yet to come, but be ready for surprises.

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Mexico
A Case of Peso Jitters
Apr 04, 2006

Luis Arcentales (New York) and Franklin Adatsi (New York)

March madness

After nearly two years of slow, but steady appreciation, the Mexican peso experienced its greatest bout of weakness in March since the peso rally began in April 2004.  The sell-off has raised a new round of questions over whether it represents a taste of what is to come, especially given Mexico’s presidential election and the divergence in the direction of monetary policy at the Fed and Mexico’s central bank.

We suspect that part of the sell-off was related to market positioning.  In the weeks leading up to March’s drop in the peso, net non-commercial IMM positioning in the peso had risen sharply.  Rapid increases in the long peso positions often prompt some currency weakness.  And indeed, now after the March sell-off when the peso went from hovering just under 10.50 to touching 11.0 on March 28, the technical position has improved once again.  Currently net non-commercial IMM positioning in the peso is just over 11,000 net-long contracts, a considerable reduction from 66,000 contracts in mid-February.  With peso net-long positioning close to its lowest levels in over a year, the risks of further downside in peso are less threatening from a technical standpoint.

Part of the sell-off may have been linked to jitters in Brazil.  But it appears to have been short-lived.  Indeed after flirting with 11.0 on the day after Brazil announced that it had a new finance minister, the peso began to regain ground during the remainder of the week.

Meanwhile, on Mexico’s election front there was little surprising news in March.  The latest polls released during March show a presidential race with few surprises: the front-runner remains with roughly the same lead while second and third places are still being fought over. 

There is, however, one more reason that was likely responsible for some of March’s sell-off: the prospects of further shrinkage of Mexico-US short term rate differentials.  With Banco de Mexico set to ease further while the Fed moves in the opposite way, the peso weakness of late seems consistent with the evidence over the past year from G10 currencies, where nominal cash yield differentials have dominated foreign exchange markets (see Stephen Jen’s “G10: Why Are Nominal Cash Yields Differentials so Dominant?,” FX Pulse, March 9, 2006). 

Concerns over the impact of monetary policy tightening by the world’s major central banks, which lead to a wave of global risk reduction, sparked the initial EM currency sell-off in early March.  In a context of higher risk aversion, idiosyncratic drivers – including narrowing Mexico-US cash yield differentials – might turn to be increasingly relevant.

Markets believe both the Fed and Banco de Mexico are nearing the end of their policy actions. This is not surprising given recent statements by both central banks, which left them with increased flexibility on coming policy decisions.  In the US, markets are fully pricing in another 25bp hike in May, and a move to 5.25% as likely.  Meanwhile, recent surveys suggest that Mexico watchers are somewhat divided on whether Banco de Mexico will lower rates by another 25bp when it meets in late April.

By contrast, we think that both central banks could act more aggressively leading to additional 100bp in US-Mexico spread compression by year-end from current levels.  Though near term support for the peso is certainly likely given a better technical position and improved trade inflows, we suspect that the interest rate differential concern could raise its head again later in the year and ultimately cause the peso to trade closer to our 11.20 year-end forecast.

Monetary Policy Outlook

Inflation in Mexico is dead and will likely remain so.  For most of the past three years core has been running between 3.5% and just below 4%.  In January, core inflation broke below the 3% threshold and by February reached a historic low of 2.90%. Meanwhile, the anticipated produce-driven spike in headline inflation to nearly 4% in January proved short lived with the latest reports showing a clear downturn.  Despite the volatility of headline readings, inflation expectations have trended lower.

The upshot of the benign inflation outlook is a central bank that still has some room to lower rates.  The next 25bp cut is likely to come on April 21, bringing overnight rates to 7.0%.  Surveys suggest that Mexico watchers are pricing slightly less than one more 25bp cut from here until year-end; by contrast, we expect a pause after April and then a cut later in the year once the elections are behind us, with overnight rates ending 2006 at 6.75%. 

To be fair, the language in the latest March monetary policy statement from Banco de Mexico did not provide clear signals about the April decision.  First, the central bank sees GDP growth this year at a strong 3.7% – the high end of its previous forecast range.  Second, instead of restating that there was still “limited” space for cuts, authorities indicated that the available “maneuvering space” for easing will depend on both the inflation outlook and “external financial” conditions – both signs that Banco de Mexico is watching the Fed and the next decision will be increasingly data driven.  Importantly, authorities seem comfortable with the peso at current levels, though further abrupt moves might lead to a pause.

In the US, markets are beginning to see 5.25% as a likely peak in the funds targetfollowing last week’s FOMC statement.  Although the Fed has a good deal of flexibility regarding its next move – one that will likely depend on data releases leading up to the May 10 FOMC meeting – our US economists believe that the benign growth backdrop points to a 25bp move to 5%.  After a possible pause, however, our economists think the Fed will move further to contain possible inflation risks.  They also indicate that the combination of dwindling economic slack and escalating costs in the context of strong US and global growth point to higher risks on the inflation front; therefore, they are calling for the Fed to move policy in a modestly restrictive stance with the Fed Funds rate reaching 5.25% and staying at that level until late 2007 (see Richard Berner’s “Acid Test,” in Global Economic Forum, March 27, 2006).

Foreigners significantly increased exposure to Mexican local rates over the past year and a half to benefit from attractive spreads to the US and the cutting cycle. The share of Mexican local bond holdings by foreigners increased from 4% in mid 2004 to 10% this March, with a greater part of the new investment going into fixed rate bonds (Bonos).  Indeed, foreigners account for 19% of MBono holdings, with a clear preference for longer duration bonds.  The recent sell-off in MXN and Mexican rates comes on the back of a less attractive risk-reward scenario given prospects of higher US yields, combined with more limited space for cutting rates in Mexico and the potential for market volatility in the run up to the contested July 2 presidential election.

Bottom line

It is a bit of a surprise that Mexico’s presidential race appears to have had such a limited impact on the currency markets.  It is difficult to blame Mexican politics on the peso sell-off in March.  Instead, the peso appears to have been caught up in a wider emerging-markets sell-off in currencies.  And to the extent that interest differentials are an important driver this year, we suspect that there are reasons to believe that the peso could end the year close to our 11.20 target.

But the path is unlikely to be smooth.  Market positioning also appeared to play a role in March’s sell-off and we could see a reversal in April.  Meanwhile, the macro backdrop remains favorable for the peso. Oil and remittances inflows have been persistently strong.  Meanwhile, the news from the manufacturing sector looks better to the benefit of the peso.  Indeed, soaring oil and manufacturing exports led to a $1.0 billion trade surplus in the first two months of the year – the widest since 1996.

More jitters are all but inevitable.  But we doubt that March’s move is a precursor to a much larger move in the months ahead.  Unless the oil picture and the US manufacturing sector shows a dramatic deterioration, we suspect that the peso will remain well-supported with the convergence flows that have been both a benefit and a curse.

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