Commodity Bubble
May 15, 2006
Stephen S. Roach (New York)
“In the midst of a slightly subpar upturn in global growth, a low-inflation world is experiencing the sharpest run-up in commodity prices in modern history”
* What’s new Asset bubbles have dominated financial market experience over the past six years. The world is now in the midst of another bubble -- this one in commodities. It, too, will burst. The only question is when. * Conclusions In the midst of a slightly subpar upturn in global growth, a low-inflation world is experiencing the sharpest run-up in commodity prices in modern history. (1) World GDP growth is likely to average 4.2% over the 2002-06 period -- fractionally below the average 4.4% pace of the four earlier global expansions. (2) Over the past four years, the Journal of Commerce gauge of industrial commodities has increased by 53% -- a sharper rise than that which occurred in any of the previous four global expansions. (3) In real terms, the JOC is up 42% over the past four years -- nearly double the 23% average gains that occurred in the two commodity booms of the 1970s. (4) All bubbles are based on plausible stories of a “new era.” China is widely thought to be the key driver that keeps pushing lofty commodity prices even higher. * Market implications The super-cycle theory of ever-rising commodity prices is based on the false premise that China stays the same course it has been on for the past 27 years. China is unlikely to do that; a rebalancing toward slower growth will reduce its impact on global commodity prices and demand. * Risks Contagion is rapidly spreading into the far corners of commodity markets -- including precious metals. Moreover, signs of psychological excess are building -- in an era of globalization, tales of the “new era” are as convincing as ever. Price increases are begetting more price increases -- indicative of a speculative blow-out that can only end badly. DETAILS Asset bubbles have dominated financial market experience over the past six years. First equities, then bonds, property, and spread assets. Like clockwork, liquidity-driven investors have migrated from asset to asset, desperately in search of yield. In my opinion, the world is now in the midst of another bubble -- this one in commodities. It, too, will burst. The only question is when. This is not about thresholds -- $700 gold, $4 copper, $70 oil, and record prices for a broad array of other base metals. I am not making this case based on the parabolic increases in many key commodity prices that have occurred over the past couple of months. I leave that to the market technicians and traders. But suffice it to say that many key materials prices are tracing out patterns that very much resemble the dot-com mania of late 1999 and early 2000. That speaks to an important aspect of any speculative bubble -- that price excesses have now permeated the far reaches of an asset class. To borrow from Yale professor Robert Shiller, who knows something about speculative excesses in markets, the bubble is an outgrowth of amplification mechanisms -- both real and psychological -- which create an unsustainable condition whereby “…price increases beget further price increases” (see Shiller’s Irrational Exuberance, second edition, 2005). Such is the case in commodity markets today. I make my case, instead, purely from the standpoint of global macro -- emphasizing the extraordinary decoupling that has occurred between a broad aggregation of industrial commodity prices and world GDP growth. This shows up loud and clear in an analysis of world economic growth and commodity prices over the past 35 years (see accompanying chart). Over this time frame, there have been five periods of extended gains in global economic activity -- the current recovery (2002-06) and four earlier recoveries -- two in the 1970s, one in the 1980s, and another in the 1990s. The current rebound, as measured on an annualized world GDP growth basis, has averaged 4.2% -- slightly weaker than the 4.4% average annualized gains in the previous four global upturns. In other words, there’s nothing all that exceptional about today’s world growth climate when compared with earlier periods global vigor. Yet the current surge in commodity prices has been off the charts when compared with those of the past. This can be seen by an examination of trends in the Journal of Commerce composite gauge of industrial materials prices -- for my money, the best of the so-called macro commodity price measures. JOC industrials include four major components -- textiles (burlap, cotton, and polyester), metals (steel, copper, aluminum, nickel, zinc, lead, and tin), petroleum products (crude oil, benzene, and ethylene), and a miscellaneous grouping (hides, plywood, rubber, red oak flooring, and tallow). Not included are agricultural products and precious metals -- seemingly tangential elements of the commodity complex that can often take on a life of their own. Over the past four years, the JOC industrial gauge has increased by 53% -- a sharper rise than that which occurred in any of the four previous periods of global recovery. Moreover, as seen in “real” terms -- scaling the JOC by the cumulative increase in the US headline CPI over the same periods -- the current surge in commodity prices stands out as even more extreme. The real JOC is up 42% over the past four years -- nearly double the 23% average gains that occurred in the two commodity booms of the 1970s and in sharp contrast with the relatively stable trends during the global growth cycles of the 1980s and 1990s. This latter result is a big deal, in my view. It is the functional equivalent of the macro smoking gun of a commodity bubble. It was one thing for commodity prices to surge during the Great Inflation of the 1970s. Such outcomes were very much an outgrowth of a generalized inflation that permeated most aspects of the cost and price structure during that period. It’s another thing altogether, however, when commodity prices surge in a low-inflation environment as they are doing today -- and when that spike actually outstrips those of the classic commodity booms of yesteryear. Perspective is key in this instance: In the midst of a slightly subpar upturn in global growth, a low-inflation world is experiencing the sharpest run-up in commodity prices in modern history. If that’s not a bubble, I don’t know what one is. Of course, there are a multitude of counter-explanations as to why this is not a commodity bubble. This is a classic response -- borrowing a page right out of the time-honored script of psychological denial that always occurs toward the end of an asset bubble. Shiller stresses that every bubble has its perfectly plausible story -- the “new era” that is always used with great passion to justify fundamental support to sharply rising asset prices. From tulips to dot-com, with plenty in between, the believers are convinced they have a credible and sustainable story. That’s very much the case with the current commodity bubble. Globalization is its story -- and China is its poster child. The basic premise of this new era is that globalization has unleashed a powerful strain of commodity-intensive global growth that caught a supply-constrained world largely by surprise. In other words, it’s not global growth per se that is driving the demand side of this commodity cycle to the upside; that’s evident from the cyclical comparison noted above, with world GDP growth in the current recovery slightly below earlier norms. Instead, the argument rests more on an increase in the commodity content per unit of world GDP. China -- the world’s greatest development story -- is the most important illustration of this trend. Here’s a nation that accounted for only about 4% of world GDP in 2005 but consumed nearly 9% of the world’s crude oil, 20% of aluminum, 30-35% of steel, iron ore, and coal, and fully 45% of all the cement in the world. With Chinese economic growth driven by the commodity-intensive activities of urbanization, industrialization, and infrastructure, there is good reason to believe that high and sharply rising commodity prices are here to stay. This is a great story -- in fact, one that I have been telling for quite some time myself. The problem with the story -- like most tales of new eras -- is that it, too, has its limits. The key here is to realize that China is not going to keep increasing the commodity-intensity of its GDP growth. In fact, in the just-enacted 11th Five-Year Plan, the Chinese leadership announced explicit targets to reduce its energy content per unit of GDP by 20% over the next five years. China’s concerns go well beyond oil. Potential bottlenecks of industrial materials, together with sharp increases in input prices such bottlenecks trigger, are viewed as a serious threat to sustainable economic growth. It is not that difficult for China -- or any country in the developing world -- to improve the commodity efficiency of its economic growth. After all, China currently consumes twice as much oil per unit of GDP as the developed world, on average. Technological change has long focused on reducing the energy and commodity content of manufactured products. In its rush to develop, China has lagged in deploying oil and other commodity-conserving production technologies. The Chinese do not have to develop new technologies to enhance commodity efficiency -- they merely need to copy those already in existence elsewhere in the world. Great at copying and courtesy of higher input prices, China’s appetite for industrial materials seems likely to diminish in the years ahead. This is a key reason why China has now embraced a very different macro strategy over the next five years -- moving away from a commodity-intensive export and investment growth dynamic toward more of a commodity-saving strain of consumer-led growth (see my 24 April Special Economic Study, “China’s Rebalancing Challenge”). Yet the super-cycle theory of ever-rising commodity prices is based on the false premise that China stays the same course it has been on for the past 27 years -- suggesting that China is expected to grab an ever-greater share of world commodity consumption. Similarly, the New Paradigm crowd of the late 1990s presumed the US was on a path of ever-accelerating productivity growth. Just as that presumption ultimately turned out to be unfounded, I suspect the coming rebalancing of the Chinese economy will succeed in reducing its commodity-intensity -- thereby lowering its global demand for industrial materials. Like Nasdaq, irrationally exuberant commodity markets will also be taken by surprise. My conclusions are macro. They are not aimed at the event-driven stories that can impact commodity price fluctuations from time to time. Nor am I expressing a view on gold or other precious metals that seem to have some very special characteristics of their own. My focus, instead, is on industrial materials -- and their relationship to real economic activity in the global economy. On a global growth-adjusted basis, the current surge in industrial commodity prices far outstrips anything we have seen in modern experience. Parabolic price increases have become the norm, spreading across an increasingly broad spectrum of the asset class with a powerful contagion. To the extent this contagion takes on a life of its own -- not uncommon for full-blown asset bubbles -- it could also infect precious metals and agricultural products. The psychological signs of excess are equally classic. From China to the “end of oil,” perfectly plausible stories of the new era abound. Price increases are begetting more price increases. Yes, it can go on for longer than we think -- speculative blow-outs usually do. But history tells us how it will end. Play the commodity bubble of 2006 at your own peril..
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The Dollar, Global Growth, and Profits
May 15, 2006
Richard Berner (New York)
I expect US profit margins to flatten over the next year, courtesy of slower domestic growth and fading corporate operating leverage. It’s especially important to make that call now, as investors seem convinced that cyclical risks of slower growth are a relic of the past. Calling the timing of any margin contraction is of course difficult; in fact, the record shows that I’ve been early, expecting margins to flatten for some time (see for example, “Corporate Profits: Deceleration Ahead,” Global Economic Forum, March 31, 2006). Furthermore, two global factors may again postpone the flattening in profit margins: The dollar’s recent decline, coupled with continued hearty global growth, could be a double-barreled boost to earnings, and thus at least partly offset some emerging challenges to the corporate bottom line. Especially because Corporate America’s results from abroad also benefit from operating leverage, the upside this year may be a pleasant surprise. The risk, however, is that investors forget that leverage can work both ways: Just as a cyclical global upswing will boost earnings this year, slower growth likely would promote a sharp deceleration in 2007. Here’s why. Home-grown factors still dominate the US corporate earnings picture, and a look at the analytics of profit margins helps sort them out. Profit margins have exploded since their trough late in 2001. Measured as the quotient of “economic” profits to corporate GDP, margins rose by more than 500 basis points to a record of 13.8% by the end of 2005. At work were four domestic factors: First, companies were able to exploit the high levels of operating leverage in their business. High fixed costs — primarily for depreciation — have given Corporate America significant operating leverage. When spread over a broader base in recovery and expansion, such costs decline significantly and contribute to a surge in margins. Over the past four years, depreciation charges as a share of GDP have declined by 220 basis points. In addition, CFOs have been extraordinarily disciplined about capital spending and capital allocation over the past four years as they purged the lingering excesses of the bubble years and markets rewarded them for boosting returns on invested capital. That capital discipline and the resulting steep climb in operating rates — 850 basis points in manufacturing — helped companies restore lost pricing power, boosting both the top and bottom lines. Third, corporate interest expense has declined as a share of corporate GDP by 170 basis points in the past four years, the product of both declining interest rates and CFOs’ efforts to clean up their balance sheets. Finally, record productivity gains kept unit labor costs either falling or subdued. Over the four years ending in 2005, productivity in nonfarm business rose by an annual average of 3.3%, restraining the rise in unit labor costs to an annual rate of 1.2%. That helped keep compensation charges level as a share of GDP. As I see it, three of those four factors are starting to fade. Operating leverage is dwindling as companies begin to shift into the long-awaited expansion phase of the capital spending revival. The combination of higher financial leverage and rising interest rates is beginning to boost interest expense. And as employment catches up with the economy and wages accelerate, unit costs will begin to grow faster as well. But globalization means that global factors now matter relatively more than in the past. Indeed, according to our US equity strategy team, the top 25 companies in the S&P 500 derive some 43% of sales from overseas operations, and S&P 500 companies as a whole obtain 27% of sales from abroad. Thus, a weaker dollar and stronger growth abroad could be powerful offsets to fading domestic support for margins. A weaker dollar, if sustained, could support earnings through three channels. First, it will translate US companies’ overseas results in euros or yen into more dollars, reversing last year’s drag on earnings from a stronger dollar. To illustrate the scope of that hit to earnings at US multinationals, we first look to overall foreign affiliate income — a close proxy for global profits — which rose only 6.7% in 2005, compared with 10.4% in 2004 and a whopping 54% in 2003. Earnings in 2005 were especially weak in the UK, where US firms are heavily exposed, falling by 16.2%. In Japan, the largest Asian market for US multinationals, a 14% rise in the dollar vs. the yen netted a rise in affiliate earnings of 2.8%. And in Europe, the origin of about half of US foreign affiliate income, an 11% rise in the dollar vs. the euro reduced the gain to 4.3%. It’s reasonable to expect significantly stronger results in dollar terms for 2006. A weaker dollar is also helping the top and bottom lines by combining with domestic factors to promote stronger pricing power for US companies (for details, see “The Dollar and Inflation,” Global Economic Forum, May 5, 2006). The effect of a weaker dollar has yet to show up in US import or domestic prices, but combined with less slack in the economy, I’m confident that it will. Finally, a weaker dollar at the margin will help US companies recapture market share. Judging by the recent gains in real US exports, which rose by 13.4% in the year ending in March, that improvement in market share may already be under way. Of course, stronger global growth is also a factor lifting both US exports and US earnings; in fact, in my judgment, global growth is more important for both than the slide in the dollar. Empirical work has long supported the idea that improving growth is several times more powerful for exports than a similar-sized percentage-point change in relative prices. And earnings are increasingly leveraged to global growth as US direct investment spreads abroad. Our work suggests that the leverage factor could be 5 to 1 or more; that is, a percentage point improvement in global growth would yield an extra 5 percentage points of US earnings growth. The outcome of this tug of war between domestic factors restraining earnings and global factors boosting them is obviously critical for financial markets. Equally, however, it’s important to compare that outcome with expectations in the investment community. According to my colleagues Henry McVey and Teun Draaisma, US and European earnings revisions are reaching “blowout” proportions, so much of this news is both in the analysis and in the price. For example, the net share of positive revisions for the S&P 500 universe reached 19% on May 10, the third-highest peak in the current bull market. And notwithstanding the very recent correction in equity markets, investors now seem to think that cyclical factors don’t matter. In contrast, we think that they now matter most. It’s certainly possible that non-US growth could remain healthy even if the pace of US economic activity slowed significantly. But what are the risks to earnings if it does not? That would expose the downside of operating leverage: Simultaneously slower growth in both the US and overseas economies would promote a significant deceleration in US earnings. Some of the risks associated with this scenario have to do with the character of these global factors. A benign decline in the dollar will likely be a boost to earnings and a plus for US equities. But a decline in the currency associated with escalating inflation expectations, a loss of confidence in US policies, or protectionism would make US assets less attractive to global investors. And of course, threats to growth, such as supply-induced energy shocks, would promote concern over future earnings gains.
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A Long-term View on Long-term Interest Rates
May 15, 2006
Joachim Fels (London)
The next bond rally My ‘cyclical’ view on global bonds, defined as a view for the next 6-12 months, hasn’t changed. Following the expected rise in long-term bond yields during the first half of this year, I look for a rally in bonds during the second half of the year and going into 2007. I assume here that US economic growth slows noticeably in response to the lagged effects of rising interest rates, higher energy prices, and a cooling housing market. I continue to think that the Fed is already in restrictive territory and virtually done tightening, and that it may even start to eye a rate cut later this year if growth slows markedly below trend. And I still look for US bonds to outperform Europe and Japan in the upcoming cyclical rally, and for risky assets to sell off. I hasten to point out, however, that my assumptions are at odds with the forecasts of our US economists, who expect only a very moderate slowdown of the economy and a further pick-up in core inflation, which would lead the Fed to raise the funds rate target twice more to 5.5%, possibly after pausing in June (see R. Berner and D. Greenlaw, US Economics: Pause or Not, the Fed has More to Do, 8 May 2006). My US colleagues have been spot-on with their forecasts over the past couple of years, so the risk to my view is clearly that they continue to be right. Time will tell. Rather than re-opening the debate on the ‘cyclical’ outlook, let me take off my strategy hat, put on my economics hat, and address the question where bond yields will be heading over what some in the bond market call the ‘secular’ horizon of, say, 3-5 years. In short, my answer is: ‘much higher’. Here’s why. Globalisation implies higher real interest rates Markets have become used to viewing globalisation and low interest rates as two sides of the same coin. You have heard the story many times: Globalisation implies a huge supply of cheap labour, mainly in China and India, which is supposedly deflationary or disinflationary. Moreover, an Asian savings glut is depressing real interest rates, and Asian central bank buying of Treasuries has compressed risk premia. I look at globalisation differently. The huge expansion of the global labour force has made capital relatively scarce. Employing this labour force will require a much larger stock of capital, which implies very high rates of investment in fixed capital for many years to come; for example, infrastructure investment in India and investment in machinery and equipment in China. Moreover, the larger demand on natural resources that goes along with development in China and India has pushed up raw materials prices, which in turn will spark higher investment in exploration in commodity-producing countries. Real long-term interest rates will have to rise, reflecting stronger investment demand and signalling the relative scarcity of capital. The high current savings rate in China and some other countries should not be extrapolated — as income prospects in these countries improve and governments build a better social safety net, savings rates are likely to decline. Lower savings and higher investment rates combined should push real interest rates higher. Why then have real interest rates been so low for such a long time in recent years? In my view, central banks’ super-expansionary monetary policies in response to the bursting of the equity bubble and the deflation fears are the main culprit for low long rates and tight risk spreads. But central banks, led by the Fed and now followed by the ECB and the Bank of Japan, are in the process of normalising global monetary conditions. The removal of the main cause for a distorted yield curve has already started to push real long yields higher. Yet, more is to come once the investment-savings dynamics described above start to unfold over the next several years. Inflation should trend higher, too I not only see real interest rates moving higher (on trend) over the next 3-5 years, but also long-term inflation expectations. The trough in global inflation occurred in 2002/2003, following more than two decades of disinflation. Headline inflation has moved higher since, reflecting mainly a rise in energy prices due to super-expansionary monetary policies and the China factor. Core inflation has remained moderate so far, but I believe the concept of core inflation (defined as the CPI excluding food and energy) is almost meaningless if food and energy prices are pushed permanently higher by globalisation. As it attempts to anchor long-term inflation expectations, it is natural for the Fed to talk about core rather than headline inflation. But break-even inflation rates (currently at 2.75% for the 10-year horizon) signal that markets doubt that headline inflation, currently around 3.5%, will come all the way down to core inflation, which is around 2%. And inflation expectations, also on a forward basis, have started to move higher recently. More is to come once Asia’s workers become consumers, too. It will be difficult for the US and Europe to immunise themselves against a rise in global inflation. Bottomline: Long rates could go to 7% Real interest rates, measured by US 10-year TIPS, are currently around 2.4%, virtually identical to our measure of the US natural rate of interest. But with global demand for capital rising I can see them easily going to 3.5% or so over the next 3-5 years. In a borderless world, real interest rates should reflect global demand and supply conditions. Put differently, if global real GDP can grow at a trend rate of 4% over the next decade, real long-term interest rates should not trade much lower than that. Inflation expectations could also rise by another percentage point or so over the next several years, bringing them up to the current rate of headline inflation in the US. If you put this all together, it is not crazy (at least in my view) to see US long-term interest rates going to 7% over the next 3-5 years. Note that the forward markets already see 10-year US swap rates at almost 6% in five years’ time. So the market has already moved half-way towards my long-term target. Don’t get me wrong: I’m still looking for a ‘cyclical’ rally in bonds on a 6-12 month view. But I herewith confess that I am a long-term bear on bonds.
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Enjoy the Good Times While They Last
May 15, 2006
Eric Chaney (London) and Thomas Gade (London)
Why we like 2006 We take a view different from the consensus regarding the current momentum of the euro area economy — and it is not because of the World Cup. We think that, in the end, the strong message delivered by business surveys will eventually appear in official growth numbers, and so we raise our full year GDP forecast from 2.1% to 2.3%. We know that, in the debate between soft data (business surveys) and hard data (industrial production, GDP), the jury is still out. However, we find the Eurostat-made 0.6% estimate for 1Q GDP growth quite encouraging. This is why we are adjusting our first half GDP forecast in the direction given by our survey-based indicators. In doing so, we feel all the more confident that credit data are clearly indicating a steady and significant acceleration in interest rate sensitive components of domestic demand, such as corporate investment, housing investment and consumer credit. Despite conflicting data signals from Germany, we believe that the German economy is really on the mend and that its close trade partners such as Italy and France are starting to benefit from its improvement. Going forward, the robustness of the German recovery will be the key parameter for the business cycle outlook in Europe. A double whammy for the cyclical outlook Although restructuring is a never-ending process, we believe that German companies have gone a long way to restore their competitiveness. From a macro angle, the most salient feature of German restructuring was the compression of real wages which, ultimately, resulted in a slight reduction of nominal compensation per employee last year. This painful adjustment is probably over, as indicated by the recent wage agreement reached in the metal industry. However, another blow to German and other European consumers’ purchasing power is unfolding: the sharp rise in commodity prices, especially gasoline, diesel and heating oil. More specific to Germany, the planned rise in the main VAT rate in early 2007 will make a further dent in more consumers’ real income. While the VAT rate hike was already discounted in our growth and inflation forecasts, we were still betting on a significant easing in oil product markets next year. Supply has been slower to react to prices than we had anticipated, and we have raised our oil price baseline from $61/bl to $73 this year and from $48 to $68 next year (See “Oil Alert: No Relief on Supply”, Eric Chaney and Richard Berner, April 21, 2006). This had to be priced into our forecasts. Our below consensus call for 2007: growth down to 1.4% European consumers and companies will be hit quickly by the rise in refined product prices, through transportation and housing costs. Although, initially, savings or profit margins may act as shock absorbers, past experiences show that households are quick to restore their level of savings and that companies are reluctant to pass higher costs into prices. Hence, both consumer spending and corporate profitability, and thus corporate investment, are likely to be hit in the second half of this year, all the more so if, as we think, oil prices are likely to climb further, as geopolitical tensions increase. Looking forward, the rise in energy prices will continue to feed through the economy through price setting mechanisms, which are subject to longer lags in the euro area than they are in the US, as the ECB has shown. Why anti-inflation credibility is crucial As has been the case since 1999, wages are unlikely to follow prices in the short term, which means that the risk of genuine “second-round” effects, or endogenous inflation, is low. Accordingly, real profits should be hit less than households’ real disposable income, which should limit considerably the long-term impact of this third oil shock. For this reason, the anti-inflation credibility of the European Central Bank is crucial. In this regard, the almost perfect stability of consumers’ inflation expectations since July 2005, despite a sizeable acceleration of headline inflation, is a good omen. Overall, we think that the impact of the oil shock will prove temporary and result in a pause in the ongoing recovery, rather than a protracted slowdown. Although we are cutting our already below consensus GDP growth forecast for 2007 from 1.6% to 1.4%, we anticipate a smart re-acceleration in the second half of 2007, as a result of declining inflation and lower interest rates. Revising up our inflation projections We revise up our annual inflation rate forecast by two-tenths to 2.3% in 2006 and by three-tenths to 2.2% in 2007. The annual inflation rate is thus expected to remain above the ECB’s inflation objective over the forecast horizon, at least on annual averages. Compared with our previous projected inflation path, we are now projecting higher headline inflation mainly due to a higher projected oil price path and a more persistent first round pass-though into core components. With unemployment likely to rise next year from still high levels, we see the risks of spill-over into wage setting as limited. In other words, we think that the current projected rise in inflation is of a temporary nature: on a 12M change basis, we foresee headline inflation dropping significantly below 2% by the end of 2007, even though the statistical effect of the German VAT rate hike will still contribute to the euro area wide measure of inflation. Headline inflation should drop to around 1.5% in early 2008, below the ECB’s target of “inflation below but close to 2%”. Higher energy prices will accelerate core inflation We have refined our econometric equations, which capture the first round pass-through of higher oil prices. As a result of incorporating a significant delay in the energy pass-through, we expect annual core consumer prices (ex energy, food & beverages and alcohol & tobacco) to rise by 1.5% in 2006 and 2.3% in 2007. While the gradual rise is mainly a result of the significantly delayed impact of energy prices on the housing component and the transport component, much of the one-off rise in 2007 is due to the three-point VAT hike in Germany. On our estimates, the German VAT hike should add 0.3 to 0.4 percentage points to annual inflation, the acceleration being spread over the first three months of 2007. Exploring alternative oil price scenarios (and betting on linearity) Because the oil price baseline we are using in our macro forecasts is fragile and uncertainties surrounding oil markets quite high, we have looked at the possible consequences of the two alternative oil price path presented in the “Oil Alert” note mentioned above. The “cool scenario” assumes an easing of diplomatic tensions in the Middle East, especially vis-à-vis Iran, and a sharper than expected slowdown in both the US and China. With crude oil price averaging $66 this year and declining to $46/bl in 2007, this scenario sees GDP growth re-accelerating significantly once the impact of the VAT rate hike fades away, and reaching 1.8% in 2007 after 2.4% this year. Despite the VAT rate hike, overall inflation would drop to 1.9% on average next year, a rate consistent with the definition of price stability endorsed by the ECB. Alternatively, the “hot scenario”, which assumes UN sanctions against Iran resulting in the loss of 2.6mb/d of crude oil (current Iranian exports), would propel crude prices above $100/bl. Assuming the impact on the global economy would continue to be linear, and that it is correctly gauged by standard econometric models (this is a critical assumption which, so far, has worked surprisingly well, even though current levels are far above data samples used in quantitative models), GDP growth would drop to 1.0% in 2007 after 2.1% this year. As a consequence, GDP would contract by 0.25% in 1Q07 on our estimates, which would raise the risk of a full-blown recession if, on top of the negative impact of a terms-of-trade shock, geopolitical uncertainties depressed corporate investment further. Although inflation would rise above 3% in early 2007, we think that the ECB would consider that the shock mainly supply side and, for that reason, would ease monetary policy to prevent a vicious deflationary circle setting in later on.
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Reiterating Our Refi-Rate Target
May 15, 2006
Elga Bartsch (London)
ECB will likely keep hiking … With above-trend GDP growth during the first three months of this year confirmed by Eurostat’s Q1 GDP estimates, the ECB should feel sufficiently comfortable to raise interest rates by at least 25 basis points (bp) at the upcoming meeting on June 8. Even though ECB Council Members have been very careful not the close the door on a larger move of 50 bp at their out-of-town meeting held in Madrid, at this stage we would deem such a bold step an outside scenario. In the run-up to the June meeting, the ECB will weigh incoming activity and inflation data against financial market developments, notably currency movements and, more important, inflation expectations embedded in inflation-indexed bonds. As ever, medium-term trends will be more important than near-term fluctuations. … interest rates gradually … As the recovery continues to gain momentum, the ECB seems to be increasingly concerned about inflation risks, stemming both from monetary developments and from potential second-round effects of the recent rise in oil prices. The recent back-up in break-even inflation rates to 2.3%, the highest level in more than a year, comes as a timely warning in this respect. On balance, the revisions to our growth and inflation projections leave our refi rate profile unchanged (see Eric Chaney and Thomas Gade’s comments elsewhere in today’s GEF). We therefore reiterate our year-end target of 3.25% for the refi-rate. The further downward revision to 2007 GDP growth reinforces our out-of-consensus call for ECB rate cuts in late 2007. Such a turnaround in the official policy rate in the euro area is currently not priced into money market futures. … despite a worsening outlook … At the June meeting, ECB President Trichet will also present a new set of staff projections. Over and above the usual adjustments — including new oil price, interest rate and currency assumptions — the next round of forecasts will also make an important methodological change. Instead of basing the projections on the assumption of unchanged interest rates, the ECB will in future base projections on the short-rate profile priced into the money market. As a result, the oil price assumption, the exchange rate assumption and the interest rate assumption will likely be raised considerably from crude oil at USD 67 per barrel, EUR/USD at 1.21 and short rates at 2.55% used in the March forecasts. Due to time-lags, the new assumptions should mainly affect the 2007 GDP estimates though. We would estimate these downside risks to amount to around half a percentage point. As a result, the ECB June staff projections for 2007 might be a lot closer to our own forecasts than to the ECB’s March projections. … and a stronger euro In recent weeks, the currency has come back into the ECB equation — at least in the eyes of many market participants. This renewed focus reflects the fact that, after a remarkable phase of stability, the euro has started to appreciate noticeably in trade-weighted terms. That said, the 3% appreciation since late February still falls short of the rise in EUR/USD of almost 8% over the period. As Asian policy-makers have started to dig in their heels and resist a further strengthening of their respective currencies against the USD, the euro might be pushed higher by default. However, our Chief currency economist, Stephen Jen, believes that the euro has likely entered overshoot territory already and any further rise should be reversed before year-end. If at all, the exchange rate is more likely to matter for the near-term pace of tightening than for the long-term target rate. The euro, among other things, could therefore prevent a potential 50 bp rate hike in June. But it is unlikely to derail our year-end target for the ECB refi rate of 3.25%. Bond yields to grind higher near term As expected, ten-year government bond yields have broken the 4% threshold. In our view, the euro area bond-market sell-off has further to go. In the light of recent price action and upwardly revised forecasts for US treasury yields, we are slightly raising our near-term target for ten-year Bund yields to 4.25% in September, from 4.15% before. With the exception of the very long end, we expect the yield curve to steepen temporarily on the back of better growth and rising inflation. Eventually, however, the yield curve should start to flatten again as ECB tightening continues and growth prospects deteriorate. This flattening will likely be led by an outright rally in the bond market later this year, as the 2007 slowdown and the ECB easing that it will likely trigger in late 2007 come into focus. With inflation concerns being more prevalent in the US than in the euro area, we would expect Bunds to start outperforming UST at that stage.
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A Mixed, But Not a Bad Message
May 15, 2006
Elga Bartsch (London)
While preliminary Q1 GDP figures were broadly in line with expectations for the euro area as a whole (see Eric Chaney’s comment in today’s GEF), the German numbers fell short of expectations by one-third. The flash estimate of Q1 German GDP posted a 0.4%Q reading, compared with our and consensus expectations of 0.6%Q. The sub-par German reading has sparked fresh concerns about the sustainability of the Euroland recovery. Bruised by yet another downside surprise in German growth, we nonetheless disagree with this view. It is important to go beyond the disappointing headline GDP growth and look at the composition of growth. Even though the detailed Q1 data set will only become available later this month, the Statistics Office indicated that Q1 GDP was boosted by both consumer spending and corporate investment in machinery and equipment. If confirmed, the positive aspect of a pick-up in domestic demand in Germany would outweigh the negative aspect of soft headline GDP growth. A turnaround in German domestic demand would constitute an important catalyst for the euro area business cycle, for two reasons. First, German domestic demand hasn’t budged for the better part of a decade. Given that Germany is the largest economy in the euro area, the change at the margin matters. Second, Germany is an important trading partner for other euro area countries. A revival of domestic demand and thus import volumes would improve their export prospects, acting as a boon against the stronger euro. While a rise in corporate spending on machinery and equipment is supported by record corporate profits, buoyant business sentiment and low interest rates, a recovery in consumer spending is more surprising in the light of the high frequency data available. Employment contracted and consumer price inflation rose in the first three months of this year. A non-annualised 1.2%Q decline in broad retail sales over the period would make a contraction of overall consumer spending seem more plausible. Contrary to previous quarters, net foreign trade did not make a significant contribution to overall GDP growth in early 2006. The main unknowns in the German business cycle, however, remain the two demand components that weren’t explicitly mentioned in the press release of the Statistics Office: construction investment and government spending. This is because both have likely been affected by special effects, such as the unusually cold winter weather and the strikes in the public sector. Gauging the impact of these special effects is key in assessing the rebound in the current quarter. At this stage, we expect a pick-up in GDP growth to up to 0.7%Q. This estimate partially hinges upon a snap-back from an artificially low Q1 GDP estimate and, hence, needs to be reviewed once we have the full data-set at hand. In the meantime, the jury is still out debating the discrepancy between so-called soft survey data, such as the Ifo business climate, and so-called hard data, such as GDP growth. In our view, the business surveys are still the more reliable cyclical indicator. But, it takes more than just looking at the headline index to extract the message. This is especially true for the Ifo business climate, where the headline index isn’t based on the answers given to detailed questions on production, orders and inventories, but comes of a separate survey of general business trends. In addition, German corporates seem to be ahead of the rest of the economy in rising to the challenges of globalisation. As a result, the corporate sector thrives while the domestic economy, including the labour market and wage income, has remained, at least until now, in the doldrums. At this particular juncture, the discrepancy between the Ifo business climate and German GDP could also be caused by a swing in the number of workdays in Q1. The non-workday adjusted year-over-year GDP growth rate, at 2.9%Y, was twice as high as the workday-adjusted one. As the Ifo business climate is seasonal, but not calendar adjusted, it might have been lifted by the very favourable year-on-year comparisons. Alas, the downside surprise in Q1 GDP together with the absence of an upward revision to Q4 GDP ‘eats’ the upside risks to our forecasts we had been signalling. Contrary to the rest of the euro area, where we revise up our forecast from 2.1% to 2.3%, the German full-year GDP forecast thus remains unchanged at 1.8% for this year. We have held onto this number since early December, and the consensus has now caught up with us. In the light of higher oil prices and a stronger euro, consensus forecasts are unlikely to rise further, we think.
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Petro-Bubbles
May 15, 2006
Serhan Cevik (London)
Oil export revenues in the Middle East have contributed to global imbalances. The insatiable global appetite, political supply constraints and a frenzy of speculative buying have resulted in the tripling of oil and natural gas prices over the past three years, bringing windfall gains to oil exporting countries. Given the geographical concentration of fossil-fuel reserves, Middle Eastern producers are the leading beneficiaries of the global commodity boom. Real GDP growth in the region accelerated to 6.5% last year, as oil export revenues surged from $150 billion in 2002 to $460 billion. According to the International Monetary Fund, oil revenues in the Middle East will increase to more than $500 billion and raise current account surpluses from $32 billion (or 5% of GDP) in 2002 to $275 billion (about 25% of GDP) this year. In our view, this flood of petrodollars contributes — even more than the cumulative current account surpluses of Asian countries — to the global savings glut that has fuelled speculative asset bubbles all around the world. Financial liquidity has generated an unprecedented interest in Middle Eastern stock markets. In contrast to the 1970s, when Middle Eastern countries spent 80% of oil revenues, today’s governments are spending less than 40% of revenues and keeping an increasing portion of savings within the region. These shifts in spending and investment patterns have created a cycle of abundant liquidity that drives spending on extravagant projects, such as indoor ski slopes in the middle of the desert and man-made islands in the ocean, as well as astronomical real estate and equity valuations in the region. Stock markets in the oil-rich states of the Middle East, which barely existed a couple of decades ago, have recently become a more important outlet for oil surpluses and repatriation of funds invested abroad. Thanks to the overwhelming abundance of petrodollar liquidity, property prices have rocketed and equity indices have posted gains of as much as 814% in Kuwait, 900% in Saudi Arabia, and 1473% in Dubai in the past five years. As a result, the region’s total market capitalisation increased from $150 billion in 2000 to a peak of $1.3 trillion earlier this year. Even though oil-driven improvements in economic conditions boosted corporate profits, price-earnings ratios in most of the stock markets reached levels that were tough to justify by any fundamental analysis, in our view. Local euphoria, not foreign money, drives asset prices in oil-exporting countries. Investing has lately become part of the popular culture in the Middle East, as the fall in interest rates and increased credit availability fuelled speculative retail buying. For example, the trading volume on the Saudi stock exchange with just 77 listed companies increased almost tenfold in the last three years to $1.1 trillion, becoming the 9th most liquid equity market in the world, just after $1.3 trillion in Italy and $1.2 trillion in South Korea. Such a speculative craze, outstripping efforts to introduce proper prudent regulation, inflated all valuation metrics — in the case of Saudi Arabia, the average P/E ratio hit a peak of 46 and even exceeded 1,000 for some companies. However, when valuations are as over-stretched as they appear in Middle Eastern markets, it does not take a lot to trigger a shift from greed to fear. And despite the price of crude oil rising to $75 a barrel, Middle Eastern countries have started experiencing a major correction this year. Governments intervened by injecting money from state investment funds into the stock markets, but shares prices in Dubai still plunged 61% and the Saudi equity index posted a 43% drop from its peak in February. A downturn in the cycle could feed through into other financial markets. Although Gulf stocks are mainly held by local investors, the risk of contagion is not negligible since Middle Eastern investors have invested heavily in other countries. In our view, the recycling of oil export revenues account for, directly and indirectly, a significant portion of the capital flows into emerging markets, which exceeded $400 billion last year. It is not surprising then that markets such as Lebanon, Egypt and even Iraq are enjoying remarkable returns. However, in an increasingly risk-averse environment, only countries that have addressed structural problems and maintained prudent macroeconomic policies throughout this extraordinary liquidity cycle can still reap the rewards of stability (see Positive Discrimination, March 15, 2006).
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Cyclical Bull, Structural Bear
May 15, 2006
Sharon Lam (Hong Kong) and Sharon S.Y. Yeshaya (Hong Kong)
Investment Case Summary & Conclusions We spent a day in Manila visiting government officials. Sentiment was upbeat and we believe the Philippines economy will perform better this year due to improved investment and continual inflows of remittances from overseas Filipino workers (OFWs). Exports registered their strongest growth in 1Q06 since 2002. There are also signs of a pickup in the property market, particularly in demand for offices. We are upgrading our Philippines 2006 GDP forecast from 4.5% to 5.5% (vs. IMF forecast of 5%). Meanwhile, fiscal reforms, which are among investors’ biggest concerns, appear on target. The VAT rate hike (from 10% to 12%) was successfully implemented in February. We particularly welcome the government’s decisiveness in setting fiscal reforms as a priority. The message is clear and consistent that the existing VAT rate hikes will not be abolished, even if the economy faces challenges such as surging oil prices. We are confident about the macro environment in the near term, yet we continue to see growth being more cyclically driven. Over the long term, the Philippines lack reforms to promote capital investment and improve competitiveness, and this is limiting the economy’s growth potential. The country remains very vulnerable to external shocks, in our view. Remittances the Driver of Growth The Filipino economy rebounded after a disrupted 3Q05 when political turmoil and severe typhoons pulled GDP growth down to a three-year low at 4.5%. The economy reaccelerated quickly in 4Q to 6.1%, thanks to a pick-up in private consumption and moderation in the investment decline. Remittances from OFWs have been keeping the Filipino economy afloat. OFW job opportunities abroad have soared since the beginning of 2003 when the global economy started its vigorous cycle. OFW remittances have driven consumption – private consumption has contributed over 80% to the country’s growth in the past three years. The government forecasts OFW remittances to reach US$11.8bn in 2006 (11% of GDP), up 10.3% YoY. For the first two months of this year, remittances totalled US$1.8bn – already on track to meet its full-year target. As January and February are usually the low season for remittances, it implies that this year’s OFW remittance target is likely to be reached with upside if we expect the global macro environment to be stable throughout the year. While most OFWs work in the US, in recent years the majority of new jobs have come from the Middle East as oil money and booming investment boost demand for Filipino construction workers. Yet, in terms of monetary value, the biggest remittance growth is still coming from the US, implying that OFWs working in the US are skilled and professional labour, and earn higher incomes. OFW remittance from the US contributed over 70% to total remittance growth in 2004 and 2005. Consequently, the sustainability of Philippines OFW remittances flow depends on the growth outlook in the US and Middle East. Our US economists continue to look for hearty growth and income pick-up in the US this year. Meanwhile, oil prices appear set to hover at current high levels. We believe Philippines’ OFW remittance flow will remain robust and may even exceed the government’s 10% growth target this year, therefore spelling further strength for consumption and the peso. Nevertheless, this also reveals that the Philippines is particularly vulnerable to the US consumer and property market as well as the global commodity market in this cycle. Recent Fiscal Reform Triumph, but No Time to Relax The VAT rate hike (to 12% from 10%) was successfully implemented in February. Recently, calls for repeal of the VAT tax have resurfaced in the local press. We sense that the government will continue to insulate the VAT from political pressures, and we think the government will continue to do so. The officials we spoke with said that the government recognized the importance of ensuring credibility in reforms, which is needed to sustain the country’s debt market attractiveness. The VAT reform is taken as a landmark medium-term success and the policymakers will make every effort to defend it against any short-term fluctuations. Along with the new tax measures, the Philippine government has implemented new tax collection measures to reduce tax evasion. These initiatives include holding the tax collection officers responsible for evasion cases and to digitalize databases. Yet, we view this as a long-term process. Meanwhile, tax collection in April fell short of the PHP79bn target. Although moderation in spending will likely offset the shortfall, faulty collections remain a lingering medium-term concern. Possibility of Another Rate Hike; Currency to Strengthen Further As a result of high oil prices, Philippines’ inflation rate reached a peak of 8.5% in 1Q05. This triggered Bangko Sentral ng Pilipinas to raise the rate three times in 2005 – 25 bps each – to take the policy rate to 7.5%. The rate hikes successfully eased inflation towards the end of 2005, but it has picked up again since the beginning of this year. The implementation of the VAT rate hike pushed up inflation in February to 7.6% from 6.7% in January. Inflation stayed at 7.6% in March. The central bank had expected the VAT rate hike to raise inflation by 2ppt. The impact so far has been less-than-expected, though we would expect to see a second-round effect from the VAT rate hike going forward. The central bank is comfortable with the inflation level. They set a 2006 inflation target of 4-5% at the end of 2004 when oil prices were not as high as today and there was no VAT rate hike anticipated. Given the new developments on oil prices and the tax hike, the central bank thinks current inflation should be regarded as contained. It sees higher inflation as more of a supply-driven phenomenon. The wild card is surely oil prices, which we believe will be the major determinant of monetary policy direction this year. The central bank forecasts Dubai oil to average US$62 per barrel this year. Oil prices have been rising faster than expected. We expect to see higher inflation towards the middle of the year, which may put pressure on the central bank to raise rates again. On a cost and benefit perspective, it also appears that more rate hikes are possible this year. Consumer and corporate loan activities are sluggish and therefore higher rates would not affect domestic demand. Meanwhile, government officials are comfortable with the prospect of a stronger currency, which in turn will help to suppress inflation and encourage consumption. With Philippine exports mostly outsourced electronics production on fixed contracts with overseas parent companies, currency movement does not have a major impact on export growth. As a result, unlike other exporting economies in the region, the Philippines does not need to pursue a weak currency policy. A strong currency, in fact, appears to be widely accepted. This also clears another obstacle on potential future rate rises. We believe PHP will strengthen further on a combination of the accelerating economy, strong remittance inflow, depreciating US$ and upside on interest rates. Sustainability of Growth Not Guaranteed The Philippines is seeing strong cyclical momentum thanks to global resilience. The country, however, lacks structural reforms to sustain growth. When the global economy turns down, the Philippines may be affected more than its regional counterparts, in our view. Lack of Productivity and Competitiveness Growth… The Philippines’ fixed asset investment to GDP ratio is the lowest among ASEAN countries. Public investment is capped by fiscal difficulty. Private investment sentiment is suppressed by political uncertainty and a lack of incentive policies. The Philippines’ growth potential is diminishing, before the country is reaching mature economic status, in our view. Without investment, productivity growth will be capped and the country will continue to lose competitiveness. The lack of infrastructure spending also creates a vicious cycle as it discourages foreign investment. Although the government is well aware of this issue, this does not appear to be near the top of its policy agenda. While the government plans to allocate 30% of the additional VAT collection to infrastructure investment, we believe this will represent less than 0.5% of its GDP each year. We should not expect any significant upside from government capex. Encouraging private sector investment is essential – in particular, efforts should be made to draw in more foreign investment. Incentives such as tax deductions must be given to promote private sector investment, yet this is again hampered by fiscal limitations. Credit growth can be used as a tool to drive investment, in our view. The NPL ratio has come down significantly from the peak of 19% in 2001 to 8%. Without doubt, the ratio needs to fall further, yet the continual restructuring of the financial system should not be an obstacle to healthy loan growth given adequate risk management. Commercial bank loan growth has been sluggish at around 3% in the past two years, and we believe there is room for growth to support capex in the country, particularly in the service sector and infrastructure development. Meanwhile, labor productivity growth is also limited as most of the skilled and educated workforce opts to work overseas. The majority of families with remitting workers are relatively wealthier and/or from urban areas, with a better education. In turn, the remittances go back to these better off families and has a minimal impact on alleviating the country’s poverty. The Philippines has the second-highest Gini index (i.e. the widest income inequality) in the region after Malaysia. Rural families have less access to working abroad and at the same time they do not receive the remittances needed for better education and training. Consequently, the domestic labour force does not see much productivity growth, in our view. …Makes the Economy Vulnerable to External Shocks OFW remittance has been the main source of consumption and growth in the Philippines. Needless to say, it hinges on external conditions. The economy lacks autonomous growth drivers. Meanwhile, OFW remittances sit mostly in bank deposits, with some channelled into domestic consumption but not into lifting the country’s growth potential. Loan growth is subdued, while securitization of the remittances is still under study (OFW remittance is equivalent to almost 10% of market capitalization). We have not seen any major initiatives from the government to make better use of the remittance flow in order to develop the economy. The Philippines economy is robust due to the prolonged global strength, but since the earnings accumulated during the boom has not been not channelled into capex or development of the capital market, economic growth will remain cyclical. Without structural fundamentals to support the economy, the Philippines is living on demand and labour regulations from abroad. We view the economy as the most vulnerable to external shocks in the region.
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