United States
Business Conditions
Apr 21, 2006

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

Business Conditions - What Slowdown?

Business conditions improved in early April, according to our most recent canvass of Morgan Stanley research analysts, contradicting signs of slowing in other business surveys.   Such monthly divergences among surveys aren’t unusual; in fact, they are common at transitions in business activity.  For the MSBCI, the seven point rebound to 60% may signal the end of the bumpy decline in the headline index since last August when the MSBCI peaked at 72%.  Similarly, the less-volatile three-month moving average edged up by one point to 56%.  Despite the threat from rising energy prices and interest rates, this straw in the wind may suggest that the second-quarter payback will be less severe than feared. 

We’ve long expected a spring “payback” in the pace of business activity, yet our survey results, while hardly conclusive, seem to hint that this payback may be short-lived.   The April results aren’t really a surprise to us: Recall in the March edition of the survey, we noted that forward-looking indicators such as advance bookings suggested that business conditions were poised to rebound.  These indicators remained strong in the April canvass, and the headline result has improved on cue. 

Among the signs of strength: First, the percentage of analysts noting improved conditions increased from 21% to 35%.   Second, the advance bookings index remained virtually unchanged, edging down one point to a brawny 75%.  Third, hiring and capital spending plans remained strong, and fourth, our business conditions expectations index increased 12 points to 74%. 

The results did show a surprise, however: 42% of analysts noted that prices charged have risen faster than unit costs over the past three months, up sharply from 20% last month.  That implies that margins are expanding again.  Pricing power remained strong for the industries covered in our survey, increasing modestly by one point to 69%.  Decelerating costs might explain the implicit margin rebound, or stepped-up volumes may have boosted operating leverage.  However, our survey may lag real-time events: Several analysts noted that commodity price pressure is easing for their companies in early April; since then, energy prices have recently eclipsed post-Katrina highs, and other commodity quotes have soared to record highs.  In any case, profit margin expectations are growing more realistic: As of last week, the Street’s sell-side analysts expect 63% of companies in the S&P 500 to have rising margins in 2006, down from 64% last month and 83% forecast last October.

Adding to the resilience in early-April results, the dispersion of business conditions tilted towards strength as a full 35% of respondents reported that business conditions improved compared to last month — a marked increase from the 21% recorded in early March.   The percentage noting deteriorating conditions remained virtually unchanged at 12%.  This month, improvement was led by the services grouping; the services sub-index increased by 12 points to 64% while the manufacturing index decreased six points to 57%. 

Bookings: Still Strong

The advance bookings index remained virtually unchanged in early April, declining one point to a still-strong 75%.   While the advance bookings index has been quite volatile over the past year, the fact that the index remained at a strong level for a second month gives us cause to believe that this recovery is sustainable.  Bookings remained strong for the industrials and IT groups and strengthened for the materials and energy and utilities groups.  The systems and PC hardware group was the only group to note lower bookings, in line with industry data and anecdotes. 

Business Conditions Expectations: Improving

We asked analysts again this month about their expectations for business conditions at the companies they cover over the next six months.  This new diffusion index increased twelve points to 74% from 62% in March.  Furthermore, a full 58% of analysts believe that business conditions will improve over the next six months, up from 45% last month.  Only 9% believe that conditions will deteriorate, down from 21% last month.  While these two data points preclude any definitive conclusions, we believe this remains a positive development.  Most sectors expect conditions to improve, while the consumer discretionary, telecom services, and utilities groups expect conditions to remain unchanged over the next six months.

Hiring Plans Gathering Strength

The percentage of groups planning to increase hiring over the next three months edged up to 37% from 36% last month.   Also, only 7% of analysts noted plans to cut payrolls, down from 19% in March.  Plans to hire remained strong for the industrials, IT, and energy sectors and improved for the healthcare and materials sectors.  The oil services, internet and PC software, and IT services companies plan to increase hiring noticeably over the next three months.  However, other popular surveys show that hiring may be moderating.  The employment indexes from both the manufacturing and non-manufacturing ISM reports declined in March and the net percentage of small businesses that plan to increase employment plummeted seven points to 9%, as reported by the NFIB.  According to our survey, recent hiring trends retreated somewhat, as the percentage of groups that hired over the past three months decreased four points to 35%. 

Capex Plans Remain Robust

We believe that the pent-up demand for capital spending remains hearty, and survey results again support our thesis.   58% of the reporting analysts noted that companies under their coverage plan to increase capex over the next three months, down from the 62% recorded in early March, but still at a historically strong level.  This month, the magnitude of planned increases was impressive.  Of the groups planning to increase capital expenditures, a full 32% plan to increase spending by 10% or more.  24% plan to increase spending by 6-10%.  All sectors had at least one industry group with plans to increase capex, but the industrials, IT, telecom services, materials, consumer discretionary, consumer staples, energy and utilities sectors were the strongest.  The oil services, electrical equipment and industrial conglomerates, internet and PC software, IT services, non-ferrous metals, coal, retailers, and gaming and lodging companies plan to increase spending by 10% or more. 

Surprise: Margins Rising?

The pricing conditions index edged up one point to 69% in early April.   The dispersion of responses remained virtually unchanged compared to last month, with 58% of the respondents noting that prices charged have increased from a year ago, 21% noting prices have not changed, and 21% noting prices have decreased.  However, the magnitude did shift slightly.  35% of analysts noted that prices charged increased by 3% or more, up from 30% last month, while 9% reported that prices have declined by 3% or more, down from 13% last month.  As in past months, strong pricing power was prevalent for most groups except IT and telecom services.  Pricing power was also weaker for the consumer discretionary group. 

We expect fading operating leverage and rising unit labor costs and interest expense to flatten profit margins over 2006, but our survey implies the opposite occurred in early April.  Material and/or labor costs outpaced prices charged for only 26% of the groups, down from 40% last month.  In sharp contrast with last month, the healthcare, industrials, IT, materials, energy and utilities sectors reported expanding margins.  Oddly, 53% of analysts noted higher margins compared to a year ago, unchanged from March.  23% of analysts noted that margins were lower, also the same as in March.

Financing: Higher Rates Not Yet Taking Their Toll

Increases in long-term rates, including a 25 basis point increase in the 10-year Treasury yield over the past month, haven’t weakened financial conditions.  Our financial conditions index rebounded three points to 55% in early April.  Only 7% of the respondents noted that financing has become more difficult to obtain and 16% noted that financing was easier to obtain, up from 11% last month.  Clearly, factors such as credit availability and credit spreads play as big a role in financial conditions as does the level of rates.

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Currencies
The Dollar to Depreciate Gradually This Year
Apr 21, 2006

Stephen Jen (London)

My Key Thesis for 2006 Remains Unchanged

I continue to hold the view that, in 2006, the USD is likely to weaken modestly against the EUR and GBP, but more sharply against the Asian currencies.  I stress that this prospective USD depreciation will take place against a very favorable backdrop of a robust US and global economy.  I expect the USD to gently turn with the US housing cycle.  EUR/USD will likely gradually drift higher, but I believe that the scope of this rally will be limited, and volatility will be high.  On the other hand, USD/Asia has much greater scope to sell off, with lower volatility and a clearer trend.  In this note, I reiterate my call on the dollar and, in a Q&A format, comment on several issues that may interest investors.

USD to Soft-Land

I will not repeat the details of what I have in mind, but only stress that a cyclical USD depreciation is likely this year.   My view should not be confused with the prevalent structurally USD-bearish view; the dollar is still sound from a structural perspective.  Ideas like wholesale USD diversification or the US adopting a weak dollar policy simply don’t make sense to me. 

Question 1.   Am I worried about the recent rise in the long bonds and oil prices?  I belong to the more sanguine camp, and believe that most of the sell-off in long bonds so far in the major economies is due to surging global demand.  Global equities are buoyant; commodity prices have also risen with crude oil prices.  Iran certainly matters, but it’s not the key factor behind the recent. 

To the extent that strong global aggregate demand may be the key reason behind the higher long bond yields and higher oil prices, the latter are only ‘headwinds’ because the global economy is running too fast.   If the global economy decelerates, these endogenous ‘headwinds’ should abate. 

Question 2.   What do I think is the Fed’s stance?  I have the following thoughts.  First, when the Fed communicates with the market, it conveys information about two moments:  the ‘mean’ and the ‘variance’ of the likely FFR trajectory.  From early 2004 until the end of 2005, the Fed essentially told the market two things: (i) the ‘mean’ of the FFR trajectory would show a gradual but positive slope; and (ii) the ‘variance’ of the FFR trajectory would be very modest.  Since late 2005, however, the Fed has changed its message: (i) the ‘mean’ of the FFR is flattening, as the Fed is close to pausing; and (ii) the ‘variance’ will rise because the Fed is now more data-dependent, as it will do whatever is appropriate given the evolution of data. 

The FFR is probably approaching a level that is consistent with growth converging to the potential rate of growth.   The risk to inflation is still slightly biased to the upside.  Thus, another hike on May 10 to 5.00% makes sense to me.  The market’s excessive focus on when the Fed will complete its tightening campaign is mis-placed, in my view.  Rather, investors should focus on the evolution of the Fed’s forecasts.  Both policy lags and the assumed future policy path are reflected in the outlook. 

Question 3.   How will the currency politics between the US and China be resolved?  We may be witnessing an important shift in the undercurrents in the US-Sino currency politics.  The scope of the debate may be shifting away from currency and toward a more comprehensive set of issues that better address the fundamental problem between the two countries, like trade.

While support for protectionism may still be entrenched on Capitol Hill, the CNY debate will most likely not intensify, and the pendulum may actually start to swing in the other direction.   What this means for CNY is that Beijing will be able to guide it stronger at its own pace, without the political pressures from the US. 

Question 4.   Will the US Treasury adopt a weak dollar policy?  No.  There is still talk in the market about the risk of the Bush Administration, taking the opportunity of a prospective Cabinet reshuffle involving Secretary Snow, to replace the current strong dollar policy with a weak dollar policy.  As I have argued before, this is highly unlikely as it is a dangerous policy with uncertain benefits. 

Bottom Line

Holding a short-dollar position is sensible, as I continue to expect the USD to weaken this year for cyclical reasons.  But I still believe that long EUR/USD is the low-quality trade that is based more on speculation (e.g., diversification) than fundamentals, while short USD/Asia is the higher-quality trade, as the fundamentals are more compelling.

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Germany
What's Next for the Ifo?
Apr 21, 2006

Elga Bartsch (London) and Thomas Gade (London)

All Eyes on Next Week’s April Ifo Index
To assess the likelihood of a potential economic slowdown in the euro area this spring caused by rapidly rising oil prices and a smartly appreciating currency, the financial markets and macroeconomists alike will be carefully monitoring the upcoming round of business surveys.   Their focus of attention is likely to be April’s Ifo business climate index, which is due to be published on April 25.  Investors will also be watching for signs of a turning point in business sentiment, which could potentially become a trigger for European equity markets to correct and European bond markets to rally (see Inching towards a Turning Point? February 15, 2006).

We have dusted off our quantitative model of factors driving the Ifo index (see What’s Driving the Ifo Survey, March 22, 2004).  Establishing which factors historically have had an effect on the Ifo business climate should help us to gauge what lies ahead for Europe’s most important monthly data report.  Usually, we provide a preliminary Ifo forecast based on our medium-term estimate for GDP growth in Germany.  Over recent quarters, a discrepancy between the Ifo business climate and GDP growth has started to materialise.  Hence, calibrating a preliminary Ifo estimate based on GDP growth has become increasingly difficult.  Our preliminary forecast is then usually submitted to a reality check when the ZEW investor sentiment is released (see Stable Not Declining Business Sentiment, April 13, 2006).  On the back of the April ZEW survey, we forecast the April Ifo index to ease slightly to 105.0 from 105.4 last month, when the widely watched indicator reached its highest level since the post-reunification months of 1991.

Examining the factors that typically drive the Ifo index, we find that the headline figure is affected by changes to the following: the German government 10-year Bund yield, short-term EURIBOR interest rates, the euro’s nominal effective exchange rate and the DAX.  In addition, previous levels of the US ISM survey and the business expectations polled by both the Ifo Institute and the ZEW Institute affect the Ifo business climate index. 

Interestingly — and this may come as a surprise to some — changes in the crude oil price do not affect the Ifo index.   This due to the fact that sometimes a rise in the oil price is triggered by strong global growth and sometimes by supply disruptions.  Hence the relationship between oil and business sentiment is not clear-cut.  That said, the recent run-up in oil prices could still affect the index indirectly via repercussions on the currency or equity markets.  Some of the aforementioned variables might still provide tailwinds for the Ifo; others might already have turned into headwinds.

In order to assess which of the two forces is likely to gain the upper hand, we input all variables which were found to be a leading indicator into a single econometric model.  We then added the workday effect because the Ifo index is seasonally rather than calendar-adjusted.  Looking at monthly changes, we find that economic and financial variables only explain 30% of the variation in the index.  This is a timely reminder that there is a high degree of ‘noise’ in the monthly changes and therefore they should not be emphasised too much.  According to the Ifo Institute, only three consecutive moves of its indicator in the same direction should be regarded as a significant trend.

Looking instead at the level of the Ifo index, we find that apart from the previous level, three variables seem to have a bearing on the index: the change in the German DAX, the change in the number of working days, and previous Ifo business expectations.  As a rule of thumb, a 10% rise in the DAX lifts the Ifo business climate by half a point, an additional workday adds a good one-tenth to the headline reading while a 10 point rise in the Ifo business expectations in the previous month boosts the headline figure by 1.3 points.

Contrary to other headline sentiment indicators, such as the ISM or the Purchasing Managers’ Indices, which are calculated as weighted averages of companies’ answers to specific questions regarding orders, production and inventories, the Ifo headline figure is generated by a geometric mean of the assessment of current business conditions and business expectations for the next six months.

On balance, we would expect business sentiment indicators to stabilise at the current elevated levels as growth on both sides of the Atlantic moderates slightly as we enter the second quarter.  We need to recognise though that with Easter falling in April this year, the number of working days is reduced by five compared with March.  This alone would shave nearly a full point off the Ifo index and thus introduces some downside risk to next week’s Ifo figure. However, the previous rise in business expectations is likely to act as an offset, in our opinion.  Exhibit 3 highlights the impact of changes in the number of working days in the next few months and how, in isolation, they are estimated to affect the business climate.  The chart highlights that after a large negative workday effect in April, a larger number of working days in May could add 0.7 points back to the headline figure.  With the benefit of hindsight, the upside surprise in the March Ifo survey can partly be traced back to a rise in the number of working days, which added 0.8 points to the headline figure.  Of course, investors should look beyond the gyrations caused by nothing else but a different number of working days.

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Japan
Post-Koizumi
Apr 21, 2006

Robert Alan Feldman (Tokyo)

Introduction

Investors are focused on the political battle to succeed Prime Minister Koizumi. What are the issues? Where do the voters stand? Who are the candidates? And what are the political dynamics? What will the result mean for markets?

Where Is the Electorate?

The two main issues facing voters are economic reform and foreign policy. On economic reform, the results of the September 2005 election speak clearly:  Voters want more reform. Since September, this impression has been strengthened by several factors. One is the continued high support rate for the Koizumi Cabinet. Another is the revival of interest in the Democratic Party of Japan (DPJ), as a result of the advent of Ichiro Ozawa as DPJ president. Ozawa is in fact an old LDP reformist politician, who bolted the party in the early 1990s because it was not reforming fast enough. Ozawa’s impact on DPJ credibility indicates to me that voters want more economic reform.

On foreign policy, Japanese voters seem very worried. The biggest concern is North Korean nuclear weapons. Concerning China, voters fear China’s large increases on military spending, the natural gas dispute in the East China Sea, China’s blockage of Japan’s bid for a permanent seat on the UN Security Council, and the anti-Japan campaign in Chinese schools and media. Indeed, Japanese perceptions of the friendliness to China have deteriorated sharply in recent years. Until 1989, about 70% of Japanese people viewed China favorably. Now the figure is about 30%.[1] Also, some Japanese worry whether the US will continue to be a reliable ally. Why, these Japanese ask themselves, would the US risk its own cities from nuclear attack from long-range North Korean missiles in order to defend Japan?

The Candidates and the Issues

The potential candidates — Cabinet Secretary Shinzo Abe (the frontrunner), Foreign Minister Taro Aso, former Cabinet Secretary Yasuo Fukuda and Finance Minister Sadakazu Tanigaki — in the LDP presidential rate have taken different stances.

In economic reform, one key distinction is between emphasis on spending cuts and on tax hikes in fiscal reform. All candidates agree on the need for spending cuts, but Tanigaki has clearly staked out a position that spending cuts simply cannot be large enough to close the deficit. Abe, in contrast, has focused sharply on spending cuts, and wants tax hikes only when room for spending cuts is exhausted.

The stances of the candidates on foreign policy also differ. The most prominent issue is China, and matters are very complex. In the economic area, all candidates see China as a natural partner for Japan. In the political sphere, Abe and Aso take a Realpolitik approach, while Fukuka takes a conciliatory approach. However, all candidates agree on two other points. One is the crucial role of the US-Japan security relationship. The second is the importance of closer ties with India, as a counterweight to China.

The Politics of the LDP Election

How will the LDP’s process of selecting the next leader affect the result? The politics are best understood by looking at the LDP veterans, the LDP voters and the voting rules.

Many LDP veterans dislike Koizumi politics. First, they dislike PM Koizumi’s top-down approach, which has reduced the veterans’ influence. Second, the skills of the veterans — budget horse-trading, support group cultivation — are less important in the policy-oriented, popular appeal, top-down style of PM Koizumi. Third, PM Koizumi has moved party personnel selection away from the ‘lifetime employment’ model and toward ‘pay-for-performance’. Even though in agreement with PM Koizumi’s policies, a significant portion of the LDP would like to turn the clock back on political style.

The LDP voters are concerned mostly about how policies affect their own interests, as citizens and as local party members. Hence, the LDP voters will more likely cast their votes on the basis of policy issues. In a recent poll, 59% of LDP voters supported Abe, and only 14% Fukuda.

The selection will be made by an electoral college, with 706 electors. Each LDP Diet member serves as an elector. Each prefecture will be allocated a minimum of three votes (total of 141 votes), and then the remaining 159 votes for the prefectures (total of 300 for the prefectures) will be allocated according to population and other factors. These prefecture votes will be split among the candidates on the basis of the results of LDP voter elections in each prefecture, based on the d’Hondt system used in all Japanese national elections. Given Abe’s high popularity among LDP voters, I believe it will be very hard for him to lose the LDP vote.

Will investors like Abe? I think that the answer is yes, with two conditions. First, he must prove that he too has Koizumi’s iron will. Second, he must at least stabilize relations with China. If he can do both, he may — like Koizumi — be a positive surprise for investors.

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Japan
Assessing Post-Revision CPI
Apr 21, 2006

Takehiro Sato (Tokyo)

We Still Peg a Negative Impact from August CPI Revision

As is widely known, revisions to the CPI that the Ministry of Internal Affairs and Communications (MIC) carries out every five years are scheduled for this August.  The market appears to be fixated on the post-revision inflation rate.  This is because the post-revision July 2001 core CPI rate was -0.31ppt lower than that of the pre-revision data in the previous benchmark year revision in August 2001. So the divergence was impossible to ignore at that time.

Five years later we have now seen the end of quantitative easing, and with the monetary policy not bound so strongly to CPI trends, we do not expect attention on the CPI figures to be as great as previously.   Nevertheless, with the core CPI rate currently at around 0.5% YoY at the highest, a protracted period of near-0% inflation would likely have an impact on both the market’s outlook on prices and interest rates. 

So we have examined the prospective impact of the revisions in August.  To sum, we estimate an approximate -0.1% impact on the core CPI rate.  As the BoJ has already indicated, the revision impact will very likely be smaller in scope than in 2001, but we certainly cannot rule out a downturn in CPI momentum from the summer on.

Crude oil, the CPI wildcard, has broken $70, and against our initial forecast, the core CPI inflation rate is likely to plateau at around +0.4% YoY during the April-June quarter.   There is risk that a 10% increase in crude oil prices could wipe out such a small impact of the revision.  Taking into account the impact of deregulation and fiscal spending cuts, however, in addition to the impact from the CPI revision, we continue to expect core CPI inflation growth to taper off in F2H06.  

We do not anticipate a relapse into deflation, naturally.   However, on the macro-policy side, there is a possibility that the market will be rather sensitive to the interest rate outlook, given our doubt as to whether a smooth return to a neutral policy interest rate will be realized as the monetary authorities speculate. Given our forecast for a protracted period of near-0% inflation, the market’s expectations for the degree of the rate hike are likely to cover an unexpectedly wide range. 

Estimating the Potential Impact of Benchmark Revisions

We prepare a rough estimate of the potential impact of benchmark revisions in the following manner.

(1) Substitution Effect

Price changes affect consumers’ purchasing behavior. Although lower (higher) prices result in relative increases (decreases) in purchase volume, CPI weightings remain fixed at the levels set when the benchmark is defined. This format results in underestimating (overestimating) items with lower (higher) prices that increase (reduce) purchase volume and higher (lower) CPI rates. We expect the benchmark revisions to initially remove such bias, and we can estimate the potential impact of revisions from changes in consumption weights for the Household Survey items.

We calculate consumption weights using the Household Survey data for all households from 2000 and 2005 respectively and identify items that change ±0.03% or more from 2000 levels in terms of the shift of the consumption weight. We then estimate a substitution effect from the weighted average of YoY changes for these items prices in the latest February 2006 data. According to this, the substitution effect surprisingly comes to +0.09pp, a positive number. So, upward bias on the CPI rate from this effect is considerably less than generally assumed, and current CPI data might even have a downward bias judging from the above outcome.

(2) Quality Adjustment and New Product Effect

The 2000 benchmark revision added the hedonic method for PCs and other items undergoing rapid technology advances to appropriately reflect quality changes in prices. PC prices hence declined almost 40% YoY in 2001, causing a relatively large divergence in the CPI rate before and after the revisions. Another reform was adjustment of survey items in intermediate years to capture changes in household consumption structure. The interim review in 2003 added PC printers and internet connection fees and broadened application of the hedonic method to digital cameras as a sub-component under cameras.

We expect an impact in the 2005 benchmark revision from information electronics equipment that has rapidly proliferated in households over the past few years, including flat-panel TVs, DVD recorders and mobile phones, and we estimate -0.05ppt contributions to CPI and CGPI from new information electronics equipment items being added in the 2005 benchmark. Yet this is substantially less than the impact from PCs in the 2000 benchmark revision.

(3) Impact on Imputed Rents

The weighting for imputed rents in the nationwide CPI is 13.6%, making it the largest category in the 598 items. The impact of revisions therefore cannot be ignored.  The YoY trend for imputed rents in the 2000 benchmark CPI data shows a basically identical trend to the existing rent deflator in the F2005 System of National Accounts (SNA, ‘Kakuhou’). If we next look at the revised imputed rents in the SNA Kakuhou figures for F2006, a gap of about 1% emerges in the imputed rent deflator growth rate between the F2005 SNA and F2006 SNA. In other words, the growth rate for the imputed rent deflator in the F2006 SNA data is about 1ppt lower than it should be for Jan-Mar 2005. If we multiply this by the weighting for imputed rents (13.6%), the new benchmark core CPI inflation rate will likely be pushed down by about 0.14ppt by the revisions to imputed rents.

Summary

Ultimately, judging from the substitution effect (+0.09ppt), the quality shift + new product impact (-0.05ppt) and the impact from imputed rents (-0.14ppt), the difference between the core CPI inflation rates between the 2000 benchmark and the 2005 benchmark is about -0.1%, so the revision will likely have only about one-third of the impact that the 2000 revisions did. However, if we also factor in the outlet impact etc., the gap between the new and old benchmark could grow slightly. Also, although not touched upon in detail above, some categories have not been radically revised for some time, such as mobile phone rates; sample changes for categories such as these could have an even greater impact on the core CPI inflation rate after the revisions.

In addition, we think important implications stem from the fact that the head of the MIC, which compiles the CPI statistics, is Heizo Takenaka, who reined in the BoJ in a previous role. So, the more earnestly the Ministry attempts to correct the various biases in the price statistics indicated by the BoJ, the more the gap between the current-basis and new-basis CPIs will widen. 

On top of the above revisions, deregulations and fiscal spending cuts could well cause the core CPI rate to turn down in the second half of F2006 despite higher oil prices, and we anticipate the core CPI rate dipping deeper into the lower half of the 0% range. This conclusion remains unchanged even after examining the impact of the CPI revisions. 

Given these changes to the fundamentals, we have our doubts as to whether the return to neutral policy interest rates will go as smoothly as the authorities envision. The global bond market is unsteady, with long-term ratings hitting 2% briefly for the first time since August 1999. However, given our forecast for a protracted period of near-0% inflation, the market’s expectation for the degree of the rate hike is likely to fluctuate within an unexpectedly wide range.

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Asia/Pacific
The Stir-fried World
Apr 21, 2006

Andy Xie (Hong Kong)

The global financial system is running the global economy.   First, it is maximizing global growth by pushing up the currencies of high-inflation economies to contain their interest rates, which results in credit growth in a lower inflation and lower interest rate environment.  Speculative capital funds the resulting current account deficit.

Second, it is keeping down the currencies of low inflation economies, pushing up their asset prices (mainly property and equity) to boost credit demand.   Their current account surpluses are tending to shrink.

Third, it is pushing up commodity prices to give developing economies more consumption power.   Their current account surpluses are tending to rise.  They usually have resource stabilization funds and are the most effective in recycling money back into the deficit economies.

The trading strategies that affect the global economy ultimately lead to low interest rates and a flat yield curve.   The biggest effect is to boost property prices, which boosts aggregate demand.  The resulting stronger economy lowers perceived risks and justifies the trading strategies — i.e. such trading strategies shift economic equilibrium to a higher growth path and become self-fulfilling.

Underneath the strong economy is a property bubble.   The global asset overvaluation (property, stocks, bonds, antiques, arts, gold, etc.) to GDP ratio is probably 50% above its norm, which puts this bubble at around US$20 trillion, by far the biggest to date in absolute and relative terms.

The trading strategies are essentially maximizing global growth without regard to balance of payments.   Without this force, global growth maximization would be constrained by each country living within its means.  From an inflation perspective, the global output gap has temporarily replaced national output gaps as the driver for inflation, which makes inflation lag growth more than in previous cycles.

Inflation is the factor most likely to end this cycle, in my view.   First, the global output gap could close soon, which would cause inflation to pick up across the world.  Second, the substitution between tradable and non-tradable through reallocation of the labor force may cease to work, as some economies prove unable to shift enough workers from manufacturing to service to satisfy service demand.

A financial crisis is the second most likely ending to the current cycle, in my opinion.   As the current global economy floats on mountains of structured financial products, it could fall apart on its own.  It could take just one incident to reverse risk appetite.  And balance of payments would then become a binding constraint again.  Global growth rate could revert to 3.5% from the 4.5-5% of the past three years.

Before either happens, I think that further developments benefiting the short-term profitability of high finance are likely.   Self-fulfilling prophesies are the norm rather than exception in this cycle.

One main implication of the new world is that, while inflation has been tame so far, it is likely to surprise on the upside as the cycle nears an end.   The investment implication is to sell bonds in all economies that have benefited from cheap imports to keep inflation down.  Almost all OECD economies fall into this category.

The Globalization of Stir-frying

Stir-frying is a Chinese cooking technique.   It involves turning over the cooked food in a wok again and again to minimize the use of cooking oil and make heat spread evenly in the food.  The technique was developed in response to shortage.

The term has been used to describe investor behavior in stock, property and art markets in China.   ‘Turning it over’ in asset markets is definitely not a response to shortage.  It spreads the holding risk among as many speculators as possible in a bubble.  It is like passing a hot potato around.  The difference is that you touch the potato many times before it drops.

Global financial markets increasingly behave like China’s stock market.   ‘Turning it over’ has become a driving force.  In this game of rapid turning-over, rumors and concepts drive the market.  The irony is that those who are doing this now are based mostly in Anglo-Saxon economies, not China.

The Anglo-Saxon version of ‘stir-frying’ involves generous use of derivatives.   In China, investors have tended towards simple warrants to provide ‘vroom’ in a rising market.  The use of sophisticated derivatives spreads risks wider than such basic Chinese stir-frying could.  It makes the game last longer. 

Stir-frying Commodities

Commodities have been flying in 2006.   The copper price is up by 41%.  In contrast, China’s copper imports fell by 19.4% and copper scrap by 5.4% in the first quarter from last year.  The usual argument to square the circle is that China will have to buy later.

The average price of Brent crude price surged 42.7% last year.   It is up by 25.2% this year so far.  However, the US oil inventory, which used to drive oil prices, is near an all-time high. 

China’s crude imports were up 3.5% while refined products fell 16.9% last year.   Crude imports did rise by 25.3% in 1Q06 on a low base, but refined products fell by 1.8% from last year.

The gold price is up by 21.5% this year, following an 8.8% increase on average last year.   India is normally considered the driver for the gold price.  However, its imports fell by 38% in 4Q05 in response to the surging price.  When 1Q06 data become available, they are likely to tell the same tale.

According to the World Gold Council, global investment demand for gold rose by 26% to 600 tons, jewelry demand by 5% to 2,736 tons, and industrial demand by 2% to 419 tons in 2005.   It is quite clear in this case that investment demand (i.e., inventory demand) is the real driver.

Silver is up by 58.1% this year.   Nobody has come up with a story to explain it.  The race is on to see who can come up with a plausible story quickest.

To be fair, the commodity world has diversified its stories from China and India to other factors.  When I talk to oil bulls, their pitch usually resembles a rap song — “Venezuela, Nigeria, Iraq, Iran!”  Everyone is supposed to be terrified and pay up for oil.  But, the horror story is not raising risk premiums on risky assets such as emerging market bonds.  Nobody seems bothered by the inconsistency.

Lack of refining capacity is another argument that pops up as frequently as Iran.   Logically, if refining capacity is the constraint, it should keep refining margins high.  Why should it keep crude prices high?  But who cares about logic now?

“Look, people pay up even when prices are high.   Who cares about anything else?” One oil bull said to me the other day.

In the world of steel, the argument is the opposite.   There is plentiful steel-making capacity.  Indeed, steel prices are down from last year.  But the iron ore price keeps rising.  One bull told me that China has itself to blame for making too much steel.

Lack of smelting capacity and strong Chinese demand are the factors cited for the high copper price.   But why are the futures prices so high?  China’s demand is cyclical.  As the current wave of investment in the electricity sector tapers, demand should normalize.  Smelting capacity should rise in response to high profitability.  There is a puzzle here too.

While arguments supporting high prices are different for different commodities and sometimes contradictory to each other, they seem to work.

But have you noticed that soft commodities are not behaving in the same way?   Many have been talking in the same way about cotton, coffee, etc.  After brief spikes, their prices have tended to reverse.

What is occurring is that commodities have become chips in financial markets for speculators to gamble.   Speculation works if: (1) the negative carry from the yield curve and warehousing cost is low; (2) there are enough speculators to keep prices high for an extended period; and (3) somebody will pay up regardless of high prices.  China is touted as the usual victim.

Financial innovations such as exchange-traded funds (ETFs) have made speculating in commodities accessible to retail investors.   ETFs, for example, hold copper more than half of the annual growth in global demand.  Financial investment in the oil market could be twice as much as China’s annual imports. 

Soft commodities cannot join the party because there is substantial negative carry from buying futures.   Soft commodities are bulky and perishable, and very costly to warehouse.  Regardless of how many bulls try to talk them up, that part of the commodity universe is unlikely to respond.

Stir-frying Emerging Economies

The risk premium on emerging market (EM) dollar debt has collapsed.   There is virtually no juice left there.  The new game is to buy local currency bonds for higher yield.  This trade has the advantage of causing the EM currencies to rise, making the trade more profitable.

This trade can last if it is good for EM economies.   In the case of high-inflation economies, it can be.  A stronger currency can cause inflation to ease, justifying lower interest rates.  Lower interest rates increase property and stock prices, increasing credit demand and boosting the economy.  Strong credit growth can lead to current account deficits.  But, the carry trades already provide the requisite capital.

Brazil, for example, is a good candidate for this trade to work.   Its current account is 1.4% of GDP in surplus.  Its inflation is already in single digits due to the appreciation of its currency by one-third in the past three years.  Its real interest rate is over 10%.  This country is a juicy target for carry trades, in my view.  It could really get going when its credit cycle turns up.

India is already advanced in this sort of dynamic.  The foreign capital inflow is mainly into its stock market due to the government restrictions on foreign ownership of its bonds.  Its stock and property markets have nearly tripled in the past three years.  Its current account deficit is already running at 4% of GDP and its credit is growing at over 30%.

The market is already familiar with the borrow-and-spend Anglo-Saxon economies.   Global finance is trying to nurture the same habit in as many developing economies as possible.

Global finance is essentially removing capital as a constraint for EM economies to maximize their growth.   The method of achieving this is to decrease risk premiums and increase asset prices.

The Proliferation of Self-fulfilling Prophesies

Taking on more risk is profitable if it leads to a virtuous cycle for a while.   In the case of Brazil, for example, it could be that a large number of foreign investors are able to push up its currency by another third, and cut its inflation and interest rates by half.  That could be enough to create a credit cycle there.  Then, once the economy accelerated, asset markets would be likely to follow, strengthening the credit cycle. 

The key to the success of self-fulfilling prophesies is herd mentality.   When a large number of speculators move in the same direction, they can shift an economy such as Brazil from one equilibrium to another.  Without the proliferation of hedge funds and proprietary trading on Wall Street, self-fulfilling prophecies would be few.  In today’s world, potential self-fulfilling prophecies tend to happen, as long as they are good for the profit of the institutions behind such trades.

The higher global growth due to financial speculation makes the economic pie bigger.   The financial sector is taking the lion’s share of the growth.  The earnings growth in this cycle is mostly at financial institutions and commodity companies.  Individuals that earn ‘big bucks’ are usually associated with high finance.

Inflation Turns Virtuous Cycles into Vicious Ones

When it becomes profitable for speculators to create a vicious cycle, they will.   For an economy, that day happens when the credit cycle is advanced — i.e., businesses and households are already stuffed with debt, and the current account deficit is large.  Speculators can push down the currency, which triggers interest rates to rise and the economy to tank, which in turn triggers further currency weakness.  As long as its currency declines faster than its interest rate rises, the speculative attack is profitable.

Some peripheral economies such as New Zealand and Iceland may have fallen into this category already.  The larger economies such as Australia and the US are not yet there.  It would take too much money to create self-fulfilling vicious cycles for them at the moment.

The emergence of inflation will likely be the tipping point, in my view.   Global inflation bottomed in 2002 and has doubled since.  The level is still low and much of the increase can be blamed on energy.  While I do not see 1970s-style high inflation, I do expect inflation normalization.

The two deflationary sources in the past ten years have been the mushrooming number of surplus workers from China’s state enterprise reforms and the decline of Japan’s property market.   Both are normalizing.

China’s labor market is still trying to absorb rural surplus labor.   However, the SoE surplus labor has been mostly absorbed in this cycle.  China can afford to improve working conditions without worrying about losing export market share.  Increasing minimum wages and worker benefits (e.g., healthcare and pensions) is a lasting trend.

Japan’s property market has at stopped its decline of the past decade.   This has given Japanese households more confidence to consume.  Japan’s consumption levels are likely to rise significantly in response to this turnaround in the property market.

When inflation keeps surprising on the upside, albeit gradually, it will decrease demand for money.   That will push up bond yields and steepen the yield curve.  I believe that we are at the beginning of a major bear market for bonds.  Moreover, as globalization has made all the bond markets correlated, there is no hiding place for bond investors.

When the yield curve steepens sharply, it will increase carry costs for commodity speculators.   That should be the point at which the commodity bubble bursts.  I believe that this day of reckoning is likely to be in 2006 rather than years away.

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Hong Kong
House Rent and Fuel Costs Drive Inflation
Apr 21, 2006

Denise Yam (Hong Kong)

CPI inflation 1.8% YoY in March.   Hong Kong’s reflation continued to be driven by the upward adjustment in housing rent (+5.3% YoY), which contributed 1.3 percentage points to overall inflation (+1.8%) in March.  Meanwhile, the rise in fuel costs is also giving a more noticeable lift to inflation.  LPG, coal gas and motor fuel prices rose by 15.3%, 11.7% and 5% YoY respectively in March, contributing 0.2 ppts to inflation.

Rising housing rent could be crowding out pricing power in other sectors.   The pace of inflation pick-up appears to be falling short of market expectations in the last few months.  Many expect that, aside from the uptrend in housing rents, price increases should accelerate in other sectors as goods and services providers pass on higher costs (rentals of office and retail premises) to consumers.  However, we have been wary that steep increases in housing rents over and above wage growth may crowd out consumption in other categories, limiting pricing power in consumer goods and services.  Indeed, retail sales data proved to be disappointing in the first two months of 2006, while CPI inflation ex-housing actually eased back below 1% YoY in March, unseen since April 2004 (excluding Lunar New Year-affected months), from an average of 1.5% in 2005.

Further renminbi appreciation remains the biggest upside risk to inflation.   We have yet to see any significant impact of the renminbi revaluation on Hong Kong’s import prices.  Hikes in minimum wages in Chinese cities expected this year also add to production costs in China.  Although we maintain our conservative view that intense competition among mainland producers will limit the pass-through of the revaluation to consumers, this remains the biggest upside risk to Hong Kong’s inflation, in our view.  We continue to see inflation trending upwards in the short term, but stabilizing in 2H06; we forecast 2% inflation in 2006 (+1.1% in 2005).

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Israel
An Ounce of Prevention, Please
Apr 21, 2006

Serhan Cevik (from Washington)

Inflation has moved above the upper limit of the central bank’s target range. The consumer price index increased by 0.3% month on month in March and 0.6%, on a cumulative basis, in the first quarter. Consequently, the 12-month inflation rate jumped from 2.4% at the end of last year to 3.6% last month. According to our calculations, the CPI posted an annualised increase of 3.8%, on a seasonally adjusted basis, over the last three months, up from an average 2.6% in 2005. The latest reading is well above the upper limit of the central bank’s target range of 1-3% and signals a change in the behaviour of inflation, in our view. Even though higher energy prices and the lagged pass-through from the shekel’s weakness earlier in the year are still making considerable contributions to the acceleration in inflation, real economic developments are becoming far more influential in shaping the inflation process. In our view, the trend shift, especially in core inflation, will become more evident in the coming months, even against the shekel’s strength, which lessens inflationary pressures in exchange rate-linked sectors of the Israeli economy.

The pace of economic activity continues to surprise to the upside. According to the revised set of national accounts, te real gross domestic product increased at an annualised rate of 5.6% in the last quarter of 2005 (compared to previous estimate of 4.1%). Though revisions did not result in a change in the annual growth rate of 5.2% last year — the Central Bureau of Statistics revised down the first half estimate — there is a clear upward momentum, particularly in business sector output growth. The latest data on retail sales as well as the improving state of the labour market confirm the return of domestic demand as a leading engine of growth, and thus our projections point towards a 4.5% increase in real GDP this year. In other words, relative to a declining trend growth rate in the preceding ten years, the Israeli economy will be expanding at an above-trend pace for the third consecutive year. As a result, the output gap — the difference between what the economy can produce and what it is actually producing — will continue narrowing and thereby raising the prospect of more inflationary pressures in the future, in our view. Although disinflationary forces in the global economy limit the upside risks to inflation, higher energy prices, the marked productivity slowdown and greater pricing power in the corporate sector present new challenges to the inflation outlook.

The unyielding expansion of money supply is becoming a more significant risk to price stability. Money supply growth has been well above 20% for some time now, indicating, in our opinion, a build-up of excess liquidity. This sustained acceleration in money supply growth and lately in credit to the private sector is an obvious sign of prolonged monetary accommodation. Even taking into account the effect of structural factors on higher money demand, historically low real interest rates certainly played an important role in increasing the growth rate of bank lending to the private sector from -5.5% in 2003 to 3.9% in 2004 and then to 10.7% last year. The latest figures show no sign of slowdown in money supply and credit growth, and therefore confirm the robust recovery in domestic demand.

As they say, an ounce of prevention is worth a pound of cure. The Bank of Israel raised short-term interest rates by 150bp in the past eight months to 5% in April. Albeit still accommodative, the monetary policy stance has clearly moved from an expansionary stage closer to a ‘neutral’ level. However, we think that keeping actual inflation as well as long-term inflation expectations anchored within the target range requires further ‘normalisation’ of monetary conditions, probably even beyond the point of neutrality. One important advantage the central bank now enjoys is the recent strengthening of the shekel — partly due to the dollar’s weakness but certainly justified by Israel’s own macroeconomic progress in the past three years — that effectively tightens the monetary stance. Nevertheless, the central bank should not, and is unlikely to, rely excessively on currency appreciation, especially when residents continue altering their portfolio allocations out of shekel-denominated assets. Moreover, the shekel’s strength, albeit supportive, would not be enough to keep inflation within the comfort zone. This is why we still expect at least 50bp more adjustment in short-term interest rates.

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