In This Issue

United States Business Conditions - Cruise Control? Currencies USD Index Priced Right; EUR/USD and USD/JPY Not Currencies When Will the ECB Turn Vigilant on EUR/USD? View GEF Archive

In April, the rebound in the MSBCI predicted increases in popular surveys such as the ISM manufacturing and non-manufacturing PMIs, bucking consensus expectations for a dip.  Another increase in those gauges could convince market participants that strong global growth and improving job and income gains are powerful offsets to the drags from rising energy prices, slowing housing activity, and decelerating home prices.

The breadth of the early-May improvement in business conditions was also impressive: The percentage of analysts noting improved conditions increased again in early May, to 42% from 35%, while our key forward-looking indicator, the advance bookings index, remained at a strong 75%.  However, both hiring and capital spending plans slipped slightly from last month, while our business conditions expectations index edged down 3 points, to 71%.  We will monitor these results closely next month to see whether they are noise or the beginning of a trend.

The dispersion of business conditions continued to tilt towards strength as 42% of respondents reported that business conditions improved compared to last month, double the percentage in March.  The percentage noting deteriorating conditions edged up to 14% from 12% in April.  Improvement was led by the manufacturing grouping; the manufacturing sub-index jumped 14 points, to 71%, while the services index dipped four points, to 60%.  As with last month, almost all sectors reported improved conditions.  The consumer discretionary and healthcare sectors had mixed conditions, while conditions for telecom services were unchanged.

As we expected, the percentage of analysts noting that prices charged have risen faster than unit costs over the past three months declined after a sharp rise in early April.  However, according to a special question asked this month, only about 20% of analysts noted that the recent rise in oil and refined product prices has decreased margins.  And on the bright side, pricing power remained strong, increasing another point, to 70%, helping to sustain margins. 

Bookings: Still Strong

Advance bookings continue to grow strongly as the advance bookings index remained at 75% in early May.  As we noted last month, strong orders suggest that future business conditions will remain strong.  Bookings remained strong for the industrials, IT, and energy group and strengthened for the financials sector.  Bookings declined for the emerging specialty finance companies, mid-cap banks, and homebuilders.

Expectations Optimistic

Analysts expect business conditions to continue to improve over the next six months.  The business conditions expectations index dipped three points, to a still-strong 71%.  This month, the percentage of analysts expecting improved conditions remained at 58%, while the percentage expecting deterioration increased to 16% from 9% last month.  While the index is still quite strong, we will monitor the results of this question closely in the future to see if the deterioration continues.  Most sectors expect conditions to improve except the consumer discretionary group, which expects conditions to deteriorate on the margin.  The telecom services sector expects conditions to remain unchanged.

Hiring Plans Moderating…

The percentage of groups planning to increase hiring over the next three months edged down four points, to 33%, slightly below the historical average of 34%.  Also, a full 21% of analysts noted that companies plan to cut payrolls over the next three months.  We believe this retreat will be short-lived, as there is still pent-up demand for hiring, and details from the April employment report, job openings, and jobless claims all suggest robust labor-market conditions.  The industrials, healthcare, and energy sectors plan to hire, while hiring plans are mixed for the financials, IT, and materials sectors.  The consumer staples and telecom services sectors plan to cut payrolls.

Hiring over the previous three months hit the all-time high previously reached last November.  Fully 42% of reporting analysts noted that companies under their coverage increased hiring, up from 35% last month.  Hiring was strongest for the industrials, healthcare, energy, and financials sectors.

…Along With Capex Plans

While we expect companies to continue to expand their capital stock, our survey suggests that the pace of expansion may be moderating.  56% of the respondents noted that companies under their coverage plan to increase capex over the next three months, down slightly from 58% last month, but at a still relatively strong level.  However, of these, only 29% plan to increase spending by 6% or more, down from 56% last month.  All sectors had at least one industry group with plans to increase capex, but plans were most prevalent for the industrials, IT, healthcare, energy, and telecom services sectors.  Oil services and drilling, trucking, electronic manufacturing services (EMS), and non-ferrous metals plan to increase capex by 10% or more.

Pricing Power Still Strong; Was the Jump in Margins Temporary?

The pricing conditions index increased another point, to 70%, in early May.  While the percentage of analysts noting that prices charged increased compared to a year ago edged down two points, to 56%, the share noting that prices decreased fell five points, to 16%.  Strong pricing power was prevalent for all groups except IT and telecom services. 

We were surprised last month that analysts suggested that profit margins bounced in the face of rising input prices.  Alas, as expected, survey results retraced some of the increase, as 37% of analysts noted that prices charged increased faster than unit costs over the past three months, down from 42% last month.  Material and/or labor costs outpaced prices charged for 29% of the groups, up from 26% last month.  Margins were squeezed at the telecom services, financials, consumer staples, and consumer discretionary companies.  The energy, healthcare, industrials, IT, and materials companies have margin expansion.  Compared to a year ago, margins are higher for 51% of the groups, down slightly from 53% last month.  26% reported lower margins.

Energy Prices Taking Their Toll

We asked analysts this month whether the recent rise in oil and refined product prices has affected business.  Slightly over one-fifth of the analysts noted that higher energy prices have decreased margins.  Oddly enough, results from our question on margins over the past three months haven’t fully reflected the impact of higher energy prices.  It is worth pointing out that 53% of analysts noted that the hike in energy prices has not affected business yet, and 12% noted that such increases have increased top-line growth. 

Financing: Still Easy

The financial conditions index fell two points, to 53%, in early May, suggesting that in the face of increasing long-term rates, financing is still relatively easy to obtain.  This month we asked analysts whether companies are shifting from equity to debt finance.  A full 56% noted that companies under their coverage have no funding needs, while 14% noted that companies will continue to stick with equity.  9% said that companies were switching from equity to other structures, which include convertible debt and hybrid securities.  Only one group is shifting from equity to debt finance, while none is switching to bank loans or commercial paper.

Declining Dollar a Tailwind?

This month we also asked analysts whether the recent decline in the dollar has affected business.  A full 63% of analysts noted that the dollar’s depreciation has not yet had an impact.  The declining dollar has decreased top-line growth for 12% of the groups and decreased margins for 7% of the groups.  Conversely, the dollar’s decline has increased top-line growth for nearly one-fifth of the industry groups and has increased margins for the systems and PC hardware group.

Analyst Commentary by S&P Major Sector

Consumer Discretionary:  Business conditions were mixed for the consumer discretionary group; most reported unchanged conditions, while the restaurants had somewhat deteriorated conditions and the home improvement retail and vendors group were somewhat improved.  No groups have plans to increase hiring, and the auto and auto-related industry is the only group with plans to increase capex.  Prices charged increased by 1-3% from a year ago for half the groups, although margins were flat to down for most groups.  Prices charged increased faster than unit costs over the past three months for the lodging companies.  Analysts expect business conditions to deteriorate somewhat over the next six months.

Consumer Staples:  Conditions improved for the consumer staples sector in early May.  No groups plan to increase hiring, but the beverage and cosmetics and household product manufacturers plan to increase capex by a slight 0-3% over the next three months.  Prices charged have increased for most groups over the past year, although margins are flat to down over the last three months.  Higher energy prices have depressed margins.  Business conditions are expected to continue to improve over the next six months.

Energy:  Business conditions improved noticeably for the oil services companies, and bookings were higher.  Companies plan to increase hiring and capex notably.  Prices charged continued to increase by 3% or more compared to a year ago and have outpaced unit costs over the past three months.  Business conditions are expected to continue to improve noticeably over the next six months.

Financials:  Business conditions improved somewhat on the margin for the financials sector, although conditions deteriorated for the large- and mid-cap banks.  The multifamily REITs, life, and non-life insurers plan to increase hiring somewhat over the next three months, while the multifamily and retail REITs and non-life insurers plan to boost capital spending.  Prices charged have been increasing due to higher rates, although margins are flat to down for most groups.  Margins have been expanding for the retail REITs and life insurers over the last three months.  Business conditions are expected to improve somewhat for the sector.

Healthcare:  Conditions were mixed for the healthcare sector; conditions improved somewhat for the healthcare distribution and technology companies but deteriorated for the HMOs and managed care companies.  Most groups plan to increase hiring somewhat and capital spending by 3-6% over the next three months.  Prices charged have increased by 3% or more over the past year and margins have expanded over the last three months for most groups.  Analysts expect business conditions to improve somewhat for most groups over the next six months. 

Industrials:  Business conditions improved for the industrials sector in early May.  Bookings were up for over half the groups, including industrial conglomerates, business services, and aerospace and defense.  Most groups have plans to increase hiring over the next three months, and nearly all have plans to increase capex.  Prices charged increased for most groups compared to a year ago, and margins are flat to up for all groups except the business services companies.  Energy prices have had a mixed effect on business for the industrials sector, and the dollar has not yet had an effect on most groups.  It has increased top-line growth for the business services and industrial conglomerates.  On net, business conditions are expected to improve somewhat over the next six months.  Conditions are expected to deteriorate for the trucking companies, since carriers are buying trucks ahead of the new, lower engine emission standards that go into effect in the beginning of 2007; thus capacity is increasing at a faster pace than demand. 

Information Technology:  Business conditions improved somewhat for the IT sector, and advance bookings increased for most groups.  Semiconductor manufacturers and specialized IT services were the only two groups with plans to increase hiring, although nearly all groups have plans to increase capex.  Prices charged continue to decline compared to a year ago.  However, since unit costs are declining faster than prices charged, margins were flat to up for most groups over the past three months.  Margins were squeezed at the EMS companies.  High energy prices have not had an effect on the IT sector, while the dollar has increased top-line growth at the software and systems and PC hardware companies.  However, it has decreased top-line growth at the communications equipment companies.  Analysts expect business conditions to improve for the sector.  Mark Edelstone expects a near-term inventory correction to take place at the semiconductor companies as increased capacity is met with seasonally weaker demand.

Materials:  Business conditions improved for the materials sector in early May, and bookings increased for the non-ferrous metals producers, which also have plans to increase both hiring and capital spending.  Prices increased by 3% or more compared to a year ago for the sector, and prices charged have outpaced unit costs over the past three months.  Analysts expect business conditions to improve for most groups in the materials sector over the next six months. 

Telecommunications Services:  Business conditions remained unchanged in early May.  While the sector continues to cut payrolls, companies do plan on increasing capital spending by 6-10%.  Prices continue to decline for the group, and labor costs are squeezing margins.  Conditions are expected to remain unchanged for the sector.

Currencies
USD Index Priced Right; EUR/USD and USD/JPY Not
May 12, 2006

Stephen Jen (London) and Luca Bindelli (London)

Valuation Update

We report the results of our updated fair value calculations.   (1) The G7 dollar index is now close to being perfectly priced, as it is very close to the centre of our valuation range.  (2) EUR/USD appears to be modestly overvalued (FV = 1.16), but it is nowhere near as overvalued as it was at end-2004.  (3) USD/JPY looks overvalued, with a FV of 101.  (4) Most of the AXJ currencies actually don’t look that cheap, on our valuation measures. 

The G7 Dollar Index was Very Fairly Valued at End-2005

Until recently the G7 USD index was extremely close to the long-term fair value according to our framework. Another observation we make here is that, back in 1985, the USD index was indeed extremely overvalued according to our framework, and the Plaza Accord seemed appropriate.  As we have long argued, it is not at all clear that an overvalued dollar was the root cause of the US C/A deficit.  Therefore, we remain unconvinced that a maxi-devaluation of the dollar would normalize global imbalances. 

Having said this, the USD is likely to weaken for cyclical reasons, as we have been arguing since last December. While a weak dollar policy may not be justified, the USD may weaken on its own, particularly against the Asian currencies. To the extent that the market pushes the dollar significantly lower against the EUR, as it did in 2004, we believe it will sow the seed for a USD bounce-back later.  Valuation matters, particularly when the size of the misalignment reaches extreme levels.  We continue to see EUR/USD as in the first phase of an overshoot. 

EUR/USD is Increasingly Mis-Priced

We also calculate the FVs for EUR/USD, USD/JPY and nine other top bilateral exchange rates, using 13 different equation specifications for each exchange rate modeled. EUR/USD’s median FV is around 1.16, implying that EUR/USD is already in an overshoot territory, and that the low we saw in late-November last year was coincidentally EUR/USD’s FV.    

Relative to the economic fundamentals that prevailed as of end-2005, the current spot EUR/USD is around 10 percent overvalued.  We would not say that the size of this misalignment is extreme as yet, though the recent trend is pushing EUR/USD deeper into the overvalued territory and could soon cause complications for the ECB.

USD/JPY is Still Significantly Overvalued

The JPY is still too cheap.  The median FV for USD/JPY is around 101. Compared to the economic fundamentals that prevailed at end-2005, the current spot rate of USD/JPY corresponds to a misalignment of 9.6 percent.   While it is not nearly as extreme as in late-2005, further JPY appreciation would be very consistent with our valuation work. 

Other G10 Exchange Rates

While the USD index is fairly priced, many bilateral exchange rates are still somewhat misaligned.  The dollar seems cheap relative to the GBP.  The EUR looks expensive against the CHF and the SEK, cheap against the NOK, and about right against the GBP.  All three commodity currencies (CAD, AUD and NZD) appear expensive. 

Most of the AXJ Currencies Don’t Appear to Be Cheap

While our big call this year has been that USD/AXJ (along with USD/JPY) will show a strong and definitive down-trend, we have often cautioned that this call is not based on valuation.  In fact, our calculations suggest that the AXJ currencies are not undervalued, as many may believe.  Rather, our call is based on the belief that a strong global recovery, with more geographical balance, should be extra positive for Asia.  Further, prospective corrections in USD/CNY and USD/JPY should drag USD/AXJ lower. 

Our FV work suggests that the three best performing currencies so far this year − the KRW, the IDR and the THB − are already overvalued.  The MYR and the PHP are slightly overvalued, and the TWD and the SGD are close to their FV.  The CNY seems cheap: the FV of USD/CNY is around 7.36.  But the key here is that the two dominant currencies in Asia − CNY and JPY − look undervalued and, if they appreciate as we have argued that they will, the AXJ currencies will likely be pushed higher in sympathy, despite the fact that they may already be expensive.  This will sow the seed for economic tensions within Asia and in the Asian currency markets, as the AXJ currencies will stay overvalued for at least the balance of this year. 

Bottom Line

We present our latest quarterly fair value calculations.  While the G7 dollar index seems fairly valued, the USD looks cheap against the EUR and the GBP, but still expensive against the JPY.  The commodity currencies look expensive.  As the USD’s cyclical descent continues, EUR and commodity currencies will likely be pushed deeper into overvalued territory while JPY will converge toward its fair value.  This is one reason why we have argued that the short USD/JPY is a ‘higher quality’ trade than the long EUR/USD trade.

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Currencies
When Will the ECB Turn Vigilant on EUR/USD?
May 12, 2006

Stephen Jen (London)

EUR/USD’s ascent will not stop until it is stopped

I believe the momentum behind the rally in EUR/USD will remain sufficiently powerful that if the ECB does not try to cap EUR/USD, it will continue to rally.  The important question this issue raises is if and when the ECB will turn vigilant on EUR/USD.  My own sense is that 1.30-1.32 is likely to be a range to which the ECB may be sensitive.  A large overshoot in EUR/USD would pose serious problems for the ECB, even though the Euroland economy should be able to absorb such an overshoot. 

Interest rate versus exchange rate tightening

As the global economy continues to recover and central banks tighten monetary conditions, there is an issue about the appropriate ‘interest rate-versus-exchange rate balance’ in the monetary conditions.  Specifically, there seems to be a tendency for every country to prefer to tighten using interest rates but for everybody else to do so through exchange rates

Beyond the question of how a strong EUR may affect the Euroland economy, at the policy level, a further question is whether a stronger EUR could effectively deal with the high monetary growth rate in Euroland, which is what really worries the ECB.

EUR/USD is primarily rallying by default, just as in 2004

EUR/USD is mostly rallying because of the USD, not because of the EUR.  EUR/USD is still, as in late-2004, seen as the path of least resistance.  As real money accounts and hedge funds diversify out of USD assets, the sheer superior liquidity that the EUR offers (not just EUR/USD, but the underlying assets such as equities and bonds) is unmatched by anything else.  EUR/USD is, in my view, primarily rallying by default, similarly to late-2004.

EUR/USD is, however, also rallying by merit this time

The obvious difference between now and late 2004 is that Euroland is indeed experiencing a cyclical recovery.  Both ‘soft’ data (i.e., surveys) and ‘hard’ data (i.e., IP) broadly validate this constructive cyclical outlook for the Euroland economy.  The fact that the Euroland economy is stronger is the single-most important difference between now and late-2004, and should, all else equal, make the European policy makers more at ease about the appreciation in EUR/USD. 

When will the ECB turn vigilant about EUR/USD?

I believe the ECB will turn sensitive to EUR/USD when it breaches the 1.30 mark. 

•           Thought 1.  FinMins may not lead the ECB this time.  It is difficult to guess at what levels of EUR/USD certain European officials will start to complain about it.  The Euroland economy has begun to recover giving the European policy makers a lot of confidence (and pride). I do not expect there to be nearly as much angst about EUR/USD’s ascent from the FinMins this time around.  In other words, back in late-2004, European FinMins started to comment on the EUR when it reached the high-1.20s range.  Warnings from the ECB came later.  This time, it may be different for the reason that the Euroland economy is more robust now and able to absorb more EUR strength. 

•           Thought 2.  But the rise in EUR matters to the ECB.  The EUR matters to the ECB mainly because too much EUR strength will undermine its ability to tighten.  Our European economists use as a rule of thumb the 6:1 ratio between Euroland’s output elasticities with respect to short-term interest rate (IR) changes and changes in the EUR TWI (XR) for thinking about the trade-offs between IR and XR movements.  If we assume that EUR/USD and EUR TWI reach similar levels to those we saw at end-2004, the impact on Euroland output would be equivalent to an additional 83 bp of tightening, essentially all the further tightening priced in the market by year-end.  Thus, a EUR overshoot would not undermine Euroland recovery but the ECB will not be able to tighten as much.  

The ECB’s interest rate profile will likely be meaningfully affected by the EUR trajectory.  A flatter yield trajectory should undermine some support for EUR/USD, thereby limiting the extent of the EUR/USD overshoot and could potentially propel a EUR/USD correction from an overshot position. 

•           Thought 3.  The ECB’s main worries are ‘nominal’ in nature.  The ECB is also concerned about the rapid M3 growth rate and loan growth.  Therefore, it would not be certain that the ECB would be indifferent about tightening the MCI through IRs or XRs: i.e., how would a strong EUR help restrain the rapid M3 growth rate?  I believe that, all else equal, the ECB should prefer to tighten through IRs, and too big an EUR/USD overshoot could compromise the ability of the ECB to rein in M3 growth.

•           Thought 4.  Disparities within the Eurozone.  A further complication is the fact that different member countries have different sensitivities toward IR and XR changes.  On average, Germany is roughly twice as sensitive to IR changes, compared to France and Italy, and about 50% more sensitive to exchange rate changes.  Thus, a tightening in MCI should affect Germany more than other economies.  In any case, the disparate economic performances and sensitivities to IR and XR changes within the Eurozone should further complicate the ECB’s policies, as it should not be indifferent about EUR/USD and the refi rate from this geographical perspective. 

Bottom Line

An overshoot in EUR/USD will not undermine the European recovery, or worry the FinMins too much, but would materially alter the path of the refi rate, in my view.  My guess is that we may start to hear ‘concerns’ from the ECB at 1.30-1.32.  There is really no clear ‘threshold of tolerance’ for the ECB because the nature of the problem now is different from that in late-2004.

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